[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2006 Edition]
[From the U.S. Government Printing Office]



[[Page i]]



          26


          Part 1 (Sec. Sec.  1.441 to 1.500)

                         Revised as of April 1, 2006


          Internal Revenue
          
          


________________________

          Containing a codification of documents of general 
          applicability and future effect

          As of April 1, 2006
          With Ancillaries
                    Published by
                    Office of the Federal Register
                    National Archives and Records
                    Administration
                    A Special Edition of the Federal Register

[[Page ii]]

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[[Page iii]]




                            Table of Contents



                                                                    Page
  Explanation.................................................       v

  Title 26:
          Chapter I--Internal Revenue Service, Department of 
          the Treasury (Continued)                                   3
  Finding Aids:
      Table of CFR Titles and Chapters........................     701
      Alphabetical List of Agencies Appearing in the CFR......     719
      Table of OMB Control Numbers............................     729
      List of CFR Sections Affected...........................     747

[[Page iv]]





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

                     Cite this Code: CFR
                     To cite the regulations in 
                       this volume use title, 
                       part and section number. 
                       Thus, 26 CFR 1.441-0 
                       refers to title 26, part 
                       1, section 441-0.

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

[[Page v]]



                               EXPLANATION

    The Code of Federal Regulations is a codification of the general and 
permanent rules published in the Federal Register by the Executive 
departments and agencies of the Federal Government. The Code is divided 
into 50 titles which represent broad areas subject to Federal 
regulation. Each title is divided into chapters which usually bear the 
name of the issuing agency. Each chapter is further subdivided into 
parts covering specific regulatory areas.
    Each volume of the Code is revised at least once each calendar year 
and issued on a quarterly basis approximately as follows:

Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1

    The appropriate revision date is printed on the cover of each 
volume.

LEGAL STATUS

    The contents of the Federal Register are required to be judicially 
noticed (44 U.S.C. 1507). The Code of Federal Regulations is prima facie 
evidence of the text of the original documents (44 U.S.C. 1510).

HOW TO USE THE CODE OF FEDERAL REGULATIONS

    The Code of Federal Regulations is kept up to date by the individual 
issues of the Federal Register. These two publications must be used 
together to determine the latest version of any given rule.
    To determine whether a Code volume has been amended since its 
revision date (in this case, April 1, 2006), consult the ``List of CFR 
Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative 
List of Parts Affected,'' which appears in the Reader Aids section of 
the daily Federal Register. These two lists will identify the Federal 
Register page number of the latest amendment of any given rule.

EFFECTIVE AND EXPIRATION DATES

    Each volume of the Code contains amendments published in the Federal 
Register since the last revision of that volume of the Code. Source 
citations for the regulations are referred to by volume number and page 
number of the Federal Register and date of publication. Publication 
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inserted following the text.

OMB CONTROL NUMBERS

    The Paperwork Reduction Act of 1980 (Pub. L. 96-511) requires 
Federal agencies to display an OMB control number with their information 
collection request.

[[Page vi]]

Many agencies have begun publishing numerous OMB control numbers as 
amendments to existing regulations in the CFR. These OMB numbers are 
placed as close as possible to the applicable recordkeeping or reporting 
requirements.

OBSOLETE PROVISIONS

    Provisions that become obsolete before the revision date stated on 
the cover of each volume are not carried. Code users may find the text 
of provisions in effect on a given date in the past by using the 
appropriate numerical list of sections affected. For the period before 
January 1, 2001, consult either the List of CFR Sections Affected, 1949-
1963, 1964-1972, 1973-1985, or 1986-2000, published in 11 separate 
volumes. For the period beginning January 1, 2001, a ``List of CFR 
Sections Affected'' is published at the end of each CFR volume.

CFR INDEXES AND TABULAR GUIDES

    A subject index to the Code of Federal Regulations is contained in a 
separate volume, revised annually as of January 1, entitled CFR Index 
and Finding Aids. This volume contains the Parallel Table of Statutory 
Authorities and Agency Rules (Table I). A list of CFR titles, chapters, 
and parts and an alphabetical list of agencies publishing in the CFR are 
also included in this volume.
    An index to the text of ``Title 3--The President'' is carried within 
that volume.
    The Federal Register Index is issued monthly in cumulative form. 
This index is based on a consolidation of the ``Contents'' entries in 
the daily Federal Register.
    A List of CFR Sections Affected (LSA) is published monthly, keyed to 
the revision dates of the 50 CFR titles.

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appearing in the Code of Federal Regulations.

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mail, [email protected].

[[Page vii]]

    The Office of the Federal Register also offers a free service on the 
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register. The NARA site also contains links to GPO Access.

                              Raymond A. Mosley,
                                    Director,
                          Office of the Federal Register.

April 1, 2006.

[[Page ix]]



                               THIS TITLE

    Title 26--Internal Revenue is composed of twenty volumes. The 
contents of these volumes represent all current regulations issued by 
the Internal Revenue Service, Department of the Treasury, as of April 1, 
2006. The first thirteen volumes comprise part 1 (Subchapter A--Income 
Tax) and are arranged by sections as follows: Sec. Sec.  1.0-1.60; 
Sec. Sec.  1.61-1.169; Sec. Sec.  1.170-1.300; Sec. Sec.  1.301-1.400; 
Sec. Sec.  1.401-1.440; Sec. Sec.  1.441-1.500; Sec. Sec.  1.501-1.640; 
Sec. Sec.  1.641-1.850; Sec. Sec.  1.851-1.907; Sec. Sec.  1.908-1.1000; 
Sec. Sec.  1.1001-1.1400; Sec. Sec.  1.1401-1.1550; and Sec.  1.1551 to 
end. The fourteenth volume containing parts 2-29, includes the remainder 
of subchapter A and all of Subchapter B--Estate and Gift Taxes. The last 
six volumes contain parts 30-39 (Subchapter C--Employment Taxes and 
Collection of Income Tax at Source); parts 40-49; parts 50-299 
(Subchapter D--Miscellaneous Excise Taxes); parts 300-499 (Subchapter 
F--Procedure and Administration); parts 500-599 (Subchapter G--
Regulations under Tax Conventions); and part 600 to end (Subchapter H--
Internal Revenue Practice).

    The OMB control numbers for Title 26 appear in Sec.  602.101 of this 
chapter. For the convenience of the user, Sec.  602.101 appears in the 
Finding Aids section of the volumes containing parts 1 to 599.

    For this volume, Elmer Barksdale was Chief Editor. The Code of 
Federal Regulations publication program is under the direction of 
Frances D. McDonald, assisted by Alomha S. Morris.

[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




         (This book contains part 1, Sec. Sec. 1.441 to 1.500)

  --------------------------------------------------------------------
                                                                    Part

chapter i--Internal Revenue Service, Department of the 
  Treasury (Continued)......................................           1

[[Page 3]]



    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)




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


  Editorial Note: IRS published a document at 45 FR 6088, Jan. 25, 1980, 
deleting statutory sections from their regulations. In Chapter I cross-
references to the deleted material have been changed to the 
corresponding sections of the IRS Code of 1954 or to the appropriate 
regulations sections. When either such change produced a redundancy, the 
cross-reference has been deleted. For further explanation, see 45 FR 
20795, March 31, 1980.

                  SUBCHAPTER A--INCOME TAX (CONTINUED)
Part                                                                Page
1               Income taxes................................           5

Supplementary Publications: Internal Revenue Service Looseleaf 
  Regulations System.

  Additional supplementary publications are issued covering Alcohol and 
Tobacco Tax Regulations, and Regulations Under Tax Conventions.

[[Page 5]]



                   SUBCHAPTER A_INCOME TAX (CONTINUED)





PART 1_INCOME TAXES--Table of Contents




                        Normal Taxes and Surtaxes

                       DEFERRED COMPENSATION, ETC.

              ACCOUNTING PERIODS AND METHODS OF ACCOUNTING

                           Accounting Periods

Sec.
1.441-0 Table of contents.
1.441-1 Period for computation of taxable income.
1.441-2 Election of taxable year consisting of 52-53 weeks.
1.441-3 Taxable year of a personal service corporation.
1.441-4 Effective date.
1.442-1 Change of annual accounting period.
1.443-1 Returns for periods of less than 12 months.
1.444-0T Table of contents (temporary).
1.444-1T Election to use a taxable year other than the required taxable 
          year (temporary).
1.444-2T Tiered structure (temporary).
1.444-3T Manner and time of making section 444 election (temporary).
1.444-4 Tiered structure.

                          Methods of Accounting

                    Methods of Accounting in General

1.446-1 General rule for methods of accounting.
1.446-1T General rule for methods of accounting (temporary).
1.446-2 Method of accounting for interest.
1.446-3 Notional principal contracts.
1.446-4 Hedging transactions.
1.446-5 Debt issuance costs.
1.446-6 REMIC inducement fees.
1.448-1 Limitation on the use of the cash receipts and disbursements 
          method of accounting.
1.448-1T Limitation on the use of the cash receipts and disbursements 
          method of accounting (temporary).
1.448-2T Nonaccrual of certain amounts by service providers (temporary).

          Taxable Year for Which Items of Gross Income Included

1.451-1 General rule for taxable year of inclusion.
1.451-2 Constructive receipt of income.
1.451-4 Accounting for redemption of trading stamps and coupons.
1.451-5 Advance payments for goods and long-term contracts.
1.451-6 Election to include crop insurance proceeds in gross income in 
          the taxable year following the taxable year of destruction or 
          damage.
1.451-7 Election relating to livestock sold on account of drought.
1.453-1--1.453-2 [Reserved]
1.453-3 Purchaser evidences of indebtedness payable on demand or readily 
          tradable.
1.453-4 Sale of real property involving deferred periodic payments.
1.453-5 Sale of real property treated on installment method.
1.453-6 Deferred payment sale of real property not on installment 
          method.
1.453-7--1.453-8 [Reserved]
1.453-9 Gain or loss on disposition of installment obligations.
1.453-10 Effective date.
1.453-11 Installment obligations received from a liquidating 
          corporation.
1.453-12 Allocation of unrecaptured section 1250 gain reported on the 
          installment method.
1.453A-0 Table of contents.
1.453A-1 Installment method of reporting income by dealers on personal 
          property.
1.453A-2 Treatment of revolving credit plans; taxable years beginning on 
          or before December 31, 1986.
1.453A-3 Requirements for adoption of or change to installment method by 
          dealers in personal property.
1.454-1 Obligations issued at discount.
1.455-1 Treatment of prepaid subscription income.
1.455-2 Scope of election under section 455.
1.455-3 Method of allocation.
1.455-4 Cessation of taxpayer's liability.
1.455-5 Definitions and other rules.
1.455-6 Time and manner of making election.
1.456-1 Treatment of prepaid dues income.
1.456-2 Scope of election under section 456.
1.456-3 Method of allocation.
1.456-4 Cessation of liability or existence.
1.456-5 Definitions and other rules.
1.456-6 Time and manner of making election.
1.456-7 Transitional rule.
1.457-1 General overviews of section 457.
1.457-2 Definitions.
1.457-3 General introduction to eligible plans.
1.457-4 Annual deferrals, deferral limitations, and deferral agreements 
          under eligible plans.
1.457-5 Individual limitation for combined annual deferrals under 
          multiple eligible plans.
1.457-6 Timing of distributions under eligible plans.
1.457-7 Taxation of Distribution Under Eligible Plans.
1.457-8 Funding rules for eligible plans.

[[Page 6]]

1.457-9 Effect on eligible plans when not administered in accordance 
          with eligibility requirements.
1.457-10 Miscellaneous provisions.
1.457-11 Tax treatment of participants if plan is not an eligible plan.
1.457-12 Effective dates.
1.458-1 Exclusion for certain returned magazines, paperbacks, or 
          records.
1.458-2 Manner of and time for making election.
1.460-0 Outline of regulations under section 460.
1.460-1 Long-term contracts.
1.460-2 Long-term manufacturing contracts.
1.460-3 Long-term construction contracts.
1.460-4 Methods of accounting for long-term contracts.
1.460-5 Cost allocation rules.
1.460-6 Look-back method.

                 Taxable Year for Which Deductions Taken

1.461-0 Table of contents.
1.461-1 General rule for taxable year of deduction.
1.461-2 Contested liabilities.
1.461-3 Prepaid interest. [Reserved]
1.461-4 Economic performance.
1.461-5 Recurring item exception.
1.461-6 Economic performance when certain liabilities are assigned or 
          are extinguished by the establishment of a fund.
1.465-1T Aggregation of certain activities (temporary).
1.465-8 General rules; interest other than that of a creditor.
1.465-20 Treatment of amounts borrowed from certain persons and amounts 
          protected against loss.
1.465-27 Qualified nonrecourse financing.
1.466-1 Method of accounting for the redemption cost of qualified 
          discount coupons.
1.466-2 Special protective election for certain taxpayers.
1.466-3 Manner of and time for making election under section 466.
1.466-4 Manner of and time for making election under section 373(c) of 
          the Revenue Act of 1978.
1.467-0 Table of contents.
1.467-1 Treatment of lessors and lessees generally.
1.467-2 Rent accrual for section 467 rental agreements without adequate 
          interest.
1.467-3 Disqualified leasebacks and long-term agreements.
1.467-4 Section 467 loan.
1.467-5 Section 467 rental agreements with variable interest.
1.467-6 Section 467 rental agreements with contingent payments. 
          [Reserved]
1.467-7 Section 467 recapture and other rules relating to dispositions 
          and modifications.
1.467-8 Automatic consent to change to constant rental accrual for 
          certain rental agreements.
1.467-9 Effective dates and automatic method changes for certain 
          agreements.
1.468A-0 Nuclear decommissioning costs; table of contents.
1.468A-1 Nuclear decommissioning costs; general rules.
1.468A-2 Treatment of electing taxpayer.
1.468A-3 Ruling amount.
1.468A-4 Treatment of nuclear decommissioning fund.
1.468A-5 Nuclear decommissioning fund qualification requirements; 
          prohibitions against self-dealing; disqualification of nuclear 
          decommissioning fund; termination of fund upon substantial 
          completion of decommissioning.
1.468A-6 Disposition of an interest in a nuclear power plant.
1.468A-7 Manner of and time for making election.
1.468A-8 Effective date and transitional rules.
1.468B Designated settlement funds.
1.468B-0 Table of contents.
1.468B-1 Qualified settlement funds.
1.468B-2 Taxation of qualified settlement funds and related 
          administrative requirements.
1.468B-3 Rules applicable to the transferor.
1.468B-4 Taxability of distributions to claimants.
1.468B-5 Effective dates and transition rules applicable to qualified 
          settlement funds.
1.468B-6 Escrow accounts, trusts, and other funds used in deferred 
          exchanges of like-kind property under section 1031(a)(3). 
          [Reserved]
1.468B-7 Pre-closing escrows.
1.468B-8 Contingent-at-closing escrows. [Reserved]
1.468B-9 Disputed ownership funds.
1.469-0 Table of contents.
1.469-1 General rules.
1.469-1T General rules (temporary).
1.469-2 Passive activity loss.
1.469-2T Passive activity loss (temporary).
1.469-3 Passive activity credit.
1.469-3T Passive activity credit (temporary).
1.469-4 Definition of activity.
1.469-4T Definition of activity (temporary).
1.469-5 Material participation.
1.469-5T Material participation (temporary).
1.469-6 Treatment of losses upon certain dispositions. [Reserved]
1.469-7 Treatment of self-charged items of interest income and 
          deduction.
1.469-8 Application of section 469 to trust, estates, and their 
          beneficiaries. [Reserved]
1.469-9 Rules for certain rental real estate activities.

[[Page 7]]

1.469-10 Application of section 469 to publicly traded partnerships.
1.469-11 Effective date and transition rules.

                               Inventories

1.471-1 Need for inventories.
1.471-2 Valuation of inventories.
1.471-3 Inventories at cost.
1.471-4 Inventories at cost or market, whichever is lower.
1.471-5 Inventories by dealers in securities.
1.471-6 Inventories of livestock raisers and other farmers.
1.471-7 Inventories of miners and manufacturers.
1.471-8 Inventories of retail merchants.
1.471-9 Inventories of acquiring corporations.
1.471-10 Applicability of long-term contract methods.
1.471-11 Inventories of manufacturers.
1.472-1 Last-in, first-out inventories.
1.472-2 Requirements incident to adoption and use of LIFO inventory 
          method.
1.472-3 Time and manner of making election.
1.472-4 Adjustments to be made by taxpayer.
1.472-5 Revocation of election.
1.472-6 Change from LIFO inventory method.
1.472-7 Inventories of acquiring corporations.
1.472-8 Dollar-value method of pricing LIFO inventories.
1.475-0 Table of contents.
1.475(a)-1--1.475(a)-2 [Reserved]
1.475(a)-3 Acquisition by a dealer of a security with a substituted 
          basis.
1.475(b)-1 Scope of exemptions from mark-to-market requirement.
1.475(b)-2 Exemptions--identification requirements.
1.475(b)-3 [Reserved]
1.475(b)-4 Exemptions--transitional issues.
1.475(c)-1 Definitions--dealer in securities.
1.475(c)-2 Definitions--security.
1.475(d)-1 Character of gain or loss.
1.475(e)-1 Effective dates.

                               Adjustments

1.481-1 Adjustments in general.
1.481-2 Limitation on tax.
1.481-3 Adjustments attributable to pre-1954 years where change was not 
          initiated by taxpayer.
1.481-4 Adjustments taken into account with consent.
1.481-5 Effective dates.
1.482-0 Outline of regulations under 482.
1.482-1 Allocation of income and deductions among taxpayers.
1.482-2 Determination of taxable income in specific situations.
1.482-3 Methods to determine taxable income in connection with a 
          transfer of tangible property.
1.482-4 Methods to determine taxable income in connection with a 
          transfer of intangible property.
1.482-5 Comparable profits method.
1.482-6 Profit split method.
1.482-7 Sharing of costs.
1.482-8 Examples of the best method rule.
1.483-1 Interest on certain deferred payments.
1.483-2 Unstated interest.
1.483-3 Test rate of interest applicable to a contract.
1.483-4 Contingent payments.

 Regulations Applicable for Taxable Years Beginning on or Before April 
                                21, 1993

1.482-1A Allocation of income and deductions among taxpayers.
1.482-2A Determination of taxable income in specific situations.
1.484-1.500 [Reserved]

    Authority: 26 U.S.C. 7805.
    Section 1.441-2T also issued under 26 U.S.C. 441(f).
    Section 1.441-3T also issued under 26 U.S.C. 441.
    Section 1.442-2T and 1.442-3T also issued under 26 U.S.C. 422, 706, 
and 1378.
    Section 1.444-0T through 1.444-3T and
    Section 1.444-4 is also issued under 26 U.S.C. 444(g).
    Section 1.446-1 also issued under 26 U.S.C. 446 and 461(h).
    Section 1.446-4 also issued under 26 U.S.C. 1502.
    Section 1.446-6 also issued under 26 U.S.C. 446 and 26 U.S.C. 860G.
    Section 1.451-5 also issued under 96 Stat. 324, 493.
    Section 1.453-11 also issued under 26 U.S.C. 453(j)(1) and (k).
    Section 1.453A-3 also issued under 26 U.S.C. 453A.
    Section 1.458-1 also issued under 26 U.S.C. 458.
    Section 1.460-1 also issued under 26 U.S.C. 460(h).
    Section 1.460-2 also issued under 26 U.S.C. 460(h).
    Section 1.460-3 also issued under 26 U.S.C. 460(h).
    Section 1.460-4 also issued under 26 U.S.C. 460(h) and 1502.
    Section 1.460-5 also issued under 26 U.S.C. 460(h).
    Section 1.460-6 also issued under 26 U.S.C. 460(h).
    Section 1.461-1 also issued under 26 U.S.C. 461(h).
    Section 1.461-2 also issued under 26 U.S.C. 461(h).
    Section 1.461-4 also issued under 26 U.S.C. 461(h).
    Section 1.461-4(d) also issued under 26 U.S.C. 460 and 26 U.S.C. 
461(h).

[[Page 8]]

    Section 1.461-5 also issued under 26 U.S.C. 461(h).
    Section 1.461-6 also issued under 26 U.S.C. 461(h).
    Section 1.465-8 also issued under 26 U.S.C. 465.
    Section 1.465-20 also issued under 26 U.S.C. 465.
    Section 1.465-27 also issued under 26 U.S.C. 465(b)(6)(B)(iii).
    Section 1.466-1 through 1.466-4 also issued under 26 U.S.C. 466.
    Section 1.467-1 is also issued under 26 U.S.C. 467.
    Section 1.467-2 is also issued under 26 U.S.C. 467.
    Section 1.467-3 is also issued under 26 U.S.C. 467.
    Section 1.467-4 is also issued under 26 U.S.C. 467.
    Section 1.467-5 is also issued under 26 U.S.C. 467.
    Section 1.467-6 is also issued under 26 U.S.C. 467.
    Section 1.467-7 is also issued under 26 U.S.C. 467.
    Section 1.467-8 is also issued under 26 U.S.C. 467.
    Section 1.467-9 is also issued under 26 U.S.C. 467.
    Section 1.468A-5 also issued under 26 U.S.C. 468A(e)(5).
    Section 1.468B-1 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-2 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-3 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-4 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-5 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-7 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-9 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.469-1 also issued under 26 U.S.C. 469.
    Section 1.469-1T also issued under 26 U.S.C. 469.
    Section 1.469-2 also issued under 26 U.S.C. 469(l).
    Section 1.469-2T also issued under 26 U.S.C. 469(l).
    Section 1.469-3 also issued under 26 U.S.C. 469(l).
    Section 1.469-3T also issued under 26 U.S.C. 469(l).
    Section 1.469-4 also issued under 26 U.S.C. 469(l).
    Section 1.469-5 also issued under 26 U.S.C. 469(l).
    Section 1.469-5T also issued under 26 U.S.C. 469(l).
    Section 1.469-7 also issued under 26 U.S.C. 469(l).
    Section 1.469-9 also issued under 26 U.S.C. 469(c)(6), (h)(2), and 
(l)(1).
    Section 1.469-11 also issued under 26 U.S.C. 469(l).
    Section 1.471 also issued under 26 U.S.C. 471.
    Section 1.471-4 also issued under 26 U.S.C. 263A.
    Section 1.471-5 also issued under 26 U.S.C. 263A.
    Section 1.471-6 also issued under 26 U.S.C. 471.
    Section 1.472-8 also issued under 26 U.S.C. 472.
    Section 1.475(a)-3 also issued under 26 U.S.C. 475(e).
    Section 1.475(b)-1 also issued under 26 U.S.C. 475(b)(4) and 26 
U.S.C. 475(e).
    Section 1.475(b)-2 also issued under 26 U.S.C. 475(b)(2) and 26 
U.S.C. 475(e).
    Section 1.475(b)-4 also issued under 26 U.S.C. 475(b)(2), 26 U.S.C. 
475(e), and 26 U.S.C. 6001.
    Section 1.475(c)-1 also issued under 26 U.S.C. 475(e).
    Section 1.475(c)-2 also issued under 26 U.S.C. 475(e) and 26 U.S.C. 
860G(e).
    Section 1.475(d)-1 also issued under 26 U.S.C. 475(e).
    Section 1.475(e)-1 also issued under 26 U.S.C. 475(e).
    Section 1.481-1 also issued under 26 U.S.C. 481.
    Section 1.481-2 also issued under 26 U.S.C. 481.
    Section 1.481-3 also issued under 26 U.S.C. 481.
    Section 1.481-4 also issued under 26 U.S.C. 481.
    Section 1.481-5 also issued under 26 U.S.C. 481.
    Section 1.482-1 also issued under 26 U.S.C. 482 and 936.
    Section 1.482-2 also issued under 26 U.S.C. 482.
    Section 1.482-3 also issued under 26 U.S.C. 482.
    Section 1.482-4 also issued under 26 U.S.C. 482.
    Section 1.482-5 also issued under 26 U.S.C. 482.
    Section 1.482-7 is also issued under 26 U.S.C. 482.
    Section 1.482-2A also issued under 26 U.S.C. 482.
    Section 1.483-1 through 1.483-3 also issued under 26 U.S.C. 483(f).
    Section 1.483-4 also issued under 26 U.S.C. 483(f).

[[Page 9]]

                 DEFERRED COMPENSATION, ETC. (CONTINUED)

              ACCOUNTING PERIODS AND METHODS OF ACCOUNTING

                           Accounting Periods



Sec. 1.441-0  Table of contents.

    This section lists the captions contained in Sec. Sec. 1.441-1 
through 1.441-4 as follows:

         Sec. 1.441-1 Period for computation of taxable income.

(a) Computation of taxable income.
(1) In general.
(2) Length of taxable year.
(b) General rules and definitions.
(1) Taxable year.
(1) Required taxable year.
(i) In general.
(ii) Exceptions.
(A) 52-53-week taxable years.
(B) Partnerships, S corporations, and PSCs.
(C) Specified foreign corporations.
(3) Annual accounting period.
(4) Calendar year.
(5) Fiscal year.
(i) Definition.
(ii) Recognition.
(6) Grandfathered fiscal year.
(7) Books.
(8) Taxpayer.
(c) Adoption of taxable year.
(1) In general.
(2) Approval required.
(i) Taxpayers with required taxable years.
(ii) Taxpayers without books.
(d) Retention of taxable year.
(e) Change of taxable year.
(f) Obtaining approval of the Commissioner or making a section 444 
          election.

    Sec. 1.441-2 Election of taxable year consisting of 52-53 weeks

(a) In general.
(1) Election.
(2) Effect.
(3) Eligible taxpayer.
(4) Example.
(b) Procedures to elect a 52-53-week taxable year.
(1) Adoption of a 52-53-week taxable year.
(i) In general.
(ii) Filing requirement.
(2) Change to (or from) a 52-53-week taxable year.
(i) In general.
(ii) Special rules for short period required to effect the change.
(3) Examples.
(c) Application of effective dates.
(1) In general.
(2) Examples.
(3) Changes in tax rates.
(4) Examples.
(d) Computation of taxable income.
(e) Treatment of taxable years ending with reference to the same 
          calendar month.
(1) Pass-through entities.
(2) Personal service corporations and employee-owners.
(3) Definitions.
(i) Pass-through entity.
(ii) Owner of a pass-through entity.
(4) Examples.
(5) Transition rule.

      Sec. 1.441-3 Taxable year of a personal service corporation

(a) Taxable year.
(1) Required taxable year.
(2) Exceptions.
(b) Adoption, change, or retention of taxable year.
(1) Adoption of taxable year.
(2) Change in taxable year.
(3) Retention of taxable year.
(4) Procedures for obtaining approval or making a section 444 election.
(5) Examples.
(c) Personal service corporation defined.
(1) In general.
(2) Testing period.
(i) In general.
(ii) New corporations.
(3) Examples.
(d) Performance of personal services.
(1) Activities described in section 448(d)(2)(A).
(2) Activities not described in section 448(d)(2)(A).
(e) Principal activity.
(1) General rule.
(2) Compensation cost.
(i) Amounts included.
(ii) Amounts excluded.
(3) Attribution of compensation cost to personal service activity.
(i) Employees involved only in the performance of personal services.
(ii) Employees involved only in activities that are not treated as the 
          performance of personal services.
(iii) Other employees.
(A) Compensation cost attributable to personal service activity.
(B) Compensation cost not attributable to personal service activity.
(f) Services substantially performed by employee-owners.
(1) General rule.
(2) Compensation cost attributable to personal services.
(3) Examples.
(g) Employee-owner defined.
(1) General rule.
(2) Special rule for independent contractors who are owners.
(h) Special rules for affiliated groups filing consolidated returns.

[[Page 10]]

(1) In general.
(2) Examples.

                      Sec. 1.441-4 Effective date

[T.D. 8996, 67 FR 35012, May 17, 2002]



Sec. 1.441-1  Period for computation of taxable income.

    (a) Computation of taxable income--(1) In general. Taxable income 
must be computed and a return must be made for a period known as the 
taxable year. For rules relating to methods of accounting, the taxable 
year for which items of gross income are included and deductions are 
taken, inventories, and adjustments, see parts II and III (section 446 
and following), subchapter E, chapter 1 of the Internal Revenue Code, 
and the regulations thereunder.
    (2) Length of taxable year. Except as otherwise provided in the 
Internal Revenue Code and the regulations thereunder (e.g., Sec. 1.441-
2 regarding 52-53-week taxable years), a taxable year may not cover a 
period of more than 12 calendar months.
    (b) General rules and definitions. The general rules and definitions 
in this paragraph (b) apply for purposes of sections 441 and 442 and the 
regulations thereunder.
    (1) Taxable year. Taxable year means--
    (i) The period for which a return is made, if a return is made for a 
period of less than 12 months (short period). See section 443 and the 
regulations thereunder;
    (ii) Except as provided in paragraph (b)(1)(i) of this section, the 
taxpayer's required taxable year (as defined in paragraph (b)(2) of this 
section), if applicable;
    (iii) Except as provided in paragraphs (b)(1)(i) and (ii) of this 
section, the taxpayer's annual accounting period (as defined in 
paragraph (b)(3) of this section), if it is a calendar year or a fiscal 
year; or
    (iv) Except as provided in paragraphs (b)(1)(i) and (ii) of this 
section, the calendar year, if the taxpayer keeps no books, does not 
have an annual accounting period, or has an annual accounting period 
that does not qualify as a fiscal year.
    (2) Required taxable year--(i) In general. Certain taxpayers must 
use the particular taxable year that is required under the Internal 
Revenue Code and the regulations thereunder (the required taxable year). 
For example, the required taxable year is--
    (A) In the case of a foreign sales corporation or domestic 
international sales corporation, the taxable year determined under 
section 441(h) and Sec. 1.921-1T(a)(11), (b)(4), and (b)(6);
    (B) In the case of a personal service corporation (PSC), the taxable 
year determined under section 441(i) and Sec. 1.441-3;
    (C) In the case of a nuclear decommissioning fund, the taxable year 
determined under Sec. 1.468A-4(c)(1);
    (D) In the case of a designated settlement fund or a qualified 
settlement fund, the taxable year determined under Sec. 1.468B-2(j);
    (E) In the case of a common trust fund, the taxable year determined 
under section 584(i);
    (F) In the case of certain trusts, the taxable year determined under 
section 644;
    (G) In the case of a partnership, the taxable year determined under 
section 706 and Sec. 1.706-1;
    (H) In the case of an insurance company, the taxable year determined 
under section 843 and Sec. 1.1502-76(a)(2);
    (I) In the case of a real estate investment trust, the taxable year 
determined under section 859;
    (J) In the case of a real estate mortgage investment conduit, the 
taxable year determined under section 860D(a)(5) and Sec. 1.860D-
1(b)(6);
    (K) In the case of a specified foreign corporation, the taxable year 
determined under section 898(c)(1)(A);
    (L) In the case of an S corporation, the taxable year determined 
under section 1378 and Sec. 1.1378-1; or
    (M) In the case of a member of an affiliated group that makes a 
consolidated return, the taxable year determined under Sec. 1.1502-76.
    (ii) Exceptions. Notwithstanding paragraph (b)(2)(i) of this 
section, the following taxpayers may have a taxable year other than 
their required taxable year:
    (A) 52-53-week taxable years. Certain taxpayers may elect to use a 
52-53-week taxable year that ends with reference to their required 
taxable year. See, for example, Sec. Sec. 1.441-3 (PSCs),

[[Page 11]]

1.706-1 (partnerships), 1.1378-1 (S corporations), and 1.1502-76(a)(1) 
(members of a consolidated group).
    (B) Partnerships, S corporations, and PSCs. A partnership, S 
corporation, or PSC may use a taxable year other than its required 
taxable year if the taxpayer elects to use a taxable year other than its 
required taxable year under section 444, elects a 52-53-week taxable 
year that ends with reference to its required taxable year as provided 
in paragraph (b)(2)(ii)(A) of this section or to a taxable year elected 
under section 444, or establishes a business purpose to the satisfaction 
of the Commissioner under section 442 (such as a grandfathered fiscal 
year).
    (C) Specified foreign corporations. A specified foreign corporation 
(as defined in section 898(b)) may use a taxable year other than its 
required taxable year if it elects a 52-53-week taxable year that ends 
with reference to its required taxable year as provided in paragraph 
(b)(2)(ii)(A) of this section or makes a one-month deferral election 
under section 898(c)(1)(B).
    (3) Annual accounting period. Annual accounting period means the 
annual period (calendar year or fiscal year) on the basis of which the 
taxpayer regularly computes its income in keeping its books.
    (4) Calendar year. Calendar year means a period of 12 consecutive 
months ending on December 31. A taxpayer who has not established a 
fiscal year must make its return on the basis of a calendar year.
    (5) Fiscal year--(i) Definition. Fiscal year means--
    (A) A period of 12 consecutive months ending on the last day of any 
month other than December; or
    (B) A 52-53-week taxable year, if such period has been elected by 
the taxpayer. See Sec. 1.441-2.
    (ii) Recognition. A fiscal year will be recognized only if the books 
of the taxpayer are kept in accordance with such fiscal year.
    (6) Grandfathered fiscal year. Grandfathered fiscal year means a 
fiscal year (other than a year that resulted in a three month or less 
deferral of income) that a partnership or an S corporation received 
permission to use on or after July 1, 1974, by a letter ruling (i.e., 
not by automatic approval).
    (7) Books. Books include the taxpayer's regular books of account and 
such other records and data as may be necessary to support the entries 
on the taxpayer's books and on the taxpayer's return, as for example, a 
reconciliation of any difference between such books and the taxpayer's 
return. Records that are sufficient to reflect income adequately and 
clearly on the basis of an annual accounting period will be regarded as 
the keeping of books. See section 6001 and the regulations thereunder 
for rules relating to the keeping of books and records.
    (8) Taxpayer. Taxpayer has the same meaning as the term person as 
defined in section 7701(a)(1) (e.g., an individual, trust, estate, 
partnership, association, or corporation) rather than the meaning of the 
term taxpayer as defined in section 7701(a)(14) (any person subject to 
tax).
    (c) Adoption of taxable year--(1) In general. Except as provided in 
paragraph (c)(2) of this section, a new taxpayer may adopt any taxable 
year that satisfies the requirements of section 441 and the regulations 
thereunder without the approval of the Commissioner. A taxable year of a 
new taxpayer is adopted by filing its first Federal income tax return 
using that taxable year. The filing of an application for automatic 
extension of time to file a Federal income tax return (e.g., Form 7004, 
``Application for Automatic Extension of Time to File Corporation Income 
Tax Return''), the filing of an application for an employer 
identification number (i.e., Form SS-4, ``Application for Employer 
Identification Number''), or the payment of estimated taxes, for a 
particular taxable year do not constitute an adoption of that taxable 
year.
    (2) Approval required--(i) Taxpayers with required taxable years. A 
newly-formed partnership, S corporation, or PSC that wants to adopt a 
taxable year other than its required taxable year, a taxable year 
elected under section 444, or a 52-53-week taxable year that ends with 
reference to its required taxable year or a taxable year elected under 
section 444 must establish a business

[[Page 12]]

purpose and obtain the approval of the Commissioner under section 442.
    (ii) Taxpayers without books. A taxpayer that must use a calendar 
year under section 441(g) and paragraph (f) of this section may not 
adopt a fiscal year without obtaining the approval of the Commissioner.
    (d) Retention of taxable year. In certain cases, a partnership, S 
corporation, electing S corporation, or PSC will be required to change 
its taxable year unless it obtains the approval of the Commissioner 
under section 442, or makes an election under section 444, to retain its 
current taxable year. For example, a corporation using a June 30 fiscal 
year that either becomes a PSC or elects to be an S corporation and, as 
a result, is required to use the calendar year under section 441(i) or 
1378, respectively, must obtain the approval of the Commissioner to 
retain its current fiscal year. Similarly, a partnership using a taxable 
year that corresponds to its required taxable year must obtain the 
approval of the Commissioner to retain such taxable year if its required 
taxable year changes as a result of a change in ownership. However, a 
partnership that previously established a business purpose to the 
satisfaction of the Commissioner to use a taxable year is not required 
to obtain the approval of the Commissioner if its required taxable year 
changes as a result of a change in ownership.
    (e) Change of taxable year. Once a taxpayer has adopted a taxable 
year, such taxable year must be used in computing taxable income and 
making returns for all subsequent years unless the taxpayer obtains 
approval from the Commissioner to make a change or the taxpayer is 
otherwise authorized to change without the approval of the Commissioner 
under the Internal Revenue Code (e.g., section 444 or 859) or the 
regulations thereunder.
    (f) Obtaining approval of the Commissioner or making a section 444 
election. See Sec. 1.442-1(b) for procedures for obtaining approval of 
the Commissioner (automatically or otherwise) to adopt, change, or 
retain an annual accounting period. See Sec. Sec. 1.444-1T and 1.444-2T 
for qualifications, and 1.444-3T for procedures, for making an election 
under section 444.

[T.D. 8996, 67 FR 35012, May 17, 2002]



Sec. 1.441-2  Election of taxable year consisting of 52-53 weeks.

    (a) In general--(1) Election. An eligible taxpayer may elect to 
compute its taxable income on the basis of a fiscal year that--
    (i) Varies from 52 to 53 weeks;
    (ii) Ends always on the same day of the week; and
    (iii) Ends always on--
    (A) Whatever date this same day of the week last occurs in a 
calendar month; or
    (B) Whatever date this same day of the week falls that is the 
nearest to the last day of the calendar month.
    (2) Effect. In the case of a taxable year described in paragraph 
(a)(1)(iii)(A) of this section, the year will always end within the 
month and may end on the last day of the month, or as many as six days 
before the end of the month. In the case of a taxable year described in 
paragraph (a)(1)(iii)(B) of this section, the year may end on the last 
day of the month, or as many as three days before or three days after 
the last day of the month.
    (3) Eligible taxpayer. A taxpayer is eligible to elect a 52-53-week 
taxable year if such fiscal year would otherwise satisfy the 
requirements of section 441 and the regulations thereunder. For example, 
a taxpayer that is required to use a calendar year under Sec. 1.441-
1(b)(2)(i)(D) is not an eligible taxpayer.
    (4) Example. The provisions of this paragraph (a) are illustrated by 
the following example:

    Example. If the taxpayer elects a taxable year ending always on the 
last Saturday in November, then for the year 2001, the taxable year 
would end on November 24, 2001. On the other hand, if the taxpayer had 
elected a taxable year ending always on the Saturday nearest to the end 
of November, then for the year 2001, the taxable year would end on 
December 1, 2001.

    (b) Procedures to elect a 52-53-week taxable year--(1) Adoption of a 
52-53-week taxable year--(i) In general. A new eligible taxpayer elects 
a 52-53-week taxable year by adopting such year in accordance with Sec. 
1.441-1(c). A newly-

[[Page 13]]

formed partnership, S corporation or personal service corporation (PSC) 
may adopt a 52-53-week taxable year without the approval of the 
Commissioner if such year ends with reference to either the taxpayer's 
required taxable year (as defined in Sec. 1.441-1(b)(2)) or the taxable 
year elected under section 444. See Sec. Sec. 1.441-3, 1.706-1, and 
1.1378-1. Similarly, a newly-formed specified foreign corporation (as 
defined in section 898(b)) may adopt a 52-53-week taxable year if such 
year ends with reference to the taxpayer's required taxable year, or, if 
the one-month deferral election under section 898(c)(1)(B) is made, with 
reference to the month immediately preceding the required taxable year. 
See Sec. 1.1502-76(a)(1) for special rules regarding subsidiaries 
adopting 52-53-week taxable years.
    (ii) Filing requirement. A taxpayer adopting a 52-53-week taxable 
year must file with its Federal income tax return for its first taxable 
year a statement containing the following information--
    (A) The calendar month with reference to which the 52-53-week 
taxable year ends;
    (B) The day of the week on which the 52-53-week taxable year always 
will end; and
    (C) Whether the 52-53-week taxable year will always end on the date 
on which that day of the week last occurs in the calendar month, or on 
the date on which that day of the week falls that is nearest to the last 
day of that calendar month.
    (2) Change to (or from) a 52-53-week taxable year--(i) In general. 
An election of a 52-53-week taxable year by an existing eligible 
taxpayer with an established taxable year is treated as a change in 
annual accounting period that requires the approval of the Commissioner 
in accordance with Sec. 1.442-1. Thus, a taxpayer must obtain approval 
to change from its current taxable year to a 52-53-week taxable year, 
even if such 52-53-week taxable year ends with reference to the same 
calendar month. Similarly, a taxpayer must obtain approval to change 
from a 52-53-week taxable year, or to change from one 52-53-week taxable 
year to another 52-53-week taxable year. However, a taxpayer may obtain 
approval for 52-53-week taxable year changes automatically to the extent 
provided in administrative procedures published by the Commissioner. See 
Sec. 1.442-1(b) for procedures for obtaining such approval.
    (ii) Special rules for the short period required to effect the 
change. If a change to or from a 52-53-week taxable year results in a 
short period (within the meaning of Sec. 1.443-1(a)) of 359 days or 
more, or six days or less, the tax computation under Sec. 1.443-1(b) 
does not apply. If the short period is 359 days or more, it is treated 
as a full taxable year. If the short period is six days or less, such 
short period is not a separate taxable year but instead is added to and 
deemed a part of the following taxable year. (In the case of a change to 
or from a 52-53-week taxable year not involving a change of the month 
with reference to which the taxable year ends, the tax computation under 
Sec. 1.443-1(b) does not apply because the short period will always be 
359 days or more, or six days or less.) In the case of a short period 
which is more than six days and less than 359 days, taxable income for 
the short period is placed on an annual basis for purposes of Sec. 
1.443-1(b) by multiplying such income by 365 and dividing the result by 
the number of days in the short period. In such case, the tax for the 
short period is the same part of the tax computed on such income placed 
on an annual basis as the number of days in the short period is of 365 
days (unless Sec. 1.443-1(b)(2), relating to the alternative tax 
computation, applies). For an adjustment in deduction for personal 
exemption, see Sec. 1.443-1(b)(1)(v).
    (3) Examples. The following examples illustrate paragraph (b)(2)(ii) 
of this section:

    Example 1. A taxpayer having a fiscal year ending April 30, obtains 
approval to change to a 52-53-week taxable year ending the last Saturday 
in April for taxable years beginning after April 30, 2001. This change 
involves a short period of 362 days, from May 1, 2001, to April 27, 
2002, inclusive. Because the change results in a short period of 359 
days or more, it is not placed on an annual basis and is treated as a 
full taxable year.
    Example 2. Assume the same conditions as Example 1, except that the 
taxpayer changes for taxable years beginning after April 30,

[[Page 14]]

2002, to a taxable year ending on the Thursday nearest to April 30. This 
change results in a short period of two days, May 1 to May 2, 2002. 
Because the short period is less than seven days, tax is not separately 
computed. This short period is added to and deemed part of the following 
52-53-week taxable year, which would otherwise begin on May 3, 2002, and 
end on May 1, 2003.

    (c) Application of effective dates--(1) In general. Except as 
provided in paragraph (c)(3) of this section, for purposes of 
determining the effective date (e.g., of legislative, regulatory, or 
administrative changes) or the applicability of any provision of the 
internal revenue laws that is expressed in terms of taxable years 
beginning, including, or ending with reference to the first or last day 
of a specified calendar month, a 52-53-week taxable year is deemed to 
begin on the first day of the calendar month nearest to the first day of 
the 52-53-week taxable year, and is deemed to end or close on the last 
day of the calendar month nearest to the last day of the 52-53-week 
taxable year, as the case may be. Examples of provisions of this title, 
the applicability of which is expressed in terms referred to in the 
preceding sentence, include the provisions relating to the time for 
filing returns and other documents, paying tax, or performing other 
acts, and the provisions of part II, subchapter B, chapter 6 (section 
1561 and following) relating to surtax exemptions of certain controlled 
corporations.
    (2) Examples. The provisions of paragraph (c)(1) of this section may 
be illustrated by the following examples:

    Example 1. Assume that an income tax provision is applicable to 
taxable years beginning on or after January 1, 2001. For that purpose, a 
52-53-week taxable year beginning on any day within the period December 
26, 2000, to January 4, 2001, inclusive, is treated as beginning on 
January 1, 2001.
    Example 2. Assume that an income tax provision requires that a 
return must be filed on or before the 15th day of the third month 
following the close of the taxable year. For that purpose, a 52-53-week 
taxable year ending on any day during the period May 25 to June 3, 
inclusive, is treated as ending on May 31, the last day of the month 
ending nearest to the last day of the taxable year, and the return, 
therefore, must be made on or before August 15.
    Example 3. Assume that a revenue procedure requires the performance 
of an act by the taxpayer within ``the first 90 days of the taxable 
year,'' by ``the 75th day of the taxable year,'' or, alternately, by 
``the last day of the taxable year.'' The taxpayer employs a 52-53-week 
taxable year that ends always on the Saturday closest to the last day of 
December. These requirements are not expressed in terms of taxable years 
beginning, including, or ending with reference to the first or last day 
of a specified calendar month, and are accordingly outside the scope of 
the rule stated in Sec. 1.441-2(c)(1). Accordingly, the taxpayer must 
perform the required act by the 90th, 75th, or last day, respectively, 
of its taxable year.
    Example 4. X, a corporation created on January 1, 2001, elects a 52-
53-week taxable year ending on the Friday nearest the end of December. 
Thus, X's first taxable year begins on Monday, January 1, 2001, and ends 
on Friday, December 28, 2001; its next taxable year begins on Saturday, 
December 29, 2001, and ends on Friday, January 3, 2003; and its next 
taxable year begins on Saturday, January 4, 2003, and ends on Friday, 
January 2, 2004. For purposes of applying the provisions of Part II, 
subchapter B, chapter 6 of the Internal Revenue Code, X's first taxable 
year is deemed to end on December 31, 2001; its next taxable year is 
deemed to begin on January 1, 2002, and end on December 31, 2002, and 
its next taxable year is deemed to begin on January 1, 2003, and end on 
December 31, 2003. Accordingly, each such taxable year is treated as 
including one and only one December 31st.

    (3) Changes in tax rates. If a change in the rate of tax is 
effective during a 52-53-week taxable year (other than on the first day 
of such year as determined under paragraph (c)(1) of this section), the 
tax for the 52-53-week taxable year must be computed in accordance with 
section 15, relating to effect of changes, and the regulations 
thereunder. For the purpose of the computation under section 15, the 
determination of the number of days in the period before the change, and 
in the period on and after the change, is to be made without regard to 
the provisions of paragraph (b)(1) of this paragraph.
    (4) Examples. The provisions of paragraph (c)(3) of this section may 
be illustrated by the following examples:

    Example 1. Assume a change in the rate of tax is effective for 
taxable years beginning after June 30, 2002. For a 52-53-week taxable 
year beginning on Friday, November 2, 2001, the tax must be computed on 
the basis of the old rates for the actual number of days from November 
2, 2001, to June 30, 2002, inclusive,

[[Page 15]]

and on the basis of the new rates for the actual number of days from 
July 1, 2002, to Thursday, October 31, 2002, inclusive.
    Example 2. Assume a change in the rate of tax is effective for 
taxable years beginning after June 30, 2001. For this purpose, a 52-53-
week taxable year beginning on any of the days from June 25 to July 4, 
inclusive, is treated as beginning on July 1. Therefore, no computation 
under section 15 will be required for such year because of the change in 
rate.

    (d) Computation of taxable income. The principles of section 451, 
relating to the taxable year for inclusion of items of gross income, and 
section 461, relating to the taxable year for taking deductions, 
generally are applicable to 52-53-week taxable years. Thus, except as 
otherwise provided, all items of income and deduction must be determined 
on the basis of a 52-53-week taxable year. However, a taxpayer may 
determine particular items as though the 52-53-week taxable year were a 
taxable year consisting of 12 calendar months, provided that practice is 
consistently followed by the taxpayer and clearly reflects income. For 
example, an allowance for depreciation or amortization may be determined 
on the basis of a 52-53-week taxable year, or as though the 52-53-week 
taxable year is a taxable year consisting of 12 calendar months, 
provided the taxpayer consistently follows that practice with respect to 
all depreciable or amortizable items.
    (e) Treatment of taxable years ending with reference to the same 
calendar month--(1) Pass-through entities. If a pass-through entity (as 
defined in paragraph (e)(3)(i) of this section) or an owner of a pass-
through entity (as defined in paragraph (e)(3)(ii) of this section), or 
both, use a 52-53-week taxable year and the taxable year of the pass-
through entity and the owner end with reference to the same calendar 
month, then, for purposes of determining the taxable year in which items 
of income, gain, loss, deductions, or credits from the pass-through 
entity are taken into account by the owner of the pass-through, the 
owner's taxable year will be deemed to end on the last day of the pass-
through's taxable year. Thus, if the taxable year of a partnership and a 
partner end with reference to the same calendar month, then for purposes 
of determining the taxable year in which that partner takes into account 
items described in section 702 and items that are deductible by the 
partnership (including items described in section 707(c)) and includible 
in the income of that partner, that partner's taxable year will be 
deemed to end on the last day of the partnership's taxable year. 
Similarly, if the taxable year of an S corporation and a shareholder end 
with reference to the same calendar month, then for purposes of 
determining the taxable year in which that shareholder takes into 
account items described in section 1366(a) and items that are deductible 
by the S corporation and includible in the income of that shareholder, 
that shareholder's taxable year will be deemed to end on the last day of 
the S corporation's taxable year.
    (2) Personal service corporations and employee-owners. If the 
taxable year of a PSC (within the meaning of Sec. 1.441-3(c)) and an 
employee-owner (within the meaning of Sec. 1.441-3(g)) end with 
reference to the same calendar month, then for purposes of determining 
the taxable year in which an employee-owner takes into account items 
that are deductible by the PSC and includible in the income of the 
employee-owner, the employee-owner's taxable year will be deemed to end 
on the last day of the PSC's taxable year.
    (3) Definitions--(i) Pass-through entity. For purposes of this 
section, a pass-through entity means a partnership, S corporation, 
trust, estate, closely-held real estate investment trust (within the 
meaning of section 6655(e)(5)(B)), common trust fund (within the meaning 
of section 584(i)), controlled foreign corporation (within the meaning 
of section 957), foreign personal holding company (within the meaning of 
section 552), or passive foreign investment company that is a qualified 
electing fund (within the meaning of section 1295).
    (ii) Owner of a pass-through entity. For purposes of this section, 
an owner of a pass-through entity generally means a taxpayer that owns 
an interest in, or stock of, a pass-through entity. For example, an 
owner of a pass-through entity includes a partner in a partnership, a 
shareholder of an S corporation, a beneficiary of a trust or an estate, 
an owner of a closely-held real

[[Page 16]]

estate investment trust (within the meaning of section 6655(e)(5)(A)), a 
participant in a common trust fund, a U.S. shareholder (as defined in 
section 951(b)) of a controlled foreign corporation, a U.S. shareholder 
(as defined in section 551(a)) of a foreign personal holding company, or 
a U.S. person that holds stock in a passive foreign investment company 
that is a qualified electing fund with respect to that shareholder.
    (4) Examples. The provisions of paragraph (e)(2) of this section may 
be illustrated by the following examples:

    Example 1. ABC Partnership uses a 52-53-week taxable year that ends 
on the Wednesday nearest to December 31, and its partners, A, B, and C, 
are individual calendar year taxpayers. Assume that, for ABC's taxable 
year ending January 3, 2001, each partner's distributive share of ABC's 
taxable income is $10,000. Under section 706(a) and paragraph (e)(1) of 
this section, for the taxable year ending December 31, 2000, A, B, and C 
each must include $10,000 in income with respect to the ABC year ending 
January 3, 2001. Similarly, if ABC makes a guaranteed payment to A on 
January 2, 2001, A must include the payment in income for A's taxable 
year ending December 31, 2000.
    Example 2. X, a PSC, uses a 52-53-week taxable year that ends on the 
Wednesday nearest to December 31, and all of the employee-owners of X 
are individual calendar year taxpayers. Assume that, for its taxable 
year ending January 3, 2001, X pays a bonus of $10,000 to each employee-
owner on January 2, 2001. Under paragraph (e)(2) of this section, each 
employee-owner must include its bonus in income for the taxable year 
ending December 31, 2000.

    (5) Transition rule. In the case of an owner of a pass-through 
entity (other than the owner of a partnership or S corporation) that is 
required by this paragraph (e) to include in income for its first 
taxable year ending on or after May 17, 2002 amounts attributable to two 
taxable years of a pass-through entity, the amount that otherwise would 
be required to be included in income for such first taxable year by 
reason of this paragraph (e) should be included in income ratably over 
the four-taxable-year period beginning with such first taxable year 
under principles similar to Sec. 1.702-3T, unless the owner of the 
pass-through entity elects to include all such income in its first 
taxable year ending on or after May 17, 2002.

[T.D. 8996, 67 FR 35012, May 17, 2002]



Sec. 1.441-3  Taxable year of a personal service corporation.

    (a) Taxable year--(1) Required taxable year. Except as provided in 
paragraph (a)(2) of this section, the taxable year of a personal service 
corporation (PSC) (as defined in paragraph (c) of this section) must be 
the calendar year.
    (2) Exceptions. A PSC may have a taxable year other than its 
required taxable year (i.e., a fiscal year) if it makes an election 
under section 444, elects to use a 52-53-week taxable year that ends 
with reference to the calendar year or a taxable year elected under 
section 444, or establishes a business purpose for such fiscal year and 
obtains the approval of the Commissioner under section 442.
    (b) Adoption, change, or retention of taxable year--(1) Adoption of 
taxable year. A PSC may adopt, in accordance with Sec. 1.441-1(c), the 
calendar year, a taxable year elected under section 444, or a 52-53-week 
taxable year ending with reference to the calendar year or a taxable 
year elected under section 444 without the approval of the Commissioner. 
See Sec. 1.441-1. A PSC that wants to adopt any other taxable year must 
establish a business purpose and obtain the approval of the Commissioner 
under section 442.
    (2) Change in taxable year. A PSC that wants to change its taxable 
year must obtain the approval of the Commissioner under section 442 or 
make an election under section 444. However, a PSC may obtain automatic 
approval for certain changes, including a change to the calendar year or 
to a 52-53-week taxable year ending with reference to the calendar year, 
pursuant to administrative procedures published by the Commissioner.
    (3) Retention of taxable year. In certain cases, a PSC will be 
required to change its taxable year unless it obtains the approval of 
the Commissioner under section 442, or makes an election under section 
444, to retain its current taxable year. For example, a corporation 
using a June 30 fiscal year that becomes a PSC and, as a result, is 
required to use the calendar year must

[[Page 17]]

obtain the approval of the Commissioner to retain its current fiscal 
year.
    (4) Procedures for obtaining approval or making a section 444 
election. See Sec. 1.442-1(b) for procedures to obtain the approval of 
the Commissioner (automatically or otherwise) to adopt, change, or 
retain a taxable year. See Sec. Sec. 1.444-1T and 1.444-2T for 
qualifications, and 1.444-3T for procedures, for making an election 
under section 444.
    (5) Examples. The provisions of paragraph (b)(4) of this section may 
be illustrated by the following examples:

    Example 1. X, whose taxable year ends on January 31, 2001, becomes a 
PSC for its taxable year beginning February 1, 2001, and does not obtain 
the approval of the Commissioner for using a fiscal year. Thus, for 
taxable years ending before February 1, 2001, this section does not 
apply with respect to X. For its taxable year beginning on February 1, 
2001, however, X will be required to comply with paragraph (a) of this 
section. Thus, unless X obtains approval of the Commissioner to use a 
January 31 taxable year, or makes a section 444 election, X will be 
required to change its taxable year to the calendar year under paragraph 
(b) of this section by using a short taxable year that begins on 
February 1, 2001, and ends on December 31, 2001. Under paragraph (b)(1) 
of this section, X may obtain automatic approval to change its taxable 
year to a calendar year. See Sec. 1.442-1(b).
    Example 2. Assume the same facts as in Example 1, except that X 
desires to change to a 52-53-week taxable year ending with reference to 
the month of December. Under paragraph (b)(1) of this section X may 
obtain automatic approval to make the change. See Sec. 1.442-1(b).

    (c) Personal service corporation defined--(1) In general. For 
purposes of this section and section 442, a taxpayer is a PSC for a 
taxable year only if--
    (i) The taxpayer is a C corporation (as defined in section 
1361(a)(2)) for the taxable year;
    (ii) The principal activity of the taxpayer during the testing 
period is the performance of personal services;
    (iii) During the testing period, those services are substantially 
performed by employee-owners (as defined in paragraph (g) of this 
section); and
    (iv) Employee-owners own (as determined under the attribution rules 
of section 318, except that the language ``any'' applies instead of ``50 
percent'' in section 318(a)(2)(C)) more than 10 percent of the fair 
market value of the outstanding stock in the taxpayer on the last day of 
the testing period.
    (2) Testing period--(i) In general. Except as otherwise provided in 
paragraph (c)(2)(ii) of this section, the testing period for any taxable 
year is the immediately preceding taxable year.
    (ii) New corporations. The testing period for a taxpayer's first 
taxable year is the period beginning on the first day of that taxable 
year and ending on the earlier of--
    (A) The last day of that taxable year; or
    (B) The last day of the calendar year in which that taxable year 
begins.
    (3) Examples. The provisions of paragraph (c)(2)(ii) of this section 
may be illustrated by the following examples:

    Example 1. Corporation A's first taxable year begins on June 1, 
2001, and A desires to use a September 30 taxable year. However, if A is 
a personal service corporation, it must obtain the Commissioner's 
approval to use a September 30 taxable year. Pursuant to paragraph 
(c)(2)(ii) of this section, A's testing period for its first taxable 
year beginning June 1, 2001, is the period June 1, 2001 through 
September 30, 2001. Thus, if, based upon such testing period, A is a 
personal service corporation, A must obtain the Commissioner's 
permission to use a September 30 taxable year.
    Example 2. The facts are the same as in Example 1, except that A 
desires to use a March 31 taxable year. Pursuant to paragraph (c)(2)(ii) 
of this section, A's testing period for its first taxable year beginning 
June 1, 2001, is the period June 1, 2001, through December 31, 2001. 
Thus, if, based upon such testing period, A is a personal service 
corporation, A must obtain the Commissioner's permission to use a March 
31 taxable year.

    (d) Performance of personal services--(1) Activities described in 
section 448(d)(2)(A). For purposes of this section, any activity of the 
taxpayer described in section 448(d)(2)(A) or the regulations thereunder 
will be treated as the performance of personal services. Therefore, any 
activity of the taxpayer that involves the performance of services in 
the fields of health, law, engineering, architecture, accounting, 
actuarial science, performing arts, or consulting (as such fields are 
defined in Sec. 1.448-1T) will be treated as the performance of 
personal services for purposes of this section.

[[Page 18]]

    (2) Activities not described in section 448(d)(2)(A). For purposes 
of this section, any activity of the taxpayer not described in section 
448(d)(2)(A) or the regulations thereunder will not be treated as the 
performance of personal services.
    (e) Principal activity--(1) General rule. For purposes of this 
section, the principal activity of a corporation for any testing period 
will be the performance of personal services if the cost of the 
corporation's compensation (the compensation cost) for such testing 
period that is attributable to its activities that are treated as the 
performance of personal services within the meaning of paragraph (d) of 
this section (i.e., the total compensation for personal service 
activities) exceeds 50 percent of the corporation's total compensation 
cost for such testing period.
    (2) Compensation cost--(i) Amounts included. For purposes of this 
section, the compensation cost of a corporation for a taxable year is 
equal to the sum of the following amounts allowable as a deduction, 
allocated to a long-term contract, or otherwise chargeable to a capital 
account by the corporation during such taxable year--
    (A) Wages and salaries; and
    (B) Any other amounts, attributable to services performed for or on 
behalf of the corporation by a person who is an employee of the 
corporation (including an owner of the corporation who is treated as an 
employee under paragraph (g)(2) of this section) during the testing 
period. Such amounts include, but are not limited to, amounts 
attributable to deferred compensation, commissions, bonuses, 
compensation includible in income under section 83, compensation for 
services based on a percentage of profits, and the cost of providing 
fringe benefits that are includible in income.
    (ii) Amounts excluded. Notwithstanding paragraph (e)(2)(i) of this 
section, compensation cost does not include amounts attributable to a 
plan qualified under section 401(a) or 403(a), or to a simplified 
employee pension plan defined in section 408(k).
    (3) Attribution of compensation cost to personal service activity--
(i) Employees involved only in the performance of personal services. The 
compensation cost for employees involved only in the performance of 
activities that are treated as personal services under paragraph (d) of 
this section, or employees involved only in supporting the work of such 
employees, are considered to be attributable to the corporation's 
personal service activity.
    (ii) Employees involved only in activities that are not treated as 
the performance of personal services. The compensation cost for 
employees involved only in the performance of activities that are not 
treated as personal services under paragraph (d) of this section, or for 
employees involved only in supporting the work of such employees, are 
not considered to be attributable to the corporation's personal service 
activity.
    (iii) Other employees. The compensation cost for any employee who is 
not described in either paragraph (e)(3)(i) or (ii) of this section (a 
mixed-activity employee) is allocated as follows--
    (A) Compensation cost attributable to personal service activity. 
That portion of the compensation cost for a mixed activity employee that 
is attributable to the corporation's personal service activity equals 
the compensation cost for that employee multiplied by the percentage of 
the total time worked for the corporation by that employee during the 
year that is attributable to activities of the corporation that are 
treated as the performance of personal services under paragraph (d) of 
this section. That percentage is to be determined by the taxpayer in any 
reasonable and consistent manner. Time logs are not required unless 
maintained for other purposes;
    (B) Compensation cost not attributable to personal service activity. 
That portion of the compensation cost for a mixed activity employee that 
is not considered to be attributable to the corporation's personal 
service activity is the compensation cost for that employee less the 
amount determined in paragraph (e)(3)(iii)(A) of this section.
    (f) Services substantially performed by employee-owners--(1) General 
rule. Personal services are substantially performed during the testing 
period by employee-owners of the corporation if

[[Page 19]]

more than 20 percent of the corporation's compensation cost for that 
period attributable to its activities that are treated as the 
performance of personal services within the meaning of paragraph (d) of 
this section (i.e., the total compensation for personal service 
activities) is attributable to personal services performed by employee-
owners.
    (2) Compensation cost attributable to personal services. For 
purposes of paragraph (f)(1) of this section--
    (i) The corporation's compensation cost attributable to its 
activities that are treated as the performance of personal services is 
determined under paragraph (e)(3) of this section; and
    (ii) The portion of the amount determined under paragraph (f)(2)(i) 
of this section that is attributable to personal services performed by 
employee-owners is to be determined by the taxpayer in any reasonable 
and consistent manner.
    (3) Examples. The provisions of this paragraph (f) may be 
illustrated by the following examples:

    Example 1. For its taxable year beginning February 1, 2001, Corp A's 
testing period is the taxable year ending January 31, 2000. During that 
testing period, A's only activity was the performance of personal 
services. The total compensation cost of A (including compensation cost 
attributable to employee-owners) for the testing period was $1,000,000. 
The total compensation cost attributable to employee-owners of A for the 
testing period was $210,000. Pursuant to paragraph (f)(1) of this 
section, the employee-owners of A substantially performed the personal 
services of A during the testing period because the compensation cost of 
A's employee-owners was more than 20 percent of the total compensation 
cost for all of A's employees (including employee-owners).
    Example 2. Corp B has the same facts as corporation A in Example 1, 
except that during the taxable year ending January 31, 2001, B also 
participated in an activity that would not be characterized as the 
performance of personal services under this section. The total 
compensation cost of B (including compensation cost attributable to 
employee-owners) for the testing period was $1,500,000 ($1,000,000 
attributable to B's personal service activity and $500,000 attributable 
to B's other activity). The total compensation cost attributable to 
employee-owners of B for the testing period was $250,000 ($210,000 
attributable to B's personal service activity and $40,000 attributable 
to B's other activity). Pursuant to paragraph (f)(1) of this section, 
the employee-owners of B substantially performed the personal services 
of B during the testing period because more than 20 percent of B's 
compensation cost during the testing period attributable to its personal 
service activities was attributable to personal services performed by 
employee-owners ($210,000).

    (g) Employee-owner defined--(1) General rule. For purposes of this 
section, a person is an employee-owner of a corporation for a testing 
period if--
    (i) The person is an employee of the corporation on any day of the 
testing period; and
    (ii) The person owns any outstanding stock of the corporation on any 
day of the testing period.
    (2) Special rule for independent contractors who are owners. Any 
person who is an owner of the corporation within the meaning of 
paragraph (g)(1)(ii) of this section and who performs personal services 
for, or on behalf of, the corporation is treated as an employee for 
purposes of this section, even if the legal form of that person's 
relationship to the corporation is such that the person would be 
considered an independent contractor for other purposes.
    (h) Special rules for affiliated groups filing consolidated 
returns--(1) In general. For purposes of applying this section to the 
members of an affiliated group of corporations filing a consolidated 
return for the taxable year--
    (i) The members of the affiliated group are treated as a single 
corporation;
    (ii) The employees of the members of the affiliated group are 
treated as employees of such single corporation; and
    (iii) All of the stock of the members of the affiliated group that 
is not owned by any other member of the affiliated group is treated as 
the outstanding stock of that corporation.
    (2) Examples. The provisions of this paragraph (h) may be 
illustrated by the following examples:

    Example 1. The affiliated group AB, consisting of corporation A and 
its wholly owned subsidiary B, filed a consolidated Federal income tax 
return for the taxable year ending January 31, 2001, and AB is 
attempting to determine whether it is affected by this section for its 
taxable year beginning February 1, 2001. During the testing period 
(i.e., the taxable year ending January 31, 2001), A did not perform 
personal services.

[[Page 20]]

However, B's only activity was the performance of personal services. On 
the last day of the testing period, employees of A did not own any stock 
in A. However, some of B's employees own stock in A. In the aggregate, 
B's employees own 9 percent of A's stock on the last day of the testing 
period. Pursuant to paragraph (h)(1) of this section, this section is 
effectively applied on a consolidated basis to members of an affiliated 
group filing a consolidated Federal income tax return. Because the only 
employee-owners of AB are the employees of B, and because B's employees 
do not own more than 10 percent of AB on the last day of the testing 
period, AB is not a PSC subject to the provisions of this section. Thus, 
AB is not required to determine on a consolidated basis whether, during 
the testing period, its principal activity is the providing of personal 
services, or the personal services are substantially performed by 
employee-owners.
    Example 2. The facts are the same as in Example 1, except that on 
the last day of the testing period A owns only 80 percent of B. The 
remaining 20 percent of B is owned by employees of B. The fair market 
value of A, including its 80 percent interest in B, as of the last day 
of the testing period, is $1,000,000. In addition, the fair market value 
of the 20 percent interest in B owned by B's employees is $50,000 as of 
the last day of the testing period. Pursuant to paragraphs (c)(1)(iv) 
and (h)(1) of this section, AB must determine whether the employee-
owners of A and B (i.e., B's employees) own more than 10 percent of the 
fair market value of A and B as of the last day of the testing period. 
Because the $140,000 [($1,000,000x.09)+$50,000] fair market value of the 
stock held by B's employees is greater than 10 percent of the aggregate 
fair market value of A and B as of the last day of the testing period, 
or $105,000 [$1,000,000+$50,000x.10], AB may be subject to this section 
if, on a consolidated basis during the testing period, the principal 
activity of AB is the performance of personal services and the personal 
services are substantially performed by employee-owners.

[T.D. 8996, 67 FR 35012, May 17, 2002]



Sec. 1.441-4  Effective date.

    Sections 1.441-0 through 1.441-3 are applicable for taxable years 
ending on or after May 17, 2002.

[T.D. 8996, 67 FR 35012, May 17, 2002]



Sec. 1.442-1  Change of annual accounting period.

    (a) Approval of the Commissioner. A taxpayer that has adopted an 
annual accounting period (as defined in Sec. 1.441-1(b)(3)) as its 
taxable year generally must continue to use that annual accounting 
period in computing its taxable income and for making its Federal income 
tax returns. If the taxpayer wants to change its annual accounting 
period and use a new taxable year, it must obtain the approval of the 
Commissioner, unless it is otherwise authorized to change without the 
approval of the Commissioner under either the Internal Revenue Code 
(e.g., section 444 and section 859) or the regulations thereunder (e.g., 
paragraph (c) of this section). In addition, as described in Sec. 
1.441-1(c) and (d), a partnership, S corporation, electing S 
corporation, or personal service corporation (PSC) generally is required 
to secure the approval of the Commissioner to adopt or retain an annual 
accounting period other than its required taxable year. The manner of 
obtaining approval from the Commissioner to adopt, change, or retain an 
annual accounting period is provided in paragraph (b) of this section. 
However, special rules for obtaining approval may be provided in other 
sections.
    (b) Obtaining approval--(1) Time and manner for requesting approval. 
In order to secure the approval of the Commissioner to adopt, change, or 
retain an annual accounting period, a taxpayer must file an application, 
generally on Form 1128, ``Application To Adopt, Change, or Retain a Tax 
Year,'' with the Commissioner within such time and in such manner as is 
provided in administrative procedures published by the Commissioner.
    (2) General requirements for approval. An adoption, change, or 
retention in annual accounting period will be approved where the 
taxpayer establishes a business purpose for the requested annual 
accounting period and agrees to the Commissioner's prescribed terms, 
conditions, and adjustments for effecting the adoption, change, or 
retention. In determining whether a taxpayer has established a business 
purpose and which terms, conditions, and adjustments will be required, 
consideration will be given to all the facts and circumstances relating 
to the adoption, change, or retention, including the tax consequences 
resulting therefrom. Generally, the requirement of a business

[[Page 21]]

purpose will be satisfied, and adjustments to neutralize any tax 
consequences will not be required, if the requested annual accounting 
period coincides with the taxpayer's required taxable year (as defined 
in Sec. 1.441-1(b)(2)), ownership taxable year, or natural business 
year. In the case of a partnership, S corporation, electing S 
corporation, or PSC, deferral of income to partners, shareholders, or 
employee-owners will not be treated as a business purpose.
    (3) Administrative procedures. The Commissioner will prescribe 
administrative procedures under which a taxpayer may be permitted to 
adopt, change, or retain an annual accounting period. These 
administrative procedures will describe the business purpose 
requirements (including an ownership taxable year and a natural business 
year) and the terms, conditions, and adjustments necessary to obtain 
approval. Such terms, conditions, and adjustments may include 
adjustments necessary to neutralize the tax effects of a substantial 
distortion of income that would otherwise result from the requested 
annual accounting period including: a deferral of a substantial portion 
of the taxpayer's income, or shifting of a substantial portion of 
deductions, from one taxable year to another; a similar deferral or 
shifting in the case of any other person, such as a beneficiary in an 
estate; the creation of a short period in which there is a substantial 
net operating loss, capital loss, or credit (including a general 
business credit); or the creation of a short period in which there is a 
substantial amount of income to offset an expiring net operating loss, 
capital loss, or credit. See, for example, Rev. Proc. 2002-39, 2002-22 
I.R.B., procedures for obtaining the Commissioner's prior approval of an 
adoption, change, or retention in annual accounting period through 
application to the national office; Rev. Proc. 2002-37, 2002-22 I.R.B., 
automatic approval procedures for certain corporations; Rev. Proc. 2002-
38, 2002-22 I.R.B., automatic approval procedures for partnerships, S 
corporations, electing S corporations, and PSCs; and Rev. Proc. 66-50, 
1966-2 C.B. 1260, automatic approval procedures for individuals. For 
availability of Revenue Procedures and Notices, see Sec. 601.601(d)(2) 
of this chapter.
    (4) Taxpayers to whom section 441(g) applies. If section 441(g) and 
Sec. 1.441-1(b)(1)(iv) apply to a taxpayer, the adoption of a fiscal 
year is treated as a change in the taxpayer's annual accounting period 
under section 442. Therefore, that fiscal year can become the taxpayer's 
taxable year only with the approval of the Commissioner. In addition to 
any other terms and conditions that may apply to such a change, the 
taxpayer must establish and maintain books that adequately and clearly 
reflect income for the short period involved in the change and for the 
fiscal year proposed.
    (c) Special rule for change of annual accounting period by 
subsidiary corporation. A subsidiary corporation that is required to 
change its annual accounting period under Sec. 1.1502-76, relating to 
the taxable year of members of an affiliated group that file a 
consolidated return, does not need to obtain the approval of the 
Commissioner or file an application on Form 1128 with respect to that 
change.
    (d) Special rule for newly married couples. (1) A newly married 
husband or wife may obtain automatic approval under this paragraph (d) 
to change his or her annual accounting period in order to use the annual 
accounting period of the other spouse so that a joint return may be 
filed for the first or second taxable year of that spouse ending after 
the date of marriage. Such automatic approval will be granted only if 
the newly married husband or wife adopting the annual accounting period 
of the other spouse files a Federal income tax return for the short 
period required by that change on or before the 15th day of the 4th 
month following the close of the short period. See section 443 and the 
regulations thereunder. If the due date for any such short-period return 
occurs before the date of marriage, the first taxable year of the other 
spouse ending after the date of marriage cannot be adopted under this 
paragraph (d). The short-period return must contain a statement at the 
top of page one of the return that it is filed under the authority of 
this paragraph (d). The newly married husband or wife need not file Form 
1128 with respect to

[[Page 22]]

a change described in this paragraph (d). For a change of annual 
accounting period by a husband or wife that does not qualify under this 
paragraph (d), see paragraph (b) of this section.
    (2) The provisions of this paragraph (d) may be illustrated by the 
following example:

    Example. H & W marry on September 25, 2001. H is on a fiscal year 
ending June 30, and W is on a calendar year. H wishes to change to a 
calendar year in order to file joint returns with W. W's first taxable 
year after marriage ends on December 31, 2001. H may not change to a 
calendar year for 2001 since, under this paragraph (d), he would have 
had to file a return for the short period from July 1 to December 31, 
2000, by April 16, 2001. Since the date of marriage occurred subsequent 
to this due date, the return could not be filed under this paragraph 
(d). Therefore, H cannot change to a calendar year for 2001. However, H 
may change to a calendar year for 2002 by filing a return under this 
paragraph (d) by April 15, 2002, for the short period from July 1 to 
December 31, 2001. If H files such a return, H and W may file a joint 
return for calendar year 2002 (which is W's second taxable year ending 
after the date of marriage).

    (e) Effective date. The rules of this section are applicable for 
taxable years ending on or after May 17, 2002.

[T.D. 8996, 67 FR 35019, May 17, 2002]



Sec. 1.443-1  Returns for periods of less than 12 months.

    (a) Returns for short period. A return for a short period, that is, 
for a taxable year consisting of a period of less than 12 months, shall 
be made under any of the following circumstances:
    (1) Change of annual accounting period. In the case of a change in 
the annual accounting period of a taxpayer, a separate return must be 
filed for the short period of less than 12 months beginning with the day 
following the close of the old taxable year and ending with the day 
preceding the first day of the new taxable year. However, such a return 
is not required for a short period of six days or less, or 359 days or 
more, resulting from a change from or to a 52-53-week taxable year. See 
section 441(f) and Sec. 1.441-2. The computation of the tax for a short 
period required to effect a change of annual accounting period is 
described in paragraph (b) of this section. In general, a return for a 
short period resulting from a change of annual accounting period shall 
be filed and the tax paid within the time prescribed for filing a return 
for a taxday of the short period. For rules applicable to a subsidiary 
corporation which becomes a member of an affiliated group which files a 
consolidated return, see Sec. 1.1502-76.
    (2) Taxpayer not in existence for entire taxable year. If a taxpayer 
is not in existence for the entire taxable year, a return is required 
for the short period during which the taxpayer was in existence. For 
example, a corporation organized on August 1 and adopting the calendar 
year as its annual accounting period is required to file a return for 
the short period from August 1 to December 31, and returns for each 
calendar year thereafter. Similarly, a dissolving corporation which 
files its returns for the calendar year is required to file a return for 
the short period from January 1 to the date it goes out of existence. 
Income for the short period is not required to be annualized if the 
taxpayer is not in existence for the entire taxable year, and, in the 
case of a taxpayer other than a corporation, the deduction under section 
151 for personal exemptions (or deductions in lieu thereof) need not be 
reduced under section 443(c). In general, the requirements with respect 
to the filing of returns and the payment of tax for a short period where 
the taxpayer has not been in existence for the entire taxable year are 
the same as for the filing of a return and the payment of tax for a 
taxable year of 12 months ending on the last day of the short period. 
Although the return of a decedent is a return for the short period 
beginning with the first day of his last taxable year and ending with 
the date of his death, the filing of a return and the payment of tax for 
a decedent may be made as though the decedent had lived throughout his 
last taxable year.
    (b) Computation of tax for short period on change of annual 
accounting period--(1) General rule. (i) If a return is made for a short 
period resulting from a change of annual accounting period, the taxable 
income for the short period shall be placed on an annual basis by 
multiplying such income by 12 and dividing the result by the number of

[[Page 23]]

months in the short period. Unless section 443(b)(2) and subparagraph 
(2) of this paragraph apply, the tax for the short period shall be the 
same part of the tax computed on the annual basis as the number of 
months in the short period is of 12 months.
    (ii) If a return is made for a short period of more than 6 days, but 
less than 359 days, resulting from a change from or to a 52-53-week 
taxable year, the taxable income for the short period shall be 
annualized and the tax computed on a daily basis, as provided in section 
441(f)(2)(B)(iii) and Sec. 1.441-2(b)(2)(ii).
    (iii) For method of computation of income for a short period in the 
case of a subsidiary corporation required to change its annual 
accounting period to conform to that of its parent, see Sec. 1.1502-
76(b).
    (iv) An individual taxpayer making a return for a short period 
resulting from a change of annual accounting period is not allowed to 
take the standard deduction provided in section 141 in computing his 
taxable income for the short period. See section 142(b)(3).
    (v) In computing the taxable income of a taxpayer other than a 
corporation for a short period (which income is to be annualized in 
order to determine the tax under section 443(b)(1)) the personal 
exemptions allowed individuals under section 151 (and any deductions 
allowed other taxpayers in lieu thereof, such as the deduction under 
section 642(b)) shall be reduced to an amount which bears the same ratio 
to the full amount of the exemptions as the number of months in the 
short period bears to 12. In the case of the taxable income for a short 
period resulting from a change from or to a 52-53-week taxable year to 
which section 441(f)(2)(B)(iii) applies, the computation required by the 
preceding sentence shall be made on a daily basis, that is, the 
deduction for personal exemptions (or any deduction in lieu thereof) 
shall be reduced to an amount which bears the same ratio to the full 
deduction as the number of days in the short period bears to 365.
    (vi) If the amount of a credit against the tax (for example, the 
credits allowable under section 34 (for dividends received on or before 
December 31, 1964), and 35 (for partially tax-exempt interest)) is 
dependent upon the amount of any item of income or deduction, such 
credit shall be computed upon the amount of the item annualized 
separately in accordance with the foregoing rules. The credit so 
computed shall be treated as a credit against the tax computed on the 
basis of the annualized taxable income. In any case in which a 
limitation on the amount of a credit is based upon taxable income, 
taxable income shall mean the taxable income computed on the annualized 
basis.
    (vii) The provisions of this subparagraph may be illustrated by the 
following examples:

    Example (1). A taxpayer with one dependent who has been granted 
permission under section 442 to change his annual accounting period 
files a return for the short period of 10 months ending October 31, 
1956. He has income and deductions as follows:

                 Income
Interest income........................  ........  .........  $10,000.00
Partially tax-exempt interest with       ........  .........      500.00
 respect to which a credit is allowable
 under section 35......................
Dividends to which sections 34 and 116   ........  .........      750.00
 are applicable........................
                                                             -----------
                                         ........  .........   11,250.00
               Deductions
Real estate taxes......................  ........  .........      200.00
2 personal exemptions at $600 on an      ........  .........    1,200.00
 annual basis..........................
The tax for the 10-month period is
 computed as follows:
Total income as above..................  ........  .........   11,250.00
Less:
  Exclusion for dividends received.....  ........     $50.00
  2 personal exemptions ($1,200x\10/     ........   1,000.00
   12\)................................
  Real estate taxes....................  ........     200.00
                                         ........   --------    1,250.00
                                                             -----------
    Taxable income for 10-month period   ........  .........   10,000.00
     before annualizing................
Taxable income annualized (10,000x\12/   ........  .........   12,000.00
 10\)..................................
Tax on $12,000 before credits..........  ........  .........    3,400.00
Deduct credits:
  Dividends received for 10-month         $750.00
   period..............................
  Less: Excluded portion...............     50.00
                                        ----------
  Included in gross income.............    700.00
  Dividend income annualized ($700x\12/    840.00
   10\)................................
  Credit (4 percent of $840)...........  ........      33.60

[[Page 24]]

 
  Partially tax-exempt interest            500.00
   included in gross income for 10-
   month period........................
  Partially tax-exempt interest            600.00
   (annualized) ($500x\12/10\).........
  Credit (3 percent of $600)...........  ........      18.00
                                         ........   --------       51.60
                                                             -----------
    Tax on $12,000 (after credits).....  ........  .........    3,348.40
                                                             -----------
Tax for 10-month period ($3,348.40x\10/  ........  .........    2,790.33
 12\)..................................
------------------------------------------------------------------------
 

    Example (2). The X Corporation makes a return for the one-month 
period ending September 30, 1956, because of a change in annual 
accounting period permitted under section 442. Income and expenses for 
the short period are as follows:

Gross operating income.......................................   $126,000
Business expenses............................................    130,000
                                                   ------------
Net loss from operations.....................................    (4,000)
Dividends received from taxable domestic corporations........     30,000
                                                   ------------
  Gross income for short period before annualizing...........     26,000
Dividends received deduction (85 percent of $30,000, but not      22,100
 in excess of 85 percent of $26,000).........................
                                                   ------------
  Taxable income for short period before annualizing.........      3,900
Taxable income annualized ($8,900x12)........................     46,800
                                                   ============
Tax on annual basis:
  $46,800 at 52 percent...........................    $24,336
  Less surtax exemption...........................      5,500
                                                     --------    $18,836
                                                              ==========
Tax for 1-month period ($18,836x\1/12\)......................      1,570
 

    Example (3). The Y Corporation makes a re- turn for the six-month 
period ending June 30, 1957, because of a change in annual accounting 
period permitted under section 442. Income for the short period is as 
follows:

Taxable income exclusive of net long-term capital gain.......    $40,000
Net long-term capital gain...................................     10,000
                                                   ------------
  Taxable income for short period before annualizing.........     50,000
Taxable income annualized ($50,000x\12/6\)...................    100,000
                                                   ============
 
              Regular tax computation
 
Taxable income annualized....................................   100,000
Tax on annual basis:
  $100,000 at 52 percent..........................    $52,000
  Less surtax exemption...........................      5,500
                                                   ============
                                                      46,500
Tax for 6-month period ($46,500x\6/12\)......................     23,250
                                                   ============
 
            Alternative tax computation
 
Taxable income annualized....................................    100,000
Less annualized capital gain ($10,000x\12/6\)................     20,000
                                                   ------------
  Annualized taxable income subject to partial tax...........     80,000
                                                   ============
            Partial tax on annual basis
 
$60,000 at 52 percent.............................    $41,600
Less surtax exemption.............................      5,500
                                                     --------    36,100
25 percent of annualized capital gain ($20,000)..............      5,000
                                                   ------------
  Alternative tax on annual basis............................     41,100
Alternative tax for 6-month period ($41,100x\6/12\)..........     20,550
 

    Since the alternative tax of $20,550 is less than the tax computed 
in the regular manner ($23,250), the corporation's tax for the 6-month 
short period is $20,550.
    (2) Exception: computation based on 12-month period. (i) A taxpayer 
whose tax would otherwise be computed under section 443(b)(1) (or 
section 441(f)(2)(B)(iii) in the case of certain changes from or to a 
52-53-week taxable year) for the short period resulting from a change of 
annual accounting period may apply to the district director to have his 
tax computed under the provisions of section 443(b)(2) and this 
subparagraph. If such application is made, as provided in subdivision 
(v) of this subparagraph, and if the taxpayer establishes the amount of 
his taxable income for the 12-month period described in subdivision (ii) 
of this subparagraph, then the tax for the short period shall be the 
greater of the following--
    (a) An amount which bears the same ratio to the tax computed on the 
taxable income which the taxpayer has established for the 12-month 
period as the taxable income computed on the basis of the short period 
bears to the taxable income for such 12-month period; or
    (b) The tax computed on the taxable income for the short period 
without placing the taxable income on an annual basis.

However, if the tax computed under section 443(b)(2) and this 
subparagraph is not less than the tax for the short period computed 
under section 443(b)(1) (or section 441(f)(2)(B)(iii) in the case of 
certain changes from or to a 52-53-week taxable year), then section 
443(b)(2) and this subparagraph do not apply.
    (ii) The term ``12-month period'' referred to in subdivision (i) of 
this subparagraph means the 12-month period beginning on the first day 
of the short period. However, if the taxpayer is not in existence at the 
end of such 12-

[[Page 25]]

month period, or if the taxpayer is a corporation which has disposed of 
substantially all of its assets before the end of such 12-month period, 
the term ``12-month period'' means the 12-month period ending at the 
close of the last day of the short period. For the purposes of the 
preceding sentence, a corporation which has ceased business and 
distributed so much of the assets used in its business that it cannot 
resume its customary operations with the remaining assets, will be 
considered to have disposed of substantially all of its assets. In the 
case of a change from a 52-53-week taxable year, the term ``12-month 
period'' means the period of 52 or 53 weeks (depending on the taxpayer's 
52-53-week taxable year) beginning on the first day of the short period.
    (iii)(a) The taxable income for the 12-month period is computed 
under the same provisions of law as are applicable to the short period 
and is computed as if the 12-month period were an actual annual 
accounting period of the taxpayer. All items which fall in such 12-month 
period must be included even if they are extraordinary in amount or of 
an unusual nature. If the taxpayer is a member of a partnership, his 
taxable income for the 12-month period shall include his distributive 
share of partnership income for any taxable year of the partnership 
ending within or with such 12-month period, but no amount shall be 
included with respect to a taxable year of the partnership ending before 
or after such 12-month period. If any other item partially applicable to 
such 12-month period can be determined only at the end of a taxable year 
which includes only part of the 12-month period, the taxpayer, subject 
to review by the Commissioner, shall apportion such item to the 12-month 
period in such manner as will most clearly reflect income for the 12-
month period.
    (b) In the case of a taxpayer permitted or required to use 
inventories, the cost of goods sold during a part of the 12-month period 
included in a taxable year shall be considered, unless a more exact 
determination is available, as such part of the cost of goods sold 
during the entire taxable year as the gross receipts from sales for such 
part of the 12-month period is of the gross receipts from sales for the 
entire taxable year. For example, the 12-month period of a corporation 
engaged in the sale of merchandise, which has a short period from 
January 1, 1956, to September 30, 1956, is the calendar year 1956. The 
three-month period, October 1, 1956, to December 31, 1956, is part of 
the taxpayer's taxable year ending September 30, 1957. The cost of goods 
sold during the three-month period, October 1, 1956, to December 31, 
1956, is such part of the cost of goods sold during the entire fiscal 
year ending September 30, 1957, as the gross receipts from sales for 
such three-month period are of the gross receipts from sales for the 
entire fiscal year.
    (c) The Commissioner may, in granting permission to a taxpayer to 
change his annual accounting period, require, as a condition to 
permitting the change, that the taxpayer must take a closing inventory 
upon the last day of the 12-month period if he wishes to obtain the 
benefits of section 443(b)(2). Such closing inventory will be used only 
for the purposes of section 443(b)(2), and the taxpayer will not be 
required to use such inventory in computing the taxable income for the 
taxable year in which such inventory is taken.
    (iv) The provisions of this subparagraph may be illustrated by the 
following examples:

    Example (1). The taxpayer in example (1) under paragraph (b)(1)(vii) 
of this section establishes his taxable income for the 12-month period 
from January 1, 1956, to December 31, 1956. The taxpayer has a short 
period of 10 months, from January 1, 1956, to October 31, 1956. The 
taxpayer files an application in accordance with subdivision (v) of this 
subparagraph to compute his tax under section 443(b)(2). The taxpayer's 
income and deductions for the 12-month period, as so established, 
follow:

                            Income
Interest income...............................................   $11,000
Partially tax-exempt interest with respect to which a credit         600
 is allowable under section 35................................
Dividends to which sections 34 and 116 are applicable.........       850
                                                       ---------
                                                                  12,450
 
                          Deductions
 
Real estate taxes.............................................       200
2 personal exemptions at $600.................................     1,200
 

[[Page 26]]

 
Tax computation for short period under section 443(b)(2)(A)(i)
 
Total income as above.........................................  $12,450
Less:
Exclusion for dividends received......................     $50
Personal exemptions...................................   1,200
Deduction for taxes...................................     200
                                                       --------
                                                        ......     1,450
                                                               ---------
   Taxable income for 12-month period.........................    11,000
                                                       =========
Tax before credits............................................    3,020
Credit for partially tax-exempt interest (3 percent of      18
 $600)................................................
Credit for dividends received (4 percent of ($850-50))      32
                                                       --------
                                                        ......        50
                                                               ---------
Tax under section 443(b)(2)(A)(i) for 12-month period.........     2,970
Taxable income for 10-month short period from example (1) of      10,000
 paragraph (b)(1)(vii) of this section before annualizing.....
Tax for short period under section 443(b)(2)(A)(i)                 2,700
 ($2,970x$10,000 (taxable income for short period)/$11,000
 (taxable income for 12-month period))........................
 
        Tax computation for short period under section
                       443(b)(2)(A)(ii)
 
Total income for 10-month short period........................   11,250
Less:
  Exclusion for dividends received....................      50
  2 personal exemptions...............................   1,200
  Real estate taxes...................................     200
                                                       --------
                                                        ......     1,450
                                                               ---------
  Taxable income for short period without annualizing and          9,800
   without proration of personal exemptions...................
Tax before credits............................................     2,572
Less credits:
  Partially tax-exempt interest (3 percent of $500)...      15
  Dividends received (4 percent of ($750-50)).........      28
                                                       --------
                                                        ......        43
                                                               ---------
   Tax for short period under section 443(b)(2)(A)(ii)........     2,529
 


The tax of $2,700 computed under section 443(b)(2)(A)(i) is greater than 
the tax of $2,529, computed under section 443(b)(2)(A)(ii), and is, 
therefore, the tax under section 443(b)(2). Since the tax of $2,700 
(computed under section 443(b)(2)) is less than the tax of $2,790.33 
(computed under section 443(b)(1)) on the annualized income of the short 
period (see example (1) of paragraph (b)(1)(vii) of this section), the 
taxpayer's tax for the 10-month short period is $2,700.
    Example (2). Assume the same facts as in example (1) of this 
subdivision, except that, during the month of November 1956, the 
taxpayer suffered a casualty loss of $5,000. The tax computation for the 
short period under section 443(b)(2) would be as follows:

Tax computation for short period under section 443(b)(2)(A)(i)
 
Taxable income for 12-month period from example (1)...........   $11,000
Less: Casualty loss...........................................     5,000
                                                     -----------
   Taxable income for 12-month period.........................     6,000
                                                     ===========
Tax before credits..................................    $1,360
Credits from example (1)............................        50
                                                     ==========
Tax under section 443(b)(2)(A)(i) for 12-month           1,310
 period.............................................
                                                     ===========
Tax for short period ($1,310x $10,000/$6,000) under      2,183
 section 443(b)(2)(A)(i)............................
 
   Tax computation for short period under section
                  443(b)(2)(A)(ii)
 
Total income for the short period...................    11,250
Less:
  Exclusion for dividends received..................        50
  2 personal exemptions.............................     1,200
  Real estate taxes.................................       200
                                                     ----------
                                                      ........     1,450
                                                               ---------
   Taxable income for short period without annualizing and         9,800
   without proration of personal exemptions...................
Tax before credits............................................    2,572
Less credits:
  Partially tax-exempt interest (3 percent of $500).        15
  Dividends received (4 percent of $750-50))........        28
                                                     -----------
                                                      ........        43
                                                               ---------
Tax for short period under section 443(b)(2)(A)(ii)...........     2,529
 


The tax of $2,529, computed under section 443(b)(2)(A)(ii) is greater 
than the tax of $2,183 computed under section 443(b)(2)- (A)(i) and is, 
therefore, the tax under section 443(b)(2). Since this tax is less than 
the tax of $2,790.33, computed under section 443(b)(1) (see example (1) 
of paragraph (b)(1)(vii) of this section), the taxpayer's tax for the 
10-month short period is $2,529.

    (v)(a) A taxpayer who wishes to compute his tax for a short period 
resulting from a change of annual accounting period under section 
443(b)(2) must make an application therefor. Except as provided in (b) 
of this subdivision, the taxpayer shall first file his return for the 
short period and compute his tax under section 443(b)(1). The 
application for the benefits of section 443(b)(2) shall subsequently be 
made in the form of a claim for credit or refund. The claim shall set 
forth the computation of the taxable income and the tax thereon for the 
12-month period and must be filed not later than the time (including 
extensions) prescribed for filing the return for the taxpayer's first 
taxable year which ends on or after the day

[[Page 27]]

which is 12 months after the beginning of the short period. For example, 
assume that a taxpayer changes his annual accounting period from the 
calendar year to a fiscal year ending September 30, and files a return 
for the short period from January 1, 1956, to September 30, 1956. His 
application for the benefits of section 443(b)(2) must be filed not 
later than the time prescribed for filing his return for his first 
taxable year which ends on or after the last day of December 1956, the 
twelfth month after the beginning of the short period. Thus, the 
taxpayer must file his application not later than the time prescribed 
for filing the return for his fiscal year ending September 30, 1957. If 
he obtains an extension of time for filing the return for such fiscal 
year, he may file his application during the period of such extension. 
If the district director determines that the taxpayer has established 
the amount of his taxable income for the 12-month period, any excess of 
the tax paid for the short period over the tax computed under section 
443(b)(2) will be credited or refunded to the taxpayer in the same 
manner as in the case of an overpayment.
    (b) If at the time the return for the short period is filed, the 
taxpayer is able to determine that the 12-month period ending with the 
close of the short period (see section 443(b)(2)- (B)(ii) and 
subparagraph (2)(ii) of this paragraph) will be used in the computations 
under section 443(b)(2), then the tax on the return for the short period 
may be determined under the provisions of section 443(b)(2). In such 
case, a return covering the 12-month period shall be attached to the 
return for the short period as a part thereof, and the return and 
attachment will then be considered as an application for the benefits of 
section 443(b)(2).
    (c) Adjustment in deduction for personal exemption. For adjustment 
in the deduction for personal exemptions in computing the tax for a 
short period resulting from a change of annual accounting period under 
section 443(b)(1) (or under section 441(f)(2)(B)(iii) in the case of 
certain changes from or to a 52-53-week taxable year), see paragraph 
(b)(1)(v) of this section.
    (d) Adjustments in exclusion of computing minimum tax for tax 
preferences. (1) If a return is made for a short period on account of 
any of the reasons specified in subsection (a) of section 443, the 
$30,000 amount specified in section 56 (relating to minimum tax for tax 
preferences), modified as provided by section 58 and the regulations 
thereunder, shall be reduced to the amount which bears the same ratio to 
such specified amount as the number of days in the short period bears to 
365.
    (2) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example. A taxpayer who is an unmarried individual has been granted 
permission under section 442 to change his annual accounting period 
files a return for the short period of 4 months ending April 30, 1970. 
The $30,000 amount specified in section 56 is reduced as follows:

    (120/365)x$30,000=$9,835.89.

    (e) Cross references. For inapplicability of section 443(b) and 
paragraph (b) of this section in computing--
    (1) Accumulated earnings tax, see section 536 and the regulations 
thereunder;
    (2) Personal holding company tax, see section 546 and the 
regulations thereunder;
    (3) Undistributed foreign personal holding company income, see 
section 557 and the regulations thereunder;
    (4) The taxable income of a regulated investment company, see 
section 852(b)(2)(E) and the regulations thereunder; and
    (5) The taxable income of a real estate investment trust, see 
section 857(b)(2)(C) and the regulations thereunder.

[T.D. 6500, 25 F.R. 11705, Nov. 26, 1960, as amended by T.D. 6598, 27 FR 
4093, Apr. 28, 1962; T.D. 6777, 29 FR 17808, Dec. 16, 1964; T.D. 7244, 
37 FR 28897, Dec. 30, 1972, T.D. 7564, 43 FR 40494, Sept. 12, 1978; T.D. 
7575, 43 FR 58816, Dec. 18, 1978; T.D. 7767, 465 FR 11265, Feb. 6, 1981; 
T.D. 8996, 67 FR 35012, May 17, 2002]



Sec. 1.444-0T  Table of contents (temporary).

    This section lists the captions that appear in the temporary 
regulations under section 444.

[[Page 28]]

 Sec. 1.444-1T Election to use a taxable year other than the required 
                        taxable year (temporary).

    (a) General rules.
    (1) Year other than required year.
    (2) Effect of section 444 election.
    (i) In general.
    (ii) Duration of section 444 election.
    (3) Section 444 election not required for certain years.
    (4) Required taxable year.
    (5) Termination of section 444 election.
    (i) In general.
    (ii) Effective date of termination.
    (iii) Example.
    (iv) Special rule for entity that liquidates or is sold prior to 
making a section 444 election, required return, or required payment.
    (6) Re-activating certain S elections.
    (i) Certain corporations electing S status that did not make a back-
up calendar year request.
    (ii) Certain corporations that revoked their S status.
    (iii) Procedures for re-activating an S election.
    (iv) Examples.
    (b) Limitation on taxable years that may be elected.
    (1) General rule.
    (2) Changes in taxable year.
    (i) In general.
    (ii) Special rule for certain existing corporations electing S 
status.
    (iii) Deferral period of the taxable year that is being changed.
    (iv) Examples.
    (3) Special rule for entities retaining 1986 taxable year.
    (4) Deferral period.
    (i) Retentions of taxable year.
    (ii) Adoptions of and changes in taxable year.
    (A) In general.
    (B) Special rule.
    (C) Examples.
    (5) Miscellaneous rules.
    (i) Special rule for determining the taxable year of a corporation 
electing S status.
    (ii) Special procedure for cases where an income tax return is 
superseded.
    (A) In general.
    (B) Procedure for superseding return.
    (iii) Anti-abuse rule.
    (iv) Special rules for partial months and 52-53-week taxable years.
    (c) Effective date.
    (d) Examples.
    (1) Changes in taxable year.
    (2) Special rule for entities retaining their 1986 taxable year.

              Sec. 1.444-2T Tiered structure (temporary).

    (a) General rule.
    (b) Definition of a member of a tiered structure.
    (1) In general.
    (2) Deferral entity.
    (i) In general.
    (ii) Grantor trusts.
    (3) Anti-abuse rule.
    (c) De minimis rules.
    (1) In general.
    (2) Downstream de minimis rule.
    (i) General rule.
    (ii) Definition of testing period.
    (iii) Definition of adjusted taxable income.
    (A) Partnership.
    (B) S corporation.
    (C) Personal service corporation.
    (iv) Special rules.
    (A) Pro-forma rule.
    (B) Reasonable estimates allowed.
    (C) Newly formed entities.
    (1) Newly formed deferral entities.
    (2) Newly formed partnership, S corporation, or personal service 
corporation desiring to make a section 444 election.
    (3) Upstream de minimis rule.
    (d) Date for determining the existence of a tiered structure.
    (1) General rule.
    (2) Special rule for taxable years beginning in 1987.
    (e) Same taxable year exception.
    (1) In general.
    (2) Definition of tiered structure.
    (i) General rule.
    (ii) Special flow-through rule for downstream controlled 
partnerships.
    (3) Determining the taxable year of a partnership or S corporation.
    (4) Special rule for 52-53-week taxable years.
    (5) Interaction with de minimis rules.
    (i) Downstream de minimis rule.
    (A) In general.
    (B) Special rule for members of a tiered structure directly owned by 
a downstream controlled partnership.
    (ii) Upstream de minimis rule.
    (f) Examples.
    (g) Effective date.

     Sec. 1.444-3T Manner and time of making section 444 election 
                              (temporary).

    (a) In general.
    (b) Manner and time of making election.
    (1) General rule.
    (2) Special extension of time for making an election.
    (3) Corporation electing to be an S corporation.
    (i) In general.
    (ii) Examples.
    (4) Back-up section 444 election.
    (i) General rule.
    (ii) Procedures for making a back-up section 444 election.
    (iii) Procedures for activating a back-up section 444 election.
    (A) Partnership and S corporations.
    (1) In general.

[[Page 29]]

    (2) Special rule if Form 720 used to satisfy return requirement.
    (B) Personal service corporations.
    (iv) Examples.
    (c) Administrative relief.
    (1) Extension of time to file income tax returns.
    (i) Automatic extension.
    (ii) Additional extensions.
    (iii) Examples.
    (2) No penalty for certain late payments.
    (i) In general.
    (ii) Example.
    (d) Effective date.

[T.D. 8205, 53 FR 19693, May 27, 1988]



Sec. 1.444-1T  Election to use a taxable year other than the required 
taxable year (temporary).

    (a) General rules--(1) Year other than required year. Except as 
otherwise provided in this section and Sec. 1.444-2T, a partnership, S 
corporation, or personal service corporation (as defined in Sec. 1.441-
3(c)) may make or continue an election (a ``section 444 election'') to 
have a taxable year other than its required taxable year. See paragraph 
(b) of this section for limitations on the taxable year that may be 
elected. See Sec. 1.444-2T for rules that generally prohibit a 
partnership, S corporation, or personal service corporation that is a 
member of a tiered structure from making or continuing a section 444 
election. See Sec. 1.444-3T for rules explaining how and when to make a 
section 444 election.
    (2) Effect of section 444 election--(i) In general. A partnership or 
S corporation that makes or continues a section 444 election shall file 
returns and make payments as required by Sec. Sec. 1.7519-1T and 
1.7519-2T. A personal service corporation that makes or continues a 
section 444 election is subject to the deduction limitation of Sec. 
1.280H-1T.
    (ii) Duration of section 444 election. A section 444 election shall 
remain in effect until the election is terminated pursuant to paragraph 
(a)(5) of this section.
    (3) Section 444 election not required for certain years. A 
partnership, S corporation, or personal service corporation is not 
required to make a section 444 election to use--
    (i) A taxable year for which such entity establishes a business 
purpose to the satisfaction of the Commissioner (i.e., approved under 
section 4 or 6 of Rev. Proc. 87-32, 1987-28 I.R.B. 14, or any successor 
revenue ruling or revenue procedure), or
    (ii) A taxable year that is a ``grandfathered fiscal year,'' within 
the meaning of section 5.01(2) of Rev. Proc. 87-32 or any successor 
revenue ruling or revenue procedure.

Although a partnership, S corporation or personal service corporation 
qualifies to use a taxable year described in paragraph (a)(3) (i) or 
(ii) of this section, such entity may, if otherwise qualified, make a 
section 444 election to use a different taxable year. Thus, for example, 
assume that a personal service corporation that historically used a 
January 31 taxable year established to the satisfaction of the 
Commissioner, under section 6 of Rev. Proc. 87-32, a business purpose to 
use a September 30 taxable year for its taxable year beginning February 
1, 1987. Pursuant to this paragraph (a)(3), such personal service 
corporation may use a September 30 taxable year without making a section 
444 election. However, the corporation may, if otherwise qualified, make 
a section 444 election to use a year ending other than September 30 for 
its taxable year beginning February 1, 1987.
    (4) Required taxable year. For purposes of this section, the term 
``required taxable year'' means the taxable year determined under 
section 706(b), 1378, or 441(i) without taking into account any taxable 
year which is allowable either--
    (i) By reason of business purpose (i.e., approved under section 4 or 
6 of Rev. Proc. 87-32 or any successor revenue ruling or procedure), or
    (ii) As a ``grandfathered fiscal year'' within the meaning of 
section 5.01(2) of Rev. Proc. 87-32, or any successor revenue ruling or 
procedure.
    (5) Termination of section 444 election--(i) In general. A section 
444 election is terminated when--
    (A) A partnership, S corporation, or personal service corporation 
changes to its required taxable year; or
    (B) A partnership, S corporation, or personal service corporation 
liquidates (including a deemed liquidation of a partnership under Sec. 
1.708-1 (b)(1)(iv)); or
    (C) A partnership, S corporation, or personal service corporation 
willfully

[[Page 30]]

fails to comply with the requirements of section 7519 or 280H, whichever 
is applicable; or
    (D) A partnership, S corporation, or personal service corporation 
becomes a member of a tiered structure (within the meaning of Sec. 
1.444-2T), unless it is a partnership or S corporation that meets the 
same taxable year exception under Sec. 1.444-2T (e); or
    (E) An S corporation's S election is terminated; or
    (F) A personal service corporation ceases to be a personal service 
corporation.

However, if a personal service corporation, that has a section 444 
election in effect, elects to be an S corporation, the S corporation may 
continue the section 444 election of the personal service corporation. 
Similarly, if an S corporation that has a section 444 election in effect 
terminates its S election and immediately becomes a personal service 
corporation, the personal service corporation may continue the section 
444 election of the S corporation. If a section 444 election is 
terminated under this paragraph (a)(5), the partnership, S corporation, 
or personal service corporation may not make another section 444 
election for any taxable year.
    (ii) Effective date of termination. A termination of a section 444 
election shall be effective--
    (A) In the case of a change to the required year, on the first day 
of the short year caused by the change;
    (B) In the case of a liquidating entity, on the date the liquidation 
is completed for tax purposes;
    (C) In the case of willful failure to comply, on the first day of 
the taxable year (determined as if a section 444 election had never been 
made) determined in the discretion of the District Director;
    (D) In the case of membership in a tiered structure, on the first 
day of the taxable year in which the entity is considered to be a member 
of a tiered structure, or such other taxable year determined in the 
discretion of the District Director;
    (E) In the case of termination of S status, on the first day of the 
taxable year for which S status no longer exists;
    (F) In the case of a personal service corporation that changes 
status, on the first day of the taxable year, for which the entity is no 
longer a personal service corporation.

In the case of a termination under this paragraph (a)(5) that results in 
a short taxable year, an income tax return is required for the short 
period. In order to allow the Service to process the affected income tax 
return in an efficient manner, a partnership, S corporation, or personal 
service corporation that files such a short period return should type or 
legibly print at the top of the first page of the income tax return for 
the short taxable year--``SECTION 444 ELECTION TERMINATED.'' In 
addition, a personal service corporation that changes its taxable year 
to the required taxable year is required to annualize its income for the 
short period.
    (iii) Example. The provisions of paragraph (a)(5)(ii) of this 
section may be illustrated by the following example.

    Example. Assume a partnership that is 100 percent owned, at all 
times, by calendar year individuals has historically used a June 30 
taxable year. Also assume the partnership makes a valid section 444 
election to retain a year ending June 30 for its taxable year beginning 
July 1, 1987. However, for its taxable year beginning July 1, 1988, the 
partnership changes to a calendar year, its required year. Based on 
these facts, the partnership's section 444 election is terminated on 
July 1, 1988, and the partnership must file a short period return for 
the period July 1, 1988-December 31, 1988. Furthermore, pursuant to 
Sec. 1.702-3T(a)(1), the partners in such partnership are not entitled 
to a 4-year spread with respect to partnership items of income and 
expense for the taxable year beginning July 1, 1988 and ending December 
31, 1988.

    (iv) Special rule for entity that liquidates or is sold prior to 
making a section 444 election, required return, or required payment. A 
partnership, S corporation, or personal service corporation that is 
liquidated or sold for tax purposes before a section 444 election, 
required return, or required payment is made for a particular year may, 
nevertheless, make or continue a section 444 election, if otherwise 
qualified. (See Sec. Sec. 1.7519-2T (a)(2) and 1.7519-1T (a)(3), 
respectively, for a description of the required return and a definition 
of the term ``required payment.'') However,

[[Page 31]]

the partnership, S corporation, or personal service corporation (or a 
trustee or agent thereof) must comply with the requirements for making 
or continuing a section 444 election. Thus, if applicable, required 
payments must be made and a subsequent claim for refund must be made in 
accordance with Sec. 1.7519-2T(a)(6). The following examples illustrate 
the application of this paragraph (a)(5)(iv).

    Example (1). Assume an existing S corporation historically used a 
June 30 taxable year and desires to make a section 444 election for its 
taxable year beginning July 1, 1987. Assume further that the S 
corporation is liquidated for tax purposes on February 15, 1988. If 
otherwise qualified, the S corporation (or a trustee or agent thereof) 
may make a section 444 election to have a taxable year beginning July 1, 
1987, and ending February 15, 1988. However, if the S corporation makes 
a section 444 election, it must comply with the requirements for making 
a section 444 election, including making required payments.
    Example (2). The facts are the same as in example (1), except that 
instead of liquidating on February 15, 1988, the shareholders of the S 
corporation sell their stock to a corporation on February 15, 1988. 
Thus, the corporation's S election is terminated on February 15, 1988. 
If otherwise qualified, the corporation may make a section 444 election 
to have a taxable year beginning July 1, 1987, and ending February 14, 
1988.
    Example (3). The facts are the same as in example (2), except that 
the new shareholders are individuals. Furthermore, the corporation's S 
election is not terminated. Based on these facts, the S corporation, if 
otherwise qualified, may make a section 444 election to retain a year 
ending June 30 for its taxable year beginning July 1, 1987. Furthermore, 
the S corporation may, if otherwise qualified, continue its section 444 
election for subsequent taxable years.

    (6) Re-activating certain S elections--(i) Certain corporations 
electing S status that did not make a back-up calendar year request. If 
a corporation that timely filed Form 2553, Election by a Small Business 
Corporation, effective for its first taxable year beginning in 1987--
    (A) Requested a fiscal year based on business purpose,
    (B) Did not agree to use a calendar year in the event its business 
purpose request was denied, and
    (C) Such business purpose request is denied or withdrawn,

such corporation may retroactively re-activate its S election by making 
a valid section 444 election for its first taxable year beginning in 
1987 and complying with the procedures in paragraph (a)(6)(iii) of this 
section.
    (ii) Certain corporations that revoked their S status. If a 
corporation that used a fiscal year revoked its S election (pursuant to 
section 1362(d)(1)) for its first taxable year beginning in 1987, such 
corporation may retroactively re-activate its S election (i.e. rescind 
its revocation) by making a valid section 444 election for its first 
taxable year beginning in 1987 and complying with the procedures in 
paragraph (a)(6)(iii) of this section.
    (iii) Procedures for re-activating an S election. A corporation re-
activating its S election pursuant to paragraph (a)(6) (i) or (ii) of 
this section must--
    (A) Obtain the consents of all shareholders who have owned stock in 
the corporation since the first day of the first taxable year of the 
corporation beginning after December 31, 1986,
    (B) Include the following statement at the top of the first page of 
the corporation's Form 1120S for its first taxable year beginning in 
1987--``SECTION 444 ELECTION--RE-ACTIVATES S STATUS,'' and
    (C) Include the following statement with Form 1120S--``RE-ACTIVATION 
CONSENTED TO BY ALL SHAREHOLDERS WHO HAVE OWNED STOCK AT ANY TIME SINCE 
THE FIRST DAY OF THE FIRST TAXABLE YEAR OF THIS CORPORATION BEGINNING 
AFTER DECEMBER 31, 1986.''
    (iv) Examples. The provisions of this paragraph (a)(6) may be 
illustrated by the following examples.

    Example (1). Assume a corporation historically used a June 30 
taxable year and such corporation timely filed Form 2553, Election by a 
Small Business Corporation, to be effective for its taxable year 
beginning July 1, 1987. On its Form 2553, the corporation requested 
permission to retain its June 30 taxable year based on business purpose. 
However, the corporation did not agree to use a calendar year in the 
event its business purpose request was denied. On April 1, 1988, the 
Internal Revenue Service notified the corporation that its business 
purpose request was denied and therefore the corporation's S election 
was not effective. Pursuant to paragraph (a)(6)(i) of this section, the 
corporation may re-activate its S election by making a valid section 444 
election and complying

[[Page 32]]

with the procedures in paragraph (a)(6)(iii) of this section.
    Example (2). The facts are the same as in example (1), except that 
as of July 26, 1988, the Internal Revenue Service has not yet determined 
whether the corporation has a valid business purpose to retain a June 30 
taxable year. Based on these facts, the corporation may, if otherwise 
qualified, make a back-up section 444 election as provided in Sec. 
1.444-3T(b)(4). If the corporation's business purpose request is 
subsequently denied, the corporation should follow the procedures in 
Sec. 1.444-3T(b)(4)(iii) for activating a back-up section 444 election 
rather than the procedures provided in this paragraph (a)(6 for re-
activating an S election.
    Example (3). Assume a corporation has historically been an S 
corporation with a March 31 taxable year. However, for its taxable year 
beginning April 1, 1987, the corporation revoked its S election pursuant 
to section 1362 (d)(1). Pursuant to paragraph (a)(6)(ii) of this 
section, such corporation may retroactively rescind its S election 
revocation by making a valid section 444 election for its taxable year 
beginning April 1, 1987, and complying with the procedures provided in 
paragraph (a)(6)(iii) of this section. If the corporation retroactively 
rescinds its S revocation, the corporation shall file a Form 1120S for 
its taxable year beginning April 1, 1987.

    (b) Limitation on taxable years that may be elected--(1) General 
rule. Except as provided in paragraphs (b)(2) and (3) of this section, a 
section 444 election may be made only if the deferral period (as defined 
in paragraph (b)(4) of this section) of the taxable year to be elected 
is not longer than three months.
    (2) Changes in taxable year--(i) In general. In the case of a 
partnership, S corporation, or personal service corporation changing its 
taxable year, such entity may make a section 444 election only if the 
deferral period of the taxable year to be elected is not longer than the 
shorter of--
    (A) Three months, or
    (B) The deferral period of the taxable year that is being changed, 
as defined in paragraph (b)(2)(iii) of this section.
    (ii) Special rule for certain existing corporations electing S 
status. If a corporation with a taxable year other than the calendar 
year--
    (A) Elected after September 18, 1986, and before January 1, 1988, 
under section 1362 of the Code to be an S corporation, and
    (B) Elected to have the calendar year as the taxable year of the S 
corporation,

then, for taxable years beginning before 1989, paragraph (b)(2)(i) of 
this section shall be applied by taking into account the deferral period 
of the last taxable year of the corporation prior to electing to be an S 
corporation, rather than the deferral period of the taxable year that is 
being changed. Thus, the provisions of the preceding sentence do not 
apply to a corporation that elected to be an S corporation for its first 
taxable year.
    (iii) Deferral period of the taxable year that is being changed. For 
purposes of paragraph (b)(2)(i)(B) of this section, the phrase 
``deferral period of the taxable year that is being changed'' means the 
deferral period of the taxable year immediately preceding the taxable 
year for which the taxpayer desires to make a section 444 election. 
Furthermore, the deferral period of such year will be determined by 
using the required taxable year of the taxable year for which the 
taxpayer desires to make a section 444 election. For example, assume P, 
a partnership that has historically used a March 31 taxable year, 
desires to change to a September 30 taxable year by making a section 444 
election for its taxable year beginning April 1, 1987. Furthermore, 
assume that pursuant to paragraph (a)(4) of this section, P's required 
taxable year for the taxable year beginning April 1, 1987 is a year 
ending December 31. Based on these facts the deferral period of the 
taxable year being changed is nine months (the period from March 31 to 
December 31).
    (iv) Examples. See paragraph (d)(1) of this section for examples 
that illustrate the provisions of this paragraph (b)(2).
    (3) Special rule for entities retaining 1986 taxable year. 
Notwithstanding paragraph (b)(2) of this section, a partnership, S 
corporation, or personal service corporation may, for its first taxable 
year beginning after December 31, 1986, if otherwise qualified, make a 
section 444 election to have a taxable year that is the same as the 
entity's last taxable year beginning in 1986. See

[[Page 33]]

paragraph (d)(2) of this section for examples that illustrate the 
provisions of this paragraph (b)(3).
    (4) Deferral period--(i) Retentions of taxable year. For a 
partnership, S corporation, or personal service corporation that desires 
to retain its taxable year by making a section 444 election, the term 
``deferral period'' means the months between the beginning of such year 
and the close of the first required taxable year (as defined in 
paragraph (a)(4) of this section). The following example illustrates the 
application of this paragraph (b)(4)(i).

    Example. AB partnership has historically used a taxable year ending 
July 31. AB desires to retain its July 31 taxable year by making a 
section 444 election for its taxable year beginning August 1, 1987. 
Calendar year individuals, A and B, each own 50 percent of the profits 
and capital of AB; thus, under paragraph (a)(4) of this section AB's 
required taxable year is the year ending December 31. Pursuant to this 
paragraph (b)(4)(i), if AB desires to retain its year ending July 31, 
the deferral period is five months (the months between July 31 and 
December 31).

    (ii) Adoptions of and changes in taxable year--(A) In general. For a 
partnership, S corporation, or personal service corporation that desires 
to adopt or change its taxable year by making a section 444 election, 
the term ``deferral period'' means the months that occur after the end 
of the taxable year desired under section 444 and before the close of 
the required taxable year.
    (B) Special rule. If a partnership, S corporation or personal 
service corporation is using the required taxable year as its taxable 
year, the deferral period is deemed to be zero.
    (C) Examples. The provisions of this paragraph (b)(4)(ii) may be 
illustrated by the following examples.

    Example (1). Assume that CD partnership has historically used the 
calendar year and that CD's required taxable year is the calendar year. 
Under the special rule provided in paragraph (b)(4)(ii)(B) of this 
section, CD's deferral period is zero. See paragraph (b)(2)(i) of this 
section for rules that preclude CD from making a section 444 election to 
change its taxable year.
    Example (2). E, a newly formed partnership, began operations on 
December 1, 1987, and is owned by calendar year individuals. E desires 
to make a section 444 election to adopt a September 30 taxable year. E's 
required taxable year is December 31. Pursuant to paragraph 
(b)(4)(ii)(A) of this section E's deferral period for the taxable year 
beginning December 1, 1987, is three months (the number of months 
between September 30 and December 31).
    Example (3). Assume that F, a personal service corporation, has 
historically used a June 30 taxable year. F desires to make a section 
444 election to change to an August 31 taxable year, effective for its 
taxable year beginning July 1, 1987. For purposes of determining the 
availability of a section 444 election for changing to the taxable year 
ending August 31, the deferral period of an August 31 taxable year is 
four months (the number of months between August 31 and December 31). 
The deferral period for F's existing June 30 taxable year is six months 
(the number of months between June 30 and December 31). Pursuant to 
Sec. 1.444-1T(b)(2)(i), F may not make a section 444 election to change 
to an August 31 taxable year.

    (5) Miscellaneous rules--(i) Special rule for determining the 
taxable year of a corporation electing S status. For purposes of this 
section, and only for purposes of this section, a corporation that 
elected to be an S corporation for a taxable year beginning in 1987 or 
1988 and which elected to be an S corporation prior to September 26, 
1988, will not be considered to have adopted or changed its taxable year 
by virtue of information included on Form 2553, Election by a Small 
Business Corporation. See example (8) in paragraph (d) of this section.
    (ii) Special procedure for cases where an income tax return is 
superseded--(A) In general. In the case of a partnership, S corporation, 
or personal service corporation that filed an income tax return for its 
first taxable year beginning after December 31, 1986, but subsequently 
makes a section 444 election that would result in a different year end 
for such taxable year, the income tax return filed pursuant to the 
section 444 election will supersede the original return. However, any 
payments of income tax made with respect to such superseded return will 
be credited to the taxpayer's superseding return and the taxpayer may 
file a claim for refund for such payments. See examples (5) and (7) in 
paragraph (d)(2) of this section.
    (B) Procedure for superseding return. In order to allow the Service 
to process the affected income tax returns in an

[[Page 34]]

efficient manner, a partnership, S corporation, or personal service 
corporation that desires to supersede an income tax return in accordance 
with paragraph (b)(5)(ii)(A) of this section, should type or legibly 
print at the top of the first page of the income tax return for the 
taxable year elected--``SECTION 444 ELECTION--SUPERSEDES PRIOR RETURN.''
    (iii) Anti-abuse rule--If an existing partnership, S corporation or 
personal service corporation (``predecessor entities''), or the owners 
thereof, transfer assets to a related party and the principal purpose of 
such transfer is to--
    (A) Create a deferral period greater than the deferral period of the 
predecessor entity's taxable year, or
    (B) Make a section 444 election following the termination of the 
predecessor entity's section 444 election,

then such transfer will be disregarded for purposes of section 444 and 
this section, even if the deferral created by such change is effectively 
eliminated by a required payment (within the meaning of section 7519) or 
deferral of a deduction (to a personal service corporation under section 
280H). The following example illustrates the application of this 
paragraph (b)(5)(iii).

    Example. Assume that P1 is a partnership that historically used the 
calendar year and is owned by calendar year partners. Assume that P1 
desires to make a section 444 election to change to a September year for 
the taxable year beginning January 1, 1988. P1 may not make a section 
444 election to change taxable years under section 444(b)(2) because its 
current deferral period is zero. Assume further that P1 transfers a 
substantial portion of its assets to a newly-formed partnership (P2), 
which is owned by the partners of P1. Absent paragraph (b)(5)(iii) of 
this section, P2 could, if otherwise qualified, make a section 444 
election under paragraph (b)(1) of this section to use a taxable year 
with a three month or less deferral period (i.e., a September 30, 
October 31, or November 30 taxable year). However, if the principal 
purpose of the asset transfer was to create a one-, two-, or three-month 
deferral period by P2 making a section 444 election, the section 444 
election shall not be given effect, even if the deferral would be 
effectively eliminated by P2 making a required payment under section 
7519.

    (iv) Special rules for partial months and 52-53-week taxable years. 
Except as otherwise provided in Sec. 1.280H-1T(c)(2)(i)(A), for 
purposes of this section and Sec. Sec. 1.7519-1T, 1.7519-2T and 1.280H-
1T--
    (A) A month of less than 16 days is disregarded, and a month of more 
than 15 days is treated as a full month; and
    (B) A 52-53-week taxable year with reference to the end of a 
particular month will be considered to be the same as a taxable year 
ending with reference to the last day of such month.
    (c) Effective date. This section is effective for taxable years 
beginning after December 31, 1986.
    (d) Examples--(1) Changes in taxable year. The following examples 
illustrate the provisions of paragraph (b)(2) of this section.

    Example (1). A is a personal service corporation that historically 
used a June 30 taxable year. A desires to make a section 444 election to 
change to an August 31 taxable year, effective with its taxable year 
beginning July 1, 1987. Under paragraph (b)(4)(ii) of this section, the 
deferred period of the taxable year to be elected is four months (the 
number of months between August 31 and December 31). Furthermore, the 
deferral period of the taxable year that is being changed is six months 
(the number of months between June 30 and December 31). Pursuant to 
paragraph (b)(2)(i) of this section, a taxpayer may, if otherwise 
qualified, make a section 444 election to change to a taxable year only 
if the deferral period of the taxable year to be elected is not longer 
than the shorter of three months or the deferred period of the taxable 
year being changed. Since the deferral period of the taxable year to be 
elected (August 31) is greater than three months, A may not make a 
section 444 election to change to the taxable year ending August 31, 
However, since the deferral period of the taxable year that is being 
changed is three months or more, A may, if otherwise qualified, make a 
section 444 election to change to a year ending September 30, 1987 
(three-month deferral period), a year ending October 31, 1987 (two-month 
deferral period), or a year ending November 30, 1987 (one-month deferral 
period). In addition, instead of making a section 444 election to change 
its taxable year, A could, if otherwise qualified, make a section 444 
election to retain its June end, pursuant to paragraph (b)(3) of this 
section.
    Example (2). B, a corporation that historically used an August 31 
taxable year, elected on November 1, 1986 to be an S corporation for its 
taxable year beginning September 1, 1986. As a condition to having the S 
election accepted, B agreed on Form 2553 to use calendar year. Pursuant 
to the general effective

[[Page 35]]

date provided in paragraph (c) of this section, B may not make a section 
444 election for its taxable year beginning in 1986. Thus, B must file a 
short period income tax return for the period September 1 to December 
31, 1986.
    Example (3). The facts are the same as in example (2), except that B 
desires to make a section 444 election for its taxable year beginning 
January 1, 1987. Absent paragraph (b)(2)(ii) of this section, B would 
not be allowed to change its taxable year because the deferral period of 
the taxable year being changed (i.e., the calendar year) is zero. 
However, pursuant to the special rule provided in paragraph (b)(2)(ii) 
of this section, B shall apply paragraph (b)(2)(i) of this section by 
taking into account the deferral period of the last taxable year of B 
prior to B's election to be an S corporation (four months), rather than 
the deferral period of B's taxable year that is being changed (zero 
months). Thus, if otherwise qualified, B may make a section 444 election 
to change to a taxable year ending September 30, October 31, or November 
30, for its taxable year beginning January 1, 1987.
    Example (4). The facts are the same as in example (3), except that B 
files a calendar year income tax return for 1987 rather than making a 
section 444 election. However, for its taxable year beginning January 1, 
1988, B desires to change its taxable year by making a section 444 
election. Given that the special rule provided in paragraph (b)(2)(ii) 
of this section applies to section 444 elections made in taxable years 
beginning before 1989, B may, if otherwise qualified, make a section 444 
election to change to a taxable year ending September 30, October 31, or 
November 30 for its taxable year beginning January 1, 1988.
    Example (5). C, a corporation that historically used a June 30 
taxable year, elected on December 15, 1986 to be an S corporation for 
its taxable year beginning July 1, 1987. As a condition to having the S 
election accepted, C agreed on Form 2553 to use a calendar year. 
Although pursuant to paragraph (b)(3) of this section, C would, if 
otherwise qualified, be allowed to retain its June 30 taxable year, C 
desires to change to a September 30 taxable year by making a section 444 
election. Pursuant to paragraph (b)(2) of this section, a taxpayer may, 
if otherwise qualified, make a section 444 election to change to a 
taxable year only if the deferral period of the taxable year to be 
elected is not longer than the shorter of three months or the deferral 
period of the taxable year being changed. Given these facts, the 
deferral period of the taxable year to be elected is 3 months (September 
30 to December 31) while the deferral period of the taxable year being 
changed is 6 months (June 30 to December 31). Thus, C may, if otherwise 
qualified, change to a September 30 taxable year for its taxable year 
beginning July 1, 1987, by making a section 444 election. The fact that 
C agreed on Form 2553 to use a calendar year is not relevant.
    Example (6). D, a corporation that historically used a March 31 
taxable year, elects on June 1, 1988 to be an S corporation for its 
taxable year beginning April 1, 1988. D desires to change to a June 30 
taxable year by making a section 444 election for its taxable year 
beginning April 1, 1988. Pursuant to paragraph (b)(2)(i) of this 
section, D may not change to a June 30 taxable year because such year 
would have a deferral period greater than 3 months. However, if 
otherwise qualified, D may make a section 444 election to change to a 
taxable year ending September 30, October 31, or November 30 for its 
taxable year beginning April 1, 1988.
    Example (7). E, a corporation that began operations on November 1, 
1986, elected to be an S corporation on December 15, 1986, for its 
taxable year beginning November 1, 1986. E filed a short period income 
tax return for the period November 1 to December 31, 1986. E desires to 
change to a September 30 taxable year by making a section 444 election 
for its taxable year beginning January 1, 1987. Although E elected to be 
an S corporation after September 18, 1986, and before January 1, 1988, 
paragraph (b)(2)(ii) of this section does not apply to E since E was not 
a C corporation prior to electing S status. Thus, E may not change its 
taxable year for the taxable year beginning January 1, 1987, by making a 
section 444 election.
    Example (8). The facts are the same as in example (7), except that E 
began operations on April 15, 1987, and elected to be an S corporation 
on June 1, 1987, for its taxable year beginning April 15, 1987. As a 
condition to being an S corporation, E agreed on Form 2553 to use a 
calendar year. E desires to make a section 444 election to use a year 
ending September 30 for its taxable year beginning April 15, 1987. 
Pursuant to paragraph (b)(5)(i) of this section, E's agreement to use a 
calendar year on Form 2553 does not mean that E has adopted a calendar 
year. Thus, E's desire to make a section 444 election to use a September 
30 taxable year will not be considered a change in taxable year and thus 
paragraph (b)(2) of this section will not apply. Instead, E will be 
subject to paragraph (b)(1) of this section. Since a September 30 
taxable year would result in only a three-month deferral period 
(September 30 to December 31), E may, if otherwise qualified, make a 
section 444 election to use a year ending September 30 for its taxable 
year beginning April 15, 1987.

    (2) Special rule for entities retaining their 1986 taxable year. The 
following examples illustrate the provisions of paragraph (b)(3) of this 
section.


[[Page 36]]


    Example (1). F, an S corporation that elected to be an S corporation 
several years ago, has historically used a June 30 taxable year. F 
desires to retain its June 30 taxable year by making a section 444 
election for its taxable year beginning July 1, 1987. Pursuant to 
paragraph (b)(4)(i) of this section, the deferral period of the taxable 
year being retained is 6 months (June 30 to December 31, F's required 
taxable year). Absent the special rule provided in paragraph (b)(3) of 
this section, F would be subject to the general rule provided in 
paragraph (b)(1) of this section which limits the deferral period of the 
taxable year elected to three months or less. However, pursuant to 
paragraph (b)(3) of this section, F may, if otherwise qualified, make a 
section 444 election to retain its year ending June 30 for its taxable 
year beginning July 1, 1987.
    Example (2). The facts are the same as in example (1), except that F 
received permission from the Commissioner to change its taxable year to 
the calendar year, and filed a short period income tax return for the 
period July 1 to December 31, 1986. F desires to make a section 444 
election to use a year ending June 30 for its taxable year beginning 
January 1, 1987. Given that F had a December 31 taxable year for its 
last taxable year beginning in 1986, the special rule provided in 
paragraph (b)(3) of this section does not allow F to use a June 30 
taxable year for its taxable year beginning January 1, 1987. 
Furthermore, pursuant to paragraph (b)(2)(i) of this section, F is not 
allowed to change its taxable year from December 31 to June 30 because 
the deferral period of the taxable year being changed is zero months.
    Example (3). G, a corporation that historically used an August 31 
taxable year, elected be an S corporation on November 15, 1986, for its 
taxable year beginning September 1, 1986. As a condition to obtaining S 
status, G agreed to use a calendar year. Thus, G filed its first S 
corporation return for the period September 1 to December 31, 1986. G 
desires to make a section 444 election to use a year ending August 31 
for its taxable year beginning January 1, 1987. Since G's last taxable 
year beginning in 1986 was a calendar year, G cannot use paragraph 
(b)(3) of this section, relating to retentions of taxable years, to 
elect an August 31 taxable year. Thus, G is subject to paragraph 
(b)(2)(i) of this section, relating to changes in taxable year. Although 
G, if otherwise qualified, may use the special rule provided in 
paragraph (b)(2)(ii) of this section, G may only change from its current 
taxable year (i.e., the calendar year) to a taxable year that has no 
more than a three-month deferral period (i.e., September 30, October 31, 
or November 30).
    Example (4). The facts are the same as in example (3), except that G 
elected to be an S corporation for its taxable year beginning September 
1, 1987, rather than its taxable year beginning September 1, 1986. As a 
condition to making its S election, G agreed, on Form 2553, to use the 
calendar year. However, G has not yet filed a short period income tax 
return for the period September 1 to December 31, 1987. Given these 
facts, paragraph (b)(3) of this section would allow G, if otherwise 
qualified, to make a section 444 election to retain an August 31 taxable 
year for its taxable year beginning September 1, 1987.
    Example (5). The facts are the same as in example (4), except that G 
has already filed a short period income tax return for the period 
September 1 to December 31, 1987. Pursuant to paragraph (b)(5)(ii)(A) of 
this section, G may supersede the return it filed for the period 
September 1 to December 31, 1987. Thus, pursuant to paragraph (b)(3) of 
this section, G may, if otherwise qualified, make a section 444 election 
to retain an August 31 taxable year for the taxable year beginning 
September 1, 1987. In addition, G should follow the special procedures 
set forth in paragraph (b)(5)(ii)(B) of this section.
    Example (6). H, a corporation that historically used a May 31 
taxable year, elects to be an S corporation on June 15, 1988 for its 
taxable year beginning June 1, 1988. H desires to make a section 444 
election to use a taxable year other than the calendar year. Since the 
taxable year in issue is not H's first taxable year beginning after 
December 31, 1986, H may not use the special rule provided in paragraph 
(b)(3)(i) and thus may not retain its May 31 year. However, H may, if 
otherwise qualified, make a section 444 election under paragraph 
(b)(2)(i) of this section, to change to a taxable year that has no more 
than a three-month deferral period (i.e., September 30, October 31, or 
November 30) for its taxable year beginning June 1, 1988.
    Example (7). I is a partnership that has historically used a 
calendar year. Sixty percent of the profits and capital of I are owned 
by Q, a corporation (that is neither an S corporation nor a personal 
service corporation) that has a June 30 taxable year, and 40 percent of 
the profits and capital are owned by R, a calendar year individual. 
Since the partner that has more than a fifty percent interest in I has a 
June 30 taxable year, I's required taxable year is June 30. Accordingly, 
I filed an income tax return for the period January 1 to June 30, 1987. 
Based on these facts, I may, pursuant to paragraph (b)(5)(ii)(A) of this 
section, disregard the income tax return filed for the period January 1 
to June 30, 1987. Thus, if otherwise qualified, I may make a section 444 
election under paragraph (b)(2)(i) of this section to use a calendar 
year for its taxable year beginning January 1, 1987. If I makes such a 
section 444

[[Page 37]]

election, I should follow the special procedures set forth in paragraph 
(b)(5)(ii)(B) of this section.

[T.D. 8205, 53 FR 19694, May 27, 1988, as amended by T.D. 8996, 67 FR 
35012, May 17, 2002]



Sec. 1.444-2T  Tiered structure (temporary).

    (a) General rule. Except as provided in paragraph (e) of this 
section, no section 444 election shall be made or continued with respect 
to a partnership, S corporation, or personal service corporation that is 
a member of a tiered structure on the date specified in paragraph (d) of 
this section. For purposes of this section, the term ``personal service 
corporation'' means a personal service corporation as defined in Sec. 
1.441-3(c).
    (b) Definition of a member of a tiered structure--(1) In general. A 
partnership, S corporation, or personal service corporation is 
considered a member of a tiered structure if--
    (i) The partnership, S corporation, or personal service corporation 
directly owns any portion of a deferral entity, or
    (ii) A deferral entity directly owns any portion of the partnership, 
S corporation, or personal service corporation.

However, see paragraph (c) of this section for certain de minimis rules, 
and see paragraph (b)(3) of this section for an anti-abuse rule. In 
addition, for purposes of this section, a beneficiary of a trust shall 
be considered to own an interest in the trust.
    (2) Deferral entity--(i) In general. For purposes of this section, 
the term ``deferral entity'' means an entity that is a partnership, S 
corporation, personal service corporation, or trust. In the case of an 
affiliated group of corporations filing a consolidated income tax return 
that is treated as a personal service corporation pursuant to Sec. 
1.441-4T (i), such affiliated group is considered to be a single 
deferral entity.
    (ii) Grantor trusts. The term ``deferral entity'' does not include a 
trust (or a portion of a trust) which is treated as owned by the grantor 
or beneficiary under Subpart E, part I, subchapter J, chapter 1, of the 
Code (relating to grantor trusts), including a trust that is treated as 
a grantor trust pursuant to section 1361(d)(1)(A) of the Code (relating 
to qualified subchapter S trusts). Thus, any taxpayer treated under 
subpart E as owning a portion of a trust shall be treated as owning the 
assets of the trust attributable to that ownership. The following 
examples illustrate the provisions of this paragraph (b)(2)(ii).

    Example (1). A, an individual, is the sole beneficiary of T. T is a 
trust that owns 50 percent of the profits and capital of X, a 
partnership that desires to make a section 444 election. Furthermore, 
pursuant to Subpart E, Part I, subchapter J, chapter 1 of the Code, A is 
treated as an owner of X. Based upon these facts, T is not a deferral 
entity and 50 percent of X is considered to be directly owned by A.
    Example (2). The facts are the same as in example (1), except that A 
is a personal service corporation rather than an individual. Given these 
facts, 50 percent of X is considered to be directly owned by A, a 
deferral entity. Thus, X is considered to be a member of a tiered 
structure.

    (3) Anti-abuse rule. Notwithstanding paragraph (b)(1) of this 
section, a partnership, S corporation, or personal service corporation 
is considered a member of a tiered structure if the partnership, S 
corporation, personal service corporation, or related taxpayers have 
organized or reorganized their ownership structure or operations for the 
principal purpose of obtaining a significant unintended tax benefit from 
making or continuing a section 444 election. For purposes of the 
preceding sentence, a significant unintended tax benefit results when a 
partnership, S corporation, or personal service corporation makes a 
section 444 election and, as a result, a taxpayer (not limited to the 
entity making the election) obtains a significant deferral of income 
substantially all of which is not eliminated by a required payment under 
section 7519. See examples (15) through (19) in paragraph (f) of this 
section.
    (c) De minimis rules--(1) In general. For rules relating to a de 
minimis exception to paragraph (b)(1)(i) of this section (the 
``downstream de minimis rule''), see paragraph (c)(2) of this section. 
For rules relating to a de minimis exception to paragraph (b)(1)(ii) of 
this section (the ``upstream de minimis

[[Page 38]]

rule''), see paragraph (c)(3) of this section. For rules relating to the 
interaction of the de minimis rules provided in this paragraph (c) and 
the ``same taxable year exception'' provided in paragraph (e) of this 
section, see paragraph (e)(5) of this section.
    (2) Downstream de minimis rule--(i) General rule. If a partnership, 
S corporation, or personal service corporation directly owns any portion 
of one or more deferral entities as of the date specified in paragraph 
(d) of this section, such ownership is disregarded for purposes of 
paragraph (b)(1)(i) of this section if, in the aggregate, all such 
deferral entities accounted for--
    (A) Not more than 5 percent of the partnership's, S corporation's, 
or personal service corporation's adjusted taxable income for the 
testing period (``5 percent adjusted taxable income test''), or
    (B) Not more than 2 percent of the partnership's, S corporation's, 
or personal service corporation's gross income for the testing period 
(``2 percent gross income test''). See section 702 (c) for rules 
relating to the determination of gross income of a partner in a 
partnership.

See examples (3) through (5) in paragraph (f) of this section.
    (ii) Definition of testing period. For purposes of this paragraph 
(c)(2), the term ``testing period'' means the taxable year that ends 
immediately prior to the taxable year for which the partnership, S 
corporation, or personal service corporation desires to make or continue 
a section 444 election. However, see the special rules provided in 
paragraph (c)(2)(iv) of this section for certain special cases (e.g., 
the partnership, S corporation, personal service corporation or deferral 
entity was not in existence during the entire testing period). The 
following example illustrates the application of this paragraph 
(c)(2)(ii).

    Example. A partnership desires to make a section 444 election for 
its taxable year beginning November 1, 1987. The testing period for 
purposes of determining whether deferral entities owned by such 
partnership are de minimis under paragraph (c)(2) of this section is the 
taxable year ending October 31, 1987. If either the partnership or the 
deferral entities were not in existence for the entire taxable year 
ending October 1, 1987, see the special rules provided in paragraph 
(c)(2)(iv) of this section.

    (iii) Definition of adjusted taxable income--(A) Partnership. In the 
case of a partnership, adjusted taxable income for purposes of paragraph 
(c)(2) of this section is an amount equal to the sum of the--
    (1) Aggregate amount of the partnership items described in section 
702(a) (other than credits and tax-exempt income),
    (2) Applicable payments defined in section 7519(d)(3) that are 
deducted in determining the amount described in paragraph 
(c)(2)(iii)(A)(1) of this section, and
    (3) Guaranteed payments defined in section 707(c) that are deducted 
in determining the amount described in paragraph (c)(2)(iii)(A)(1) of 
this section and are not otherwise included in paragraph 
(c)(2)(iii)(A)(2) of this section. For purposes of determining the 
aggregate amount of partnership items under paragraph (c)(2)(iii)(A)(1) 
of this section, deductions and losses are treated as negative income. 
Thus, for example, if under section 702(a) a partnership has $1,000 of 
ordinary taxable income, $500 of specially allocated deductions, and 
$300 of capital loss, the partnership's aggregate amount of partnership 
items under paragraph (c)(2)(iii)(A)(1) of this section is $200 ($1,000-
$500-$300).
    (B) S corporation. In the case of an S corporation, adjusted taxable 
income for purposes of paragraph (c)(2) of this section is an amount 
equal to the sum of the--
    (1) Aggregate amount of the S corporation items described in section 
1366(a) (other than credits and tax-exempt income), and
    (2) Applicable payments defined in section 7519(d)(3) that are 
deducted in determining the amount described in paragraph 
(c)(2)(iii)(B)(1) of this section.

For purposes of determining the aggregate amount of S corporation items 
under paragraph (c)(2)(iii)(B)(1) of this section, deductions and losses 
are treated as negative income. Thus, for example, if under section 
1366(a) an S corporation has $2,000 of ordinary taxable income, $1,000 
of deductions described in section 1366(a)(1)(A) of the

[[Page 39]]

Code, and $500 of capital loss, the S corporation's aggregate amount of 
S corporation items under paragraph (c)(2)(iii)(B)(1) of this section is 
$500 ($2,000-$1,000-$500).
    (C) Personal service corporation. In the case of a personal service 
corporation, adjusted taxable income for purposes of paragraph (c)(2) of 
this section is an amount equal to the sum of the--
    (1) Taxable income of the personal service corporation, and
    (2) Applicable amounts defined in section 280H(f)(1) that are 
deducted in determining the amount described in paragraph 
(c)(2)(iii)(C)(1) of this section.
    (iv) Special rules--(A) Pro-forma rule. Except as provided in 
paragraph (c)(iv)(C)(2) of this section, if a partnership, S 
corporation, or personal service corporation directly owns any interest 
in a deferral entity as of the date specified in paragraph (d) of this 
section and such ownership interest is different in amount from the 
partnership's, S corporation's, or personal service corporation's 
interest on any day during the testing period, the 5 percent adjusted 
taxable income test and the 2 percent gross income test must be applied 
on a pro-forma basis (i.e., adjusted taxable income and gross income 
must be calculated for the testing period assuming that the partnership, 
S corporation, or personal service corporation owned the same interest 
in the deferral entity that it owned as of the date specified in 
paragraph (d) of this section). The following example illustrates the 
application of this paragraph (c)(2)(iv)(A).

    Example. A personal service corporation desiring to make a section 
444 election for its taxable year beginning October 1, 1987, acquires a 
25 percent ownership interest in a partnership on or after October 1, 
1987. Furthermore, the partnership has been in existence for several 
years. The personal service corporation must modify its calculations of 
the 5 percent adjusted taxable income test and the 2 percent gross 
income test for the testing period ended September 30, 1987, by assuming 
that the personal service corporation owned 25 percent of the 
partnership during such testing period and the personal service 
corporation's adjusted taxable income and gross income were 
correspondingly adjusted.

    (B) Reasonable estimates allowed. If the information necessary to 
complete the pro-forma calculation described in paragraph (c)(2)(iv)(A) 
of this section is not readily available, the partnership, S 
corporation, or personal service corporation may make a reasonable 
estimate of such information.
    (C) Newly formed entities--(1) Newly formed deferral entities. If a 
partnership, S corporation, or personal service corporation owns any 
portion of a deferral entity on the date specified in paragraph (d) of 
this section and such deferral entity was not in existence during the 
entire testing period (hereinafter referred to as a ``newly formed 
deferral entity''), both the 5 percent adjusted taxable income test and 
the 2 percent gross income test are modified as follows. First, the 
partnership, S corporation, or personal service corporation shall 
calculate the percentage of its adjusted taxable income or gross income 
that is attributable to deferral entities, excluding newly formed 
deferral entities. Second, the partnership, S corporation, or personal 
service corporation shall calculate (on the date specified in paragraph 
(d) of this section) the percentage of the tax basis of its assets that 
are attributable to its tax basis with respect to its ownership 
interests in all newly formed deferral entities. If the sum of the two 
percentages is 5 percent or less, the deferral entities are considered 
de minimis and are disregarded for purposes of paragraph (b)(1)(i) of 
this section. If the sum of the two percentages is greater than 5 
percent, the deferral entities do not qualify for the de minimis rule 
provided in paragraph (c)(2) of this section and thus the partnership, S 
corporation, or personal service corporation is considered to be a 
member of a tiered structure for purposes of this section.
    (2) Newly formed partnership, S corporation, or personal service 
corporation desiring to make a section 444 election. If a partnership, S 
corporation, or personal service corporation desires to make a section 
444 election for the first taxable year of its existence, the 5 percent 
adjusted taxable income test and the 2 percent gross income test are 
replaced by a 5 percent of assets test. Thus, if on the date specified 
in paragraph (d) of this section, 5 percent or less of the assets 
(measured by reference to the tax basis of the assets) of

[[Page 40]]

the newly formed partnership, S corporation, or personal service 
corporation are attributable to the tax basis with respect to its 
ownership interests in the deferral entities, the deferral entities will 
be considered de minimis and will be disregarded for purposes of 
paragraph (b)(1)(i) of this section.
    (3) Upstream de minimis rule. If a partnership, S corporation, or 
personal service corporation is directly owned by one or more deferral 
entities as of the date specified in paragraph (d) of this section, such 
ownership is disregarded for purposes of paragraph (b)(1)(ii) of this 
section if on the date specified in paragraph (d) of this section the 
deferral entities directly own, in the aggregate, 5 percent or less of--
    (i) An interest in the current profits of the partnership, or
    (ii) The stock (measured by value) of the S corporation or personal 
service corporation.

See examples (6) and (7) in paragraph (f) of this section.
    (d) Date for determining the existence of a tiered structure--(1) 
General rule. For purposes of paragraph (a) of this section, a 
partnership, S corporation, or personal service corporation will be 
considered a member of a tiered structure for a particular taxable year 
if the partnership, S corporation, or personal service corporation is a 
member of a tiered structure on the last day of the required taxable 
year (as defined in section 444 (e) of the Code) ending within such 
year. If a particular taxable year does not include the last day of the 
required taxable year for such year, the partnership, S corporation, or 
personal service corporation will not be considered a member of a tiered 
structure for such year. The following examples illustrate the 
application of this paragraph (d)(1).

    Example (1). Assume that a newly formed partnership whose first 
taxable year begins November 1, 1988, desires to adopt a September 30 
taxable year by making a section 444 election. Furthermore, assume that 
for its taxable year beginning November 1, 1988, the partnership's 
required taxable year is December 31. If the partnership is a member of 
a tiered structure on December 31, 1988, it will not be eligible to make 
a section 444 election for a taxable year beginning November 1, 1988, 
and ending September 30, 1989.
    Example (2). Assume an S corporation that historically used a June 
30 taxable year desires to make a section 444 election to change to a 
year ending September 30 for its taxable year beginning July 1, 1987. If 
the S corporation can make the section 444 election, it will have a 
short taxable year beginning July 1, 1987, and ending September 30, 
1987. Given these facts, the short taxable year beginning July 1, 1987, 
does not include the last day of the S corporation's required taxable 
year for such year (i.e., December 31, 1987). Thus, pursuant to 
paragraph (d)(1) of this section, the S corporation will not be 
considered a member of a tiered structure for its taxable year beginning 
July 1, 1987, and ending September 30, 1987.

    (2) Special rule for taxable years beginning in 1987. For purposes 
of paragraph (a) of this section, a partnership, S corporation, or 
personal service corporation will not be considered a member of a tiered 
structure for a taxable year beginning in 1987 if the partnership, S 
corporation, or personal service corporation is not a member of a tiered 
structure on the day the partnership, S corporation, or personal service 
corporation timely files its section 444 election for such year. The 
following examples illustrate the application of this paragraph (d)(2).

    Example (1). Assume that a partnership desires to retain a June 30 
taxable year by making a section 444 election for its taxable year 
beginning July 1, 1987. Furthermore, assume that the partnership's 
required taxable year for such year is December 31 and that the 
partnership was a member of a tiered structure on such date. Also assume 
that the partnership was not a member of a tiered structure as of the 
date it timely filed its section 444 election for its taxable year 
beginning July 1, 1987. Based upon the special rule provided in this 
paragraph (d)(2), the partnership will not be considered a member of a 
tiered structure for its taxable year beginning July 1, 1987.
    Example (2). Assume the same facts as in example (1), except that 
the partnership was a member of a tiered structure on the date it filed 
its section 444 election for its taxable year beginning July 1, 1987, 
but was not a member of a tiered structure on December 31, 1987. 
Paragraph (d)(1) of this section would still apply and thus the 
partnership would not be considered part of a tiered structure for its 
taxable year beginning July 1, 1987. However, the partnership would be 
considered a member of a tiered structure for its taxable year beginning 
July 1, 1988, if the partnership was a member of a tiered structure on 
December 31, 1988.


[[Page 41]]


    (e) Same taxable year exception--(1) In general. Although a 
partnership or S corporation is a member of a tiered structure as of the 
date specified in paragraph (d) of this section, the partnership, S 
corporation may make or continue a section 444 election if the tiered 
structure (as defined in paragraph (e)(2) of this section) consists 
entirely of partnerships or S corporations (or both), all of which have 
the same taxable year as determined under paragraph (e)(3) of this 
section. However, see paragraph (e)(5) of this section for the 
interaction of the de minimis rules provided in paragraph (c) of this 
section with the same taxable year exception. For purposes of this 
paragraph (e), two or more entities are considered to have the same 
taxable year if their taxable years end on the same day, even though 
they begin on different days. See examples (8) through (14) in paragraph 
(f) of this section.
    (2) Definition of tiered structure--(i) General rule. For purposes 
of the same taxable year exception, the members of a tiered structure 
are defined to include the following entities--
    (A) The partnership or S corporation that desires to qualify for the 
same taxable year exception,
    (B) A deferral entity (or entities) directly owned (in whole or in 
part) by the partnership or S corporation that desires to qualify for 
the same taxable year exception,
    (C) A deferral entity (or entities) directly owning any portion of 
the partnership or S corporation that desires to qualify for the same 
taxable year exception, and
    (D) A deferral entity (or entities) directly owned (in whole or in 
part) by a ``downstream controlled partnership,'' as defined in 
paragraph (e)(2)(ii) of this section.
    (ii) Special flow-through rule for downstream controlled 
partnerships. If more than 50 percent of a partnership's profits and 
capital are owned by a partnership or S corporation that desires to 
qualify for the same taxable year exception, such owned partnership is 
considered a downstream controlled partnership for purposes of paragraph 
(e)(2)(i) of this section. Furthermore, if more than 50 percent of a 
partnership's profits and capital are owned by a downstream controlled 
partnership, such owned partnership is considered a downstream 
controlled partnership for purposes of paragraph (e)(2)(i) of this 
section.
    (3) Determining the taxable year of a partnership or S corporation. 
The taxable year of a partnership or S corporation to be taken into 
account for purposes of paragraph (e)(1) of this section is the taxable 
year ending with or prior to the date specified in paragraph (d) of this 
section. Furthermore, the determination of such taxable year will take 
into consideration any section 444 elections made by the partnership or 
S corporation. See examples (10) and (11) in paragraph (f) of this 
section.
    (4) Special rule for 52-53-week taxable years. For purposes of this 
paragraph (e), a 52-53-week taxable year with reference to the end of a 
particular month will be considered to be the same as a taxable year 
ending with reference to the last day of such month.
    (5) Interaction with de minimis rules--(i) Downstream de minimis 
rule--(A) In general. If a partnership or S corporation that desires to 
make or continue a section 444 election is a member of a tiered 
structure (as defined in paragraph (e)(2) of this section) and directly 
owns any member (or members) of the tiered structure with a taxable year 
different from the taxable year of the partnership or S corporation, 
such ownership is disregarded for purposes of the same taxable year 
exception of paragraph (e)(1) of this section provided that, in the 
aggregate, the de minimis rule of paragraph (c)(2) of this section is 
satisfied with respect to such owned member (or members). The following 
example illustrates the application of this paragraph (e)(5)(i)(A).

    Example. P, a partnership with a June 30 taxable year, owns 60 
percent of P1, another partnership with a June 30 taxable year. P also 
owns 1 percent of P2 and P3, calendar year partnerships. If, in the 
aggregate, P's ownership interests in P2 and P3 are considered de 
minimis under paragraph (c)(2) of this section, P meets the same taxable 
year exception and may make a section 444 election to retain its June 30 
taxable year.

    (B) Special rule for members of a tiered structure directly owned by 
a downstream controlled partnership. For purposes of paragraph 
(e)(5)(i)(A) of this section, a

[[Page 42]]

partnership or S corporation desiring to make or continue a section 444 
election is considered to directly own any member of the tiered 
structure (as defined in paragraph (e)(2) of this section) directly 
owned by a downstream controlled partnership (as defined in paragraph 
(e)(2)(ii) of this section). The adjusted taxable income or gross income 
of the partnership or S corporation that is attributable to a member of 
a tiered structure directly owned by a downstream controlled partnership 
equals the adjusted taxable income or gross income of such member 
multiplied by the partnership's or S corporation's indirect ownership 
percentage of such member. The following example illustrates the 
application of this paragraph (e)(5)(i)(B).

    Example. P, a partnership, desires to retain its June 30 taxable 
year by making a section 444 election. However, as of the date specified 
in paragraph (d) of this section, P owns 75 percent of P1, a June 30 
partnership, and P1 owns 40 percent of P2, a calendar year partnership. 
P also owns 25 percent of P3, a calendar year partnership. Pursuant to 
paragraphs (e)(5)(i) (A) and (B) of this section, P may only qualify to 
use the same taxable year exception if, in the aggregate, P2 and P3 are 
de minimis with respect to P. Pursuant to paragraph (e)(5)(i)(B) of this 
section, P's adjusted taxable income or gross income attributable to P2 
equals 30 percent (75 percent times 40 percent) of P2's adjusted taxable 
income or gross income.

    (ii) Upstream de minimis rule. If a partnership or S corporation 
that desires to make or continue a section 444 election is a member of a 
tiered structure (as defined in paragraph (e)(2) of this section) and is 
owned directly by a member (or members) of the tiered structure with 
taxable years different from the taxable year of the partnership or S 
corporation, such ownership is disregarded for purposes of the same 
taxable year exception of paragraph (e)(1) of this section provided 
that, in the aggregate, the de minimis rule of paragraph (c)(3) of this 
section is satisfied with respect to such owning member (or members). 
See example (12) of paragraph (f) of this section.
    (f) Examples. The provisions of this section may be illustrated by 
the following examples.

    Example (1). A, a partnership, desires to make or continue a section 
444 election. However, on the date specified in paragraph (d) of this 
section, A is owned by a combination of individuals and S corporations. 
The S corporations are deferral entities, as defined in paragraph (b)(2) 
of this section. Thus, pursuant to paragraph (b)(1)(ii) of this section, 
A will be a member of a tiered structure unless under paragraph (c)(3) 
of this section, the S corporations, in the aggregate, own a de minimis 
portion of A. If the S corporations' ownership in A is not considered de 
minimis under paragraph (c)(3) of this section, A is a member of a 
tiered structure and will be allowed to make or continue a section 444 
election only if it meets the same taxable year exception provided in 
paragraph (e) of this section.
    Example (2). B, a partnership, desires to make or continue a section 
444 election. However, on the date specified in paragraph (d) of this 
section, B is a partner in two partnerships, B1 and B2. B1 and B2 are 
deferral entities, as defined in paragraph (b)(2) of this section. Thus, 
under paragraph (b)(1)(i) of this section, B will be a member of a 
tiered structure unless B's aggregate ownership interests in B1 and B2 
are considered de minimis under paragraph (c)(2) of this section. If B 
is a member of a tiered structure on the date specified in paragraph (d) 
of this section, B will be allowed to make or continue a section 444 
election only if it meets the same taxable year exception provided in 
paragraph (e) of this section.
    Example (3). C, a partnership with a September 30 taxable year, is 
100 percent owned by calendar year individuals. C desires to make a 
section 444 election for its taxable year beginning October 1, 1987. 
However, on the date specified in paragraph (d) of this section, C owns 
a 1 percent interest in C1, a partnership. C does not own any other 
interest in a deferral entity. For the taxable year ended September 30, 
1987, 10 percent of C's adjusted taxable income (as defined in paragraph 
(c)(2)(iii) of this section) was attributable to C's partnership 
interest in C1. Furthermore, 4 percent of C's gross income for the 
taxable year ended September 30, 1987, was attributable to C's 
partnership interest in C1. Under paragraph (c)(2) of this section, C's 
partnership interest in C1 is not de minimis because during the testing 
period more than 5 percent of C's adjusted taxable income is 
attributable to C1 and more than 2 percent of C's gross income is 
attributable to C1. Thus, C is a member of a tiered structure for its 
taxable year beginning October 1, 1987.
    Example (4). The facts are the same as example (3), except that for 
the taxable year ended September 30, 1987, only 2 percent of C's 
adjusted taxable income was attributable to C1. Under paragraph (c)(2) 
of this section, C's partnership interest in C1 is considered de minimis 
for purposes of determining whether C is a member of a tiered structure

[[Page 43]]

because not more than 5 percent of C's adjusted taxable income during 
the testing period is attributable to C1. Thus, C is not a member of a 
tiered structure for its taxable year beginning October 1, 1987.
    Example (5). The facts are the same as example (4), except that in 
addition to owning C1, C also owns 15 percent of C2, another 
partnership. For the taxable year ended September 30, 1987, 2 percent of 
C's adjusted taxable income is attributable to C1 and an additional 4 
percent is attributable to C2. Furthermore, for the taxable year ended 
September 30, 1987, 4 percent of C's gross income is attributable to C1 
while 3 percent is attributable to C2. Under paragraph (c)(2) of this 
section, C1 and C2 must be aggregated for purposes of determining 
whether C meets either the 5 percent adjusted taxable income test or the 
2 percent gross income test. Since C's adjusted taxable income 
attributable to C1 and C2 is 6 percent (2 percent + 4 percent) and C's 
gross income attributable to C1 and C2 is 7 percent (4 percent + 3 
percent), C does not meet the downstream de minimis rule provided in 
paragraph (c)(2) of this section. Thus, C is a member of a tiered 
structure for its taxable year beginning October 1, 1987.
    Example (6). The facts are the same as example (3), except that 
instead of determining whether C is part of a tiered structure, the 
issue is whether C1 is part of a tiered structure. In addition, assume 
that on the date specified in paragraph (d) of this section, the 
remaining 99 percent of C1 is owned by calendar year individuals and C1 
does not own an interest in any deferral entity. Although C in Example 
(3) was considered to be a part of a tiered structure by virtue of its 
ownership interest in C1, C1 must be tested separately to determine 
whether it is part of a tiered structure. Since C's interest in C1 is 5 
percent or less, C's interest in C1 is de minimis with respect to C1. 
See paragraph (c)(3) of this section. Thus, based upon these facts, C1 
is not part of a tiered structure.
    Example (7). The facts are the same as example (6), except that the 
remaining 99 percent of C1 is owned 94 percent by calendar year 
individuals and 5 percent by C3, another partnership. Thus, deferral 
entities own 6 percent of C1 (1 percent owned by C and 5 percent owned 
by C3). Under paragraph (c)(3) of this section, deferral entities own 
more than a de minimis interest (i.e., 5 percent) of C1, and thus C1 is 
part of a tiered structure.
    Example (8). D, a partnership with a September 30 taxable year, 
desires to make a section 444 election for its taxable year beginning 
October 1, 1987. On December 31, 1987, and the date D plans to file its 
section 444 election, D is 10 percent owned by D1, a personal service 
corporation with a September 30 taxable year, and 90 percent owned by 
calendar year individuals. Furthermore, D1 will retain its September 30 
taxable year because it previously established a business purpose for 
such year. Since D is owned in part by D1, a personal service 
corporation, and the ownership interest is not de minimis under 
paragraph (c)(3) of this section, D is considered a member of a tiered 
structure for its taxable year beginning October 1, 1987. Furthermore, 
although D and D1 have the same taxable year, D does not qualify for the 
same taxable year exception provided in paragraph (e) of this section 
because D1 is a personal service corporation rather than a partnership 
or S corporation. Thus, pursuant to paragraph (a) of this section, D may 
not make a section 444 election for its taxable year beginning October 
1, 1987.
    Example (9). The facts are the same as example (8), except that D1 
is a partnership rather than a personal service corporation. Based upon 
these facts, D qualifies for the same taxable year exception provided in 
paragraph (e) of this section. Thus, D may make a section 444 election 
for its taxable year beginning October 1, 1987.
    Example (10). The facts are the same as example (9), except that D1 
has not established a business purpose for a September 30 taxable year. 
In addition, D1 does not desire to make a section 444 election and, 
under section 706(b), D1 will be required to change to a calendar year 
for its taxable year beginning October 1, 1987. Pursuant to paragraph 
(e)(3) of this section, D and D1 do not have the same taxable year for 
purposes of the same taxable year exception provided in paragraph (e) of 
this section. Thus, D may not make a section 444 election for its 
taxable year beginning October 1, 1987.
    Example (11). The facts are the same as example (8), except that D1 
is a partnership with a March 31 taxable year. Furthermore, for its 
taxable year beginning April 1, 1987, D1 will change to a September 30 
taxable year by making a section 444 election. Pursuant to paragraph 
(e)(3) of this section, D1 is considered to have a September 30 taxable 
year for purposes of determining whether D qualifies for the same 
taxable year exception provided in paragraph (e) of this section. Since 
both D and D1 will have the same taxable year as of the date specified 
in paragraph (d) of this section, D may make a section 444 election for 
its taxable year beginning October 1, 1987.
    Example (12). The facts are the same as example (11), except that 
instead of the remaining 90 percent of D being owned by calendar year 
individuals, it is owned 86 percent by individuals and 4 percent by D2, 
a calendar year partnership. Thus, D, a September 30 partnership, is 10 
percent owned by D1, a September 30 partnership, 86 percent owned by 
calendar year individuals, and 4 percent owned by D2, a calendar year 
partnership. Under paragraph (e)(5)(ii) of this section, D2's ownership 
interest in D is considered de minimis for purposes of the same taxable 
year exception. Since D2's ownership

[[Page 44]]

interest in D is considered de minimis, it is disregarded for purposes 
of determining whether D qualifies for the same taxable year exception 
provided in paragraph (e) of this section. Thus, since both D and D1 
will have the same taxable year as of the date specified in paragraph 
(d) of this section, D may make a section 444 election for its taxable 
year beginning October 1, 1987.
    Example (13). E, a partnership with a June 30 taxable year, desires 
to make a section 444 election for its taxable year beginning July 1, 
1987. On the date specified in paragraph (d) of this section, E is 100 
percent owned by calendar year individuals; E owns 99 percent of the 
profits and capital of E1, a partnership with a June 30 taxable year; 
and E1 owns 30 percent of the profits and capital of E2, a partnership 
with a September 30 taxable year. E owns no other deferral entities. 
Pursuant to paragraph (b)(1)(i) of this section, E is considered to be a 
member of a tiered structure. Furthermore, pursuant to paragraph (e) of 
this section, E does not qualify for the same taxable year exception 
because E2 does not have the same taxable year as E and E1.
    Example (14). The facts are the same as example (13), except that E 
owns only 49 percent (rather than 99 percent) of the profits and capital 
of E1. Pursuant to paragraph (e) of this section, E qualifies for the 
same taxable year exception because E and E1 have the same taxable year. 
Pursuant to paragraph (e) of this section, E1's ownership interest in E2 
is disregarded since E does not own more than 50 percent of E1's profits 
and capital.
    Example (15). Prior to consideration of the anti-abuse rule provided 
in paragraph (b)(3) of this section, H, a partnership that commenced 
operations on October 1, 1987, is eligible to make a section 444 
election for its taxable year beginning October 1, 1987. Although H may 
obtain a significant deferral of income substantially all of which is 
not eliminated by a required payment under section 7519 (since there 
will be no required payment for H's first taxable year), the anti-abuse 
rule of paragraph (b)(3) will not apply unless the principal purpose of 
organizing H was the attainment of a significant deferral of income that 
would result from making a section 444 election.
    Example (16). F, a partnership with a January 31 taxable year, 
desires to make a section 444 election to retain its January 31 taxable 
year for the taxable year beginning February 1, 1987. F is 100 percent 
owned by calendar year individuals. Prior to the date specified in 
paragraph (d) of this section, F contributes substantially all of its 
assets to F1, a partnership, in exchange for a 51 percent interest in 
F1. The remaining 49 percent of F1 is owned by the calendar year 
individuals owning 100 percent of F. If F is allowed to make a section 
444 election to retain its January 31 taxable year, F1's required 
taxable year will be January 31 since a majority of F1's partners use a 
January 31 taxable year (see Sec. 1.706-3T). F's principal purpose for 
creating F1 and contributing its assets to F1 is to obtain an 11-month 
deferral on 49 percent of the income previously earned by F and now 
earned by F1. Pursuant to paragraph (b)(3) of this section, F is not 
allowed to make a section 444 election for its taxable year beginning 
February 1, 1987.
    Example (17). The facts are the same as in example (16), except that 
F does not create F1 and contribute its assets to F1 until immediately 
after F makes its section 444 election for the taxable year beginning 
February 1, 1987. Thus, F is allowed to make a section 444 election for 
its taxable year beginning February 1, 1987. However, pursuant to 
paragraph (b)(3) of this section, F will have its section 444 election 
terminated for subsequent years unless the tax deferral inherent in the 
structure is eliminated (e.g., F1 is liquidated or the individual owners 
of F contribute their interests in F1 to F) prior to the date specified 
in paragraph (d) of this section for subsequent taxable years beginning 
on or after February 1, 1988.
    Example (18). The facts are the same as in example (16), except that 
F1 is 99 percent owned by F and none of the individual owners of F own 
any portion of F1. Furthermore, F obtained no tax benefit from creating 
and contributing assets to F1. Given these facts paragraph (b)(3) of 
this section does not apply and thus, F may make a section 444 election 
for its taxable year beginning February 1, 1987.
    Example (19). G, a partnership with an October 31 taxable year, 
desires to retain its October 31 taxable year for its taxable year 
beginning November 1, 1987. However, as of December 31, 1987, G owns a 
30 percent interest in G1, a calendar year partnership. G owns no other 
deferral entity, and G is 100 percent owned by calendar year 
individuals. Furthermore, G's interest in G1 does not meet the de 
minimis rule provided in paragraph (c)(3) of this section. Thus, in 
order to avoid being a tiered structure, G sells its interest in G1 to 
an unrelated third party prior to the date G timely makes it section 444 
election for its taxable year beginning November 1, 1987. Although the 
sale of G1 allows G to qualify to make a section 444 election, and 
therefore to obtain a significant tax benefit, such benefit is not 
unintended. Thus, paragraph (b)(3) of this section does not apply, and G 
may make a section 444 election for its taxable year beginning November 
1, 1987.


[[Page 45]]


    (g) Effective date. This section is effective for taxable years 
beginning after December 31, 1986.

[T.D. 8205, 53 FR 19698, May 27, 1988, as amended by T.D. 8996, 67 FR 
35012, May 17, 2002]



Sec. 1.444-3T  Manner and time of making section 444 election 
(temporary).

    (a) In general. A section 444 election shall be made in the manner 
and at the time provided in this section.
    (b) Manner and time of making election--(1) General rule. A section 
444 election shall be made by filing a properly prepared Form 8716, 
``Election to Have a Tax Year Other Than a Required Tax Year,'' with the 
Service Center indicated by the instructions to Form 8716. Except as 
provided in paragraphs (b) (2) and (4) of this section, Form 8716 must 
be filed by the earlier of--

    (i) The 15th day of the fifth month following the month that 
includes the first day of the taxable year for which the election will 
first be effective, or
    (ii) The due date (without regard to extensions) of the income tax 
return resulting from the section 444 election.

In addition, a copy of Form 8716 must be attached to Form 1065 or Form 
1120 series form, whichever is applicable, for the first taxable year 
for which the section 444 election is made. Form 8716 shall be signed by 
any person who is authorized to sign Form 1065 or Form 1120 series form, 
whichever is applicable. (See sections 6062 and 6063, relating to the 
signing of returns.) The provisions of this paragraph (b)(1) may be 
illustrated by the following examples.

    Example (1). A, a partnership that began operations on September 10, 
1988, is qualified to make a section 444 election to use a September 30 
taxable year for its taxable year beginning September 10, 1988. Pursuant 
to paragraph (b)(1) of this section, A must file Form 8716 by the 
earlier of the 15th day of the fifth month following the month that 
includes the first day of the taxable year for which the election will 
first be effective (i.e., February 15, 1989) or the due date (without 
regard to extensions) of the partnership's tax return for the period 
September 10, 1988 to September 30, 1988 (i.e., January 15, 1989). Thus, 
A must file Form 8716 by January 15, 1989.
    Example (2). The facts are the same as in example (1), except that A 
began operations on October 20, 1988. Based upon these facts, A must 
file Form 8716 by March 15, 1989, the 15th day of the fifth month 
following the month that includes the first day of the taxable year for 
which the election will first be effective.
    Example (3). B is a corporation that first becomes a personal 
service corporation for its taxable year beginning September 1, 1988. B 
qualifies to make a section 444 election to use a September 30 taxable 
year for its taxable year beginning September 1, 1988. Pursuant to this 
paragraph (b)(1), B must file Form 8716 by December 15, 1988, the due 
date of the income tax return for the short period September 1 to 
September 30, 1988.

    (2) Special extension of time for making an election. If, pursuant 
to paragraph (b)(1) of this section, the due date for filing Form 8716 
is prior to July 26, 1988, such date is extended to July 26, 1988. The 
provisions of this paragraph (b)(2) may be illustrated by the following 
examples.

    Example (1). B, a partnership that historically used a June 30 
taxable year, is qualified to make a section 444 election to retain a 
June 30 taxable year for its taxable year beginning July 1, 1987. Absent 
paragraph (b)(2) of this section, B would be required to file Form 8716 
by December 15, 1987. However, pursuant to paragraph (b)(2) of this 
section, B's due date for filing Form 8716 is extended to July 26, 1988.
    Example (2). C, a partnership that began operations on January 20, 
1988, is qualified to make a section 444 election to use a year ending 
September 30 for its taxable year beginning January 20, 1988. Absent 
paragraph (b)(2) of this section, C is required to file Form 8716 by 
June 15, 1988 (the 15th day of the fifth month following the month that 
includes the first day of the taxable year for which the election will 
first be effective). However, pursuant to paragraph (b)(2) of this 
section, the due date for filing Form 8716 is July 26, 1988.

    (3) Corporation electing to be an S corporation--(i) In general. A 
corporation electing to be an S corporation is subject to the same time 
and manner rules for filing Form 8716 as any other taxpayer making a 
section 444 election. Thus, a corporation electing to be an S 
corporation that desires to make a section 444 election is not required 
to file Form 8716 with its Form 2553, ``Election by a Small Business 
Corporation.'' However, a corporation electing to be an S corporation 
after September 26, 1988, is required to state on Form 2553 its 
intention to--


[[Page 46]]


    (A) Make a section 444 election, if qualified, or
    (B) Make a ``back-up section 444 election'' as described in 
paragraph (b)(4) of this section.

If a corporation electing to be an S corporation fails to state either 
of the above intentions, the District Director may, at his discretion, 
disregard any section 444 election for such taxpayer.
    (ii) Examples. The provisions of this paragraph (b)(3) may be 
illustrated by the following examples.

    Example (1). D is a corporation that commences operations on October 
1, 1988, and elects to be an S corporation for its taxable year 
beginning October 1, 1988. All of D's shareholders use the calendar year 
as their taxable year. D desires to adopt a September 30 taxable year. D 
does not believe it has a business purpose for a September 30 taxable 
year and thus it must make a section 444 election to use such year. 
Based on these facts, D must, pursuant to the instructions to Form 2553, 
state on Form 2553 that, if qualified, it will make a section 444 
election to adopt a year ending September 30 for its taxable year 
beginning October 1, 1988. If D is qualified (i.e., D is not a member of 
a tiered structure on December 31, 1988) to make a section 444 election 
for its taxable year beginning October 1, 1988, D must file Form 8716 by 
March 15, 1989. If D ultimately is not qualified to make a section 444 
election for its taxable year beginning October 1, 1988, D's election to 
be an S corporation will not be effective unless, pursuant to the 
instructions to Form 2553, D made a back-up calendar year election 
(i.e., an election to adopt the calendar year in the event D ultimately 
is not qualified to make a section 444 election for such year).
    Example (2). The facts are the same as in example (1), except that D 
believes it can establish, to the satisfaction of the Commissioner, a 
business purpose for adopting a September 30 taxable year. However, D 
desires to make a ``back-up section 444 election'' (see paragraph (b)(4) 
of this section) in the event that the Commissioner does not grant 
permission to adopt a September 30 taxable year based upon business 
purpose. Based on these facts, D must, pursuant to the instructions to 
Form 2553, state on Form 2553 its intention, if qualified, to make a 
back-up section 444 election to adopt a September 30 taxable year. If, 
by March 15, 1989, D has not received permission to adopt a September 30 
taxable year and D is qualified to make a section 444 election, D must 
make a back-up election in accordance with paragraph (b)(4) of this 
section.

    (4) Back-up section 444 election--(i) General rule. A taxpayer that 
has requested (or is planning to request) permission to use a particular 
taxable year based upon business purpose, may, if otherwise qualified, 
file a section 444 election (referred to as a ``back-up section 444 
election''). If the Commissioner subsequently denies the business 
purpose request, the taxpayer will, if otherwise qualified, be required 
to activate the back-up section 444 election. See examples (1) and (2) 
in paragraph (b)(4)(iv) of this section.
    (ii) Procedures for making a back-up section 444 election. In 
addition to following the general rules provided in this section, a 
taxpayer making a back-up section 444 election should, in order to allow 
the Service to process the affected returns in an efficient manner, type 
or legibly print the words ``BACK-UP ELECTION'' at the top of Form 8716, 
``Election to Have a Tax Year Other Than a Required Tax Year.'' However, 
if such Form 8716 is filed on or after the date a Form 1128, Application 
for Change in Accounting Period, is filed with respect to a period that 
begins on the same date, the words ``FORM 1128 BACK-UP ELECTION'' should 
be typed or legibly printed at the top of Form 8716.
    (iii) Procedures for activating a back-up section 444 election--(A) 
Partnerships and S corporations--(1) In general. A back-up section 444 
election made by a partnership or S corporation is activated by filing 
the return required in Sec. 1.7519-2T (a)(2)(i) and making the payment 
required in Sec. 1.7519-1T. The due date for filing such return and 
payment will be the later of--

    (i) The due dates provided in Sec. 1.7519-2T, or
    (ii) 60 days from the date the Commissioner denies the business 
purpose request.

However, interest will be assessed (at the rate provided in section 6621 
(a)(2)) on any required payment made after the due date (without regard 
to any extension for a back-up election) provided in Sec. 1.7519-2T 
(a)(4)(i) or (a)(4)(ii), whichever is applicable, for such payment. 
Interest will be calculated from such due date to the date such amount 
is actually paid. Interest assessed under this paragraph will be 
separate

[[Page 47]]

from any required payments. Thus, interest will not be subject to refund 
under Sec. 1.7519-2T.
    (2) Special rule if Form 720 used to satisfy return requirement. If, 
pursuant to Sec. 1.7519-2T (a)(3), a partnership or S corporation must 
use Form 720, ``Quarterly Federal Excise Tax Return,'' to satisfy the 
return requirement of Sec. 1.7519-2T (a)(2), then in addition to 
following the general rules provided in Sec. 1.7519-2T, the partnership 
or S corporation must type or legibly print the words ``ACTIVATING BACK-
UP ELECTION'' on the top of Form 720. A partnership or S corporation 
that would otherwise file a Form 720 on or before the date specified in 
paragraph (b)(4)(iii)(A)(1) of this section may satisfy the return 
requirement by including the necessary information on such Form 720. 
Alternatively, such partnership or S corporation may file an additional 
Form 720 (i.e., a Form 720 separate from the Form 720 it would otherwise 
file). Thus, for example, if the due date for activating an S 
corporation's back-up election is November 15, 1988, and the S 
corporation must file a Form 720 by October 31, 1988, to report 
manufacturers excise tax for the third quarter of 1988, the S 
corporation may use that Form 720 to activate its back-up election. 
Alternatively, the S corporation may file its regular Form 720 that is 
due October 31, 1988, and file an additional Form 720 by November 15, 
1988, activating its back-up election.
    (B) Personal service corporations. A back-up section 444 election 
made by a personal service corporation is activated by filing Form 8716 
with the personal service corporation's original or amended income tax 
return for the taxable year in which the election is first effective, 
and typing or legibly printing the words--``ACTIVATING BACK-UP 
ELECTION'' on the top of such income tax return.
    (iv) Examples. The provisions of this paragraph (b)(4) may be 
illustrated by the following examples. Also see example (2) in paragraph 
(b)(3) of this section.

    Example (1). E, a partnership that historically used a June 30 
taxable year, requested (pursuant to section 6 of Rev. Proc. 87-32, 
1987-28 I.R.B. 14) permission from the Commissioner to retain a June 30 
taxable year for its taxable year beginning July 1, 1987. Furthermore, E 
is qualified to make a section 444 election to retain a June 30 taxable 
year for its taxable year beginning July 1, 1987. However, as of the 
date specified in paragraph (b)(2) of this section, the Commissioner has 
not determined whether E has a valid business purpose for retaining its 
June 30 taxable year. Based on these facts, E may, by the date specified 
in paragraph (b)(2) of this section, make a back-up section 444 election 
to retain its June 30 taxable year.
    Example (2). The facts are the same as in example (1). In addition, 
on August 12, 1988, the Internal Revenue Service notifies E that its 
business purpose request is denied. E asks for reconsideration of the 
Service's decision, and the Service sustains the original denial on 
September 30, 1988. Based on these facts, E must activate its back-up 
section 444 election within 60 days after September 30, 1988.
    Example (3). The facts are the same as in example (1), except that E 
desires to make a section 444 election to use a year ending September 30 
for its taxable year beginning July 1, 1987. Although E qualifies to 
make a section 444 election to retain its June 30 taxable year, E may 
make a back-up section 444 election for a September 30 taxable year.

    (c) Administrative relief--(1) Extension of time to file income tax 
returns--(i) Automatic extension. If a partnership, S corporation, or 
personal service corporation makes a section 444 election (or does not 
make a section 444 election, either because it is ineligible or because 
it decides not to make the election, and therefore changes to its 
required taxable year) for its first taxable year beginning after 
December 31, 1986, the due date for filing its income tax return for 
such year shall be the later of--

    (A) The due date established under--

    (1) Section 6072, in the case of Form 1065,
    (2) Sec. 1.6037-1 (b), in the case of Form 1120S,
    (3) Section 6072 (b), in the case of other Form 1120 series form; or
    (B) August 15, 1988.

The words ``SECTION 444 RETURN'' should, in order to allow the Service 
to process the affected returns in an efficient manner, be typed or 
legibly printed at the top of the Form 1065 or Form 1120 series form, 
whichever is applicable, filed under this paragraph (c)(1)(i).
    (ii) Additional extensions. If the due date of the income tax return 
for the

[[Page 48]]

first taxable year beginning after December 31, 1986, extended as 
provided in paragraph (c)(1)(i)(B) of this section, occurs before the 
date that is 6 months after the date specified in paragraph (c)(1)(i)(A) 
of this section, the partnership, S corporation, or personal service 
corporation may request an additional extension or extensions of time 
(up to 6 months after the date specified in paragraph (c)(1)(i)(A) of 
this section) to file its income tax return for such first taxable year. 
The request must be made by the later of the date specified in paragraph 
(c)(1)(i)(A) or (c)(1)(i)(B) of this section and must be made on Form 
7004, ``Application for Automatic Extension of Time To File Corporation 
Income Tax Return'', or Form 2758, ``Application for Extension of Time 
to File U.S. Partnership, Fiduciary, and Certain Other Returns,'' 
whichever is applicable, in accordance with the form and its 
instructions. In addition, the following words should be typed or 
legibly printed at the top of the form--``SECTION 444 REQUEST FOR 
ADDITIONAL EXTENSION.''
    (iii) Examples. The provisions of paragraph (c)(1) of this section 
may be illustrated by the following examples.

    Example (1). G, a partnership that historically used a January 31 
taxable year, makes a section 444 election to retain such year for its 
taxable year beginning February 1, 1987. Absent paragraph (c)(1)(i) of 
this section, G's Form 1065 for the taxable year ending January 31, 
1988, is due on or before May 15, 1988. However, if G types or legibly 
prints ``SECTION 444 RETURN'' at the top of Form 1065 for such year, 
paragraph (c)(1)(i) of this section automatically extends the due date 
of such return to August 15, 1988.
    Example (2). The facts are the same as in example (1), except that G 
desires to extend the due date of its income tax return for the year 
ending January 31, 1988, to a date beyond August 15, 1988. Pursuant to 
paragraph (c)(1)(ii) of this section, G may extend such return to 
November 15, 1988 (i.e., the date that is up to 6 months after May 15, 
1988, the normal due date of the return). However, in order to obtain 
this additional extension, G must file Form 2758 pursuant to paragraph 
(c)(1)(i) of this section on or before August 15, 1988.
    Example (3). H, a partnership that historically used a May 31 
taxable year, makes a section 444 election to use a year ending 
September 30 for its taxable year beginning on June 1, 1987. Absent 
paragraph (c)(1)(i) of this section, H's Form 1065 for the taxable year 
beginning June 1, 1987, and ending September 30, 1987, is due on or 
before January 15, 1988. However, if H types or legibly prints ``SECTION 
444 RETURN'' at the top of Form 1065 for such year, paragraph (c)(1)(i) 
of this section automatically extends the due date of such return to 
August 15, 1988.
    Example (4). The facts are the same as in example (3), except H 
desires to further extend (i.e., extend beyond August 15, 1988) the due 
date of its income tax return for its taxable year beginning June 1, 
1987, and ending September 30, 1987. Since August 15, 1988, is 6 months 
or more after the due date (without extensions) of such return, 
paragraph (c)(1)(ii) of this section prevents H from further extending 
the time for filing such return.
    Example (5). I, a partnership that historically used a June 30 
taxable year, considered making a section 44 election to retain such 
taxable year, but eventually decided to change to a December 31, taxable 
year (I's required taxable year). Absent paragraph (c)(1)(i) of this 
section, I's Form 1065 for the taxable year beginning July 1, 1987, and 
ending December 31, 1987, is due on or before April 15, 1988. Pursuant 
to paragraph (c)(1)(i) of this section, if I types or legibly prints 
``SECTION 444 RETURN'' at the top of Form 1065 for such year, paragraph 
(c)(1)(i) of this section automatically extends the due date of such 
return to August 15, 1988. In addition, I may further extend such return 
pursuant to paragraph (c)(1)(ii) of this section.

    (2) No penalty for certain late payments--(i) In general. In the 
case of a personal service corporation or S corporation described in 
paragraph (c)(1)(i) of this section, no penalty under section 6651 
(a)(2) will be imposed for failure to pay income tax (if any) for the 
first taxable year beginning after December 31, 1986, but only for the 
period beginning with the last date for payment and ending with the 
later of the date specified in paragraph (c)(1)(i) or paragraph 
(c)(1)(ii) of this section.
    (ii) Example. The provisions of paragraph (c)(2)(i) of this section 
may be illustrated by the following example.

    Example. J, a personal service corporation that historically used a 
January 31 taxable year, makes a section 444 election to retain such 
year for its taxable year beginning February 1, 1987. The last date 
(without extension) for payment of J's income tax (if any) for its 
taxable year beginning February 1, 1987, is April 15, 1988. However, 
under paragraph (c)(2)(i) of this section, no penalty under section 
6651(a)(2) will be imposed on

[[Page 49]]

any underpayment of income tax for the period beginning April 15, 1988 
and ending August 15, 1988.

    (d) Effective date. This section is effective for taxable years 
beginning after December 31, 1986.

[T.D. 8205, 53 FR 19703, May 27, 1988]



Sec. 1.444-4  Tiered structure.

    (a) Electing small business trusts. For purposes of Sec. 1.444-2T, 
solely with respect to an S corporation shareholder, the term deferral 
entity does not include a trust that is treated as an electing small 
business trust under section 1361(e). An S corporation with an electing 
small business trust as a shareholder may make an election under section 
444. This paragraph is applicable to taxable years beginning on and 
after December 29, 2000; however, taxpayers may voluntarily apply it to 
taxable years of S corporations beginning after December 31, 1996.
    (b) Certain tax-exempt trusts. For purposes of Sec. 1.444-2T, 
solely with respect to an S corporation shareholder, the term deferral 
entity does not include a trust that is described in section 401(a) or 
501(c)(3), and is exempt from taxation under section 501(a). An S 
corporation with a trust as a shareholder that is described in section 
401(a) or section 501(c)(3), and is exempt from taxation under section 
501(a) may make an election under section 444. This paragraph is 
applicable to taxable years beginning on and after December 29, 2000; 
however taxpayers may voluntarily apply it to taxable years of S 
corporations beginning after December 31, 1997.
    (c) Certain terminations disregarded--(1) In general. An S 
corporation that is described in this paragraph (c)(1) may request that 
a termination of its election under section 444 be disregarded, and that 
the S corporation be permitted to resume use of the year it previously 
elected under section 444, by following the procedures of paragraph 
(c)(2) of this section. An S corporation is described in this paragraph 
if the S corporation is otherwise qualified to make a section 444 
election, and its previous election was terminated under Sec. 1.444-
2T(a) solely because--
    (i) In the case of a taxable year beginning after December 31, 1996, 
a trust that is treated as an electing small business trust became a 
shareholder of such S corporation; or
    (ii) In the case of a taxable year beginning after December 31, 
1997, a trust that is described in section 401(a) or 501(c)(3), and is 
exempt from taxation under section 501(a) became a shareholder of such S 
corporation.
    (2) Procedure--(i) In general. An S corporation described in 
paragraph (c)(1) of this section that wishes to make the request 
described in paragraph (c)(1) of this section must do so by filing Form 
8716, ``Election To Have a Tax Year Other Than a Required Tax Year,'' 
and typing or printing legibly at the top of such form--``CONTINUATION 
OF SECTION 444 ELECTION UNDER Sec. 1.444-4.'' In order to assist the 
Internal Revenue Service in updating the S corporation's account, on 
Line 5 the Box ``Changing to'' should be checked. Additionally, the 
election month indicated must be the last month of the S corporation's 
previously elected section 444 election year, and the effective year 
indicated must end in 2002.
    (ii) Time and place for filing Form 8716. Such form must be filed on 
or before October 15, 2002, with the service center where the S 
corporation's returns of tax (Forms 1120S) are filed. In addition, a 
copy of the Form 8716 should be attached to the S corporation's short 
period Federal income tax return for the first election year beginning 
on or after January 1, 2002.
    (3) Effect of request--(i) Taxable years beginning on or after 
January 1, 2002. An S corporation described in paragraph (c)(1) of this 
section that requests, in accordance with this paragraph, that a 
termination of its election under section 444 be disregarded will be 
permitted to resume use of the year it previously elected under section 
444, commencing with its first taxable year beginning on or after 
January 1, 2002. Such S corporation will be required to file a return 
under Sec. 1.7519-2T for each taxable year beginning on or after 
January 1, 2002. No payment under section 7519 will be due with respect 
to the first taxable year beginning on or after January 1, 2002. 
However, a required payment will be due on or before May 15, 2003, with 
respect to such S corporation's second continued section 444

[[Page 50]]

election year that begins in calendar year 2002.
    (ii) Taxable years beginning prior to January 1, 2002. An S 
corporation described in paragraph (c)(1) of this section that requests, 
in accordance with this paragraph, that a termination of its election 
under section 444 be disregarded will not be required to amend any prior 
Federal income tax returns, make any required payments under section 
7519, or file any returns under Sec. 1.7519-2T, with respect to taxable 
years beginning on or after the date the termination of its section 444 
election was effective and prior to January 1, 2002.
    (iii) Section 7519: required payments and returns. The Internal 
Revenue Service waives any requirement for an S corporation described in 
paragraph (c)(1) of this section to file the federal tax returns and 
make any required payments under section 7519 for years prior to the 
taxable year of continuation as described in paragraph (c)(3)(i) of this 
section, if for such years the S corporation filed its federal income 
tax returns on the basis of its required taxable year.

[T.D. 8994, 67 FR 34394, May 14, 2002]

                          Methods of Accounting

                    methods of accounting in general



Sec. 1.446-1  General rule for methods of accounting.

    (a) General rule. (1) Section 446(a) provides that taxable income 
shall be computed under the method of accounting on the basis of which a 
taxpayer regularly computes his income in keeping his books. The term 
``method of accounting'' includes not only the overall method of 
accounting of the taxpayer but also the accounting treatment of any 
item. Examples of such over-all methods are the cash receipts and 
disbursements method, an accrual method, combinations of such methods, 
and combinations of the foregoing with various methods provided for the 
accounting treatment of special items. These methods of accounting for 
special items include the accounting treatment prescribed for research 
and experimental expenditures, soil and water conservation expenditures, 
depreciation, net operating losses, etc. Except for deviations permitted 
or required by such special accounting treatment, taxable income shall 
be computed under the method of accounting on the basis of which the 
taxpayer regularly computes his income in keeping his books. For 
requirement respecting the adoption or change of accounting method, see 
section 446(e) and paragraph (e) of this section.
    (2) It is recognized that no uniform method of accounting can be 
prescribed for all taxpayers. Each taxpayer shall adopt such forms and 
systems as are, in his judgment, best suited to his needs. However, no 
method of accounting is acceptable unless, in the opinion of the 
Commissioner, it clearly reflects income. A method of accounting which 
reflects the consistent application of generally accepted accounting 
principles in a particular trade or business in accordance with accepted 
conditions or practices in that trade or business will ordinarily be 
regarded as clearly reflecting income, provided all items of gross 
income and expense are treated consistently from year to year.
    (3) Items of gross income and expenditures which are elements in the 
computation of taxable income need not be in the form of cash. It is 
sufficient that such items can be valued in terms of money. For general 
rules relating to the taxable year for inclusion of income and for 
taking deductions, see sections 451 and 461, and the regulations 
thereunder.
    (4) Each taxpayer is required to make a return of his taxable income 
for each taxable year and must maintain such accounting records as will 
enable him to file a correct return. See section 6001 and the 
regulations thereunder. Accounting records include the taxpayer's 
regular books of account and such other records and data as may be 
necessary to support the entries on his books of account and on his 
return, as for example, a reconciliation of any differences between such 
books and his return. The following are among the essential features 
that must be considered in maintaining such records:
    (i) In all cases in which the production, purchase, or sale of 
merchandise of any kind is an income-producing factor, merchandise on 
hand (including

[[Page 51]]

finished goods, work in process, raw materials, and supplies) at the 
beginning and end of the year shall be taken into account in computing 
the taxable income of the year. (For rules relating to computation of 
inventories, see section 263A, 471, and 472 and the regulations 
thereunder.)
    (ii) Expenditures made during the year shall be properly classified 
as between capital and expense. For example, expenditures for such items 
as plant and equipment, which have a useful life extending substantially 
beyond the taxable year, shall be charged to a capital account and not 
to an expense account.
    (iii) In any case in which there is allowable with respect to an 
asset a deduction for depreciation, amortization, or depletion, any 
expenditures (other than ordinary repairs) made to restore the asset or 
prolong its useful life shall be added to the asset account or charged 
against the appropriate reserve.
    (b) Exceptions. (1) If the taxpayer does not regularly employ a 
method of accounting which clearly reflects his income, the computation 
of taxable income shall be made in a manner which, in the opinion of the 
Commissioner, does clearly reflect income.
    (2) A taxpayer whose sole source of income is wages need not keep 
formal books in order to have an accounting method. Tax returns, copies 
thereof, or other records may be sufficient to establish the use of the 
method of accounting used in the preparation of the taxpayer's income 
tax returns.
    (c) Permissible methods--(1) In general. Subject to the provisions 
of paragraphs (a) and (b) of this section, a taxpayer may compute his 
taxable income under any of the following methods of accounting:
    (i) Cash receipts and disbursements method. Generally, under the 
cash receipts and disbursements method in the computation of taxable 
income, all items which constitute gross income (whether in the form of 
cash, property, or services) are to be included for the taxable year in 
which actually or constructively received. Expenditures are to be 
deducted for the taxable year in which actually made. For rules relating 
to constructive receipt, see Sec. 1.451-2. For treatment of an 
expenditure attributable to more than one taxable year, see section 
461(a) and paragraph (a)(1) of Sec. 1.461-1.
    (ii) Accrual method. (A) Generally, under an accrual method, income 
is to be included for the taxable year when all the events have occurred 
that fix the right to receive the income and the amount of the income 
can be determined with reasonable accuracy. Under such a method, a 
liability is incurred, and generally is taken into account for Federal 
income tax purposes, in the taxable year in which all the events have 
occurred that establish the fact of the liability, the amount of the 
liability can be determined with reasonable accuracy, and economic 
performance has occurred with respect to the liability. (See paragraph 
(a)(2)(iii)(A) of Sec. 1.461-1 for examples of liabilities that may not 
be taken into account until after the taxable year incurred, and see 
Sec. Sec. 1.461-4 through 1.461-6 for rules relating to economic 
performance.) Applicable provisions of the Code, the Income Tax 
Regulations, and other guidance published by the Secretary prescribe the 
manner in which a liability that has been incurred is taken into 
account. For example, section 162 provides that a deductible liability 
generally is taken into account in the taxable year incurred through a 
deduction from gross income. As a further example, under section 263 or 
263A, a liability that relates to the creation of an asset having a 
useful life extending substantially beyond the close of the taxable year 
is taken into account in the taxable year incurred through 
capitalization (within the meaning of Sec. 1.263A-1(c)(3)) and may 
later affect the computation of taxable income through depreciation or 
otherwise over a period including subsequent taxable years, in 
accordance with applicable Internal Revenue Code sections and related 
guidance.
    (B) The term ``liability'' includes any item allowable as a 
deduction, cost, or expense for Federal income tax purposes. In addition 
to allowable deductions, the term includes any amount otherwise 
allowable as a capitalized cost, as a cost taken into account in 
computing cost of goods sold, as a cost allocable to a long-term 
contract, or as

[[Page 52]]

any other cost or expense. Thus, for example, an amount that a taxpayer 
expends or will expend for capital improvements to property must be 
incurred before the taxpayer may take the amount into account in 
computing its basis in the property. The term ``liability'' is not 
limited to items for which a legal obligation to pay exists at the time 
of payment. Thus, for example, amounts prepaid for goods or services and 
amounts paid without a legal obligation to do so may not be taken into 
account by an accrual basis taxpayer any earlier than the taxable year 
in which those amounts are incurred.
    (C) No method of accounting is acceptable unless, in the opinion of 
the Commissioner, it clearly reflects income. The method used by the 
taxpayer in determining when income is to be accounted for will 
generally be acceptable if it accords with generally accepted accounting 
principles, is consistently used by the taxpayer from year to year, and 
is consistent with the Income Tax Regulations. For example, a taxpayer 
engaged in a manufacturing business may account for sales of the 
taxpayer's product when the goods are shipped, when the product is 
delivered or accepted, or when title to the goods passes to the 
customers, whether or not billed, depending on the method regularly 
employed in keeping the taxpayer's books.
    (iii) Other permissible methods. Special methods of accounting are 
described elsewhere in chapter 1 of the Code and the regulations 
thereunder. For example, see the following sections and the regulations 
thereunder: Sections 61 and 162, relating to the crop method of 
accounting; section 453, relating to the installment method; section 
460, relating to the long-term contract methods. In addition, special 
methods of accounting for particular items of income and expense are 
provided under other sections of chapter 1. For example, see section 
174, relating to research and experimental expenditures, and section 
175, relating to soil and water conservation expenditures.
    (iv) Combinations of the foregoing methods. (a) In accordance with 
the following rules, any combination of the foregoing methods of 
accounting will be permitted in connection with a trade or business if 
such combination clearly reflects income and is consistently used. Where 
a combination of methods of accounting includes any special methods, 
such as those referred to in subdivision (iii) of this subparagraph, the 
taxpayer must comply with the requirements relating to such special 
methods. A taxpayer using an accrual method of accounting with respect 
to purchases and sales may use the cash method in computing all other 
items of income and expense. However, a taxpayer who uses the cash 
method of accounting in computing gross income from his trade or 
business shall use the cash method in computing expenses of such trade 
or business. Similarly, a taxpayer who uses an accrual method of 
accounting in computing business expenses shall use an accrual method in 
computing items affecting gross income from his trade or business.
    (b) A taxpayer using one method of accounting in computing items of 
income and deductions of his trade or business may compute other items 
of income and deductions not connected with his trade or business under 
a different method of accounting.
    (2) Special rules. (i) In any case in which it is necessary to use 
an inventory the accrual method of accounting must be used with regard 
to purchases and sales unless otherwise authorized under subdivision 
(ii) of this subparagraph.
    (ii) No method of accounting will be regarded as clearly reflecting 
income unless all items of gross profit and deductions are treated with 
consistency from year to year. The Commissioner may authorize a taxpayer 
to adopt or change to a method of accounting permitted by this chapter 
although the method is not specifically described in the regulations in 
this part if, in the opinion of the Commissioner, income is clearly 
reflected by the use of such method. Further, the Commissioner may 
authorize a taxpayer to continue the use of a method of accounting 
consistently used by the taxpayer, even though not specifically 
authorized by the regulations in this part, if, in the opinion of the 
Commissioner, income is clearly reflected by the use of such

[[Page 53]]

method. See section 446(a) and paragraph (a) of this section, which 
require that taxable income shall be computed under the method of 
accounting on the basis of which the taxpayer regularly computes his 
income in keeping his books, and section 446(e) and paragraph (e) of 
this section, which require the prior approval of the Commissioner in 
the case of changes in accounting method.
    (iii) The timing rules of Sec. 1.1502-13 are a method of accounting 
for intercompany transactions (as defined in Sec. 1.1502-13(b)(1)(i)), 
to be applied by each member of a consolidated group in addition to the 
member's other methods of accounting. See Sec. 1.1502-13(a)(3)(i). This 
paragraph (c)(2)(iii) is applicable to consolidated return years 
beginning on or after November 7, 2001.
    (d) Taxpayer engaged in more than one business. (1) Where a taxpayer 
has two or more separate and distinct trades or businesses, a different 
method of accounting may be used for each trade or business, provided 
the method used for each trade or business clearly reflects the income 
of that particular trade or business. For example, a taxpayer may 
account for the operations of a personal service business on the cash 
receipts and disbursements method and of a manufacturing business on an 
accrual method, provided such businesses are separate and distinct and 
the methods used for each clearly reflect income. The method first used 
in accounting for business income and deductions in connection with each 
trade or business, as evidenced in the taxpayer's income tax return in 
which such income or deductions are first reported, must be consistently 
followed thereafter.
    (2) No trade or business will be considered separate and distinct 
for purposes of this paragraph unless a complete and separable set of 
books and records is kept for such trade or business.
    (3) If, by reason of maintaining different methods of accounting, 
there is a creation or shifting of profits or losses between the trades 
or businesses of the taxpayer (for example, through inventory 
adjustments, sales, purchases, or expenses) so that income of the 
taxpayer is not clearly reflected, the trades or businesses of the 
taxpayer will not be considered to be separate and distinct.
    (e) Requirement respecting the adoption or change of accounting 
method. (1) A taxpayer filing his first return may adopt any permissible 
method of accounting in computing taxable income for the taxable year 
covered by such return. See section 446(c) and paragraph (c) of this 
section for permissible methods. Moreover, a taxpayer may adopt any 
permissible method of accounting in connection with each separate and 
distinct trade or business, the income from which is reported for the 
first time. See section 446(d) and paragraph (d) of this section. See 
also section 446(a) and paragraph (a) of this section.
    (2)(i) Except as otherwise expressly provided in chapter 1 of the 
Code and the regulations thereunder, a taxpayer who changes the method 
of accounting employed in keeping his books shall, before computing his 
income upon such new method for purposes of taxation, secure the consent 
of the Commissioner. Consent must be secured whether or not such method 
is proper or is permitted under the Internal Revenue Code or the 
regulations thereunder.
    (ii) (a) [Reserved]. For further guidance, see Sec. 1.446-
1T(e)(2)(ii)(a).
    (b) [Reserved]. For further guidance, see Sec. 1.446-
1T(e)(2)(ii)(b).
    (c) A change in an overall plan or system of identifying or valuing 
items in inventory is a change in method of accounting. Also a change in 
the treatment of any material item used in the overall plan for 
identifying or valuing items in inventory is a change in method of 
accounting.
    (d) Changes involving depreciable or amortizable assets. [Reserved]. 
For further guidance, see Sec. 1.446-1T(e)(2)(ii)(d).
    (iii) Examples. [Reserved]. For further guidance, see Sec. 1.446-
1T(e)(2)(iii).
    (3)(i) Except as otherwise provided under the authority of paragraph 
(e)(3)(ii) of this section, to secure the Commissioner's consent to a 
taxpayer's change in method of accounting the taxpayer must file an 
application on Form 3115 with the Commissioner during the taxable year 
in which the taxpayer desires to make the change in method of 
accounting. To the extent applicable, the taxpayer must furnish

[[Page 54]]

all information requested on the Form 3115. This information includes 
all classes of items that will be treated differently under the new 
method of accounting, any amounts that will be duplicated or omitted as 
a result of the proposed change, and the taxpayer's computation of any 
adjustments necessary to prevent such duplications or omissions. The 
Commissioner may require such other information as may be necessary to 
determine whether the proposed change will be permitted. Permission to 
change a taxpayer's method of accounting will not be granted unless the 
taxpayer agrees to the Commissioner's prescribed terms and conditions 
for effecting the change, including the taxable year or years in which 
any adjustment necessary to prevent amounts from being duplicated or 
omitted is to be taken into account. See section 481 and the regulations 
thereunder, relating to certain adjustments resulting from accounting 
method changes, and section 472 and the regulations thereunder, relating 
to adjustments for changes to and from the last-in, first-out inventory 
method. For any Form 3115 filed on or after May 15, 1997, see Sec. 
1.446-1T(e)(3)(i)(B).
    (ii) Notwithstanding the provisions of paragraph (e)(3)(i) of this 
section, the Commissioner may prescribe administrative procedures under 
which taxpayers will be permitted to change their method of accounting. 
The administrative procedures shall prescribe those terms and conditions 
necessary to obtain the Commissioner's consent to effect the change and 
to prevent amounts from being duplicated or omitted. The terms and 
conditions that may be prescribed by the Commissioner may include terms 
and conditions that require the change in method of accounting to be 
effected on a cut-off basis or by an adjustment under section 481(a) to 
be taken into account in the taxable year or years prescribed by the 
Commissioner.
    (iii) This paragraph (e)(3) applies to Forms 3115 filed on or after 
December 31, 1997. For other Forms 3115, see Sec. 1.446-1(e)(3) in 
effect prior to December 31, 1997 (Sec. 1.446-1(e)(3) as contained in 
the 26 CFR part 1 edition revised as of April 1, 1997).
    (4) Effective date. [Reserved]. For further guidance, see Sec. 
1.446(e)-1T(e)(4)(i) and (ii).

[T.D. 6500, 25 FR 11708, Nov. 26, 1960, as amended by T.D. 7073, 35 FR 
17710, Nov. 18, 1970; T.D. 7285, 38 FR 26184, Sept. 19, 1973; T.D. 8067, 
51 FR 378, Jan. 6, 1986; T.D. 8131, 52 FR 10084, Mar. 30, 1987; T.D. 
8408, 57 FR 12419, Apr. 10, 1992; T.D. 8482, 58 FR 42233, Aug. 9, 1993; 
T.D. 8608, 60 FR 40078, Aug. 7, 1995; T.D. 8719, 62 FR 26741, May 15, 
1997; T.D. 8742, 62 FR 68169, Dec. 31, 1997; T.D. 8929, 66 FR 2223, Jan. 
11, 2001; T.D. 9025, 67 FR 76985, Dec. 16, 2002; T.D. 9105, 69 FR 8, 
Jan. 2, 2004]



Sec. 1.446-1T  General rule for methods of accounting (temporary).

    (a) through (e)(2)(i) [Reserved]. For further guidance, see Sec. 
1.446-1(a) through (e)(2)(i).
    (e)(2)(ii)(a) A change in the method of accounting includes a change 
in the overall plan of accounting for gross income or deductions or a 
change in the treatment of any material item used in such overall plan. 
Although a method of accounting may exist under this definition without 
the necessity of a pattern of consistent treatment of an item, in most 
instances a method of accounting is not established for an item without 
such consistent treatment. A material item is any item that involves the 
proper time for the inclusion of the item in income or the taking of a 
deduction. Changes in method of accounting include a change from the 
cash receipts and disbursement method to an accrual method, or vice 
versa, a change involving the method or basis used in the valuation of 
inventories (see sections 471 and 472 and the regulations under sections 
471 and 472), a change from the cash or accrual method to a long-term 
contract method, or vice versa (see Sec. 1.460-4), certain changes in 
computing depreciation or amortization (see paragraph (e)(2)(ii)(d) of 
this section), a change involving the adoption, use or discontinuance of 
any other specialized method of computing taxable income, such as the 
crop method, and a change where the Internal Revenue Code and 
regulations under the Code specifically require that the consent of the 
Commissioner must be obtained before adopting such a change.

[[Page 55]]

    (b) A change in method of accounting does not include correction of 
mathematical or posting errors, or errors in the computation of tax 
liability (such as errors in computation of the foreign tax credit, net 
operating loss, percentage depletion, or investment credit). Also, a 
change in method of accounting does not include adjustment of any item 
of income or deduction that does not involve the proper time for the 
inclusion of the item of income or the taking of a deduction. For 
example, corrections of items that are deducted as interest or salary, 
but that are in fact payments of dividends, and of items that are 
deducted as business expenses, but which are in fact personal expenses, 
are not changes in method of accounting. In addition, a change in the 
method of accounting does not include an adjustment with respect to the 
addition to a reserve for bad debts. Although such adjustment may 
involve the question of the proper time for the taking of a deduction, 
such items are traditionally corrected by adjustment in the current and 
future years. For the treatment of the adjustment of the addition to a 
bad debt reserve (for example, for banks under section 585 of the 
Internal Revenue Code), see the regulations under section 166 of the 
Internal Revenue Code. A change in the method of accounting also does 
not include a change in treatment resulting from a change in underlying 
facts. For further guidance on changes involving depreciable or 
amortizable assets, see paragraph (e)(2)(ii)(d) of this section and 
Sec. 1.1016-3T(h).
    (c) [Reserved]. For further guidance, see Sec. 1.446-
1(e)(2)(ii)(c).
    (d) Changes involving depreciable or amortizable assets--(1) Scope. 
This paragraph (e)(2)(ii)(d) applies to property subject to section 167, 
168, 197, 1400I, 1400L(b), or 1400L(c), or to section 168 prior to its 
amendment by the Tax Reform Act of 1986 (100 Stat. 2121) (former section 
168).
    (2) Changes in depreciation or amortization that are a change in 
method of accounting. Except as provided in paragraph (e)(2)(ii)(d)(3) 
of this section, a change in the treatment of an asset from 
nondepreciable or nonamortizable to depreciable or amortizable, or vice 
versa, is a change in method of accounting. Additionally, a correction 
to require depreciation or amortization in lieu of a deduction for the 
cost of depreciable or amortizable assets that had been consistently 
treated as an expense in the year of purchase, or vice versa, is a 
change in method of accounting. Further, except as provided in paragraph 
(e)(2)(ii)(d)(3) of this section, the following changes in computing 
depreciation or amortization are a change in method of accounting:
    (i) A change in the depreciation or amortization method, period of 
recovery, or convention of a depreciable or amortizable asset.
    (ii) A change from not claiming to claiming the additional first 
year depreciation deduction provided by section 168(k) or 1400L(b) for, 
and the resulting change to the amount otherwise allowable as a 
depreciation deduction for the remaining adjusted depreciable basis (or 
similar basis) of, qualified property, 50-percent bonus depreciation 
property, or qualified New York Liberty Zone property, provided the 
taxpayer did not make the election out of the additional first year 
depreciation deduction (or did not make a deemed election out of the 
additional first year depreciation deduction; for further guidance, see 
Rev. Proc. 2002-33 (2002-1 C.B. 963), Rev. Proc. 2003-50 (2003-29 I.R.B. 
119), and Sec. 601.601(d)(2)(ii)(b) of this chapter) for the class of 
property in which the qualified property, the 50-percent bonus 
depreciation property, or the qualified New York Liberty Zone property 
is included.
    (iii) A change from claiming the 30-percent additional first year 
depreciation deduction to claiming the 50-percent additional first year 
depreciation deduction for 50-percent bonus depreciation property 
(provided the property is not included in any class of property for 
which the taxpayer elected the 30-percent, instead of the 50-percent, 
additional first year depreciation deduction) or a change from claiming 
the 50-percent additional first year depreciation deduction to claiming 
the 30-percent additional first year depreciation deduction for 
qualified property (including property that is included in a class of 
property for which the taxpayer elected the 30-percent, instead of

[[Page 56]]

the 50-percent, additional first year depreciation deduction) or 
qualified New York Liberty Zone property, and the resulting change to 
the amount otherwise allowable as a depreciation deduction for the 
property's remaining adjusted depreciable basis (or similar basis). This 
paragraph (e)(2)(ii)(d)(2)(iii) does not apply if a taxpayer is making a 
late election or revoking a timely valid election under section 168(k) 
or 1400L(b) (see paragraph (e)(2)(ii)(d)(3)(iii) of this section).
    (iv) A change from claiming to not claiming the additional first 
year depreciation deduction for an asset that is not qualified property, 
50-percent bonus depreciation property, or qualified New York Liberty 
Zone property, and the resulting change to the amount otherwise 
allowable as a depreciation deduction for the property's depreciable 
basis.
    (v) A change in salvage value to zero for a depreciable or 
amortizable asset for which the salvage value is expressly treated as 
zero by the Internal Revenue Code (for example, section 168(b)(4)), the 
regulations under the Code (for example, Sec. 1.197-2(f)(1)(ii)), or 
other guidance published in the Internal Revenue Bulletin.
    (vi) A change in the accounting for depreciable or amortizable 
assets from a single asset account to a multiple asset account 
(pooling), or vice versa, or from one type of multiple asset account 
(pooling) to a different type of multiple asset account (pooling).
    (vii) For depreciable or amortizable assets that are mass assets 
accounted for in multiple asset accounts or pools, a change in the 
method of identifying which assets have been disposed. For purposes of 
this paragraph (e)(2)(ii)(d)(2)(vii), the term mass assets means a mass 
or group of individual items of depreciable or amortizable assets that 
are not necessarily homogeneous, each of which is minor in value 
relative to the total value of the mass or group, numerous in quantity, 
usually accounted for only on a total dollar or quantity basis, with 
respect to which separate identification is impracticable, and placed in 
service in the same taxable year.
    (viii) Any other change in depreciation or amortization as the 
Secretary may designate by publication in the Federal Register or in the 
Internal Revenue Bulletin (see Sec. 601.601(d)(2) of this chapter).
    (3) Changes in depreciation or amortization that are not a change in 
method of accounting--(i) Useful life. An adjustment in the useful life 
of a depreciable or amortizable asset for which depreciation is 
determined under section 167 (other than under section 168, section 
1400I, section 1400L, or former section 168) is not a change in method 
of accounting. This adjustment in useful life is corrected by 
adjustments in the taxable year in which the conditions known to exist 
at the end of that taxable year changed thereby resulting in a 
redetermination of the useful life under Sec. 1.167(a)-1(b) (or if the 
period of limitation for assessment under section 6501(a) has expired 
for that taxable year, in the first succeeding taxable year open under 
the period of limitation for assessment), and in subsequent taxable 
years. In other situations, the adjustment in useful life may be 
corrected by adjustments in the earliest taxable year open under the 
period of limitation for assessment under section 6501(a) or the 
earliest taxable year under examination by the Internal Revenue Service 
(IRS) but in no event earlier than the placed-in-service year of the 
asset, and in subsequent taxable years. However, if a taxpayer initiates 
the correction in useful life, in lieu of filing amended Federal tax 
returns (for example, because the conditions known to exist at the end 
of a prior taxable year changed thereby resulting in a redetermination 
of the useful life under Sec. 1.167(a)-1(b)), the taxpayer may correct 
the adjustment in useful life by adjustments in the current and 
subsequent taxable years. This paragraph (e)(2)(ii)(d)(3)(i) does not 
apply if a taxpayer is changing to or from a useful life (or recovery 
period or amortization period) that is specifically assigned by the 
Internal Revenue Code (for example, section 167(f)(1), section 168(c), 
section 197), the regulations under the Code, or other guidance 
published in the Internal Revenue Bulletin and, therefore, such change 
is a change in method of accounting (unless paragraph 
(e)(2)(ii)(d)(3)(v) of this section applies).

[[Page 57]]

    (ii) Change in use. A change in computing depreciation or 
amortization allowances in the taxable year in which the use of an asset 
changes in the hands of the same taxpayer is not a change in method of 
accounting.
    (iii) Elections. Generally, the making of a late depreciation or 
amortization election or the revocation of a timely valid depreciation 
or amortization election is not a change in method of accounting, except 
as otherwise expressly provided by the Internal Revenue Code, the 
regulations under the Code, or other guidance published in the Internal 
Revenue Bulletin. This paragraph (e)(2)(ii)(d)(3)(iii) also applies to 
making a late election or revoking a timely valid election made under 
section 13261(g)(2) or (3) of the Revenue Reconciliation Act of 1993 
(107 Stat. 312, 540) (relating to amortizable section 197 intangibles). 
A taxpayer may request consent to make a late election or revoke a 
timely valid election by submitting a request for a private letter 
ruling.
    (iv) Salvage value. Except as provided under paragraph 
(e)(2)(ii)(d)(2)(v) of this section, a change in salvage value of a 
depreciable or amortizable asset is not treated as a change in method of 
accounting.
    (v) Placed-in-service date. Any change in the placed-in-service date 
of a depreciable or amortizable asset is not treated as a change in 
method of accounting. The change in placed-in-service date may be 
corrected by adjustments in the earliest taxable year open under the 
period of limitation for assessment under section 6501(a) or the 
earliest taxable year under examination by the IRS but in no event 
earlier than the placed-in-service year of the asset, and in subsequent 
taxable years. However, if a taxpayer initiates the change in placed-in-
service date, in lieu of filing amended federal tax returns, the 
taxpayer may correct the placed-in-service date by adjustments in the 
current and subsequent taxable years.
    (vi) Any other change in depreciation or amortization as the 
Secretary may designate by publication in the Federal Register or in the 
Internal Revenue Bulletin (see Sec. 601.601(d)(2) of this chapter).
    (4) Item being changed. For purposes of a change in depreciation or 
amortization to which this paragraph (e)(2)(ii)(d) applies, the item 
being changed generally is the depreciation treatment of each individual 
depreciable or amortizable asset. However, the item is the depreciation 
treatment of each vintage account with respect to a depreciable asset 
for which depreciation is determined under Sec. 1.167(a)-11 (CLADR 
property). Further, a change in computing depreciation or amortization 
under section 167 (other than under section 168, section 1400I, section 
1400L, or former section 168) is permitted only with respect to all 
assets in a particular account (as defined in Sec. 1.167(a)-7) or 
vintage account.
    (5) Special rules. For purposes of a change in depreciation or 
amortization to which this paragraph (e)(2)(ii)(d) applies--
    (i) Declining balance method to the straight line method for MACRS 
property. For tangible, depreciable property subject to section 168 
(MACRS property) that is depreciated using the 200-percent or 150-
percent declining balance method of depreciation under section 168(b)(1) 
or (2), a taxpayer may change without the consent of the Commissioner 
from the declining balance method of depreciation to the straight line 
method of depreciation in the first taxable year in which the use of the 
straight line method with respect to the adjusted depreciable basis of 
the MACRS property as of the beginning of that year will yield a 
depreciation allowance that is greater than the depreciation allowance 
yielded by the use of the declining balance method. When the change is 
made, the adjusted depreciable basis of the MACRS property as of the 
beginning of the taxable year is recovered through annual depreciation 
allowances over the remaining recovery period (for further guidance, see 
section 6.06 of Rev. Proc. 87-57 (1987-2 C.B. 687) and Sec. 
601.601(d)(2)(ii)(b) of this chapter).
    (ii) Depreciation method changes for section 167 property. For a 
depreciable or amortizable asset for which depreciation is determined 
under section 167 (other than under section 168, section 1400I, section 
1400L, or former section 168), see Sec. 1.167(e)-1T(b), (c), and (d) 
for

[[Page 58]]

the changes in depreciation method that are permitted to be made without 
the consent of the Commissioner. For CLADR property, see Sec. 1.167(a)-
11(c)(1)(iii) for the changes in depreciation method for CLADR property 
that are permitted to be made without the consent of the Commissioner. 
Further, see Sec. 1.167(a)-11(b)(4)(iii)(c) for how to correct an 
incorrect classification or characterization of CLADR property.
    (iii) Section 481 adjustment. Except as otherwise expressly provided 
by the Internal Revenue Code, the regulations under the Code, or other 
guidance published in the Internal Revenue Bulletin, no section 481 
adjustment is required or permitted for a change from one permissible 
method of computing depreciation or amortization to another permissible 
method of computing depreciation or amortization for an asset because 
this change is implemented by either a cut-off method (for further 
guidance, see section 2.06 of Rev. Proc. 97-27 (1997-1 C.B. 680), 
section 2.06 of Rev. Proc. 2002-9 (2002-1 C.B. 327), and Sec. 
601.601(d)(2)(ii)(b) of this chapter) or a modified cut-off method 
(under which the adjusted depreciable basis of the asset as of the 
beginning of the year of change is recovered using the new permissible 
method of accounting), as appropriate. However, a change from an 
impermissible method of computing depreciation or amortization to a 
permissible method of computing depreciation or amortization for an 
asset results in a section 481 adjustment. Similarly, a change in the 
treatment of an asset from nondepreciable or nonamortizable to 
depreciable or amortizable (or vice versa) or a change in the treatment 
of an asset from expensing to depreciating (or vice versa) results in a 
section 481 adjustment.
    (iii) Examples. The rules of this paragraph (e) are illustrated by 
the following examples:

    Example 1. Although the sale of merchandise is an income producing 
factor, and therefore inventories are required, a taxpayer in the retail 
jewelry business reports his income on the cash receipts and 
disbursements method of accounting. A change from the cash receipts and 
disbursements method of accounting to the accrual method of accounting 
is a change in the overall plan of accounting and thus is a change in 
method of accounting.
    Example 2. A taxpayer in the wholesale dry goods business computes 
its income and expenses on the accrual method of accounting and files 
its Federal income tax returns on such basis except for real estate 
taxes which have been reported on the cash receipts and disbursements 
method of accounting. A change in the treatment of real estate taxes 
from the cash receipts and disbursements method to the accrual method is 
a change in method of accounting because such change is a change in the 
treatment of a material item within his overall accounting practice.
    Example 3. A taxpayer in the wholesale dry goods business computes 
its income and expenses on the accrual method of accounting and files 
its Federal income tax returns on such basis. Vacation pay has been 
deducted in the year in which paid because the taxpayer did not have a 
completely vested vacation pay plan, and, therefore, the liability for 
payment did not accrue until that year. Subsequently, the taxpayer 
adopts a completely vested vacation pay plan that changes its year for 
accruing the deduction from the year in which payment is made to the 
year in which the liability to make the payment now arises. The change 
for the year of deduction of the vacation pay plan is not a change in 
method of accounting but results, instead, because the underlying facts 
(that is, the type of vacation pay plan) have changed.
    Example 4. From 1968 through 1970, a taxpayer has fairly allocated 
indirect overhead costs to the value of inventories on a fixed 
percentage of direct costs. If the ratio of indirect overhead costs to 
direct costs increases in 1971, a change in the underlying facts has 
occurred. Accordingly, an increase in the percentage in 1971 to fairly 
reflect the increase in the relative level of indirect overhead costs is 
not a change in method of accounting but is a change in treatment 
resulting from a change in the underlying facts.
    Example 5. A taxpayer values inventories at cost. A change in the 
basis for valuation of inventories from cost to the lower of cost or 
market is a change in an overall practice of valuing items in inventory. 
The change, therefore, is a change in method of accounting for 
inventories.
    Example 6. A taxpayer in the manufacturing business has for many 
taxable years valued its inventories at cost. However, cost has been 
improperly computed since no overhead costs have been included in 
valuing the inventories at cost. The failure to allocate an appropriate 
portion of overhead to the value of inventories is contrary to the 
requirement of the Internal Revenue Code and the regulations under the 
Code. A change requiring appropriate allocation of overhead is a change 
in method of accounting because it

[[Page 59]]

involves a change in the treatment of a material item used in the 
overall practice of identifying or valuing items in inventory.
    Example 7. A taxpayer has for many taxable years valued certain 
inventories by a method which provides for deducting 20 percent of the 
cost of the inventory items in determining the final inventory 
valuation. The 20 percent adjustment is taken as a ``reserve for price 
changes.'' Although this method is not a proper method of valuing 
inventories under the Internal Revenue Code or the regulations under the 
Code, it involves the treatment of a material item used in the overall 
practice of valuing inventory. A change in such practice or procedure is 
a change of method of accounting for inventories.
    Example 8. A taxpayer has always used a base stock system of 
accounting for inventories. Under this system a constant price is 
applied to an assumed constant normal quantity of goods in stock. The 
base stock system is an overall plan of accounting for inventories which 
is not recognized as a proper method of accounting for inventories under 
the regulations. A change in this practice is, nevertheless, a change of 
method of accounting for inventories.
    Example 9. In 2000, A1, a calendar year taxpayer engaged in the 
trade or business of manufacturing knitted goods, purchased and placed 
in service a building and its components at a total cost of $10,000,000 
for use in its manufacturing operations. A1 classified the $10,000,000 
as nonresidential real property under section 168(e). A1 did not make 
any elections under section 168 on its 2000 Federal tax return. As a 
result, on its 2000, 2001, and 2002 federal tax returns, A1 depreciated 
the $10,000,000 under the general depreciation system of section 168(a), 
using the straight line method of depreciation, a 39-year recovery 
period, and the mid-month convention. In 2003, A1 completes a cost 
segregation study on the building and its components and identifies 
items that cost a total of $1,500,000 as section 1245 property. As a 
result, the $1,500,000 should have been classified in 2000 as 5-year 
property under section 168(e) and depreciated on A1's 2000, 2001, and 
2002 Federal tax returns under the general depreciation system, using 
the 200-percent declining balance method of depreciation, a 5-year 
recovery period, and the half-year convention. Pursuant to paragraph 
(e)(2)(ii)(d)(2)(i) of this section, A1's change to this depreciation 
method, recovery period, and convention is a change in method of 
accounting. This method change results in a section 481 adjustment. The 
useful life exception under paragraph (e)(2)(ii)(d)(3)(i) of this 
section does not apply because the assets are depreciated under section 
168.
    Example 10. In 1996, B, a calendar year taxpayer, purchased and 
placed in service new equipment at a total cost of $1,000,000 for use in 
its plant located outside the United States. The equipment is 15-year 
property under section 168(e) with a class life of 20 years. The 
equipment is required to be depreciated under the alternative 
depreciation system of section 168(g). However, B incorrectly 
depreciated the equipment under the general depreciation system of 
section 168(a), using the 150-percent declining balance method, a 15-
year recovery period, and the half-year convention. In 2003, the IRS 
examines B's 2000 Federal income tax return and changes the depreciation 
of the equipment to the alternative depreciation system, using the 
straight line method of depreciation, a 20-year recovery period, and the 
half-year convention. Pursuant to paragraph (e)(2)(ii)(d)(2)(i) of this 
section, this change in depreciation method and recovery period made by 
the IRS is a change in method of accounting. This method change results 
in a section 481 adjustment. The useful life exception under paragraph 
(e)(2)(ii)(d)(3)(i) of this section does not apply because the assets 
are depreciated under section 168.
    Example 11. In May 2001, C, a calendar year taxpayer, purchased and 
placed in service equipment for use in its trade or business. C never 
held this equipment for sale. However, C incorrectly treated the 
equipment as inventory on its 2001 and 2002 Federal tax returns. In 
2003, C realizes that the equipment should have been treated as a 
depreciable asset. Pursuant to paragraph (e)(2)(ii)(d)(2) of this 
section, C's change in the treatment of the equipment from inventory to 
a depreciable asset is a change in method of accounting. This method 
change results in a section 481 adjustment.
    Example 12. Since 2001, D, a calendar year taxpayer, has used the 
distribution fee period method to amortize distributor commissions and, 
under that method, established pools to account for the distributor 
commissions (for further guidance, see Rev. Proc. 2000-38 (2000-2 C.B. 
310) and Sec. 601.601(d)(2)(ii)(b) of this chapter). A change in the 
accounting of distributor commissions under the distribution fee period 
method from pooling to single asset accounting is a change in method of 
accounting pursuant to paragraph (e)(2)(ii)(d)(2)(vi) of this section. 
This method change results in no section 481 adjustment because the 
change is from one permissible method to another permissible method.
    Example 13. Since 2000, E, a calendar year taxpayer, has accounted 
for items of MACRS property that are mass assets in pools. Each pool 
includes only the mass assets that are placed in service by E in the 
same taxable year. E is able to identify the cost basis of each asset in 
each pool. None of the pools are general asset accounts under section 
168(i)(4) and the regulations under section 168(i)(4). E identified any 
dispositions of these mass assets by specific identification. Because of

[[Page 60]]

changes in E's recordkeeping in 2003, it is impracticable for E to 
continue to identify disposed mass assets using specific identification. 
As a result, E wants to change to a first-in, first-out method under 
which the mass assets disposed of in a taxable year are deemed to be 
from the pool with the earliest placed-in-service year in existence as 
of the beginning of the taxable year of each disposition. Pursuant to 
paragraph (e)(2)(ii)(d)(2)(vii) of this section, this change is a change 
in method of accounting. This method change results in no section 481 
adjustment because the change is from one permissible method to another 
permissible method.
    Example 14. In August 2001, F, a calendar taxpayer, purchased and 
placed in service a copier for use in its trade or business. F 
incorrectly classified the copier as 7-year property under section 
168(e). F made no elections under section 168 on its 2001 Federal tax 
return. As a result, on its 2001 and 2002 Federal tax returns, F 
depreciated the copier under the general depreciation system of section 
168(a), using the 200-percent declining balance method of depreciation, 
a 7-year recovery period, and the half-year convention. In 2003, F 
realizes that the copier is 5-year property and should have been 
depreciated on its 2001 and 2002 Federal tax returns under the general 
depreciation system using a 5-year recovery period rather than a 7-year 
recovery period. Pursuant to paragraph (e)(2)(ii)(d)(2)(i) of this 
section, F's change in recovery period from 7 to 5 years is a change in 
method of accounting. This method change results in a section 481 
adjustment. The useful life exception under paragraph 
(e)(2)(ii)(d)(3)(i) of this section does not apply because the copier is 
depreciated under section 168.
    Example 15. In 1998, G, a calendar year taxpayer, purchased and 
placed in service an intangible asset that is not an amortizable section 
197 intangible and that is not described in section 167(f). G amortized 
the cost of the intangible asset under section 167(a) using the straight 
line method of depreciation and a useful life of 13 years. In 2003, 
because of changing conditions, G changes the remaining useful life of 
the intangible asset to 2 years. Pursuant to paragraph 
(e)(2)(ii)(d)(3)(i) of this section, G's change in useful life is not a 
change in method of accounting because the intangible asset is 
depreciated under section 167 and G is not changing to or from a useful 
life that is specifically assigned by the Internal Revenue Code, the 
regulations under the Code, or other guidance published in the Internal 
Revenue Bulletin.
    Example 16. In July 2001, H, a calendar year taxpayer, purchased and 
placed in service ``off-the-shelf'' computer software and a new 
computer. The cost of the new computer and computer software are 
separately stated. H incorrectly included the cost of this software as 
part of the cost of the computer, which is 5-year property under section 
168(e). On its 2001 Federal tax return, H elected to depreciate its 5-
year property placed in service in 2001 under the alternative 
depreciation system of section 168(g). The class life for a computer is 
5 years. As a result, because H included the cost of the computer 
software as part of the cost of the computer hardware, H depreciated the 
cost of the software under the alternative depreciation system, using 
the straight line method of depreciation, a 5-year recovery period, and 
the half-year convention. In 2003, H realizes that the cost of the 
software should have been amortized under section 167(f)(1), using the 
straight line method of depreciation, a 36-month useful life, and a 
monthly convention. H's change from 5-years to 36-months is a change in 
method of accounting because H is changing to a useful life that is 
specifically assigned by section 167(f)(1). The change in convention 
from the half-year to the monthly convention also is a change in method 
of accounting. Both changes result in a section 481 adjustment.
    Example 17. On September 15, 2001, I2, a calendar year taxpayer, 
purchased and placed in service new equipment at a total cost of 
$500,000 for use in its business. The equipment is 5-year property under 
section 168(e) with a class life of 9 years and is qualified property 
under section 168(k). I2 did not place in service any other depreciable 
property in 2001. Section 168(g)(1)(A) through (D) do not apply to the 
equipment. I2 intended to elect the alternative depreciation system 
under section 168(g) for 5-year property placed in service in 2001. 
However, I2 did not make the election. Instead, I2 deducted on its 2001 
Federal tax return the 30-percent additional first year depreciation 
attributable to the equipment and, on its 2001 and 2002 Federal tax 
returns, depreciated the remaining adjusted depreciable basis of the 
equipment under the general depreciation system under 168(a), using the 
200-percent declining balance method, a 5-year recovery period, and the 
half-year convention. In 2003, I2 realizes its failure to make the 
alternative depreciation system election in 2001 and files a Form 3115 
to change its method of depreciating the remaining adjusted depreciable 
basis of the 2001 equipment to the alternative depreciation system. 
Because this equipment is not required to be depreciated under the 
alternative depreciation system, I2 is attempting to make an election 
under section 168(g)(7). However, this election must be made in the 
taxable year in which the equipment is placed in service (2001) and, 
consequently, I2 is attempting to make a late election under section 
168(g)(7). Accordingly, I2's change to the alternative depreciation 
system is not a change in accounting method pursuant to paragraph 
(e)(2)(ii)(d)(3)(iii) of

[[Page 61]]

this section. Instead, I2 must submit a request for a private letter 
ruling under Sec. 301.9100-3 of this chapter, requesting an extension 
of time to make the alternative depreciation system election on its 2001 
Federal tax return.

    (3) [Reserved]. For further guidance, see Sec. 1.446-1(e)(3).
    (4) Effective date--(i) In general. Except as provided in paragraphs 
(e)(3)(iii) and (e)(4)(ii) of this section, paragraph (e) of this 
section applies on or after December 30, 2003. For the applicability of 
regulations before December 30, 2003, see Sec. 1.446-1(e) in effect 
prior to December 30, 2003 (Sec. 1.446-1(e) as contained in 26 CFR part 
1 edition revised as of April 1, 2003).
    (ii) Changes involving depreciable or amortizable assets. With 
respect to paragraph (e)(2)(ii)(d) of this section, paragraph 
(e)(2)(iii) Examples 9 through 17 of this section, the addition of the 
language ``certain changes in computing depreciation or amortization 
(see paragraph (e)(2)(ii)(d) of this section)'' to the last sentence of 
paragraph (e)(2)(ii)(a) of this section, and the removal of all language 
regarding useful life and the sentence ``On the other hand, a correction 
to require depreciation in lieu of a deduction for the cost of a class 
of depreciable assets which had been consistently treated as an expense 
in the year of purchase involves the question of the proper timing of an 
item, and is to be treated as a change in method of accounting'' from 
paragraph (e)(2)(ii)(b) of this section--
    (A) For any change in depreciation or amortization that is a change 
in method of accounting, this section applies to such a change in method 
of accounting made for taxable years ending on or after December 30, 
2003; and
    (B) For any change in depreciation or amortization that is not a 
change in method of accounting, this section applies to such a change 
made for taxable years ending on or after December 30, 2003.
    (iii) The applicability of paragraph (e) of this section expires on 
or before December 29, 2006.

[T.D. 9105, 69 FR 8, Jan. 2, 2004; 69 FR 5273, Feb. 4, 2004]



Sec. 1.446-2  Method of accounting for interest.

    (a) Applicability--(1) In general. This section provides rules for 
determining the amount of interest that accrues during an accrual period 
(other than interest described in paragraph (a)(2) of this section) and 
for determining the portion of a payment that consists of accrued 
interest. For purposes of this section, interest includes original issue 
discount and amounts treated as interest (whether stated or unstated) in 
any lending or deferred payment transaction. Accrued interest determined 
under this section is taken into account by a taxpayer under the 
taxpayer's regular method of accounting (e.g., an accrual method or the 
cash receipts and disbursements method). Application of an exception 
described in paragraph (a)(2) of this section to one party to a 
transaction does not affect the application of this section to any other 
party to the transaction.
    (2) Exceptions--(i) Interest included or deducted under certain 
other provisions. This section does not apply to interest that is taken 
into account under--
    (A) Sections 1272(a), 1275, and 163(e) (income and deductions 
relating to original issue discount);
    (B) Section 467(a)(2) (certain payments for the use of property or 
services);
    (C) Sections 1276 through 1278 (market discount);
    (D) Sections 1281 through 1283 (discount on certain short-term 
obligations);
    (E) Section 7872(a) (certain loans with below-market interest 
rates); or
    (F) Section 1.1272-3 (an election by a holder to treat all interest 
on a debt instrument as original issue discount).
    (ii) De minimis original issue discount. This section does not apply 
to de minimis original issue discount (other than de minimis original 
issue discount treated as qualified stated interest) as determined under 
Sec. 1.1273-1(d). See Sec. 1.163-7 for the treatment of de minimis 
original issue discount by the issuer and Sec. Sec. 1.1273-1(d) and 
1.1272-3 for the treatment of de minimis original issue discount by the 
holder.
    (b) Accrual of qualified stated interest. Qualified stated interest 
(as defined in Sec. 1.1273-1(c)) accrues ratably over the

[[Page 62]]

accrual period (or periods) to which it is attributable and accrues at 
the stated rate for the period (or periods).
    (c) Accrual of interest other than qualified stated interest. 
Subject to the modifications in paragraph (d) of this section, the 
amount of interest (other than qualified stated interest) that accrues 
for any accrual period is determined under rules similar to those in the 
regulations under sections 1272 and 1275 for the accrual of original 
issue discount. The preceding sentence applies regardless of any 
contrary formula agreed to by the parties.
    (d) Modifications--(1) Issue price. The issue price of the loan or 
contract is equal to--
    (i) In the case of a contract for the sale or exchange of property 
to which section 483 applies, the amount described in Sec. 1.483-
2(a)(1)(i) or (ii), whichever is applicable;
    (ii) In the case of a contract for the sale or exchange of property 
to which section 483 does not apply, the stated principal amount; or
    (iii) In any other case, the amount loaned.
    (2) Principal payments that are not deferred payments. In the case 
of a contract to which section 483 applies, principal payments that are 
not deferred payments are ignored for purposes of determining yield and 
adjusted issue price.
    (e) Allocation of interest to payments--(1) In general. Except as 
provided in paragraphs (e)(2), (e)(3), and (e)(4) of this section, each 
payment under a loan (other than payments of additional interest or 
similar charges provided with respect to amounts that are not paid when 
due) is treated as a payment of interest to the extent of the accrued 
and unpaid interest determined under paragraphs (b) and (c) of this 
section as of the date the payment becomes due.
    (2) Special rule for points deductible under section 461(g)(2). If a 
payment of points is deductible by the borrower under section 461(g)(2), 
the payment is treated by the borrower as a payment of interest.
    (3) Allocation respected in certain small transactions. [Reserved]
    (4) Pro rata prepayments. Accrued but unpaid interest is allocated 
to a pro rata prepayment under rules similar to those for allocating 
accrued but unpaid original issue discount to a pro rata prepayment 
under Sec. 1.1275-2(f). For purposes of the preceding sentence, a pro 
rata prepayment is a payment that is made prior to maturity that--
    (i) Is not made pursuant to the contract's payment schedule; and
    (ii) Results in a substantially pro rata reduction of each payment 
remaining to be paid on the contract.
    (f) Aggregation rule. For purposes of this section, all contracts 
calling for deferred payments arising from the same transaction (or a 
series of related transactions) are treated as a single contract. This 
rule, however, generally only applies to contracts involving a single 
borrower and a single lender.
    (g) Debt instruments denominated in a currency other than the U.S. 
dollar. This section applies to a debt instrument that provides for all 
payments denominated in, or determined by reference to, the functional 
currency of the taxpayer or qualified business unit of the taxpayer 
(even if that currency is other than the U.S. dollar). See Sec. 1.988-
2(b) to determine interest income or expense for debt instruments that 
provide for payments denominated in, or determined by reference to, a 
nonfunctional currency.
    (h) Example. The following example illustrates the rules of this 
section.

    Example. Allocation of unstated interest to deferred payments--(i) 
Facts. On July 1, 1996, A sells his personal residence to B for a stated 
purchase price of $1,297,143.66. The property is not personal use 
property (within the meaning of section 1275(b)(3)) in the hands of B. 
Under the loan agreement, B is required to make two installment payments 
of $648,571.83 each, the first due on June 30, 1998, and the second due 
on June 30, 2000. Both A and B use the cash receipts and disbursements 
method of accounting and use a calendar year for their taxable year.
    (ii) Amount of unstated interest. Under section 483, the agreement 
does not provide for adequate stated interest. Thus, the loan's yield is 
the test rate of interest determined under Sec. 1.483-3. Assume that 
both A and B use annual accrual periods and that the test rate of 
interest is 9.2 percent, compounded annually. Under Sec. 1.483-2, the 
present value of the deferred payments is $1,000,000. Thus, the 
agreement has unstated interest of $297,143.66.
    (iii) First two accrual periods. Under paragraph (d)(1) of this 
section, the issue price at

[[Page 63]]

the beginning of the first accrual period is $1,000,000 (the amount 
described in Sec. 1.483-2(a)(1)(i)). Under paragraph (c) of this 
section, the amount of interest that accrues for the first accrual 
period is $92,000 ($1,000,000x.092) and the amount of interest that 
accrues for the second accrual period is $100,464 ($1,092,000x.092). 
Thus, $192,464 of interest has accrued as of the end of the second 
accrual period. Under paragraph (e)(1) of this section, the $648,571.83 
payment made on June 30, 1998, is treated first as a payment of interest 
to the extent of $192,464. The remainder of the payment ($456,107.83) is 
treated as a payment of principal. Both A and B take the payment of 
interest ($192,464) into account in 1998.
    (iv) Second two accrual periods. The adjusted issue price at the 
beginning of the third accrual period is $543,892.17 
($1,092,000+$100,464-$648,571.83). The amount of interest that accrues 
for the third accrual period is $50,038.08 ($543,892.17x.092) and the 
amount of interest that accrues for the final accrual period is 
$54,641.58, the excess of the amount payable at maturity ($648,571.83), 
over the adjusted issue price at the beginning of the accrual period 
($593,930.25). As of the date the second payment becomes due, 
$104,679.66 of interest has accrued. Thus, of the $648,571.83 payment 
made on June 30, 2000, $104,679.66 is treated as interest and 
$543,892.17 is treated as principal. Both A and B take the payment of 
interest ($104,679.66) into account in 2000.

    (i) [Reserved]
    (j) Effective date. This section applies to debt instruments issued 
on or after April 4, 1994, and to lending transactions, sales, and 
exchanges that occur on or after April 4, 1994. Taxpayers, however, may 
rely on this section for debt instruments issued after December 21, 
1992, and before April 4, 1994, and for lending transactions, sales, and 
exchanges that occur after December 21, 1992, and before April 4, 1994.

[T.D. 8517, 59 FR 4804, Feb. 2, 1994]



Sec. 1.446-3  Notional principal contracts.

    (a) Table of contents. This paragraph (a) lists captioned paragraphs 
contained in Sec. 1.446-3.

               Sec. 1.446-3 Notional principal contracts.

    (a) Table of contents.
    (b) Purpose.
    (c) Definitions and scope.
    (1) Notional principal contract.
    (i) In general.
    (ii) Excluded contracts.
    (iii) Transactions within section 475.
    (iv) Transactions within section 988.
    (2) Specified index.
    (3) Notional principal amount.
    (4) Special definitions.
    (i) Related person and party to the contract.
    (ii) Objective financial information.
    (iii) Dealer in notional principal contracts.
    (d) Taxable year of inclusion and deduction.
    (e) Periodic payments.
    (1) Definition.
    (2) Recognition rules.
    (i) In general.
    (ii) Rate set in arrears.
    (iii) Notional principal amount set in arrears.
    (3) Examples.
    (f) Nonperiodic payments.
    (1) Definition.
    (2) Recognition rules.
    (i) In general.
    (ii) General rule for swaps.
    (iii) Alternative methods for swaps.
    (A) Prepaid swaps.
    (B) Other nonperiodic swap payments.
    (iv) General rule for caps and floors.
    (v) Alternative methods for caps and floors that hedge debt 
instruments.
    (A) Prepaid caps and floors.
    (B) Other caps and floors.
    (C) Special method for collars.
    (vi) Additional methods.
    (3) Term of extendible or terminable contracts.
    (4) Examples.
    (g) Special rules.
    (1) Disguised notional principal contracts.
    (2) Hedged notional principal contracts.
    (3) Options and forwards to enter into notional principal contracts.
    (4) Swaps with significant nonperiodic payments.
    (5) Caps and floors that are significantly in-the-money. [Reserved]
    (6) Examples.
    (h) Termination payments.
    (1) Definition.
    (2) Taxable year of inclusion and deduction by original parties.
    (3) Taxable year of inclusion and deduction by assignees.
    (4) Special rules.
    (i) Assignment of one leg of a contract.
    (ii) Substance over form.
    (5) Examples.
    (i) Anti-abuse rule.
    (j) Effective date.

    (b) Purpose. The purpose of this section is to enable the clear 
reflection of the income and deductions from notional principal 
contracts by prescribing accounting methods that reflect the economic 
substance of such contracts.

[[Page 64]]

    (c) Definitions and scope--(1) Notional principal contract--(i) In 
general. A notional principal contract is a financial instrument that 
provides for the payment of amounts by one party to another at specified 
intervals calculated by reference to a specified index upon a notional 
principal amount in exchange for specified consideration or a promise to 
pay similar amounts. An agreement between a taxpayer and a qualified 
business unit (as defined in section 989(a)) of the taxpayer, or among 
qualified business units of the same taxpayer, is not a notional 
principal contract because a taxpayer cannot enter into a contract with 
itself. Notional principal contracts governed by this section include 
interest rate swaps, currency swaps, basis swaps, interest rate caps, 
interest rate floors, commodity swaps, equity swaps, equity index swaps, 
and similar agreements. A collar is not itself a notional principal 
contract, but certain caps and floors that comprise a collar may be 
treated as a single notional principal contract under paragraph 
(f)(2)(v)(C) of this section. A contract may be a notional principal 
contract governed by this section even though the term of the contract 
is subject to termination or extension. Each confirmation under a master 
agreement to enter into agreements governed by this section is treated 
as a separate notional principal contract.
    (ii) Excluded contracts. A contract described in section 1256(b), a 
futures contract, a forward contract, and an option are not notional 
principal contracts. An instrument or contract that constitutes 
indebtedness under general principles of Federal income tax law is not a 
notional principal contract. An option or forward contract that entitles 
or obligates a person to enter into a notional principal contract is not 
a notional principal contract, but payments made under such an option or 
forward contract may be governed by paragraph (g)(3) of this section.
    (iii) Transactions within section 475. To the extent that the rules 
provided in paragraphs (e) and (f) of this section are inconsistent with 
the rules that apply to any notional principal contract that is governed 
by section 475 and regulations thereunder, the rules of section 475 and 
the regulations thereunder govern.
    (iv) Transactions within section 988. To the extent that the rules 
provided in this section are inconsistent with the rules that apply to 
any notional principal contract that is also a section 988 transaction 
or that is integrated with other property or debt pursuant to section 
988(d), the rules of section 988 and the regulations thereunder govern.
    (2) Specified index. A specified index is--
    (i) A fixed rate, price, or amount;
    (ii) A fixed rate, price, or amount applicable in one or more 
specified periods followed by one or more different fixed rates, prices, 
or amounts applicable in other periods;
    (iii) An index that is based on objective financial information (as 
defined in paragraph (c)(4)(ii) of this section); and
    (iv) An interest rate index that is regularly used in normal lending 
transactions between a party to the contract and unrelated persons.
    (3) Notional principal amount. For purposes of this section, a 
notional principal amount is any specified amount of money or property 
that, when multiplied by a specified index, measures a party's rights 
and obligations under the contract, but is not borrowed or loaned 
between the parties as part of the contract. The notional principal 
amount may vary over the term of the contract, provided that it is set 
in advance or varies based on objective financial information (as 
defined in paragraph (c)(4)(ii) of this section).
    (4) Special definitions--(i) Related person and party to the 
contract. A related person is a person related (within the meaning of 
section 267(b) or 707(b)(1)) to one of the parties to the notional 
principal contract or a member of the same consolidated group (as 
defined in Sec. 1.1502-1(h)) as one of the parties to the contract. For 
purposes of this paragraph (c), a related person is considered to be a 
party to the contract.
    (ii) Objective financial information. For purposes of this paragraph 
(c), objective financial information is any current, objectively 
determinable financial or economic information that is not within the 
control of any of the parties to the contract and is not

[[Page 65]]

unique to one of the parties' circumstances (such as one party's 
dividends, profits, or the value of its stock). Thus, for example, a 
notional principal amount may be based on a broadly-based equity index 
or the outstanding balance of a pool of mortgages, but not on the value 
of a party's stock.
    (iii) Dealer in notional principal contracts. A dealer in notional 
principal contracts is a person who regularly offers to enter into, 
assume, offset, assign, or otherwise terminate positions in notional 
principal contracts with customers in the ordinary course of a trade or 
business.
    (d) Taxable year of inclusion and deduction. For all purposes of the 
Code, the net income or net deduction from a notional principal contract 
for a taxable year is included in or deducted from gross income for that 
taxable year. The net income or net deduction from a notional principal 
contract for a taxable year equals the total of all of the periodic 
payments that are recognized from that contract for the taxable year 
under paragraph (e) of this section and all of the nonperiodic payments 
that are recognized from that contract for the taxable year under 
paragraph (f) of this section.
    (e) Periodic payments--(1) Definition. Periodic payments are 
payments made or received pursuant to a notional principal contract that 
are payable at intervals of one year or less during the entire term of 
the contract (including any extension periods provided for in the 
contract), that are based on a specified index described in paragraph 
(c)(2)(i), (iii), or (iv) of this section (appropriately adjusted for 
the length of the interval), and that are based on either a single 
notional principal amount or a notional principal amount that varies 
over the term of the contract in the same proportion as the notional 
principal amount that measures the other party's payments. Payments to 
purchase or sell a cap or a floor, however, are not periodic payments.
    (2) Recognition rules--(i) In general. All taxpayers, regardless of 
their method of accounting, must recognize the ratable daily portion of 
a periodic payment for the taxable year to which that portion relates.
    (ii) Rate set in arrears. If the amount of a periodic payment is not 
determinable at the end of a taxable year because the value of the 
specified index is not fixed until a date that occurs after the end of 
the taxable year, the ratable daily portion of a periodic payment that 
relates to that taxable year is generally based on the specified index 
that would have applied if the specified index were fixed as of the last 
day of the taxable year. If a taxpayer determines that the value of the 
specified index as of the last day of the taxable year does not provide 
a reasonable estimate of the specified index that will apply when the 
payment is fixed, the taxpayer may use a reasonable estimate of the 
specified index each year, provided that the taxpayer (and any related 
person that is a party to the contract) uses the same method to make the 
estimate consistently from year to year and uses the same estimate for 
purposes of all financial reports to equity holders and creditors. The 
taxpayer's treatment of notional principal contracts with substantially 
similar specified indices will be considered in determining whether the 
taxpayer's estimate of the specified index is reasonable. Any difference 
between the amount that is recognized under this paragraph (e)(2)(ii) 
and the corresponding portion of the actual payment that becomes fixed 
under the contract is taken into account as an adjustment to the net 
income or net deduction from the notional principal contract for the 
taxable year during which the payment becomes fixed.
    (iii) Notional principal amount set in arrears. Rules similar to the 
rules of paragraph (e)(2)(ii) of this section apply if the amount of a 
periodic payment is not determinable at the end of a taxable year 
because the notional principal amount is not fixed until a date that 
occurs after the end of the taxable year.
    (3) Examples. The following examples illustrate the application of 
paragraph (e) of this section.

    Example 1. Accrual of periodic swap payments. (a) On April 1, 1995, 
A enters into a contract with unrelated counterparty B under which, for 
a term of five years, A is obligated to make a payment to B each April 
1, beginning April 1, 1996, in an amount equal

[[Page 66]]

to the London Interbank Offered Rate (LIBOR), as determined on the 
immediately preceding April 1, multiplied by a notional principal amount 
of $100 million. Under the contract, B is obligated to make a payment to 
A each April 1, beginning April 1, 1996, in an amount equal to 8% 
multiplied by the same notional principal amount. A and B are calendar 
year taxpayers that use the accrual method of accounting. On April 1, 
1995, LIBOR is 7.80%.
    (b) This contract is a notional principal contract as defined by 
paragraph (c)(1) of this section, and both LIBOR and a fixed interest 
rate of 8% are specified indices under paragraph (c)(2) of this section. 
All of the payments to be made by A and B are periodic payments under 
paragraph (e)(1) of this section because each party's payments are based 
on a specified index described in paragraphs (c)(2)(iii) and (c)(2)(i) 
of this section, respectively, are payable at periodic intervals of one 
year or less throughout the term of the contract, and are based on a 
single notional principal amount.
    (c) Under the terms of the swap agreement, on April 1, 1996, B is 
obligated to make a payment to A of $8,000,000 (8%x$100,000,000) and A 
is obligated to make a payment to B of $7,800,000 (7.80%x$100,000,000). 
Under paragraph (e)(2)(i) of this section, the ratable daily portions 
for 1995 are the amounts of these periodic payments that are 
attributable to A's and B's taxable year ending December 31, 1995. The 
ratable daily portion of the 8% fixed leg is $6,010,929 (275 days/366 
daysx$8,000,000), and the ratable daily portion of the floating leg is 
$5,860,656 (275 days/366 daysx$7,800,000). The net amount for the 
taxable year is the difference between the ratable daily portions of the 
two periodic payments, or $150,273 ($6,010,929--$5,860,656). 
Accordingly, A has net income of $150,273 from this swap for 1995, and B 
has a corresponding net deduction of $150,273.
    (d) The $49,727 unrecognized balance of the $200,000 net periodic 
payment that is made on April 1, 1996, is included in A's and B's net 
income or net deduction from the contract for 1996.
    (e) If the parties had entered into the contract on February 1, 
1995, the result would not change because no portion of either party's 
obligation to make a payment under the swap relates to the period prior 
to April 1, 1995. Consequently, under paragraph (e)(2) of this section, 
neither party would accrue any income or deduction from the swap for the 
period from February 1, 1995, through March 31, 1995.
    Example 2. Accrual of periodic swap payments by cash method 
taxpayer. (a) On April 1, 1995, C enters into a contract with unrelated 
counterparty D under which, for a period of five years, C is obligated 
to make a fixed payment to D each April 1, beginning April 1, 1996, in 
an amount equal to 8% multiplied by a notional principal amount of $100 
million. D is obligated to make semi-annual payments to C each April 1 
and October 1, beginning October 1, 1995, in an amount equal to one-half 
of the LIBOR amount as of the first day of the preceding 6-month period 
multiplied by the notional principal amount. The payments are to be 
calculated using a 30/360 day convention. C is a calendar year taxpayer 
that uses the accrual method of accounting. D is a calendar year 
taxpayer that uses the cash receipts and disbursements method of 
accounting. LIBOR is 7.80% on April 1, 1995, and 7.46% on October 1, 
1995.
    (b) This contract is a notional principal contract as defined by 
paragraph (c)(1) of this section, and LIBOR and the fixed interest rate 
of 8% are each specified indices under paragraph (c)(2) of this section. 
All of the payments to be made by C and D are periodic payments under 
paragraph (e)(1) of this section because they are each based on 
appropriate specified indices, are payable at periodic intervals of one 
year or less throughout the term of the contract, and are based on a 
single notional principal amount.
    (c) Under the terms of the swap agreement, D pays C $3,900,000 
(0.5x7.8%x$100,000,000) on October 1, 1995. In addition, D is obligated 
to pay C $3,730,000 (0.5x7.46%x$100,000,000) on April 1, 1996. C is 
obligated to pay D $8,000,000 on April 1, 1996. Under paragraph 
(e)(2)(i) of this section, C's and D's ratable daily portions for 1995 
are the amounts of the periodic payments that are attributable to their 
taxable year ending December 31, 1995. The ratable daily portion of the 
8% fixed leg is $6,000,000 (270 days/360 daysx$8,000,000), and the 
ratable daily portion of the floating leg is $5,765,000 ($3,900,000 + 
(90 days/180 daysx$3,730,000)). Thus, C's net deduction from the 
contract for 1995 is $235,000 ($6,000,000--$5,765,000) and D reports 
$235,000 of net income from the contract for 1995.
    (d) The net unrecognized balance of $135,000 ($2,000,000 balance of 
the fixed leg--$1,865,000 balance of the floating leg) is included in 
C's and D's net income or net deduction from the contract for 1996.
    Example 3. Accrual of swap payments on index set in arrears. (a) The 
facts are the same as in Example 1, except that A's obligation to make 
payments based upon LIBOR is determined by reference to LIBOR on the day 
each payment is due. LIBOR is 8.25% on December 31, 1995, and 8.16% on 
April 1, 1996.
    (b) On December 31, 1995, the amount that A is obligated to pay B is 
not known because it will not become fixed until April 1, 1996. Under 
paragraph (e)(2)(ii) of this section, the ratable daily portion of the 
periodic payment from A to B for 1995 is based on the value of LIBOR on 
December 31, 1995 (unless A or B determines that the value of LIBOR on 
that day does not reasonably estimate the value of the specified index). 
Thus, the ratable daily portion of the floating leg is

[[Page 67]]

$6,198,770 (275 days/366 daysx8.25%x$100,000,000), while the ratable 
daily portion of the fixed leg is $6,010,929 (275 days/366 
daysx$8,000,000). The net amount for 1995 on this swap is $187,841 
($6,198,770--$6,010,929). Accordingly, B has $187,841 of net income from 
the swap in 1995, and A has a net deduction of $187,841.
    (c) On April 1, 1996, A makes a net payment to B of $160,000 
($8,160,000 payment on the floating leg--$8,000,000 payment on the fixed 
leg). For purposes of determining their net income or net deduction from 
this contract for the year ended December 31, 1996, B and A must adjust 
the net income and net deduction they recognized in 1995 by $67,623 (275 
days/366 daysx($8,250,000 presumed payment on the floating leg--
$8,160,000 actual payment on the floating leg)).

    (f) Nonperiodic payments--(1) Definition. A nonperiodic payment is 
any payment made or received with respect to a notional principal 
contract that is not a periodic payment (as defined in paragraph (e)(1) 
of this section) or a termination payment (as defined in paragraph (h) 
of this section). Examples of nonperiodic payments are the premium for a 
cap or floor agreement (even if it is paid in installments), the payment 
for an off-market swap agreement, the prepayment of part or all of one 
leg of a swap, and the premium for an option to enter into a swap if and 
when the option is exercised.
    (2) Recognition rules--(i) In general. All taxpayers, regardless of 
their method of accounting, must recognize the ratable daily portion of 
a nonperiodic payment for the taxable year to which that portion 
relates. Generally, a nonperiodic payment must be recognized over the 
term of a notional principal contract in a manner that reflects the 
economic substance of the contract.
    (ii) General rule for swaps. A nonperiodic payment that relates to a 
swap must be recognized over the term of the contract by allocating it 
in accordance with the forward rates (or, in the case of a commodity, 
the forward prices) of a series of cash-settled forward contracts that 
reflect the specified index and the notional principal amount. For 
purposes of this allocation, the forward rates or prices used to 
determine the amount of the nonperiodic payment will be respected, if 
reasonable. See paragraph (f)(4) Example 7 of this section.
    (iii) Alternative methods for swaps. Solely for purposes of 
determining the timing of income and deductions, a nonperiodic payment 
made or received with respect to a swap may be allocated to each period 
of the swap contract using one of the methods described in this 
paragraph (f)(2)(iii). The alternative methods may not be used by a 
dealer in notional principal contracts (as defined in paragraph 
(c)(4)(iii) of this section) for swaps entered into or acquired in its 
capacity as a dealer.
    (A) Prepaid swaps. An upfront payment on a swap may be amortized by 
assuming that the nonperiodic payment represents the present value of a 
series of equal payments made throughout the term of the swap contract 
(the level payment method), adjusted as appropriate to take account of 
increases or decreases in the notional principal amount. The discount 
rate used in this calculation must be the rate (or rates) used by the 
parties to determine the amount of the nonperiodic payment. If that rate 
is not readily ascertainable, the discount rate used must be a rate that 
is reasonable under the circumstances. Under this method, an upfront 
payment is allocated by dividing each equal payment into its principal 
recovery and time value components. The principal recovery components of 
the equal payments are treated as periodic payments that are deemed to 
be made on each of the dates that the swap contract provides for 
periodic payments by the payor of the nonperiodic payment or, if none, 
on each of the dates that the swap contract provides for periodic 
payments by the recipient of the nonperiodic payment. The time value 
component is needed to compute the amortization of the nonperiodic 
payment, but is otherwise disregarded. See paragraph (f)(4) Example 5 of 
this section.
    (B) Other nonperiodic swap payments. Nonperiodic payments on a swap 
other than an upfront payment may be amortized by treating the contract 
as if it provided for a single upfront payment (equal to the present 
value of the nonperiodic payments) and a loan between the parties. The 
discount rate (or rates) used in determining the deemed upfront payment 
and the time value

[[Page 68]]

component of the deemed loan is the same as the rate (or rates) used in 
the level payment method. The single upfront payment is then amortized 
under the level payment method described in paragraph (f)(2)(iii)(A) of 
this section. The time value component of the loan is not treated as 
interest, but, together with the amortized amount of the deemed upfront 
payment, is recognized as a periodic payment. See paragraph (f)(4) 
Example 6 of this section. If both parties make nonperiodic payments, 
this calculation is done separately for the nonperiodic payments made by 
each party.
    (iv) General rule for caps and floors. A payment to purchase or sell 
a cap or floor must be recognized over the term of the agreement by 
allocating it in accordance with the prices of a series of cash-settled 
option contracts that reflect the specified index and the notional 
principal amount. For purposes of this allocation, the option pricing 
used by the parties to determine the total amount paid for the cap or 
floor will be respected, if reasonable. Only the portion of the purchase 
price that is allocable to the option contract or contracts that expire 
during a particular period is recognized for that period. Thus, under 
this paragraph (f)(2)(iv), straight-line or accelerated amortization of 
a cap premium is generally not permitted. See paragraph (f)(4) Examples 
1 and 2 of this section.
    (v) Alternative methods for caps and floors that hedge debt 
instruments. Solely for purposes of determining the timing of income and 
deductions, if a cap or floor is entered into primarily to reduce risk 
with respect to a specific debt instrument or group of debt instruments 
held or issued by the taxpayer, the taxpayer may amortize a payment to 
purchase or sell the cap or floor using the methods described in this 
paragraph (f)(2)(v), adjusted as appropriate to take account of 
increases or decreases in the notional principal amount. The alternative 
methods may not be used by a dealer in notional principal contracts (as 
defined in paragraph (c)(4)(iii) of this section) for caps or floors 
entered into or acquired in its capacity as a dealer.
    (A) Prepaid caps and floors. A premium paid upfront for a cap or a 
floor may be amortized using the ``level payment method'' described in 
paragraph (f)(2)(iii)(A) of this section. See paragraph (f)(4) Example 3 
of this section.
    (B) Other caps and floors. Nonperiodic payments on a cap or floor 
other than an upfront payment are amortized by treating the contract as 
if it provided for a single upfront payment (equal to the present value 
of the nonperiodic payments) and a loan between the parties as described 
in paragraph (f)(2)(iii)(B) of this section. Under the level payment 
method, a cap or floor premium paid in level annual installments over 
the term of the contract is effectively included or deducted from income 
ratably, in accordance with the level payments. See paragraph (f)(4) 
Example 4 of this section.
    (C) Special method for collars. A taxpayer may also treat a cap and 
a floor that comprise a collar as a single notional principal contract 
and may amortize the net nonperiodic payment to enter into the cap and 
floor over the term of the collar in accordance with the methods 
prescribed in this paragraph (f)(2)(v).
    (vi) Additional methods. The Commissioner may, by a revenue ruling 
or a revenue procedure published in the Internal Revenue Bulletin, 
provide alternative methods for allocating nonperiodic payments that 
relate to a notional principal contract to each year of the contract. 
See Sec. 601.601(d)(2)(ii)(b) of this chapter.
    (3) Term of extendible or terminable contracts. For purposes of this 
paragraph (f), the term of a notional principal contract that is subject 
to extension or termination is the reasonably expected term of the 
contract.
    (4) Examples. The following examples illustrate the application of 
paragraph (f) of this section.

    Example 1. Cap premium amortized using general rule. (a) On January 
1, 1995, when LIBOR is 8%, F pays unrelated party E $600,000 for a 
contract that obligates E to make a payment to F each quarter equal to 
one-quarter of the excess, if any, of three-month LIBOR over 9% with 
respect to a notional principal amount of $25 million. Both E and F are 
calendar year taxpayers. E provides F with a schedule of allocable 
premium amounts indicating that the cap was priced according to a 
reasonable variation of the Black-Scholes option pricing formula and

[[Page 69]]

that the total premium is allocable to the following periods:

------------------------------------------------------------------------
                                                              Pricing
                                                            allocation
------------------------------------------------------------------------
1995....................................................         $55,000
1996....................................................         225,000
1997....................................................         320,000
                                                         ---------------
                                                                $600,000
------------------------------------------------------------------------

    (b) This contract is a notional principal contract as defined by 
paragraph (c)(1) of this section, and LIBOR is a specified index under 
paragraph (c)(2)(iii) of this section. Any payments made by E to F are 
periodic payments under paragraph (e)(1) of this section because they 
are payable at periodic intervals of one year or less throughout the 
term of the contract, are based on an appropriate specified index, and 
are based on a single notional principal amount. The $600,000 cap 
premium paid by F to E is a nonperiodic payment as defined in paragraph 
(f)(1) of this section.
    (c) The Black-Scholes model is recognized in the financial industry 
as a standard technique for pricing interest rate cap agreements. 
Therefore, because E has used a reasonable option pricing model, the 
schedule generated by E is consistent with the economic substance of the 
cap, and may be used by both E and F for calculating their ratable daily 
portions of the cap premium. Under paragraph (f)(2)(iv) of this section, 
E recognizes the ratable daily portion of the cap premium as income, and 
F recognizes the ratable daily portion of the cap premium as a deduction 
based on the pricing schedule. Thus, E and F account for the contract as 
follows:

------------------------------------------------------------------------
                                                           Ratable daily
                                                              portion
------------------------------------------------------------------------
1995....................................................         $55,000
1996....................................................         225,000
1997....................................................         320,000
                                                         ---------------
                                                                $600,000
------------------------------------------------------------------------

    (d) Any periodic payments under the cap agreement (that is, payments 
that E makes to F because LIBOR exceeds 9%) are included in the parties' 
net income or net deduction from the contract in accordance with 
paragraph (e)(2) of this section.
    Example 2. Cap premium allocated to proper period. (a) The facts are 
the same as in Example 1, except that the cap is purchased by F on 
November 1, 1994. The first determination date under the cap agreement 
is January 31, 1995 (the last day of the first quarter to which the 
contract relates). LIBOR is 9.1% on December 31, 1994, and is 9.15% on 
January 31, 1995.
    (b) E and F recognize $9,192 (61 days/365 daysx$55,000) as the 
ratable daily portion of the nonperiodic payment for 1994, and include 
that amount in their net income or net deduction from the contract for 
1994. If E's pricing model allocated the cap premium to each quarter 
covered by the contract, the ratable daily portion would be 61 days/92 
days times the premium allocated to the first quarter.
    (c) Under paragraph (e)(2)(ii) of this section, E and F calculate 
the payments using LIBOR as of December 31, 1994. F recognizes as income 
the ratable daily portion of the presumed payment, or $4,144 (61 days/92 
daysx.25x.001x$25,000,000). Thus, E reports $5,048 of net income from 
the contract for 1994 ($9,192-$4,144), and F reports a net deduction 
from the contract of $5,048.
    (d) On January 31, 1995, E pays F $9,375 (.25x.0015x$25,000,000) 
under the terms of the cap agreement. For purposes of determining their 
net income or net deduction from this contract for the year ended 
December 31, 1995, E and F must adjust their respective net income and 
net deduction from the cap by $2,072 (61 days/92 daysx($9,375 actual 
payment under the cap on January 31, 1995--$6,250 presumed payment under 
the cap on December 31, 1994)).
    Example 3. Cap premium amortized using alternative method. (a) The 
facts are the same as in Example 1, except that the cap provides for 
annual payments by E and is entered into by F primarily to reduce risk 
with respect to a debt instrument issued by F. F elects to amortize the 
cap premium using the alternative level payment method provided under 
paragraph (f)(2)(v)(A) of this section. Under that method, F amortizes 
the cap premium by assuming that the $600,000 is repaid in 3 equal 
annual payments of $241,269, assuming a discount rate of 10%. Each 
payment is divided into a time value component and a principal 
component, which are set out below.

----------------------------------------------------------------------------------------------------------------
                                                                                Time value         Principal
                                                           Level payment        component          component
----------------------------------------------------------------------------------------------------------------
1995...................................................           $241,269            $60,000           $181,269
1996...................................................            241,269             41,873            199,396
1997...................................................            241,269             21,934            219,335
                                                        --------------------------------------------------------
                                                                  $723,807           $123,807           $600,000
----------------------------------------------------------------------------------------------------------------


[[Page 70]]

    (b) The net of the ratable daily portions of the principal component 
and the payments, if any, received from E comprise F's annual net income 
or net deduction from the cap. The time value components are needed only 
to compute the ratable daily portions of the cap premium, and are 
otherwise disregarded.
    Example 4. Cap premium paid in level installments and amortized 
using alternative method. (a) The facts are the same as in Example 3, 
except that F agrees to pay for the cap in three level installments of 
$241,269 (a total of $723,807) on December 31, 1995, 1996, and 1997. The 
present value of three payments of $241,269, discounted at 10%, is 
$600,000. For purposes of amortizing the cap premium under the 
alternative method provided in paragraph (f)(2)(v)(B) of this section, F 
is treated as paying $600,000 for the cap on January 1, 1995, and 
borrowing $600,000 from E that will be repaid in three annual 
installments of $241,269. The time value component of the loan is 
computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                Time value         Principal
                                                            Loan balance        component          component
----------------------------------------------------------------------------------------------------------------
1995...................................................           $600,000            $60,000           $181,269
1996...................................................            418,731             41,873            199,396
1997...................................................            219,335             21,934            219,335
                                                                           -------------------------------------
                                                         .................           $123,807           $600,000
----------------------------------------------------------------------------------------------------------------

    (b) F is treated as making periodic payments equal to the amortized 
principal components from a $600,000 cap paid in advance (as described 
in Example 3), increased by the time value components of the $600,000 
loan, which totals $241,269 each year. The time value components of the 
$600,000 loan are included in the periodic payments made by F, but are 
not characterized as interest income or expense. The effect of the 
alternative method in this situation is to allow F to amortize the cap 
premium in level installments, the same way it is paid. The net of the 
ratable daily portions of F's deemed periodic payments and the payments, 
if any, received from E comprise F's annual net income or net deduction 
from the cap.
    Example 5. Upfront interest rate swap payment amortized using 
alternative method. (a) On January 1, 1995, G enters into an interest 
rate swap agreement with unrelated counterparty H under which, for a 
term of five years, G is obligated to make annual payments at 11% and H 
is obligated to make annual payments at LIBOR on a notional principal 
amount of $100 million. At the time G and H enter into this swap 
agreement, the rate for similar on-market swaps is LIBOR to 10%. To 
compensate for this difference, on January 1, 1995, H pays G a yield 
adjustment fee of $3,790,786. G provides H with information that 
indicates that the amount of the yield adjustment fee was determined as 
the present value, at 10% compounded annually, of five annual payments 
of $1,000,000 (1%x$100,000,000). G and H are calendar year taxpayers.
    (b) This contract is a notional principal contract as defined by 
paragraph (c)(1) of this section. The yield adjustment fee is a 
nonperiodic payment as defined in paragraph (f)(1) of this section.
    (c) Under the alternative method described in paragraph 
(f)(2)(iii)(A) of this section, the yield adjustment fee is recognized 
over the life of the agreement by assuming that the $3,790,786 is repaid 
in five level payments. Assuming a constant yield to maturity and annual 
compounding at 10%, the ratable daily portions are computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                Time value         Principal
                                                           Level payment        component          component
----------------------------------------------------------------------------------------------------------------
1995...................................................         $1,000,000           $379,079           $620,921
1996...................................................          1,000,000            316,987            683,013
1997...................................................          1,000,000            248,685            751,315
1998...................................................          1,000,000            173,554            826,446
1999...................................................          1,000,000             90,909            909,091
                                                        --------------------------------------------------------
                                                                $5,000,000         $1,209,214         $3,790,786
----------------------------------------------------------------------------------------------------------------

    (d) G also makes swap payments to H at 11%, while H makes swap 
payments to G based on LIBOR. The net of the ratable daily portions of 
the 11% payments by G, the LIBOR payments by H, and the principal 
component of the yield adjustment fee paid by H determines the annual 
net income or net deduction from the contract for both G and H. The time 
value components are needed only to compute the ratable daily portions 
of the yield adjustment fee paid by H, and are otherwise disregarded.
    Example 6. Backloaded interest rate swap payment amortized using 
alternative method.

[[Page 71]]

(a) The facts are the same as in Example 5, but H agrees to pay G a 
yield adjustment fee of $6,105,100 on December 31, 1999. Under the 
alternative method in paragraph (f)(2)(iii)(B) of this section, H is 
treated as paying a yield adjustment fee of $3,790,786 (the present 
value of $6,105,100, discounted at a 10% rate with annual compounding) 
on January 1, 1995. Solely for timing purposes, H is treated as 
borrowing $3,790,786 from G. Assuming annual compounding at 10%, the 
time value component is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                Time value         Principal
                                                            Loan balance        component          component
----------------------------------------------------------------------------------------------------------------
1995...................................................         $3,790,786           $379,079                  0
1996...................................................          4,169,865            416,987                  0
1997...................................................          4,586,852            458,685                  0
1998...................................................          5,045,537            504,554                  0
1999...................................................          5,550,091            555,009          6,105,100
----------------------------------------------------------------------------------------------------------------

    (b) The amortization of H's yield adjustment fee is equal to the 
amortization of a yield adjustment fee of $3,790,786 paid in advance (as 
described in Example 5), increased by the time value component of the 
$3,790,786 deemed loan from G to H. Thus, the amount of H's yield 
adjustment fee that is allocated to 1995 is $1,000,000 ($620,921 + 
$379,079). The time value components of the $3,790,786 loan are included 
in the periodic payments paid by H, but are not characterized as 
interest income or expense. The net of the ratable daily portions of the 
11% swap payments by G, and the LIBOR payments by H, added to the 
principal components from Example 5 and the time value components from 
this Example 6, determines the annual net income or net deduction from 
the contract for both G and H.
    Example 7. Nonperiodic payment on a commodity swap amortized under 
general rule. (a) On January 1, 1995, I enters into a commodity swap 
agreement with unrelated counterparty J under which, for a term of three 
years, I is obligated to make annual payments based on a fixed price of 
$2.35 per bushel times a notional amount of 100,000 bushels of corn and 
J is obligated to make annual payments equal to the spot price times the 
same notional amount. Assume that on January 1, 1995, the price of a one 
year forward for corn is $2.40 per bushel, of a two year forward $2.55 
per bushel, and of a 3 year forward $2.75 per bushel. To compensate for 
the below-market fixed price provided in the swap agreement, I pays J 
$53,530 for entering into the swap. I and J are calendar year taxpayers.
    (b) This contract is a notional principal contract as defined by 
paragraph (c)(1) of this section, and $2.35 and the spot price of corn 
are specified indices under paragraphs (c)(2)(i) and (iii) of this 
section, respectively. The $53,530 payment is a nonperiodic payment as 
defined by paragraph (f)(1) of this section.
    (c) Assuming that I does not use the alternative methods provided 
under paragraph (f)(2)(iii) of this section, paragraph (f)(2)(ii) of 
this section requires that I recognize the nonperiodic payment over the 
term of the agreement by allocating the payment to each forward contract 
in accordance with the forward price of corn. Solely for timing 
purposes, I treats the $53,530 nonperiodic payment as a loan that J will 
repay in three installments of $5,000, $20,000, and $40,000, the 
expected payouts on the in-the-money forward contracts. With annual 
compounding at 8%, the ratable daily portions are computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                          Expected forward      Time value         Principal
                                                              payment           component          component
----------------------------------------------------------------------------------------------------------------
1995...................................................             $5,000             $4,282               $718
1996...................................................             20,000              4,225             15,775
1997...................................................             40,000              2,963             37,037
                                                        --------------------------------------------------------
                                                                   $65,000            $11,470            $53,530
----------------------------------------------------------------------------------------------------------------

    (d) The ratable daily portion of the principal component is added to 
I's periodic payments in computing its net income or net deduction from 
the notional principal contract for each taxable year. The time value 
components are needed only to compute the principal components, and are 
otherwise disregarded.

    (g) Special rules--(1) Disguised notional principal contracts. The 
Commissioner may recharacterize all or part of a transaction (or series 
of transactions) if the effect of the transaction (or series of 
transactions) is to avoid the application of this section.

[[Page 72]]

    (2) Hedged notional principal contracts. If a taxpayer, either 
directly or through a related person (as defined in paragraph (c)(4)(i) 
of this section), reduces risk with respect to a notional principal 
contract by purchasing, selling, or otherwise entering into other 
notional principal contracts, futures, forwards, options, or other 
financial contracts (other than debt instruments), the taxpayer may not 
use the alternative methods provided in paragraphs (f)(2)(iii) and (v) 
of this section. Moreover, where such positions are entered into to 
avoid the appropriate timing or character of income from the contracts 
taken together, the Commissioner may require that amounts paid to or 
received by the taxpayer under the notional principal contract be 
treated in a manner that is consistent with the economic substance of 
the transaction as a whole.
    (3) Options and forwards to enter into notional principal contracts. 
An option or forward contract that entitles or obligates a person to 
enter into a notional principal contract is subject to the general rules 
of taxation for options or forward contracts. Any payment with respect 
to the option or forward contract is treated as a nonperiodic payment 
for the underlying notional principal contract under the rules of 
paragraphs (f) and (g)(4) or (g)(5) of this section if and when the 
underlying notional principal contract is entered into.
    (4) Swaps with significant nonperiodic payments. A swap with 
significant nonperiodic payments is treated as two separate transactions 
consisting of an on-market, level payment swap and a loan. The loan must 
be accounted for by the parties to the contract independently of the 
swap. The time value component associated with the loan is not included 
in the net income or net deduction from the swap under paragraph (d) of 
this section, but is recognized as interest for all purposes of the 
Internal Revenue Code. See paragraph (g)(6) Example 3 of this section. 
For purposes of section 956, the Commissioner may treat any nonperiodic 
swap payment, whether or not it is significant, as one or more loans.
    (5) Caps and floors that are significantly in-the-money. [Reserved]
    (6) Examples. The following examples illustrate the application of 
paragraph (g) of this section.

    Example 1. Cap hedged with options.(a) On January 1, 1995, K sells 
to unrelated counterparty L three cash settlement European-style put 
options on Eurodollar time deposits with a strike rate of 9%. The 
options have exercise dates of January 1, 1996, January 1, 1997, and 
January 1, 1998, respectively. If LIBOR exceeds 9% on any of the 
exercise dates, L will be entitled, by exercising the relevant option, 
to receive from K an amount that corresponds to the excess of LIBOR over 
9% times $25 million. L pays K $650,000 for the three options. 
Furthermore, K is related to F, the cap purchaser in paragraph (f)(4) 
Example 1 of this section.
    (b) K's option agreements with L reduce risk with respect to F's cap 
agreement with E. Accordingly, under paragraph (g)(2) of this section, F 
cannot use the alternative methods provided in paragraph (f)(2)(v) of 
this section to amortize the premium paid under the cap agreement. F 
must amortize the cap premium it paid in accordance with paragraph 
(f)(2)(iv) of this section.
    (c) The method that E may use to account for its agreement with F is 
not affected by the application of paragraph (g)(2) of this section to 
F.
    Example 2. Nonperiodic payment that is not significant. (a) On 
January 1, 1995, G enters into an interest rate swap agreement with 
unrelated counterparty H under which, for a term of five years, G is 
obligated to make annual payments at 11% and H is obligated to make 
annual payments at LIBOR on a notional principal amount of $100 million. 
At the time G and H enter into this swap agreement, the rate for similar 
on-market swaps is LIBOR to 10%. To compensate for this difference, on 
January 1, 1995, H pays G a yield adjustment fee of $3,790,786. G 
provides H with information that indicates that the amount of the yield 
adjustment fee was determined as the present value, at 10% compounded 
annually, of five annual payments of $1,000,000 (1%x$100,000,000). G and 
H are calendar year taxpayers. (These facts are the same as in paragraph 
(f)(4) Example 5 of this section.)
    (b) In this situation, the yield adjustment fee of $3,790,786 is not 
a significant nonperiodic payment within the meaning of paragraph (g)(4) 
of this section, in light of the amount of the fee in proportion to the 
present value of the total amount of fixed payments due under the 
contract. Accordingly, no portion of the swap is recharacterized as a 
loan for purposes of this section.
    Example 3. Significant nonperiodic payment. (a) On January 1, 1995, 
unrelated parties M and N enter into an interest rate swap contract. 
Under the terms of the contract, N agrees to make five annual payments 
to M

[[Page 73]]

equal to LIBOR times a notional principal amount of $100 million. In 
return, M agrees to pay N 6% of $100 million annually, plus $15,163,147 
on January 1, 1995. At the time M and N enter into this swap agreement 
the rate for similar on- market swaps is LIBOR to 10%, and N provides M 
with information that the amount of the initial payment was determined 
as the present value, at 10% compounded annually, of five annual 
payments from M to N of $4,000,000 (4% of $100,000,000).
    (b) Although the parties have characterized this transaction as an 
interest rate swap, the $15,163,147 payment from M to N is significant 
when compared to the present value of the total fixed payments due under 
the contract. Accordingly, under paragraph (g)(4) of this section, the 
transaction is recharacterized as consisting of both a $15,163,147 loan 
from M to N that N repays in installments over the term of the 
agreement, and an interest rate swap between M and N in which M 
immediately pays the installment payments on the loan back to N as part 
of its fixed payments on the swap in exchange for the LIBOR payments by 
N.
    (c) The yield adjustment fee is recognized over the life of the 
agreement by treating the $15,163,147 as a loan that will be repaid with 
level payments over five years. Assuming a constant yield to maturity 
and annual compounding at 10%, M and N account for the principal and 
interest on the loan as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                 Interest          Principal
                                                           Level payment        component          component
----------------------------------------------------------------------------------------------------------------
1995...................................................         $4,000,000         $1,516,315         $2,483,685
1996...................................................          4,000,000          1,267,946          2,732,054
1997...................................................          4,000,000            994,741          3,005,259
1998...................................................          4,000,000            694,215          3,305,785
1999...................................................          4,000,000            363,636          3,636,364
                                                        --------------------------------------------------------
                                                               $20,000,000         $4,836,853        $15,163,147
----------------------------------------------------------------------------------------------------------------

    (d) M recognizes interest income, and N claims an interest 
deduction, each taxable year equal to the interest component of the 
deemed installment payments on the loan. These interest amounts are not 
included in the parties' net income or net deduction from the swap 
contract under paragraph (d) of this section. The principal components 
are needed only to compute the interest component of the level payment 
for the following period, and do not otherwise affect the parties' net 
income or net deduction from this contract.
    (e) N also makes swap payments to M based on LIBOR, and receives 
swap payments from M at a fixed rate that is equal to the sum of the 
stated fixed rate and the rate calculated by dividing the deemed level 
annual payments on the loan by the notional principal amount. Thus, the 
fixed rate on this swap is 10%, which is the sum of the stated rate of 
6% and the rate calculated by dividing the annual loan payment of 
$4,000,000 by the notional principal amount of $100,000,000, or 4%. 
Using the methods provided in paragraph (e)(2) of this section, the swap 
payments from M to N of $10,000,000 (10% of $100,000,000) and the LIBOR 
swap payments from N to M are included in the parties' net income or net 
deduction from the contract for each taxable year.
    Example 4. Swaps recharacterized as a loan. (a) The facts are the 
same as in Example 3, except that on January 1, 1995, N also enters into 
an interest rate swap agreement with unrelated counterparty O under 
which, for a term of five years, N is obligated to make annual payments 
at 12% and O is obligated to make annual payments at LIBOR on a notional 
principal amount of $100 million. At the time N and O enter into this 
swap agreement, the rate for similar on-market swaps is LIBOR to 10%. To 
compensate for this difference, O pays N an upfront yield adjustment fee 
of $7,581,574. This yield adjustment fee equals the present value, at 
10% compounded annually, of five annual payments of $2,000,000 (2% of 
$100,000,000).
    (b) In substance, these two interest rate swaps are the equivalent 
of a fixed rate borrowing by N of $22,744,721 ($15,163,147 from M plus 
$7,581,574 from O). Under paragraph (g)(2) of this section, if these 
positions were entered into to avoid interest character on a net loan 
position, the Commissioner may recharacterize the swaps as a loan which 
N will repay with interest in five annual installments of $6,000,000 
each (the difference between the 12% N pays under the swap with O and 
the 6% N receives under the swap with M, multiplied by the $100,000,000 
notional principal amount).
    (c) N recognizes no net income or net deduction from these contracts 
under paragraph (d) of this section because, as to N, there is no 
notional principal contract income or expense. However, the 
recharacterization of N's separate transactions as a loan has no effect 
on the way M and O must each account for their notional principal 
contracts under paragraphs (d) through (g) of this section.

    (h) Termination payments--(1) Definition. A payment made or received 
to

[[Page 74]]

extinguish or assign all or a proportionate part of the remaining rights 
and obligations of any party under a notional principal contract is a 
termination payment to the party making the termination payment and the 
party receiving the payment. A termination payment includes a payment 
made between the original parties to the contract (an extinguishment), a 
payment made between one party to the contract and a third party (an 
assignment), and any gain or loss realized on the exchange of one 
notional principal contract for another. Where one party assigns its 
remaining rights and obligations to a third party, the original 
nonassigning counterparty realizes gain or loss if the assignment 
results in a deemed exchange of contracts and a realization event under 
section 1001.
    (2) Taxable year of inclusion and deduction by original parties. 
Except as otherwise provided (for example, in section 453, section 1092, 
or Sec. 1.446-4), a party to a notional principal contract recognizes a 
termination payment in the year the contract is extinguished, assigned, 
or exchanged. When the termination payment is recognized, the party also 
recognizes any other payments that have been made or received pursuant 
to the notional principal contract, but that have not been recognized 
under paragraph (d) of this section. If only a proportionate part of a 
party's rights and obligations is extinguished, assigned, or exchanged, 
then only that proportion of the unrecognized payments is recognized 
under the previous sentence.
    (3) Taxable year of inclusion and deduction by assignees. A 
termination payment made or received by an assignee pursuant to an 
assignment of a notional principal contract is recognized by the 
assignee under the rules of paragraphs (f) and (g)(4) or (g)(5) of this 
section as a nonperiodic payment for the notional principal contract 
that is in effect after the assignment.
    (4) Special rules--(i) Assignment of one leg of a contract. A 
payment is not a termination payment if it is made or received by a 
party in exchange for assigning all or a portion of one leg of a 
notional principal contract at a time when a substantially proportionate 
amount of the other leg remains unperformed and unassigned. The payment 
is either an amount loaned, an amount borrowed, or a nonperiodic 
payment, depending on the economic substance of the transaction to each 
party. This paragraph (h)(4)(i) applies whether or not the original 
notional principal contract is terminated as a result of the assignment.
    (ii) Substance over form. Any economic benefit that is given or 
received by a taxpayer in lieu of a termination payment is a termination 
payment.
    (5) Examples. The following examples illustrate the application of 
this paragraph (h). The contracts in the examples are not hedging 
transactions as defined in Sec. 1.1221-2(b), and all of the examples 
assume that no loss-deferral rules apply.

    Example 1. Termination by extinguishment. (a) On January 1, 1995, P 
enters into an interest rate swap agreement with unrelated counterparty 
Q under which, for a term of seven years, P is obligated to make annual 
payments based on 10% and Q is obligated to make semi-annual payments 
based on LIBOR and a notional principal amount of $100 million. P and Q 
are both calendar year taxpayers. On January 1, 1997, when the fixed 
rate on a comparable LIBOR swap has fallen to 9.5%, P pays Q $1,895,393 
to terminate the swap.
    (b) The payment from P to Q extinguishes the swap contract and is a 
termination payment, as defined in paragraph (h)(1) of this section, for 
both parties. Accordingly, under paragraph (h)(2) of this section, P 
recognizes a loss of $1,895,393 in 1997 and Q recognizes $1,895,393 of 
gain in 1997.
    Example 2. Termination by assignment. (a) The facts are the same as 
in Example 1, except that on January 1, 1997, P pays unrelated party R 
$1,895,393 to assume all of P's rights and obligations under the swap 
with Q. In return for this payment, R agrees to pay 10% of $100 million 
annually to Q and to receive LIBOR payments from Q for the remaining 
five years of the swap.
    (b) The payment from P to R terminates P's interest in the swap 
contract with Q and is a termination payment, as defined in paragraph 
(h)(1) of this section, for P. Under paragraph (h)(2) of this section, P 
recognizes a loss of $1,895,393 in 1997. Whether Q also has a 
termination payment with respect to the payment from P to R is 
determined under section 1001.
    (c) Under paragraph (h)(3) of this section, the assignment payment 
that R receives from P is a nonperiodic payment for an interest rate 
swap. Because the assignment payment is not a significant nonperiodic 
payment within the meaning of paragraph

[[Page 75]]

(g)(1) of this section, R amortizes the $1,895,393 over the five year 
term of the swap agreement under paragraph (f)(2) of this section.
    Example 3. Assignment of swap with yield adjustment fee. (a) The 
facts are the same as in Example 2, except that on January 1, 1995, Q 
paid P a yield adjustment fee to enter into the seven year interest rate 
swap. In accordance with paragraph (f)(2) of this section, P and Q 
included the ratable daily portions of that nonperiodic payment in their 
net income or net deduction from the contract for 1995 and 1996. On 
January 1, 1997, $300,000 of the nonperiodic payment has not yet been 
recognized by P and Q.
    (b) Under paragraph (h)(2) of this section, P recognizes a loss of 
$1,595,393 ($1,895,393-$300,000) in 1997. R accounts for the termination 
payment in the same way it did in Example 2; the existence of an 
unamortized payment with respect to the original swap has no effect on 
R.
    Example 4. Assignment of one leg of a swap. (a) On January 1, 1995, 
S enters into an interest rate swap agreement with unrelated 
counterparty T under which, for a term of five years, S will make annual 
payments at 10% and T will make annual payments at LIBOR on a notional 
principal amount of $50 million. On January 1, 1996, unrelated party U 
pays T $15,849,327 for the right to receive the four remaining 
$5,000,000 payments from S. Under the terms of the agreement between S 
and T, S is notified of this assignment, and S is contractually bound 
thereafter to make its payments to U on the appropriate payment dates. 
S's obligation to pay U is conditioned on T making its LIBOR payment to 
S on the appropriate payment dates.
    (b) Because T has assigned to U its rights to the fixed rate 
payments, but not its floating rate obligations under the notional 
principal contract, U's payment to T is not a termination payment as 
defined in paragraph (h)(1) of this section, but is covered by paragraph 
(h)(4)(i) of this section. The economic substance of the transaction 
between T and U is a loan that does not affect the way that S and T 
account for the notional principal contract under this section.

    (i) Anti-abuse rule. If a taxpayer enters into a transaction with a 
principal purpose of applying the rules of this section to produce a 
material distortion of income, the Commissioner may depart from the 
rules of this section as necessary to reflect the appropriate timing of 
income and deductions from the transaction.
    (j) Effective date. These regulations are effective for notional 
principal contracts entered into on or after December 13, 1993.

[T.D. 8491, 58 FR 53128, Oct. 14, 1993; 59 FR 9411, Feb. 28, 1994, as 
amended by T.D. 8554, 59 FR 36358, July 18, 1994]



Sec. 1.446-4  Hedging transactions.

    (a) In general. Except as provided in this paragraph (a), a hedging 
transaction as defined in Sec. 1.1221-2(b) (whether or not the 
character of gain or loss from the transaction is determined under Sec. 
1.1221-2) must be accounted for under the rules of this section. To the 
extent that provisions of any other regulations governing the timing of 
income, deductions, gain, or loss are inconsistent with the rules of 
this section, the rules of this section control.
    (1) Trades or businesses excepted. A taxpayer is not required to 
account for hedging transactions under the rules of this section for any 
trade or business in which the cash receipts and disbursements method of 
accounting is used or in which Sec. 1.471-6 is used for inventory 
valuations if, for all prior taxable years ending on or after September 
30, 1993, the taxpayer met the $5,000,000 gross receipts test of section 
448(c) (or would have met that test if the taxpayer were a corporation 
or partnership). A taxpayer not required to use the rules of this 
section may nonetheless use a method of accounting that is consistent 
with these rules.
    (2) Coordination with other sections. This section does not apply 
to--
    (i) Any position to which section 475(a) applies;
    (ii) An integrated transaction subject to Sec. 1.1275-6;
    (iii) Any section 988 hedging transaction if the transaction is 
integrated under Sec. 1.988-5 or if other regulations issued under 
section 988(d) (or an advance ruling described in 1.988-5(e)) govern 
when gain or loss from the transaction is taken into account; or
    (iv) The determination of the issuer's yield on an issue of tax-
exempt bonds for purposes of the arbitrage restrictions to which Sec. 
1.148-4(h) applies.
    (b) Clear reflection of income. The method of accounting used by a 
taxpayer for a hedging transaction must clearly reflect income. To 
clearly reflect income, the method used must

[[Page 76]]

reasonably match the timing of income, deduction, gain, or loss from the 
hedging transaction with the timing of income, deduction, gain, or loss 
from the item or items being hedged. Taking gains and losses into 
account in the period in which they are realized may clearly reflect 
income in the case of certain hedging transactions. For example, where a 
hedge and the item being hedged are disposed of in the same taxable 
year, taking realized gain or loss into account on both items in that 
taxable year may clearly reflect income. In the case of many hedging 
transactions, however, taking gains and losses into account as they are 
realized does not result in the matching required by this section.
    (c) Choice of method and consistency. For any given type of hedging 
transaction, there may be more than one method of accounting that 
satisfies the clear reflection requirement of paragraph (b) of this 
section. A taxpayer is generally permitted to adopt a method of 
accounting for a particular type of hedging transaction that clearly 
reflects the taxpayer's income from that type of transaction. See 
paragraph (e) of this section for requirements and limitations on the 
taxpayer's choice of method. Different methods of accounting may be used 
for different types of hedging transactions and for transactions that 
hedge different types of items. Once a taxpayer adopts a method of 
accounting, however, that method must be applied consistently and can 
only be changed with the consent of the Commissioner, as provided by 
section 446(e) and the regulations and procedures thereunder.
    (d) Recordkeeping requirements--(1) In general. The books and 
records maintained by a taxpayer must contain a description of the 
accounting method used for each type of hedging transaction. The 
description of the method or methods used must be sufficient to show how 
the clear reflection requirement of paragraph (b) of this section is 
satisfied.
    (2) Additional identification. In addition to the identification 
required by Sec. 1.1221-2(f), the books and records maintained by a 
taxpayer must contain whatever more specific identification with respect 
to a transaction is necessary to verify the application of the method of 
accounting used by the taxpayer for the transaction. This additional 
identification may relate to the hedging transaction or to the item, 
items, or aggregate risk being hedged. The additional identification 
must be made at the time specified in Sec. 1.1221-2(f)(2) and must be 
made on, and retained as part of, the taxpayer's books and records.
    (3) Transactions in which character of gain or loss is not 
determined under Sec. 1.1221-2. A section 988 transaction, as defined 
in section 988(c)(1), or a qualified fund, as defined in section 
988(c)(1)(E)(iii), is subject to the identification and recordkeeping 
requirements of Sec. 1.1221-2(f). See Sec. 1.1221-2(a)(4).
    (e) Requirements and limitations with respect to hedges of certain 
assets and liabilities. In the case of certain hedging transactions, 
this paragraph (e) provides guidance in determining whether a taxpayer's 
method of accounting satisfies the clear reflection requirement of 
paragraph (b) of this section. Even if these rules are satisfied, 
however, the taxpayer's method, as actually applied to the taxpayer's 
hedging transactions, must clearly reflect income by meeting the 
matching requirement of paragraph (b) of this section.
    (1) Hedges of aggregate risk--(i) In general. The method of 
accounting used for hedges of aggregate risk must comply with the 
matching requirements of paragraph (b) of this section. Even though a 
taxpayer may not be able to associate the hedging transaction with any 
particular item being hedged, the timing of income, deduction, gain, or 
loss from the hedging transaction must be matched with the timing of the 
aggregate income, deduction, gain, or loss from the items being hedged. 
For example, if a notional principal contract hedges a taxpayer's 
aggregate risk, taking into account income, deduction, gain, or loss 
under the provisions of Sec. 1.446-3 may clearly reflect income. See 
paragraph (e)(5) of this section.
    (ii) Mark-and-spread method. The following method may be appropriate 
for taking into account income, deduction, gain, or loss from hedges of 
aggregate risk:

[[Page 77]]

    (A) The hedging transactions are marked to market at regular 
intervals for which the taxpayer has the necessary data, but no less 
frequently than quarterly; and
    (B) The income, deduction, gain, or loss attributable to the 
realization or periodic marking to market of hedging transactions is 
taken into account over the period for which the hedging transactions 
are intended to reduce risk. Although the period over which the hedging 
transactions are intended to reduce risk may change, the period must be 
reasonable and consistent with the taxpayer's hedging policies and 
strategies.
    (2) Hedges of items marked to market. In the case of a transaction 
that hedges an item that is marked to market under the taxpayer's method 
of accounting, marking the hedge to market clearly reflects income.
    (3) Hedges of inventory--(i) In general. If a hedging transaction 
hedges purchases of inventory, gain or loss on the hedging transaction 
may be taken into account in the same period that it would be taken into 
account if the gain or loss were treated as an element of the cost of 
inventory. Similarly, if a hedging transaction hedges sales of 
inventory, gain or loss on the hedging transaction may be taken into 
account in the same period that it would be taken into account if the 
gain or loss were treated as an element of sales proceeds. If a hedge is 
associated with a particular purchase or sales transaction, the gain or 
loss on the hedge may be taken into account when it would be taken into 
account if it were an element of cost incurred in, or sales proceeds 
from, that transaction. As with hedges of aggregate risk, however, a 
taxpayer may not be able to associate hedges of inventory purchases or 
sales with particular purchase or sales transactions. In order to match 
the timing of income, deduction, gain, or loss from the hedge with the 
timing of aggregate income, deduction, gain, or loss from the hedged 
purchases or sales, it may be appropriate for a taxpayer to account for 
its hedging transactions in the manner described in paragraph (e)(1)(ii) 
of this section, except that the gain or loss that is spread to each 
period is taken into account when it would be if it were an element of 
cost incurred (purchase hedges), or an element of proceeds from sales 
made (sales hedges), during that period.
    (ii) Alternative methods for certain inventory hedges. In lieu of 
the method described in paragraph (e)(3)(i) of this section, other 
simpler, less precise methods may be used in appropriate cases where the 
clear reflection requirement of paragraph (b) of this section is 
satisfied. For example:
    (A) Taking into account realized gains and losses on both hedges of 
inventory purchases and hedges of inventory sales when they would be 
taken into account if the gains and losses were elements of inventory 
cost in the period realized may clearly reflect income in some 
situations, but does not clearly reflect income for a taxpayer that uses 
the last-in, first-out method of accounting for the inventory; and
    (B) Marking hedging transactions to market with resulting gain or 
loss taken into account immediately may clearly reflect income even 
though the inventory that is being hedged is not marked to market, but 
only if the inventory is not accounted for under either the last-in, 
first-out method or the lower-of-cost-or-market method and only if items 
are held in inventory for short periods of time.
    (4) Hedges of debt instruments. Gain or loss from a transaction that 
hedges a debt instrument issued or to be issued by a taxpayer, or a debt 
instrument held or to be held by a taxpayer, must be accounted for by 
reference to the terms of the debt instrument and the period or periods 
to which the hedge relates. A hedge of an instrument that provides for 
interest to be paid at a fixed rate or a qualified floating rate, for 
example, generally is accounted for using constant yield principles. 
Thus, assuming that a fixed rate or qualified floating rate instrument 
remains outstanding, hedging gain or loss is taken into account in the 
same periods in which it would be taken into account if it adjusted the 
yield of the instrument over the term to which the hedge relates. For 
example, gain or loss realized on a transaction that hedged an 
anticipated fixed rate borrowing for its entire term is accounted for, 
solely for purposes of this section, as if it decreased or increased the 
issue price of

[[Page 78]]

the debt instrument. Similarly, gain or loss realized on a transaction 
that hedges a contingent payment on a debt instrument subject to Sec. 
1.1275-4(c) (a contingent payment debt instrument issued for nonpublicly 
traded property) is taken into account when the contingent payment is 
taken into account under Sec. 1.1275-4(c).
    (5) Notional principal contracts. The rules of Sec. 1.446-3 govern 
the timing of income and deductions with respect to a notional principal 
contract unless, because the notional principal contract is part of a 
hedging transaction, the application of those rules would not result in 
the matching that is needed to satisfy the clear reflection requirement 
of paragraph (b) and, as applicable, (e)(4) of this section. For 
example, if a notional principal contract hedges a debt instrument, the 
method of accounting for periodic payments described in Sec. 1.446-3(e) 
and the methods of accounting for nonperiodic payments described in 
Sec. 1.446-3(f)(2)(iii) and (v) generally clearly reflect the 
taxpayer's income. The methods described in Sec. 1.446-3(f)(2)(ii) and 
(iv), however, generally do not clearly reflect the taxpayer's income in 
that situation.
    (6) Disposition of hedged asset or liability. If a taxpayer hedges 
an item and disposes of, or terminates its interest in, the item but 
does not dispose of or terminate the hedging transaction, the taxpayer 
must appropriately match the built-in gain or loss on the hedging 
transaction to the gain or loss on the disposed item. To meet this 
requirement, the taxpayer may mark the hedge to market on the date it 
disposes of the hedged item. If the taxpayer intends to dispose of the 
hedging transaction within a reasonable period, however, it may be 
appropriate to match the realized gain or loss on the hedging 
transaction with the gain or loss on the disposed item. If the taxpayer 
intends to dispose of the hedging transaction within a reasonable period 
and the hedging transaction is not actually disposed of within that 
period, the taxpayer must match the gain or loss on the hedge at the end 
of the reasonable period with the gain or loss on the disposed item. For 
purposes of this paragraph (e)(6), a reasonable period is generally 7 
days.
    (7) Recycled hedges. If a taxpayer enters into a hedging transaction 
by recycling a hedge of a particular hedged item to serve as a hedge of 
a different item, as described in Sec. 1.1221-2(d)(4), the taxpayer 
must match the built-in gain or loss at the time of the recycling to the 
gain or loss on the original hedged item, items, or aggregate risk. 
Income, deduction, gain, or loss attributable to the period after the 
recycling must be matched to the new hedged item, items, or aggregate 
risk under the principles of paragraph (b) of this section.
    (8) Unfulfilled anticipatory transactions--(i) In general. If a 
taxpayer enters into a hedging transaction to reduce risk with respect 
to an anticipated asset acquisition, debt issuance, or obligation, and 
the anticipated transaction is not consummated, any income, deduction, 
gain, or loss from the hedging transaction is taken into account when 
realized.
    (ii) Consummation of anticipated transaction. A taxpayer consummates 
a transaction for purposes of paragraph (e)(8)(i) of this section upon 
the occurrence (within a reasonable interval around the expected time of 
the anticipated transaction) of either the anticipated transaction or a 
different but similar transaction for which the hedge serves to 
reasonably reduce risk.
    (9) Hedging by members of a consolidated group--(i) General rule: 
single-entity approach. In general, a member of a consolidated group 
must account for its hedging transactions as if all of the members were 
separate divisions of a single corporation. Thus, the timing of the 
income, deduction, gain, or loss on a hedging transaction must match the 
timing of income, deduction, gain, or loss from the item or items being 
hedged. Because all of the members are treated as if they were divisions 
of a single corporation, intercompany transactions are neither hedging 
transactions nor hedged items for these purposes.
    (ii) Separate-entity election. If a consolidated group makes an 
election under Sec. 1.1221-2(e)(2), then paragraph (e)(9)(i) of this 
section does not apply. Thus, in that case, each member of the 
consolidated group must account for its hedging transactions in a manner

[[Page 79]]

that meets the requirements of paragraph (b) of this section. For 
example, the income, deduction, gain, or loss from intercompany hedging 
transactions (as defined in Sec. 1.1221-2(e)(2)(ii)) is taken into 
account under the timing rules of Sec. 1.446-4 rather than under the 
timing rules of Sec. 1.1502-13.
    (iii) Definitions. For definitions of consolidated group, divisions 
of a single corporation, intercompany transaction, and member, see 
section 1502 and the regulations thereunder.
    (iv) Effective date. This paragraph (e)(9) applies to transactions 
entered into on or after March 8, 1996.
    (f) Type or character of income and deduction. The rules of this 
section govern the timing of income, deduction, gain, or loss on hedging 
transactions but do not affect the type or character of income, 
deduction, gain, or loss produced by the transaction. Thus, for example, 
the rules of paragraph (e)(3) of this section do not affect the 
computation of cost of goods sold or sales proceeds for a taxpayer that 
hedges inventory purchases or sales. Similarly, the rules of paragraph 
(e)(4) of this section do not increase or decrease the interest income 
or expense of a taxpayer that hedges a debt instrument or a liability.
    (g) Effective date. This section applies to hedging transactions 
entered into on or after October 1, 1994.
    (h) Consent to change methods of accounting. The Commissioner grants 
consent for a taxpayer to change its methods of accounting for 
transactions that are entered into on or after October 1, 1994, and that 
are described in paragraph (a) of this section. This consent is granted 
only for changes for the taxable year containing October 1, 1994. The 
taxpayer must describe its new methods of accounting in a statement that 
is included in its Federal income tax return for that taxable year.

[T.D. 8554, 59 FR 36358, July 18, 1994, as amended by T.D. 8653, 61 FR 
519, Jan. 8, 1996; T.D. 8674, 61 FR 30138, June 14, 1996; T.D. 8985, 67 
FR 12865, Mar. 20, 2002; 67 FR 31955, May 13, 2002]



Sec. 1.446-5  Debt issuance costs.

    (a) In general. This section provides rules for allocating debt 
issuance costs over the term of the debt. For purposes of this section, 
the term debt issuance costs means those transaction costs incurred by 
an issuer of debt (that is, a borrower) that are required to be 
capitalized under Sec. 1.263(a)-5. If these costs are otherwise 
deductible, they are deductible by the issuer over the term of the debt 
as determined under paragraph (b) of this section.
    (b) Method of allocating debt issuance costs--(1) In general. Solely 
for purposes of determining the amount of debt issuance costs that may 
be deducted in any period, these costs are treated as if they adjusted 
the yield on the debt. To effect this, the issuer treats the costs as if 
they decreased the issue price of the debt. See Sec. 1.1273-2 to 
determine issue price. Thus, debt issuance costs increase or create 
original issue discount and decrease or eliminate bond issuance premium.
    (2) Original issue discount. Any resulting original issue discount 
is taken into account by the issuer under the rules in Sec. 1.163-7, 
which generally require the use of a constant yield method (as described 
in Sec. 1.1272-1) to compute how much original issue discount is 
deductible for a period. However, see Sec. 1.163-7(b) for special rules 
that apply if the total original issue discount on the debt is de 
minimis.
    (3) Bond issuance premium. Any remaining bond issuance premium is 
taken into account by the issuer under the rules of Sec. 1.163-13, 
which generally require the use of a constant yield method for purposes 
of allocating bond issuance premium to accrual periods.
    (c) Examples. The following examples illustrate the rules of this 
section:

    Example 1. (i) On January 1, 2004, X borrows $10,000,000. The 
principal amount of the loan ($10,000,000) is repayable on December 31, 
2008, and payments of interest in the amount of $500,000 are due on 
December 31 of each year the loan is outstanding. X incurs debt issuance 
costs of $130,000 to facilitate the borrowing.
    (ii) Under Sec. 1.1273-2, the issue price of the loan is 
$10,000,000. However, under paragraph (b) of this section, X reduces the 
issue price of the loan by the debt issuance costs of $130,000, 
resulting in an issue price of $9,870,000. As a result, X treats the 
loan as having original issue discount in the amount of $130,000 (stated 
redemption price at maturity of $10,000,000 minus the issue price of 
$9,870,000). Because this amount of original issue discount is more than 
the de minimis amount of original issue discount for the

[[Page 80]]

loan determined under Sec. 1.1273-1(d) ($125,000 ($10,000,000 x .0025 x 
5)), X must allocate the original issue discount to each year based on 
the constant yield method described in Sec. 1.1272-1(b). See Sec. 
1.163-7(a). Based on this method and a yield of 5.30%, compounded 
annually, the original issue discount is allocable to each year as 
follows: $23,385 for 2004, $24,625 for 2005, $25,931 for 2006, $27,306 
for 2007, and $28,753 for 2008.
    Example 2. (i) Assume the same facts as in Example 1, except that X 
incurs debt issuance costs of $120,000 rather than $130,000.
    (ii) Under Sec. 1.1273-2, the issue price of the loan is 
$10,000,000. However, under paragraph (b) of this section, X reduces the 
issue price of the loan by the debt issuance costs of $120,000, 
resulting in an issue price of $9,880,000. As a result, X treats the 
loan as having original issue discount in the amount of $120,000 (stated 
redemption price at maturity of $10,000,000 minus the issue price of 
$9,880,000). Because this amount of original issue discount is less than 
the de minimis amount of original issue discount for the loan determined 
under Sec. 1.1273-1(d) ($125,000), X does not have to use the constant 
yield method described in Sec. 1.1272-1(b) to allocate the original 
issue discount to each year. Instead, under Sec. 1.163-7(b)(2), X can 
choose to allocate the original issue discount to each year on a 
straight-line basis over the term of the loan or in proportion to the 
stated interest payments ($24,000 each year). X also could choose to 
deduct the original issue discount at maturity of the loan. X makes its 
choice by reporting the original issue discount in a manner consistent 
with the method chosen on X's timely filed federal income tax return for 
2004. If X wanted to use the constant yield method, based on a yield of 
5.279%, compounded annually, the original issue discount is allocable to 
each year as follows: $21,596 for 2004, $22,736 for 2005, $23,937 for 
2006, $25,200 for 2007, and $26,531 for 2008.

    (d) Effective date. This section applies to debt issuance costs paid 
or incurred for debt instruments issued on or after December 31, 2003.
    (e) Accounting method changes--(1) Consent to change. An issuer 
required to change its method of accounting for debt issuance costs to 
comply with this section must secure the consent of the Commissioner in 
accordance with the requirements of Sec. 1.446-1(e). Paragraph (e)(2) 
of this section provides the Commissioner's automatic consent for 
certain changes.
    (2) Automatic consent. The Commissioner grants consent for an issuer 
to change its method of accounting for debt issuance costs incurred for 
debt instruments issued on or after December 31, 2003. Because this 
change is made on a cut-off basis, no items of income or deduction are 
omitted or duplicated and, therefore, no adjustment under section 481 is 
allowed. The consent granted by this paragraph (e)(2) applies provided--
    (i) The change is made to comply with this section;
    (ii) The change is made for the first taxable year for which the 
issuer must account for debt issuance costs under this section; and
    (iii) The issuer attaches to its federal income tax return for the 
taxable year containing the change a statement that it has changed its 
method of accounting under this section.

[T.D. 9107, 69 FR 464, Jan. 5, 2004]



Sec. 1.446-6  REMIC inducement fees.

    (a) Purpose. This section provides specific timing rules for the 
clear reflection of income from an inducement fee received in connection 
with becoming the holder of a noneconomic REMIC residual interest. An 
inducement fee must be included in income over a period reasonably 
related to the period during which the applicable REMIC is expected to 
generate taxable income or net loss allocable to the holder of the 
noneconomic residual interest.
    (b) Definitions. For purposes of this section:
    (1) Applicable REMIC. The applicable REMIC is the REMIC that issued 
the noneconomic residual interest with respect to which the inducement 
fee is paid.
    (2) Inducement fee. An inducement fee is the amount paid to induce a 
person to become the holder of a noneconomic residual interest in an 
applicable REMIC.
    (3) Noneconomic residual interest. A REMIC residual interest is a 
noneconomic residual interest if it is a noneconomic residual interest 
within the meaning of Sec. 1.860E-1(c)(2).
    (4) Remaining anticipated weighted average life. The remaining 
anticipated weighted average life is the anticipated weighted average 
life determined using the methodology set forth in Sec. 1.860E-
1(a)(3)(iv) applied as of the date of acquisition of the noneconomic 
residual interest.

[[Page 81]]

    (5) REMIC. The term REMIC has the same meaning in this section as 
given in Sec. 1.860D-1.
    (c) General rule. All taxpayers, regardless of their overall method 
of accounting, must recognize an inducement fee over the remaining 
expected life of the applicable REMIC in a manner that reasonably 
reflects, without regard to this paragraph, the after-tax costs and 
benefits of holding that noneconomic residual interest.
    (d) Special rule on disposition of a residual interest. If any 
portion of an inducement fee received with respect to becoming the 
holder of a noneconomic residual interest in an applicable REMIC has not 
been recognized in full by the holder as of the time the holder 
transfers, or otherwise ceases to be the holder for Federal tax purposes 
of, that residual interest in the applicable REMIC, then the holder must 
include the unrecognized portion of the inducement fee in income at that 
time. This rule does not apply to a transaction to which section 
381(c)(4) applies.
    (e) Safe harbors. If inducement fees are recognized in accordance 
with a method described in this paragraph (e), that method complies with 
the requirements of paragraph (c) of this section.
    (1) The book method. Under the book method, an inducement fee is 
recognized in accordance with the method of accounting, and over the 
same period, used by the taxpayer for financial reporting purposes 
(including consolidated financial statements to shareholders, partners, 
beneficiaries, and other proprietors and for credit purposes), provided 
that the inducement fee is included in income for financial reporting 
purposes over a period that is not shorter than the period during which 
the applicable REMIC is expected to generate taxable income.
    (2) The modified REMIC regulatory method. Under the modified REMIC 
regulatory method, the inducement fee is recognized ratably over the 
remaining anticipated weighted average life of the applicable REMIC as 
if the inducement fee were unrecognized gain being included in gross 
income under Sec. 1.860F-2(b)(4)(iii).
    (3) Additional safe harbor methods. The Commissioner, by revenue 
ruling or revenue procedure (see Sec. 1.601(d)(2) of this chapter), may 
provide additional safe harbor methods for recognizing inducement fees 
relating to noneconomic REMIC residual interests.
    (f) Method of accounting. The treatment of inducement fees is a 
method of accounting to which the provisions of sections 446 and 481 and 
the regulations thereunder apply. A taxpayer is generally permitted to 
adopt a method of accounting for inducement fees that satisfies the 
requirements of paragraph (c) of this section. Once a taxpayer adopts a 
method of accounting for inducement fees, that method must be applied 
consistently to all inducement fees received in connection with 
noneconomic REMIC residual interests and may be changed only with the 
consent of the Commissioner, as provided by section 446(e) and the 
regulations and procedures thereunder.
    (g) Effective date. This section is applicable for taxable years 
ending on or after May 11, 2004.

[T.D. 9128, 69 FR 26041, May 11, 2004]



Sec. 1.448-1  Limitation on the use of the cash receipts and 
disbursements method of accounting.

    (a)-(f) [Reserved]
    (g) Treatment of accounting method change and timing rules for 
section 481(a) adjustment--(1) Treatment of change in accounting method. 
Notwithstanding any other procedure published prior to January 7, 1991, 
concerning changes from the cash method, any taxpayer to whom section 
448 applies must change its method of accounting in accordance with the 
provisions of this paragraph (g) and paragraph (h) of this section. In 
the case of any taxpayer required by this section to change its method 
of accounting for any taxable year, the change shall be treated as a 
change initiated by the taxpayer. The adjustments required under section 
481(a) with respect to the change in method of accounting of such a 
taxpayer shall not be reduced by amounts attributable to taxable years 
preceding the Internal Revenue Code of 1954. Paragraph (h)(2) of this 
section provides procedures under which a taxpayer may change to an 
overall accrual method of accounting for the first taxable year the 
taxpayer is subject to this section (``first section 448 year'').

[[Page 82]]

If the taxpayer complies with the provisions of paragraph (h)(2) of this 
section for its first section 448 year, the change shall be treated as 
made with the consent of the Commissioner. Paragraph (h)(3) of this 
section provides procedures under which a taxpayer may change to other 
than an overall accrual method of accounting for its first section 448 
year. Unless the taxpayer complies with the provisions of paragraph 
(h)(2) or (h)(3) of this section for its first section 448 year, the 
taxpayer must comply with the provisions of paragraph (h)(4) of this 
section. See paragraph (h) of this section for rules to effect a change 
in method of accounting.
    (2) Timing rules for section 481(a) adjustment--(i) In general. 
Except as otherwise provided in paragraphs (g)(2)(ii) and (g)(3) of this 
section, a taxpayer required by this section to change from the cash 
method must take the net section 481(a) adjustment into account over the 
section 481(a) adjustment period as determined under the applicable 
administrative procedures issued under Sec. 1.446-1(e)(3)(ii) for 
obtaining the Commissioner's consent to a change in accounting method 
(for example, see Rev. Proc. 2002-9 (2002-1 C.B. 327) and Rev. Proc. 97-
27 (1997-1 C.B. 680) (also see Sec. 601.601(d)(2) of this chapter)), 
provided the taxpayer complies with the provisions of paragraph (h)(2) 
or (3) of this section for its first section 448 year.
    (ii) Hospital timing rules--(A) In general. In the case of a 
hospital that is required by this section to change from the cash 
method, the section 481(a) adjustment shall be taken into account 
ratably (beginning with the year of change) over 10 years, provided the 
taxpayer complies with the provisions of paragraph (h)(2) or (h)(3) of 
this section for its first section 448 year.
    (B) Definition of hospital. For purposes of paragraph (g) of this 
section, a hospital is an institution--
    (1) Accredited by the Joint Commission on Accreditation of 
Healthcare Organizations or its predecessor (the JCAHO) (or accredited 
or approved by a program of the qualified governmental unit in which 
such institution is located if the Secretary of Health and Human 
Services has found that the accreditation or comparable approval 
standards of such qualified governmental unit are essentially equivalent 
to those of the JCAHO);
    (2) Used primarily to provide, by or under the supervision of 
physicians, to inpatients diagnostic services and therapeutic services 
for medical diagnosis, treatment, and care of injured, disabled, or sick 
persons;
    (3) Requiring every patient to be under the care and supervision of 
a physician; and
    (4) Providing 24-hour nursing services rendered or supervised by a 
registered professional nurse and having a licensed practical nurse or 
registered nurse on duty at all times.

For purposes of this section, an entity need not be owned by or on 
behalf of a governmental unit or by a section 501(c)(3) organization, or 
operated by a section 501(c)(3) organization, in order to be considered 
a hospital. In addition, for purposes of this section, a hospital does 
not include a rest or nursing home, continuing care facility, daycare 
center, medical school facility, research laboratory, or ambulatory care 
facility.
    (C) Dual function facilities. With respect to any taxpayer whose 
operations consist both of a hospital, and other facilities not 
qualifying as a hospital, the portion of the adjustment required by 
section 481(a) that is attributable to the hospital shall be taken into 
account in accordance with the rules of paragraph (g)(2) of this section 
relating to hospitals. The portion of the adjustment required by section 
481(a) that is not attributable to the hospital shall be taken into 
account in accordance with the rules of paragraph (g)(2) of this section 
not relating to hospitals.
    (iii) Untimely change in method of accounting to comply with this 
section. Unless a taxpayer (including a hospital and a cooperative) 
required by this section to change from the cash method complies with 
the provisions of paragraph (h)(2) or (h)(3) of this section for its 
first section 448 year within the time prescribed by those paragraphs, 
the taxpayer must take the section 481 (a) adjustment into account under 
the provisions of any applicable administrative procedure that is 
prescribed by the Commissioner after January 7,

[[Page 83]]

1991, specifically for purposes of complying with this section. Absent 
such an administrative procedure, a taxpayer must request a change under 
Sec. 1.446-1(e)(3) and shall be subject to any terms and conditions 
(including the year of change) as may be imposed by the Commissioner.
    (3) Special timing rules for section 481(a) adjustment--(i)Cessation 
of trade or business. If the taxpayer ceases to engage in the trade or 
business to which the section 481(a) adjustment relates, or if the 
taxpayer operating the trade or business terminates existence, and such 
cessation or termination occurs prior to the expiration of the 
adjustment period described in paragraph (g)(2)(i) or (ii) of this 
section, the taxpayer must take into account, in the taxable year of 
such cessation or termination, the balance of the adjustment not 
previously taken into account in computing taxable income. For purposes 
of this paragraph (g)(3)(i), the determination as to whether a taxpayer 
has ceased to engage in the trade or business to which the section 
481(a) adjustment relates, or has terminated its existence, is to be 
made under the principles of Sec. 1.446-1(e)(3)(ii) and its underlying 
administrative procedures.
    (ii) De minimis rule for a taxpayer other than a cooperative. 
Notwithstanding paragraph (g)(2)(i) and (ii) of this section, a taxpayer 
other than a cooperative (within the meaning of section 1381(a)) that is 
required to change from the cash method by this section may elect to 
use, in lieu of the adjustment period described in paragraph (g)(2)(i) 
and (ii) of this section, the adjustment period for de minimis section 
481(a) adjustments provided in the applicable administrative procedure 
issued under Sec. 1.446-1(e)(3)(ii) for obtaining the Commissioner's 
consent to a change in accounting method. A taxpayer may make an 
election under this paragraph (g)(3)(ii) only if--
    (A) The taxpayer's entire net section 481(a) adjustment (whether 
positive or negative) is a de minimis amount as determined under the 
applicable administrative procedure issued under Sec. 1.446-1(e)(3)(ii) 
for obtaining the Commissioner's consent to a change in accounting 
method,
    (B) The taxpayer complies with the provisions of paragraph (h)(2) or 
(3) of this section for its first section 448 year,
    (C) The return for such year is due (determined with regard to 
extensions) after December 27, 1993, and
    (D) The taxpayer complies with any applicable instructions to Form 
3115 that specify the manner of electing the adjustment period for de 
minimis section 481(a) adjustments.
    (4) Additional rules relating to section 481(a) adjustment. In 
addition to the rules set forth in paragraph (g) (2) and (3) of this 
section, the following rules shall apply in taking the section 481(a) 
adjustment into account--
    (i) Any net operating loss and tax credit carryforwards will be 
allowed to offset any positive section 481(a) adjustment,
    (ii) Any net operating loss arising in the year of change or in any 
subsequent year that is attributable to a negative section 481(a) 
adjustment may be carried back to earlier taxable years in accordance 
with section 172, and
    (iii) For purposes of determining estimated income tax payments 
under sections 6654 and 6655, the section 481(a) adjustment will be 
recognized in taxable income ratably throughout a taxable year.
    (5) Outstanding section 481(a) adjustment from previous change in 
method of accounting. If a taxpayer changed its method of accounting to 
the cash method for a taxable year prior to the year the taxpayer was 
required by this section to change from the cash method (the section 448 
year), any section 481(a) adjustment from such prior change in method of 
accounting that is outstanding as of the section 448 year shall be taken 
into account in accordance with the provisions of this paragraph (g)(5). 
A taxpayer shall account for any remaining portion of the prior section 
481(a) adjustment outstanding as of the section 448 year by continuing 
to take such remaining portion into account under the provisions and 
conditions of the prior change in method of accounting, or, at the 
taxpayer's option, combining or netting the remaining portion of the 
prior section 481(a) adjustment with the section 481(a) adjustment 
required under this section,

[[Page 84]]

and taking into account under the provisions of this section the 
resulting net amount of the adjustment. Any taxpayer choosing to combine 
or net the section 481(a) adjustments as described in the preceding 
sentence shall indicate such choice on the Form 3115 required to be 
filed by such taxpayer under the provisions of paragraph (h) of this 
section.
    (h) Procedures for change in method of accounting--(1) 
Applicability. Paragraph (h) of this section applies to taxpayers who 
change from the cash method as required by this section. Paragraph (h) 
of this section does not apply to a change in accounting method required 
by any Code section (or regulations thereunder) other than this section.
    (2) Automatic rule for changes to an overall accrual method--(i) 
Timely changes in method of accounting. Notwithstanding any other 
available procedures to change to the accrual method of accounting, a 
taxpayer to whom paragraph (h) of this section applies who desires to 
make a change to an overall accrual method for its first section 448 
year must make that change under the provisions of this paragraph 
(h)(2). A taxpayer changing to an overall accrual method under this 
paragraph (h)(2) must file a current Form 3115 by the time prescribed in 
paragraph (h)(2)(ii). In addition, the taxpayer must set forth on a 
statement accompanying the Form 3115 the period over which the section 
481(a) adjustment will be taken into account and the basis for such 
conclusion. Moreover, the taxpayer must type or legibly print the 
following statement at the top of page 1 of the Form 3115: ``Automatic 
Change to Accrual Method--Section 448.'' The consent of the Commissioner 
to the change in method of accounting is granted to taxpayers who change 
to an overall accrual method under this paragraph (h)(2). See paragraph 
(g)(2)(i), (g)(2)(ii), or (g)(3) of this section, whichever is 
applicable, for rules to account for the section 481(a) adjustment.
    (ii) Time and manner for filing Form 3115--(A) In general. Except as 
provided in paragraph (h)(2)(ii)(B) of this section, the Form 3115 
required by paragraph (h)(2)(i) must be filed no later than the due date 
(determined with regard to extensions) of the taxpayer's federal income 
tax return for the first section 448 year and must be attached to that 
return.
    (B) Extension of filing deadline. Notwithstanding paragraph 
(h)(2)(ii)(A) of this section, the filing of the Form 3115 required by 
paragraph (h)(2)(i) shall not be considered late if such Form 3115 is 
attached to a timely filed amended income tax return for the first 
section 448 year, provided that--
    (1) The taxpayer's first section 448 year is a taxable year that 
begins (or, pursuant to Sec. 1.441-2(c), is deemed to begin) in 1987, 
1988, 1989, or 1990,
    (2) The taxpayer has not been contacted for examination, is not 
before appeals, and is not before a federal court with respect to an 
income tax issue (each as defined in applicable administrative 
pronouncements), unless the taxpayer also complies with any requirements 
for approval in those applicable administrative pronouncements, and
    (3) Any amended return required by this paragraph (h)(2)(ii)(B) is 
filed on or before July 8, 1991.

Filing an amended return under this paragraph (h)(2)(ii)(B) does not 
extend the time for making any other election. Thus, for example, 
taxpayers that comply with this section by filing an amended return 
pursuant to this paragraph (h)(2)(ii)(B) may not elect out of section 
448 pursuant to paragraph (i)(2) of this section.
    (3) Changes to a method other than overall accrual method--(i) In 
general. A taxpayer to whom paragraph (h) of this section applies who 
desires to change to a special method of accounting must make that 
change under the provisions of this paragraph (h)(3), except to the 
extent other special procedures have been promulgated regarding the 
special method of accounting. Such a taxpayer includes taxpayers who 
change to both an accrual method of accounting and a special method of 
accounting such as a long-term contract method. In order to change an 
accounting method under this paragraph (h)(3), a taxpayer must submit an 
application for change in accounting method under the applicable 
administrative procedures in effect at the time of change, including the 
applicable procedures regarding the time

[[Page 85]]

and place of filing the application for change in method. Moreover, a 
taxpayer who changes an accounting method under this paragraph (h)(3) 
must type or legibly print the following statement on the top of page 1 
of Form 3115: ``Change to a Special Method of Accounting--Section 448.'' 
The filing of a Form 3115 by any taxpayer requesting a change of method 
of accounting under this paragraph (h)(3) for its taxable year beginning 
in 1987 will not be considered late if the form is filed with the 
appropriate office of the Internal Revenue Service on or before the 
later of: the date that is the 180th day of the taxable year of change; 
or September 14, 1987. If the Commissioner approves the taxpayer's 
application for change in method of accounting, the timing of the 
adjustment required under section 481 (a), if applicable, will be 
determined under the provisions of paragraph (g)(2)(i), (g)(2)(ii), or 
(g)(3) of this section, whichever is applicable. If the Commissioner 
denies the taxpayer's application for change in accounting method, or if 
the taxpayer's application is untimely, the taxpayer must change to an 
overall accrual method of accounting under the provisions of either 
paragraph (h)(2) or (h)(4) of this section, whichever is applicable.
    (ii) Extension of filing deadline. Notwithstanding paragraph 
(h)(3)(i) of this section, if the events or circumstances which under 
section 448 disqualify a taxpayer from using the cash method occur after 
the time prescribed under applicable procedures for filing the Form 
3115, the filing of such form shall not be considered late if such form 
is filed on or before 30 days after the close of the taxable year.
    (4) Untimely change in method of accounting to comply with this 
section. Unless a taxpayer to whom paragraph (h) of this section applies 
complies with the provisions of paragraph (h)(2) or (h)(3) of this 
section for its first section 448 year, the taxpayer must comply with 
the requirements of Sec. 1.446-1 (e)(3) (including any applicable 
administrative procedure that is prescribed thereunder after January 7, 
1991 specifically for purposes of complying with this section) in order 
to secure the consent of the Commissioner to change to a method of 
accounting that is in compliance with the provisions of this section. 
The taxpayer shall be subject to any terms and conditions (including the 
year of change) as may be imposed by the Commissioner.
    (i) Effective date--(1) In general. Except as provided in paragraph 
(i)(2), (3), (4), and (5) of this section, this section applies to any 
taxable year beginning after December 31, 1986.
    (2) Election out of section 448--(i) In general. A taxpayer may 
elect not to have this section apply to any (A) transaction with a 
related party (within the meaning of section 267(b) of the Internal 
Revenue Code of 1954, as in effect on October 21, 1986), (B) loan, or 
(C) lease, if such transaction, loan, or lease was entered into on or 
before September 25, 1985. Any such election described in the preceding 
sentence may be made separately with respect to each transaction, loan, 
or lease. For rules relating to the making of such election, see Sec. 
301.9100-7T (temporary regulations relating to elections under the Tax 
Reform Act of 1986). Notwithstanding the provisions of this paragraph 
(i)(2), the gross receipts attributable to a transaction, loan, or lease 
described in this paragraph (i)(2) shall be taken into account for 
purposes of the $5,000,000 gross receipts test described in paragraph 
(f) of this section.
    (ii) Special rules for loans. If the taxpayer makes an election 
under paragraph (i)(2)(i) of this section with respect to a loan entered 
into on or before September 25, 1985, the election shall apply only with 
respect to amounts that are attributable to the loan balance outstanding 
on September 25, 1985. The election shall not apply to any amounts 
advanced or lent after September 25, 1985, regardless of whether the 
loan agreement was entered into on or before such date. Moreover, any 
payments made on outstanding loan balances after September 25, 1985, 
shall be deemed to first extinguish loan balances outstanding on 
September 25, 1985, regardless of any contrary treatment of such loan 
payments by the borrower and lender.
    (3) Certain contracts entered into before September 25, 1985. This 
section does not apply to a contract for the acquisition

[[Page 86]]

or transfer of real property or a contract for services related to the 
acquisition or development of real property if--
    (i) The contract was entered into before September 25, 1985; and
    (ii) The sole element of the contract which was not performed as of 
September 25, 1985, was payment for such property or services.
    (4) Transitional rule for paragraphs (g) and (h) of this section. To 
the extent the provisions of paragraphs (g) and (h) of this section were 
not reflected in paragraphs (g) and (h) of Sec. 1.448-1T (as set forth 
in 26 CFR part 1 as revised on April 1, 1993), paragraphs (g) and (h) of 
this section will not be adversely applied to a taxpayer with respect to 
transactions entered into before December 27, 1993.
    (5) Effective date of paragraph (g)(2)(i). Paragraph (g)(2)(i) of 
this section applies to taxable years ending on or after June 16, 2004.

[T.D. 8514, 58 FR 68299, Dec. 27, 1993, as amended by T.D. 8996, 67 FR 
35012, May 17, 2002; T.D. 9131, 69 FR 33572, June 16, 2004]



Sec. 1.448-1T  Limitation on the use of the cash receipts and 
disbursements method of accounting (temporary).

    (a) Limitation on accounting method--(1) In general. This section 
prescribes regulations under section 448 relating to the limitation on 
the use of the cash receipts and disbursements method of accounting (the 
cash method) by certain taxpayers.
    (2) Limitation rule. Except as otherwise provided in this section, 
the computation of taxable income using the cash method is prohibited in 
the case of a--
    (i) C corporation,
    (ii) Partnership with a C corporation as a partner, or
    (iii) Tax shelter.

A partnership is described in paragraph (a)(2)(ii) of this section, if 
the partnership has a C corporation as a partner at any time during the 
partnership's taxable year beginning after December 31, 1986.
    (3) Meaning of C corporation. For purposes of this section, the term 
``C corporation'' includes any corporation that is not an S corporation. 
For example, a regulated investment company (as defined in section 851) 
or a real estate investment trust (as defined in section 856) is a C 
corporation for purposes of this section. In addition, a trust subject 
to tax under section 511 (b) shall be treated, for purposes of this 
section, as a C corporation, but only with respect to the portion of its 
activities that constitute an unrelated trade or business. Similarly, 
for purposes of this section, a corporation that is exempt from federal 
income taxes under section 501 (a) shall be treated as a C corporation 
only with respect to the portion of its activities that constitute an 
unrelated trade or business. Moreover, for purposes of determining 
whether a partnership has a C corporation as a partner, any partnership 
described in paragraph (a)(2)(ii) of this section is treated as a C 
corporation. Thus, if partnership ABC has a partner that is a 
partnership with a C corporation, then, for purposes of this section, 
partnership ABC is treated as a partnership with a C corporation 
partner.
    (4) Treatment of a combination of methods. For purposes of this 
section, the use of a method of accounting that records some, but not 
all, items on the cash method shall be considered the use of the cash 
method. Thus, a C corporation that uses a combination of accounting 
methods including the use of the cash method is subject to this section.
    (b) Tax shelter defined--(1) In general. For purposes of this 
section, the term ``tax shelter'' means any--
    (i) Enterprise (other than a C corporation) if at any time 
(including taxable years beginning before January 1, 1987) interests in 
such enterprise have been offered for sale in any offering required to 
be registered with any federal or state agency having the authority to 
regulate the offering of securities for sale,
    (ii) Syndicate (within the meaning of paragraph (b)(3) of this 
section), or
    (iii) Tax shelter within the meaning of section 6662(d)(2)(C).
    (2) Requirement of registration. For purposes of paragraph (b)(1)(i) 
of this section, an offering is required to be registered with a federal 
or state agency if, under the applicable federal or

[[Page 87]]

state law, failure to register the offering would result in a violation 
of the applicable federal or state law (regardless of whether the 
offering is in fact registered). In addition, an offering is required to 
be registered with a federal or state agency if, under the applicable 
federal or state law, failure to file a notice of exemption from 
registration would result in a violation of the applicable federal or 
state law (regardless of whether the notice is in fact filed).
    (3) Meaning of syndicate. For purposes of paragraph (b)(1)(ii) of 
this section, the term ``syndicate'' means a partnership or other entity 
(other than a C corporation) if more than 35 percent of the losses of 
such entity during the taxable year (for taxable years beginning after 
December 31, 1986) are allocated to limited partners or limited 
entrepreneurs. For purposes of this paragraph (b)(3), the term ``limited 
entrepreneur'' has the same meaning given such term in section 464 
(e)(2). In addition, in determining whether an interest in a partnership 
is held by a limited partner, or an interest in an entity or enterprise 
is held by a limited entrepreneur, section 464 (c)(2) shall apply in the 
case of the trade or business of farming (as defined in paragraph (d)(2) 
of this section), and section 1256 (e)(3)(C) shall apply in any other 
case. Moreover, for purposes of this paragraph (b)(3), the losses of a 
partnership, entity, or enterprise (the enterprise) means the excess of 
the deductions allowable to the enterprise over the amount of income 
recognized by such enterprise under the enterprise's method of 
accounting used for federal income tax purposes (determined without 
regard to this section). For this purpose, gains or losses from the sale 
of capital assets or section 1221 (2) assets are not taken into account.
    (4) Presumed tax avoidance. For purposes of paragraph (b)(1)(iii) of 
this section, marketed arrangements in which persons carrying on farming 
activities using the services of a common managerial or administrative 
service will be presumed to have the principal purpose of tax avoidance 
if such persons use borrowed funds to prepay a substantial portion of 
their farming expenses (e.g., payment for farm supplies that will not be 
used or consumed until a taxable year subsequent to the taxable year of 
payment).
    (5) Taxable year tax shelter must change accounting method. A 
partnership, entity, or enterprise that is a tax shelter must change 
from the cash method for the later of (i) the first taxable year 
beginning after December 31, 1986, or (ii) the taxable year that such 
partnership, entity, or enterprise becomes a tax shelter.
    (c) Effect of section 448 on other provisions. Nothing in section 
448 shall have any effect on the application of any other provision of 
law that would otherwise limit the use of the cash method, and no 
inference shall be drawn from section 448 with respect to the 
application of any such provision. For example, nothing in section 448 
affects the requirement of section 447 that certain corporations must 
use an accrual method of accounting in computing taxable income from 
farming, or the requirement of Sec. 1.446-1(c)(2) that an accrual 
method be used with regard to purchases and sales of inventory. 
Similarly, nothing in section 448 affects the authority of the 
Commissioner under section 446(b) to require the use of an accounting 
method that clearly reflects income, or the requirement under section 
446(e) that a taxpayer secure the consent of the Commissioner before 
changing its method of accounting. For example, a taxpayer using the 
cash method may be required to change to an accrual method of accounting 
under section 446(b) because such method clearly reflects that 
taxpayer's income, even though the taxpayer is not prohibited by section 
448 from using the cash method. Similarly, a taxpayer using an accrual 
method of accounting that is not prohibited by section 448 from using 
the cash method may not change to the cash method unless the taxpayer 
secures the consent of the Commissioner under section 446(e), and, in 
the opinion of the Commissioner, the use of the cash method clearly 
reflects that taxpayer's income under section 446(b).
    (d) Exception for farming business--(1) In general. Except in the 
case of a tax shelter, this section shall not apply to

[[Page 88]]

any farming business. A taxpayer engaged in a farming business and a 
separate nonfarming business is not prohibited by this section from 
using the cash method with respect to the farming business, even though 
the taxpayer may be prohibited by this section from using the cash 
method with respect to the nonfarming business.
    (2) Meaning of farming business. For purposes of paragraph (d) of 
this section, the term ``farming business'' means--
    (i) The trade or business of farming as defined in section 
263A(e)(4) (including the operation of a nursery or sod farm, or the 
raising or harvesting of trees bearing fruit, nuts, or other crops, or 
ornamental trees), or
    (ii) The raising, harvesting , or growing of trees described in 
section 263A(c)(5) (relating to trees raised, harvested, or grown by the 
taxpayer other than trees described in paragraph (d)(2)(i) of this 
section).

Thus, for purposes of this section, the term ``farming business'' 
includes the raising of timber. For purposes of this section, the term 
``farming business'' does not include the processing of commodities or 
products beyond those activities normally incident to the growing, 
raising or harvesting of such products. For example, assume that a C 
corporation taxpayer is in the business of growing and harvesting wheat 
and other grains. The taxpayer processes the harvested grains to produce 
breads, cereals, and similar food products which it sells to customers 
in the course of its business. Although the taxpayer is in the farming 
business with respect to the growing and harvesting of grain, the 
taxpayer is not in the farming business with respect to the processing 
of such grains to produce food products which the taxpayer sells to 
customers. Similarly, assume that a taxpayer is in the business of 
raising poultry or other livestock. The taxpayer uses the livestock in a 
meat processing operation in which the livestock are slaughtered, 
processed, and packaged or canned for sale to customers. Although the 
taxpayer is in the farming business with respect to the raising of 
livestock, the taxpayer is not in the farming business with respect to 
the meat processing operation. However, under this section the term 
``farming business'' does include processing activities which are 
normally incident to the growing, raising or harvesting of agricultural 
products. For example, assume a taxpayer is in the business of growing 
fruits and vegetables. When the fruits and vegetables are ready to be 
harvested, the taxpayer picks, washes, inspects, and packages the fruits 
and vegetables for sale. Such activities are normally incident to the 
raising of these crops by farmers. The taxpayer will be considered to be 
in the business of farming with respect to the growing of fruits and 
vegetables, and the processing activities incident to the harvest.
    (e) Exception for qualified personal service corporation--(1) In 
general. Except in the case of a tax shelter, this section does not 
apply to a qualified personal service corporation.
    (2) Certain treatment for qualified personal service corporation. 
For purposes of paragraph (a)(2)(ii) of this section (relating to 
whether a partnership has a C corporation as a partner), a qualified 
personal service corporation shall be treated as an individual.
    (3) Meaning of qualified personal service corporation. For purposes 
of this section, the term ``qualified personal service corporation'' 
means any corporation that meets--
    (i) The function test paragraph (e)(4) of this section, and
    (ii) The ownership test of paragraph (e)(5) of this section.
    (4) Function test--(i) In general. A corporation meets the function 
test if substantially all the corporation's activities for a taxable 
year involve the performance of services in one or more of the following 
fields--

    (A) Health,
    (B) Law,
    (C) Engineering (including surveying and mapping),
    (D) Architecture,
    (E) Accounting,
    (F) Actuarial science,
    (G) Performing arts, or
    (H) Consulting.

Substantially all of the activities of a corporation are involved in the 
performance of services in any field described in the preceding sentence 
(a qualifying field), only if 95 percent or

[[Page 89]]

more of the time spent by employees of the corporation, serving in their 
capacity as such, is devoted to the performance of services in a 
qualifying field. For purposes of determining whether this 95 percent 
test is satisfied, the performance of any activity incident to the 
actual performance of services in a qualifying field is considered the 
performance of services in that field. Activities incident to the 
performance of services in a qualifying field include the supervision of 
employees engaged in directly providing services to clients, and the 
performance of administrative and support services incident to such 
activities.
    (ii) Meaning of services performed in the field of health. For 
purposes of paragraph (e)(4)(i)(A) of this section, the performance of 
services in the field of health means the provision of medical services 
by physicians, nurses, dentists, and other similar healthcare 
professionals. The performance of services in the field of health does 
not include the provision of services not directly related to a medical 
field, even though the services may purportedly relate to the health of 
the service recipient. For example, the performance of services in the 
field of health does not include the operation of health clubs or health 
spas that provide physical exercise or conditioning to their customers.
    (iii) Meaning of services performed in the field of performing arts. 
For purposes of paragraph (e)(4)(i)(G) of this section, the performance 
of services in the field of the performing arts means the provision of 
services by actors, actresses, singers, musicians, entertainers, and 
similar artists in their capacity as such. The performance of services 
in the field of the performing arts does not include the provision of 
services by persons who themselves are not performing artists (e.g., 
persons who may manage or promote such artists, and other persons in a 
trade or business that relates to the performing arts). Similarly, the 
performance of services in the field of the performing arts does not 
include the provision of services by persons who broadcast or otherwise 
disseminate the performances of such artists to members of the public 
(e.g., employees of a radio station that broadcasts the performances of 
musicians and singers). Finally, the performance of services in the 
field of the performing arts does not include the provision of services 
by athletes.
    (iv) Meaning of services performed in the field of consulting--(A) 
In general. For purposes of paragraph (e)(4)(i)(H) of this section, the 
performance of services in the field of consulting means the provision 
of advice and counsel. The performance of services in the field of 
consulting does not include the performance of services other than 
advice and counsel, such as sales or brokerage services, or economically 
similar services. For purposes of the preceding sentence, the 
determination of whether a person's services are sales or brokerage 
services, or economically similar services, shall be based on all the 
facts and circumstances of that person's business. Such facts and 
circumstances include, for example, the manner in which the taxpayer is 
compensated for the services provided (e.g., whether the compensation 
for the services is contingent upon the consummation of the transaction 
that the services were intended to effect).
    (B) Examples. The following examples illustrate the provisions of 
paragraph (e)(4)(iv)(A) of this section. The examples do not address all 
types of services that may or may not qualify as consulting. The 
determination of whether activities not specifically addressed in the 
examples qualify as consulting shall be made by comparing the service 
activities in question to the types of service activities discussed in 
the examples. With respect to a corporation which performs services 
which qualify as consulting under this section, and other services which 
do not qualify as consulting, see paragraph (e)(4)(i) of this section 
which requires that substantially all of the corporation's activities 
involve the performance of services in a qualifying field.

    Example (1). A taxpayer is in the business of providing economic 
analyses and forecasts of business prospects for its clients. Based on 
these analyses and forecasts, the taxpayer advises its clients on their 
business activities. For example, the taxpayer may analyze the economic 
conditions and outlook for a particular industry which a client is 
considering entering. The taxpayer will then make recommendations and 
advise the client on the prospects of entering the industry, as

[[Page 90]]

well as on other matters regarding the client's activities in such 
industry. The taxpayer provides similar services to other clients, 
involving, for example, economic analyses and evaluations of business 
prospects in different areas of the United States or in other countries, 
or economic analyses of overall economic trends and the provision of 
advice based on these analyses and evaluations. The taxpayer is 
considered to be engaged in the performance of services in the field of 
consulting.
    Example (2). A taxpayer is in the business of providing services 
that consist of determining a client's electronic data processing needs. 
The taxpayer will study and examine the client's business, focusing on 
the types of data and information relevant to the client and the needs 
of the client's employees for access to this information. The taxpayer 
will then make recommendations regarding the design and implementation 
of data processing systems intended to meet the needs of the client. The 
taxpayer does not, however, provide the client with additional computer 
programming services distinct from the recommendations made by the 
taxpayer with respect to the design and implementation of the client's 
data processing systems. The taxpayer is considered to be engaged in the 
performance of services in the field of consulting.
    Example (3). A taxpayer is in the business of providing services 
that consist of determining a client's management and business structure 
needs. The taxpayer will study the client's organization, including, for 
example, the departments assigned to perform specific functions, lines 
of authority in the managerial hierarchy, personnel hiring, job 
responsibility, and personnel evaluations and compensation. Based on the 
study, the taxpayer will then advise the client on changes in the 
client's management and business structure, including, for example, the 
restructuring of the client's departmental systems or its lines of 
managerial authority. The taxpayer is considered to be engaged in the 
performance of services in the field of consulting.
    Example (4). A taxpayer is in the business of providing financial 
planning services. The taxpayer will study a particular client's 
financial situation, including, for example, the client's present 
income, savings and investments, and anticipated future economic and 
financial needs. Based on this study, the taxpayer will then assist the 
client in making decisions and plans regarding the client's financial 
activities. Such financial planning includes the design of a personal 
budget to assist the client in monitoring the client's financial 
situation, the adoption of investment strategies tailored to the 
client's needs, and other similar services. The taxpayer is considered 
to be engaged in the performance of services in the field of consulting.
    Example (5). A taxpayer is in the business of executing transactions 
for customers involving various types of securities or commodities 
generally traded through organized exchanges or other similar networks. 
The taxpayer provides its clients with economic analyses and forecasts 
of conditions in various industries and businesses. Based on these 
analyses, the taxpayer makes recommendations regarding transactions in 
securities and commodities. Clients place orders with the taxpayer to 
trade securities or commodities based on the taxpayer's recommendations. 
The taxpayer's compensation for its services is typically based on the 
trade orders. The taxpayer is not considered to be engaged in the 
performance of services in the field of consulting. The taxpayer is 
engaged in brokerage services. Relevant to this determination is the 
fact that the compensation of the taxpayer for its services is 
contingent upon the consummation of the transaction the services were 
intended to effect (i.e., the execution of trade orders for its 
clients).
    Example (6). A taxpayer is in the business of studying a client's 
needs regarding its data processing facilities and making 
recommendations to the client regarding the design and implementation of 
data processing systems. The client will then order computers and other 
data processing equipment through the taxpayer based on the taxpayer's 
recommendations. The taxpayer's compensation for its services is 
typically based on the equipment orders made by the clients. The 
taxpayer is not considered to be engaged in the performance of services 
in the field of consulting. The taxpayer is engaged in the performance 
of sales services. Relevant to this determination is the fact that the 
compensation of the taxpayer for its services it contingent upon the 
consummation of the transaction the services were intended to effect 
(i.e., the execution of equipment orders for its clients).
    Example (7). A taxpayer is in the business of assisting businesses 
in meeting their personnel requirements by referring job applicants to 
employers with hiring needs in a particular area. The taxpayer may be 
informed by potential employers of their need for job applicants, or, 
alternatively, the taxpayer may become aware of the client's personnel 
requirements after the taxpayer studies and examines the client's 
management and business structure. The taxpayer's compensation for its 
services is typically based on the job applicants, referred by the 
taxpayer to the clients, who accept employment positions with the 
clients. The taxpayer is not considered to be engaged in the performance 
of services in the field of consulting. The taxpayer is involved in the 
performance of services economically similar to brokerage services. 
Relevant to this determination

[[Page 91]]

is the fact that the compensation of the taxpayer for its services is 
contingent upon the consummation of the transaction the services were 
intended to effect (i.e., the hiring of a job applicant by the client).
    Example (8). The facts are the same as in example (7), except that 
the taxpayer's clients are individuals who use the services of the 
taxpayer to obtain employment positions. The taxpayer is typically 
compensated by its clients who obtain employment as a result of the 
taxpayer's services. For the reasons set forth in example (7), the 
taxpayer is not considered to be engaged in the performance of services 
in the field of consulting.
    Example (9). A taxpayer is in the business of assisting clients in 
placing advertisements for their goods and services. The taxpayer 
analyzes the conditions and trends in the client's particular industry, 
and then makes recommendations to the client regarding the types of 
advertisements which should be placed by the client and the various 
types of advertising media (e.g., radio, television, magazines, etc.) 
which should be used by the client. The client will then purchase, 
through the taxpayer, advertisements in various media based on the 
taxpayer's recommendations. The taxpayer's compensation for its services 
is typically based on the particular orders for advertisements which the 
client makes. The taxpayer is not considered to be engaged in the 
performance of services in the field of consulting. The taxpayer is 
engaged in the performance of services economically similar to brokerage 
services. Relevant to this determination is the fact that the 
compensation of the taxpayer for its services is contingent upon the 
consummation of the transaction the services were intended to effect 
(i.e., the placing of advertisements by clients).
    Example (10). A taxpayer is in the business of selling insurance 
(including life and casualty insurance), annuities, and other similar 
insurance products to various individual and business clients. The 
taxpayer will study the particular client's financial situation, 
including, for example, the client's present income, savings and 
investments, business and personal insurance risks, and anticipated 
future economic and financial needs. Based on this study, the taxpayer 
will then make recommendations to the client regarding the desirability 
of various insurance products. The client will then purchase these 
various insurance products through the taxpayer. The taxpayer's 
compensation for its services is typically based on the purchases made 
by the clients. The taxpayer is not considered to be engaged in the 
performance of services in the field of consulting. The taxpayer is 
engaged in the performance of brokerage or sales services. Relevant to 
this determination is the fact that the compensation of the taxpayer for 
its services is contingent upon the consummation of the transaction the 
services were intended to effect (i.e., the purchase of insurance 
products by its clients).

    (5) Ownership test--(i) In general. A corporation meets the 
ownership test, if at all times during the taxable year, substantially 
all the corporation's stock, by value, is held, directly or indirectly, 
by--
    (A) Employees performing services for such corporation in connection 
with activities involving a field referred to in paragraph (e)(4) of 
this section,
    (B) Retired employees who had performed such services for such 
corporation,
    (C) The estate of any individual described in paragraph (e)(5)(i) 
(A) or (B) of this section, or
    (D) Any other person who acquired such stock by reason of the death 
of an individual described in paragraph (e)(5)(i) (A) or (B) of this 
section, but only for the 2-year period beginning on the date of the 
death of such individual.

For purposes of this paragraph (e)(5) of this section, the term 
``substantially all'' means an amount equal to or greater than 95 
percent.
    (ii) Definition of employee. For purposes of the ownership test of 
this paragraph (e)(5) of this section, a person shall not be considered 
an employee of a corporation unless the services performed by that 
person for such corporation, based on the facts and circumstances, are 
more than de minimis. In addition, a person who is an employee of a 
corporation shall not be treated as an employee of another corporation 
merely by reason of the employer corporation and the other corporation 
being members of the same affiliated group or otherwise related.
    (iii) Attribution rules. For purposes of this paragraph (e)(5) of 
this section, a corporation's stock is considered held indirectly by a 
person if, and to the extent, such person owns a proportionate interest 
in a partnership, S corporation, or qualified personal service 
corporation that owns such stock. No other arrangement or type of 
ownership shall constitute indirect ownership of a corporation's stock 
for purposes of this paragraph (e)(5) of this

[[Page 92]]

section. Moreover, stock of a corporation held by a trust is considered 
held by a person if, and to the extent, such person is treated under 
subpart E, part I, subchapter J, chapter 1 of the Code as the owner of 
the portion of the trust that consists of such stock.
    (iv) Disregard of community property laws. For purposes of this 
paragraph (e)(5) of this section, community property laws shall be 
disregarded. Thus, in determining the stock ownership of a corporation, 
stock owned by a spouse solely by reason of community property laws 
shall be treated as owned by the other spouse.
    (v) Treatment of certain stock plans. For purposes of this paragraph 
(e)(5) of this section, stock held by a plan described in section 401 
(a) that is exempt from tax under section 501 (a) shall be treated as 
held by an employee described in paragraph (e)(5)(i)(A) of this section.
    (vi) Special election for certain affiliated groups. For purposes of 
determining whether the stock ownership test of this paragraph (e)(5) of 
this section has been met, at the election of the common parent of an 
affiliated group (within the meaning of section 1504 (a)), all members 
of such group shall be treated as one taxpayer if substantially all 
(within the meaning of paragraph (e)(4)(i) of this section) the 
activities of all such members (in the aggregate) are in the same field 
described in paragraph (e)(4)(i)(A)-(H) of this section. For rules 
relating to the making of the election, see 26 CFR 5h.5 (temporary 
regulations relating to elections under the Tax Reform Act of 1986).
    (vii) Examples. The following examples illustrate the provisions of 
paragraph (e) of this section:

    Example (1). (i) X, a Corporation, is engaged in the business of 
providing accounting services to its clients. These services consist of 
the preparation of audit and financial statements and the preparation of 
tax returns. For purposes of section 448, such services consist of the 
performance of services in the field of accounting. In addition, for 
purposes of section 448, the supervision of employees directly preparing 
the statements and returns, and the performance of all administrative 
and support services incident to such activities (including secretarial, 
janitorial, purchasing, personnel, security, and payroll services) are 
the performance of services in the field of accounting.
    (ii) In addition, X owns and leases a portion of an office building. 
For purposes of this section, the following types of activities 
undertaken by the employees of X shall be considered as the performance 
of services in a field other than the field of accounting: (A) services 
directly relating to the leasing activities, e.g., time spent in leasing 
and maintaining the leased portion of the building; (B) supervision of 
employees engaged in directly providing services in the leasing 
activity; and (C) all administrative and support services incurred 
incident to services described in (A) and (B). The leasing activities of 
X are considered the performance of services in a field other than the 
field of accounting, regardless of whether such leasing activities 
constitute a trade or business under the Code. If the employees of X 
spend 95% or more of their time in the performance of services in the 
field of accounting, X satisfies the function test of paragraph (e)(4) 
of this section.
    Example (2). Assume that Y, a C corporation, meets the function test 
of paragraph (e)(4) of this section. Assume further that all the 
employees of Y are performing services for Y in a qualifying field as 
defined in paragraph (e)(4) of this section. P, a partnership, owns 40%, 
by value, of the stock of Y. The remaining 60% of the stock of Y is 
owned directly by employees of Y. Employees of Y have an aggregate 
interest of 90% in the capital and profits of P. This, 96% of the stock 
of Y is held directly, or indirectly, by employees of Y performing 
services in a qualifying field. Accordingly, Y meets the ownership test 
of paragraph (e)(5) of this section and is a qualified personal service 
corporation.
    Example (3). The facts are the same as in example (2), except that 
40% of the stock of Y is owned by Z, a C corporation. The remaining 60% 
of the stock is owned directly by the employees of Y. Employees of Y own 
90% of the stock, by value, of Z. Assume that Z independently qualifies 
as a personal service corporation. The result is the same as in example 
(2), i.e., 96% of the stock of Y is held, directly or indirectly, by 
employees of Y performing services in a qualifying field. Thus, Y is a 
qualified personal service corporation.
    Example (4). The facts are the same as in example (3), except that Z 
does not independently qualify as a personal service corporation. 
Because Z is not a qualified personal service corporation, the Y stock 
owned by Z is not treated as being held indirectly by the Z 
shareholders. Consequently, only 60% of the stock of Y is held, directly 
or indirectly, by employees of Y. Thus, Y does not meet the ownership 
test of paragraph (e)(5) of this section, and is not a qualified 
personal service corporation.

[[Page 93]]

    Example (5). Assume that W, a C corporation, meets the function test 
of paragraph (e)(4) of this section. In addition, assume that all the 
employees of W are performing services for W in a qualifying field. 
Nominal legal title to 100% of the stock of W is held by employees of W. 
However, due solely to the operation of community property laws, 20% of 
the stock of W is held by spouses of such employees who themselves are 
not employees of W. In determining the ownership of the stock, community 
property laws are disregarded. Thus, Y meets the ownership test of 
paragraph (e)(5) of this section, and is a qualified personal service 
corporation.
    Example (6). Assume that 90% of the stock of T, a C corporation, is 
directly owned by the employees of T. Spouses of T's employees directly 
own 5% of the stock of T. The spouses are not employees of T, and their 
ownership does not occur solely by operation of community property laws. 
In addition, 5% of the stock of T is held by trusts (other than a trust 
described in section 401(a) that is exempt from tax under section 
501(a)), the sole beneficiaries of which are employees of T. The 
employees are not treated as owners of the trusts under subpart E, part 
I, subchapter J, chapter 1 of the Code. Since a person is not treated as 
owning the stock of a corporation owned by that person's spouse, or by 
any portion of a trust that is not treated as owned by such person under 
subpart E, only 90% of the stock of T is treated as held, directly or 
indirectly, by employees of T. Thus, T does not meet the ownership test 
of paragraph (e)(5) of this section, and is not a qualified personal 
service corporation.
    Example (7). Assume that Y, a C corporation, directly owns all the 
stock of three subsidiaries, F, G, and H. Y is a common parent of an 
affiliated group within the meaning of section 1504(a) consisting of Y, 
F, G, and H. Y is not engaged in the performance of services in a 
qualifying field. Instead, Y is a holding company whose activities 
consist of its ownership and investment in its operating subsidiaries. 
Substantially all the activities of F involve the performance of 
services in the field of engineering. In addition, a majority of (but 
not substantially all) the activities of G involve the performance of 
services in the field of engineering; the remainder of G's services 
involve the performance of services in a nonqualifying field. Moreover, 
a majority of (but not substantially all) the activities of H involve 
the performance of services in the field of engineering; the remainder 
of H's activities involve the performance of services in the field of 
architecture. Nevertheless, substantially all the activities of the 
group consisting of Y, F, G, and H, in the aggregate, involve the 
performance of services in the field of engineering. Accordingly, Y 
elects under paragraph (e)(5)(vi) of this section to be treated as one 
taxpayer for determining the ownership test of paragraph (e)(5) of this 
section. Assume that substantially all the stock of Y (by value) is held 
by employees of F, G, or H who perform services in connection with a 
qualifying field (engineering or architecture). Thus, for purposes of 
determining whether any member corporation is a qualified personal 
service corporation, the ownership test of paragraph (e)(5) of this 
section has been satisfied. Since F and H satisfy the function test of 
paragraph (e)(4) of this section, F and H are qualified personal service 
corporations. However, since Y and G each fail the function test of 
paragraph (e)(4) of this section, neither corporation is a qualified 
personal service corporation.
    Example (8). The facts are the same as in example (7), except that 
less than substantially all the activities of the group consisting of Y, 
F, G, and H, in the aggregate, are performed in the field of 
engineering. Substantially all the activities of the group consisting of 
Y, F, G, and H, are, in the aggregate, performed in two fields, the 
fields of engineering and architecture. Y may not elect to have the 
affiliated group treated as one taxpayer for purposes of determining 
whether group members meet the ownership test of paragraph (e)(5) of 
this section. The election is available only if substantially all the 
activities of the group, in the aggregate, involve the performance of 
services in only one qualifying field. Moreover, none of the group 
members are qualified personal service corporations. Y fails the 
function test of paragraph (e)(4) of this section because less than 
substantially all the activities of Y are performed in a qualifying 
field. In addition, F, G, and H fail the ownershp test of paragraph 
(e)(5) of this section because substantially all their stock is owned by 
Y and not by their employees. The owners of Y are not deemed to 
indirectly own the stock owned by Y because Y is not a qualified 
personal service corporation.
    Example (9). (i) The facts are the same as in example (8), except Y 
itself satisfies the function tests of paragraph (e)(4) of this section 
because substantially all the activities of Y involve the performance of 
services in the field of engineering. In addition, assume that all 
employees of Y are involved in the performance of services in the field 
of engineering, and that all such employees own 100% of Y's stock. 
Moreover, assume that one-third of all the employees of Y are separately 
employed by F. Similarly, another one-third of the employees of Y are 
separately employed by G and H, respectively. None of the employees of Y 
are employed by more than one of Y's subsidiaries. Also, no other 
persons except the employees of Y are employed by any of the 
subsidiaries.
    (ii) Y is a personal service corporation under section 448 because Y 
satisfies both

[[Page 94]]

the function and the ownership test of paragraphs (e) (4) and (5) of 
this section. As in example (8), Y is unable to make the election to 
have the affiliated group treated as one taxpayer for purposes of 
determining whether group members meet the ownership test of paragraph 
(e)(5) of this section because less than substantially all the 
activities, in the aggregate, of the group members are performed in one 
of the qualifying fields. However, because Y is a personal service 
corporation, the stock owned by Y is treated as indirectly owned, 
proportionately, by the owners of Y. Thus, the employees of F are 
collectively treated as owning one-third of the stock of F, G, and H. 
The employees of G and H are similarly treated as owning one-third of 
each subsidiary's stock.
    (iii) F, G, and H each fail the ownership test of paragraph (e)(5) 
of this section because less than substantially all of each 
corporation's stock is owned by the employees of the respective 
corporation. Only one-third of each corporation's stock is owned by 
employees of that corporation. Thus, F, G, and H are not qualified 
personal service corporations.
    Example (10). (i) Assume that Y, a C corporation, directly owns all 
the stock of three subsidiaries, F, G, and Z. Y is a common parent of an 
affiliated group within the meaning of section 1504(a) consisting of Y, 
F, and G. Z is a foreign corporation and is excluded from the affiliated 
group under section 1504. Assume that Y is a holding company whose 
activities consist of its ownership and investment in its operating 
subsidiaries. Substantially all the activities of F, G, and Z involve 
the performance of services in the field of engineering. Assume that 
employees of Z own one-third of the stock of Y and that none of these 
employees are also employees of Y, F, or G. In addition, assume that Y 
elects to be treated as one taxpayer for determining whether group 
members meet the ownership tests of paragraph (e)(5) of this section. 
Thus, Y, F, and G are treated as one taxpayer for purposes of the 
ownership test.
    (ii) None of the members of the group are qualified personal service 
corporations. Y, F, and G fail the ownership test of paragraph (e)(5) of 
this section because less than substantially all the stock of Y is owned 
by employees of either Y, F, or G. Moreover, Z fails the ownership test 
of paragraph (e)(5) of this section because substantially all its stock 
is owned by Y and not by its employees.

    (6) Application of function and ownership tests. A corporation that 
fails the function test of paragraph (e)(4) of this section for any 
taxable year, or that fails the ownership test of paragraph (e)(5) of 
this section at any time during any taxable year, shall change from the 
cash method effective for the year in which the corporation fails to 
meet the function test or the ownership test. For example, if a personal 
service corporation fails the function test for taxable year 1987, such 
corporation must change from the cash method effective for taxable year 
1987. A corporation that fails the function or ownership test for a 
taxable year shall not be treated as a qualified personal service 
corporation for any part of that taxable year.
    (f) Exception for entities with gross receipts of not more than $5 
million--(1) In general. Except in the case of a tax shelter, this 
section shall not apply to any C corporation or partnership with a C 
corporation as a partner for any taxable year if, for all prior taxable 
years beginning after December 31, 1985, such corporation or partnership 
(or any predecessor thereof) meets the $5,000,000 gross receipts test of 
paragraph (f)(2) of this section.
    (2) The $5,000,000 gross receipts test--(i) In general. A 
corporation meets the $5,000,000 gross receipts test of this paragraph 
(f)(2) for any prior taxable year if the average annual gross receipts 
of such corporation for the 3 taxable years (or, if shorter, the taxable 
years during which such corporation was in existence) ending with such 
prior taxable year does not exceed $5,000,000. In the case of a C 
corporation exempt from federal income taxes under section 501(a), or a 
trust subject to tax under section 511(b) that is treated as a C 
corporation under paragraph (a)(3) of this section, only gross receipts 
from the activities of such corporation or trust that constitute 
unrelated trades or businesses are taken into account in determining 
whether the $5,000,000 gross receipts test is satisfied. A partnership 
with a C corporation as a partner meets the $5,000,000 gross receipts 
test of this paragraph (f)(2) for any prior taxable year if the average 
annual gross receipts of such partnership for the 3 taxable years (or, 
if shorter, the taxable years during which such partnership was in 
existence) ending with such prior year does not exceed $5,000,000. The 
gross receipts of the corporate partner are not taken into account in 
determining whether the partnership meets the $5,000,000 gross receipts 
test.

[[Page 95]]

    (ii) Aggregation of gross receipts. For purposes of determining 
whether the $5,000,000 gross receipts test has been satisfied, all 
persons treated as a single employer under section 52 (a) or (b), or 
section 414 (m) or (o) (or who would be treated as a single employer 
under such sections if they had employees) shall be treated as one 
person. Gross receipts attributable to transactions between persons who 
are treated as a common employer under this paragraph shall not be taken 
into account in determining whether the $5,000,000 gross receipts test 
is satisified.
    (iii) Treatment of short taxable year. In the case of any taxable 
year of less than 12 months (a short taxable year), the gross receipts 
shall be annualized by (A) multiplying the gross receipts for the short 
period by 12 and (B) dividing the result by the number of months in the 
short period.
    (iv) Determination of gross receipts--(A) In general. The term 
``gross receipts'' means gross receipts of the taxable year in which 
such receipts are properly recognized under the taxpayer's accounting 
method used in that taxable year (determined without regard to this 
section) for federal income tax purposes. For this purpose, gross 
receipts include total sales (net of returns and allowances) and all 
amounts received for services. In addition, gross receipts include any 
income from investments, and from incidental or outside sources. For 
example, gross receipts include interest (including original issue 
discount and tax-exempt interest within the meaning of section 103), 
dividends, rents, royalties, and annuities, regardless of whether such 
amounts are derived in the ordinary course of the taxpayer's trade of 
business. Gross receipts are not reduced by cost of goods sold or by the 
cost of property sold if such property is described in section 1221 (1), 
(3), (4) or (5). With respect to sales of capital assets as defined in 
section 1221, or sales of property described in 1221 (2) (relating to 
property used in a trade or business), gross receipts shall be reduced 
by the taxpayer's adjusted basis in such property. Gross receipts do not 
include the repayment of a loan or similar instrument (e.g., a repayment 
of the principal amount of a loan held by a commercial lender). Finally, 
gross receipts do not include amounts received by the taxpayer with 
respect to sales tax or other similar state and local taxes if, under 
the applicable state or local law, the tax is legally imposed on the 
purchaser of the good or service, and the taxpayer merely collects and 
remits the tax to the taxing authority. If, in contrast, the tax is 
imposed on the taxpayer under the applicable law, then gross receipts 
shall include the amounts received that are allocable to the payment of 
such tax.
    (3) Examples. The following examples illustrate the provisions of 
paragraph (f) of this section:

    Example (1). X, a calendar year C corporation, was formed on January 
1, 1986. Assume that in 1986 X has gross receipts of $15 million. For 
taxable year 1987, this section applies to X because in 1986, the period 
during which X was in existence, X has average annual gross receipts of 
more than $5 million.
    Example (2). Y, a calendar year C corporation that is not a 
qualified personal service corporation, has gross receipts of $10 
million, $9 million, and $4 million for taxable years 1984, 1985, and 
1986, respectively. In taxable year 1986, X has average annual gross 
receipts for the 3-taxable-year period ending with 1986 of $7.67 million 
($10 million + 9 million + 4 million /3). Thus, for taxable year 1987, 
this section applies and Y must change from the cash method for such 
year.
    Example (3). Z, a C corporation which is not a qualified personal 
service corporation, has a 5% partnership interest in ZAB partnership, a 
calendar year cash method taxpayer. All other partners of ZAB 
partnership are individuals. Z corporation has average annual gross 
receipts of $100,000 for the 3-taxable-year period ending with 1986 
(i.e., 1984, 1985 and 1986). The ZAB partnership has average annual 
gross receipts of $6 million for the same 3-taxable-year period. Since 
ZAB fails to meet the $5,000,000 gross receipts test for 1986, this 
section applies to ZAB for its taxable year beginning January 1, 1987. 
Accordingly, ZAB must change from the cash method for its 1987 taxable 
year. The gross receipts of Z corporation are not relevant in 
determining whether ZAB is subject to this section.
    Example (4). The facts are the same as in example (3), except that 
during the 1987 taxable year of ZAB, the Z corporation transfers its 
partnership interest in ZAB to an individual. Under paragraph (a)(1) of 
this section, ZAB is treated as a partnership with a C corporation as a 
partner. Thus, this section requires ZAB to change from the cash method 
effective for its taxable year 1987. If

[[Page 96]]

ZAB later desires to change its method of accounting to the cash method 
for its taxable year beginning January 1, 1988 (or later), ZAB must 
comply with all requirements of law, including sections 446(b), 446(e), 
and 481, to effect the change.
    Example (5). X, a C corporation that is not a qualified personal 
service corporation, was formed on January 1, 1986, in a transaction 
described in section 351. In the transaction, A, an individual, 
contributed all of the assets and liabilities of B, a trade or business, 
to X, in return for the receipt of all the outstanding stock of X. 
Assume that in 1986 X has gross receipts of $4 million. In 1984 and 
1985, the gross receipts of B, the trade or business, were $10 million 
and $7 million respectively. The gross receipts test is applied for the 
period during which X and its predecessor trade or business were in 
existence. X has average annual gross receipts for the 3-taxable-year 
period ending with 1986 of $7 million ($10 million + $7 million + $4 
million/3). Thus, for taxable year 1987, this section applies and X must 
change from the cash method for such year.

[T.D. 8143, 52 FR 22766, June 16, 1987, as amended by T.D. 8329, 56 FR 
485, Jan. 7, 1991; T.D. 8514, 58 FR 68299, Dec. 27, 1993; T.D. 9174, 70 
FR 704, Jan. 5, 2005]



Sec. 1.448-2T  Nonaccrual of certain amounts by service providers 
(temporary).

    (a) In general. This section applies to taxpayers qualified to use a 
nonaccrual-experience method of accounting provided for in section 
448(d)(5) with respect to amounts to be received for the performance of 
services. Except as otherwise provided in this section, a taxpayer is 
qualified to use a nonaccrual-experience method of accounting if the 
taxpayer uses an accrual method of accounting with respect to amounts to 
be received for the performance of services by the taxpayer and either--
    (1) The services are in fields referred to in section 448(d)(2)(A) 
and as described in Sec. 1.448-1T(e)(4) (i.e., health, law, 
engineering, architecture, accounting, actuarial science, performing 
arts, or consulting); or
    (2) The taxpayer meets the $5 million annual gross receipts test of 
section 448(c) and Sec. 1.448-1T(f)(2) for all prior taxable years.
    (b) Nonaccrual-experience method; treatment as method of accounting. 
Any taxpayer who satisfies the requirements of this section is not 
required to accrue any portion of amounts to be received from the 
performance of services that, on the basis of such person's experience, 
and to the extent determined under the computation or formula used by 
the taxpayer and allowed under this section, will not be collected. This 
nonaccrual of amounts to be received for the performance of services 
shall be treated as a method of accounting under the Code (a nonaccrual-
experience method).
    (c) Method not available if interest charged on amounts due. A 
nonaccrual-experience method of accounting may not be used with respect 
to amounts due for which interest is required to be paid or for which 
there is any penalty for failure to timely pay any amounts due. For this 
purpose, the taxpayer will be treated as charging interest or penalties 
for late payment if the contract or agreement expressly provides for the 
charging of interest or penalties for late payment, regardless of the 
practice of the parties. If the contract or agreement does not expressly 
provide for the charging of interest or penalties for late payment, the 
determination of whether the taxpayer charges interest or penalties for 
late payment will be made based on all of the facts and circumstances of 
the transaction, and not merely on the characterization by the parties 
or the treatment of the transaction under state or local law. However, 
the offering of a discount for early payment of an amount due will not 
be regarded as the charging of interest or penalties for late payment 
under this section, if--
    (1) The full amount due is otherwise accrued as gross income by the 
taxpayer at the time the services are provided; and
    (2) The discount for early payment is treated as an adjustment to 
gross income in the year of payment, if payment is received within the 
time required for allowance of such discount. See paragraph (f) Example 
1 of this section for an example of this rule.
    (d) Method not available for certain receivables--(1) Amounts earned 
and recognized through the performance of services.

[[Page 97]]

A nonaccrual-experience method of accounting may be used only with 
respect to amounts earned by the taxpayer and otherwise recognized in 
income (an account receivable) through the performance of services by 
such taxpayer. For example, a nonaccrual-experience method may not be 
used with respect to amounts owed to the taxpayer by reason of the 
taxpayer's activities with respect to lending money, selling goods, or 
acquiring accounts receivable or other rights to receive payment from 
other persons (including persons related to the taxpayer) regardless of 
whether those persons earned such amounts through the provision of 
services.
    (2) Special rule. Except as otherwise provided, for purposes of this 
section, accounts receivable do not include amounts that are not billed 
(e.g., for charitable or pro bono services) or amounts contractually not 
collectible (e.g., amounts in excess of a fee schedule agreed to by 
contract). See paragraph (f) Examples 2 and 3 of this section for 
examples of this rule.
    (e) Use of experience to estimate uncollectible amounts--(1) In 
general. In determining the portion of any amount due which, on the 
basis of experience, will not be collected, the taxpayer may use one of 
four safe harbor nonaccrual-experience methods of accounting provided in 
paragraphs (e)(2) through (e)(5) of this section. Alternatively, the 
taxpayer may use any other nonaccrual-experience method (``alternative 
nonaccrual-experience method'') that clearly reflects the taxpayer's 
nonaccrual-experience, subject to the requirements of paragraph (e)(6) 
of this section. The safe harbor nonaccrual-experience methods provided 
in paragraphs (e)(2) through (e)(5) of this section will be presumed to 
clearly reflect a taxpayer's nonaccrual-experience. For purposes of 
determining a taxpayer's nonaccrual-experience under any method provided 
in this paragraph (e), accounts receivable described in paragraphs (c) 
and (d) of this section are not taken into account. See paragraph (g) of 
this section for procedures to obtain automatic consent to change to one 
of the safe harbor nonaccrual experience methods or to an alternative 
nonaccrual-experience method.
    (2) Safe harbor 1: Six-year moving average method--(i) General rule. 
A taxpayer may use a nonaccrual experience method under which the 
taxpayer determines the uncollectible amount (six-year moving average 
amount) by multiplying its accounts receivable balance at the end of the 
current year by a percentage (six-year moving average percentage). The 
six-year moving average percentage is computed by dividing--
    (A) The total bad debts (with respect to accounts receivable) 
sustained throughout the period consisting of the taxable year and the 
five preceding taxable years (or, with the approval of the Commissioner, 
a shorter period), adjusted for recoveries of bad debts during such 
period; by
    (B) The sum of the accounts receivable earned throughout the entire 
six (or fewer) taxable year period (i.e., the total amount of sales 
resulting in accounts receivable). See paragraph (f) Example 4 of this 
section for an example of this method.
    (ii) Period of less than six taxable years. A period shorter than 
six taxable years generally will be appropriate only if the short period 
consists of consecutive taxable years and there is a change in the type 
of a substantial portion of the outstanding accounts receivable such 
that the risk of loss is substantially increased. A decline in the 
general economic conditions in the area, which substantially increases 
the risk of loss, is a relevant factor in determining whether a shorter 
period is appropriate. However, approval to use a shorter period will 
not be granted unless the taxpayer supplies specific evidence that the 
accounts receivable outstanding at the close of the taxable years for 
the shorter period requested are not comparable in nature and risk to 
accounts receivable outstanding at the close of the six taxable years. A 
substantial increase in a taxpayer's bad debt experience is not, by 
itself, sufficient to justify the use of a shorter period. If approval 
is granted to use a shorter period, the experience for the excluded 
taxable years shall not be used for any subsequent year. A request for 
approval to exclude the experience of a prior taxable year shall be made 
in accordance with the applicable

[[Page 98]]

procedures for requesting a letter ruling and shall include a statement 
of the reasons such experience should be excluded. A request will not be 
considered unless it is sent to the Commissioner at least 30 days before 
the close of the first taxable year for which such approval is 
requested.
    (iii) Special rule for new taxpayers. In the case of any current 
taxable year that is preceded by less than 5 taxable years, paragraph 
(e)(2)(i) of this section shall be applied by using the experience of 
the current year and the actual number of preceding taxable years.
    (3) Safe harbor 2: Actual experience method--(i) Option A: Three-
year moving average. A taxpayer may use a nonaccrual-experience method 
under which the taxpayer determines the uncollectible amount (actual 
nonaccrual-experience amount) by multiplying its year-end accounts 
receivable balance by a percentage (three-year moving average 
nonaccrual-experience percentage) reflecting its actual nonaccrual 
experience with respect to its accounts receivable balance at the 
beginning of the current taxable year and the two immediately preceding 
taxable years. Under this safe harbor method, a taxpayer is allowed to 
increase its actual nonaccrual-experience amount by 5 percent (adjusted 
nonaccrual-experience amount). The taxpayer's three-year moving average 
nonaccrual-experience percentage, actual nonaccrual-experience amount, 
and adjusted nonaccrual-experience amount are determined according to 
the following steps:
    (A) STEP 1. Track the receivables in the taxpayer's accounts 
receivable balance at the beginning of the current taxable year to 
determine the dollar amount of the accounts receivable actually 
determined to be uncollectible and charged off and not recovered or 
determined to be collectible by the date selected by the taxpayer 
(determination date) for the taxable year. The determination date may 
not be later than the earlier of the due date, including extensions, for 
filing the taxpayer's federal income tax return for that taxable year or 
the date on which the taxpayer timely files such return for that taxable 
year.
    (B) STEP 2. Repeat STEP 1 for the taxpayer's accounts receivable 
balance at the beginning of each of the two immediately preceding 
taxable years.
    (C) STEP 3. To determine the taxpayer's three-year moving average 
nonaccrual-experience percentage, divide the sum of the net 
uncollectible amounts from STEP 1 and STEP 2 by the sum of the accounts 
receivable balance at the beginning of the current taxable year and the 
accounts receivable balance at the beginning of each of the two 
preceding taxable years.
    (D) STEP 4. Multiply the percentage computed in STEP 3 by the 
taxpayer's accounts receivable balance at the end of the current taxable 
year. The product is the taxpayer's actual nonaccrual-experience amount 
for the current taxable year.
    (E) STEP 5. To determine the taxpayer's adjusted nonaccrual-
experience amount, multiply the actual nonaccrual-experience amount from 
STEP 4 by 1.05. See paragraph (f) Example 5 of this section for an 
example of this method.
    (ii) Option B: Up to three-year moving average. Alternatively, 
except as provided in paragraph (e)(3)(iii) of this section, in 
computing its adjusted nonaccrual-experience amount described in 
paragraph (e)(3)(i) of this section, a taxpayer may use: its current 
year nonaccrual-experience percentage for the first taxable year this 
method is used; a two-year moving average nonaccrual-experience 
percentage for the second taxable year this method is used; and a three-
year moving average nonaccrual-experience percentage for the third, and 
each succeeding, taxable year this method is used. See paragraph (f) 
Examples 6, 7, and 8 of this section for examples of this method.
    (iii) Special rule for new taxpayers. Any newly formed taxpayer that 
wants to use the safe harbor nonaccrual-experience method of accounting 
described in paragraph (e)(3)(ii) of this section in its first taxable 
year and does not have any accounts receivable upon formation will not 
be able to exclude any portion of its year-end accounts receivable from 
income for its first taxable year because the taxpayer does not have any 
accounts receivable on the first day of the taxable year to track. 
Therefore, the taxpayer must begin creating its three-year moving 
average

[[Page 99]]

in its second taxable year by tracking the accounts receivables as of 
the first day of its second taxable year.
    (4) Safe harbor 3: Modified Black Motor method--(i) In general. A 
taxpayer may use a nonaccrual-experience method under which the taxpayer 
determines the uncollectible amount (modified Black Motor amount) by 
multiplying its accounts receivable balance at the end of the current 
taxable year by a percentage (Black Motor moving average percentage), 
and then reducing the resulting amount by the credit charges (accounts 
receivable) generated and written off during the current taxable year. 
The Black Motor moving average percentage is computed by dividing--
    (A) The total bad debts sustained in the current taxable year and 
the five preceding taxable years (or, with the approval of the 
Commissioner, a shorter period), adjusted for recoveries of bad debts 
during such period; by
    (B) The sum of accounts receivable at the end of the current taxable 
year and the five preceding (or fewer) taxable years. See paragraph (f) 
Example 10 of this section for an example of this method.
    (ii) Period of less than six taxable years. The rules of paragraph 
(e)(2)(ii) of this section (regarding periods of less than six taxable 
years) shall apply to taxpayers using the Modified Black Motor method.
    (iii) Special rules for new taxpayers. In the case of any current 
taxable year that is preceded by less than 5 taxable years, paragraph 
(e)(4)(i) of this section shall be applied by using the experience of 
the current taxable year and the actual number of preceding taxable 
years.
    (5) Safe harbor 4: Modified six-year moving average method--(i) In 
general. A taxpayer may use a nonaccrual-experience method under which 
the taxpayer determines the uncollectible amount (modified six-year 
moving average amount) by multiplying its accounts receivable balance at 
the end of the current year by a percentage (modified six-year moving 
average percentage). The modified six-year moving average percentage is 
computed by dividing--
    (A) The total bad debts sustained in the current taxable year and 
the five preceding taxable years (or, with the approval of the 
Commissioner, a shorter period) other than the credit charges (accounts 
receivable) that were written off in the same taxable year they were 
generated, adjusted for recoveries of bad debts during such period; by
    (B) The sum of accounts receivable at the end of the current taxable 
year and the five preceding (or fewer) taxable years. See paragraph (f) 
Example 11 of this section for an example of this method.
    (ii) Period of less than six taxable years. The rules of paragraph 
(e)(2)(ii) of this section (regarding periods of less than six taxable 
years) shall apply to taxpayers using the Modified six-year moving 
average method.
    (iii) Special rules for new taxpayers. In the case of any current 
taxable year that is preceded by less than 5 taxable years, paragraph 
(e)(5)(i) of this section shall be applied by using the experience of 
the current taxable year and the actual number of preceding taxable 
years.
    (6) Alternative nonaccrual-experience method--(i) In general. A 
taxpayer may use any alternative nonaccrual-experience method that 
clearly reflects the taxpayer's actual nonaccrual-experience, provided 
the taxpayer's alternative nonaccrual-experience method meets the self-
test requirements described in this paragraph (e)(6).
    (ii) Self-testing. A taxpayer using, or desiring to use, an 
alternative nonaccrual-experience method must ``self-test'' its 
alternative nonaccrual-experience method for its first taxable year 
ending after March 9, 2002, for which the taxpayer uses, or desires to 
use, that alternative nonaccrual-experience method (first-year self-
test), and every three taxable years thereafter (three-year self-test). 
Each self-test shall be performed by comparing the nonaccrual-experience 
amount under the taxpayer's alternative nonaccrual-experience method 
(alternative nonaccrual-experience amount) with the nonaccrual-
experience amount that would have resulted from use of one safe harbor 
method described in paragraph (e)(2), (e)(3), (e)(4), or (e)(5) of this 
section selected by the taxpayer for use in conducting the self test 
(safe harbor comparison method), for the test period.

[[Page 100]]

    (iii) Selection of safe harbor comparison method--(A) First-year 
self-test. For purposes of conducting the first-year self-test required 
under paragraph (e)(6)(ii) of this section, a taxpayer may self-test its 
alternative nonaccrual-experience method against any safe harbor method 
provided in paragraphs (e)(2) through (e)(5) of this section. See 
paragraph (f) Example 12 of this section for an example of this rule.
    (B) Three-year self-test. For purposes of conducting any three-year 
self-test required under paragraph (e)(6)(ii) of this section, the 
taxpayer must self-test its alternative nonaccrual-experience method 
against the same safe harbor comparison method used for the immediately 
preceding self-test. For purposes of the three-year self-test, the 
cumulative nonaccrual-experience amount for the safe harbor comparison 
method is computed by using, for each taxable year of the test period, 
the same safe harbor comparison method used during the immediately 
preceding self test (cumulative safe harbor nonaccrual-experience 
amount). See paragraph (f) Example 13 of this section for an example of 
this rule.
    (C) Change of safe harbor comparison method. (1) A taxpayer that 
wants to change the safe harbor comparison method it uses for purposes 
of the self-testing requirement of paragraph (e)(6)(ii) of this section 
may do so only for the first taxable year following any three-year self-
test period and in accordance with this paragraph (e)(6)(iii)(C). A 
change in the taxpayer's safe harbor comparison method is a change in 
method of accounting to which the procedures of sections 446 and 481, 
and the regulations thereunder, apply.
    (2) For the taxable year a taxpayer wishes to change its safe harbor 
comparison method, the taxpayer must self-test its alternative 
nonaccrual-experience method against any safe harbor method provided in 
paragraphs (e)(2) through (e)(5) of this section other than the safe 
harbor comparison method currently used by the taxpayer and such self-
test shall be conducted as if such self-test was a first-year self-test.
    (3) If the self-test described in paragraph (e)(6)(iii)(C)(2) of 
this section results in the taxpayer's alternative nonaccrual-experience 
method clearly reflecting the taxpayer's nonaccrual-experience as 
determined under paragraph (e)(6)(iv) of this section, then the taxpayer 
may change its safe harbor comparison method in accordance with the 
procedures under paragraph (g)(3) of this section. Such change shall be 
made on a cut-off basis and without audit protection.
    (4) If the self-test described in paragraph (e)(6)(iii)(C)(2) of 
this section results in the taxpayer's alternative nonaccrual-experience 
method not clearly reflecting the taxpayer's nonaccrual-experience as 
determined under paragraph (e)(6)(vi)(A) of this section, then the 
taxpayer cannot use the safe harbor comparison method selected and must 
either--
    (i) Continue using its current safe harbor comparison method; or
    (ii) Select another safe harbor comparison method, subject to the 
requirements of paragraphs (e)(6)(iii)(C)(2) and (3) of this section.
    (5) If a taxpayer meets the requirements of this paragraph 
(e)(6)(iii)(C) to change its safe harbor comparison method, the new safe 
harbor comparison method is not used for purposes of conducting the 
three-year self-test required by paragraph (e)(6)(ii) of this section 
for the taxable year immediately preceding the taxable year the taxpayer 
is permitted to change its safe harbor comparison method. The taxpayer's 
former safe harbor comparison method is used for purposes of conducting 
such three-year self-test and for purposes of determining any recapture 
amount under paragraph (e)(6)(vi)(B) of this section.
    (iv) Treated as clearly reflecting nonaccrual-experience. If the 
alternative nonaccrual-experience amount for the first-year self-test 
(or the cumulative nonaccrual-experience amount for the three-year self-
test, as applicable) is less than or equal to the nonaccrual-experience 
amount determined under paragraph (e)(6)(iii)(A) of this section (first-
year self-test) or the cumulative safe harbor nonaccrual-experience 
amount determined under paragraph (e)(6)(iii)(B) of this section (three-
year self-test), as applicable, for the test period, then--

[[Page 101]]

    (A) The taxpayer's alternative nonaccrual-experience method will be 
treated as clearly reflecting its nonaccrual-experience for the test 
period; and
    (B) The taxpayer may continue to use that alternative nonaccrual-
experience method, subject to a requirement to self-test again after 
three taxable years.
    (v) Contemporaneous documentation. For purposes of paragraph (e)(6) 
of this section, a taxpayer must document in its books and records, in 
the taxable year any first-year or three-year self-test is performed, 
the safe harbor comparison method used to conduct the self-test, 
including appropriate documentation and computations that resulted in 
the determination that the taxpayer's alternative nonaccrual-experience 
method clearly reflected the taxpayer's nonaccrual-experience for the 
applicable test period.
    (vi) Special rules for alternative nonaccrual-experience method. (A) 
First-year self-test. If, as a result of the first-year self-test 
requirement of paragraph (e)(6)(ii) of this section, the alternative 
nonaccrual-experience amount for the test period is greater than the 
safe harbor nonaccrual-experience amount for the test period, then--
    (1) The taxpayer's alternative nonaccrual-experience method will be 
treated as not clearly reflecting its nonaccrual-experience;
    (2) The taxpayer will not be permitted to use that alternative 
nonaccrual-experience method in such taxable year; and
    (3) The taxpayer must change to (or adopt) for such taxable year 
either--
    (i) A safe harbor nonaccrual-experience method described in 
paragraphs (e)(2) through (e)(5) of this section; or
    (ii) Another alternative nonaccrual-experience method, subject to 
the first-year self-test requirement of paragraph (e)(6)(ii) of this 
section. See paragraph (f) Example 14 of this section for an example of 
this rule.
    (B) Three-year self-test. If, as a result of the three-year self-
test requirement of paragraph (e)(6)(ii) of this section, the cumulative 
alternative nonaccrual-experience amount for the test period is greater 
than the cumulative safe harbor nonaccrual-experience amount for the 
test period, the taxpayer's alternative nonaccrual-experience amount 
will be limited to the cumulative safe harbor nonaccrual-experience 
amount for the test period. Any excess of the taxpayer's cumulative 
alternative nonaccrual-experience amount over the taxpayer's cumulative 
safe harbor nonaccrual-experience amount excluded from income during the 
test period must be recaptured into income in accordance with paragraph 
(e)(6)(vii) of this section. The taxpayer may continue to use its 
alternative nonaccrual-experience method, subject to the three-year 
self-test requirement in paragraph (e)(6)(ii) of this section. See 
paragraph (f) Example 15 of this section for an example of this rule.
    (vii) Recapture. Any amount required to be recaptured pursuant to 
paragraph (e)(6)(vi)(B) of this section must be included in income in 
the third taxable year of the three-year self-test period. See paragraph 
(f) Example 15 of this section for an example of this rule.
    (7) Special rules--(i) Application to specific accounts receivable. 
The nonaccrual-experience method shall be applied with respect to each 
account receivable of the taxpayer that is eligible for such method. 
With respect to a particular account receivable, the taxpayer will 
determine, in the manner prescribed in paragraphs (e)(2) through (e)(6) 
of this section (whichever applies), the amount of such account 
receivable that is not expected to be collected. Such determination 
shall be made only once with respect to each account receivable, 
regardless of the term of such receivable. The estimated uncollectible 
amount shall not be recognized as gross income. Thus, the amount 
recognized as gross income shall be the amount that would otherwise be 
recognized as gross income with respect to the account receivable, less 
the amount which is not expected to be collected. A taxpayer that 
excludes an amount from income during a taxable year as a result of the 
taxpayer's use of a nonaccrual-experience method cannot deduct in any 
subsequent taxable year the amount excluded from income. Thus, the 
taxpayer cannot deduct the excluded amount in a subsequent taxable year 
in

[[Page 102]]

which the taxpayer actually determines that the amount is uncollectible 
and charges it off. If a taxpayer using a nonaccrual-experience method 
determines that an amount that was not excluded from income is 
uncollectible and should be charged off (e.g., a calendar-year taxpayer 
determines on November 1st that an account receivable that was 
originated on May 1st of the same year is uncollectible and should be 
charged off) the taxpayer may deduct the amount charged off when it is 
charged off, but must include any subsequent recoveries in income. The 
reasonableness of a taxpayer's determinations that amounts are 
uncollectible and should be charged off may be considered on 
examination. See paragraph (f) Example 16 of this section for an example 
of this rule.
    (ii) Charge-off. For purposes of this section, amounts charged-off 
shall include only those amounts that would otherwise be allowable under 
section 166(a).
    (iii) Recoveries. Regardless of the nonaccrual-experience method of 
accounting used by a taxpayer under this section, the taxpayer must take 
into account recoveries of amounts previously charged off. If, in a 
subsequent taxable year, a taxpayer recovers an amount previously 
excluded from income under a nonaccrual-experience method or charged 
off, the taxpayer must include the recovered amount in income in that 
subsequent taxable year. See paragraph (f) Example 17 of this section 
for an example of this rule.
    (iv) Application of nonaccrual-experience method. The rules of 
section 448(d)(5) and the regulations thereunder shall be applied 
separately to each taxpayer. For purposes of section 448(d)(5), the term 
``taxpayer'' has the same meaning as the term ``person'' defined in 
section 7701(a)(1) (rather than the meaning of the term ``taxpayer'' 
defined in section 7701(a)(14)).
    (v) Record keeping requirements. (A) A taxpayer using a nonaccrual-
experience method shall keep such books and records as are sufficient to 
establish the amount of any exclusion from gross income under section 
448(d)(5) for the taxable year, including books and records 
demonstrating--
    (1) The nature of the taxpayer's nonaccrual-experience method;
    (2) Whether, for any particular taxable year, the taxpayer qualifies 
to use its nonaccrual-experience method (including the self-testing 
requirements of paragraph (e)(6)(ii) of this section (if applicable));
    (3) The taxpayer's determination that amounts are uncollectible; and
    (4) The proper amount that is excludable under the taxpayer's 
nonaccrual-experience method.
    (B) A taxpayer that does not maintain records of the data that are 
sufficient to establish the amount of any exclusion from gross income 
under section 448(d)(5) for the taxable year may be subject to being 
changed by the IRS on examination to the specific charge-off method. See 
Sec. 1.6001-1 for rules regarding records.
    (f) Examples. The following examples illustrate the provisions of 
this section. In each example, the taxpayer uses a calendar year for 
federal income tax purposes and an accrual method of accounting, does 
not require the payment of interest or penalties with respect to past 
due accounts receivable and, in the case of Examples 5 through 8 and 12 
through 15, selects an appropriate determination date for each taxable 
year.

    Example 1. Charging interest and/or penalties. A has two billing 
methods for the amounts to be received from A's provision of services 
described in paragraph (a)(1) of this section. Under one method, for 
amounts that are more than 90 days past due, A charges interest at a 
market rate until such amounts (together with interest) are paid. Under 
the other billing method, A charges no interest for amounts past due. 
Pursuant to paragraph (c) of this section, A may not use a nonaccrual-
experience method of accounting with respect to any of the amounts 
billed under the method that charges interest on amounts that are more 
than 90 days past due. A may, however, use the nonaccrual-experience 
method with respect to the amounts billed under the method that does not 
charge interest for amounts past due.
    Example 2. Contractual allowance or adjustment. B, a healthcare 
provider, performs a medical procedure on individual C, who has health 
insurance coverage with IC, an insurance company. B bills IC and C for 
$5,000, B's standard charge for this medical procedure. However, B has a 
contract with IC that obligates B to accept $3,500 as full payment for 
the medical procedure if the procedure is

[[Page 103]]

provided to a patient insured by IC. Under the contract, only $3,500 of 
the $5,000 billed by B is legally collectible from IC and C. The 
remaining $1,500 represents a contractual allowance or contractual 
adjustment. Thus, pursuant to paragraph (d)(2) of this section, the 
remaining $1,500 is not a contractually collectible amount for purposes 
of this section and B may not use a nonaccrual-experience method with 
respect to this portion of the accounts receivable.
    Example 3. Charitable or pro bono services. D, a law firm, agrees to 
represent individual E in a legal matter and to provide services to E on 
a pro bono basis. D normally charges $500 for these services. Because D 
performed its services to E pro bono, D's services were never billed or 
intended to result in revenue. Thus, pursuant to paragraph (d)(2) of 
this section, the $500 forgone legal fee is not a collectible amount for 
purposes of this section and D may not use a nonaccrual-experience 
method with respect to this portion of the accounts receivable.
    Example 4. Safe harbor 1: Six-year moving average method. (i) F uses 
the six-year moving average method described in paragraph (e)(2) of this 
section. F's total accounts receivable and bad debt experience for the 
current taxable year (2002) and the five preceding taxable years are as 
follows:

------------------------------------------------------------------------
                                                              Bad debts
                                                   Total       adjusted
                 Taxable year                     accounts       for
                                                 receivable   recoveries
------------------------------------------------------------------------
1997..........................................      $30,000       $5,700
1998..........................................       40,000        7,200
1999..........................................       40,000       11,000
2000..........................................       60,000       10,200
2001..........................................       70,000       14,000
2002..........................................       90,000       16,800
                                               -------------------------
    Total.....................................     $330,000      $64,900
------------------------------------------------------------------------

    (ii) Thus, F's six-year moving average percentage is 19.67% 
($64,900/$330,000). Assume that $49,300 of the total $90,000 of accounts 
receivable earned throughout the taxable year 2002 is outstanding as of 
the close of that taxable year. F's nonaccrual-experience amount using 
the six-year moving average safe harbor method is computed by 
multiplying $49,300 by the six-year moving average percentage of .1967, 
or $9,697. Thus, F may exclude $9,697 from gross income for 2002.
    Example 5. Safe harbor 2: Actual experience method (Option A). (i) G 
is eligible to use a nonaccrual-experience method and wishes to adopt 
the actual experience method of paragraph (e)(3)(i) of this section. G 
has the data necessary to track the uncollectible amounts in its 
beginning-of-year accounts receivable for the current taxable year and 
the two immediately preceding taxable years. G determines that its 
actual accounts receivable collection experience is as follows:

------------------------------------------------------------------------
                                                           Beginning A/R
                                                               amount
                                               Total A/R    charged off
                                               balance at        by
                Taxable year                   beginning   determination
                                                of year         date
                                                           (adjusted for
                                                            recoveries)
------------------------------------------------------------------------
2000........................................   $1,000,000       $35,000
2001........................................      760,000        75,000
2002........................................    1,975,000        65,000
                                             ---------------------------
    Total...................................   $3,735,000      $175,000
------------------------------------------------------------------------

    (ii) G's ending A/R Balance on 12/31/2002 is $880,000. In 2002, G 
chooses to compute its nonaccrual-experience amount by using the three-
year moving average under Option A of paragraph (e)(3)(i) of this 
section. Thus, G's three-year moving average nonaccrual-experience 
percentage is 4.7%, determined by dividing the sum of the amount of G's 
receivables in its account on January 1st of 2000, 2001, and 2002, that 
were determined to be uncollectible and charged off (adjusted for 
recoveries) on or before the corresponding determination dates, by the 
sum of the balances of G's accounts receivable account on January 1st of 
2000, 2001, and 2002 (i.e., $175,000/$3,735,000 or 4.7%). Thus, G's 
actual nonaccrual-experience amount for 2002 is determined by 
multiplying this percentage by the balance of G's accounts receivable 
account on December 31, 2002 (i.e., $880,000 x 4.7% = $41,360). G is 
permitted to exclude from gross income in 2002 an amount equal to 105% 
of G's actual nonaccrual-experience amount, or $43,428 ($41,360 x 105%). 
This is G's adjusted nonaccrual-experience amount for 2002.
    Example 6. Safe harbor 2: Actual experience method (Option B). The 
facts are the same as Example 5, except that G has not maintained the 
data necessary to use Option A of paragraph (e)(3)(i) of this section. G 
determines that, of its 2002 beginning-of-year receivables of 
$1,975,000, $65,000 were determined to be uncollectible and charged off 
(adjusted for recoveries) on or before September 15, 2003, the date G 
timely files its federal income tax return for 2002 (the determination 
date). G chooses to use Option B of paragraph (e)(3)(ii) of this section 
to compute its adjusted nonaccrual-experience amount for 2002. G's 
current year nonaccrual-experience percentage is 3.3%, determined by 
dividing the amount of G's receivables in its account on January 1, 
2002, that were charged off as uncollectible (adjusted for recoveries) 
on or before the determination date, by the balance of G's accounts 
receivable account on January 1, 2002 (i.e., $65,000/$1,975,000 or 
3.3%). Thus, G's actual nonaccrual-experience amount for 2002 is 
determined by multiplying this percentage by the balance of G's accounts 
receivable account on December 31, 2002 (i.e., $880,000 x 3.3% = 
$29,040). G is permitted to exclude from gross income in 2002

[[Page 104]]

an amount equal to 105% of G's actual nonaccrual-experience amount, or 
$30,492 ($29,040 x 105%). This is G's adjusted nonaccrual-experience 
amount for 2002.
    Example 7. (i) The facts are the same as Example 6. G determines 
that its accounts receivable collection experience for 2003 is as 
follows:

------------------------------------------------------------------------
                                                           Beginning A/R
                                                               amount
                                               Total A/R    charged off
                                               balance at        by
                Taxable year                   beginning   determination
                                                of year         date
                                                           (adjusted for
                                                            recoveries)
------------------------------------------------------------------------
2002........................................   $1,975,000       $65,000
2003........................................      880,000        95,000
                                             ---------------------------
    Total...................................   $2,855,000      $160,000
------------------------------------------------------------------------

    (ii) G's ending A/R Balance on 12/31/2003 is $2,115,000. In 2003, G 
must compute its nonaccrual-experience amount using an average of its 
actual nonaccrual-experience for 2002 and 2003 (in accordance with 
Option B of paragraph (e)(3)(ii) of this section). Thus, G's two-year 
moving average nonaccrual-experience percentage is 5.6%, determined by 
dividing the sum of the amount of G's receivables in its accounts on 
January 1st of 2002 and 2003, that were determined to be uncollectible 
and charged off (adjusted for recoveries) on or before the corresponding 
determination dates, by the sum of the balances of G's accounts 
receivable account on January 1st of 2002 and 2003 (i.e., $160,000/
$2,855,000 or 5.6%). Thus, G's actual nonaccrual-experience amount for 
2003 is determined by multiplying this percentage by the balance of G's 
accounts receivable account on December 31, 2003 (i.e., $2,115,000 x 
5.6% = $118,440). G is permitted to exclude from gross income in 2003 an 
amount equal to 105% of G's actual nonaccrual-experience amount, or 
$124,362 ($118,440 x 105%). This is G's adjusted nonaccrual-experience 
amount for 2003.
    Example 8. (i) The facts are the same as Example 7. G determines 
that its accounts receivable collection experience for 2004 is as 
follows:

------------------------------------------------------------------------
                                                           Beginning A/R
                                                               amount
                                               Total A/R    charged off
                                               balance at        by
                Taxable year                   beginning   determination
                                                of year         date
                                                           (adjusted for
                                                            recoveries)
------------------------------------------------------------------------
2002........................................   $1,975,000       $65,000
2003........................................      880,000        95,000
2004........................................    2,115,000       105,000
                                             ---------------------------
    Total...................................   $4,970,000      $265,000
------------------------------------------------------------------------

    (ii) G's ending A/R Balance on 12/31/2004 is $1,600,000. In 2004, G 
must compute its nonaccrual-experience amount using an average of its 
actual nonaccrual-experience for 2002, 2003, and 2004 (in accordance 
with Option B of paragraph (e)(3)(ii) of this section). Thus, G's actual 
three-year moving average nonaccrual-experience percentage is 5.3%, 
determined by dividing the sum of the amount of G's receivables in its 
account on January 1st of 2002, 2003, and 2004, that were determined to 
be uncollectible and charged off (adjusted for recoveries) on or before 
the corresponding determination dates, by the sum of the balances of G's 
accounts receivable account on January 1st of 2002, 2003, and 2004 
(i.e., $265,000/$4,970,000 or 5.3%). Thus, G's actual nonaccrual-
experience amount for 2004 is determined by multiplying this percentage 
by the balance of G's accounts receivable account on December 31, 2004 
(i.e., $1,600,000 x 5.3% = $84,800). G is permitted to exclude from 
gross income in 2004 an amount equal to 105% of G's actual nonaccrual-
experience amount, or $89,040 ($84,800 x 105%). This is G's adjusted 
nonaccrual-experience amount for 2004. Thereafter, G must continue to 
use a three-year moving average to compute its actual nonaccrual-
experience, or obtain approval of the Commissioner to change its 
nonaccrual-experience method of accounting.
    Example 9. H has not tracked its 2002 beginning-of-year accounts 
receivable. Therefore, H may not use the actual experience method 
described in paragraph (e)(3) of this section for 2002. H may use this 
method for 2003 if H tracks its 2003 beginning-of-year receivables, and 
otherwise complies with the requirements of this section.
    Example 10. Safe harbor 3: Modified Black Motor method. (i) J uses 
the modified Black Motor method described in paragraph (e)(4) of this 
section. J's total accounts receivable and bad debt experience for the 
current taxable year (2002) and the five preceding taxable years are as 
follows:

------------------------------------------------------------------------
                                                  Accounts
                                                 receivable   Bad debts
                 Taxable year                    at end of    (adjusted
                                                  taxable        for
                                                    year     recoveries)
------------------------------------------------------------------------
1997..........................................     $130,000       $9,100
1998..........................................      140,000        7,000
1999..........................................      140,000       14,000
2000..........................................      160,000       14,400
2001..........................................      170,000       20,400
2002..........................................      180,000       10,800
                                               -------------------------
    Total.....................................     $920,000      $75,700
------------------------------------------------------------------------

    (ii) Thus, J's Black Motor moving average percentage is 8.228% 
($75,700/$920,000). Assume that the credit charges (accounts receivable) 
generated and written off during the current taxable year were $3,600. 
J's modified Black Motor amount is $11,210, computed by multiplying J's 
accounts receivable at December 31, 2002 ($180,000) by the Black Motor 
moving average percentage of .08228 and reducing the

[[Page 105]]

resulting amount by $3,600 (J's credit charges (accounts receivable) 
generated and written off during the 2002 taxable year). Thus, J may 
exclude $11,210 from gross income for 2002.
    Example 11. Safe harbor 4: Modified six-year moving average method. 
(i) The facts are the same as Example 10, except that J uses the 
modified six-year moving average method described in paragraph (e)(5) of 
this section. Assume further that the credit charges (accounts 
receivable) that were written off in the same taxable year they were 
generated, adjusted for recoveries of bad debts during such period are 
as follows:

------------------------------------------------------------------------
                                                                Credit
                                                               charges
                                                             written off
                                                               in same
                                                               taxable
                        Taxable Year                           year as
                                                              generated
                                                              (adjusted
                                                                 for
                                                             recoveries)
------------------------------------------------------------------------
1997.......................................................       $3,033
1998.......................................................        2,333
1999.......................................................        4,667
2000.......................................................        4,800
2001.......................................................        6,800
2002.......................................................        3,600
                                                            ------------
    Total..................................................      $25,233
------------------------------------------------------------------------

    (ii) Thus, J's modified six-year moving average percentage is 5.486% 
(($75,700--$25,233)/$920,000). J's modified six-year moving average 
amount is $9,875, computed by multiplying J's accounts receivable at 
December 31, 2002 ($180,000) by the modified six-year moving average 
percentage of .05486. Thus, J may exclude $9,875 from gross income for 
2002.
    Example 12. Selection of a safe harbor method. (i) Beginning in 
2002, K is eligible to use a nonaccrual-experience method and wishes to 
adopt an alternative nonaccrual-experience method similar to the method 
described in Black Motor Co. v. Comm'r, 41 B.T.A. 300 (1940), aff'd, 125 
F.2d 977 (6th Cir. 1942). Pursuant to paragraph (e)(6)(ii) of this 
section, K must self-test its alternative nonaccrual-experience method 
for the first taxable year it is used (2002), and every three taxable 
years thereafter for which K uses its alternative nonaccrual-experience 
method. Pursuant to paragraph (e)(6)(iii) of this section, K selects 
safe harbor 2 (actual experience method) for purposes of conducting its 
first year self-test. Thus, beginning in 2002, K must begin tracking its 
beginning-of-year accounts receivable and computing its actual 
nonaccrual-experience as provided in paragraph (e)(3) of this section. 
However, because K lacks the data to use Option A (three-year moving 
average) under paragraph (e)(3)(i) of this section, K selects Option B 
(up to three-year moving average) under paragraph (e)(3)(ii) of this 
section. K's actual nonaccrual-experience amount and alternative 
nonaccrual-experience amount for 2002 are set forth below:

------------------------------------------------------------------------
                                              Beginning A/R
                                                  amount
                                  Total A/R    charged off   Alternative
                                  balance at        by       nonaccrual-
          Taxable year            beginning   determination   experience
                                   of year         date         amount
                                              (adjusted for
                                               recoveries)
------------------------------------------------------------------------
2002...........................     $350,000       $14,000       $20,700
------------------------------------------------------------------------

    (ii) K's ending A/R Balance on 12/31/2002 is $500,000. K's actual 
nonaccrual-experience percentage is 4%, determined by dividing the 
amount of K's receivables in its account on January 1, 2002, that were 
charged off as uncollectible (adjusted for recoveries) on or before the 
determination date, by the balance of K's accounts receivable account on 
January 1, 2002 (i.e., $14,000/$350,000 or 4%). Thus, K's actual 
nonaccrual-experience amount for 2002 is determined by multiplying this 
percentage by the balance of K's accounts receivable account on December 
31, 2002 (i.e., $500,000 x 4% = $20,000). Because K's alternative 
nonaccrual-experience amount for 2002 ($20,700) is not greater than 105% 
of its actual nonaccrual-experience amount for 2002 (i.e., $20,000 x 
1.05 = $21,000), pursuant to paragraph (e)(6)(iv) of this section, K's 
alternative nonaccrual-experience method will be treated as clearly 
reflecting its nonaccrual-experience for the test period 2002. Pursuant 
to paragraph (e)(6)(iv)(B) of this section, K may continue to use its 
alternative nonaccrual-experience method. Additionally, pursuant to 
paragraph (e)(6)(iv)(B) of this section, K is required to self-test its 
alternative nonaccrual-experience method again in 2006, for taxable 
years 2003 through 2005 and, pursuant to paragraph (e)(6)(iii)(B) of 
this section, K must self-test its alternative nonaccrual-experience 
method against the actual experience method when conducting its three 
year self-test in 2006.
    Example 13. (i) The facts are the same as Example 12. K's 
alternative nonaccrual-experience amounts for taxable years 2003-2005 
are as follows:

[[Page 106]]



----------------------------------------------------------------------------------------------------------------
                                                                         Beginning A/R
                                                                             amount
                                                             Total A/R    charged off      Actual    Alternative
                                                             balance at        by       nonaccrual-  nonaccrual-
                       Taxable Year                          beginning   determination   experience   experience
                                                              of year         date         amount       amount
                                                                         (adjusted for
                                                                          recoveries)
----------------------------------------------------------------------------------------------------------------
2003......................................................     $440,000       $30,000       $42,329      $43,050
2004......................................................      760,000        65,000       138,183      140,200
2005......................................................    1,965,000        65,000       101,106      110,550
                                                           -----------------------------------------------------
    Total.................................................   $3,165,000      $160,000      $281,618     $293,800
----------------------------------------------------------------------------------------------------------------

    (ii) Assume that K's ending A/R balance on 12/31/05 is $2,000,000. 
Because K's cumulative alternative nonaccrual-experience amount for the 
test period ($293,800) is not greater than K's cumulative adjusted 
nonaccrual-experience amount (cumulative actual nonaccrual-experience 
amount x 105%) for the same period ($281,618 x 1.05 = $295,699), 
pursuant to paragraph (e)(6)(iv) of this section K's alternative 
nonaccrual-experience method will be treated as clearly reflecting its 
nonaccrual-experience for the test period. Pursuant to paragraph 
(e)(6)(iv)(B) of this section, K may continue to use its alternative 
nonaccrual-experience method. Additionally, pursuant to paragraph 
(e)(6)(iv)(B) of this section, K is required to self-test its 
alternative nonaccrual-experience method again in 2009, for taxable 
years 2006 through 2008 and, pursuant to paragraph (e)(6)(iii)(B) of 
this section, K must self-test its alternative nonaccrual-experience 
method against the actual experience method when conducting its three 
year self-test in 2009.
    Example 14. The facts are the same as Example 12, except that K's 
alternative nonaccrual-experience amount for 2002 is $22,000. Because 
K's alternative nonaccrual-experience amount for 2002 ($22,000) is 
greater than 105% of its actual nonaccrual-experience amount for 2002 
(i.e., $20,000 x 1.05 = $21,000), pursuant to paragraph (e)(6)(vi)(A) of 
this section, K's alternative nonaccrual-experience method will be 
treated as not clearly reflecting its nonaccrual experience for 2002. 
Accordingly, K must either adopt a safe harbor nonaccrual-experience 
method described in paragraphs (e)(2) (six-year moving average method), 
(e)(3) (actual experience method), (e)(4) (modified Black Motor method), 
or (e)(5) (modified six-year moving average method) of this section, or 
an alternative nonaccrual-experience method under paragraph (e)(6) of 
this section (subject to the self-testing requirements of paragraph 
(e)(6)(ii) of this section).
    Example 15. The facts are the same as Example 13, except that K's 
cumulative alternative nonaccrual-experience amount for 2003-2005 is 
$300,000. Because K's cumulative alternative nonaccrual-experience 
amount for the three-year test period (taxable years 2003-2005) is 
greater than its cumulative adjusted nonaccrual-experience amount for 
the three-year test period ($295,699), pursuant to paragraph 
(e)(6)(vi)(B) of this section the $4,301 excess of K's cumulative 
alternative nonaccrual-experience amount over K's cumulative adjusted 
nonaccrual-experience amount for the three year test period must be 
recaptured into income in 2005 in accordance with paragraph (e)(6)(vii) 
of this section. K may continue to use its alternative nonaccrual-
experience method, subject to the three-year self-test requirement in 
paragraph (e)(6)(ii) of this section.
    Example 16. Subsequent worthlessness of year-end receivable. The 
facts are the same as Example 4. Assume that one of the accounts 
receivable outstanding at the end of 2002 was for $8,000, and that in 
2003, under section 166, the entire amount of this receivable becomes 
wholly worthless. Because F did not accrue as income $1,573 of this 
account receivable ($8,000 x .1967) under the nonaccrual-experience 
method in 2002, pursuant to paragraph (e)(7)(i) of this section F may 
not deduct this portion of the account receivable as a bad debt 
deduction under section 166 in 2003. F may deduct the remaining balance 
of the receivable in 2003 as a bad debt deduction under section 166 
($8,000 - $1,574 = $6,426).
    Example 17. Subsequent collection of year-end receivable. The facts 
are the same as in Example 4. Assume that an account receivable of 
$1,700 outstanding at the end of 2002 was collected in full by F in 
2003. Pursuant to paragraph (e)(7)(iii) of this section, F must 
recognize additional gross income in 2003 equal to the portion of this 
receivable that F excluded from gross income in the prior year ($1,700 x 
.1967 = $334).

    (g) Changes to a nonaccrual-experience method of accounting--(1) In 
general. A change to a nonaccrual-experience method is a change in 
method of accounting to which the provisions of sections 446 and 481, 
and the regulations thereunder, apply.
    (2) Taxpayers no longer qualified under section 448 to use a 
nonaccrual-experience method--(i) First taxable year ending

[[Page 107]]

after March 9, 2002. For a taxpayer who no longer qualifies under 
section 448(d)(5), as amended, to use a nonaccrual-experience method, 
consent is hereby granted to change from the nonaccrual-experience 
method to the specific charge-off method for its first taxable year 
ending after March 9, 2002. Such change shall be made in accordance with 
the provisions of this paragraph (g)(2). Pursuant to the consent granted 
by this paragraph (g)(2), a taxpayer described in this paragraph (g)(2) 
that is using a nonaccrual experience method must change such method of 
accounting to the specific charge-off method for its first taxable year 
ending after March 9, 2002. The net amount of the required section 
481(a) adjustment is to be taken into account over a period of 4 taxable 
years (or, if less, the number of taxable years that the taxpayer has 
used the nonaccrual-experience method). The taxpayer should attach Form 
3115 to its income tax return for the year of change, and write ``Change 
from the Nonaccrual-Experience Method under Sec. 1.448-2T(g)'' at the 
top of the form. However, such a taxpayer is not required to file a Form 
3115 with the national office, or pay any associated user fee.
    (ii) For taxable years subsequent to first taxable year ending after 
March 9, 2002. Taxpayers who no longer qualify under section 448(d)(5), 
as amended, to use a nonaccrual-experience method in a taxable year 
subsequent to the first taxable year ending after March 9, 2002, must 
follow the administrative procedures issued under Sec. 1.446-
1(e)(3)(ii) for obtaining the Commissioner's automatic consent to a 
change in accounting method. (For further guidance, for example, see 
Rev. Proc. 2002-9, 2002-1 C.B. 327, and Sec. 601.601(d)(2)(ii)(b) of 
this chapter.)
    (3) Taxpayers permitted to use a nonaccrual-experience method--(i) 
In general. Except as provided in paragraphs (g)(3)(ii) (regarding scope 
limitations) and (g)(4) (regarding certain concurrent changes) of this 
section, a taxpayer that wants to change to a nonaccrual-experience 
method provided in this section, change from one nonaccrual-experience 
method to another nonaccrual-experience method provided in this section, 
and/or change to a periodic system (for further guidance, for example, 
see Notice 88-51, 1988-1 C.B. 535, and Sec. 601.601(d)(2)(ii)(b) of 
this chapter), must follow the administrative procedures issued under 
Sec. 1.446-1(e)(3)(ii) for obtaining the Commissioner's automatic 
consent to a change in accounting method (for further guidance, for 
example, see Rev. Proc. 2002-9, 2002-1 C.B. 327, and Sec. 
601.601(d)(2)(ii)(b) of this chapter).
    (ii) Scope limitations. Any limitations on obtaining the automatic 
consent of the Commissioner do not apply to a taxpayer that wants to 
change to a nonaccrual-experience method of accounting provided in this 
section, and/or change to a periodic system (for further guidance, for 
example, see Notice 88-51, 1988-1 C.B. 535, and Sec. 
601.601(d)(2)(ii)(b) of this chapter), for either its first or second 
taxable year ending after March 9, 2002, provided the taxpayer's 
nonaccrual-experience method of accounting is not an issue under 
consideration for taxable years under examination at the time the Form 
3115 is filed with the national office. A taxpayer's nonaccrual-
experience method of accounting is an issue under consideration for the 
taxable years under examination if the taxpayer receives written 
notification (for example, by examination plan, information document 
request (IDR), or notification of proposed adjustments or income tax 
examination changes) from the examining agent(s) specifically citing the 
treatment of the nonaccrual-experience method of accounting as an issue 
under consideration.
    (iii) Form 3115 must be completed. When filing the Form 3115, the 
taxpayer must complete all applicable parts of the form and write 
``Automatic Change to Nonaccrual-Experience Method'' at the top of the 
form.
    (4) Certain concurrent changes--(i) Taxpayers concurrently changing 
to an accrual method of accounting--(A) Automatic consent. Taxpayers 
that want to change to a nonaccrual-experience method of accounting for 
the same taxable year for which they are required to change to an 
accrual method of accounting under section 448 and the regulations 
thereunder may concurrently change their method of accounting to a 
nonaccrual-experience method (with or

[[Page 108]]

without also changing to a periodic system (for further guidance, for 
example, see Notice 88-51, 1988-1 C.B. 535, and Sec. 
601.601(d)(2)(ii)(b) of this chapter)), under this paragraph (g)(4)(i) 
with automatic consent of the Commissioner if they otherwise qualify 
under this section to use a nonaccrual-experience method of accounting. 
Taxpayers changing to a nonaccrual-experience method under this 
paragraph (g)(4)(i) must comply with the provisions of Sec. 1.448-
1(h)(2). Moreover, such taxpayers must type or legibly print the 
following statement at the top of page 1 of Form 3115, ``Automatic 
Change to Nonaccrual-Experience Method and Overall Accrual Method.'' The 
consent of the Commissioner to change to a nonaccrual experience method 
is granted to taxpayers changing to such method under this paragraph 
(g)(4)(i).
    (B) Section 481(a) adjustment. In the case of a taxpayer changing to 
a nonaccrual-experience method under this paragraph (g)(4)(i), the 
section 481(a) adjustment resulting from the change to a nonaccrual-
experience method of accounting will be combined or netted with the net 
section 481(a) adjustment resulting from the change under Sec. 1.448-
1(h)(2), and the resulting net section 481(a) adjustment will be taken 
into account over the section 481(a) adjustment period as determined 
under the applicable administrative procedures issued under Sec. 1.446-
1(e)(3)(ii) for obtaining the Commissioner's consent to a change in 
accounting method.
    (ii) Taxpayers concurrently changing to a permissible special 
method--(A) Prior consent. A taxpayer required to change to an accrual 
method of accounting under section 448 and the regulations thereunder 
that, as part of such change, also wants to change to a nonaccrual 
experience method of accounting and a permissible special method of 
accounting under Sec. 1.448-1(h)(3), may concurrently change its method 
of accounting to a nonaccrual-experience method of accounting (with or 
without also changing to a periodic system (for further guidance, for 
example, see Notice 88-51, 1988-1 C.B. 535, and Sec. 
601.601(d)(2)(ii)(b) of this chapter)), under this paragraph (g)(4)(ii) 
with the prior consent of the Commissioner if the taxpayer otherwise 
qualifies under this section to use a nonaccrual-experience method of 
accounting. Taxpayers changing to a nonaccrual-experience method under 
this paragraph (g)(4)(ii) must comply with the provisions of Sec. 
1.448-1(h)(3). Moreover, such taxpayers must type or legibly print the 
following statement at the top of page 1 of Form 3115, ``Change to 
Nonaccrual-Experience Method and Special Method of Accounting--Section 
448.''
    (B) Section 481(a) adjustment. The section 481(a) adjustment 
resulting from a change in method of accounting described under this 
paragraph (g)(4)(ii) must be taken into account in accordance with the 
rules provided in paragraph (g)(4)(i)(B) of this section.
    (h) Transition rules--(1) In general. If a taxpayer adopted or 
changed to a nonaccrual-experience method of accounting in accordance 
with the provisions of Notice 2003-12 for any taxable year ending after 
March 9, 2002, and, on or before October 20, 2003, and for such taxable 
year the taxpayer would like to change to a different nonaccrual-
experience method of accounting as provided in paragraphs (e)(2) through 
(e)(6) of this section, and/or change to a periodic system (for further 
guidance, for example, see Notice 88-51, 1988-1 C.B. 535, and Sec. 
601.601(d)(2)(ii)(b) of this chapter), the taxpayer must follow the 
administrative procedures issued under Sec. 1.446-1(e)(3)(ii) for 
obtaining the Commissioner's automatic consent to a change in accounting 
method (for further guidance, for example, see Rev. Proc. 2002-9, 2002-1 
C.B. 327, and Sec. 601.601(d)(2)(ii)(b) of this chapter) and must file 
the original Form 3115 either--
    (i) With an amended federal income tax return (or a qualified 
amended return under Rev. Proc. 94-69, 1994-2 C.B. 804, if applicable; 
hereinafter, referred to in this section as a ``qualified amended 
return'') on or before December 31, 2003, for the taxpayer's first 
taxable year ending after March 9, 2002, and any affected subsequent 
taxable year, and include the statement ``Filed Pursuant to Sec. 1.448-
2T(h)(1)(i)'' at the top of any amended federal income tax return (or 
qualified amended return);
    (ii) With the taxpayer's timely filed federal income tax return for 
the second taxable year ending after March 9,

[[Page 109]]

2002, if this return has not been filed on or before September 4, 2003; 
or
    (iii) If the taxpayer's federal income tax return for the second 
taxable year ending after March 9, 2002, was filed on or before 
September 4, 2003, with an amended federal income tax return (or a 
qualified amended return) on or before December 31, 2003, for the second 
taxable year ending after March 9, 2002, and include the statement 
``Filed Pursuant to Sec. 1.448-2T(h)(1)(iii)'' at the top of the 
amended federal income tax return (or qualified amended return).
    (2) Pending Form 3115. If a taxpayer filed a Form 3115 under the 
applicable administrative procedures with the national office to make a 
change in its method of accounting under section 448(d)(5), as amended, 
for a year of change for which this regulation is effective and the 
application or ruling request is pending with the national office on 
September 4, 2003, the taxpayer must notify the national office in 
writing prior to November 3, 2003, if the taxpayer wants to withdraw its 
Form 3115 under such administrative procedures. If the taxpayer notifies 
the national office within the time provided in this paragraph (h)(2), 
the taxpayer's Form 3115, and any user fee that was submitted with the 
Form 3115, will be returned to the taxpayer. A taxpayer whose Form 3115 
is returned under this paragraph (h)(2) may file a new Form 3115 under 
the provisions prescribed in paragraphs (g) and (h) of this section. If 
the taxpayer does not notify the national office within the time 
provided in this paragraph (h)(2), the national office will continue to 
process the taxpayer's Form 3115 in accordance with the administrative 
procedures under which it was originally filed.
    (i) [Reserved]
    (j) Audit protection. If a taxpayer uses one of the nonaccrual-
experience methods of accounting described in paragraphs (e)(3) (actual 
experience method), (e) (4) (modified Black Motor method), or (e)(5) 
(modified six-year moving average method) of this section to determine 
its amount excluded from gross income under section 448(d)(5), as 
amended, the taxpayer's use of that method will not be raised as an 
issue by the IRS in a taxable year that ends before September 4, 2003. 
If the taxpayer uses one of the nonaccrual-experience methods of 
accounting described in paragraphs (e)(3), (e)(4), or (e)(5) of this 
section, and its use of such method is an issue under consideration in 
examination (as defined in paragraph (g)(3)(ii) of this section), in 
appeals, or before the U.S. Tax Court in a taxable year that ends before 
September 4, 2003, that issue will not be further pursued by the IRS.
    (k) Effective date. This section is applicable for taxable years 
ending after March 9, 2002. The applicability of this section expires on 
or before September 5, 2006.

[T.D. 9090, 68 FR 52500, Sept. 4, 2003; 68 FR 62516, Nov. 5, 2003, as 
amended at 68 FR 66708, Nov. 28, 2003]

          taxable year for which items of gross income included



Sec. 1.451-1  General rule for taxable year of inclusion.

    (a) General rule. Gains, profits, and income are to be included in 
gross income for the taxable year in which they are actually or 
constructively received by the taxpayer unless includible for a 
different year in accordance with the taxpayer's method of accounting. 
Under an accrual method of accounting, income is includible in gross 
income when all the events have occurred which fix the right to receive 
such income and the amount thereof can be determined with reasonable 
accuracy. Therefore, under such a method of accounting if, in the case 
of compensation for services, no determination can be made as to the 
right to such compensation or the amount thereof until the services are 
completed, the amount of compensation is ordinarily income for the 
taxable year in which the determination can be made. Under the cash 
receipts and disbursements method of accounting, such an amount is 
includible in gross income when actually or constructively received. 
Where an amount of income is properly accrued on the basis of a 
reasonable estimate and the exact amount is subsequently determined, the 
difference, if any, shall be taken into account for the taxable year in 
which such determination is made. To the extent that income is 
attributable

[[Page 110]]

to the recovery of bad debts for accounts charged off in prior years, it 
is includible in the year of recovery in accordance with the taxpayer's 
method of accounting, regardless of the date when the amounts were 
charged off. For treatment of bad debts and bad debt recoveries, see 
sections 166 and 111 and the regulations thereunder. For rules relating 
to the treatment of amounts received in crop shares, see section 61 and 
the regulations thereunder. For the year in which a partner must include 
his distributive share of partnership income, see section 706(a) and 
paragraph (a) of Sec. 1.706-1. If a taxpayer ascertains that an item 
should have been included in gross income in a prior taxable year, he 
should, if within the period of limitation, file an amended return and 
pay any additional tax due. Similarly, if a taxpayer ascertains that an 
item was improperly included in gross income in a prior taxable year, he 
should, if within the period of limitation, file claim for credit or 
refund of any overpayment of tax arising therefrom.
    (b) Special rule in case of death. (1) A taxpayer's taxable year 
ends on the date of his death. See section 443(a)(2) and paragraph 
(a)(2) of Sec. 1.443-1. In computing taxable income for such year, 
there shall be included only amounts properly includible under the 
method of accounting used by the taxpayer. However, if the taxpayer used 
an accrual method of accounting, amounts accrued only by reason of his 
death shall not be included in computing taxable income for such year. 
If the taxpayer uses no regular accounting method, only amounts actually 
or constructively received during such year shall be included. (For 
rules relating to the inclusion of partnership income in the return of a 
decedent partner, see subchapter K, chapter 1 of the Code, and the 
regulations thereunder.)
    (2) If the decedent owned an installment obligation the income from 
which was taxable to him under section 453, no income is required to be 
reported in the return of the decedent by reason of the transmission at 
death of such obligation. See section 453(d)(3). For the treatment of 
installment obligations acquired by the decedent's estate or by any 
person by bequest, devise, or inheritance from the decedent, see section 
691(a)(4) and the regulations thereunder.
    (c) Special rule for employee tips. Tips reported by an employee to 
his employer in a written statement furnished to the employer pursuant 
to section 6053(a) shall be included in gross income of the employee for 
the taxable year in which the written statement is furnished the 
employer. For provisions relating to the reporting of tips by an 
employee to his employer, see section 6053 and Sec. 31.6053-1 of this 
chapter (Employment Tax Regulations).
    (d) Special rule for ratable inclusion of original issue discount. 
For ratable inclusion of original issue discount in respect of certain 
corporate obligations issued after May 27, 1969, see section 1232(a)(3).
    (e) Special rule for inclusion of qualified tax refund effected by 
allocation. For rules relating to the inclusion in income of an amount 
paid by a taxpayer in respect of his liability for a qualified State 
individual income tax and allocated or reallocated in such a manner as 
to apply it toward the taxpayer's liability for the Federal income tax, 
see paragraph (f)(1) of Sec. 301.6361-1 of this chapter (Regulations on 
Procedure and Administration).
    (f) Timing of income from notional principal contracts. For the 
timing of income with respect to notional principal contracts, see Sec. 
1.446-3.
    (g) Timing of income from section 467 rental agreements. For the 
timing of income with respect to section 467 rental agreements, see 
section 467 and the regulations thereunder.

[T.D. 6500, 25 FR 11709, Nov. 26, 1960, as amended by T.D. 7001, 34 FR 
997, Jan. 23, 1969; T.D. 7154, 36 FR 24996, Dec. 28, 1971; 43 FR 59357, 
Dec. 20, 1978; T.D. 8491, 58 FR 53135, Oct. 14, 1993; T.D. 8820, 64 FR 
26851, May 18, 1999]



Sec. 1.451-2  Constructive receipt of income.

    (a) General rule. Income although not actually reduced to a 
taxpayer's possession is constructively received by him in the taxable 
year during which it is credited to his account, set apart for him, or 
otherwise made available so that he may draw upon it at any time, or so 
that he could have drawn upon it

[[Page 111]]

during the taxable year if notice of intention to withdraw had been 
given. However, income is not constructively received if the taxpayer's 
control of its receipt is subject to substantial limitations or 
restrictions. Thus, if a corporation credits its employees with bonus 
stock, but the stock is not available to such employees until some 
future date, the mere crediting on the books of the corporation does not 
constitute receipt. In the case of interest, dividends, or other 
earnings (whether or not credited) payable in respect of any deposit or 
account in a bank, building and loan association, savings and loan 
association, or similar institution, the following are not substantial 
limitations or restrictions on the taxpayer's control over the receipt 
of such earnings:
    (1) A requirement that the deposit or account, and the earnings 
thereon, must be withdrawn in multiples of even amounts;
    (2) The fact that the taxpayer would, by withdrawing the earnings 
during the taxable year, receive earnings that are not substantially 
less in comparison with the earnings for the corresponding period to 
which the taxpayer would be entitled had he left the account on deposit 
until a later date (for example, if an amount equal to three months' 
interest must be forfeited upon withdrawal or redemption before maturity 
of a one year or less certificate of deposit, time deposit, bonus plan, 
or other deposit arrangement then the earnings payable on premature 
withdrawal or redemption would be substantially less when compared with 
the earnings available at maturity);
    (3) A requirement that the earnings may be withdrawn only upon a 
withdrawal of all or part of the deposit or account. However, the mere 
fact that such institutions may pay earnings on withdrawals, total or 
partial, made during the last three business days of any calendar month 
ending a regular quarterly or semiannual earnings period at the 
applicable rate calculated to the end of such calendar month shall not 
constitute constructive receipt of income by any depositor or account 
holder in any such institution who has not made a withdrawal during such 
period;
    (4) A requirement that a notice of intention to withdraw must be 
given in advance of the withdrawal. In any case when the rate of 
earnings payable in respect of such a deposit or account depends on the 
amount of notice of intention to withdraw that is given, earnings at the 
maximum rate are constructively received during the taxable year 
regardless of how long the deposit or account was held during the year 
or whether, in fact, any notice of intention to withdraw is given during 
the year. However, if in the taxable year of withdrawal the depositor or 
account holder receives a lower rate of earnings because he failed to 
give the required notice of intention to withdraw, he shall be allowed 
an ordinary loss in such taxable year in an amount equal to the 
difference between the amount of earnings previously included in gross 
income and the amount of earnings actually received. See section 165 and 
the regulations thereunder.
    (b) Examples of constructive receipt. Amounts payable with respect 
to interest coupons which have matured and are payable but which have 
not been cashed are constructively received in the taxable year during 
which the coupons mature, unless it can be shown that there are no funds 
available for payment of the interest during such year. Dividends on 
corporate stock are constructively received when unqualifiedly made 
subject to the demand of the shareholder. However, if a dividend is 
declared payable on December 31 and the corporation followed its usual 
practice of paying the dividends by checks mailed so that the 
shareholders would not receive them until January of the following year, 
such dividends are not considered to have been constructively received 
in December. Generally, the amount of dividends or interest credited on 
savings bank deposits or to shareholders of organizations such as 
building and loan associations or cooperative banks is income to the 
depositors or shareholders for the taxable year when credited. However, 
if any portion of such dividends or interest is not subject to 
withdrawal at the

[[Page 112]]

time credited, such portion is not constructively received and does not 
constitute income to the depositor or shareholder until the taxable year 
in which the portion first may be withdrawn. Accordingly, if, under a 
bonus or forfeiture plan, a portion of the dividends or interest is 
accumulated and may not be withdrawn until the maturity of the plan, the 
crediting of such portion to the account of the shareholder or depositor 
does not constitute constructive receipt. In this case, such credited 
portion is income to the depositor or shareholder in the year in which 
the plan matures. However, in the case of certain deposits made after 
December 31, 1970, in banks, domestic building and loan associations, 
and similar financial institutions, the ratable inclusion rules of 
section 1232(a)(3) apply. See Sec. 1.1232-3A. Accrued interest on 
unwithdrawn insurance policy dividends is gross income to the taxpayer 
for the first taxable year during which such interest may be withdrawn 
by him.

[T.D. 6723, 29 FR 5342, Apr. 21, 1964; as amended by T.D. 7154, 36 FR 
24997, Dec. 28, 1971; T.D. 7663, 44 FR 76782, Dec. 28, 1979]



Sec. 1.451-4  Accounting for redemption of trading stamps and coupons.

    (a) In general--(1) Subtraction from receipts. If an accrual method 
taxpayer issues trading stamps or premium coupons with sales, or an 
accrual method taxpayer is engaged in the business of selling trading 
stamps or premium coupons, and such stamps or coupons are redeemable by 
such taxpayer in merchandise, cash, or other property, the taxpayer 
should, in computing the income from such sales, subtract from gross 
receipts with respect to sales of such stamps or coupons (or from gross 
receipts with respect to sales with which trading stamps or coupons are 
issued) an amount equal to--
    (i) The cost to the taxpayer of merchandise, cash, and other 
property used for redemptions in the taxable year,
    (ii) Plus the net addition to the provision for future redemptions 
during the taxable year (or less the net subtraction from the provision 
for future redemptions during the taxable year).
    (2) Trading stamp companies. For purposes of this section, a 
taxpayer will be considered as being in the business of selling trading 
stamps or premium coupons if--
    (i) The trading stamps or premium coupons sold by him are issued by 
purchasers to promote the sale of their merchandise or services,
    (ii) The principal activity of the trade or business is the sale of 
such stamps or coupons,
    (iii) Such stamps or coupons are redeemable by the taxpayer for a 
period of at least 1 year from the date of sale, and
    (iv) Based on his overall experience, it is estimated that not more 
than two-thirds of the stamps or coupons sold which it is estimated, 
pursuant to paragraph (c) of this section, will be ultimately redeemed, 
will be redeemed within 6 months of the date of sale.
    (b) Computation of the net addition to or subtraction from the 
provision for future redemptions--(1) Determination of the provision for 
future redemptions. (i) The provision for future redemptions as of the 
end of a taxable year is computed by multiplying ``estimated future 
redemptions'' (as defined in subdivision (ii) of this subparagraph) by 
the estimated average cost of redeeming each trading stamp or coupon 
(computed in accordance with subdivision (iii) of this subparagraph).
    (ii) For purposes of this section, the term ``estimated future 
redemptions'' as of the end of a taxable year means the number of 
trading stamps or coupons outstanding as of the end of such year that it 
is reasonably estimated will ultimately be presented for redemption. 
Such estimate shall be determined in accordance with the rules contained 
in paragraph (c) of this section.
    (iii) For purposes of this section, the estimated average cost of 
redeeming each trading stamp or coupon shall be computed by including 
only the costs to the taxpayer of acquiring the merchandise, cash, or 
other property needed to redeem such stamps or coupons. The term ``the 
costs to the taxpayer of acquiring the merchandise, cash, or other 
property needed to redeem such stamps or coupons'' includes only the 
price charged by the seller (less trade or other discounts, except 
strictly cash discounts approximating a fair interest

[[Page 113]]

rate, which may be deducted or not at the option of the taxpayer 
provided a consistent course is followed) plus transportation or other 
necessary charges in acquiring possession of the goods. Items such as 
the costs of advertising, catalogs, operating redemption centers, 
transporting merchandise or other property from a central warehouse to a 
branch warehouse (or from a warehouse to a redemption center), and 
storing the merchandise or other property used to redeem stamps or 
coupons should not be included in costs of redeeming stamps or premium 
coupons, but rather should be accounted for in accordance with the 
provisions of sections 162 and 263.
    (2) Changes in provision for future redemptions. For purposes of 
this section, a ``net addition to'' or ``net subtraction from'' the 
provision for future redemptions for a taxable year is computed as 
follows:
    (i) Carry over the provision for future redemptions (if any) as of 
the end of the preceding taxable year,
    (ii) Compute the provision for future redemptions as of the end of 
the taxable year in accordance with subparagraph (1) of this paragraph, 
and
    (iii) If the amount referred to in subdivision (ii) of this 
subparagraph exceeds the amount referred to in subdivision (i) of this 
subparagraph, such excess is the net addition to the provision for 
future redemptions for the taxable year. On the other hand, if the 
amount referred to in such subdivision (i) exceeds the amount referred 
to in such subdivision (ii), such excess is the net subtraction from the 
provision for future redemptions for the taxable year.
    (3) Example. The provisions of this paragraph and paragraph (a)(1) 
of this section may be illustrated by the following example:

    Example. (a) X Company, a calendar year accrual method taxpayer, is 
engaged in the business of selling trading stamps to merchants. In 1971, 
its first year of operation, X sells 10 million stamps at $5 per 1,000; 
it redeems 3 million stamps for merchandise and cash of an average value 
of $3 per 1,000 stamps. At the end of 1971 it is estimated (pursuant to 
paragraph (c) of this section) that a total of 9 million stamps of the 
10 million stamps issued in 1971 will eventually be presented for 
redemption. At this time it is estimated that the average cost of 
redeeming stamps (as described in subparagraph (1)(iii) of this 
paragraph) would continue to be $3 per 1,000 stamps. Under these 
circumstances, X computes its gross income from sales of trading stamps 
as follows:

Gross receipts from sales (10 million stamps at $5    ........   $50,000
 per 1,000).........................................
Less:
  Cost of actual redemptions (3 million stamps at $3    $9,000  ........
   per 1,000).......................................
  Provision for future redemptions on December 31,      18,000  ........
   1971 (9 million stamps - 3 million stamps x $3
   per 1,000).......................................
                                                     ----------
                                                      ........    27,000
                                                               ---------
1971 gross income from sales of stamps..............  ........    23,000
 

    (b) In 1972, X also sells 10 million stamps at $5 per 1,000 stamps. 
During 1972 X redeems 7 million stamps at an average cost of $3.01 per 
1,000 stamps. At the end of 1972 it is determined that the estimated 
future redemptions (within the meaning of subparagraph (1)(ii) of this 
paragraph) is 8 million. It is further determined that the estimated 
average cost of redeeming stamps would continue to be $3.01 per 1,000 
stamps. X thus computes its gross income from sales of trading stamps 
for 1972 as follows:

Gross receipts from sales (10 million stamps at $5 per 1,000).  $50,000
Less:
  Cost of actual redemptions (7 million stamps at      $21,070
   $3.01 per 1,000).................................
Plus:
  Provision for future redemptions on Dec. 31, 1972     24,080
   (8 million stamps at $3.01 per 1,000)............
Minus provision for future redemptions on Dec. 31,      18,000
 1971...............................................
                                                     ----------
Addition to provision for future redemptions........     6,080
                                                     ----------
   Total cost of redemptions..................................    27,150
                                                               ---------
1972 Gross income from sales of stamps..............  ........    22,850
 

    (c) Estimated future redemptions--(1) In general. A taxpayer may use 
any method of determining the estimated future redemptions as of the end 
of a year so long as--
    (i) Such method results in a reasonably accurate estimate of the 
stamps or coupons outstanding at the end of such year that will 
ultimately be presented for redemption,
    (ii) Such method is used consistently, and
    (iii) Such taxpayer complies with the requirements of this paragraph 
and paragraphs (d) and (e) of this section.
    (2) Utilization of prior redemption experience. Normally, the 
estimated future

[[Page 114]]

redemptions of a taxpayer shall be determined on the basis of such 
taxpayer's prior redemption experience. However, if the taxpayer does 
not have sufficient redemption experience to make a reasonable 
determination of his ``estimated future redemptions,'' or if because of 
a change in his mode of operation or other relevant factors the 
determination cannot reasonably be made completely on the basis of the 
taxpayer's own experience, the experiences of similarly situated 
taxpayers may be used to establish an experience factor.
    (3) One method of determining estimated future redemptions. One 
permissible method of determining the estimated future redemptions as of 
the end of the current taxable year is as follows:
    (i) Estimate for each preceding taxable year and the current taxable 
year the number of trading stamps or coupons issued for each such year 
which will ultimately be presented for redemption.
    (ii) Determine the sum of the estimates under subdivision (i) of 
this subparagraph for each taxable year prior to and including the 
current taxable year.
    (iii) The difference between the sum determined under subdivision 
(ii) of this subparagraph and the total number of trading stamps or 
coupons which have already been presented for redemption is the 
estimated future redemptions as of the end of the current taxable year.
    (4) Determination of an ``estimated redemption percentage.'' For 
purposes of applying subparagraph (3)(i) of this paragraph, one 
permissible method of estimating the number of trading stamps or coupons 
issued for a taxable year that will ultimately be presented for 
redemption is to multiply such number of stamps issued for such year by 
an ``estimated redemption percentage.'' For purposes of this section the 
term ``estimated redemption percentage'' for a taxable year means a 
fraction, the numerator of which is the number of trading stamps or 
coupons issued during a taxable year that it is reasonably estimated 
will ultimately be redeemed, and the denominator of which is the number 
of trading stamps or coupons issued during such year. Consequently, the 
product of such percentage and the number of stamps issued for such year 
equals the number of trading stamps or coupons issued for such year that 
it is estimated will ultimately be redeemed.
    (5) Five-year rule. (i) One permissible method of determining the 
``estimated redemption percentage'' for a taxable year is to--
    (a) Determine the percentage which the total number of stamps or 
coupons redeemed in the taxable year and the 4 preceding taxable years 
is of the total number of stamps or coupons issued or sold in such 5 
years; and
    (b) Multiply such percentage by an appropriate growth factor as 
determined pursuant to guidelines published by the Commissioner.
    (ii) If a taxpayer uses the method described in subdivision (i) of 
this subparagraph for a taxable year, it will normally be presumed that 
such taxpayer's ``estimated redemption percentage'' is reasonably 
accurate.
    (6) Other methods of determining estimated future redemptions. (i) 
If a taxpayer uses a method of determining his ``estimated future 
redemptions'' (other than a method which applies the 5-year rule as 
described in subparagraph (5)(i) of this paragraph) such as a 
probability sampling technique, the appropriateness of the method 
(including the appropriateness of the sampling technique, if any) and 
the accuracy and reliability of the results obtained must, if requested, 
be demonstrated to the satisfaction of the district director.
    (ii) No inference shall be drawn from subdivision (i) of this 
subparagraph that the use of any method to which such subdivision 
applies is less acceptable than the method described in subparagraph 
(5)(i) of this paragraph. Therefore, certain probability sampling 
techniques used in determining estimated future redemptions may result 
in reasonably accurate and reliable estimates. Such a sampling technique 
will be considered appropriate if the sample is--
    (a) Taken in accordance with sound statistical sampling principles,
    (b) In accordance with such principles, sufficiently broad to 
produce a reasonably accurate result, and

[[Page 115]]

    (c) Taken with sufficient frequency as to produce a reasonably 
accurate result.


In addition, if the sampling technique is appropriate, the results 
obtained therefrom in determining estimated future redemptions will be 
considered accurate and reliable if the evaluation of such results is 
consistent with sound statistical principles. Ordinarily, samplings and 
recomputations of the estimated future redemptions will be required 
annually. However, the facts and circumstances in a particular case may 
justify such a recomputation being taken less frequently than annually. 
In addition, the Commissioner may prescribe procedures indicating that 
samples made to update the results of a sample of stamps redeemed in a 
prior year need not be the same size as the sample of such prior year.
    (d) Consistency with financial reporting--(1) Estimated future 
redemptions. For taxable years beginning after August 22, 1972, the 
estimated future redemptions must be no greater than the estimate that 
the taxpayer uses for purposes of all reports (including consolidated 
financial statements) to shareholders, partners, beneficiaries, other 
proprietors, and for credit purposes.
    (2) Average cost of redeeming stamps. For taxable years beginning 
after August 22, 1972, the estimated average cost of redeeming each 
stamp or coupon must be no greater than the average cost of redeeming 
each stamp or coupon (computed in accordance with paragraph (b)(1)(iii) 
of this section) that the taxpayer uses for purposes of all reports 
(including consolidated financial statements) to shareholders, partners, 
beneficiaries, other proprietors, and for credit purposes.
    (e) Information to be furnished with return--(1) In general. For 
taxable years beginning after August 22, 1972, a taxpayer described in 
paragraph (a) of this section who uses a method of determining the 
``estimated future redemptions'' other than that described in paragraph 
(c)(5)(i) of this section shall file a statement with his return showing 
such information as is necessary to establish the correctness of the 
amount subtracted from gross receipts in the taxable year.
    (2) Taxpayers using the 5-year rule. If a taxpayer uses the method 
of determining estimated future redemptions described in paragraph 
(c)(5)(i) of this section, he shall file a statement with his return 
showing, with respect to the taxable year and the 4 preceding taxable 
years--
    (i) The total number of stamps or coupons issued or sold during each 
year, and
    (ii) The total number of stamps or coupons redeemed in each such 
year.
    (3) Trading stamp companies. In addition to the information required 
by subparagraph (1) or (2) of this paragraph, a taxpayer engaged in the 
trade or business of selling trading stamps or premium coupons shall 
include with the statement described in subparagraph (1) or (2) of this 
paragraph such information as may be necessary to satisfy the 
requirements of paragraph (a)(2)(iv) of this section.

[T.D. 7201, 37 FR 16911, Aug. 23, 1972, as amended by T.D. 7201, 37 FR 
18617, Sept. 14, 1972]



Sec. 1.451-5  Advance payments for goods and long-term contracts.

    (a) Advance payment defined. (1) For purposes of this section, the 
term ``advance payment'' means any amount which is received in a taxable 
year by a taxpayer using an accrual method of accounting for purchases 
and sales or a long-term contract method of accounting (described in 
Sec. 1.451-3), pursuant to, and to be applied against, an agreement:
    (i) For the sale or other disposition in a future taxable year of 
goods held by the taxpayer primarily for sale to customers in the 
ordinary course of his trade or business, or
    (ii) For the building, installing, constructing or manufacturing by 
the taxpayer of items where the agreement is not completed within such 
taxable year.
    (2) For purposes of subparagraph (1) of this paragraph:
    (i) The term ``agreement'' includes (a) a gift certificate that can 
be redeemed for goods, and (b) an agreement which obligates a taxpayer 
to perform activities described in subparagraph (1)(i) or (ii) of this 
paragraph and which also contains an obligation to perform

[[Page 116]]

services that are to be performed as an integral part of such 
activities; and
    (ii) Amounts due and payable are considered ``received''.
    (3) If a taypayer (described in subparagraph (1) of this paragraph) 
receives an amount pursuant to, and to be applied against, an agreement 
that not only obligates the taxpayer to perform the activities described 
in subparagraph (1) (i) and (ii) of this paragraph, but also obligates 
the taxpayer to perform services that are not to be performed as an 
integral part of such activities, such amount will be treated as an 
``advance payment'' (as defined in subparagraph (1) of this paragraph) 
only to the extent such amount is properly allocable to the obligation 
to perform the activities described in subparagraph (1) (i) and (ii) of 
this paragraph. The portion of the amount not so allocable will not be 
considered an ``advance payment'' to which this section applies. If, 
however, the amount not so allocable is less than 5 percent of the total 
contract price, such amount will be treated as so allocable except that 
such treatment cannot result in delaying the time at which the taxpayer 
would otherwise accrue the amounts attributable to the activities 
described in subparagraph (1) (i) and (ii) of this paragraph.
    (b) Taxable year of inclusion--(1) In general. Advance payments must 
be included in income either--
    (i) In the taxable year of receipt; or
    (ii) Except as provided in paragraph (c) of this section.
    (a) In the taxable year in which properly accruable under the 
taxpayer's method of accounting for tax purposes if such method results 
in including advance payments in gross receipts no later than the time 
such advance payments are included in gross receipts for purposes of all 
of his reports (including consolidated financial statements) to 
shareholders, partners, beneficiaries, other proprietors, and for credit 
purposes, or
    (b) If the taxpayer's method of accounting for purposes of such 
reports results in advance payments (or any portion of such payments) 
being included in gross receipts earlier than for tax purposes, in the 
taxable year in which includible in gross receipts pursuant to his 
method of accounting for purposes of such reports.
    (2) Examples. This paragraph may be illustrated by the following 
examples:

    Example (1). S, a retailer who uses for tax purposes and for 
purposes of the reports referred to in subparagraph (1)(ii)(a) of this 
paragraph, an accrual method of accounting under which it accounts for 
its sales of goods when the goods are shipped, receives advance payments 
for such goods. Such advance payments must be included in gross receipts 
for tax purposes either in the taxable year the payments are received or 
in the taxable year such goods are shipped (except as provided in 
paragraph (c) of this section).
    Example (2). T, a manufacturer of household furniture, is a calendar 
year taxpayer who uses an accrual method of accounting pursuant to which 
income is accrued when furniture is shipped for purposes of its 
financial reports (referred to in subparagraph (1)(ii)(a) of this 
paragraph) and an accrual method of accounting pursuant to which the 
income is accrued when furniture is delivered and accepted for tax 
purposes. See Sec. 1.446-1(c)(1)(ii). In 1974, T receives an advance 
payment of $8,000 from X with respect to an order of furniture to be 
manufactured for X for a total price of $20,000. The furniture is 
shipped to X in December 1974, but it is not delivered to and accepted 
by X until January 1975. As a result of this contract, T must include 
the entire advance payment in its gross income for tax purposes in 1974 
pursuant to subparagraph (1)(ii)(b) of this paragraph. T must include 
the remaining $12,000 of the gross contract price in its gross income in 
1975 for tax purposes.

    (3) Long-term contracts. In the case of a taxpayer accounting for 
advance payments for tax purposes pursuant to a long-term contract 
method of accounting under Sec. 1.460-4, or of a taxpayer accounting 
for advance payments with respect to a long-term contract pursuant to an 
accrual method of accounting referred to in the succeeding sentence, 
advance payments shall be included in income in the taxable year in 
which properly included in gross receipts pursuant to such method of 
accounting (without regard to the financial reporting requirement 
contained in subparagraph (1)(ii) (a) or (b) of this paragraph). An 
accrual method of accounting to which the preceding sentence applies 
shall consist of any method of accounting under which the income is 
accrued when, and costs are accumulated until, the subject matter of the 
contract (or, if the subject matter of the

[[Page 117]]

contract consists of more than one item, an item) is shipped, delivered, 
or accepted.
    (4) Installment method. The financial reporting requirement of 
subparagraph (1)(ii) (a) or (b) of this paragraph shall not be construed 
to prevent the use of the installment method under section 453. See 
Sec. 1.446-1(c)(1)(ii).
    (c) Exception for inventoriable goods. (1)(i) If a taxpayer receives 
an advance payment in a taxable year with respect to an agreement for 
the sale of goods properly includible in his inventory, or with respect 
to an agreement (such as a gift certificate) which can be satisfied with 
goods or a type of goods that cannot be identified in such taxable year, 
and on the last day of such taxable year the taxpayer--
    (a) Is accounting for advance payments pursuant to a method 
described in paragraph (b)(1)(ii) of this section for tax purposes,
    (b) Has received ``substantial advance payments'' (as defined in 
subparagraph (3) of this paragraph) with respect to such agreement, and
    (c) Has on hand (or available to him in such year through his normal 
source of supply) goods of substantially similar kind and in sufficient 
quantity to satisfy the agreement in such year,


then all advance payments received with respect to such agreement by the 
last day of the second taxable year following the year in which such 
substantial advance payments are received, and not previously included 
in income in accordance with the taxpayer's accrual method of 
accounting, must be included in income in such second taxable year.
    (ii) If advance payments are required to be included in income in a 
taxable year solely by reason of subdivision (i) of this subparagraph, 
the taxpayer must take into account in such taxable year the costs and 
expenditures included in inventory at the end of such year with respect 
to such goods (or substantially similar goods) on hand or, if no such 
goods are on hand by the last day of such second taxable year, the 
estimated cost of goods necessary to satisfy the agreement.
    (iii) Subdivision (ii) of this subparagraph does not apply if the 
goods or type of goods with respect to which the advance payment is 
received are not identifiable in the year the advance payments are 
required to be included in income by reason of subdivision (i) of this 
subparagraph (for example, where an amount is received for a gift 
certificate).
    (2) If subparagraph (1)(i) of this paragraph is applicable to 
advance payments received with respect to an agreement, any advance 
payments received with respect to such agreement subsequent to such 
second taxable year must be included in gross income in the taxable year 
of receipt. To the extent estimated costs of goods are taken into 
account in a taxable year pursuant to subparagraph (1)(ii) of this 
paragraph, such costs may not again be taken into account in another 
year. In addition, any variances between the costs or estimated costs 
taken into account pursuant to subparagraph (1)(ii) of this paragraph 
and the costs actually incurred in fulfilling the taxpayer's obligations 
under the agreement must be taken into account as an adjustment to the 
cost of goods sold in the year the taxpayer completes his obligations 
under such agreement.
    (3) For purposes of subparagraph (1) of this paragraph, a taxpayer 
will be considered to have received ``substantial advance payments'' 
with respect to an agreement by the last day of a taxable year if the 
advance payments received with respect to such agreement during such 
taxable year plus the advance payments received prior to such taxable 
year pursuant to such agreement, equal or exceed the total costs and 
expenditures reasonably estimated as includible in inventory with 
respect to such agreement. Advance payments received in a taxable year 
with respect to an agreement (such as a gift certificate) under which 
the goods or type of goods to be sold are not identifiable in such year 
shall be treated as ``substantial advance payments'' when received.
    (4) The application of this paragraph is illustrated by the 
following example:

    Example. In 1971, X, a calendar year accrual method taxpayer, enters 
into a contract for the sale of goods (properly includible in X's 
inventory) with a total contract price of $100. X estimates that his 
total inventoriable costs and expenditures for the goods will be $50. X 
receives the following advance payments with respect to the contract:

[[Page 118]]



1971.........................................................        $35
1972.........................................................         20
1973.........................................................         15
1974.........................................................         10
1975.........................................................         10
1976.........................................................         10
 

    The goods are delivered pursuant to the customer's request in 1977. 
X's closing inventory for 1972 of the type of goods involved in the 
contract is sufficient to satisfy the contract. Since advance payments 
received by the end of 1972 exceed the inventoriable costs X estimates 
that he will incur, such payments constitute ``substantial advance 
payments''. Accordingly, all payments received by the end of 1974, the 
end of the second taxable year following the taxable year during which 
``substantial advance payments'' are received, are includible in gross 
income for 1974. Therefore, for taxable year 1974 X must include $80 in 
his gross income. X must include in his cost of goods sold for 1974 the 
cost of such goods (or similar goods) on hand or, if no such goods are 
on hand, the estimated inventoriable costs necessary to satisfy the 
contract. Since no further deferral is allowable for such contract, X 
must include in his gross income for the remaining years of the 
contract, the advance payment received each year. Any variance between 
estimated costs and the costs actually incurred in fulfilling the 
contract is to be taken into account in 1977, when the goods are 
delivered. See paragraph (c)(2) of this section.

    (d) Information schedule. If a taxpayer accounts for advance 
payments pursuant to paragraph (b)(1)(ii) of this section, he must 
attach to his income tax return for each taxable year to which such 
provision applies an annual information schedule reflecting the total 
amount of advance payments received in the taxable year, the total 
amount of advance payments received in prior taxable years which has not 
been included in gross income before the current taxable year, and the 
total amount of such payments received in prior taxable years which has 
been included in gross income for the current taxable year.
    (e) Adoption of method. (1) For taxable years ending on or after 
December 31, 1969, and before January 1, 1971, a taxpayer (even if he 
has already filed an income tax return for a taxable year ending within 
such period) may secure the consent of the Commissioner to change his 
method of accounting for such year to a method prescribed in paragraph 
(b)(1)(ii) of this section in the manner prescribed in section 446 and 
the regulations thereunder, if an application to secure such consent is 
filed on Form 3115 within 180 days after March 23, 1971.
    (2) A taxpayer who is already reporting his income in accordance 
with a method prescribed in paragraph (b)(1)(ii)(a) of this section need 
not secure the consent of the Commissioner to continue to utilize this 
method. However, such a taxpayer, for all taxable years ending after 
March 23, 1971, must comply with the requirements of paragraphs 
(b)(1)(ii)(a) (including the financial reporting requirement) and (d) 
(relating to an annual information schedule) of this section.
    (f) Cessation of taxpayer's liability. If a taxpayer has adopted a 
method prescribed in paragraph (b)(1)(ii) of this section, and if in a 
taxable year the taxpayer dies, ceases to exist in a transaction other 
than one to which section 381(a) applies, or his liability under the 
agreement otherwise ends, then so much of the advance payment as was not 
includible in his gross income in preceding taxable years shall be 
included in his gross income for such taxable year.
    (g) Special rule for certain transactions concerning natural 
resources. A transaction which is treated as creating a mortgage loan 
pursuant to section 636 and the regulations thereunder rather than as a 
sale shall not be considered a ``sale or other disposition'' within the 
meaning of paragraph (a)(1) of this section. Consequently, any payment 
received pursuant to such a transaction, which payment would otherwise 
qualify as an ``advance payment'', will not be treated as an ``advance 
payment'' for purposes of this section.

[T.D. 7103, 36 FR 5495, Mar. 24, 1971, as amended by T.D. 7397, 41 FR 
2641, Jan. 19, 1976; T.D. 8067, 51 FR 393, Jan. 6, 1986; T.D. 8929, 66 
FR 2224, Jan. 11, 2001]



Sec. 1.451-6  Election to include crop insurance proceeds in gross 
income in the taxable year following the taxable year of destruction 
or damage.

    (a) In general. (1) For taxable years ending after December 30, 
1969, a taxpayer reporting gross income on the cash receipts and 
disbursements method of accounting may elect to include insurance 
proceeds received as a result

[[Page 119]]

of the destruction of, or damage to, crops in gross income for the 
taxable year following the taxable year of the destruction or damage, if 
the taxpayer establishes that, under the taxpayer's normal business 
practice, the income from those crops would have been included in gross 
income for any taxable year following the taxable year of the 
destruction or damage. However, if the taxpayer receives the insurance 
proceeds in the taxable year following the taxable year of the 
destruction or damage, the taxpayer shall include the proceeds in gross 
income for the taxable year of receipt without having to make an 
election under section 451(d) and this section. For the purposes of this 
section only, federal payments received as a result of destruction or 
damage to crops caused by drought, flood, or any other natural disaster, 
or the inability to plant crops because of such a natural disaster, 
shall be treated as insurance proceeds received as a result of 
destruction or damage to crops. The preceding sentence shall apply to 
payments that are received by the taxpayer after December 31, 1973.
    (2) In the case of a taxpayer who receives insurance proceeds as a 
result of the destruction of, or damage to, two or more specific crops, 
if such proceeds may, under section 451(d) and this section, be included 
in gross income for the taxable year following the taxable year of such 
destruction or damage, and if such taxpayer makes an election under 
section 451(d) and this section with respect to any portion of such 
proceeds, then such election will be deemed to cover all of such 
proceeds which are attributable to crops representing a single trade or 
business under section 446(d). A separate election must be made with 
respect to insurance proceeds attributable to each crop which represents 
a separate trade or business under section 446(d).
    (b)(1) Time and manner of making election. The election to include 
in gross income insurance proceeds received as a result of destruction 
of, or damage to, the taxpayer's crops in the taxable year following the 
taxable year of such destruction or damage shall be made by means of a 
statement attached to the taxpayer's return (or an amended return) for 
the taxable year of destruction or damage. The statement shall include 
the name and address of the taxpayer (or his duly authorized 
representative), and shall set forth the following information:
    (i) A declaration that the taxpayer is making an election under 
section 451(d) and this section;
    (ii) Identification of the specific crop or crops destroyed or 
damaged;
    (iii) A declaration that under the taxpayer's normal business 
practice the income derived from the crops which were destroyed or 
damaged would have been included in this gross income for a taxable year 
following the taxable year of such destruction or damage;
    (iv) The cause of destruction or damage of crops and the date or 
dates on which such destruction or damage occurred;
    (v) The total amount of payments received from insurance carriers, 
itemized with respect to each specific crop and with respect to the date 
each payment was received;
    (vi) The name(s) of the insurance carrier or carriers from whom 
payments were received.
    (2) Scope of election. Once made, an election under section 451(d) 
is binding for the taxable year for which made unless the district 
director consents to a revocation of such election. Requests for consent 
to revoke an election under section 451(d) shall be made by means of a 
letter to the district director for the district in which the taxpayer 
is required to file his return, setting forth the taxpayer's name, 
address, and identification number, the year for which it is desired to 
revoke the election, and the reasons therefor.

[T.D. 7097, 36 FR 5215, Mar. 18, 1971, as amended by T.D. 7526, 42 FR 
64624, Dec. 27, 1977; T.D. 8429, 57 FR 38595, Aug. 26, 1992]



Sec. 1.451-7  Election relating to livestock sold on account of drought.

    (a) In general. Section 451(e) provides that for taxable years 
beginning after December 31, 1975, a taxpayer whose principal trade or 
business is farming (within the meaning of Sec. 6420 (c)(3)) and who 
reports taxable income on the cash receipts and disbursements method of 
accounting may elect to defer for one year a certain portion of income. 
The income which may be deferred is the

[[Page 120]]

amount of gain realized during the taxable year from the sale or 
exchange of that number of livestock sold or exchanged solely on account 
of a drought which caused an area to be designated as eligible for 
assistance by the Federal Government (regardless of whether the 
designation is made by the President or by an agency or department of 
the Federal Government). That number is equal to the excess of the 
number of livestock sold or exchanged over the number which would have 
been sold or exchanged had the taxpayer followed its usual business 
practices in the absence of such drought. For example, if in the past it 
has been a taxpayer's practice to sell or exchange annually 400 head of 
beef cattle but due to qualifying drought conditions 550 head were sold 
in a given taxable year, only income from the sale of 150 head may 
qualify for deferral under this section. The election is not available 
with respect to livestock described in section 1231(b)(3) (relating to 
cattle, horses (and other livestock) held by the taxpayer for 24 months 
(12 months) and used for draft, breeding, dairy, or sporting purposes).
    (b) Usual business. The determination of the number of animals which 
a taxpayer would have sold if it had followed its usual business 
practice in the absence of drought will be made in light of all facts 
and circumstances. In the case of taxpayers who have not established a 
usual business practice, reliance will be placed upon the usual business 
practice of similarly situated taxpayers in the same general region as 
the taxpayer.
    (c) Special rules--(1) Connection with drought area. To qualify 
under section 451(e) and this section, the livestock need not be raised, 
and the sale or exchange need not take place, in a drought area. 
However, the sale or exchange of the livestock must occur solely on 
account of drought conditions, the existence of which affected the 
water, grazing, or other requirements of the livestock so as to 
necessitate their sale or exchange.
    (2) Sale prior to designation of area as eligible for Federal 
assistance. The provisions of this section will apply regardless of 
whether all or a portion of the excess number of animals were sold or 
exchanged before an area becomes eligible for Federal assistance, so 
long as the drought which caused such dispositions also caused the area 
to be designated as eligible for Federal assistance.
    (d) Classifications of livestock with respect to which the election 
may be made. The election to have the provisions of section 451(e) apply 
must be made separately for each broad generic classification of animals 
(e.g., hogs, sheep, cattle) for which the taxpayer wishes the provisions 
to apply. Separate elections shall not be made solely by reason of the 
animals' age, sex, or breed.
    (e) Computation--(1) Determination of amount deferred. The amount of 
income which may be deferred for a classification of livestock pursuant 
to this section shall be determined in the following manner. The total 
amount of income realized from the sale or exchange of all livestock in 
the classification during the taxable year shall be divided by the total 
number of all such livestock sold. The resulting quotient shall then be 
multiplied by the excess number of such livestock sold on account of 
drought.
    (2) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example. A, a calendar year taxpayer, normally sells 100 head of 
beef cattle a year. As the result of drought conditions existing during 
1976, A sells 135 head during that year. A realizes $35,100 of income 
from the sale of the 135 head. On August 9, 1976, as a result of the 
drought, the affected area was declared a disaster area thereby eligible 
for Federal assistance. The amount of income which A may defer until 
1977, presuming the other provisions of this section are met, is 
determined as follows:
$35,100 (total income from sales of beef cattle)/135 (total number of 
          beef cattle sold)x35 (excess number of beef cattle sold, i.e. 
          135-100)=$9,100 (amount which A may defer until 1977)

    (f) Successive elections. If a taxpayer makes an election under 
section 451(e) for successive years, the amount deferred from one year 
to the next year shall not be deemed to have been received from the sale 
or exchange of livestock during the later year. In addition, in 
determining the taxpayer's normal business practice for the later

[[Page 121]]

year, earlier years for which an election under section 451(e) was made 
shall not be considered.
    (g) Time and manner of making election. The election provided for in 
this section must be made by the later of (1) the due date for filing 
the income tax return (determined with regard to any extensions of time 
granted the taxpayer for filing such return) for the taxable year in 
which the early sale of livestock occurs, or (2) (the 90th day after the 
date these regulations are published as a Treasury decision in the 
Federal Register). The election must be made separately for each taxable 
year to which it is to apply. It must be made by attaching a statement 
to the return or an amended return for such taxable year. The statement 
shall include the name and address of the taxpayer and shall set forth 
the following information for each classification of livestock for which 
the election is made:
    (1) A declaration that the taxpayer is making an election under 
section 451(e);
    (2) Evidence of the existence of the drought conditions which forced 
the early sale or exchange of the livestock and the date, if known, on 
which an area was designated as eligible for assistance by the Federal 
Government as a result of the drought conditions.
    (3) A statement explaining the relationship of the drought area to 
the taxpayer's early sale or exchange of the livestock;
    (4) The total number of animals sold in each of the three preceding 
years;
    (5) The number of animals which would have been sold in the taxable 
year had the taxpayer followed its normal business practice in the 
absence of drought;
    (6) The total number of animals sold, and the number sold on account 
of drought, during the taxable year; and
    (7) A computation, pursuant to paragraph (e) of this section, of the 
amount of income to be deferred for each such classification.
    (h) Revocation of election. Once an election under this section is 
made for a taxable year, it may be revoked only with the approval of the 
Commissioner.
    (i) Cross reference. For provisions relating to the involuntary 
conversion of livestock sold on account of drought see section 1033(e) 
and the regulations thereunder.

[T.D. 7526, 42 FR 64624, Dec. 27, 1977]



Sec. Sec. 1.453-1--1.453-2  [Reserved]



Sec. 1.453-3  Purchaser evidences of indebtedness payable on demand 
or readily tradable.

    (a) In general. A bond or other evidence of indebtedness 
(hereinafter in this section referred to as an obligation) issued by any 
person and payable on demand shall not be treated as an evidence of 
indebtedness of the purchaser in applying section 453(b) to a sale or 
other disposition of real property or to a casual sale or other casual 
disposition of personal property. In addition, an obligation issued by a 
corporation or a government or political subdivision thereof--
    (1) With interest coupons attached (whether or not the obligation is 
readily tradable in an established securities market),
    (2) In registered form (other than an obligation issued in 
registered form which the taxpayer establishes will not be readily 
tradable in an established securities market), or
    (3) In any other form designed to render such obligation readily 
tradable in an established securities market shall not be treated as an 
evidence of indebtedness of the purchaser in applying section 453(b) to 
a sale or other disposition of real property or to a casual sale or 
other casual disposition of personal property. For purposes of this 
section, an obligation is to be considered in registered form if it is 
registered as to principal, interest, or both and if its transfer must 
be effected by the surrender of the old instrument and either the 
reissuance by the corporation of the old instrument to the new holder or 
the issuance by the corporation of a new instrument to the new holder.
    (b) Treatment as payment. If under section 453(b)(3) an obligation 
is not treated as an evidence of indebtedness of the purchaser, then--
    (1) For purposes of determining whether the payments received in the 
taxable year of the sale or disposition

[[Page 122]]

exceed 30 percent of the selling price, and
    (2) For purposes of returning income on the installment method 
during the taxable year of the sale or disposition or in a subsequent 
taxable year, the receipt by the seller of such obligation shall be 
treated as a payment. The rules stated in this paragraph may be 
illustrated by the following examples:

 
$250,000 payment (i.e., 250 of corporation
Y's registered bonds each with a principal
  amount and fair market value of $1,000)
-------------------------------------------  =         25 percent
 $1 million selling price (i.e., $250,000
 of corporation Y's registered bonds plus
       promissory note of $750,000)
------------------------------------------------------------------------
 

    Example (1). On July 1, 1970, A, an individual on the cash method of 
accounting reporting on a calendar year basis, transferred all of his 
stock in corporation X (traded on an established securities market and 
having a fair market value of $1 million) to corporation Y in exchange 
for 250 of corporation Y's registered bonds (which are traded in an 
over-the-counter bond market) each with a principal amount and fair 
market value of $1,000 (with interest payable at the rate of 8 percent 
per year), and Y's unsecured promissory note, with a principal amount of 
$750,000. At the time of such exchange A's basis in the corporation X 
stock is $900,000. The promissory note is payable at the rate of $75,000 
annually, due on July 1, of each year following 1970, until the 
principal balance is paid. The note provides for the payment of interest 
at the rate of 10 percent per year also payable on July 1 of each year. 
Under the rule stated in subparagraph (1) of this paragraph, the 250 
registered bonds of corporation Y are treated as a payment for purposes 
of the 30 percent test described in section 453(b)(2)(A)(ii). The 
payment on account of the bonds equals 25 percent of the selling price 
determined as follows:
    Since the payments received in the taxable year of the sale do not 
exceed 30 percent of the selling price and the sales price exceeds 
$1,000, A may report the income received on the sale of his corporation 
X stock on the installment method. A elects to report the income on the 
installment method. The gross profit to be realized when the corporation 
X stock is fully paid for is 10 percent of the total contract price, 
computed as follows: $100,000 gross profit (i.e., $1 million contract 
price less $900,000 basis in corporation X stock) over $1 million 
contract price. However, since subparagraph (2) of this paragraph also 
treats the 250 corporation Y registered bonds as a payment for purposes 
of reporting income, A must include $25,000 (i.e., 10 percent times 
$250,000) in his gross income for calendar year 1970, the taxable year 
of sale.
    Example (2). Assume the same facts as in example (1). Assume further 
that on July 1, 1971, corporation Y makes its first installment payment 
to A under the terms of the unsecured promissory note with 75 more of 
its $1,000 registered bonds. A must include $7,500 (i.e., 10 percent 
gross profit percentage times $75,000) in his gross income for calendar 
year 1971. In addition, A includes the interest payment made by 
corporation Y on July 1, in his gross income for 1971.

    (c) Payable on demand. Under section 453(b)(3), an obligation shall 
be treated as payable on demand only if the obligation is treated as 
payable on demand under applicable state or local law.
    (d) Designed to be readily tradable in an established securities 
market--(1) In general. Obligations issued by a corporation or 
government or political subdivision thereof will be deemed to be in a 
form designed to render such obligations readily tradable in an 
established securities market if--
    (i) Steps necessary to create a market for them are taken at the 
time of issuance (or later, if taken pursuant to an expressed or implied 
agreement or understanding which existed at the time of issuance),
    (ii) If they are treated as readily tradable in an established 
securities market under subparagraph (2) of this paragraph, or
    (iii) If they are convertible obligations to which paragraph (e) of 
this section applies.
    (2) Readily tradable in an established securities market. An 
obligation will be treated as readily tradable in an established 
securities market if--
    (i) The obligation is part of an issue or series of issues which are 
readily tradable in an established securities market, or
    (ii) The corporation issuing the obligation has other obligations of 
a comparable character which are described in subdivision (i) of this 
subparagraph.

For purposes of subdivision (ii) of this subparagraph, the determination 
as to whether there exist obligations of a comparable character depends 
upon the particular facts and circumstances. Factors to be considered in 
making such determination include, but are

[[Page 123]]

not limited to, substantial similarity with respect to the presence and 
nature of security for the obligation, the number of obligations issued 
(or to be issued), the number of holders of such obligation, the 
principal amount of the obligation, and other relevant factors.
    (3) Readily tradable. For purposes of subparagraph (2)(i) of this 
paragraph, an obligation shall be treated as readily tradable if it is 
regularly quoted by brokers or dealers making a market in such 
obligation or is part of an issue a portion of which is in fact traded 
in an established securities market.
    (4) Established securities market. For purposes of this paragraph, 
the term established securities market includes (i) a national 
securities exchange which is registered under section 6 of the 
Securities and Exchange Act of 1934 (15 U.S.C. 78f), (ii) an exchange 
which is exempted from registration under section 5 of the Securities 
Exchange Act of 1935 (15 U.S.C. 78e) because of its limited volume of 
transactions, and (iii) any over-the-counter market. For purposes of 
this subparagraph, an over-the-counter market is reflected by the 
existence of an interdealer quotation system. An interdealer quotation 
system is any system of general circulation to brokers and dealers which 
regularly disseminates quotations of obligations by identified brokers 
or dealers, other than a quotation sheet prepared and distributed by a 
broker or dealer in the regular course of his business and containing 
only quotations of such broker or dealer.
    (5) Examples. The rules stated in this paragraph may be illustrated 
by the following examples:

    Example (1). On June 1, 1971, 25 individuals owning equal interests 
in a tract of land with a fair market value of $1 million sell the land 
to corporation Y. The $1 million sales price is represented by 25 bonds 
issued by corporation Y each having a face value of $40,000. The bonds 
are not in registered form and do not have interest coupons attached, 
and, in addition, are payable in 120 equal installments each due on the 
first business day of each month. In addition, the bonds are negotiable 
and may be assigned by the holder to any other person. However, the 
bonds are not quoted by any brokers or dealers who deal in corporate 
bonds, and, furthermore, there are no comparable obligations of 
corporation Y (determined with reference to the characteristics set 
forth in subparagraph (2) of this paragraph) which are so quoted. 
Therefore, the bonds are not treated as readily tradable in an 
established securities market. In addition, under the particular facts 
and circumstances stated, the bonds will not be considered to be in a 
form designed to render them readily tradeable in an established 
securities market. Since the bonds are not in registered form, do not 
have coupons attached, are not in a form designed to render them readily 
tradable in an established securities market, the receipt of such bonds 
by the holder is not treated as a payment for purposes of section 
453(b), notwithstanding that they are freely assignable.
    Example (2). On April 1, 1972, corporation M purchases in a casual 
sale of personal property a fleet of trucks from corporation N in 
exchange for corporation M's negotiable notes, not in registered form 
and without coupons attached. The corporation M notes are comparable to 
earlier notes issued by corporation M, which notes are quoted in the 
Eastern Bond section of the National daily quotation sheet, which is an 
interdealer quotation system. Both issues of notes are unsecured, held 
by more than 100 holders, have a maturity date of more than 5 years, and 
were issued for a comparable principal amount. On the basis of these 
similar characteristics it appears that the latest notes will also be 
readily tradable. Since an interdealer system reflects an over-the-
counter market, the earlier notes are treated as readily tradable in an 
established securities market. Since the later notes are obligations 
comparable to the earlier ones, which are treated as readily tradable in 
an established securities market, the later notes are also treated as 
readily tradable in an established securities market (whether or not 
such notes are actually traded).

    (e) Special rule for convertible securities--(1) General rule. For 
purposes of paragraph (d)(1) of this section, if an obligation contains 
a right whereby the holder of such obligation may convert it directly or 
indirectly into another obligation which would be treated as a payment 
under paragraph (b) of this section or may convert it directly or 
indirectly into stock which would be treated as readily tradable or 
designed to be readily tradable in an established securities market 
under paragraph (d) of this section, the convertible obligation shall be 
considered to be in a form designed to render such obligation readily 
tradable in an established securities market unless such obligation is 
convertible only at a substantial discount. In determining whether the

[[Page 124]]

stock or obligation, into which an obligation is convertible, is readily 
tradable or designed to be readily tradable in an established securities 
market, the rules stated in paragraph (d) of this section shall apply, 
and for purposes of such paragraph (d) if such obligation is convertible 
into stock then the term ``stock'' shall be substituted for the term 
``obligation'' wherever it appears in such paragraph (d).
    (2) Substantial discount rule. Whether an obligation is convertible 
at a substantial discount depends upon the particular facts and 
circumstances. A substantial discount shall be considered to exist if at 
the time the convertible obligation is issued, the fair market value of 
the stock or obligation into which the obligation is convertible is less 
than 80 percent of the fair market value of the obligation (determined 
by taking into account all relevant factors, including proper discount 
to reflect the fact that the convertible obligation is not readily 
tradable in an established securities market and any additional 
consideration required to be paid by the taxpayer). Also, if a privilege 
to convert an obligation into stock or an obligation which is readily 
tradable in an established securities market may not be exercised within 
a period of 1 year from the date the obligation is issued, a substantial 
discount shall be considered to exist.
    (f) Effective date. The provisions of this section shall apply to 
sales or other dispositions occurring after May 27, 1969, which are not 
made pursuant to a binding written contract entered into on or before 
such date. No inference shall be drawn from this section as to any 
question of law concerning the application of section 453 to sales or 
other dispositions occurring on or before May 27, 1969.

[T.D. 7197, 37 FR 13532, July 11, 1972]



Sec. 1.453-4  Sale of real property involving deferred periodic payments.

    (a) In general. Sales of real property involving deferred payments 
include (1) agreements of purchase and sale which contemplate that a 
conveyance is not to be made at the outset, but only after all or a 
substantial portion of the selling price has been paid, and (2) sales in 
which there is an immediate transfer of title, the vendor being 
protected by a mortgage or other lien as to deferred payments.
    (b) Classes of sales. Such sales, under either paragraph (a) (1) or 
(2) of this section, fall into two classes when considered with respect 
to the terms of sale, as follows:
    (1) Sales of real property which may be accounted for on the 
installment method, that is, sales of real property in which (i) there 
are no payments during the taxable year of the sale or (ii) the payments 
in such taxable year (exclusive of evidences of indebtedness of the 
purchaser) do not exceed 30 percent of the selling price, or
    (2) Deferred-payment sales of real property in which the payments 
received in cash or property other than evidences of indebtedness of the 
purchaser during the taxable year in which the sale is made exceed 30 
percent of the selling price.
    (c) Determination of ``selling price''. In the sale of mortgaged 
property the amount of the mortgage, whether the property is merely 
taken subject to the mortgage or whether the mortgage is assumed by the 
purchaser, shall, for the purpose of determining whether a sale is on 
the installment plan, be included as a part of the ``selling price''; 
and for the purpose of determining the payments and the total contract 
price as those terms are used in section 453, and Sec. Sec. 1.453-1 
through 1.453-7, the amount of such mortgage shall be included only to 
the extent that it exceeds the basis of the property. The term 
``payments'' does not include amounts received by the vendor in the year 
of sale from the disposition to a third person of notes given by the 
vendee as part of the purchase price which are due and payable in 
subsequent years. Commissions and other selling expenses paid or 
incurred by the vendor shall not reduce the amount of the payments, the 
total contract price, or the selling price.

[T.D. 6500, 25 FR 11715, Nov. 26, 1960]



Sec. 1.453-5  Sale of real property treated on installment method.

    (a) In general. In any transaction described in paragraph (b)(1) of 
Sec. 1.453-4, that is, sales of real property in which

[[Page 125]]

there are no payments during the year of sale or the payments in that 
year do not exceed 30 percent of the selling price, the vendor may 
return as income from each such transaction in any taxable year that 
proportion of the installment payments actually received in that year 
which the gross profit (as described in paragraph (b) of Sec. 1.453-1) 
realized or to be realized when the property is paid for bears to the 
total contract price. In any case, the sale of each lot or parcel of a 
subdivided tract must be treated as a separate transaction and gain or 
loss computed accordingly. (See paragraph (a) of Sec. 1.61-6.)
    (b) Defaults and repossessions--(1) Effective date. This paragraph 
shall apply only with respect to taxable years beginning before 
September 3, 1964, in respect of which an election has not been properly 
made to have the provisions of section 1038 apply. For rules applicable 
to taxable years beginning after September 2, 1964, and for taxable 
years beginning after December 31, 1957, to which such an election 
applies, see section 1038, and Sec. Sec. 1.1038-1 through 1.1038-3.
    (2) Gain or loss on reacquisition of property. If the purchaser of 
real property on the installment plan defaults in any of his payments, 
and the vendor returning income on the installment method reacquires the 
property sold, whether title thereto had been retained by the vendor or 
transferred to the purchaser, gain or loss for the year in which the 
reacquisition occurs is to be computed upon any installment obligations 
of the purchaser which are satisfied or discharged upon the 
reacquisition or are applied by the vendor to the purchase or bid price 
of the property. Such gain or loss is to be measured by the difference 
between the fair market value at the date of reacquisition of the 
property reacquired (including the fair market value of any fixed 
improvements placed on the property by the purchaser) and the basis in 
the hands of the vendor of the obligations of the purchaser which are so 
satisfied, discharged, or applied, with proper adjustment for any other 
amounts realized or costs incurred in connection with the reacquisition.
    (3) Fair market value of reacquired property. If the property 
reacquired is bid in by the vendor at a foreclosure sale, the fair 
market value of the property shall be presumed to be the purchase or bid 
price thereof in the absence of clear and convincing proof to the 
contrary.
    (4) Basis of obligations. The basis in the hands of the vendor of 
the obligations of the purchaser satisfied, discharged, or applied upon 
the reacquisition of the property will be the excess of the face value 
of such obligations over an amount equal to the income which would be 
returnable were the obligations paid in full. For definition of the 
basis of an installment obligation, see section 453(d)(2) and paragraph 
(b)(2) of Sec. 1.453-9.
    (5) Bad debt deduction. No deduction for a bad debt shall in any 
case be taken on account of any portion of the obligations of the 
purchaser which are treated by the vendor as not having been satisfied, 
discharged, or applied upon the reacquisition of the property, unless it 
is clearly shown that after the property was reacquired the purchaser 
remained liable for such portion; and in no event shall the amount of 
the deduction exceed the basis in the hands of the vendor of the portion 
of the obligations with respect to which the purchaser remained liable 
after the reacquisition. See section 166 and the regulations thereunder.
    (6) Basis of reacquired property. If the property reacquired is 
subsequently sold, the basis for determining gain or loss is the fair 
market value of the property at the date of reacquisition, including the 
fair market value of any fixed improvements placed on the property by 
the purchaser.

[T.D. 6500, 25 FR 11716, Nov. 26, 1960, as amended by T.D. 6916, 32 FR 
5923, Apr. 13, 1967]



Sec. 1.453-6  Deferred payment sale of real property not on installment 
method.

    (a) Value of obligations. (1) In transactions included in paragraph 
(b)(2) of Sec. 1.453-4, that is, sales of real property involving 
deferred payments in which the payments received during the year of sale 
exceed 30 percent of the selling price, the obligations of the purchaser

[[Page 126]]

received by the vendor are to be considered as an amount realized to the 
extent of their fair market value in ascertaining the profit or loss 
from the transaction. Such obligations, however, are not considered in 
determining whether the payments during the year of sale exceed 30 
percent of the selling price.
    (2) If the obligations received by the vendor have no fair market 
value, the payments in cash or other property having a fair market value 
shall be applied against and reduce the basis of the property sold and, 
if in excess of such basis, shall be taxable to the extent of the 
excess. Gain or loss is realized when the obligations are disposed of or 
satisfied, the amount thereof being the difference between the reduced 
basis as provided in the preceding sentence and the amount realized 
therefor. Only in rare and extraordinary cases does property have no 
fair market value.
    (b) Repossession of property where title is retained by vendor--(1) 
Gain or loss on repossession. If the vendor in sales referred to in 
paragraph (a) of this section has retained title to the property and the 
purchaser defaults in any of his payments, and the vendor repossesses 
the property, the difference between--
    (i) The entire amount of the payments actually received on the 
contract and retained by the vendor plus the fair market value at the 
time of repossession of fixed improvements placed on the property by the 
purchaser, and
    (ii) The sum of the profits previously returned as income in 
connection therewith and an amount representing what would have been a 
proper adjustment for exhaustion, wear and tear, obsolescence, 
amortization, and depletion of the property during the period the 
property was in the hands of the purchaser had the sale not been made, 
will constitute gain or loss, as the case may be, to the vendor for the 
year in which the property is repossessed.
    (2) Basis of repossessed property. The basis of the property 
described in subparagraph (1) of this paragraph in the hands of the 
vendor will be the original basis at the time of the sale plus the fair 
market value at the time of repossession of fixed improvements placed on 
the property by the purchaser, except that, with respect to 
repossessions occurring after September 18, 1958, the basis of the 
property shall be reduced by what would have been a proper adjustment 
for exhaustion, wear and tear, obsolescence, amortization, and depletion 
of the property during the period the property was in the hands of the 
purchaser if the sale had not been made.
    (c) Reacquisition of property where title is transferred to 
purchaser--(1) Gain or loss on reacquisition. If the vendor in sales 
described in paragraph (a) of this section has previously transferred 
title to the purchaser, and the purchaser defaults in any of his 
payments, and the vendor accepts a voluntary reconveyance of the 
property, in partial or full satisfaction of the unpaid portion of the 
purchase price, the receipt of the property so reacquired, to the extent 
of its fair market value at that time, including the fair market value 
of fixed improvements placed on the property by the purchaser, shall be 
considered as the receipt of payment on the obligations satisfied. If 
the fair market value of the property is greater than the basis of the 
obligations of the purchaser so satisfied (generally, such basis being 
the fair market value of such obligations previously recognized in 
computing income), the excess constitutes ordinary income. If the value 
of such property is less than the basis of such obligations, the 
difference may be deducted as a bad debt if uncollectible, except that, 
if the obligations satisfied are securities (as defined in section 
165(g)(2)(C)), any gain or loss resulting from the transaction is a 
capital gain or loss subject to the provisions of sections 1201 through 
1241.
    (2) Basis of reacquired property. If the reacquired property 
described in subparagraph (1) of this paragraph is subsequently sold, 
the basis for determining gain or loss is the fair market value of the 
property at the date of reacquisition, including the fair market value 
of the fixed improvements placed on the property by the purchaser. See 
section 166 and the regulations thereunder with respect to property 
reacquired by the vendor in a foreclosure proceeding.

[[Page 127]]

    (d) Effective date. Paragraphs (b) and (c) of this section shall 
apply only with respect to taxable years beginning before September 3, 
1964, in respect of which an election has not been properly made to have 
the provisions of section 1038 apply. For rules applicable to taxable 
years beginning after September 2, 1964, and for taxable years beginning 
after December 31, 1957, to which such an election applies, see section 
1038, and Sec. Sec. 1.1038-1 through 1.1038-3.

[T.D. 6500, 25 FR 11716, Nov. 26, 1960, as amended by T.D. 6916, 32 FR 
5923, Apr. 13, 1967]



Sec. Sec. 1.453-7--1.453-8  [Reserved]



Sec. 1.453-9  Gain or loss on disposition of installment obligations.

    (a) In general. Subject to the exceptions contained in section 
453(d)(4) and paragraph (c) of this section, the entire amount of gain 
or loss resulting from any disposition or satisfaction of installment 
obligations, computed in accordance with section 453(d), is recognized 
in the taxable year of such disposition or satisfaction and shall be 
considered as resulting from the sale or exchange of the property in 
respect of which the installment obligation was received by the 
taxpayer.
    (b) Computation of gain or loss. (1) The amount of gain or loss 
resulting under paragraph (a) of this section is the difference between 
the basis of the obligation and (i) the amount realized, in the case of 
satisfaction at other than face value or in the case of a sale or 
exchange, or (ii) the fair market value of the obligation at the time of 
disposition, if such disposition is other than by sale or exchange.
    (2) The basis of an installment obligation shall be the excess of 
the face value of the obligation over an amount equal to the income 
which would be returnable were the obligation satisfied in full.
    (3) The application of subparagraphs (1) and (2) of this paragraph 
may be illustrated by the following examples:

    Example (1). In 1960 the M Corporation sold a piece of unimproved 
real estate to B for $20,000. The company acquired the property in 1948 
at a cost of $10,000. During 1960 the company received $5,000 cash and 
vendee's notes for the remainder of the selling price, or $15,000, 
payable in subsequent years. In 1962, before the vendee made any further 
payments, the company sold the notes for $13,000 in cash. The 
corporation makes its returns on the calendar year basis. The income to 
be reported for 1962 is $5,500, computed as follows:

Proceeds of sale of notes...........................  ........   $13,000
Selling price of property...........................   $20,000
Cost of property....................................    10,000
                                                     ----------
  Total profit......................................    10,000
  Total contract price..............................    20,000
                                                     ==========
Percent of profit, or proportion of each payment
 returnable as income, $10,000 divided by $20,000,
 50 percent.
Face value of notes.................................    15,000
Amount of income returnable were the notes satisfied     7,500
 in full, 50 percent of $15,000.....................
                                                     ----------
Basis of obligation--excess of face value of notes       7,500
 over amount of income returnable were the notes
 satisfied in full..................................
                                                     ----------
   Taxable income to be reported for 1962.....................     5,500
 

    Example (2). Suppose in example (1) the M Corporation, instead of 
selling the notes, distributed them in 1962 to its shareholders as a 
dividend, and at the time of such distribution, the fair market value of 
the notes was $14,000. The income to be reported for 1962 is $6,500, 
computed as follows:

Fair market value of notes....................................   $14,000
Basis of obligation--excess of face value of notes over amount     7,500
 of income returnable were the notes satisfied in full
 (computed as in example (1)).................................
                                                               =========
  Taxable income to be reported for 1962......................     6,500
 

    (c) Disposition from which no gain or loss is recognized. (1)(i) 
Under section 453(d)(4)(A), no gain or loss shall be recognized to a 
distributing corporation with respect to the distribution made after 
November 13, 1966, of installment obligations if (a) the distribution is 
made pursuant to a plan for the complete liquidation of a subsidiary 
under section 332, and (b) the basis of the such obligations in the 
hands of the distributee is determined under section 334(b)(1).
    (ii) Under section 453(d)(4)(B), no gain or loss shall be recognized 
to a distributing corporation with respect to the distribution of 
installment obligations if the distribution is made, pursuant to a plan 
for the complete liquidation of a corporation which meets the 
requirements of section 337, under conditions whereby no gain or loss 
would have

[[Page 128]]

been recognized to the corporation had such installment obligations been 
sold or exchanged on the day of the distribution. The preceding sentence 
shall not apply to the extent that under section 453(d)(1) gain to the 
distributing corporation would be considered as gain to which section 
341(f)(2), 617(d)(1), 1245(a)(1), 1250(a)(1), 1251(c)(1), 1252(a)(1), or 
1254(a)(1) applies, computed under the principles of the regulations 
under such provisions. See paragraph (d) of Sec. 1.1245-6, paragraph 
(c)(6) of Sec. 1.1250-1, paragraph (e)(6) of Sec. 1.1251-1, paragraph 
(d)(3) of Sec. 1.1252-1, and paragraph (d) of Sec. 1.1254-1.
    (2) Where the Code provides for exceptions to the recognition of 
gain or loss in the case of certain dispositions, no gain or loss shall 
result under section 453(d) in the case of a disposition of an 
installment obligation. Such exceptions include: Certain transfers to 
corporations under sections 351 and 361; contributions of property to a 
partnership by a partner under section 721; and distributions by a 
partnership to a partner under section 731 (except as provided by 
section 736 and section 751).
    (3) Any amount received by a person in payment or settlement of an 
installment obligation acquired in a transaction described in 
subparagraphs (1) or (2) of this paragraph (other than an amount 
received by a stockholder with respect to an installment obligation 
distributed to him pursuant to section 337) shall be considered to have 
the character it would have had in the hands of the person from whom 
such installment obligation was acquired.
    (d) Carryover of installment method. For the treatment of income 
derived from installment obligations received in transactions to which 
section 381 (a) is applicable, see section 381(c)(8) and the regulations 
thereunder.
    (e) Installment obligations transmitted at death. Where installment 
obligations are transmitted at death, see section 691(a)(4) and the 
regulations thereunder for the treatment of amounts considered income in 
respect of a decedent.
    (f) Losses. See subchapter P (section 1201 and following), chapter 1 
of the Code, as to the limitation on capital losses sustained by 
corporations and the limitation as to both capital gains and capital 
losses of individuals.
    (g) Disposition of installment obligations to life insurance 
companies. (1) Notwithstanding the provisions of section 453(d)(4) and 
paragraph (c) of this section or any provision of subtitle A relating to 
the nonrecognition of gain, the entire amount of any gain realized on 
the disposition of an installment obligation by any person, other than a 
life insurance company (as defined in section 801(a) and paragraph (b) 
of Sec. 1.801-3), to a life insurance company or to a partnership of 
which a life insurance company is a partner shall be recognized and 
treated in accordance with section 453(d)(1) and paragraphs (a) and (b) 
of this section. If a corporation which is a life insurance company for 
the taxable year was a corporation which was not a life insurance 
company for the preceding taxable year, such corporation shall be 
treated, for purposes of section 453(d)(1) and this paragraph, as having 
transferred to a life insurance company, on the last day of the 
preceding taxable year, all installment obligations which it held on 
such last day. The gain, if any, realized by reason of the installment 
obligations being so transferred shall be recognized and treated in 
accordance with section 453(d)(1) and paragraphs (a) and (b) of this 
section. Similarly, a partnership of which a life insurance company 
becomes a partner shall be treated, for purposes of section 453(d)(1) 
and this paragraph, as having transferred to a life insurance company, 
on the last day of the preceding taxable year of such partnership, all 
installment obligations which it holds at the time such life insurance 
company becomes a partner. The gain, if any, realized by reason of the 
installment obligations being so transferred shall be recognized and 
treated in accordance with section 453(d)(1) and paragraphs (a) and (b) 
of this section.
    (2) The provisions of section 453(d)(5) and subparagraph (1) of this 
paragraph shall not apply to losses sustained in connection with the 
disposition of installment obligations to a life insurance company.
    (3) For the effective date of the provisions of section 453(d)(5) 
and this paragraph, see paragraph (f) of Sec. 1.453-10.

[[Page 129]]

    (4) Application of the provisions of this paragraph may be 
illustrated by the following examples:

    Example (1). A, an individual, in a transaction to which section 351 
applies, transfers in 1961 certain assets, including installment 
obligations, to a new corporation, X, which qualifies as a life 
insurance company (as defined in section 801(a)) for the year 1961. A 
makes his return on the calendar year basis. Section 453(d)(5) provides 
that the nonrecognition provisions of section 351 will not apply to the 
installment obligations transferred by A to X Corporation. Therefore, 
the entire amount of any gain realized by A on the transfer of the 
installment obligations shall be recognized in 1961, with the amount of 
any such gain computed in accordance with the provisions of section 
453(d)(1) and paragraph (b) of this section.
    Example (2). The M Corporation did not qualify as a life insurance 
company (as defined in section 801(a)) for the taxable year 1958. On 
December 31, 1958, it held $60,000 of installment obligations. The M 
Corporation qualified as a life insurance company for the taxable year 
1959. Accordingly, the M Corporation is treated as having transferred to 
a life insurance company, on December 31, 1958, the $60,000 of 
installment obligations it held on such date. The gain, if any, realized 
by M by reason of such installment obligations being so transferred 
shall be recognized in the taxable year 1958, with the amount of any 
such gain computed in accordance with the provisions of section 
453(d)(1) and paragraph (b) of this section.
    Example (3). During its taxable year 1958, none of the partners of 
the N partnership qualified as a life insurance company (as defined in 
section 801(a)). The N partnership held $30,000 of installment 
obligations on December 31, 1958. On July 30, 1959, the O Corporation, a 
life insurance company (as defined in section 801(a)), became a partner 
in the partnership. The N partnership held $50,000 of installment 
obligations on July 30, 1959. Pursuant to section 453(d)(5), the N 
partnership is treated as having transferred to a life insurance 
company, on December 31, 1958, the $50,000 of installment obligations it 
held on July 30, 1959. The gain, if any, realized by the N partnership 
by reason of such installment obligations being so transferred shall be 
recognized in the taxable year 1958, with the amount of any such gain 
computed in accordance with the provisions of section 453(d)(1) and 
paragraph (b) of this section.
    Example (4). In 1960, the P Corporation, in a reorganization 
qualifying under section 368(a), transferred certain assets (including 
installment obligations) to the R Corporation, a life insurance company 
as defined in section 801(a). P realized a loss upon the transfer of the 
installment obligations, which was not recognized under section 361. 
Pursuant to subparagraph (2) of paragraph (c) of this section, no loss 
with respect to the transfer of these obligations will be recognized to 
P under section 453(d)(1).

[T.D. 6500, 25 FR 11718, Nov. 26, 1960, as amended by T.D. 6590, 27 FR 
1319, Feb. 13, 1962; T.D. 7084, 36 FR 267, Jan. 8, 1971; T.D. 7418, 41 
FR 18812, May 7, 1976; T.D. 8586, 60 FR 2500, Jan. 10, 1995]



Sec. 1.453-10  Effective date.

    (a) Except as provided in this section, the provisions of section 
453 and Sec. Sec. 1.453-1 through 1.453-9 shall apply to taxable years 
beginning after December 31, 1953, and ending after August 16, 1954.
    (b) The provisions of paragraphs (a) (2) and (3), (b), and (c) of 
Sec. 1.453-8 shall apply to taxable years ending after December 17, 
1958.
    (c) Under the provisions of sections 453(b) and 7851(a)(1)(C), 
section 453(b)(1) and the regulations with respect thereto shall also 
apply--
    (1) To a sale or other disposition during a taxable year beginning 
before January 1, 1954, only if the income was returnable (by reason of 
section 44(b) of the Internal Revenue Code of 1939) on the basis and in 
the manner prescribed in section 44(a) of such code.
    (2) To a sale or other disposition during a taxable year beginning 
after December 31, 1953, and ending before August 17, 1954, though such 
taxable year is subject to the provisions of the Internal Revenue Code 
of 1939.
    (d) Under the provisions of sections 453(c)(1)(B) and 7851(a)(1)(C) 
section 453(c) and the regulations with respect thereto shall also apply 
to taxable years beginning after December 31, 1953, and ending before 
August 17, 1954, though such taxable years are subject to the provisions 
of the Internal Revenue Code of 1939.
    (e) The provisions of paragraph (b)(3) of Sec. 1.453-6 shall apply 
to repossessions occurring after December 18, 1958.
    (f) The provisions of section 453(d)(5) and paragraph (g) of Sec. 
1.453-9 shall apply to taxable years ending after December 31, 1957, but 
only as to transfers or other dispositions of installment obligations 
occurring after such date.

[T.D. 6500, 25 FR 11718, Nov. 26, 1960, as amended by T.D. 6590, 27 FR 
1320, Feb. 13, 1962; T.D. 6682, 28 FR 11177, Oct. 18, 1963]

[[Page 130]]



Sec. 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 Sec. 
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 Sec. 
1.1275-1(b)) and the amount of any qualified stated interest (as defined 
in Sec. 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 Sec. 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 Sec. 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 Sec. 
1.1275-5), the shareholder uses the equivalent fixed rate debt 
instrument (within the meaning of Sec. 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 Sec. 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.

[[Page 131]]

    (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 Sec. 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 Sec. 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 Sec. Sec. 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).

[[Page 132]]

    (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 Sec. 
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.

[[Page 133]]

    (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

[[Page 134]]

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 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   Cash and
                      Item                        installment    other
                                                  obligations   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
------------------------------------------------------------------------
\1\ Face amount $240,000.

    (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.

[[Page 135]]

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,

[[Page 136]]

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.

[T.D. 8762, 63 FR 4170, Jan. 28, 1998]



Sec. 1.453-12  Allocation of unrecaptured section 1250 gain reported 
on the installment method.

    (a) General rule. Unrecaptured section 1250 gain, as defined in 
section 1(h)(7), is reported on the installment method if that method 
otherwise applies under section 453 or 453A and the corresponding 
regulations. If gain from an installment sale includes unrecaptured 
section 1250 gain and adjusted net capital gain (as defined in section 
1(h)(4)), the unrecaptured section 1250 gain is taken into account 
before the adjusted net capital gain.
    (b) Installment payments from sales before May 7, 1997. The amount 
of unrecaptured section 1250 gain in an installment payment that is 
properly taken into account after May 6, 1997, from a sale before May 7, 
1997, is determined as if, for all payments properly taken into account 
after the date of sale but before May 7, 1997, unrecaptured section 1250 
gain had been taken into account before adjusted net capital gain.
    (c) Installment payments received after May 6, 1997, and on or 
before August 23, 1999. If the amount of unrecaptured section 1250 gain 
in an installment payment that is properly taken into account after May 
6, 1997, and on or before August 23, 1999, is less than the amount that 
would have been taken into account under this section, the lesser amount 
is used to determine the amount of unrecaptured section 1250 gain that 
remains to be taken into account.
    (d) Examples. In each example, the taxpayer, an individual whose 
taxable year is the calendar year, does not elect out of the installment 
method. The installment obligation bears adequate stated interest, and 
the property sold is real property held in a trade or business that 
qualifies as both section 1231 property and section 1250 property. In 
all taxable years, the taxpayer's marginal tax rate on ordinary income 
is 28 percent. The following examples illustrate the rules of this 
section:

    Example 1. General rule. This example illustrates the rule of 
paragraph (a) of this section as follows:
    (i) In 1999, A sells property for $10,000, to be paid in ten equal 
annual installments beginning on December 1, 1999. A originally 
purchased the property for $5000, held the property for several years, 
and took straight-line depreciation deductions in the amount of $3000. 
In each of the years 1999-2008, A has no other capital or section 1231 
gains or losses.
    (ii) A's adjusted basis at the time of the sale is $2000. Of A's 
$8000 of section 1231 gain on the sale of the property, $3000 is 
attributable to prior straight-line depreciation deductions and is 
unrecaptured section 1250 gain. The gain on each installment payment is 
$800.
    (iii) As illustrated in the table in this paragraph (iii) of this 
Example 1., A takes into account the unrecaptured section 1250 gain 
first. Therefore, the gain on A's first three payments, received in 
1999, 2000, and 2001, is taxed at 25 percent. Of the $800 of gain on the 
fourth payment, received in 2002, $600 is taxed at 25 percent and the 
remaining $200 is taxed at 20 percent. The gain on A's remaining six 
installment payments is taxed at 20 percent. The table is as follows:

[[Page 137]]



----------------------------------------------------------------------------------------------------------------
                                                                                                         Total
                                        1999       2000       2001       2002       2003    2004-2008     gain
----------------------------------------------------------------------------------------------------------------
Installment gain...................        800        800        800        800        800       4000       8000
Taxed at 25%.......................        800        800        800        600  .........  .........       3000
Taxed at 20%.......................  .........  .........  .........        200        800       4000       5000
Remaining to be taxed at 25%.......       2200       1400        600  .........  .........  .........  .........
----------------------------------------------------------------------------------------------------------------

    Example 2. Installment payments from sales prior to May 7, 1997. 
This example illustrates the rule of paragraph (b) of this section as 
follows:
    (i) The facts are the same as in Example 1 except that A sold the 
property in 1994, received the first of the ten annual installment 
payments on December 1, 1994, and had no other capital or section 1231 
gains or losses in the years 1994-2003.
    (ii) As in Example 1, of A's $8000 of gain on the sale of the 
property, $3000 was attributable to prior straight-line depreciation 
deductions and is unrecaptured section 1250 gain.
    (iii) As illustrated in the following table, A's first three 
payments, in 1994, 1995, and 1996, were received before May 7, 1997, and 
taxed at 28 percent. Under the rule described in paragraph (b) of this 
section, A determines the allocation of unrecaptured section 1250 gain 
for each installment payment after May 6, 1997, by taking unrecaptured 
section 1250 gain into account first, treating the general rule of 
paragraph (a) of this section as having applied since the time the 
property was sold, in 1994. Consequently, of the $800 of gain on the 
fourth payment, received in 1997, $600 is taxed at 25 percent and the 
remaining $200 is taxed at 20 percent. The gain on A's remaining six 
installment payments is taxed at 20 percent. The table is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                         Total
                                        1994       1995       1996       1997       1998    1999-2003     gain
----------------------------------------------------------------------------------------------------------------
Installment gain...................        800        800        800        800        800       4000       8000
Taxed at 28%.......................        800        800        800  .........  .........  .........       2400
Taxed at 25%.......................  .........  .........  .........        600  .........  .........        600
Taxed at 20%.......................  .........  .........  .........        200        800       4000       5000
Remaining to be taxed at 25%.......       2200       1400        600  .........  .........  .........  .........
----------------------------------------------------------------------------------------------------------------

    Example 3. Effect of section 1231(c) recapture. This example 
illustrates the rule of paragraph (a) of this section when there are 
non-recaptured net section 1231 losses, as defined in section 
1231(c)(2), from prior years as follows:
    (i) The facts are the same as in Example 1, except that in 1999 A 
has non-recaptured net section 1231 losses from the previous four years 
of $1000.
    (ii) As illustrated in the table in paragraph (iv) of this Example 
3, in 1999, all of A's $800 installment gain is recaptured as ordinary 
income under section 1231(c). Under the rule described in paragraph (a) 
of this section, for purposes of determining the amount of unrecaptured 
section 1250 gain remaining to be taken into account, the $800 
recaptured as ordinary income under section 1231(c) is treated as 
reducing unrecaptured section 1250 gain, rather than adjusted net 
capital gain. Therefore, A has $2200 of unrecaptured section 1250 gain 
remaining to be taken into account.
    (iii) In the year 2000, A's installment gain is taxed at two rates. 
First, $200 is recaptured as ordinary income under section 1231(c). 
Second, the remaining $600 of gain on A's year 2000 installment payment 
is taxed at 25 percent. Because the full $800 of gain reduces 
unrecaptured section 1250 gain, A has $1400 of unrecaptured section 1250 
gain remaining to be taken into account.
    (iv) The gain on A's installment payment received in 2001 is taxed 
at 25 percent. Of the $800 of gain on the fourth payment, received in 
2002, $600 is taxed at 25 percent and the remaining $200 is taxed at 20 
percent. The gain on A's remaining six installment payments is taxed at 
20 percent. The table is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                         Total
                                        1999       2000       2001       2002       2003    2004-2008     gain
----------------------------------------------------------------------------------------------------------------
Installment gain...................        800        800        800        800        800       4000       8000
Taxed at ordinary rates under              800        200  .........  .........  .........  .........       1000
 section 1231(c)...................
Taxed at 25%.......................  .........        600        800        600  .........  .........       2000
Taxed at 20%.......................  .........  .........  .........        200        800       4000       5000
Remaining non-recaptured net               200  .........  .........  .........  .........  .........  .........
 section 1231 losses...............

[[Page 138]]

 
Remaining to be taxed at 25%.......       2200       1400        600  .........  .........  .........  .........
----------------------------------------------------------------------------------------------------------------

    Example 4. Effect of a net section 1231 loss. This example 
illustrates the application of paragraph (a) of this section when there 
is a net section 1231 loss as follows:
    (i) The facts are the same as in Example 1 except that A has section 
1231 losses of $1000 in 1999.
    (ii) In 1999, A's section 1231 installment gain of $800 does not 
exceed A's section 1231 losses of $1000. Therefore, A has a net section 
1231 loss of $200. As a result, under section 1231(a) all of A's section 
1231 gains and losses are treated as ordinary gains and losses. As 
illustrated in the following table, A's entire $800 of installment gain 
is ordinary gain. Under the rule described in paragraph (a) of this 
section, for purposes of determining the amount of unrecaptured section 
1250 gain remaining to be taken into account, A's $800 of ordinary 
section 1231 installment gain in 1999 is treated as reducing 
unrecaptured section 1250 gain. Therefore, A has $2200 of unrecaptured 
section 1250 gain remaining to be taken into account.
    (iii) In the year 2000, A has $800 of section 1231 installment gain, 
resulting in a net section 1231 gain of $800. A also has $200 of non-
recaptured net section 1231 losses. The $800 gain is taxed at two rates. 
First, $200 is taxed at ordinary rates under section 1231(c), 
recapturing the $200 net section 1231 loss sustained in 1999. Second, 
the remaining $600 of gain on A's year 2000 installment payment is taxed 
at 25 percent. As in Example 3, the $200 of section 1231(c) gain is 
treated as reducing unrecaptured section 1250 gain, rather than adjusted 
net capital gain. Therefore, A has $1400 of unrecaptured section 1250 
gain remaining to be taken into account.
    (iv) The gain on A's installment payment received in 2001 is taxed 
at 25 percent, reducing the remaining unrecaptured section 1250 gain to 
$600. Of the $800 of gain on the fourth payment, received in 2002, $600 
is taxed at 25 percent and the remaining $200 is taxed at 20 percent. 
The gain on A's remaining six installment payments is taxed at 20 
percent. The table is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                         Total
                                        1999       2000       2001       2002       2003    2004-2008     gain
----------------------------------------------------------------------------------------------------------------
Installment gain...................        800        800        800        800        800       4000       8000
Ordinary gain under section 1231(a)        800  .........  .........  .........  .........  .........        800
Taxed at ordinary rates under        .........        200  .........  .........  .........  .........        200
 section 1231(c)...................
Taxed at 25%.......................  .........        600        800        600  .........  .........       2000
Taxed at 20%.......................  .........  .........  .........        200        800       4000       5000
Net section 1231 loss..............        200  .........  .........  .........  .........  .........  .........
Remaining to be taxed at 25%.......       2200       1400        600  .........  .........  .........  .........
----------------------------------------------------------------------------------------------------------------

    (e) Effective date. This section applies to installment payments 
properly taken into account after August 23, 1999.

[T.D. 8836, 64 FR 45875, Aug. 23, 1999]



Sec. 1.453A-0  Table of contents.

    This section lists the paragraphs and subparagraphs contained in 
Sec. Sec. 1.453A-1 through 1.453A-3.

  Sec. 1.453A-1 Installment method of reporting income by dealers in 
                           personal property.

    (a) In general.
    (b) Effect of security.
    (c) Definition of dealer, sale, and sale on the installment plan.
    (d) Installment plans.
    (1) Traditional installment plans.
    (2) Revolving credit plans.
    (e) Installment income of dealers in personal property.
    (1) In general.
    (2) Gross profit and total contract price.
    (3) Carrying changes not included in total contract price.
    (f) Other accounting methods.
    (g) Records.
    (h) Effective date.

   Sec. 1.453A-2 Treatment of revolving credit plans; taxable years 
                beginning on or before December 31, 1986.

    (a) In general.
    (b) Coordination with traditional installment plan.
    (c) Revolving credit plans.
    (d) Effective date.

  Sec. 1.453A-3 Requirements for adoption of or change to installment 
                 method by dealers in personal property.

    (a) In general.

[[Page 139]]

    (b) Time and manner of electing installment method reporting.
    (1) Time for election.
    (2) Adoption of installation method.
    (3) Change to installment method.
    (4) Deemed elections.
    (c) Consent.
    (d) Cut-off method for amounts previously accrued.
    (e) Effective date.

[T.D. 8270, 54 FR 46376, Nov. 3, 1989]



Sec. 1.453A-1  Installment method of reporting income by dealers on 
personal property.

    (a) In general. A dealer (as defined in paragraph (c)(1) of this 
section) may elect to return the income from the sale of personal 
property on the installment method if such sale is a sale on the 
installment plan (as defined in paragraphs (c)(3) and (d) of this 
section). Under the installment method of accounting, a taxpayer may 
return as income from installment sales in any taxable year that 
proportion of the installment payments actually received in that year 
which the gross profit realized or to be realized when the property is 
paid for bears to the total contract price. For this purpose, gross 
profit means sales less cost of goods sold. See paragraph (d) of this 
section for additional rules relating to the computation of income under 
the installment method of accounting. In addition, see Sec. 1.453A-2 
for rules treating revolving credit plans as installment plans for 
taxable years beginning on or before December 31, 1986.
    (b) Effect of security. A dealer may adopt (but is not required to 
do so) one of the following four ways of protecting against loss in case 
of default by the purchaser:
    (1) An agreement that title is to remain in the vendor until 
performance of the purchaser's part of the transaction is completed;
    (2) A form of contract in which title is conveyed to the purchaser 
immediately, but subject to a lien for the unpaid portion of the selling 
price;
    (3) A present transfer of title to the purchaser, who at the same 
time executes a reconveyance in the form of a chattel mortgage to the 
vendor; or
    (4) A conveyance to a trustee pending performance of the contract 
and subject to its provisions.
    (c) Definitions of dealer, sale, and sale on the installment plan. 
For purposes of the regulations under section 453A--
    (1) The term ``dealer'' means a person who regularly sells or 
otherwise disposes of personal property on the installment plan;
    (2) The term ``sale'' includes sales and other dispositions; and
    (3) Except as provided in paragraph (d)(2) of this section, the term 
``sale on the installment plan'' means--
    (i) A sale of personal property by the taxpayer under any plan for 
the sale of personal property, which plan, by its terms and conditions, 
contemplates that each sale under the plan will be paid for in two or 
more payments; or
    (ii) A sale of personal property by the taxpayer under any plan for 
the sale of personal property--
    (A) Which plan, by its terms and conditions, contemplates that such 
sale will be paid for in two or more payments; and
    (B) Which sale is in fact paid for in two or more payments.
    (d) Installment plans--(1) Traditional installment plans. A 
traditional installment plan usually has the following characteristics:
    (i) The execution of a separate installment contract for each sale 
or disposition of personal property; and
    (ii) The retention by the dealer of some type of security interest 
in such property.

Normally, a sale under a traditional installment plan meets the 
requirements of paragraph (c)(3)(i) of this section.
    (2) Revolving credit plans. Sales under a revolving credit plan 
(within the meaning of Sec. 1.453A-2(c)(1))--
    (i) Are treated, for taxable years beginning on or before December 
31, 1986, as sales on the installment plan to the extent provided in 
Sec. 1.453A-2, which provides for the application of the requirements 
of paragraph (c)(3)(ii) of this section to sales under revolving credit 
plans; and
    (ii) Are not treated as sales on the installment plan for taxable 
years beginning after December 31, 1986.
    (e) Installment income of dealers in personal property--(1) In 
general. The income from sales on the installment plan of a dealer may 
be ascertained by treating as income that proportion of

[[Page 140]]

the total payments received in the taxable year from sales on the 
installment plan (such payments being allocated to the year against the 
sales of which they apply) which the gross profit realized or to be 
realized on the total sales on the installment plan made during each 
year bears to the total contract price of all such sales made during 
that respective year. However, if the dealer demonstrates to the 
satisfaction of the district director that income from sales on the 
installment plan is clearly reflected, the income from such sales may be 
ascertained by treating as income that proportion of the total payments 
received in the taxable year from sales on the installment plan (such 
payments being allocated to the year against the sales of which they 
apply) which either:
    (i) The gross profit realized or to be realized on the total credit 
sales made during each year bears to the total contract price of all 
credit sales during that respective year, or
    (ii) The gross profit realized or to be realized on all sales made 
during each year bears to the total contract price of all sales made 
during that respective year.

A dealer who desires to compute income by the installment method shall 
maintain accounting records in such a manner as to enable an accurate 
computation to be made by such method in accordance with the provisions 
of this section, section 446, and Sec. 1.446-1.
    (2) Gross profit and total contract price. For purposes of paragraph 
(e)(1) of this section, in computing the gross profit realized or to be 
realized on the total sales on the installment plan, there shall be 
included in the total selling price and, thus, in the total contract 
price of all such sales.
    (i) The amount of carrying charges or interest which is determined 
at the time of each sale and is added to the established cash selling 
price of such property and is treated as part of the selling price for 
customer billing purposes, and
    (ii) In the case of sales made in taxable years beginning on or 
after January 1, 1960, the amount of carrying charges or interest 
determined with respect to such sales which are added contemporaneously 
with the sale on the books of account of the seller but are treated as 
periodic service charges for customer billing purposes.

Any change in the amount of the carrying charges or interest in a year 
subsequent to the sale will not affect the computation of the gross 
profit for the year of sale but will be taken into account at the time 
the carrying charges or interest are adjusted. The application of this 
paragraph (e)(2) to carrying charges or interest described in paragraph 
(e)(2)(ii) of this section may be illustrated by the following example:

    Example. X Corporation makes sales on the traditional installment 
plan. The customer's order specifies that the total price consists of a 
cash price plus a ``time price differential'' of 1\1/2\ percent per 
month on the outstanding balance in the customer's account, and the 
customer is billed in this manner. On its books and for purposes of 
reporting to stockholders, X Corporation consistently makes the 
following entries each month when it records its sales. A debit entry is 
make to accounts receivable (for the total price) and balancing credit 
entries are made to sales (for the established selling price) and to a 
reserve account for collection expense (for the amount of the time price 
differential). In computing the gross profit realized or to be realized 
on the total sales on the installment plan, the total selling price and, 
thus, the total contract price for purposes of this paragraph (e) would, 
with respect to sales made in taxable years beginning on or after 
January 1, 1960, include the time price differential.

    (3) Carrying charges not included in total contract price. In the 
case of sales by dealers in personal property made during taxable years 
beginning after December 31, 1963, the income from which is returned on 
the installment method, if the carrying charges or interest with respect 
to such sales is not included in the total contract price, payments 
received with respect to such sales shall be treated as applying first 
against such carrying charges or interest.
    (f) Other accounting methods. If the vendor chooses as a matter of 
consistent practice to return the income from installment sales on an 
accrual method (,) such a course is permissible.
    (g) Records. In adopting the installment method of accounting the 
seller

[[Page 141]]

must maintain such records as are necessary to clearly reflect income in 
accordance with this section, section 446 and Sec. 1.446-1.
    (h) Effective date. This section applies for taxable years beginning 
after December 31, 1953, and ending after August 16, 1954, but generally 
does not apply to sales made after December 31, 1987, in taxable years 
ending after such date. For sales made after December 31, 1987, sales 
made by a dealer in personal or real property shall not be treated as 
sales on the installment plan. (However, see section 453(l)(2) for 
exceptions to this rule.)

[T.D. 8270, 54 FR 46377, Nov. 3, 1989]



Sec. 1.453A-2  Treatment of revolving credit plans; taxable years 
beginning on or before December 31, 1986.

    (a) In general. If a dealer sells or otherwise disposes of personal 
property under a revolving credit plan--
    (1) Such sales will be treated as sales on the installment plan to 
the extent provided in paragraph (c) of this section;
    (2) Income from sales treated as sales on the installment plan under 
paragraph (c) of this section may be returned on the installment method; 
and
    (3) Income returned on the installment method is computed in 
accordance with Sec. 1.453A-1, except that--
    (i) The gross profit on such sales is computed without regard to 
Sec. 1.453A-1(e)(2);
    (ii) Under the circumstances described in paragraph (c)(6)(vi) of 
this section, the taxpayer may, in computing income for a taxable year, 
treat all such sales as sales made in such taxable year for purposes of 
applying the gross profit percentage; and
    (iii) The rule contained in Sec. 1.453A-1(e)(3) is applied in 
accordance with paragraph (c)(6)(v) of this section.
    (b) Coordination with traditional installment plan. A dealer who 
makes sales of personal property under both a revolving credit plan and 
a traditional installment plan (1) may elect to report only sales under 
the traditional installment plan on the installment method, (2) may 
elect to report only sales under the revolving credit plan on the 
installment method, or (3) may elect to report both sales under the 
revolving credit plan and the traditional installment plan on the 
installment method.
    (c) Revolving credit plans. (1) To the extent provided in this 
paragraph (c) sales under a revolving credit plan will be treated as 
sales on the installment plan. The term ``revolving credit plan'' 
includes cycle budget accounts, flexible budget accounts, continuous 
budget accounts, and other similar plans or arrangements for the sale of 
personal property under which the customer agrees to pay each billing-
month (as defined in paragraph (c)(6)(iii) of this section) a part of 
the outstanding balance of the customer's account. Sales under a 
revolving credit plan do not constitute sales on the installment plan 
merely by reason of the fact that the total debt at the end of a 
billing-month is paid in installments. The terms and conditions of a 
revolving credit plan do not contemplate that each sale under the plan 
will be paid for in two or more payments and thus do not meet the 
requirements of Sec. 1.453A-1(c)(3)(i). In addition, since under a 
revolving credit plan payments are not generally applied to liquidate 
any particular sale, and since the terms and conditions of such plan 
contemplate that account balances may be paid in full or in 
installments, it is generally impossible to determine that a particular 
sale under a revolving credit plan is to be or is in fact paid for in 
installments so as to meet the requirements of Sec. 1.453A-1 
(c)(3)(ii). However, paragraphs (c) (2) and (3) of this section provides 
rules under which a certain percentage of charges under a revolving 
credit plan will be treated as sales on the installment plan. For 
purposes of arriving at this percentage, these rules, in general, treat 
as sales on the plan those sales under a revolving installment credit 
plan:
    (i) Which are of the type which the terms and conditions of the plan 
contemplate will be paid for in two or more installments and
    (ii) Which are charged to accounts on which subsequent payments 
indicate that such sales are being paid for in two or more installments.
    (2)(i) The percentage of charges under a revolving credit plan which 
will be

[[Page 142]]

treated as sales on the installment plan shall be computed by making an 
actual segregation of charges in a probability sample of the revolving 
credit accounts and by applying the rules contained in paragraph (c)(3) 
of this section to determine what percentage of charges in the sample is 
to be treated as sales on the installment plan. (See paragraph (c)(5) of 
this section for rules to be used if some of the sales under a revolving 
credit plan are nonpersonal property sales (as defined in paragraph 
(c)(6)(iv) of this section).) Such segregation shall be made of charges 
which make up the balances in the sample accounts as of the end of each 
customer's last billing-month ending within the taxable year. (See 
paragraph (c)(6)(v) of this section for rules to be used in determining 
which charges make up the balance of an account.) However, in making 
such segregation, any account to which a sale is charged during the 
taxable year on which no payment is credited after the billing-month 
within which the sale is made (hereinafter called the ``billing-month of 
sale'') and on or before the end of the first billing-month ending in 
the taxpayer's next taxable year shall be disregarded and not taken into 
account in the determination of what percentage of charges in the sample 
is to be treated as sales on the installment plan. In order to obtain a 
probability sample, the accounts shall be selected in accordance with 
generally accepted probability sampling techniques. The appropriateness 
of the sampling technique and the accuracy and reliability of the 
results obtained must, if requested, be demonstrated to the satisfaction 
of the district director. If the district director is not satisfied that 
the taxpayer's sample is appropriate or that the results obtained are 
accurate and reliable, the taxpayer shall recompute the sample 
percentage or make appropriate adjustments to the original computations 
in a manner satisfactory to the district director. The taxpayer shall 
maintain records in sufficient detail to show the method of computing 
and applying the sample.
    (ii) For taxable years ending before January 31, 1964, a taxpayer 
who has reported for income tax purposes all or a portion of sales under 
a revolving credit plan as sales on the installment method may apply the 
percentage obtained for the first taxable year ending on or after such 
date in determining the percentage of charges under a revolving credit 
plan for such prior taxable year (or years) which will be treated as 
sales on the installment plan. However, in computing the percentage to 
be applied in determining the percentage of charges under a revolving 
credit plan which will be treated as sales on the installment plan for 
such prior taxable year (or years), the rule stated in Sec. 1.453A-
1(e)(3) shall not apply. See paragraph (c)(6)(v) of this section for 
rules relating to the application of payments to finance charges for 
such prior taxable years.
    (3) For the purpose of determining the percentage described in 
paragraph (c)(2) of this section, a charge under a revolving credit plan 
will be treated as a sale on the installment plan only if such charge is 
a sale (as defined in paragraph (c)(6) of this section) and meets the 
following requirements:
    (i) The sale must be of the type which the terms and conditions of 
the plan contemplate will be paid for in two or more installments. If 
the aggregate of sales charged during a billing-month to an account 
under a revolving credit plan exceeds the required monthly payment, then 
all sales during such billing-month shall be considered to be of the 
type which the terms and conditions of such plan contemplate will be 
paid for in two or more installments. The required monthly payment shall 
be the amount of the payment which the terms and conditions of the 
revolving credit contract require the customer to make with respect to a 
billing-month. If the amount of such payment is not fixed at the date 
the contract is entered into, but is dependent upon the balance of the 
account, then such amount shall be the amount that the customer is 
required to pay (but not including any past-due payments) as shown on 
the statement either:
    (A) For the last billing-month ending within the taxpayer's taxable 
year or
    (B) For the billing-month of sale, whichever method the taxpayer 
adopts for all accounts. A taxpayer shall not change such method of 
determining the required monthly payment based upon

[[Page 143]]

the balance of the account without obtaining the consent of the district 
director. In any case where the required monthly payment is not set in 
accordance with a consistent method used during the entire taxable year, 
the district director may determine the required monthly payment in 
accordance with the method used during the major portion of such taxable 
year if the use of such method is necessary in order to reflect properly 
the income from sales under a revolving credit plan. The requirements 
stated in this paragraph (c)(3)(i) may be illustrated by the following 
examples:

    Example (1). Under the terms of a revolving credit plan the required 
monthly payment to be made by customer A is $20. During the billing-
month ending in December, sales aggregating $80 are charged to customer 
A's account, and during the next billing-month, ending in January, sales 
aggregating $19.95 and finance charges of $.60 are charged to A's 
account. Since the aggregate of sales charged to customer A's account 
during the billing-month ending in December ($80) exceeds the required 
monthly payment ($20), the terms and conditions of the plan contemplate 
that the sales charged during such billing-month are of the type which 
will be paid for in two or more installments. Since the aggregate of 
sales charged to customer A's account during the billing-month ending in 
January ($19.95) does not exceed the required monthly payment, the sales 
making up the aggregate of sales in such billing-month are not of the 
type which the terms and conditions of the plan contemplate will be paid 
for in two or more installments.
    Example (2). The terms of a revolving credit plan require a payment 
of 20 percent of the balance of the customer's account as of the end of 
the billing-month for which the statement is rendered. A customer makes 
purchases aggregating $25 in the customer's next to the last billing-
month ending within the taxpayer's taxable year, and the balance at the 
end of that month is $150. At the end of the customer's last billing-
month ending within the taxpayer's taxable year, the balance of the 
account has decreased to $110. If the taxpayer determines the required 
monthly payment by reference to the payment required on the statement 
for the last billing-month ending within the taxable year and applies 
such method consistently to all accounts, then the sales making up the 
$25 aggregate of sales are of the type which the terms and conditions of 
the plan contemplate will be paid for in two or more installments. 
Although such aggregate was less than the $30 payment (20%x$150) 
required on the statement rendered for the billing-month of sales. It 
was more than the $22 (20%x$110) that the customer was required to pay 
on the statement rendered for his last billing-month ending within the 
taxable year, and thus meets the requirements of this paragraph 
(c)(3)(i). If, however, the taxpayer determines the required monthly 
payment by reference to the payment required on the statement for the 
billing-month of sale, then the sales making up the aggregate of sales 
during such billing-month do not meet the requirements of this paragraph 
(c)(3)(i) because such aggregate was less than the $30 payment required 
on the statement rendered for such month.

    (ii) The sale must be charged to an account on which the first 
payment after the billing-month of sale indicates that the sale is being 
paid in installments. The first payment after the billing-month of sale 
indicates that the sale is being paid in installments if, and only if, 
such payment is an amount which is less than the balance of the account 
as of the close of the billing-month of sale. For purposes of this 
paragraph (c)(3)(ii), such balance shall be reduced by any return or 
allowance credited to the account after the close of the billing-month 
of sale and before the close of the billing-month within which the first 
payment after the billing-month of sale is credited to the account, 
unless the taxpayer demonstrates that the return or allowance was 
attributable to a charge made in a month subsequent to the billing-month 
of sale. The requirements stated in this paragraph (c)(3)(ii) may be 
illustrated by the following examples, in which it is assumed that the 
taxpayer's annual accounting period ends on January 31.

    Example (1). Customer A's revolving credit account shows the 
following sales and payments:

------------------------------------------------------------------------
                                            Aggregate
               Month ending                  sales in  Payments  Balance
                                              month
------------------------------------------------------------------------
December 20...............................       $150         0     $150
January 20................................         75       $30      195
February 20...............................          0       195        0
------------------------------------------------------------------------


All sales made in the billing-month ending December 20 meet the 
requirements of this paragraph (c)(3)(ii) because the first payment on 
the account after such billing-month ($30) was less than the balance of 
the account as of the close of such billing-month ($150); and none of 
the sales made in the billing-month ending January 20 meets the 
requirements of

[[Page 144]]

this paragraph (c)(3)(ii) because the balance of the account as of the 
end of such billing-month was liquidated in one payment. By application 
of the rules of paragraph (c)(6)(v) of this section, the balance in the 
account as of the last billing-month ending in the taxable year ($195) 
consists of $120 of the $150 of sales made in the billing-month ending 
December 20 and all of the $75 of sales made in the billing-month ending 
January 20. Therefore, $120 of the account balance meets the 
requirements of this paragraph (c)(3)(ii) and $75 does not.
    Example (2). Customer B's revolving credit account shows the 
following sales and payments:

------------------------------------------------------------------------
                                            Aggregate
               Month ending                  sales in  Payments  Balance
                                              month
------------------------------------------------------------------------
December 20...............................       $ 50         0     $ 50
January 20................................        100         0      150
February 20...............................          0       $50      100
------------------------------------------------------------------------


None of the sales made in the billing-month ending December 20 meets the 
requirements of this paragraph (c)(3)(ii) because the first payment 
credited to the account after such billing-month ($50) is not less than 
the balance of the account as of the close of such month ($50). All of 
the sales made in the billing-month ending January 20 meet the 
requirements of this paragraph (c)(3)(ii) because the first payment 
after such billing-month ($50) is less than the balance of the account 
as of the close of such month ($150).
    Example (3). Customer C's revolving credit account shows the 
following purchases and credits:

------------------------------------------------------------------------
         Month ending               Item       Charges  Credits  Balance
------------------------------------------------------------------------
January 20....................  Coat........       $55  .......  .......
                                Dress.......        40  .......  .......
                                Shirt.......         5  .......     $100
February 20...................  Return......  ........       $5  .......
                                Payments....  ........       95        0
------------------------------------------------------------------------


None of the sales made in the billing-month ending January 20 meets the 
requirements of this paragraph (c)(3)(ii) because the first payment 
credited to the account after such billing-month ($95) was equal to the 
balance of the account as of the end of such billing-month, $95. For 
this purpose, the balance of $100 is reduced by the $5 return which was 
credited to the account after the close of the billing-month of sale and 
before the close of the billing-month within which the first payment 
after the billing-month of sale is credited.

    (4) The provisions of paragraphs (c) (2) and (3) of this section may 
be illustrated by the following examples in which it is assumed that the 
taxpayer is a dealer whose annual accounting period ends on January 31.

    Example (1). Customer A's revolving credit ledger account shows the 
following:

----------------------------------------------------------------------------------------------------------------
                                                  Aggregate
                  Month ending                     sales in   Returns and    Payments     Finance      Balance
                                                  month \1\    allowances                 charges
----------------------------------------------------------------------------------------------------------------
January 20.....................................       $15.00            0            0            0       $15.00
February 20....................................            0            0            0        $0.15        15.15
----------------------------------------------------------------------------------------------------------------
\1\ Including sales of personal property and nonpersonal property sales.


For purposes of the segregation provided for in paragraph (c)(2)(i) of 
this section, customer A's account will be disregarded and not taken 
into account in the determination of what percentage of charges in the 
sample is to be treated as sales on the installment plan because no 
payment was credited to that account after the billing-month of sale and 
on or before February 20.
    Example (2). This example is applicable with respect to sales made 
during taxable years beginning before January 1, 1964. Under the terms 
of corporation X's revolving credit plan, payments are required in 
accordance with the following schedule:

 
                                                                Required
                                                                monthly
                                                                payment
 
Unpaid balance:
    0 to $99.99..............................................        $20
    $100 to $199.99..........................................         40
    $200 to $299.99..........................................         60
 

    Customer B's revolving credit ledger account for the period 
beginning on September 21, 1963, and ending February 20, 1964, shows the 
following:

----------------------------------------------------------------------------------------------------------------
                                                  Aggregate
                  Month ending                     sales in   Returns and    Payments     Finance      Balances
                                                  month \1\    allowances                 charges
----------------------------------------------------------------------------------------------------------------
October 20.....................................       $55.00            0            0            0       $55.00

[[Page 145]]

 
November 20....................................        45.00            0       $20.00        $0.35        80.35
December 20....................................        20.00            0        20.00          .60        80.95
January 20.....................................        26.00        $5.00        20.00          .61        82.56
February 20....................................            0        10.00        72.56            0            0
----------------------------------------------------------------------------------------------------------------
\1\ Including sales of personal property and nonpersonal property sales.


The three $20 payments and the $5 return or allowance made in the 
billing-months ending in the taxable year are applied under the rules in 
paragraph (c)(6)(v) of this section to liquidate the earliest 
outstanding charges, first to the $55 aggregate of sales in the billing-
month ending October 20 and next to $10 of the aggregate of sales made 
in the billing-month ending November 20. Thus, the balance of the 
account as of the close of the billing-month ending January 20, $82.56, 
is made up as follows:

Remainder of sales in billing-month ending Nov. 20 ($45-$10)...   $35.00
Finance charges for billing-month ending Nov. 20...............     0.35
Sales for billing-month ending Dec. 20.........................    20.00
Finance charge for billing-month ending Dec. 20................     0.60
Sales for billing-month ending Jan. 20.........................    26.00
Finance charge for billing-month ending Jan. 20................     0.61
                                                                --------
      Total....................................................    82.56
 

The sales of $35 remaining from the aggregate of sales for the billing-
month ending November 20 meet the requirements of paragraph (c)(3)(i) of 
this section because the aggregate of sales charged during such billing-
month ($45) exceeds the required monthly payment ($20), and such sales 
meet the requirements of paragraph (c)(3)(ii) of this section because 
the first payment after the billing-month of sale ($20) is an amount 
less than the balance of the account as of the close of such month 
($80.35). Therefore, $35 of sales will be treated as sales on the 
installment plan. The $20 aggregate of sales charged during the billing-
month ending December 20 does not meet the requirements of paragraph 
(c)(3)(i) of this section because it is in an amount which does not 
exceed the required monthly payment ($20). (The finance charge of $0.60 
added in the billing-month does not enter into the determination of the 
aggregate of sales for the month because the term ``sales'' (as defined 
in paragraph (c)(6)(i) of this section does not include finance 
charges). The $26 aggregate of sales for the billing-month ending 
January 20 does not meet the requirements of paragraph (c)(3)(ii) of 
this section because the first payment after such billing-month ($72.56) 
was equal to the balance of the account as of the close of such billing-
month ($72.56). For this purpose, the balance of $82.56 is reduced by 
the $10 return or allowance which was credited after the billing-month 
of sale and before February 20. Thus, of the $82.56 balance of B's 
account as of the close of the last billing-month ending within 
corporation X's taxable year, $35 will be treated as sales on the 
installment plan for purposes of determining the percentage provided for 
paragraph (c)(2) of this section.
    Example (3). This example is applicable with respect to sales made 
during taxable years beginning after December 31, 1963. Assume the facts 
in example (2), except that Customer B's revolving credit ledger account 
is for the period beginning on September 21, 1964 and ending February 
20, 1965. Since payments received are first used to liquidate any 
outstanding finance charges under the rule in paragraph (c)(6)(v) of 
this section, the $20 payment in December liquidated the $0.35 finance 
charge accrued at the end of the November billing-month and the $20 
payment in January liquidated the $0.60 finance charge accrued at the 
end of the December billing-month. The balance of the three $20 payments 
($59.05) and the $5 return or allowance are applied (under the rules in 
paragraph (c)(6)(v) of this section) to liquidate the earliest 
outstanding sales, first to the $55 aggregate of sales in the billing-
month ending October 20 and next to $9.05 of the aggregate of sales made 
in the billing-month ending November 20. Thus, the balance of the 
account as of the close of the billing-month ending January 20, $82.56, 
is made up as follows:

Remainder of sales in billing-month ending Nov. 20 ($45-$9.05).   $35.95
Sales for billing-month ending Dec. 20.........................    20.00
Sales for billing-month ending Jan. 20.........................    26.00
Finance charge for billing-month ending Jan. 20................     0.61
                                                                --------
      Total....................................................    82.56
 


The sales of $35.95 remaining from the aggregate of sales for the 
billing-month ending November 20 meet the requirements of paragraph 
(c)(3)(i) of this section because the aggregate of sales charged during 
such billing-month ($45) exceeds the required monthly payment ($20), and 
such sales meet the requirements of paragraph (c)(3)(ii) of this section 
because the first payment after the billing-month of sale ($20) is an 
amount less than the balance of the account as of the close of such 
month ($80.35). Therefore, $35.95 of sales will be treated as sales on 
the installment plan. The $20 aggregate of sales charged during the 
billing-month ending December 20 does not meet the requirements of 
paragraph (c)(3)(i) of this section because it is in an amount which 
does not exceed the

[[Page 146]]

required monthly payment ($20). The $26 aggregate of sales for the 
billing-month ending January 20 does not meet the requirements of 
paragraph (c)(3)(ii) of this section because the first payment after 
such billing-month ($72.56) was equal to the balance of the account as 
of the close of such billing-month ($72.56). For this purpose, the 
balance of $82.56 is reduced by the $10 return or allowance which was 
credited after the billing-month of sale and before February 20. Thus, 
of the $82.56 balance of B's account as of the close of the last 
billing-month ending within corporation X's taxable year $35.95 will be 
treated as sales on the installment plan for purposes of determining the 
percentage provided for in paragraph (c)(2) of this section.

    (5) Sales under a revolving credit plan which are nonpersonal 
property sales (as defined in paragraph (c)(6)(iv) of this section) do 
not constitute sales on the installment plan. Therefore, the charges 
under a revolving credit plan must be reduced by the nonpersonal 
property sales, if any, under such plan, before application of the 
sample percentage as provided for in paragraph (c)(2)(i) of this 
section. The taxpayer may treat as the nonpersonal property sales under 
the plan for the taxable year an amount which bears the same ratio to 
the total sales under the revolving credit plan made in the taxable year 
as the total nonpersonal property sales made in such year bears to the 
total sales made in such year.
    (6) For purposes of this paragraph (c)--
    (i) The term ``sales'' includes sales of services, such as a charge 
for watch repair, as well as sales of property, but does not include 
finance or service charges.
    (ii) The term ``charges'' includes sales of services and property as 
well as finance or service charges.
    (iii) A billing-month is that period of time for which a periodic 
statement of charges and credits is rendered to a customer.
    (iv) The term ``nonpersonal property sales'' means all sales which 
are not sales of personal property made by the taxpayer. Thus, sales of 
a department leased by the taxpayer to another are nonpersonal property 
sales. Likewise, charges for services rendered by the taxpayer are 
nonpersonal property sales unless such services are incidental to and 
rendered contemporaneously with the sale of personal property, in which 
case such charges shall be considered as constituting part of the 
selling price of such property.
    (v) Except as otherwise provided in this paragraph (c)(6)(v), each 
payment received from a customer under a revolving credit plan before 
the close of the last billing-month ending in the taxable year shall be 
applied to liquidate the earliest outstanding charges under such plan, 
notwithstanding any rule of law or contract provision to the contrary. 
For purposes of determining which charges remain in the balance of an 
account at the end of the last billing-month ending in the taxable year, 
the taxpayer may apply returns and allowances which are credited before 
the close of the last billing-month ending in the taxable year either 
(A) to liquidate or reduce the charge for the specific item so returned 
or for which an allowance is permitted, or (B) to liquidate or reduce 
the earliest outstanding charges. The method so selected for applying 
returns and allowances shall be followed on a consistent basis from year 
to year unless the district director consents to a change. Additionally, 
finance or service charges which are computed on the basis of the 
balance of the account at the end of the previous billing-month (usually 
reduced by payments during the current billing-month) are accrued at the 
end of the current billing-month and are therefore considered, for 
purposes of determining the earliest outstanding charges, as charged to 
the account after any sales made during the current billing month. 
However, for purposes of determining which charges remain in the balance 
of an account at the end of the last billing-month ending in a taxable 
year which began after December 31, 1963, payments received during such 
year shall be applied first against any finance or service charges which 
were outstanding at the time such payment was received. The preceding 
sentence shall not apply with respect to a computation made for purposes 
of applying the rule described in paragraph (c)(2)(ii) of this section.
    (vi) The taxpayer shall allocate those sales under a revolving 
credit plan which are treated as sales on the installment plan to the 
proper year of sale in order to apply the appropriate

[[Page 147]]

gross profit percentage as provided for in Sec. 1.453A-1(e). This 
allocation shall be made on the basis of the percentages of charges 
treated as sales on the installment plan which are attributable to each 
taxable year as determined in the sample of accounts described in 
paragraph (c)(2) of this section. However, if the taxpayer demonstrates 
to the satisfaction of the district director that income from sales on 
the installment plan is clearly reflected, all sales may be considered 
as being made in the taxable year for purposes of applying the gross 
profit percentage.
    (7) The provisions of this paragraph (c) may be illustrated by the 
following example:

    Example. Corporation X is a dealer and has elected to report on the 
installment method those sales under its revolving credit plan which may 
be treated as sales on the installment plan. Corporation X's taxable 
year ends on January 31, and the total balance of all its revolving 
credit accounts as of January 31, 1964, is $2,000,000. The total sales 
made in the taxable year are $10,000,000 of which $500,000 are 
nonpersonal property sales. The gross profit percentage realized or to 
be realized on all sales made in the taxable year is 40 percent. The 
amount of the gross profit contained in the year-end balance of 
$2,000,000 which may be deferred to succeeding years is computed as 
follows:
    (i) In order to reduce the charges appearing in the year-end balance 
of revolving credit accounts receivable by the nonpersonal property 
sales contained therein, corporation X determines the amount of such 
nonpersonal property sales under the method permitted in paragraph 
(c)(5) of this section. Corporation X first determines the ratio which 
total nonpersonal property sales made during the year ($500,000) bears 
to total sales made during the year ($10,000,000), and then applies the 
percentage (5 percent) thus obtained to the year-end balance of 
revolving credit accounts receivable ($2,000,000). The nonpersonal 
property sales thus determined ($100,000) is subtracted from such year-
end balance to obtain the charges under the revolving credit plan 
appearing in the year-end balance ($1,900,000) to which the sample 
percentage is to be applied.
    (ii) In accordance with generally accepted sampling techniques, the 
taxpayer selects a probability sample of all revolving credit accounts 
having balances for billing-months ending in January 1964. The technique 
employed results in a random selection of accounts with total balances 
of $100,000.
    (iii) Analysis of these sample accounts discloses that of the 
$100,000 of balances, $10,000 of balances are in accounts on which no 
payment was credited after a billing-month of sale and on or before the 
end of the first billing-month ending in the taxable year beginning 
February 1, 1964. These balances are, therefore, disregarded and not 
taken into account in the determination of what percentage of sales in 
the sample is to be treated as sales on the installment plan. Of the 
remaining $90,000 of balances, the taxpayer determines, by analyzing the 
ledger cards in the sample, that $63,000 of balances are composed of 
sales which meet the requirements of paragraphs (c)(3) (i) and (ii) of 
this section and are thus treated as sales on the installment plan. The 
remaining $27,000 of balances either did not meet the requirements of 
paragraphs (c)(3) (i) and (ii) of this section or were not sales (as 
defined in paragraph (c)(6)(i) of this section). The percentage of 
charges in the sample treated as sales on the installment plan is, 
therefore, 70 percent ($63,000 / $90,000).
    (iv) The charges in the year-end balance which are to be treated as 
sales on the installment plan, $1,330,000, are computed by multiplying 
the charges to which the sample percentage is applied ($1,900,000) by 
the sample percentage (70 percent).
    (v) The deferred gross profit attributable to sales under the 
revolving credit plan for the taxable year, $532,000, is determined by 
multiplying the amount treated as sales on the installment plan 
($1,330,000), by the gross profit percentage (40 percent). (Corporation 
X will be able to demonstrate to the satisfaction of the district 
director that (A) since the gross profit percentage for all sales does 
not vary materially from the gross profit percentage for all sales made 
under the revolving credit plan, (B) since only an insubstantial amount 
of sales included in year-end account balances was made prior to the 
taxable year, and (C) since the prior year's gross profit percentage 
does not vary materially from the gross profit percentage for the 
taxable year, income from sales on the installment plan will be clearly 
reflected by applying the current year's gross profit percentage for all 
sales under the revolving credit plan treated as sales on the 
installment plan.)

    (d) Effective date. This section applies for taxable years beginning 
after December 31, 1953, and ending after August 16, 1954, but does not 
apply for any taxable year beginning after December 31, 1986. For 
taxable years beginning after December 31, 1986, sales under a revolving 
credit plan shall not be treated as sales on the installment plan.

[T.D. 8269, 54 FR 46375, Nov. 3, 1989]

[[Page 148]]



Sec. 1.453A-3  Requirements for adoption of or change to installment 
method by dealers in personal property.

    (a) In general. A dealer (within the meaning of Sec. 1.453A-
1(c)(1)) may adopt or change to the installment method for a type or 
types of sales on the installment plan (within the meaning of Sec. 
1.453A-1(c)(3) and (d)) in the manner prescribed in this section. This 
section applies only to dealers and only with respect to their sales on 
the installment plan.
    (b) Time and manner of electing installment method reporting--(1) 
Time for election. An election to adopt or change to the installment 
method for a type or types of sales must be made on an income tax return 
for the taxable year of the election, filed on or before the time 
specified (including extensions thereof) for filing such return.
    (2) Adoption of installment method. A taxpayer who adopts the 
installment method for the first taxable year in which sales are made on 
an installment plan of any kind must indicate in the income tax return 
for that taxable year that the installment method of accounting is being 
adopted and specify the type or types of sales included within the 
election. If a taxpayer in the year of the initial election made only 
one type of sale on the installment plan, but during a subsequent 
taxable year makes another type of sale on the installment plan and 
adopts the installment method for that other type of sale, the taxpayer 
must indicate in the income tax return for the subsequent year that an 
election is being made to adopt the installment method of accounting for 
the additional type of sale.
    (3) Change to installment method. A taxpayer who changes to the 
installment method for a particular type or types of sales on the 
installment plan in acordance with this section must, for each type of 
sale on the installment plan for which the installment method is to be 
used, attach a separate statement to the income tax return for the 
taxable year with respect to which the change is made. Each statement 
must show the method of accounting used in computing taxable income 
before the change and the type of sale on the installment plan for which 
the installment method is being elected.
    (4) Deemed elections. A dealer (including a person who is a dealer 
as a result of the recharacterization of transactions as sales) is 
deemed to have elected the installment method if the dealer treats a 
sale on the installment plan as a transaction other than a sale and 
fails to report the full amount of gain in the year of the sale. For 
example, if a transaction treated by a dealer as a lease is 
recharacterized by the Internal Revenue Service as a sale on the 
installment plan, the dealer will be deemed to have elected the 
installment method assuming the dealer failed to report the full amount 
of gain in the year of the transaction.
    (c) Consent. A dealer may adopt or change to the installment method 
for sales on the installment plan without the consent of the 
Commissioner. However, a dealer may not change from the installment 
method to the accrual method of accounting or to any other method of 
accounting without the consent of the Commissioner.
    (d) Cut-off method for amounts previously accrued. An election to 
change to the installment method for a type of sale applies only with 
respect to sales made on or after the first day of the taxable year of 
change. Thus, payments received in the taxable year of the change, or in 
subsequent years, in respect of an installment obligation which arose in 
a taxable year prior to the taxable year of change are not taken into 
account on the installment method, but rather must be accounted for 
under the taxpayer's method of accounting in use in the prior year.
    (e) Effective date. This section applies to sales by dealers in 
taxable years ending after October 19, 1980, but generally does not 
apply to sales made after December 31, 1987. For sales made after 
December 31, 1987, sales by a dealer in personal or real property shall 
not be treated as sales on the installment plan. (However, see section 
453(l)(2) for certain exceptions to this rule.) For rules relating to 
sales by dealers in taxable years ending before October 20, 1980, see 26 
CFR 1.453-7 and 1.453-8 (rev. as of April 1, 1987).

[T.D. 8269, 54 FR 46375, Nov. 3, 1989]

[[Page 149]]



Sec. 1.454-1  Obligations issued at discount.

    (a) Certain non-interest-bearing obligations issued at discount--(1) 
Election to include increase in income currently. If a taxpayer owns--
    (i) A non-interest-bearing obligation issued at a discount and 
redeemable for fixed amounts increasing at stated intervals (other than 
an obligation issued by a corporation after May 27, 1969, as to which 
ratable inclusion of original issue discount is required under section 
1232(a)(3)), or
    (ii) An obligation of the United States, other than a current income 
obligation, in which he retains his investment in a matured series E 
U.S. savings bond, or
    (iii) A nontransferable obligation (whether or not a current income 
obligation) of the United States for which a series E U.S. savings bond 
was exchanged (whether or not at final maturity) in an exchange upon 
which gain is not recognized because of section 1037(a) (or so much of 
section 1031(b) as relates to section 1037),

and if the increase, if any, in redemption price of such obligation 
described in subdivision (i), (ii), or (iii) of this subparagraph during 
the taxable year (as described in subparagraph (2) of this paragraph) 
does not constitute income for such year under the method of accounting 
used in computing his taxable income, then the taxpayer may, at his 
election, treat the increase as constituting income for the year in 
which such increase occurs. If the election is not made and section 1037 
(or so much of section 1031 as relates to section 1037) does not apply, 
the taxpayer shall treat the increase as constituting income for the 
year in which the obligation is redeemed or disposed of, or finally 
matures, whichever is earlier. Any such election must be made in the 
taxpayer's return and may be made for any taxable year. If an election 
is made with respect to any such obligation described in subdivision 
(i), (ii), or (iii) of this subparagraph, it shall apply also to all 
other obligations of the type described in such subdivisions owned by 
the taxpayer at the beginning of the first taxable year to which the 
election applies, and to those thereafter acquired by him, and shall be 
binding for the taxable year for which the return is filed and for all 
subsequent taxable years, unless the Commissioner permits the taxpayer 
to change to a different method of reporting income from such 
obligations. See section 446(e) and paragraph (e) of Sec. 1.446-1, 
relating to requirement respecting a change of accounting method. 
Although the election once made is binding upon the taxpayer, it does 
not apply to a transferee of the taxpayer.
    (2) Amount of increase in case of non-interest-bearing obligations. 
In any case in which an election is made under section 454, the amount 
which accrues in any taxable year to which the election applies is 
measured by the actual increase in the redemption price occurring in 
that year. This amount does not accrue ratably between the dates on 
which the redemption price changes. For example, if two dates on which 
the redemption price increases (February 1 and August 1) fall within a 
taxable year and if the redemption price increases in the amount of 50 
cents on each such date, the amount accruing in that year would be $1 
($0.50 on February 1 and $0.50 on August 1). If the taxpayer owns a non-
interest-bearing obligation of the character described in subdivision 
(i), (ii), or (iii) of subparagraph (1) of this paragraph acquired prior 
to the first taxable year to which his election applies, he must also 
include in gross income for such first taxable year (i) the increase in 
the redemption price of such obligation occurring between the date of 
acquisition of the obligation and the first day of such first taxable 
year and (ii), in a case where a series E bond was exchanged for such 
obligation, the increase in the redemption price of such series E bond 
occurring between the date of acquisition of such series E bond and the 
date of the exchange.
    (3) Amount of increase in case of current income obligations. If an 
election is made under section 454 and the taxpayer owns, at the 
beginning of the first taxable year to which the election applies, a 
current income obligation of the character described in subparagraph 
(1)(iii) of this paragraph acquired prior to such taxable year, he must 
also include in gross income for such first taxable year the increase in 
the

[[Page 150]]

redemption price of the series E bond which was surrendered to the 
United States in exchange for such current income obligation; the amount 
of the increase is that occurring between the date of acquisition of the 
series E bond and the date of the exchange.
    (4) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example (1). Throughout the calendar year 1954, a taxpayer who uses 
the cash receipts and disbursements method of accounting holds series E 
U.S. savings bonds having a maturity value of $5,000 and a redemption 
value at the beginning of the year 1954 of $4,050 and at the end of the 
year 1954 of $4,150. He purchased the bonds on January 1, 1949, for 
$3,750, and holds no other obligation of the type described in this 
section. If the taxpayer exercises the election in his return for the 
calendar year 1954, he is required to include $400 in taxable income 
with respect to such bonds. Of this amount, $300 represents the increase 
in the redemption price before 1954 and $100 represents the increase in 
the redemption price in 1954. The increases in redemption value 
occurring in subsequent taxable years are includible in gross income for 
such taxable years.
    Example (2). In 1958 B, a taxpayer who uses the cash receipts and 
disbursements method of accounting and the calendar year as his taxable 
year, purchased for $7,500 a series E United States savings bond with a 
face value of $10,000. In 1965, when the stated redemption value of the 
series E bond is $9,760, B surrenders it to the United States in 
exchange solely for a $10,000 series H U.S. current income savings bond 
in an exchange qualifying under section 1037(a), after paying $240 
additional consideration. On the exchange of the series E bond for the 
series H bond in 1965, B realizes a gain of $2,260 ($9,760 less $7,500), 
none of which is recognized for that year by reason of section 1037(a). 
B retains the series H bond and redeems it at maturity in 1975 for 
$10,000, but in 1966 he exercises the election under section 454(a) in 
his return for that year with respect to five series E bonds he 
purchased in 1960. B is required to include in gross income for 1966 the 
increase in redemption price occurring before 1966 and in 1966 with 
respect to the series E bonds purchased in 1960; he is also required to 
include in gross income for 1966 the $2,260 increase in redemption price 
of the series E bond which was exchanged in 1965 for the series H bond.

    (b) Short-term obligations issued on a discount basis. In the case 
of obligations of the United States or any of its possessions, or of a 
State, or Territory, or any political subdivision thereof, or of the 
District of Columbia, issued on a discount basis and payable without 
interest at a fixed maturity date not exceeding one year from the date 
of issue, the amount of discount at which such obligation originally 
sold does not accrue until the date on which such obligation is 
redeemed, sold, or otherwise disposed of. This rule applies regardless 
of the method of accounting used by the taxpayer. For examples 
illustrating rules for computation of income from sale or other 
disposition of certain obligations of the type described in this 
paragraph, see section 1221 and the regulations thereunder.
    (c) Matured U.S. savings bonds--(1) Inclusion of increase in income 
upon redemption or final maturity. If a taxpayer (other than a 
corporation) holds--
    (i) A matured series E U.S. savings bond,
    (ii) An obligation of the United States, other than a current income 
obligation, in which he retains his investment in a matured series E 
U.S. savings bond, or
    (iii) A nontransferable obligation (whether or not a current income 
obligation) of the United States for which a series E U.S. savings bond 
was exchanged (whether or not at final maturity) in an exchange upon 
which gain is not recognized because of section 1037(a) (or so much of 
section 1031(b) as relates to section 1037(a)),

the increase in redemption price of the series E bond in excess of the 
amount paid for such series E bond shall be included in the gross income 
of such taxpayer for the taxable year in which the obligation described 
in subdivision (i), (ii), or (iii) of this subparagraph is redeemed or 
disposed of, or finally matures, whichever is earlier, but only to the 
extent such increase has not previously been includible in the gross 
income of such taxpayer or any other taxpayer. If such obligation is 
partially redeemed before final maturity, or partially disposed of by 
being partially reissued to another owner, such increase in redemption 
price shall be included in the gross income of such taxpayer for such 
taxable year on a basis proportional to the total denomination of 
obligations redeemed or disposed of. The provisions of section 454 (c) 
and of this subparagraph shall not apply in the

[[Page 151]]

case of any taxable year for which the taxpayer's taxable income is 
computed under an accrual method of accounting or for a taxable year for 
which an election made by the taxpayer under section 454(a) and 
paragraph (a) of this section applies. For rules respecting the 
character of the gain realized upon the disposition or redemption of an 
obligation described in subdivision (iii) of this subparagraph, see 
paragraph (b) of Sec. 1.1037-1.
    (2) Illustrations. The application of this paragraph may be 
illustrated by the following examples, in which it is assumed that the 
taxpayer uses the cash receipts and disbursements method of accounting 
and the calendar year as his taxable year:

    Example (1). On June 1, 1941, A purchased for $375 a series E U.S. 
savings bond which was redeemable at maturity (10 years from issue date) 
for $500. At maturity of the bond, A exercised the option of retaining 
the matured series E bond for the 10-year extended maturity period. On 
June 2, 1961, A redeemed the series E bond, at which time the stated 
redemption value was $674.60. A never elected under section 454(a) to 
include the annual increase in redemption price in gross income 
currently. Under section 454(c), A is required to include $299.60 
($674.60 less $375) in gross income for 1961 by reason of his redemption 
of the bond.
    Example (2). The facts are the same as in example (2) in paragraph 
(a)(4) of this section. On redemption of the series H bond received in 
the exchange qualifying under section 1037(a), B realizes a gain of 
$2,260, determined as provided in example (5) in paragraph (b)(4) of 
Sec. 1.1037-1. None of this amount is includible in B's gross income 
for 1975, such amount having already been includible in his gross income 
for 1966 because of his election under section 454(a).
    Example (3). C, who had elected under section 454(a) to include the 
annual increase in the redemption price of his non-interest-bearing 
obligations in gross income currently, owned a $1,000 series E U.S. 
savings bond, which was purchased on October 1, 1949, for $750, C died 
on February 1, 1955, when the redemption value of the bond was $820. The 
bond was immediately reissued to D, his only heir, who has not made an 
election under section 454(a). On January 15, 1960, when the redemption 
value of the bond is $1,000, D surrenders it to the United States in 
exchange solely for a $1,000 series H U.S. savings bond in an exchange 
qualifying under the provisions of section 1037(a). For 1960 D properly 
does not return any income from the exchange of bonds, although he 
returns the interest payments on the series H bond for the taxable years 
in which they are received. On September 1, 1964, prior to maturity of 
the series H bond, D redeems it for $1,000. For 1964, D must include 
$180 in gross income under section 454(c) from the redemption of the 
series H bond, that is, the amount of the increase in the redemption 
price of the series E bond ($1,000 less $820) occurring between February 
1, 1955, and January 15, 1960, the period during which he owned the 
series E bond.

[T.D. 6500, 25 FR 11719, Nov. 26, 1960, as amended by T.D. 6935, 32 FR 
15820, Nov. 17, 1967; T.D. 7154, 36 FR 24997, Dec. 28, 1971]



Sec. 1.455-1  Treatment of prepaid subscription income.

    Effective with respect to taxable years beginning after December 31, 
1957, section 455 permits certain taxpayers to elect with respect to a 
trade or business in connection with which prepaid subscription income 
is received, to include such income in gross income for the taxable 
years during which a liability exists to furnish or deliver a newspaper, 
magazine, or other periodical. If a taxpayer does not elect to treat 
prepaid subscription income under the provisions of section 455, such 
income is includible in gross income for the taxable year in which 
received by the taxpayer, unless under the method or practice of 
accounting used in computing taxable income such amount is to be 
properly accounted for as of a different period.

[T.D. 6591, 27 FR 1798, Feb. 27, 1962]



Sec. 1.455-2  Scope of election under section 455.

    (a) If a taxpayer makes an election under section 455 and Sec. 
1.455-6 with respect to a trade or business, all prepaid subscription 
income from such trade or business shall be included in gross income for 
the taxable years during which the liability exists to furnish or 
deliver a newspaper, magazine, or other periodical. Such election shall 
be applicable to all prepaid subscription income received in connection 
with the trade or business for which the election is made; except that 
the taxpayer may further elect to include in gross income for the 
taxable year of receipt (as described in section 455(d)(3) and paragraph 
(c) of Sec. 1.455-5) the entire amount of any prepaid subscription 
income if the liability from which it arose is to

[[Page 152]]

end within 12 months after the date of receipt, hereinafter sometimes 
referred to as ``within 12 months'' election.
    (b) If the taxpayer is engaged in more than one trade or business in 
which a liability is incurred to furnish or deliver a newspaper, 
magazine, or other periodical, a separate election 455 with respect to 
each such trade or business. In addition, a taxpayer may make a separate 
``within 12 months'' election for each separate trade or business for 
which it has made an election under section 455.
    (c) An election made under section 455 shall be binding for the 
first taxable year for which the election is made and for all subsequent 
taxable years, unless the taxpayer secures the consent of the 
Commissioner to the revocation of such election. Thus, in any case where 
the taxpayer has elected a method prescribed by section 455 for the 
inclusion of prepaid subscription income in gross income, such method of 
reporting income may not be changed without the prior approval of the 
Commissioner. In order to secure the Commissioner's consent to the 
revocation of such election, an application must be filed with the 
Commissioner in accordance with section 446(e) and the regulations 
thereunder. For purposes of subtitle A of the Code, the computation of 
taxable income under an election made under section 455 shall be treated 
as a method of accounting. For adjustments required by changes in method 
of accounting, see section 481 and the regulations thereunder.
    (d) An election made under section 455 shall not apply to any 
prepaid subscription income received before the first taxable year to 
which the election applies. For example, Corporation M, which computes 
its taxable income under an accrual method of accounting and files its 
income tax returns on the calendar year basis, publishes a monthly 
magazine and customarily sells subscriptions on a 3-year basis. In 1958 
it received $135,000 of 3-year prepaid subscription income for 
subscriptions beginning during 1958, and in 1959 it received $142,000 of 
prepaid subscription income for subscriptions beginning after December 
31, 1958. In February 1959 it elected, with the consent of the 
Commissioner, to report its prepaid subscription income under the 
provisions of section 455 for the year 1959 and subsequent taxable 
years. The $135,000 received in 1958 from prepaid subscriptions must be 
included in gross income in full in that year, and no part of such 1958 
income shall be allocated to the years 1959, 1960, and 1961 during which 
M was under a liability to deliver its magazine. The $142,000 received 
in 1959 from prepaid subscriptions shall be allocated to the years 1959, 
1960, 1961, and 1962.
    (e) No election may be made under section 455 with respect to a 
trade or business if, in computing taxable income, the cash receipts and 
disbursements method of accounting is used with respect to such trade or 
business. However, if the taxpayer is on a ``combination'' method of 
accounting under section 446(c)(4) and the regulations thereunder, it 
may elect the benefits of section 455 if it uses an accrual method of 
accounting for subscription income

[T.D. 6591, 27 FR 1798, Feb. 27, 1962]



Sec. 1.455-3  Method of allocation.

    (a) Prepaid subscription income to which section 455 applies shall 
be included in gross income for the taxable years during which the 
liability to which the income relates is discharged or is deemed to be 
discharged on the basis of the taxpayer's experience.
    (b) For purposes of determining the period or periods over which the 
liability of the taxpayer extends, and for purposes of allocating 
prepaid subscription income to such periods, the taxpayer may aggregate 
similar transactions during the taxable year in any reasonable manner, 
provided the method of aggregation and allocation is consistently 
followed.

[T.D. 6591, 27 FR 1798, Feb. 27, 1962]



Sec. 1.455-4  Cessation of taxpayer's liability.

    (a) If a taxpayer has elected to apply the provisions of section 455 
to a trade or business in connection with which prepaid subscription 
income is received, and if its liability to furnish or deliver a 
newspaper, magazine, or other periodical ends for any reason, then so 
much of the prepaid subscription income attributable to such liability 
as

[[Page 153]]

was not includible in its gross income under section 455 for preceding 
taxable years shall be included in its gross income for the taxable year 
in which such liability ends. A taxpayer's liability may end, for 
example, because of the cancellation of a subscription. See section 
381(c)(4) and the regulations thereunder for the treatment of prepaid 
subscription income in a transaction to which section 381(a) applies.
    (b) If a taxpayer who has elected to apply the provisions of section 
455 to a trade or business dies or ceases to exist, then so much of the 
prepaid subscription income attributable to such trade or business which 
was not includible in its gross income under section 455 for preceding 
taxable years shall be included in its gross income for the taxable year 
in which such death or cessation of existence occurs. See section 
381(c)(4) and the regulations thereunder for the treatment of prepaid 
subscription income in a transaction to which section 381(a) applies.

[T.D. 6591, 27 FR 1799, Feb. 27, 1962]



Sec. 1.455-5  Definitions and other rules.

    (a) Prepaid subscription income. (1) The term ``prepaid subscription 
income'' means any amount includible in gross income which is received 
in connection with, and is directly attributable to, a liability of the 
taxpayer which extends beyond the close of the taxable year in which 
such amount is received and which is income from a newspaper, magazine, 
or other periodical. For example where Corporation X, a publisher of 
newspapers, magazines, and other periodicals makes sales on a 
subscription basis and the purchaser pays the subscription price in 
advance, prepaid subscription income would include the amounts actually 
received by X in connection with its liability to furnish or deliver the 
newspaper, magazine, or other periodical.
    (2) For purposes of section 455, prepaid subscription income does 
not include amounts received by a taxpayer in connection with sales of 
subscriptions on a prepaid basis where such taxpayer does not have the 
liability to furnish or deliver a newspaper, magazine, or other 
periodical. The provisions of this subparagraph may be illustrated by 
the following example. Corporation D has a contract with each of several 
large publishers which grants it the right to sell subscriptions to 
their periodicals. Corporation D collects the subscription price from 
the subscribers, retains a portion thereof as its commission and remits 
the balance to the publishers. The amount retained by Corporation D 
represents commissions on the sale of subscriptions, and is not prepaid 
subscription income for purposes of section 455 since the commissions 
represent compensation for services rendered and are not directly 
attributable to a liability of Corporation D to furnish or deliver a 
newspaper, magazine, or other periodical.
    (b) Liability. The term ``liability'' means a liability of the 
taxpayer to furnish or deliver a newspaper, magazine, or other 
periodical.
    (c) Receipt of prepaid subscription income. For purposes of section 
455, prepaid subscription income shall be treated as received during the 
taxable year for which it is includible in gross income under section 
451, relating to general rule for taxable year of inclusion, without 
regard to section 455.
    (d) Treatment of prepaid subscription income under an established 
accounting method. Notwithstanding the provisions of section 455 and 
Sec. 1.455-1, any taxpayer who, for taxable years beginning before 
January 1, 1958, has reported prepaid subscription income for income tax 
purposes under an established and consistent method or practice of 
deferring such income may continue to report such income in accordance 
with such method or practice for all subsequent taxable years to which 
section 455 applies without making an election under section 455.

[T.D. 6591, 27 FR 1799, Feb. 27, 1962]



Sec. 1.455-6  Time and manner of making election.

    (a) Election without consent. (1) A taxpayer may, without consent, 
elect to treat prepaid subscription income of a trade or business under 
section 455 for the first taxable year--
    (i) Which begins after December 31, 1957, and
    (ii) In which there is received prepaid subscription income from the 
trade or business for which the election is

[[Page 154]]

made. Such an election shall be made not later than the time prescribed 
by law for filing the income tax return for such year (including 
extensions thereof), and shall be made by means of a statement attached 
to such return.
    (2) The statement shall indicate that the taxpayer is electing to 
apply the provisions of section 455 to his trade or business, and shall 
contain the following information:
    (i) The name and a description of the taxpayer's trade or business 
to which the election is to apply;
    (ii) The method of accounting used in such trade or business;
    (iii) The total amount of prepaid subscription income from such 
trade or business for the taxable year;
    (iv) The period or periods over which the liability of the taxpayer 
to furnish or deliver a newspaper, magazine, or other periodical 
extends;
    (v) The amount of prepaid subscription income applicable to each 
such period; and
    (vi) A description of the method used in allocating the prepaid 
subscription income to each such period.

In any case in which prepaid subscription income is received from more 
than one trade or business, the statement shall set forth the required 
information with respect to each trade or business subject to the 
election.
    (3) See paragraph (c) of this section for additional information 
required to be submitted with the statement if the taxpayer also elects 
to include in gross income for the taxable year of receipt the entire 
amount of prepaid subscription income attributable to a liability which 
is to end within 12 months after the date of receipt.
    (b) Election with consent. A taxpayer may, with the consent of the 
Commissioner, elect at any time to apply the provisions of section 455 
to any trade or business in which it receives prepaid subscription 
income. The request for such consent shall be in writing, signed by the 
taxpayer or its authorized representative, and shall be addressed to the 
Commissioner of Internal Revenue, Attention: T:R:C, Washington, D.C. 
20224. The request must be filed on or before the later of the following 
dates:
    (1) 90 days after the beginning of the first taxable year to which 
the election is to apply or
    (2) May 28, 1962, and must contain the information described in 
paragraph (a)(2) of this section.

See paragraph (c) of this section for additional information required to 
be submitted with the request if the taxpayer also elects to include in 
gross income for the taxable year of receipt the entire amount of 
prepaid subscription income attributable to a liability which is to end 
within 12 months after the date of receipt.
    (c) ``Within 12 months'' election. (1) A taxpayer who elects to 
apply the provisions of section 455 to any trade or business may also 
elect to include in gross income for the taxable year of receipt (as 
described in section 455(d)(3) and paragraph (c) of Sec. 1.455-5) the 
entire amount of any prepaid subscription income from such trade or 
business if the liability from which it arose is to end within 12 months 
after the date of receipt. Any such election is binding for the first 
taxable year for which it is effective and for all subsequent taxable 
years, unless the taxpayer secures permission from the Commissioner to 
treat such income differently. Application to revoke or change a 
``within 12 months'' election shall be made in accordance with the 
provisions of section 446(e) and the regulations thereunder.
    (2) The ``within 12 months'' election shall be made by including in 
the statement required by paragraph (a) of this section or the request 
described in paragraph (b) of this section, whichever is applicable, a 
declaration that the taxpayer elects to include such income in gross 
income in the taxable year of receipt, and the amount of such income. If 
the taxpayer is engaged in more than one trade or business for which the 
election under section 455 is made, it must include, in such statement 
or request, a declaration for each trade or business for which it makes 
the ``within 12 months'' election. See also paragraph (e) of Sec. 
1.455-2.
    (3) If the taxpayer does not make the ``within 12 months'' election 
for its trade or business at the time prescribed for making the election 
to include prepaid subscription income in

[[Page 155]]

gross income for the taxable years during which its liability to furnish 
or deliver a newspaper, magazine, or other periodical exists for such 
trade or business, but later wishes to make such election, it must apply 
for permission from the Commissioner. Such application shall be made in 
accordance with the provisions of section 446(e) and the regulations 
thereunder.

[T.D. 6591, 27 FR 1799, Feb. 27, 1962]



Sec. 1.456-1  Treatment of prepaid dues income.

    Effective for taxable years beginning after December 31, 1960, a 
taxpayer which is a membership organization (as described in paragraph 
(c) of Sec. 1.456-5) and which receives prepaid dues income as 
described in paragraph (a) of Sec. 1.456-5 in connection with its trade 
or business of rendering services or making available membership 
privileges may elect under section 456 to include such income in gross 
income ratably over the taxable years during which its liability (as 
described in paragraph (b) of Sec. 1.456-5) to render such services or 
extend such privileges exists, if such liability does not extend over a 
period of time in excess of 36 months. If the taxpayer does not elect to 
treat prepaid dues income under section 456, or if such income may not 
be reported under section 456, as for example, where the income relates 
to a liability to render services or make available membership 
privileges which extends beyond 36 months, then such income is 
includible in gross income for the taxable year in which it is received 
(as described in paragraph (d) of Sec. 1.456-5).

[T.D. 6937, 32 FR 16394, Nov. 30, 1967]



Sec. 1.456-2  Scope of election under section 456.

    (a) An election made under section 456 and Sec. 1.456-6, shall be 
applicable to all prepaid dues income received in connection with the 
trade or business for which the election is made. However, the taxpayer 
may further elect to include in gross income for the taxable year of 
receipt the entire amount of any prepaid dues income attributable to a 
liability extending beyond the close of the taxable year but ending 
within 12 months after the date of receipt, hereinafter referred to as 
the ``within 12 months'' election.
    (b) If the taxpayer is engaged in more than one trade or business in 
connection with which prepaid dues income is received, a separate 
election may be made under section 456 with respect to each such trade 
or business. In addition, a taxpayer may make a separate ``within 12 
months'' election for each separate trade or business for which it has 
made an election under section 456.
    (c) A section 456 election and a ``within 12 months'' election shall 
be binding for the first taxable year for which the election is made and 
for all subsequent taxable years, unless the taxpayer secures the 
consent of the Commissioner to the revocation of either election. In 
order to secure the Commissioner's consent to the revocation of the 
section 456 election or the ``within 12 months'' election, an 
application must be filed with the Commissioner in accordance with 
section 446(e) and the regulations thereunder. However, an application 
for consent to revoke the section 456 election or the ``within 12 
months'' election in the case of all taxable years which end before 
November 30, 1967 must be filed on or before February 28, 1968. For 
purposes of Subtitle A of the Code, the computation of taxable income 
under an election made under section 456 or under the ``within 12 
months'' election shall be treated as a method of accounting. For 
adjustments required by changes in method of accounting, see section 481 
and the regulations thereunder.
    (d) Except as provided in section 456(d) and Sec. 1.456-7, an 
election made under section 456 shall not apply to any prepaid dues 
income received before the first taxable year to which the election 
applies. For example, Corporation X, a membership organization which 
files its income tax returns on a calendar year basis, customarily sells 
3-year memberships, payable in advance. In 1961 it received $160,000 of 
prepaid dues income for 3-year memberships beginning during 1961, and in 
1962 it received $185,000 of prepaid dues income for 3-year memberships 
beginning on January 1, 1962. In March 1962 it

[[Page 156]]

elected, with the consent of the Commissioner, to report its prepaid 
dues income under the provisions of section 456 for the year 1962 and 
subsequent taxable years. The $160,000 received in 1961 from prepaid 
dues must be included in gross income in full in that year, and except 
as provided in section 456(d) and Sec. 1.456-7, no part of such income 
shall be allocated to the taxable years 1962, 1963, and 1964 during 
which X was under a liability to make available its membership 
privileges. The $185,000 received in 1962 from prepaid dues income shall 
be allocated to the years 1962, 1963, and 1964.
    (e) No election may be made under section 456 with respect to a 
trade or business if, in computing taxable income, the cash receipts and 
disbursements method (or a hybrid thereof) of accounting is used with 
respect to such trade or business, unless the combination of the section 
456 election and the taxpayer's hybrid method of accounting does not 
result in a material distortion of income.

[T.D. 6937, 32 FR 16394, Nov. 30, 1967; 32 FR 17479, Dec. 6, 1967]



Sec. 1.456-3  Method of allocation.

    (a) Prepaid dues income for which an election has been made under 
section 456 shall be included in gross income over the period of time 
during which the liability to render services or make available 
membership privileges exists. The liability to render the services or 
make available the membership privileges shall be deemed to exist 
ratably over the period of time such services are required to be 
rendered, or such membership privileges are required to be made 
available. Thus, the prepaid dues income shall be included in gross 
income ratably over the period of the membership contract. For example, 
Corporation X, a membership organization, which files its income tax 
returns on a calendar year basis, elects, for its taxable year beginning 
January 1, 1961, to report its prepaid dues income in accordance with 
the provisions of section 456. On March 31, 1961, it sells a 2-year 
membership for $48 payable in advance, the membership to extend from May 
1, 1961, to April 30, 1963. X shall include in its gross income for the 
taxable year 1961 \8/24\ of the $48, or $16, and for the taxable year 
1962 \12/24\ of the $48, or $24, and for the taxable year 1963 \4/24\ of 
the $48, or $8.
    (b) For purposes of determining the period or periods over which the 
liability of the taxpayer exists, and for purposes of allocating prepaid 
dues income to such periods, the taxpayer may aggregate similar 
transactions during the taxable year in any reasonable manner, provided 
the method of aggregation and allocation is consistently followed.

[T.D. 6937, 32 FR 16395, Nov. 30, 1967]



Sec. 1.456-4  Cessation of liability or existence.

    (a) If a taxpayer has elected to apply the provisions of section 456 
to a trade or business in connection with which prepaid dues income is 
received, and if the taxpayer's liability to render services or make 
available membership privileges ends for any reason, as for example, 
because of the cancellation of a membership then so much of the prepaid 
dues income attributable to such liability as was not includible in the 
taxpayer's gross income under section 456 for preceding taxable years 
shall be included in gross income for the taxable year in which such 
liability ends. This paragraph shall not apply to amounts includible in 
gross income under Sec. 1.456-7.
    (b) If a taxpayer which has elected to apply the provisions of 
section 456 ceases to exist, then the prepaid dues income which was not 
includible in gross income under section 456 for preceding taxable years 
shall be included in the taxpayer's gross income for the taxable year in 
which such cessation of existence occurs. This paragraph shall not apply 
to amounts includible in gross income under Sec. 1.456-7.
    (c) If a taxpayer is a party to a transaction to which section 
381(a) applies and the taxpayer's method of accounting with respect to 
prepaid dues income is used by the acquiring corporation under the 
provisions of section 381(c)(4), then neither the liability nor the 
existence of the taxpayer shall be deemed to have ended or ceased. In 
such cases see section 381(c)(4) and the regulations thereunder for the 
treatment of the portion of prepaid dues income which was not included 
in gross

[[Page 157]]

income under section 456 for preceding taxable years.

[T.D. 6937, 32 FR 16395, Nov. 30, 1967]



Sec. 1.456-5  Definitions and other rules.

    (a) Prepaid dues income. (1) The term ``prepaid dues income'' means 
any amount for membership dues includible in gross income which is 
received by a membership organization in connection with, and is 
directly attributable to, a liability of the taxpayer to render services 
or make available membership privileges over a period of time which 
extends beyond the close of the taxable year in which such amount is 
received.
    (2) For purposes of section 456, prepaid dues income does not 
include amounts received by a taxpayer in connection with sales of 
memberships on a prepaid basis where the taxpayer does not have the 
liability to furnish the services or make available the membership 
privileges. For example, where a taxpayer has a contract with several 
membership organizations to sell memberships in such organizations and 
retains a portion of the amounts received from the sale of such 
memberships and remits the balance to the membership organizations, the 
amounts retained by such taxpayer represent commissions and do not 
constitute prepaid dues income for purposes of section 456.
    (b) Liability. The term ``liability'' means a liability of the 
taxpayer to render services or make available membership privileges over 
a period of time which does not exceed 36 months. Thus, if during the 
taxable year a taxpayer sells memberships for more than 36 months and 
also memberships for 36 months or less, section 456 does not apply to 
the income from the sale of memberships for more than 36 months. For the 
purpose of determining the duration of a liability, a bona fide renewal 
of a membership shall not be considered to be a part of the existing 
membership.
    (c) Membership organization. (1) The term ``membership 
organization'' means a corporation, association, federation, or other 
similar organization meeting the following requirements:
    (i) It is organized without capital stock of any kind.
    (ii) Its charter, bylaws, or other written agreement or contract 
expressly prohibits the distribution of any part of the net earnings 
directly or indirectly, in money, property, or services, to any member, 
and
    (iii) No part of the net earnings of which is in fact distributed to 
any member either directly or indirectly, in money, property, or 
services.
    (2) For purposes of this paragraph an increase in services or 
reduction in dues to all members shall generally not be considered 
distributions of net earnings.
    (3) If a corporation, association, federation, or other similar 
organization subsequent to the time it elects to report its prepaid dues 
income in accordance with the provisions of section 456, (i) issues any 
kind of capital stock either to any member or nonmember, (ii) amends its 
charter, bylaws, or other written agreement or contract to permit 
distributions of its net earnings to any member or, (iii) in fact, 
distributes any part of its net earnings either in money, property, or 
services to any member, then immediately after such event the 
organization shall not be considered a membership organization within 
the meaning of section 456(e)(3).
    (d) Receipt of prepaid dues income. For purposes of section 456, 
prepaid dues income shall be treated as received during the taxable year 
for which it is includible in gross income under section 451, relating 
to the general rule for taxable year of inclusion, without regard to 
section 456.

[T.D. 6937, 32 FR 16395, Nov. 30, 1967]



Sec. 1.456-6  Time and manner of making election.

    (a) Election without consent. A taxpayer may make an election under 
section 456 without the consent of the Commissioner for the first 
taxable year beginning after December 31, 1960, in which it receives 
prepaid dues income in the trade or business for which such election is 
made. The election must be made not later than the time prescribed by 
law for filing the income tax return for such year (including extensions 
thereof). The election must be made by means of a statement attached to 
such return. In addition, there should be attached a copy of a typical 
membership contract used by

[[Page 158]]

the organization and a copy of its charter, bylaws, or other written 
agreement or contract of organization or association. The statement 
shall indicate that the taxpayer is electing to apply the provisions of 
section 456 to the trade or business, and shall contain the following 
information:
    (1) The taxpayer's name and a description of the trade or business 
to which the election is to apply.
    (2) The method of accounting used for prepaid dues income in the 
trade or business during the first taxable year for which the election 
is to be effective and during each of 3 preceding taxable years, and if 
there was a change in the method of accounting for prepaid dues income 
during such 3-year period, a detailed explanation of such change 
including the adjustments necessary to prevent duplications or omissions 
of income.
    (3) Whether any type of deferral method for prepaid dues income has 
been used during any of the 3 taxable years preceding the first taxable 
year for which the election is effective. Where any type of such 
deferral method has been used during this period, an explanation of the 
method and a schedule showing the amounts received in each such year and 
the amounts deferred to each succeeding year.
    (4) A schedule with appropriate explanations showing:
    (i) The total amount of prepaid dues income received in the trade or 
business in the first taxable year for which the election is effective 
and the amount of such income to be included in each taxable year in 
accordance with the election,
    (ii) The total amount, if any, of prepayments of dues received in 
the first taxable year for which the election is effective which are 
directly attributable to a liability of the taxpayer to render services 
or make available membership privileges over a period of time in excess 
of 36 months, and
    (iii) The total amount, if any, of prepaid dues income received in 
the trade or business in--
    (a) The taxable year preceding the first taxable year for which the 
election is effective if all memberships sold by the taxpayer are for 
periods of 1 year or less,
    (b) Each of the 2 taxable years preceding the first taxable year for 
which the election is effective if any memberships are sold for periods 
in excess of 1 year but none are sold for periods in excess of 2 years, 
or
    (c) Each of the 3 taxable years preceding the first taxable year for 
which the election is effective if any memberships are sold for periods 
in excess of 2 years.


In each case there shall be set forth the amount of such income which 
would have been includible in each taxable year had the election been 
effective for the years for which the information is required.

In any case in which prepaid dues income is received from more than one 
trade or business, the statement shall set forth separately the required 
information with respect to each trade or business for which the 
election is made. See paragraph (c) of this section for additional 
information required to be submitted with the statement if the taxpayer 
also elects to include in gross income for the taxable year of receipt 
the entire amount of prepaid dues income attributable to a liability 
which is to end within 12 months after the date of receipt.
    (b) Election with consent. A taxpayer may elect with the consent of 
the Commissioner, to apply the provisions of section 456 to any trade or 
business in which it receives prepaid dues income. The request for such 
consent shall be in writing, signed by the taxpayer or its authorized 
representative, and shall be addressed to the Commissioner of Internal 
Revenue, Washington, D.C. 20224. The request must be filed on or before 
the later of the following dates:
    (1) 90 days after the beginning of the first taxable year to which 
the election is to apply, or
    (2) February 28, 1968 and should contain the information described 
in paragraph (a) of this section.

See paragraph (c) of this section for additional information required to 
be submitted with the request if the taxpayer also elects to include in 
gross income for the taxable year of receipt the entire amount of 
prepaid dues income attributable to a liability which

[[Page 159]]

is to end within 12 months after the date of receipt.
    (c) ``Within 12 months'' election. (1) The ``within 12 months'' 
election shall be made by including in the statement required by 
paragraph (a) of this section or the request described in paragraph (b) 
of this section, whichever is applicable, a declaration that the 
taxpayer elects to include such income in gross income in the taxable 
year of receipt, and the amount of such income for each taxable year to 
which the election is to apply which has ended prior to the time such 
statement or request is filed. If the taxpayer is engaged in more than 
one trade or business for which the election under section 456 is made, 
it must include, in such statement or request, a declaration for each 
trade or business for which it wishes to make the ``within 12 months'' 
election.
    (2) If the taxpayer does not make the ``within 12 months'' election 
for a trade or business at the time it makes the election under 
paragraph (a) or (b) of this section, but later wishes to make such 
election, it must apply for permission from the Commissioner. Such 
application shall be made in accordance with the provisions of section 
446(e).

[T.D. 6937, 32 FR 16395, Nov. 30, 1967; 32 FR 17479, Dec. 6, 1967]



Sec. 1.456-7  Transitional rule.

    (a) Under section 456(d)(1), a taxpayer making an election under 
section 456 shall include in its gross income for the first taxable year 
to which the election applies and for each of the 2 succeeding taxable 
years not only that portion of prepaid dues income which is includible 
in gross income for each such taxable year under section 456(a), but 
also an additional amount equal to that portion of the total prepaid 
dues income received in each of the 3 taxable years preceding the first 
taxable year to which the election applies which would have been 
includible in gross income for such first taxable year and such 2 
succeeding taxable years had the election under section 456 been 
effective during such 3 preceding taxable years. In computing such 
additional amounts--
    (1) In the case of taxpayers who did not include in gross income for 
the taxable year preceding the first taxable year for which the election 
is effective, that portion of the prepaid dues income received in such 
year attributable to a liability which is to end within 12 months after 
the date of receipt, no effect shall be given to a ``within 12 months'' 
election made under paragraph (c) of Sec. 1.456-6, and
    (2) There shall be taken into account only prepaid dues income 
arising from a trade or business with respect to which an election is 
made under section 456 and Sec. 1.456-6.

Section 481 and the regulations thereunder shall have no application to 
the additional amounts includible in gross income under section 456(d) 
and this section, but section 481 and the regulations thereunder shall 
apply to prevent other amounts from being duplicated or omitted.
    (b) A taxpayer who makes an election with respect to prepaid dues 
income, and who includes in gross income for any taxable year to which 
the election applies an additional amount computed under section 
456(d)(1) and paragraph (a) of this section, shall be permitted under 
section 456(d)(2) to deduct for such taxable year and for each of the 4 
succeeding taxable years an amount equal to one-fifth of such additional 
amount, but only to the extent that such additional amount was also 
included in the taxpayer's gross income for any of the 3 taxable years 
preceding the first taxable year to which such election applies. The 
taxpayer shall maintain books and records in sufficient detail to enable 
the district director to determine upon audit that the additional 
amounts were included in the taxpayer's gross income for any of the 3 
taxable years preceding such first taxable year. If, however, the 
taxpayer ceases to exist, as described in paragraph (b) of Sec. 1.456-
4, and there is included in gross income, under such paragraph, of the 
year of cessation the entire portion of prepaid dues income not 
previously includible in gross income under section 456 for preceding 
taxable years (other than for amounts received prior to the first year 
for which an election was made), all the amounts not previously deducted 
under this paragraph shall be permitted as a deduction in the year of 
cessation of existence.

[[Page 160]]

    (c) The provisions of this section may be illustrated by the 
following example:

    Example. (1) Assume that X Corporation, a membership organization 
qualified to make the election under section 456, elects to report its 
prepaid dues income in accordance with the provisions of section 456 for 
its taxable year ending December 31, 1961. Assume further that X 
Corporation receives in the middle of each taxable year $3,000 of 
prepaid dues income in connection with a liability to render services 
over a 3-year period beginning with the date of receipt. Under section 
456(a), X Corporation will report income received in 1961 and subsequent 
years as follows:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                  Total
                        Year of receipt                         receipts    1961      1962      1963      1964      1965      1966      1967      1968
--------------------------------------------------------------------------------------------------------------------------------------------------------
1961..........................................................    $3,000      $500    $1,000    $1,000      $500  ........  ........  ........  ........
1962..........................................................     3,000  ........       500     1,000     1,000      $500  ........  ........  ........
1963..........................................................     3,000  ........  ........       500     1,000     1,000      $500  ........  ........
1964..........................................................     3,000  ........  ........  ........       500     1,000     1,000      $500  ........
1965..........................................................     3,000  ........  ........  ........  ........       500     1,000     1,000      $500
1966..........................................................     3,000  ........  ........  ........  ........  ........       500     1,000     1,000
1967..........................................................     3,000  ........  ........  ........  ........  ........  ........       500     1,000
1968..........................................................     3,000  ........  ........  ........  ........  ........  ........  ........       500
--------------------------------------------------------------------------------------------------------------------------------------------------------
  Total reportable under section 456(a).................................       500     1,500     2,500     3,000     3,000     3,000     3,000     3,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (2) Under section 456(d) (1), X Corporation must include in its 
gross income for the first taxable year to which the election applies 
and for each of the 2 succeeding taxable years, the amounts which would 
have been included in those years had the election been effective 3 
years earlier. If the election had been effective in 1958, the following 
amounts received in 1958, 1959, and 1960 would have been reported in 
1961 and subsequent years:

----------------------------------------------------------------------------------------------------------------
                                                                                 Years of including additional
                                                                    Amount                  amounts
                         Year of receipt                           received  -----------------------------------
                                                                                 1961        1962        1963
----------------------------------------------------------------------------------------------------------------
1958............................................................      $3,000        $500  ..........  ..........
1959............................................................       3,000       1,000        $500  ..........
1960............................................................       3,000       1,000       1,000        $500
----------------------------------------------------------------------------------------------------------------
 Total additional amounts to be included under section 456(d)(1)       2,500       1,500         500
----------------------------------------------------------------------------------------------------------------

    (3) Having included the additional amounts as required by section 
456(d)(1), and assuming such amounts were actually included in gross 
income in the 3 taxable years preceding the first taxable year for which 
the election is effective, X Corporation is entitled to deduct under 
section 456(d)(2) in the year of inclusion and in each of the succeeding 
4 years an amount equal to one-fifth of the amounts included, as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                                         Years of deduction
           Year of inclusion              Amount  --------------------------------------------------------------
                                                     1961     1962     1963     1964     1965     1966     1967
----------------------------------------------------------------------------------------------------------------
1961...................................    $2,500     $500     $500     $500     $500     $500  .......  .......
1962...................................     1,500  .......      300      300      300      300     $300  .......
1963...................................       500  .......  .......      100      100      100      100      $10
                                        -----------
  Total amount deductible under section       500      800      900      900      900      400      100
   456(d)(2)...........................
----------------------------------------------------------------------------------------------------------------

    (4) The net result of the inclusions under section 456(d)(1) and the 
deductions under section 456(d)(2) may be summarized as follows:

----------------------------------------------------------------------------------------------------------------
                                            1961     1962     1963     1964     1965     1966     1967     1968
----------------------------------------------------------------------------------------------------------------
Amount includible under section 456(a)..     $500   $1,500   $2,500   $3,000   $3,000   $3,000   $3,000   $3,000
Amount includible under section             2,500    1,500      500  .......  .......  .......  .......  .......
 456(d)(1)..............................
                                         -----------------------------------------------------------------------
   Total................................    3,000    3,000    3,000    3,000    3,000    3,000    3,000    3,000
Amount deductible under section               500      800      900      900      900      400      100  .......
 456(d)(2)..............................
                                         -----------------------------------------------------------------------

[[Page 161]]

 
   Net amount reportable under section      2,500    2,200    2,100    2,100    2,100    2,600    2,900    3,000
   456..................................
----------------------------------------------------------------------------------------------------------------


[T.D. 6937, 32 FR 16396, Nov. 30. 1967]



Sec. 1.457-1  General overviews of section 457.

    Section 457 provides rules for nonqualified deferred compensation 
plans established by eligible employers as defined under Sec. 1.457-
2(d). Eligible employers can establish either deferred compensation 
plans that are eligible plans and that meet the requirements of section 
457(b) and Sec. Sec. 1.457-3 through 1.457-10, or deferred compensation 
plans or arrangements that do not meet the requirements of section 
457(b) and Sec. Sec. 1.457-3 through 1.457-10 and that are subject to 
tax treatment under section 457(f) and Sec. 1.457-11.

[T.D. 9075, 68 FR 41234, July 11, 2003]



Sec. 1.457-2  Definitions.

    This section sets forth the definitions that are used under 
Sec. Sec. 1.457-1 through 1.457-11.
    (a) Amount(s) deferred. Amount(s) deferred means the total annual 
deferrals under an eligible plan in the current and prior years, 
adjusted for gain or loss. Except as provided at Sec. Sec. 1.457-
4(c)(1)(iii) and 1.457-6(a), amount(s) deferred includes any rollover 
amount held by an eligible plan as provided under Sec. 1.457-10(e).
    (b) Annual deferral(s)--(1) Annual deferral(s) means, with respect 
to a taxable year, the amount of compensation deferred under an eligible 
plan, whether by salary reduction or by nonelective employer 
contribution. The amount of compensation deferred under an eligible plan 
is taken into account as an annual deferral in the taxable year of the 
participant in which deferred, or, if later, the year in which the 
amount of compensation deferred is no longer subject to a substantial 
risk of forfeiture.
    (2) If the amount of compensation deferred under the plan during a 
taxable year is not subject to a substantial risk of forfeiture, the 
amount taken into account as an annual deferral is not adjusted to 
reflect gain or loss allocable to the compensation deferred. If, 
however, the amount of compensation deferred under the plan during the 
taxable year is subject to a substantial risk of forfeiture, the amount 
of compensation deferred that is taken into account as an annual 
deferral in the taxable year in which the substantial risk of forfeiture 
lapses must be adjusted to reflect gain or loss allocable to the 
compensation deferred until the substantial risk of forfeiture lapses.
    (3) If the eligible plan is a defined benefit plan within the 
meaning of section 414(j), the annual deferral for a taxable year is the 
present value of the increase during the taxable year of the 
participant's accrued benefit that is not subject to a substantial risk 
of forfeiture (disregarding any such increase attributable to prior 
annual deferrals). For this purpose, present value must be determined 
using actuarial assumptions and methods that are reasonable (both 
individually and in the aggregate), as determined by the Commissioner.
    (4) For purposes solely of applying Sec. 1.457-4 to determine the 
maximum amount of the annual deferral for a participant for a taxable 
year under an eligible plan, the maximum amount is reduced by the amount 
of any deferral for the participant under a plan described at paragraph 
(k)(4)(i) of this section (relating to certain plans in existence before 
January 1, 1987) as if that deferral were an annual deferral under 
another eligible plan of the employer.
    (c) Beneficiary. Beneficiary means a person who is entitled to 
benefits in respect of a participant following the participant's death 
or an alternate payee as described in Sec. 1.457-10(c).
    (d) Catch-up. Catch-up amount or catch-up limitation for a 
participant for a taxable year means the annual deferral permitted under 
section 414(v) (as described in Sec. 1.457-4(c)(2)) or section 
457(b)(3) (as described in Sec. 1.457-4(c)(3)) to the extent the amount 
of the annual deferral for the participant for

[[Page 162]]

the taxable year is permitted to exceed the plan ceiling applicable 
under section 457(b)(2) (as described in Sec. 1.457-4(c)(1)).
    (e) Eligible employer. Eligible employer means an entity that is a 
State that establishes a plan or a tax-exempt entity that establishes a 
plan. The performance of services as an independent contractor for a 
State or local government or a tax-exempt entity is treated as the 
performance of services for an eligible employer. The term eligible 
employer does not include a church as defined in section 3121(w)(3)(A), 
a qualified church-controlled organization as defined in section 
3121(w)(3)(B), or the Federal government or any agency or 
instrumentality thereof. Thus, for example, a nursing home which is 
associated with a church, but which is not itself a church (as defined 
in section 3121(w)(3)(A)) or a qualified church-controlled organization 
as defined in section 3121(w)(3)(B)), would be an eligible employer if 
it is a tax-exempt entity as defined in paragraph (m) of this section.
    (f) Eligible plan. An eligible plan is a plan that meets the 
requirements of Sec. Sec. 1.457-3 through 1.457-10 that is established 
and maintained by an eligible employer. An eligible governmental plan is 
an eligible plan that is established and maintained by an eligible 
employer as defined in paragraph (l) of this section. An arrangement 
does not fail to constitute a single eligible governmental plan merely 
because the arrangement is funded through more than one trustee, 
custodian, or insurance carrier. An eligible plan of a tax-exempt entity 
is an eligible plan that is established and maintained by an eligible 
employer as defined in paragraph (m) of this section.
    (g) Includible compensation. Includible compensation of a 
participant means, with respect to a taxable year, the participant's 
compensation, as defined in section 415(c)(3), for services performed 
for the eligible employer. The amount of includible compensation is 
determined without regard to any community property laws.
    (h) Ineligible plan. Ineligible plan means a plan established and 
maintained by an eligible employer that is not maintained in accordance 
with Sec. Sec. 1.457-3 through 1.457-10. A plan that is not established 
by an eligible employer as defined in paragraph (e) of this section is 
neither an eligible nor an ineligible plan.
    (i) Nonelective employer contribution. A nonelective employer 
contribution is a contribution made by an eligible employer for the 
participant with respect to which the participant does not have the 
choice to receive the contribution in cash or property. Solely for 
purposes of section 457 and Sec. Sec. 1.457-2 through 1.457-11, the 
term nonelective employer contribution includes employer contributions 
that would be described in section 401(m) if they were contributions to 
a qualified plan.
    (j) Participant. Participant in an eligible plan means an individual 
who is currently deferring compensation, or who has previously deferred 
compensation under the plan by salary reduction or by nonelective 
employer contribution and who has not received a distribution of his or 
her entire benefit under the eligible plan. Only individuals who perform 
services for the eligible employer, either as an employee or as an 
independent contractor, may defer compensation under the eligible plan.
    (k) Plan. Plan includes any agreement or arrangement between an 
eligible employer and a participant or participants (including an 
individual employment agreement) under which the payment of compensation 
is deferred (whether by salary reduction or by nonelective employer 
contribution). The following types of plans are not treated as 
agreements or arrangements under which compensation is deferred: a bona 
fide vacation leave, sick leave, compensatory time, severance pay, 
disability pay, or death benefit plan described in section 
457(e)(11)(A)(i) and any plan paying length of service awards to bona 
fide volunteers (and their beneficiaries) on account of qualified 
services performed by such volunteers as described in section 
457(e)(11)(A)(ii). Further, the term plan does not include any of the 
following (and section 457 and Sec. Sec. 1.457-2 through 1.457-11 do 
not apply to any of the following)--
    (1) Any nonelective deferred compensation under which all 
individuals

[[Page 163]]

(other than those who have not satisfied any applicable initial service 
requirement) with the same relationship with the eligible employer are 
covered under the same plan with no individual variations or options 
under the plan as described in section 457(e)(12), but only to the 
extent the compensation is attributable to services performed as an 
independent contractor;
    (2) An agreement or arrangement described in Sec. 1.457-11(b);
    (3) Any plan satisfying the conditions in section 1107(c)(4) of the 
Tax Reform Act of 1986 (100 Stat. 2494) (TRA '86) (relating to certain 
plans for State judges); and
    (4) Any of the following plans or arrangements (to which specific 
transitional statutory exclusions apply)--
    (i) A plan or arrangement of a tax-exempt entity in existence prior 
to January 1, 1987, if the conditions of section 1107(c)(3)(B) of the 
TRA '86, as amended by section 1011(e)(6) of the Technical and 
Miscellaneous Revenue Act of 1988 (102 Stat. 3700) (TAMRA), are 
satisfied (see Sec. 1.457-2(b)(4) for a special rule regarding such 
plan);
    (ii) A collectively bargained nonelective deferred compensation plan 
in effect on December 31, 1987, if the conditions of section 6064(d)(2) 
of TAMRA are satisfied;
    (iii) Amounts described in section 6064(d)(3) of TAMRA (relating to 
certain nonelective deferred compensation arrangements in effect before 
1989); and
    (iv) Any plan satisfying the conditions in section 1107(c)(4) or (5) 
of TRA '86 (relating to certain plans for certain individuals with 
respect to which the Service issued guidance before 1977).
    (l) State. State means a State (treating the District of Columbia as 
a State as provided under section 7701(a)(10)), a political subdivision 
of a State, and any agency or instrumentality of a State.
    (m) Tax-exempt entity. Tax-exempt entity includes any organization 
exempt from tax under subtitle A of the Internal Revenue Code, except 
that a governmental unit (including an international governmental 
organization) is not a tax-exempt entity.
    (n) Trust. Trust means a trust described under section 457(g) and 
Sec. 1.457-8. Custodial accounts and contracts described in section 
401(f) are treated as trusts under the rules described in Sec. 1.457-
8(a)(2).

[T.D. 9075, 68 FR 41234, July 11, 2003; 68 FR 51446, Aug. 27, 2003]



Sec. 1.457-3  General introduction to eligible plans.

    (a) Compliance in form and operation. An eligible plan is a written 
plan established and maintained by an eligible employer that is 
maintained, in both form and operation, in accordance with the 
requirements of Sec. Sec. 1.457-4 through 1.457-10. An eligible plan 
must contain all the material terms and conditions for benefits under 
the plan. An eligible plan may contain certain optional features not 
required for plan eligibility under section 457(b), such as 
distributions for unforeseeable emergencies, loans, plan-to-plan 
transfers, additional deferral elections, acceptance of rollovers to the 
plan, and distributions of smaller accounts to eligible participants. 
However, except as otherwise specifically provided in Sec. Sec. 1.457-4 
through 1.457-10, if an eligible plan contains any optional provisions, 
the optional provisions must meet, in both form and operation, the 
relevant requirements under section 457 and Sec. Sec. 1.457-2 through 
1.457-10.
    (b) Treatment as single plan. In any case in which multiple plans 
are used to avoid or evade the requirements of Sec. Sec. 1.457-4 
through 1.457-10, the Commissioner may apply the rules under Sec. Sec. 
1.457-4 through 1.457-10 as if the plans were a single plan. See also 
Sec. 1.457-4(c)(3)(v) (requiring an eligible employer to have no more 
than one normal retirement age for each participant under all of the 
eligible plans it sponsors), the second sentence of Sec. 1.457-4(e)(2) 
(treating deferrals under all eligible plans under which an individual 
participates by virtue of his or her relationship with a single employer 
as a single plan for purposes of determining excess deferrals), and 
Sec. 1.457-5 (combining annual deferrals under all eligible plans).

[T.D. 9075, 68 FR 41234, July 11, 2003]

[[Page 164]]



Sec. 1.457-4  Annual deferrals, deferral limitations, and deferral 
agreements under eligible plans.

    (a) Taxation of annual deferrals. Annual deferrals that satisfy the 
requirements of paragraphs (b) and (c) of this section are excluded from 
the gross income of a participant in the year deferred or contributed 
and are not includible in gross income until paid to the participant in 
the case of an eligible governmental plan, or until paid or otherwise 
made available to the participant in the case of an eligible plan of a 
tax-exempt entity. See Sec. 1.457-7.
    (b) Agreement for deferral. In order to be an eligible plan, the 
plan must provide that compensation may be deferred for any calendar 
month by salary reduction only if an agreement providing for the 
deferral has been entered into before the first day of the month in 
which the compensation is paid or made available. A new employee may 
defer compensation payable in the calendar month during which the 
participant first becomes an employee if an agreement providing for the 
deferral is entered into on or before the first day on which the 
participant performs services for the eligible employer. An eligible 
plan may provide that if a participant enters into an agreement 
providing for deferral by salary reduction under the plan, the agreement 
will remain in effect until the participant revokes or alters the terms 
of the agreement. Nonelective employer contributions are treated as 
being made under an agreement entered into before the first day of the 
calendar month.
    (c) Maximum deferral limitations--(1) Basic annual limitation. (i) 
Except as described in paragraphs (c)(2) and (3) of this section, in 
order to be an eligible plan, the plan must provide that the annual 
deferral amount for a taxable year (the plan ceiling) may not exceed the 
lesser of--
    (A) The applicable annual dollar amount specified in section 
457(e)(15): $11,000 for 2002; $12,000 for 2003; $13,000 for 2004; 
$14,000 for 2005; and $15,000 for 2006 and thereafter. After 2006, the 
$15,000 amount is adjusted for cost-of-living in the manner described in 
paragraph (c)(4) of this section; or
    (B) 100 percent of the participant's includible compensation for the 
taxable year.
    (ii) The amount of annual deferrals permitted by the 100 percent of 
includible compensation limitation under paragraph (c)(1)(i)(B) of this 
section is determined under section 457(e)(5) and Sec. 1.457-2(g).
    (iii) For purposes of determining the plan ceiling under this 
paragraph (c), the annual deferral amount does not include any rollover 
amounts received by the eligible plan under Sec. 1.457-10(e).
    (iv) The provisions of this paragraph (c)(1) are illustrated by the 
following examples:

    Example 1. (i) Facts. Participant A, who earns $14,000 a year, 
enters into a salary reduction agreement in 2006 with A's eligible 
employer and elects to defer $13,000 of A's compensation for that year. 
A is not eligible for the catch-up described in paragraph (c)(2) or (3) 
of this section, participates in no other retirement plan, and has no 
other income exclusions taken into account in computing includible 
compensation.
    (ii) Conclusion. The annual deferral limit for A in 2006 is the 
lesser of $15,000 or 100 percent of includible compensation, $14,000. 
A's annual deferral of $13,000 is permitted under the plan because it is 
not in excess of $14,000 and thus does not exceed 100 percent of A's 
includible compensation.
    Example 2. (i) Facts. Assume the same facts as in Example 1, except 
that A's eligible employer provides an immediately vested, matching 
employer contribution under the plan for participants who make salary 
reduction deferrals under A's eligible plan. The matching contribution 
is equal to 100 percent of elective contributions, but not in excess of 
10 percent of compensation (in A's case, $1,400).
    (ii) Conclusion. Participant A's annual deferral exceeds the 
limitations of this paragraph (c)(1). A's maximum deferral limitation in 
2006 is $14,000. A's salary reduction deferral of $13,000 combined with 
A's eligible employer's nonelective employer contribution of $1,400 
exceeds the basic annual limitation of this paragraph (c)(1) because A's 
annual deferrals total $14,400. A has an excess deferral for the taxable 
year of $400, the amount exceeding A's permitted annual deferral 
limitation. The $400 excess deferral is treated as described in 
paragraph (e) of this section.
    Example 3. (i) Facts. Beginning in year 2002, Eligible Employer X 
contributes $3,000 per year for five years to B's eligible plan account. 
B's interest in the account vests in 2006. B has annual compensation of 
$50,000 in each of the five years 2002 through 2006. B is

[[Page 165]]

41 years old. B is not eligible for the catch-up described in paragraph 
(c)(2) or (3) of this section, participates in no other retirement plan, 
and has no other income exclusions taken into account in computing 
includible compensation. Adjusted for gain or loss, the value of B's 
benefit when B's interest in the account vests in 2006 is $17,000.
    (ii) Conclusion. Under this vesting schedule, $17,000 is taken into 
account as an annual deferral in 2006. B's annual deferrals under the 
plan are limited to a maximum of $15,000 in 2006. Thus, the aggregate of 
the amounts deferred, $17,000, is in excess of B's maximum deferral 
limitation by $2,000. The $2,000 is treated as an excess deferral 
described in paragraph (e) of this section.

    (2) Age 50 catch-up--(i) In general. In accordance with section 
414(v) and the regulations thereunder, an eligible governmental plan may 
provide for catch-up contributions for a participant who is age 50 by 
the end of the year, provided that such age 50 catch-up contributions do 
not exceed the catch-up limit under section 414(v)(2) for the taxable 
year. The maximum amount of age 50 catch-up contributions for a taxable 
year under section 414(v) is as follows: $1,000 for 2002; $2,000 for 
2003; $3,000 for 2004; $4,000 for 2005; and $5,000 for 2006 and 
thereafter. After 2006, the $5,000 amount is adjusted for cost-of-
living. For additional guidance, see regulations under section 414(v).
    (ii) Coordination with special section 457 catch-up. In accordance 
with sections 414(v)(6)(C) and 457(e)(18), the age 50 catch-up described 
in this paragraph (c)(2) does not apply for any taxable year for which a 
higher limitation applies under the special section 457 catch-up under 
paragraph (c)(3) of this section. Thus, for purposes of this paragraph 
(c)(2)(ii) and paragraph (c)(3) of this section, the special section 457 
catch-up under paragraph (c)(3) of this section applies for any taxable 
year if and only if the plan ceiling taking into account paragraph 
(c)(1) of this section and the special section 457 catch-up described in 
paragraph (c)(3) of this section (and disregarding the age 50 catch-up 
described in this paragraph (c)(2)) is larger than the plan ceiling 
taking into account paragraph (c)(1) of this section and the age 50 
catch-up described in this paragraph (c)(2) (and disregarding the 
special section 457 catch-up described in paragraph (c)(3) of this 
section). Thus, if a plan so provides, a participant who is eligible for 
the age 50 catch-up for a year and for whom the year is also one of the 
participant's last three taxable years ending before the participant 
attains normal retirement age is eligible for the larger of--
    (A) The plan ceiling under paragraph (c)(1) of this section and the 
age 50 catch-up described in this paragraph (c)(2) (and disregarding the 
special section 457 catch-up described in paragraph (c)(3) of this 
section) or
    (B) The plan ceiling under paragraph (c)(1) of this section and the 
special section 457 catch-up described in paragraph (c)(3) of this 
section (and disregarding the age 50 catch-up described in this 
paragraph (c)(2)).
    (iii) Examples. The provisions of this paragraph (c)(2) are 
illustrated by the following examples:

    Example 1. (i) Facts. Participant C, who is 55, is eligible to 
participate in an eligible governmental plan in 2006. The plan provides 
a normal retirement age of 65. The plan provides limitations on annual 
deferrals up to the maximum permitted under paragraphs (c)(1) and (3) of 
this section and the age 50 catch-up described in this paragraph (c)(2). 
For 2006, C will receive compensation of $40,000 from the eligible 
employer. C desires to defer the maximum amount possible in 2006. The 
applicable basic dollar limit of paragraph (c)(1)(i)(A) of this section 
is $15,000 for 2006 and the additional dollar amount permitted under the 
age 50 catch-up is $5,000 for 2006.
    (ii) Conclusion. C is eligible for the age 50 catch-up in 2006 
because C is 55 in 2006. However, C is not eligible for the special 
section 457 catch-up under paragraph (c)(3) of this section in 2006 
because 2006 is not one of the last three taxable years ending before C 
attains normal retirement age. Accordingly, the maximum that C may defer 
for 2006 is $20,000.
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that, in 2006, C will attain age 62. The maximum amount that C can elect 
under the special section 457 catch-up under paragraph (c)(3) of this 
section is $2,000 for 2006.
    (ii) Conclusion. The maximum that C may defer for 2006 is $20,000. 
This is the sum of the basic plan ceiling under paragraph (c)(1) of this 
section equal to $15,000 and the age 50 catch-up equal to $5,000. The 
special section 457 catch-up under paragraph (c)(3) of this section is 
not applicable since it provides a smaller plan ceiling.
    Example 3. (i) Facts. The facts are the same as in Example 2, except 
that the maximum additional amount that C can elect under the

[[Page 166]]

special section 457 catch-up under paragraph (c)(3) of this section is 
$7,000 for 2006.
    (ii) Conclusion. The maximum that C may defer for 2006 is $22,000. 
This is the sum of the basic plan ceiling under paragraph (c)(1) of this 
section equal to $15,000, plus the additional special section 457 catch-
up under paragraph (c)(3) of this section equal to $7,000. The 
additional dollar amount permitted under the age 50 catch-up is not 
applicable to C for 2006 because it provides a smaller plan ceiling.

    (3) Special section 457 catch-up--(i) In general. Except as provided 
in paragraph (c)(2)(ii) of this section, an eligible plan may provide 
that, for one or more of the participant's last three taxable years 
ending before the participant attains normal retirement age, the plan 
ceiling is an amount not in excess of the lesser of--
    (A) Twice the dollar amount in effect under paragraph (c)(1)(i)(A) 
of this section; or
    (B) The underutilized limitation determined under paragraph 
(c)(3)(ii) of this section.
    (ii) Underutilized limitation. The underutilized amount determined 
under this paragraph (c)(3)(ii) is the sum of--
    (A) The plan ceiling established under paragraph (c)(1) of this 
section for the taxable year; plus
    (B) The plan ceiling established under paragraph (c)(1) of this 
section (or under section 457(b)(2) for any year before the 
applicability date of this section) for any prior taxable year or years, 
less the amount of annual deferrals under the plan for such prior 
taxable year or years (disregarding any annual deferrals under the plan 
permitted under the age 50 catch-up under paragraph (c)(2) of this 
section).
    (iii) Determining underutilized limitation under paragraph 
(c)(3)(ii)(B) of this section. A prior taxable year is taken into 
account under paragraph (c)(3)(ii)(B) of this section only if it is a 
year beginning after December 31, 1978, in which the participant was 
eligible to participate in the plan, and in which compensation deferred 
(if any) under the plan during the year was subject to a plan ceiling 
established under paragraph (c)(1) of this section. This paragraph 
(c)(3)(iii) is subject to the special rules in paragraph (c)(3)(iv) of 
this section.
    (iv) Special rules concerning application of the coordination limit 
for years prior to 2002 for purposes of determining the underutilized 
limitation--(A) General rule. For purposes of determining the 
underutilized limitation for years prior to 2002, participants remain 
subject to the rules in effect prior to the repeal of the coordination 
limitation under section 457(c)(2). Thus, the applicable basic annual 
limitation under paragraph (c)(1) of this section and the special 
section 457 catch-up under this paragraph (c)(3) for years in effect 
prior to 2002 are reduced, for purposes of determining a participant's 
underutilized amount under a plan, by amounts excluded from the 
participant's income for any prior taxable year by reason of a 
nonelective employer contribution, salary reduction or elective 
contribution under any other eligible section 457(b) plan, or a salary 
reduction or elective contribution under any 401(k) qualified cash or 
deferred arrangement, section 402(h)(1)(B) simplified employee pension 
(SARSEP), section 403(b) annuity contract, and section 408(p) simple 
retirement account, or under any plan for which a deduction is allowed 
because of a contribution to an organization described in section 
501(c)(18) (pre-2002 coordination plans). Similarly, in applying the 
section 457(b)(2)(B) limitation for includible compensation for years 
prior to 2002, the limitation is 33\1/3\ percent of the participant's 
compensation includible in gross income.
    (B) Coordination limitation applied to participant. For purposes of 
determining the underutilized limitation for years prior to 2002, the 
coordination limitation applies to pre-2002 coordination plans of all 
employers for whom a participant has performed services, whether or not 
those are plans of the participant's current eligible employer. Thus, 
for purposes of determining the amount excluded from a participant's 
gross income in any prior taxable year under paragraph (c)(3)(ii)(B) of 
this section, the participant's annual deferrals under an eligible plan, 
and salary reduction or elective deferrals under all other pre-2002 
coordination plans, must be determined on an aggregate basis. To the 
extent that the combined deferrals for years prior to 2002 exceeded the

[[Page 167]]

maximum deferral limitations, the amount is treated as an excess 
deferral under paragraph (e) of this section for those prior years.
    (C) Special rule where no annual deferrals under the eligible plan. 
A participant who, although eligible, did not defer any compensation 
under the eligible plan in any year before 2002 is not subject to the 
coordinated deferral limit, even though the participant may have 
deferred compensation under one of the other pre-2002 coordination 
plans. An individual is treated as not having deferred compensation 
under an eligible plan for a prior taxable year if all annual deferrals 
under the plan are distributed in accordance with paragraph (e) of this 
section. Thus, to the extent that a participant participated solely in 
one or more of the other pre-2002 coordination plans during a prior 
taxable year (and not the eligible plan), the participant is not subject 
to the coordinated limitation for that prior taxable year. However, the 
participant is treated as having deferred an amount in a prior taxable 
year, for purposes of determining the underutilized limitation for that 
prior taxable year under this paragraph (c)(3)(iv)(C), to the extent of 
the participant's aggregate salary reduction contributions and elective 
deferrals under all pre-2002 coordination plans up to the maximum 
deferral limitations in effect under section 457(b) for that prior 
taxable year. To the extent an employer did not offer an eligible plan 
to an individual in a prior given year, no underutilized limitation is 
available to the individual for that prior year, even if the employee 
subsequently becomes eligible to participate in an eligible plan of the 
employer.
    (D) Examples. The provisions of this paragraph (c)(3)(iv) are 
illustrated by the following examples:

    Example 1. (i) Facts. In 2001 and in years prior to 2001, 
Participant D earned $50,000 a year and was eligible to participate in 
both an eligible plan and a section 401(k) plan. However, D had always 
participated only in the section 401(k) plan and had always deferred the 
maximum amount possible. For each year before 2002, the maximum amount 
permitted under section 401(k) exceeded the limitation of paragraph 
(c)(3)(i) of this section. In 2002, D is in the 3-year period prior to 
D's attainment of the eligible plan's normal retirement age of 65, and D 
now wants to participate in the eligible plan and make annual deferrals 
of up to $30,000 under the plan's special section 457 catch-up 
provisions.
    (ii) Conclusion. Participant D is treated as having no underutilized 
amount under paragraph (c)(3)(ii)(B) of this section for 2002 for 
purposes of the catch-up limitation under section 457(b)(3) and 
paragraph (c)(3) of this section because, in each of the years before 
2002, D has deferred an amount equal to or in excess of the limitation 
of paragraph (c)(3)(i) of this section under all of D's coordinated 
plans.
    Example 2. (i) Facts. Assume the same facts as in Example 1, except 
that D only deferred $2,500 per year under the section 401(k) plan for 
one year before 2002.
    (ii) Conclusion. D is treated as having an underutilized amount 
under paragraph (c)(3)(ii)(B) of this section for 2002 for purposes of 
the special section 457 catch-up limitation. This is because D has 
deferred an amount for prior years that is less than the limitation of 
paragraph (c)(1)(i) of this section under all of D's coordinated plans.
    Example 3. (i) Facts. Participant E, who earned $15,000 for 2000, 
entered into a salary reduction agreement in 2000 with E's eligible 
employer and elected to defer $3,000 for that year under E's eligible 
plan. For 2000, E's eligible employer provided an immediately vested, 
matching employer contribution under the plan for participants who make 
salary reduction deferrals under E's eligible plan. The matching 
contribution was equal to 67 percent of elective contributions, but not 
in excess of 10 percent of compensation before salary reduction 
deferrals (in E's case, $1,000). For 2000, E was not eligible for any 
catch-up contribution, participated in no other retirement plan, and had 
no other income exclusions taken into account in computing taxable 
compensation.
    (ii) Conclusion. Participant E's annual deferral equaled the maximum 
limitation of section 457(b) for 2000. E's maximum deferral limitation 
in 2000 was $4,000 because E's includible compensation was $12,000 
($15,000 minus the deferral of $3,000) and the applicable limitation for 
2000 was one third of the individual's includible compensation (one-
third of $12,000 equals $4,000). E's salary reduction deferral of $3,000 
combined with E's eligible employer's matching contribution of $1,000 
equals the limitation of section 457(b) for 2000 because E's annual 
deferrals totaled $4,000. E's underutilized amount for 2000 is zero.

    (v) Normal retirement age--(A) General rule. For purposes of the 
special section 457 catch-up in this paragraph (c)(3), a plan must 
specify the normal retirement age under the plan. A plan may define 
normal retirement age as any

[[Page 168]]

age that is on or after the earlier of age 65 or the age at which 
participants have the right to retire and receive, under the basic 
defined benefit pension plan of the State or tax-exempt entity (or a 
money purchase pension plan in which the participant also participates 
if the participant is not eligible to participate in a defined benefit 
plan), immediate retirement benefits without actuarial or similar 
reduction because of retirement before some later specified age, and 
that is not later than age 70\1/2\. Alternatively, a plan may provide 
that a participant is allowed to designate a normal retirement age 
within these ages. For purposes of the special section 457 catch-up in 
this paragraph (c)(3), an entity sponsoring more than one eligible plan 
may not permit a participant to have more than one normal retirement age 
under the eligible plans it sponsors.
    (B) Special rule for eligible plans of qualified police or 
firefighters. An eligible plan with participants that include qualified 
police or firefighters as defined under section 415(b)(2)(H)(ii)(I) may 
designate a normal retirement age for such qualified police or 
firefighters that is earlier than the earliest normal retirement age 
designated under the general rule of paragraph (c)(3)(i)(A) of this 
section, but in no event may the normal retirement age be earlier than 
age 40. Alternatively, a plan may allow a qualified police or 
firefighter participant to designate a normal retirement age that is 
between age 40 and age 70\1/2\.
    (vi) Examples. The provisions of this paragraph (c)(3) are 
illustrated by the following examples:

    Example 1. (i) Facts. Participant F, who will turn 61 on April 1, 
2006, becomes eligible to participate in an eligible plan on January 1, 
2006. The plan provides a normal retirement age of 65. The plan provides 
limitations on annual deferrals up to the maximum permitted under 
paragraphs (c)(1) through (3) of this section. For 2006, F will receive 
compensation of $40,000 from the eligible employer. F desires to defer 
the maximum amount possible in 2006. The applicable basic dollar limit 
of paragraph (c)(1)(i)(A) of this section is $15,000 for 2006 and the 
additional dollar amount permitted under the age 50 catch-up in 
paragraph (c)(2) of this section for an individual who is at least age 
50 is $5,000 for 2006.
    (ii) Conclusion. F is not eligible for the special section 457 
catch-up under paragraph (c)(3) of this section in 2006 because 2006 is 
not one of the last three taxable years ending before F attains normal 
retirement age. Accordingly, the maximum that F may defer for 2006 is 
$20,000. See also paragraph (c)(2)(iii) Example 1 of this section.
    Example 2. (i) Facts. The facts are the same as in Example 1 except 
that, in 2006, F elects to defer only $2,000 under the plan (rather than 
the maximum permitted amount of $20,000). In addition, assume that the 
applicable basic dollar limit of paragraph (c)(1)(i)(A) of this section 
continues to be $15,000 for 2007 and the additional dollar amount 
permitted under the age 50 catch-up in paragraph (c)(2) of this section 
for an individual who is at least age 50 continues to be $5,000 for 
2007. In F's taxable year 2007, which is one of the last three taxable 
years ending before F attains the plan's normal retirement age of 65, F 
again receives a salary of $40,000 and elects to defer the maximum 
amount permissible under the plan's catch-up provisions prescribed under 
paragraph (c) of this section.
    (ii) Conclusion. For 2007, which is one of the last three taxable 
years ending before F attains the plan's normal retirement age of 65, 
the applicable limit on deferrals for F is the larger of the amount 
under the special section 457 catch-up or $20,000, which is the basic 
annual limitation ($15,000) and the age 50 catch-up limit of section 
414(v) ($5,000). For 2007, F's special section 457 catch-up amount is 
the lesser of two times the basic annual limitation ($30,000) or the sum 
of the basic annual limitation ($15,000) plus the $13,000 underutilized 
limitation under paragraph (c)(3)(ii) of this section (the $15,000 plan 
ceiling in 2006, minus the $2,000 contributed for F in 2006), or 
$28,000. Thus, the maximum amount that F may defer in 2007 is $28,000.
    Example 3. (i) Facts. The facts are the same as in Examples 1 and 2, 
except that F does not make any contributions to the plan before 2010. 
In addition, assume that the applicable basic dollar limitation of 
paragraph (c)(1)(i)(A) of this section continues to be $15,000 for 2010 
and the additional dollar amount permitted under the age 50 catch-up in 
paragraph (c)(2) of this section for an individual who is at least age 
50 continues to be $5,000 for 2010. In F's taxable year 2010, the year 
in which F attains age 65 (which is the normal retirement age under the 
plan), F desires to defer the maximum amount possible under the plan. 
F's compensation for 2010 is again $40,000.
    (ii) Conclusion. For 2010, the maximum amount that F may defer is 
$20,000. The special section 457 catch-up provisions under paragraph 
(c)(3) of this section are not applicable because 2010 is not a taxable 
year ending before the year in which F attains normal retirement age.


[[Page 169]]


    (4) Cost-of-living adjustment. For years beginning after December 
31, 2006, the $15,000 dollar limitation in paragraph (c)(1)(i)(A) of 
this section will be adjusted to take into account increases in the 
cost-of-living. The adjustment in the dollar limitation is made at the 
same time and in the same manner as under section 415(d) (relating to 
qualified plans under section 401(a)), except that the base period is 
the calendar quarter beginning July 1, 2005 and any increase which is 
not a multiple of $500 will be rounded to the next lowest multiple of 
$500.
    (d) Deferral of sick, vacation, and back pay under an eligible 
plan--(1) In general. An eligible plan may provide that a participant 
may elect to defer accumulated sick pay, accumulated vacation pay, and 
back pay under an eligible plan if the requirements of section 457(b) 
are satisfied. For example, the plan must provide, in accordance with 
paragraph (b) of this section, that these amounts may be deferred for 
any calendar month only if an agreement providing for the deferral is 
entered into before the beginning of the month in which the amounts 
would otherwise be paid or made available and the participant is an 
employee in that month. In the case of accumulated sick pay, vacation 
pay, or back pay that is payable before the participant has a severance 
from employment, the requirements of the preceding sentence are deemed 
to be satisfied if the agreement providing for the deferral is entered 
into before the amount is currently available (as defined in regulations 
under section 401(k)).
    (2) Examples. The provisions of this paragraph (d) are illustrated 
by the following examples:

    Example 1. (i) Facts. Participant G, who is age 62 in 2003, is an 
employee who participates in an eligible plan providing a normal 
retirement age of 65. Under the terms of G's employer's eligible plan 
and G's sick leave plan, G may, during November of 2003 (which is one of 
the three years prior to normal retirement age), make a one-time 
election to contribute amounts representing accumulated sick pay to the 
eligible plan in December of 2003 (within the maximum deferral 
limitations). Alternatively, such amounts may remain in the ``bank'' 
under the sick leave plan. No cash out of the sick pay is available 
until the month in which a participant ceases to be employed by the 
employer. The total value of G's accumulated sick pay (determined, in 
accordance with the terms of the sick leave plan, by reference to G's 
current salary) is $4,000 in December of 2003.
    (ii) Conclusion. Under the terms of the eligible plan and sick leave 
plan, G may elect before December of 2003 to defer the $4,000 value of 
accumulated sick pay under the eligible plan, provided that G's other 
annual deferrals to the eligible plan for 2003, when added to the 
$4,000, do not exceed G's maximum deferral limitation for the year.
    Example 2. (i) Facts. Same facts as in Example 1, except that G will 
separate from service on January 17, 2004, and elects, on January 4, 
2004, to defer G's accumulated sick and vacation pay (which totals 
$12,000) that is payable on January 15, 2004.
    (ii) Conclusion. G may elect before January 15, 2004 to defer the 
accumulated sick and vacation pay under the eligible plan, even if the 
election is made after the beginning of January, because the agreement 
providing for the deferral is entered into before the amount is 
currently available and G does not cease to be an employee before the 
amount is currently available. G will have $12,000 of includible 
compensation in 2004 because the deferral is taken into account in the 
definition of includible compensation.
    Example 3. (i) Facts. Employer X maintains an eligible plan and a 
vacation leave plan. Under the terms of the vacation leave plan, 
employees generally accrue three weeks of vacation per year. Up to one 
week's unused vacation may be carried over from one year to the next, so 
that in any single year an employee may have a maximum of four weeks 
vacation time. At the beginning of each calendar year, under the terms 
of the eligible plan (which constitutes an agreement providing for the 
deferral), the value of any unused vacation time from the prior year in 
excess of one week is automatically contributed to the eligible plan, to 
the extent of the employee's maximum deferral limitations. Amounts in 
excess of the maximum deferral limitations are forfeited.
    (ii) Conclusion. The value of the unused vacation pay contributed to 
X's eligible plan pursuant to the terms of the plan and the terms of the 
vacation leave plan is treated as an annual deferral to the eligible 
plan in the calendar year the contribution is made. No amounts 
contributed to the eligible plan will be considered made available to a 
participant in X's eligible plan.

    (e) Excess deferrals under an eligible plan--(1) In general. Any 
amount deferred under an eligible plan for the taxable year of a 
participant that exceeds the maximum deferral limitations set forth in 
paragraphs (c)(1) through (3) of this section, and any

[[Page 170]]

amount that exceeds the individual limitation under Sec. 1.457-5, 
constitutes an excess deferral that is taxable in accordance with Sec. 
1.457-11 for that taxable year. Thus, an excess deferral is includible 
in gross income in the taxable year deferred or, if later, the first 
taxable year in which there is no substantial risk of forfeiture.
    (2) Excess deferrals under an eligible governmental plan other than 
as a result of the individual limitation. In order to be an eligible 
governmental plan, the plan must provide that any excess deferral 
resulting from a failure of a plan to apply the limitations of 
paragraphs (c)(1) through (3) of this section to amounts deferred under 
the eligible plan (computed without regard to the individual limitation 
under Sec. 1.457-5) will be distributed to the participant, with 
allocable net income, as soon as administratively practicable after the 
plan determines that the amount is an excess deferral. For purposes of 
determining whether there is an excess deferral resulting from a failure 
of a plan to apply the limitations of paragraphs (c)(1) through (3) of 
this section, all plans under which an individual participates by virtue 
of his or her relationship with a single employer are treated as a 
single plan (without regard to any differences in funding). An eligible 
governmental plan does not fail to satisfy the requirements of 
paragraphs (a) through (d) of this section or Sec. Sec. 1.457-6 through 
1.457-10 (including the distribution rules under Sec. 1.457-6 and the 
funding rules under Sec. 1.457-8) solely by reason of a distribution 
made under this paragraph (e)(2). If such excess deferrals are not 
corrected by distribution under this paragraph (e)(2), the plan will be 
an ineligible plan under which benefits are taxable in accordance with 
Sec. 1.457-11.
    (3) Excess deferrals under an eligible plan of a tax-exempt employer 
other than as a result of the individual limitation. If a plan of a tax-
exempt employer fails to comply with the limitations of paragraphs 
(c)(1) through (3) of this section, the plan will be an ineligible plan 
under which benefits are taxable in accordance with Sec. 1.457-11. 
However, a plan may distribute to a participant any excess deferrals 
(and any income allocable to such amount) not later than the first April 
15 following the close of the taxable year of the excess deferrals. In 
such a case, the plan will continue to be treated as an eligible plan. 
However, any excess deferral is included in the gross income of a 
participant for the taxable year of the excess deferral. If the excess 
deferrals are not corrected by distribution under this paragraph (e)(3), 
the plan is an ineligible plan under which benefits are taxable in 
accordance with Sec. 1.457-11. For purposes of determining whether 
there is an excess deferral resulting from a failure of a plan to apply 
the limitations of paragraphs (c)(1) through (3) of this section, all 
eligible plans under which an individual participates by virtue of his 
or her relationship with a single employer are treated as a single plan.
    (4) Excess deferrals arising from application of the individual 
limitation. An eligible plan may provide that an excess deferral that is 
a result solely of a failure to comply with the individual limitation 
under Sec. 1.457-5 for a taxable year may be distributed to the 
participant, with allocable net income, as soon as administratively 
practicable after the plan determines that the amount is an excess 
deferral. An eligible plan does not fail to satisfy the requirements of 
paragraphs (a) through (d) of this section or Sec. Sec. 1.457-6 through 
1.457-10 (including the distribution rules under Sec. 1.457-6 and the 
funding rules under Sec. 1.457-8) solely by reason of a distribution 
made under this paragraph (e)(4). Although a plan will still maintain 
eligible status if excess deferrals are not distributed under this 
paragraph (e)(4), a participant must include the excess amounts in 
income as provided in paragraph (e)(1) of this section.
    (5) Examples. The provisions of this paragraph (e) are illustrated 
by the following examples:

    Example 1. (i) Facts. In 2006, the eligible plan of State Employer X 
in which Participant H participates permits a maximum deferral of the 
lesser of $15,000 or 100 percent of includible compensation. In 2006, H, 
who has compensation of $28,000, nevertheless defers $16,000 under the 
eligible plan. Participant H is age 45 and normal retirement age under 
the plan is age 65. For 2006, the applicable dollar limit under 
paragraph (c)(1)(i)(A) of this section is $15,000. Employer X discovers

[[Page 171]]

the error in January of 2007 when it completes H's 2006 Form W-2 and 
promptly distributes $1,022 to H (which is the sum of the $1,000 excess 
and $22 of allocable net income).
    (ii) Conclusion. Participant H has deferred $1,000 in excess of the 
$15,000 limitation provided for under the plan for 2006. The $1,000 
excess must be included by H in H's income for 2006. In order to correct 
the failure and still be an eligible plan, the plan must distribute the 
excess deferral, with allocable net income, as soon as administratively 
practicable after determining that the amount exceeds the plan deferral 
limitations. In this case, $22 of the distribution of $1,022 is included 
in H's gross income for 2007 (and is not an eligible rollover 
distribution). If the excess deferral were not distributed, the plan 
would be an ineligible plan with respect to which benefits are taxable 
in accordance with Sec. 1.457-11.
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that X uses a number of separate arrangements with different trustees 
and annuity insurers to permit employees to defer and H elects deferrals 
under several of the funding arrangements none of which exceeds $15,000 
for any individual funding arrangement, but which total $16,000.
    (ii) Conclusion. The conclusion is the same as in Example 1.
    Example 3. (i) Facts. The facts are the same as in Example 1, except 
that H's deferral under the eligible plan is limited to $11,000 and H 
also makes a salary reduction contribution of $5,000 to an annuity 
contract under section 403(b) with the same Employer X.
    (ii) Conclusion. H's deferrals are within the plan deferral 
limitations of Employer X. Because of the repeal of the application of 
the coordination limitation under former paragraph (2) of section 
457(c), H's salary reduction deferrals under the annuity contract are no 
longer considered in determining H's applicable deferral limits under 
paragraphs (c)(1) through (3) of this section.
    Example 4. (i) Facts. The facts are the same as in Example 1, except 
that H's deferral under the eligible governmental plan is limited to 
$14,000 and H also makes a deferral of $4,000 to an eligible 
governmental plan of a different employer. Participant H is age 45 and 
normal retirement age under both eligible plans is age 65.
    (ii) Conclusion. Because of the application of the individual 
limitation under Sec. 1.457-5, H has an excess deferral of $3,000 (the 
sum of $14,000 plus $4,000 equals $18,000, which is $3,000 in excess of 
the dollar limitation of $15,000). The $3,000 excess deferral, with 
allocable net income, may be distributed from either plan as soon as 
administratively practicable after determining that the combined amount 
exceeds the deferral limitations. If the $3,000 excess deferral is not 
distributed to H, each plan will continue to be an eligible plan, but 
the $3,000 must be included by H in H's income for 2006.
    Example 5. (i) Facts. Assume the same facts as in Example 3, except 
that H's deferral under the eligible governmental plan is limited to 
$14,000 and H also makes a deferral of $4,000 to an eligible plan of 
Employer Y, a tax-exempt entity.
    (ii) Conclusion. The results are the same as in Example 3, namely, 
because of the application of the individual limitation under Sec. 
1.457-5, H has an excess deferral of $3,000. If the $3,000 excess 
deferral is not distributed to H, each plan will continue to be an 
eligible plan, but the $3,000 must be included by H in H's income for 
2006.
    Example 6. (i) Facts. Assume the same facts as in Example 5, except 
that X is a tax-exempt entity and thus its plan is an eligible plan of a 
tax-exempt entity.
    (ii) Conclusion. The results are the same as in Example 5, namely, 
because of the application of the individual limitation under Sec. 
1.457-5, H has an excess deferral of $3,000. If the $3,000 excess 
deferral is not distributed to H, each plan will continue to be an 
eligible plan, but the $3,000 must be included by H into H's income for 
2006.

[T.D. 9075, 68 FR 41234, July 11, 2003; 68 FR 51446, Aug. 27, 2003]



Sec. 1.457-5  Individual limitation for combined annual deferrals 
under multiple eligible plans

    (a) General rule. The individual limitation under section 457(c) and 
this section equals the basic annual deferral limitation under Sec. 
1.457-4(c)(1)(i)(A), plus either the age 50 catch-up amount under Sec. 
1.457-4(c)(2), or the special section 457 catch-up amount under Sec. 
1.457-4(c)(3), applied by taking into account the combined annual 
deferral for the participant for any taxable year under all eligible 
plans. While an eligible plan may include provisions under which it will 
limit deferrals to meet the individual limitation under section 457(c) 
and this section, annual deferrals by a participant that exceed the 
individual limit under section 457(c) and this section (but do not 
exceed the limits under Sec. 1.457-4(c)) will not cause a plan to lose 
its eligible status. However, to the extent the combined annual 
deferrals for a participant for any taxable year exceed the individual 
limitation under section 457(c) and this section for that year, the 
amounts are treated as excess deferrals as described in Sec. 1.457-
4(e).

[[Page 172]]

    (b) Limitation applied to participant. The individual limitation in 
this section applies to eligible plans of all employers for whom a 
participant has performed services, including both eligible governmental 
plans and eligible plans of a tax-exempt entity and both eligible plans 
of the employer and eligible plans of other employers. Thus, for 
purposes of determining the amount excluded from a participant's gross 
income in any taxable year (including the underutilized limitation under 
Sec. 1.457-4 (c)(3)(ii)(B)), the participant's annual deferral under an 
eligible plan, and the participant's annual deferrals under all other 
eligible plans, must be determined on an aggregate basis. To the extent 
that the combined annual deferral amount exceeds the maximum deferral 
limitation applicable under Sec. 1.457-4 (c)(1)(i)(A), (c)(2), or 
(c)(3), the amount is treated as an excess deferral under Sec. 1.457-
4(e).
    (c) Special rules for catch-up amounts under multiple eligible 
plans. For purposes of applying section 457(c) and this section, the 
special section 457 catch-up under Sec. 1.457-4 (c)(3) is taken into 
account only to the extent that an annual deferral is made for a 
participant under an eligible plan as a result of plan provisions 
permitted under Sec. 1.457-4 (c)(3). In addition, if a participant has 
annual deferrals under more than one eligible plan and the applicable 
catch-up amount under Sec. 1.457-4 (c)(2) or (3) is not the same for 
each such eligible plan for the taxable year, section 457(c) and this 
section are applied using the catch-up amount under whichever plan has 
the largest catch-up amount applicable to the participant.
    (d) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. (i) Facts. Participant F is age 62 in 2006 and 
participates in two eligible plans during 2006, Plans J and K, which are 
each eligible plans of two different governmental entities. Each plan 
includes provisions allowing the maximum annual deferral permitted under 
Sec. 1.457-4(c)(1) through (3). For 2006, the underutilized amount 
under Sec. 1.457-4 (c)(3)(ii)(B) is $20,000 under Plan J and is $40,000 
under Plan K. Normal retirement age is age 65 under both plans. 
Participant F defers $15,000 under each plan. Participant F's includible 
compensation is in each case in excess of the deferral. Neither plan 
designates the $15,000 contribution as a catch-up permitted under each 
plan's special section 457 catch-up provisions.
    (ii) Conclusion. For purposes of applying this section to 
Participant F for 2006, the maximum exclusion is $20,000. This is equal 
to the sum of $15,000 plus $5,000, which is the age 50 catch-up amount. 
Thus, F has an excess amount of $10,000 which is treated as an excess 
deferral for Participant F for 2006 under Sec. 1.457-4(e).
    Example 2. (i) Facts. Participant E, who will turn 63 on April 1, 
2006, participates in four eligible plans during 2006 Plan W which is an 
eligible governmental plan; and Plans X, Y, and Z which are each 
eligible plans of three different tax-exempt entities. For 2006, the 
limitation that applies to Participant E under all four plans under 
Sec. 1.457-4 (c)(1)(i)(A) is $15,000. For 2006, the additional age 50 
catch-up limitation that applies to Participant E under all four plans 
under Sec. 1.457-4 (c)(2) is $5,000. Further, for 2006, different 
limitations under Sec. 1.457-4(c)(3) and (c)(3)(ii)(B) apply to 
Participant E under each of these plans, as follows: under Plan W, the 
underutilized limitation under Sec. 1.457-4 (c)(3)(ii)(B) is $7,000; 
under Plan X, the underutilized limitation under Sec. 1.457-4 
(c)(3)(ii)(B) is $2,000; under Plan Y, the underutilized limitation 
under Sec. 1.457-4 (c)(3)(ii)(B) is $8,000; and under Plan Z, Sec. 
1.457-4 (c)(3) is not applicable since normal retirement age is age 62 
under Plan Z. Participant E's includible compensation is in each case in 
excess of any applicable deferral.
    (ii) Conclusion. For purposes of applying this section to 
Participant E for 2006, Participant E could elect to defer $23,000 under 
Plan Y, which is the maximum deferral limitation under Sec. 1.457-4 
(c)(1) through (3), and to defer no amount under Plans W, X, and Z. The 
$23,000 maximum amount is equal to the sum of $15,000 plus $8,000, which 
is the catch-up amount applicable to Participant E under Plan Y and 
which is the largest catch-up amount applicable to Participant E under 
any of the four plans for 2006. Alternatively, Participant E could 
instead elect to defer the following combination of amounts: an 
aggregate total of $20,000 to any of the four plans; or $22,000 to Plan 
W and none to any of the other three plans.
    (iii) If the underutilized amount under Plans W, X, and Y for 2006 
were in each case zero (because E had always contributed the maximum 
amount or E was a new participant) or an amount not in excess of $5,000, 
the maximum exclusion under this section would be $20,000 for 
Participant E for 2006 ($15,000 plus the $5,000 age 50 catch-up amount), 
which Participant E could contribute to any of the plans.

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51446, Aug. 26, 2003]

[[Page 173]]



Sec. 1.457-6  Timing of distributions under eligible plans.

    (a) In general. Except as provided in paragraph (c) of this section 
(relating to distributions on account of an unforeseeable emergency), 
paragraph (e) of this section (relating to distributions of small 
accounts), Sec. 1.457-10(a) (relating to plan terminations), or Sec. 
1.457-10(c) (relating to domestic relations orders), amounts deferred 
under an eligible governmental plan may not be paid to a participant or 
beneficiary before the participant has a severance from employment with 
the eligible employer or when the participant attains age 70\1/2\, if 
earlier. For rules relating to loans, see paragraph (f) of this section. 
This section does not apply to distributions of excess amounts under 
Sec. 1.457-4(e). However, except to the extent set forth by the 
Commissioner in revenue rulings, notices, and other guidance published 
in the Internal Revenue Bulletin, this section applies to amounts held 
in a separate account for eligible rollover distributions maintained by 
an eligible governmental plan as described in Sec. 1.457-10(e)(2).
    (b) Severance from employment--(1) Employees. An employee has a 
severance from employment with the eligible employer if the employee 
dies, retires, or otherwise has a severance from employment with the 
eligible employer. See regulations under section 401(k) for additional 
guidance concerning severance from employment.
    (2) Independent contractors--(i) In general. An independent 
contractor is considered to have a severance from employment with the 
eligible employer upon the expiration of the contract (or in the case of 
more than one contract, all contracts) under which services are 
performed for the eligible employer if the expiration constitutes a 
good-faith and complete termination of the contractual relationship. An 
expiration does not constitute a good faith and complete termination of 
the contractual relationship if the eligible employer anticipates a 
renewal of a contractual relationship or the independent contractor 
becoming an employee. For this purpose, an eligible employer is 
considered to anticipate the renewal of the contractual relationship 
with an independent contractor if it intends to contract again for the 
services provided under the expired contract, and neither the eligible 
employer nor the independent contractor has eliminated the independent 
contractor as a possible provider of services under any such new 
contract. Further, an eligible employer is considered to intend to 
contract again for the services provided under an expired contract if 
the eligible employer's doing so is conditioned only upon incurring a 
need for the services, the availability of funds, or both.
    (ii) Special rule. Notwithstanding paragraph (b)(2)(i) of this 
section, the plan is considered to satisfy the requirement described in 
paragraph (a) of this section that no amounts deferred under the plan be 
paid or made available to the participant before the participant has a 
severance from employment with the eligible employer if, with respect to 
amounts payable to a participant who is an independent contractor, an 
eligible plan provides that--
    (A) No amount will be paid to the participant before a date at least 
12 months after the day on which the contract expires under which 
services are performed for the eligible employer (or, in the case of 
more than one contract, all such contracts expire); and
    (B) No amount payable to the participant on that date will be paid 
to the participant if, after the expiration of the contract (or 
contracts) and before that date, the participant performs services for 
the eligible employer as an independent contractor or an employee.
    (c) Rules applicable to distributions for unforeseeable 
emergencies--(1) In general. An eligible plan may permit a distribution 
to a participant or beneficiary faced with an unforeseeable emergency. 
The distribution must satisfy the requirements of paragraph (c)(2) of 
this section.
    (2) Requirements--(i) Unforeseeable emergency defined. An 
unforeseeable emergency must be defined in the plan as a severe 
financial hardship of the participant or beneficiary resulting from an 
illness or accident of the participant or beneficiary, the participant's 
or beneficiary's spouse, or the participant's or beneficiary's dependent 
(as defined in section 152(a)); loss of

[[Page 174]]

the participant's or beneficiary's property due to casualty (including 
the need to rebuild a home following damage to a home not otherwise 
covered by homeowner's insurance, e.g., as a result of a natural 
disaster); or other similar extraordinary and unforeseeable 
circumstances arising as a result of events beyond the control of the 
participant or the beneficiary. For example, the imminent foreclosure of 
or eviction from the participant's or beneficiary's primary residence 
may constitute an unforeseeable emergency. In addition, the need to pay 
for medical expenses, including non-refundable deductibles, as well as 
for the cost of prescription drug medication, may constitute an 
unforeseeable emergency. Finally, the need to pay for the funeral 
expenses of a spouse or a dependent (as defined in section 152(a)) may 
also constitute an unforeseeable emergency. Except as otherwise 
specifically provided in this paragraph (c)(2)(i), the purchase of a 
home and the payment of college tuition are not unforeseeable 
emergencies under this paragraph (c)(2)(i).
    (ii) Unforeseeable emergency distribution standard. Whether a 
participant or beneficiary is faced with an unforeseeable emergency 
permitting a distribution under this paragraph (c) is to be determined 
based on the relevant facts and circumstances of each case, but, in any 
case, a distribution on account of unforeseeable emergency may not be 
made to the extent that such emergency is or may be relieved through 
reimbursement or compensation from insurance or otherwise, by 
liquidation of the participant's assets, to the extent the liquidation 
of such assets would not itself cause severe financial hardship, or by 
cessation of deferrals under the plan.
    (iii) Distribution necessary to satisfy emergency need. 
Distributions because of an unforeseeable emergency must be limited to 
the amount reasonably necessary to satisfy the emergency need (which may 
include any amounts necessary to pay any federal, state, or local income 
taxes or penalties reasonably anticipated to result from the 
distribution).
    (d) Minimum required distributions for eligible plans. In order to 
be an eligible plan, a plan must meet the distribution requirements of 
section 457(d)(1) and (2). Under section 457(d)(2), a plan must meet the 
minimum distribution requirements of section 401(a)(9). See section 
401(a)(9) and the regulations thereunder for these requirements. Section 
401(a)(9) requires that a plan begin lifetime distributions to a 
participant no later than April 1 of the calendar year following the 
later of the calendar year in which the participant attains age 70\1/2\ 
or the calendar year in which the participant retires.
    (e) Distributions of smaller accounts--(1) In general. An eligible 
plan may provide for a distribution of all or a portion of a 
participant's benefit if this paragraph (e)(1) is satisfied. This 
paragraph (e)(1) is satisfied if the participant's total amount deferred 
(the participant's total account balance) which is not attributable to 
rollover contributions (as defined in section 411(a)(11)(D)) is not in 
excess of the dollar limit under section 411(a)(11)(A), no amount has 
been deferred under the plan by or for the participant during the two-
year period ending on the date of the distribution, and there has been 
no prior distribution under the plan to the participant under this 
paragraph (e). An eligible plan is not required to permit distributions 
under this paragraph (e).
    (2) Alternative provisions possible. Consistent with the provisions 
of paragraph (e)(1) of this section, a plan may provide that the total 
amount deferred for a participant or beneficiary will be distributed 
automatically to the participant or beneficiary if the requirements of 
paragraph (e)(1) of this section are met. Alternatively, if the 
requirements of paragraph (e)(1) of this section are met, the plan may 
provide for the total amount deferred for a participant or beneficiary 
to be distributed to the participant or beneficiary only if the 
participant or beneficiary so elects. The plan is permitted to 
substitute a specified dollar amount that is less than the total amount 
deferred. In addition, these two alternatives can be combined; for 
example, a plan could provide for automatic distributions for up to 
$500, but allow a participant or beneficiary to elect a distribution if 
the total account balance is above $500.

[[Page 175]]

    (f) Loans from eligible plans--(1) Eligible plans of tax-exempt 
entities. If a participant or beneficiary receives (directly or 
indirectly) any amount deferred as a loan from an eligible plan of a 
tax-exempt entity, that amount will be treated as having been paid or 
made available to the individual as a distribution under the plan, in 
violation of the distribution requirements of section 457(d).
    (2) Eligible governmental plans. The determination of whether the 
availability of a loan, the making of a loan, or a failure to repay a 
loan made from a trustee (or a person treated as a trustee under section 
457(g)) of an eligible governmental plan to a participant or beneficiary 
is treated as a distribution (directly or indirectly) for purposes of 
this section, and the determination of whether the availability of the 
loan, the making of the loan, or a failure to repay the loan is in any 
other respect a violation of the requirements of section 457(b) and the 
regulations, depends on the facts and circumstances. Among the facts and 
circumstances are whether the loan has a fixed repayment schedule and 
bears a reasonable rate of interest, and whether there are repayment 
safeguards to which a prudent lender would adhere. Thus, for example, a 
loan must bear a reasonable rate of interest in order to satisfy the 
exclusive benefit requirement of section 457(g)(1) and Sec. 1.457-
8(a)(1). See also Sec. 1.457-7(b)(3) relating to the application of 
section 72(p) with respect to the taxation of a loan made under an 
eligible governmental plan, and Sec. 1.72(p)-1 relating to section 
72(p)(2).
    (3) Example. The provisions of paragraph (f)(2) of this section are 
illustrated by the following example:

    Example. (i) Facts. Eligible Plan X of State Y is funded through 
Trust Z. Plan X permits an employee's account balance under Plan X to be 
paid in a single sum at severance from employment with State Y. Plan X 
includes a loan program under which any active employee with a vested 
account balance may receive a loan from Trust Z. Loans are made pursuant 
to plan provisions regarding loans that are set forth in the plan under 
which loans bear a reasonable rate of interest and are secured by the 
employee's account balance. In order to avoid taxation under Sec. 
1.457-7(b)(3) and section 72(p)(1), the plan provisions limit the amount 
of loans and require loans to be repaid in level installments as 
required under section 72(p)(2). Participant J's vested account balance 
under Plan X is $50,000. J receives a loan from Trust Z in the amount of 
$5,000 on December 1, 2003, to be repaid in level installments made 
quarterly over the 5-year period ending on November 30, 2008. 
Participant J makes the required repayments until J has a severance from 
employment from State Y in 2005 and subsequently fails to repay the 
outstanding loan balance of $2,250. The $2,250 loan balance is offset 
against J's $80,000 account balance benefit under Plan X, and J elects 
to be paid the remaining $77,750 in 2005.
    (ii) Conclusion. The making of the loan to J will not be treated as 
a violation of the requirements of section 457(b) or the regulations. 
The cancellation of the loan at severance from employment does not cause 
Plan X to fail to satisfy the requirements for plan eligibility under 
section 457. In addition, because the loan satisfies the maximum amount 
and repayment requirements of section 72(p)(2), J is not required to 
include any amount in income as a result of the loan until 2005, when J 
has income of $2,250 as a result of the offset (which is a permissible 
distribution under this section) and income of $77,750 as a result of 
the distribution made in 2005.

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51446, Aug. 27, 2003]



Sec. 1.457-7  Taxation of Distributions Under Eligible Plans.

    (a) General rules for when amounts are included in gross income. The 
rules for determining when an amount deferred under an eligible plan is 
includible in the gross income of a participant or beneficiary depend on 
whether the plan is an eligible governmental plan or an eligible plan of 
a tax-exempt entity. Paragraph (b) of this section sets forth the rules 
for an eligible governmental plan. Paragraph (c) of this section sets 
forth the rules for an eligible plan of a tax-exempt entity.
    (b) Amounts included in gross income under an eligible governmental 
plan--(1) Amounts included in gross income in year paid under an 
eligible governmental plan. Except as provided in paragraphs (b)(2) and 
(3) of this section (or in Sec. 1.457-10(c) relating to payments to a 
spouse or former spouse pursuant to a qualified domestic relations 
order), amounts deferred under an eligible governmental plan are 
includible in the gross income of a participant or beneficiary for the

[[Page 176]]

taxable year in which paid to the participant or beneficiary under the 
plan.
    (2) Rollovers to individual retirement arrangements and other 
eligible retirement plans. A trustee-to-trustee transfer in accordance 
with section 401(a)(31) (generally referred to as a direct rollover) 
from an eligible government plan is not includible in gross income of a 
participant or beneficiary in the year transferred. In addition, any 
payment made from an eligible government plan in the form of an eligible 
rollover distribution (as defined in section 402(c)(4)) is not 
includible in gross income in the year paid to the extent the payment is 
transferred to an eligible retirement plan (as defined in section 
402(c)(8)(B)) within 60 days, including the transfer to the eligible 
retirement plan of any property distributed from the eligible 
governmental plan. For this purpose, the rules of section 402(c)(2) 
through (7) and (9) apply. Any trustee-to-trustee transfer under this 
paragraph (b)(2) from an eligible government plan is a distribution that 
is subject to the distribution requirements of Sec. 1.457-6.
    (3) Amounts taxable under section 72(p)(1). In accordance with 
section 72(p), the amount of any loan from an eligible governmental plan 
to a participant or beneficiary (including any pledge or assignment 
treated as a loan under section 72(p)(1)(B)) is treated as having been 
received as a distribution from the plan under section 72(p)(1), except 
to the extent set forth in section 72(p)(2) (relating to loans that do 
not exceed a maximum amount and that are repayable in accordance with 
certain terms) and Sec. 1.72(p)-1. Thus, except to the extent a loan 
satisfies section 72(p)(2), any amount loaned from an eligible 
governmental plan to a participant or beneficiary (including any pledge 
or assignment treated as a loan under section 72(p)(1)(B)) is includible 
in the gross income of the participant or beneficiary for the taxable 
year in which the loan is made. See generally Sec. 1.72(p)-1.
    (4) Examples. The provisions of this paragraph (b) are illustrated 
by the following examples:

    Example 1. (i) Facts. Eligible Plan G of a governmental entity 
permits distribution of benefits in a single sum or in installments of 
up to 20 years, with such benefits to commence at any date that is after 
severance from employment (up to the later of severance from employment 
or the plan's normal retirement age of 65). Effective for participants 
who have a severance from employment after December 31, 2001, Plan X 
allows an election--as to both the date on which payments are to begin 
and the form in which payments are to be made--to be made by the 
participant at any time that is before the commencement date selected. 
However, Plan X chooses to require elections to be filed at least 30 
days before the commencement date selected in order for Plan X to have 
enough time to be able to effectuate the election.
    (ii) Conclusion. No amounts are included in gross income before 
actual payments begin. If installment payments begin (and the 
installment payments are payable over at least 10 years so as not to be 
eligible rollover distributions), the amount included in gross income 
for any year is equal to the amount of the installment payment paid 
during the year.
    Example 2. (i) Facts. Same facts as in Example 1, except that the 
same rules are extended to participants who had a severance from 
employment before January 1, 2002.
    (ii) Conclusion. For all participants (that is, both those who have 
a severance from employment after December 31, 2001, and those who have 
a severance from employment before January 1, 2002, including those 
whose benefit payments have commenced before January 1, 2002), no 
amounts are included in gross income before actual payments begin. If 
installment payments begin (and the installment payments are payable 
over at least 10 years so as not to be eligible rollover distributions), 
the amount included in gross income for any year is equal to the amount 
of the installment payment paid during the year.

    (c) Amounts included in gross income under an eligible plan of a 
tax-exempt entity--(1) Amounts included in gross income in year paid or 
made available under an eligible plan of a tax-exempt entity. Amounts 
deferred under an eligible plan of a tax-exempt entity are includible in 
the gross income of a participant or beneficiary for the taxable year in 
which paid or otherwise made available to the participant or beneficiary 
under the plan. Thus, amounts deferred under an eligible plan of a tax-
exempt entity are includible in the gross income of the participant or 
beneficiary in the year the amounts are first made available under the 
terms of the plan, even if the plan has not distributed the amounts 
deferred. Amounts deferred under an eligible plan of a tax-exempt

[[Page 177]]

entity are not considered made available to the participant or 
beneficiary solely because the participant or beneficiary is permitted 
to choose among various investments under the plan.
    (2) When amounts deferred are considered to be made available under 
an eligible plan of a tax-exempt entity--(i) General rule. Except as 
provided in paragraphs (c)(2)(ii) through (iv) of this section, amounts 
deferred under an eligible plan of a tax-exempt entity are considered 
made available (and, thus, are includible in the gross income of the 
participant or beneficiary under this paragraph (c)) at the earliest 
date, on or after severance from employment, on which the plan allows 
distributions to commence, but in no event later than the date on which 
distributions must commence pursuant to section 401(a)(9). For example, 
in the case of a plan that permits distribution to commence on the date 
that is 60 days after the close of the plan year in which the 
participant has a severance from employment with the eligible employer, 
amounts deferred are considered to be made available on that date. 
However, distributions deferred in accordance with paragraphs (c)(2)(ii) 
through (iv) of this section are not considered made available prior to 
the applicable date under paragraphs (c)(2)(ii) through (iv) of this 
section. In addition, no portion of a participant or beneficiary's 
account is treated as made available (and thus currently includible in 
income) under an eligible plan of a tax-exempt entity merely because the 
participant or beneficiary under the plan may elect to receive a 
distribution in any of the following circumstances:
    (A) A distribution in the event of an unforeseeable emergency to the 
extent the distribution is permitted under Sec. 1.457-6(c).
    (B) A distribution from an account for which the total amount 
deferred is not in excess of the dollar limit under section 
411(a)(11)(A) to the extent the distribution is permitted under Sec. 
1.457-6(e).
    (ii) Initial election to defer commencement of distributions--(A) In 
general. An eligible plan of a tax-exempt entity may provide a period 
for making an initial election during which the participant or 
beneficiary may elect, in accordance with the terms of the plan, to 
defer the payment of some or all of the amounts deferred to a fixed or 
determinable future time. The period for making this initial election 
must expire prior to the first time that any such amounts would be 
considered made available under the plan under paragraph (c)(2)(i) of 
this section.
    (B) Failure to make initial election to defer commencement of 
distributions. Generally, if no initial election is made by a 
participant or beneficiary under this paragraph (c)(2)(ii), then the 
amounts deferred under an eligible plan of a tax-exempt entity are 
considered made available and taxable to the participant or beneficiary 
in accordance with paragraph (c)(2)(i) of this section at the earliest 
time, on or after severance from employment ( but in no event later than 
the date on which distributions must commence pursuant to section 
401(a)(9)), that distribution is permitted to commence under the terms 
of the plan. However, the plan may provide for a default payment 
schedule that applies if no election is made. If the plan provides for a 
default payment schedule, the amounts deferred are includible in the 
gross income of the participant or beneficiary in the year the amounts 
deferred are first made available under the terms of the default payment 
schedule.
    (iii) Additional election to defer commencement of distribution. An 
eligible plan of a tax-exempt entity is permitted to provide that a 
participant or beneficiary who has made an initial election under 
paragraph (c)(2)(ii)(A) of this section may make one additional election 
to defer (but not accelerate) commencement of distributions under the 
plan before distributions have commenced in accordance with the initial 
deferral election under paragraph (c)(2)(ii)(A) of this section. Amounts 
payable to a participant or beneficiary under an eligible plan of a tax-
exempt entity are not treated as made available merely because the plan 
allows the participant to make an additional election under this 
paragraph (c)(2)(iii).

[[Page 178]]

A participant or beneficiary is not precluded from making an additional 
election to defer commencement of distributions merely because the 
participant or beneficiary has previously received a distribution under 
Sec. 1.457-6(c) because of an unforeseeable emergency, has received a 
distribution of smaller amounts under Sec. 1.457-6(e), has made (and 
revoked) other deferral or method of payment elections within the 
initial election period, or is subject to a default payment schedule 
under which the commencement of benefits is deferred (for example, until 
a participant is age 65).
    (iv) Election as to method of payment. An eligible plan of a tax-
exempt entity may provide that an election as to the method of payment 
under the plan may be made at any time prior to the time the amounts are 
distributed in accordance with the participant or beneficiary's initial 
or additional election to defer commencement of distributions under 
paragraph (c)(2)(ii) or (iii) of this section. Where no method of 
payment is elected, the entire amount deferred will be includible in the 
gross income of the participant or beneficiary when the amounts first 
become made available in accordance with a participant's initial or 
additional elections to defer under paragraphs (c)(2)(ii) and (iii) of 
this section, unless the eligible plan provides for a default method of 
payment (in which case amounts are considered made available and taxable 
when paid under the terms of the default payment schedule). A method of 
payment means a distribution or a series of periodic distributions 
commencing on a date determined in accordance with paragraph (c)(2)(ii) 
or (iii) of this section.
    (3) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. (i) Facts. Eligible Plan X of a tax-exempt entity 
provides that a participant's total account balance, representing all 
amounts deferred under the plan, is payable to a participant in a single 
sum 60 days after severance from employment throughout these examples, 
unless, during a 30-day period immediately following the severance, the 
participant elects to receive the single sum payment at a later date 
(that is not later than the plan's normal retirement age of 65) or 
elects to receive distribution in 10 annual installments to begin 60 
days after severance from employment (or at a later date, if so elected, 
that is not later than the plan's normal retirement age of 65). On 
November 13, 2004, K, a calendar year taxpayer, has a severance from 
employment with the eligible employer. K does not, within the 30-day 
window period, elect to postpone distributions to a later date or to 
receive payment in 10 fixed annual installments.
    (ii) Conclusion. The single sum payment is payable to K 60 days 
after the date K has a severance from employment (January 12, 2005), and 
is includible in the gross income of K in 2005 under section 457(a).
    Example 2. (i) Facts. The terms of eligible Plan X are the same as 
described in Example 1. Participant L participates in eligible Plan X. 
On November 11, 2003, L has a severance from the employment of the 
eligible employer. On November 24, 2003, L makes an initial deferral 
election not to receive the single-sum payment payable 60 days after the 
severance, and instead elects to receive the amounts in 10 annual 
installments to begin 60 days after severance from employment.
    (ii) Conclusion. No portion of L's account is considered made 
available in 2003 or 2004 before a payment is made and no amount is 
includible in the gross income of L until distributions commence. The 
annual installment payable in 2004 will be includible in L's gross 
income in 2004.
    Example 3. (i) Facts. The facts are the same as in Example 1, except 
that eligible Plan X also provides that those participants who are 
receiving distributions in 10 annual installments may, at any time and 
without restriction, elect to receive a cash out of all remaining 
installments. Participant M elects to receive a distribution in 10 
annual installments commencing in 2004.
    (ii) Conclusion. M's total account balance, representing the total 
of the amounts deferred under the plan, is considered made available and 
is includible in M's gross income in 2004.
    Example 4. (i) Facts. The facts are the same as in Example 3, except 
that, instead of providing for an unrestricted cashout of remaining 
payments, the plan provides that participants or beneficiaries who are 
receiving distributions in 10 annual installments may accelerate the 
payment of the amount remaining payable to the participant upon the 
occurrence of an unforeseeable emergency as described in Sec. 1.457-
6(c)(1) in an amount not exceeding that described in Sec. 1.457-
6(c)(2).
    (ii) Conclusion. No amount is considered made available to 
participant M on account of M's right to accelerate payments upon the 
occurrence of an unforeseeable emergency.
    Example 5. (i) Facts. Eligible Plan Y of a tax-exempt entity 
provides that distributions will commence 60 days after a participant's 
severance from employment unless

[[Page 179]]

the participant elects, within a 30-day window period following 
severance from employment, to defer distributions to a later date (but 
no later than the year following the calendar year the participant 
attains age 70\1/2\). The plan provides that a participant who has 
elected to defer distributions to a later date may make an election as 
to form of distribution at any time prior to the 30th day before 
distributions are to commence.
    (ii) Conclusion. No amount is considered made available prior to the 
date distributions are to commence by reason of a participant's right to 
defer or make an election as to the form of distribution.
    Example 6. (i) Facts. The facts are the same as in Example 1, except 
that the plan also permits participants who have made an initial 
election to defer distribution to make one additional deferral election 
at any time prior to the date distributions are scheduled to commence. 
Participant N has a severance from employment at age 50. The next day, 
during the 30-day period provided in the plan, N elects to receive 
distribution in the form of 10 annual installment payments beginning at 
age 55. Two weeks later, within the 30-day window period, N makes a new 
election permitted under the plan to receive 10 annual installment 
payments beginning at age 60 (instead of age 55). When N is age 59, N 
elects under the additional deferral election provisions, to defer 
distributions until age 65.
    (ii) Conclusion. In this example, N's election to defer 
distributions until age 65 is a valid election. The two elections N 
makes during the 30-day window period are not additional deferral 
elections described in paragraph (c)(2)(iii) of this section because 
they are made before the first permissible payout date under the plan. 
Therefore, the plan is not precluded from allowing N to make the 
additional deferral election. However, N can make no further election to 
defer distributions beyond age 65 (or accelerate distribution before age 
65) because this additional deferral election can only be made once.

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003]



Sec. 1.457-8  Funding rules for eligible plans.

    (a) Eligible governmental plans--(1) In general. In order to be an 
eligible governmental plan, all amounts deferred under the plan, all 
property and rights purchased with such amounts, and all income 
attributable to such amounts, property, or rights, must be held in trust 
for the exclusive benefit of participants and their beneficiaries. A 
trust described in this paragraph (a) that also meets the requirements 
of Sec. Sec. 1.457-3 through 1.457-10 is treated as an organization 
exempt from tax under section 501(a), and a participant's or 
beneficiary's interest in amounts in the trust is includible in the 
gross income of the participants and beneficiaries only to the extent, 
and at the time, provided for in section 457(a) and Sec. Sec. 1.457-4 
through 1.457-10.
    (2) Trust requirement. (i) A trust described in this paragraph (a) 
must be established pursuant to a written agreement that constitutes a 
valid trust under State law. The terms of the trust must make it 
impossible, prior to the satisfaction of all liabilities with respect to 
participants and their beneficiaries, for any part of the assets and 
income of the trust to be used for, or diverted to, purposes other than 
for the exclusive benefit of participants and their beneficiaries.
    (ii) Amounts deferred under an eligible governmental plan must be 
transferred to a trust within a period that is not longer than is 
reasonable for the proper administration of the participant accounts (if 
any). For purposes of this requirement, the plan may provide for amounts 
deferred for a participant under the plan to be transferred to the trust 
within a specified period after the date the amounts would otherwise 
have been paid to the participant. For example, the plan could provide 
for amounts deferred under the plan at the election of the participant 
to be contributed to the trust within 15 business days following the 
month in which these amounts would otherwise have been paid to the 
participant.
    (3) Custodial accounts and annuity contracts treated as trusts--(i) 
In general. For purposes of the trust requirement of this paragraph (a), 
custodial accounts and annuity contracts described in section 401(f) 
that satisfy the requirements of this paragraph (a)(3) are treated as 
trusts under rules similar to the rules of section 401(f). Therefore, 
the provisions of Sec. 1.401(f)-1(b) will generally apply to determine 
whether a custodial account or an annuity contract is treated as a 
trust. The use of a custodial account or annuity contract as part of an 
eligible governmental plan does not preclude the use of a trust or 
another custodial account or annuity contract as part of the same

[[Page 180]]

plan, provided that all such vehicles satisfy the requirements of 
section 457(g)(1) and (3) and paragraphs (a)(1) and (2) of this section 
and that all assets and income of the plan are held in such vehicles.
    (ii) Custodial accounts--(A) In general. A custodial account is 
treated as a trust, for purposes of section 457(g)(1) and paragraphs 
(a)(1) and (2) of this section, if the custodian is a bank, as described 
in section 408(n), or a person who meets the nonbank trustee 
requirements of paragraph (a)(3)(ii)(B) of this section, and the account 
meets the requirements of paragraphs (a)(1) and (2) of this section, 
other than the requirement that it be a trust.
    (B) Nonbank trustee status. The custodian of a custodial account may 
be a person other than a bank only if the person demonstrates to the 
satisfaction of the Commissioner that the manner in which the person 
will administer the custodial account will be consistent with the 
requirements of section 457(g)(1) and (3). To do so, the person must 
demonstrate that the requirements of Sec. 1.408-2(e)(2) through (6) 
(relating to nonbank trustees) are met. The written application must be 
sent to the address prescribed by the Commissioner in the same manner as 
prescribed under Sec. 1.408-2(e). To the extent that a person has 
already demonstrated to the satisfaction of the Commissioner that the 
person satisfies the requirements of Sec. 1.408-2(e) in connection with 
a qualified trust (or custodial account or annuity contract) under 
section 401(a), that person is deemed to satisfy the requirements of 
this paragraph (a)(3)(ii)(B).
    (iii) Annuity contracts. An annuity contract is treated as a trust 
for purposes of section 457(g)(1) and paragraph (a)(1) of this section 
if the contract is an annuity contract, as defined in section 401(g), 
that has been issued by an insurance company qualified to do business in 
the State, and the contract meets the requirements of paragraphs (a)(1) 
and (2) of this section, other than the requirement that it be a trust. 
An annuity contract does not include a life, health or accident, 
property, casualty, or liability insurance contract.
    (4) Combining assets. [Reserved]
    (b) Eligible plans maintained by tax-exempt entity--(1) General 
rule. In order to be an eligible plan of a tax-exempt entity, the plan 
must be unfunded and plan assets must not be set aside for participants 
or their beneficiaries. Under section 457(b)(6) and this paragraph (b), 
an eligible plan of a tax-exempt entity must provide that all amounts 
deferred under the plan, all property and rights to property (including 
rights as a beneficiary of a contract providing life insurance 
protection) purchased with such amounts, and all income attributable to 
such amounts, property, or rights, must remain (until paid or made 
available to the participant or beneficiary) solely the property and 
rights of the eligible employer (without being restricted to the 
provision of benefits under the plan), subject only to the claims of the 
eligible employer's general creditors.
    (2) Additional requirements. For purposes of paragraph (b)(1) of 
this section, the plan must be unfunded regardless of whether or not the 
amounts were deferred pursuant to a salary reduction agreement between 
the eligible employer and the participant. Any funding arrangement under 
an eligible plan of a tax-exempt entity that sets aside assets for the 
exclusive benefit of participants violates this requirement, and amounts 
deferred are generally immediately includible in the gross income of 
plan participants and beneficiaries. Nothing in this paragraph (b) 
prohibits an eligible plan from permitting participants and their 
beneficiaries to make an election among different investment options 
available under the plan, such as an election affecting the investment 
of the amounts described in paragraph (b)(1) of this section.

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003]



Sec. 1.457-9  Effect on eligible plans when not administered in 
accordance with eligibility requirements.

    (a) Eligible governmental plans. A plan of a State ceases to be an 
eligible governmental plan on the first day of the first plan year 
beginning more than 180 days after the date on which the Commissioner 
notifies the State in writing that the plan is being administered in

[[Page 181]]

a manner that is inconsistent with one or more of the requirements of 
Sec. Sec. 1.457-3 through 1.457-8 or 1.447-10. However, the plan may 
correct the plan inconsistencies specified in the written notification 
before the first day of that plan year and continue to maintain plan 
eligibility. If a plan ceases to be an eligible governmental plan, 
amounts subsequently deferred by participants will be includible in 
income when deferred, or, if later, when the amounts deferred cease to 
be subject to a substantial risk of forfeiture, as provided at Sec. 
1.457-11. Amounts deferred before the date on which the plan ceases to 
be an eligible governmental plan, and any earnings thereon, will be 
treated as if the plan continues to be an eligible governmental plan and 
will not be includible in participant's or beneficiary's gross income 
until paid to the participant or beneficiary.
    (b) Eligible plans of tax-exempt entities. A plan of a tax-exempt 
entity ceases to be an eligible plan on the first day that the plan 
fails to satisfy one or more of the requirements of Sec. Sec. 1.457-3 
through 1.457-8, or Sec. 1.457-10. See Sec. 1.457-11 for rules 
regarding the treatment of an ineligible plan.

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003]



Sec. 1.457-10  Miscellaneous provisions.

    (a) Plan terminations and frozen plans--(1) In general. An eligible 
employer may amend its plan to eliminate future deferrals for existing 
participants or to limit participation to existing participants and 
employees. An eligible plan may also contain provisions that permit plan 
termination and permit amounts deferred to be distributed on 
termination. In order for a plan to be considered terminated, amounts 
deferred under an eligible plan must be distributed to all plan 
participants and beneficiaries as soon as administratively practicable 
after termination of the eligible plan. The mere provision for, and 
making of, distributions to participants or beneficiaries upon a plan 
termination will not cause an eligible plan to cease to satisfy the 
requirements of section 457(b) or the regulations.
    (2) Employers that cease to be eligible employers--(i) Plan not 
terminated. An eligible employer that ceases to be an eligible employer 
may no longer maintain an eligible plan. If the employer was a tax-
exempt entity and the plan is not terminated as permitted under 
paragraph (a)(2)(ii) of this section, the tax consequences to 
participants and beneficiaries in the previously eligible (unfunded) 
plan of an ineligible employer are determined in accordance with either 
section 451 if the employer becomes an entity other than a State or 
Sec. 1.457-11 if the employer becomes a State. If the employer was a 
State and the plan is neither terminated as permitted under paragraph 
(a)(2)(ii) of this section nor transferred to another eligible plan of 
that State as permitted under paragraph (b) of this section, the tax 
consequences to participants in the previously eligible governmental 
plan of an ineligible employer, the assets of which are held in trust 
pursuant to Sec. 1.457-8(a), are determined in accordance with section 
402(b) (section 403(c) in the case of an annuity contract) and the trust 
is no longer to be treated as a trust that is exempt from tax under 
section 501(a).
    (ii) Plan termination. As an alternative to determining the tax 
consequences to the plan and participants under paragraph (a)(2)(i) of 
this section, the employer may terminate the plan and distribute the 
amounts deferred (and all plan assets) to all plan participants as soon 
as administratively practicable in accordance with paragraph (a)(1) of 
this section. Such distribution may include eligible rollover 
distributions in the case of a plan that was an eligible governmental 
plan. In addition, if the employer is a State, another alternative to 
determining the tax consequences under paragraph (a)(2)(i) of this 
section is to transfer the assets of the eligible governmental plan to 
an eligible governmental plan of another eligible employer within the 
same State under the plan-to-plan transfer rules of paragraph (b) of 
this section.
    (3) Examples. The provisions of this paragraph (a) are illustrated 
by the following examples:

    Example 1. (i) Facts. Employer Y, a corporation that owns a State 
hospital, sponsors an eligible governmental plan funded through a trust. 
Employer Y is acquired by a for-profit

[[Page 182]]

hospital and Employer Y ceases to be an eligible employer under section 
457(e)(1) or Sec. 1.457-2(e). Employer Y terminates the plan and, 
during the next 6 months, distributes to participants and beneficiaries 
all amounts deferred that were under the plan.
    (ii) Conclusion. The termination and distribution does not cause the 
plan to fail to be an eligible governmental plan. Amounts that are 
distributed as eligible rollover distributions may be rolled over to an 
eligible retirement plan described in section 402(c)(8)(B).
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that Employer Y decides to continue to maintain the plan.
    (ii) Conclusion. If Employer Y continues to maintain the plan, the 
tax consequences to participants and beneficiaries will be determined in 
accordance with either section 402(b) if the compensation deferred is 
funded through a trust, section 403(c) if the compensation deferred is 
funded through annuity contracts, or Sec. 1.457-11 if the compensation 
deferred is not funded through a trust or annuity contract. In addition, 
if Employer Y continues to maintain the plan, the trust will no longer 
be treated as exempt from tax under section 501(a).
    Example 3. (i) Facts. Employer Z, a corporation that owns a tax-
exempt hospital, sponsors an unfunded eligible plan. Employer Z is 
acquired by a for-profit hospital and is no longer an eligible employer 
under section 457(e)(1) or Sec. 1.457-2(e). Employer Z terminates the 
plan and distributes all amounts deferred under the eligible plan to 
participants and beneficiaries within a one-year period.
    (ii) Conclusion. Distributions under the plan are treated as made 
under an eligible plan of a tax-exempt entity and the distributions of 
the amounts deferred are includible in the gross income of the 
participant or beneficiary in the year distributed.
    Example 4. (i) Facts. The facts are the same as in Example 3, except 
that Employer Z decides to maintain instead of terminate the plan.
    (ii) Conclusion. If Employer Z maintains the plan, the tax 
consequences to participants and beneficiaries in the plan will 
thereafter be determined in accordance with section 451.

    (b) Plan-to-plan transfers--(1) General rule. An eligible 
governmental plan may provide for the transfer of amounts deferred by a 
participant or beneficiary to another eligible governmental plan if the 
conditions in paragraphs (b)(2), (3), or (4) of this section are met. An 
eligible plan of a tax-exempt entity may provide for transfers of 
amounts deferred by a participant to another eligible plan of a tax-
exempt entity if the conditions in paragraph (b)(5) of this section are 
met. In addition, an eligible governmental plan may accept transfers 
from another eligible governmental plan as described in the first 
sentence of this paragraph (b)(1), and an eligible plan of a tax-exempt 
entity may accept transfers from another eligible plan of a tax-exempt 
entity as described in the preceding sentence. However, a State may not 
transfer the assets of its eligible governmental plan to a tax-exempt 
entity's eligible plan and the plan of a tax-exempt entity may not 
accept such a transfer. Similarly, a tax-exempt entity may not transfer 
the assets of its eligible plan to an eligible governmental plan and an 
eligible governmental plan may not accept such a transfer. In addition, 
if the conditions in paragraph (b)(4) of this section (relating to 
permissive past service credit and repayments under section 415) are 
met, an eligible governmental plan of a State may provide for the 
transfer of amounts deferred by a participant or beneficiary to a 
qualified plan (under section 401(a)) maintained by a State. However, a 
qualified plan may not transfer assets to an eligible governmental plan 
or to an eligible plan of a tax-exempt entity, and an eligible 
governmental plan or the plan of a tax-exempt entity may not accept such 
a transfer.
    (2) Requirements for post-severance plan-to-plan transfers among 
eligible governmental plans. A transfer under paragraph (b)(1) of this 
section from an eligible governmental plan to another eligible 
governmental plan is permitted if the following conditions are met--
    (i) The transferor plan provides for transfers;
    (ii) The receiving plan provides for the receipt of transfers;
    (iii) The participant or beneficiary whose amounts deferred are 
being transferred will have an amount deferred immediately after the 
transfer at least equal to the amount deferred with respect to that 
participant or beneficiary immediately before the transfer; and
    (iv) In the case of a transfer for a participant, the participant 
has had a severance from employment with the

[[Page 183]]

transferring employer and is performing services for the entity 
maintaining the receiving plan.
    (3) Requirements for plan-to-plan transfers of all plan assets of 
eligible governmental plan. A transfer under paragraph (b)(1) of this 
section from an eligible governmental plan to another eligible 
governmental plan is permitted if the following conditions are met--
    (i) The transfer is from an eligible governmental plan to another 
eligible governmental plan within the same State;
    (ii) All of the assets held by the transferor plan are transferred;
    (iii) The transferor plan provides for transfers;
    (iv) The receiving plan provides for the receipt of transfers;
    (v) The participant or beneficiary whose amounts deferred are being 
transferred will have an amount deferred immediately after the transfer 
at least equal to the amount deferred with respect to that participant 
or beneficiary immediately before the transfer; and
    (vi) The participants or beneficiaries whose deferred amounts are 
being transferred are not eligible for additional annual deferrals in 
the receiving plan unless they are performing services for the entity 
maintaining the receiving plan.
    (4) Requirements for plan-to-plan transfers among eligible 
governmental plans of the same employer. A transfer under paragraph 
(b)(1) of this section from an eligible governmental plan to another 
eligible governmental plan is permitted if the following conditions are 
met--
    (i) The transfer is from an eligible governmental plan to another 
eligible governmental plan of the same employer (and, for this purpose, 
the employer is not treated as the same employer if the participant's 
compensation is paid by a different entity);
    (ii) The transferor plan provides for transfers;
    (iii) The receiving plan provides for the receipt of transfers;
    (iv) The participant or beneficiary whose amounts deferred are being 
transferred will have an amount deferred immediately after the transfer 
at least equal to the amount deferred with respect to that participant 
or beneficiary immediately before the transfer; and
    (v) The participant or beneficiary whose deferred amounts are being 
transferred is not eligible for additional annual deferrals in the 
receiving plan unless the participant or beneficiary is performing 
services for the entity maintaining the receiving plan.
    (5) Requirements for post-severance plan-to-plan transfers among 
eligible plans of tax-exempt entities. A transfer under paragraph (b)(1) 
of this section from an eligible plan of a tax-exempt employer to 
another eligible plan of a tax-exempt employer is permitted if the 
following conditions are met--
    (i) The transferor plan provides for transfers;
    (ii) The receiving plan provides for the receipt of transfers;
    (iii) The participant or beneficiary whose amounts deferred are 
being transferred will have an amount deferred immediately after the 
transfer at least equal to the amount deferred with respect to that 
participant or beneficiary immediately before the transfer; and
    (iv) In the case of a transfer for a participant, the participant 
has had a severance from employment with the transferring employer and 
is performing services for the entity maintaining the receiving plan.
    (6) Treatment of amount transferred following a plan-to-plan 
transfer between eligible plans. Following a transfer of any amount 
between eligible plans under paragraphs (b)(1) through (b)(5) of this 
section--
    (i) The transferred amount is subject to the restrictions of Sec. 
1.457-6 (relating to when distributions are permitted to be made to a 
participant under an eligible plan) in the receiving plan in the same 
manner as if the transferred amount had been originally been deferred 
under the receiving plan if the participant is performing services for 
the entity maintaining the receiving plan, and
    (ii) In the case of a transfer between eligible plans of tax-exempt 
entities, except as otherwise determined by the Commissioner, the 
transferred amount is subject to Sec. 1.457-7(c)(2) (relating to when 
amounts are considered to be

[[Page 184]]

made available under an eligible plan of a tax-exempt entity) in the 
same manner as if the elections made by the participant or beneficiary 
under the transferor plan had been made under the receiving plan.
    (7) Examples. The provisions of paragraphs (b)(1) through (6) of 
this section are illustrated by the following examples:

    Example 1. (i) Facts. Participant A, the president of City X's 
hospital, has accepted a position with another hospital which is a tax-
exempt entity. A participates in the eligible governmental plan of City 
X. A would like to transfer the amounts deferred under City X's eligible 
governmental plan to the eligible plan of the tax-exempt hospital.
    (ii) Conclusion. City X's plan may not transfer A's amounts deferred 
to the tax-exempt employer's eligible plan. In addition, because the 
amounts deferred would no longer be held in trust for the exclusive 
benefit of participants and their beneficiaries, the transfer would 
violate the exclusive benefit rule of section 457(g) and Sec. 1.457-
8(a).
    Example 2. (i) Facts. County M, located in State S, operates several 
health clinics and maintains an eligible governmental plan for employees 
of those clinics. One of the clinics operated by County M is being 
acquired by a hospital operated by State S, and employees of that clinic 
will become employees of State S. County M permits those employees to 
transfer their balances under County M's eligible governmental plan to 
the eligible governmental plan of State S.
    (ii) Conclusion. If the eligible governmental plans of County M and 
State S provide for the transfer and acceptance of the transfer (and the 
other requirements of paragraph (b)(1) of this section are satisfied), 
then the requirements of paragraph (b)(2) of this section are satisfied 
and, thus, the transfer will not cause either plan to violate the 
requirements of section 457 or these regulations.
    Example 3. (i) Facts. City Employer Z, a hospital, sponsors an 
eligible governmental plan. City Employer Z is located in State B. All 
of the assets of City Employer Z are being acquired by a tax-exempt 
hospital. City Employer Z, in accordance with the plan-to-plan transfer 
rules of paragraph (b) of this section, would like to transfer the total 
amount of assets deferred under City Employer Z's eligible governmental 
plan to the acquiring tax-exempt entity's eligible plan.
    (ii) Conclusion. City Employer Z may not permit participants to 
transfer the amounts to the eligible plan of the tax-exempt entity. In 
addition, because the amounts deferred would no longer be held in trust 
for the exclusive benefit of participants and their beneficiaries, the 
transfer would violate the exclusive benefit rule of section 457(g) and 
Sec. 1.457-8(a).
    Example 4. (i) Facts. The facts are the same as in Example 3, except 
that City Employer Z, instead of transferring all of its assets to the 
eligible plan of the tax-exempt entity, decides to transfer all of the 
amounts deferred under City Z's eligible governmental plan to the 
eligible governmental plan of County B in which City Z is located. 
County B's eligible plan does not cover employees of City Z, but is 
willing to allow the assets of City Z's plan to be transferred to County 
B's plan, a related state government entity, also located in State B.
    (ii) Conclusion. If City Employer Z's (transferor) eligible 
governmental plan provides for such transfer and the eligible 
governmental plan of County B permits the acceptance of such a transfer 
(and the other requirements of paragraph (b)(1) of this section are 
satisfied), then the requirements of paragraph (b)(3) of this section 
are satisfied and, thus, City Employer Z may transfer the total amounts 
deferred under its eligible governmental plan, prior to termination of 
that plan, to the eligible governmental plan maintained by County B. 
However, the participants of City Employer Z whose deferred amounts are 
being transferred are not eligible to participate in the eligible 
governmental plan of County B, the receiving plan, unless they are 
performing services for County B.
    Example 5. (i) Facts. State C has an eligible governmental plan. 
Employees of City U in State C are among the eligible employees for 
State C's plan and City U decides to adopt another eligible governmental 
plan only for its employees. State C decides to allow employees to elect 
to transfer all of the amounts deferred for an employee under State C's 
eligible governmental plan to City U's eligible governmental plan.
    (ii) Conclusion. If State C's (transferor) eligible governmental 
plan provides for such transfer and the eligible governmental plan of 
City U permits the acceptance of such a transfer (and the other 
requirements of paragraph (b)(1) of this section are satisfied), then 
the requirements of paragraph (b)(4) of this section are satisfied and, 
thus, State C may transfer the total amounts deferred under its eligible 
governmental plan to the eligible governmental plan maintained by City 
U.

    (8) Purchase of permissive past service credit by plan-to-plan 
transfers from an eligible governmental plan to a qualified plan--(i) 
General rule. An eligible governmental plan of a State may provide for 
the transfer of amounts deferred by a participant or beneficiary to a 
defined benefit governmental plan (as defined in section 414(d)), and no 
amount

[[Page 185]]

shall be includible in gross income by reason of the transfer, if the 
conditions in paragraph (b)(8)(ii) of this section are met. A transfer 
under this paragraph (b)(8) is not treated as a distribution for 
purposes of Sec. 1.457-6. Therefore, such a transfer may be made before 
severance from employment.
    (ii) Conditions for plan-to-plan transfers from an eligible 
governmental plan to a qualified plan. A transfer may be made under this 
paragraph (b)(8) only if the transfer is either--
    (A) For the purchase of permissive past service credit (as defined 
in section 415(n)(3)(A)) under the receiving defined benefit 
governmental plan; or
    (B) A repayment to which section 415 does not apply by reason of 
section 415(k)(3).
    (iii) Example. The provisions of this paragraph (b)(8) are 
illustrated by the following example:

    Example. (i) Facts. Plan X is an eligible governmental plan 
maintained by County Y for its employees. Plan X provides for 
distributions only in the event of death, an unforeseeable emergency, or 
severance from employment with County Y (including retirement from 
County Y). Plan S is a qualified defined benefit plan maintained by 
State T for its employees. County Y is within State T. Employee A is an 
employee of County Y and is a participant in Plan X. Employee A 
previously was an employee of State T and is still entitled to benefits 
under Plan S. Plan S includes provisions allowing participants in 
certain plans, including Plan X, to transfer assets to Plan S for the 
purchase of past service credit under Plan S and does not permit the 
amount transferred to exceed the amount necessary to fund the benefit 
resulting from the past service credit. Although not required to do so, 
Plan X allows Employee A to transfer assets to Plan S to provide a past 
service benefit under Plan S.
    (ii) Conclusion. The transfer is permitted under this paragraph 
(b)(8).

    (c) Qualified domestic relations orders under eligible plans--(1) 
General rule. An eligible plan does not become an ineligible plan 
described in section 457(f) solely because its administrator or sponsor 
complies with a qualified domestic relations order as defined in section 
414(p), including an order requiring the distribution of the benefits of 
a participant to an alternate payee in advance of the general rules for 
eligible plan distributions under Sec. 1.457-6. If a distribution or 
payment is made from an eligible plan to an alternate payee pursuant to 
a qualified domestic relations order, rules similar to the rules of 
section 402(e)(1)(A) shall apply to the distribution or payment.
    (2) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. (i) Facts. Participant C and C's spouse D are divorcing. 
C is employed by State S and is a participant in an eligible plan 
maintained by State S. C has an account valued at $100,000 under the 
plan. Pursuant to the divorce, a court issues a qualified domestic 
relations order on September 1, 2003 that allocates 50 percent of C's 
$100,000 plan account to D and specifically provides for an immediate 
distribution to D of D's share within 6 months of the order. Payment is 
made to D in January of 2004.
    (ii) Conclusion. State S's eligible plan does not become an 
ineligible plan described in section 457(f) and Sec. 1.457-11 solely 
because its administrator or sponsor complies with the qualified 
domestic relations order requiring the immediate distribution to D in 
advance of the general rules for eligible plan distributions under Sec. 
1.457-6. In accordance with section 402(e)(1)(A), D (not C) must include 
the distribution in gross income. The distribution is includible in D's 
gross income in 2004. If the qualified domestic relations order were to 
provide for distribution to D at a future date, amounts deferred 
attributable to D's share will be includible in D's gross income when 
paid to D.
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that S is a tax-exempt entity, instead of a State.
    (ii) Conclusion. State S's eligible plan does not become an 
ineligible plan described in section 457(f) and Sec. 1.457-11 solely 
because its administrator or sponsor complies with the qualified 
domestic relations order requiring the immediate distribution to D in 
advance of the general rules for eligible plan distributions under Sec. 
1.457-6. In accordance with section 402(e)(1)(A), D (not C) must include 
the distribution in gross income. The distribution is includible in D's 
gross income in 2004, assuming that the plan did not make the 
distribution available to D in 2003. If the qualified domestic relations 
order were to provide for distribution to D at a future date, amounts 
deferred attributable to D's share would be includible in D's gross 
income when paid or made available to D.

    (d) Death benefits and life insurance proceeds. A death benefit plan 
under section 457(e)(11) is not an eligible plan. In addition, no amount 
paid or made available under an eligible plan as

[[Page 186]]

death benefits or life insurance proceeds is excludable from gross 
income under section 101.
    (e) Rollovers to eligible governmental plans--(1) General rule. An 
eligible governmental plan may accept contributions that are eligible 
rollover distributions (as defined in section 402(c)(4)) made from 
another eligible retirement plan (as defined in section 402(c)(8)(B)) if 
the conditions in paragraph (e)(2) of this section are met. Amounts 
contributed to an eligible governmental plan as eligible rollover 
distributions are not taken into account for purposes of the annual 
limit on annual deferrals by a participant in Sec. 1.457-4(c) or Sec. 
1.457-5, but are otherwise treated in the same manner as amounts 
deferred under section 457 for purposes of Sec. Sec. 1.457-3 through 
1.457-9 and this section.
    (2) Conditions for rollovers to an eligible governmental plan. An 
eligible governmental plan that permits eligible rollover distributions 
made from another eligible retirement plan to be paid into the eligible 
governmental plan is required under this paragraph (e)(2) to provide 
that it will separately account for any eligible rollover distributions 
it receives. A plan does not fail to satisfy this requirement if it 
separately accounts for particular types of eligible rollover 
distributions (for example, if it maintains a separate account for 
eligible rollover distributions attributable to annual deferrals that 
were made under other eligible governmental plans and a separate account 
for amounts attributable to other eligible rollover distributions), but 
this requirement is not satisfied if any such separate account includes 
any amount that is not attributable to an eligible rollover 
distribution.
    (3) Example. The provisions of this paragraph (e) are illustrated by 
the following example:

    Example. (i) Facts. Plan T is an eligible governmental plan that 
provides that employees who are eligible to participate in Plan T may 
make rollover contributions to Plan T from amounts distributed to an 
employee from an eligible retirement plan. An eligible retirement plan 
is defined in Plan T as another eligible governmental plan, a qualified 
section 401(a) or 403(a) plan, or a section 403(b) contract, or an 
individual retirement arrangement (IRA) that holds such amounts. Plan T 
requires rollover contributions to be paid by the eligible retirement 
plan directly to Plan T (a direct rollover) or to be paid by the 
participant within 60 days after the date on which the participant 
received the amount from the other eligible retirement plan. Plan T does 
not take rollover contributions into account for purposes of the plan's 
limits on amounts deferred that conform to Sec. 1.457-4(c). Rollover 
contributions paid to Plan T are invested in the trust in the same 
manner as amounts deferred under Plan T and rollover contributions (and 
earnings thereon) are available for distribution to the participant at 
the same time and in the same manner as amounts deferred under Plan T. 
In addition, Plan T provides that, for each participant who makes a 
rollover contribution to Plan T, the Plan T record-keeper is to 
establish a separate account for the participant's rollover 
contributions. The record-keeper calculates earnings and losses for 
investments held in the rollover account separately from earnings and 
losses on other amounts held under the plan and calculates disbursements 
from and payments made to the rollover account separately from 
disbursements from and payments made to other amounts held under the 
plan.
    (ii) Conclusion. Plan T does not lose its status as an eligible 
governmental plan as a result of the receipt of rollover contributions. 
The conclusion would not be different if the Plan T record-keeper were 
to establish two separate accounts, one of which is for the 
participant's rollover contributions attributable to annual deferrals 
that were made under an eligible governmental plan and the other of 
which is for other rollover contributions.

    (f) Deemed IRAs under eligible governmental plans. See regulations 
under section 408(q) for guidance regarding the treatment of separate 
accounts or annuities as individual retirement plans (IRAs).

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003]



Sec. 1.457-11  Tax treatment of participants if plan is not an 
eligible plan.

    (a) In general. Under section 457(f), if an eligible employer 
provides for a deferral of compensation under any agreement or 
arrangement that is an ineligible plan--
    (1) Compensation deferred under the agreement or arrangement is 
includible in the gross income of the participant or beneficiary for the 
first taxable year in which there is no substantial risk of forfeiture 
(within the meaning

[[Page 187]]

of section 457(f)(3)(B)) of the rights to such compensation;
    (2) If the compensation deferred is subject to a substantial risk of 
forfeiture, the amount includible in gross income for the first taxable 
year in which there is no substantial risk of forfeiture includes 
earnings thereon to the date on which there is no substantial risk of 
forfeiture;
    (3) Earnings credited on the compensation deferred under the 
agreement or arrangement that are not includible in gross income under 
paragraph (a)(2) of this section are includible in the gross income of 
the participant or beneficiary only when paid or made available to the 
participant or beneficiary, provided that the interest of the 
participant or beneficiary in any assets (including amounts deferred 
under the plan) of the entity sponsoring the agreement or arrangement is 
not senior to the entity's general creditors; and
    (4) Amounts paid or made available to a participant or beneficiary 
under the agreement or arrangement are includible in the gross income of 
the participant or beneficiary under section 72, relating to annuities.
    (b) Exceptions. Paragraph (a) of this section does not apply with 
respect to--
    (1) A plan described in section 401(a) which includes a trust exempt 
from tax under section 501(a);
    (2) An annuity plan or contract described in section 403;
    (3) That portion of any plan which consists of a transfer of 
property described in section 83;
    (4) That portion of any plan which consists of a trust to which 
section 402(b) applies; or
    (5) A qualified governmental excess benefit arrangement described in 
section 415(m).
    (c) Amount included in income. The amount included in gross income 
on the applicable date under paragraphs (a)(1) and (a)(2) of this 
section is equal to the present value of the compensation (including 
earnings to the extent provided in paragraph (a)(2) of this section) on 
that date. For purposes of applying section 72 on the applicable date 
under paragraphs (a)(3) and (4) of this section, the participant is 
treated as having paid investment in the contract (or basis) to the 
extent that the deferred compensation has been taken into account by the 
participant in accordance with paragraphs (a)(1) and (a)(2) of this 
section.
    (d) Coordination of section 457(f) with section 83--(1) General 
rules. Under paragraph (b)(3) of this section, section 457(f) and 
paragraph (a) of this section do not apply to that portion of any plan 
which consists of a transfer of property described in section 83. For 
this purpose, a transfer of property described in section 83 means a 
transfer of property to which section 83 applies. Section 457(f) and 
paragraph (a) of this section do not apply if the date on which there is 
no substantial risk of forfeiture with respect to compensation deferred 
under an agreement or arrangement that is not an eligible plan is on or 
after the date on which there is a transfer of property to which section 
83 applies. However, section 457(f) and paragraph (a) of this section 
apply if the date on which there is no substantial risk of forfeiture 
with respect to compensation deferred under an agreement or arrangement 
that is not an eligible plan precedes the date on which there is a 
transfer of property to which section 83 applies. If deferred 
compensation payable in property is includible in gross income under 
section 457(f), then, as provided in section 72, the amount includible 
in gross income when that property is later transferred or made 
available to the service provider is the excess of the value of the 
property at that time over the amount previously included in gross 
income under section 457(f).
    (2) Examples. The provisions of this paragraph (d) are illustrated 
in the following examples:

    Example 1. (i) Facts. As part of an arrangement for the deferral of 
compensation, an eligible employer agrees on December 1, 2002 to pay an 
individual rendering services for the eligible employer a specified 
dollar amount on January 15, 2005. The arrangement provides for the 
payment to be made in the form of property having a fair market value 
equal to the specified dollar amount. The individual's rights to the 
payment are not subject to a substantial risk of forfeiture (within the 
meaning of section 457(f)(3)(B)).
    (ii) Conclusion. In this Example 1, because there is no substantial 
risk of forfeiture with

[[Page 188]]

respect to the agreement to transfer property in 2005, the present value 
(as of December 1, 2002) of the payment is includible in the 
individual's gross income for 2002. Under paragraph (a)(4) of this 
section, when the payment is made on January 15, 2005, the amount 
includible in the individual's gross income is equal to the excess of 
the fair market value of the property when paid, over the amount that 
was includible in gross income for 2002 (which is the basis allocable to 
that payment).
    Example 2. (i) Facts. As part of an arrangement for the deferral of 
compensation, individuals A and B rendering services for a tax-exempt 
entity each receive in 2010 property that is subject to a substantial 
risk of forfeiture (within the meaning of section 457(f)(3)(B) and 
within the meaning of section 83(c)(1)). Individual A makes an election 
to include the fair market value of the property in gross income under 
section 83(b) and individual B does not make this election. The 
substantial risk of forfeiture for the property transferred to 
individual A lapses in 2012 and the substantial risk of forfeiture for 
the property transferred to individual B also lapses in 2012. Thus, the 
property transferred to individual A is included in A's gross income for 
2010 when A makes a section 83(b) election and the property transferred 
to individual B is included in B's gross income for 2012 when the 
substantial risk of forfeiture for the property lapses.
    (ii) Conclusion. In this Example 2, in each case, the compensation 
deferred is not subject to section 457(f) or this section because 
section 83 applies to the transfer of property on or before the date on 
which there is no substantial risk of forfeiture with respect to 
compensation deferred under the arrangement.
    Example 3. (i) Facts. In 2004, Z, a tax-exempt entity, grants an 
option to acquire property to employee C. The option lacks a readily 
ascertainable fair market value, within the meaning of section 83(e)(3), 
has a value on the date of grant equal to $100,000, and is not subject 
to a substantial risk of forfeiture (within the meaning of section 
457(f)(3)(B) and within the meaning of section 83(c)(1)). Z exercises 
the option in 2012 by paying an exercise price of $75,000 and receives 
property that has a fair market value (for purposes of section 83) equal 
to $300,000.
    (ii) Conclusion. In this Example 3, under section 83(e)(3), section 
83 does not apply to the grant of the option. Accordingly, C has income 
of $100,000 in 2004 under section 457(f). In 2012, C has income of 
$125,000, which is the value of the property transferred in 2012, minus 
the allocable portion of the basis that results from the $100,000 of 
income in 2004 and the $75,000 exercise price.
    Example 4. (i) Facts. In 2010, X, a tax-exempt entity, agrees to pay 
deferred compensation to employee D. The amount payable is $100,000 to 
be paid 10 years later in 2020. The commitment to make the $100,000 
payment is not subject to a substantial risk of forfeiture. In 2010, the 
present value of the $100,000 is $50,000. In 2018, X transfers to D 
property having a fair market value (for purposes of section 83) equal 
to $70,000. The transfer is in partial settlement of the commitment made 
in 2010 and, at the time of the transfer in 2018, the present value of 
the commitment is $80,000. In 2020, X pays D the $12,500 that remains 
due.
    (ii) Conclusion. In this Example 4, D has income of $50,000 in 2010. 
In 2018, D has income of $30,000, which is the amount transferred in 
2018, minus the allocable portion of the basis that results from the 
$50,000 of income in 2010. (Under section 72(e)(2)(B), income is 
allocated first. The income is equal to $30,000 ($80,000 minus the 
$50,000 basis), with the result that the allocable portion of the basis 
is equal to $40,000 ($70,000 minus the $30,000 of income).) In 2020, D 
has income of $2,500 ($12,500 minus $10,000, which is the excess of the 
original $50,000 basis over the $40,000 basis allocated to the transfer 
made in 2018).

[T.D. 9075, 68 FR 41240, July 11, 2003]



Sec. 1.457-12  Effective dates.

    (a) General effective date. Except as otherwise provided in this 
section, Sec. Sec. 1.457-1 through 1.457-11 apply for taxable years 
beginning after December 31, 2001.
    (b) Transition period for eligible plans to comply with EGTRRA. For 
taxable years beginning after December 31, 2001, and before January 1, 
2004, a plan does not fail to be an eligible plan as a result of 
requirements imposed by the Economic Growth and Tax Relief 
Reconciliation Act of 2001 (115 Stat. 385) (EGTRRA) (Public Law 107-16) 
June 7, 2001, if it is operated in accordance with a reasonable, good 
faith interpretation of EGTRRA.
    (c) Special rule for distributions from rollover accounts. The last 
sentence of Sec. 1.457-6(a) (relating to distributions of amounts held 
in a separate account for eligible rollover distributions) applies for 
taxable years beginning after December 31, 2003.
    (d) Special rule for options. Section 1.457-11(d) does not apply 
with respect to an option without a readily ascertainable fair market 
value (within the meaning of section 83(e)(3)) that was granted on or 
before May 8, 2002.
    (e) Special rule for qualified domestic relations orders. Section 
1.457-10(c) (relating to qualified domestic relations

[[Page 189]]

orders) applies for transfers, distributions, and payments made after 
December 31, 2001.

[T.D. 9075, 68 FR 41240, July 11, 2003]



Sec. 1.458-1  Exclusion for certain returned magazines, paperbacks, 
or records.

    (a) In general--(1) Introduction. For taxable years beginning after 
September 30, 1979, section 458 allows accrual basis taxpayers to elect 
to use a method of accounting that excludes from gross income some or 
all of the income attributable to qualified sales during the taxable 
year of magazines, paperbacks, or records, that are returned before the 
close of the applicable merchandise return period for that taxable year. 
Any amount so excluded cannot be excluded or deducted from gross income 
for the taxable year in which the merchandise is returned to the 
taxpayer. For the taxable year in which the taxpayer first uses this 
method of accounting, the taxpayer is not allowed to exclude from gross 
income amounts attributable to merchandise returns received during the 
taxable year that would have been excluded from gross income for the 
prior taxable year had the taxpayer used this method of accounting for 
that prior year. (See paragraph (e) of this section for rules describing 
how this amount should be taken into account.) The election to use this 
method of accounting shall be made in accordance with the rules 
contained in section 458(c) and in Sec. 1.458-2 and this section. A 
taxpayer that does not elect to use this method of accounting can reduce 
income for returned merchandise only for the taxable year in which the 
merchandise is actually returned unsold by the purchaser.
    (2) Effective date. While this section is generally effective only 
for taxable years beginning after August 31, 1984, taxpayers may rely on 
the provisions of paragraphs (a) through (f) of this section in taxable 
years beginning after September 30, 1979.
    (b) Definitions--(1) Magazine. ``Magazine'' means a publication, 
usually paper-backed and sometimes illustrated, that is issued at 
regular intervals and contains stories, poems, articles, features, etc. 
This term includes periodicals, but does not include newspapers or 
volumes of a single publication issued at various intervals. However, 
volumes of a single publication that are issued at least annually, are 
related by title or subject matter to a magazine, and would otherwise 
qualify as a magazine, will be treated as a magazine.
    (2) Paperback. ``Paperback'' means a paperback book other than a 
magazine. Unlike a hardback book, which usually has stiff front and back 
covers that enclose pages bound to a separate spine, a paperback book is 
characterized by a flexible outer cover to which the pages of the book 
are directly affixed.
    (3) Record. ``Record'' means a disc, tape, or similar item on which 
music, spoken or other sounds are recorded. However, the term does not 
include blank records, tapes, etc., on which it is expected the ultimate 
purchaser will record. The following items, provided they carry pre-
recorded sound, are examples of ``records'': audio and video cassettes, 
eight-track tapes, reel-to-reel tapes, cylinders, and flat, compact, and 
laser discs.
    (4) Qualified sale. In order for a sale to be considered a qualified 
sale, both of the following conditions must be met:
    (i) The taxpayer must be under a legal obligation (as determined by 
applicable State law), at the time of sale, to adjust the sales price of 
the magazine, paperback, or record on account of the purchaser's failure 
to resell it; and
    (ii) The taxpayer must actually adjust the sales price of the 
magazine, paperback, or record to reflect the purchaser's failure to 
resell the merchandise. The following are examples of adjustments to the 
sales price of unsold merchandise: Cash refunds, credits to the account 
of the purchaser, and repurchases of the merchandise. The adjustment 
need not be equal to the full amount of the sales price of the item. 
However, a markdown of the sales price under an agreement whereby the 
purchaser continues to hold the merchandise for sale or other 
disposition (other than solely for scrap) does not constitute an 
adjustment resulting from a failure to resell.

[[Page 190]]

    (5) Merchandise return period--(i) In general. Unless the taxpayer 
elects a shorter period, the ``merchandise return period'' is the period 
that ends 2 months and 15 days after the close of the taxable year for 
sales of magazines and 4 months and 15 days after the close of the 
taxable year for sales of paperbacks and records.
    (ii) Election to use shorter period. The taxpayer may select a 
shorter merchandise return period than the applicable period set forth 
in paragraph (b)(5)(i) of this section.
    (iii) Change in merchandise return period. Any change in the 
merchandise return period after its initial establishment will be 
treated as a change in method of accounting.
    (c) Amount of the exclusion--(1) In general. Except as otherwise 
provided in paragraph (g) of this section, the amount of the gross 
income exclusion with respect to any qualified sale is equal to the 
lesser of--
    (i) The amount covered by the legal obligation referred to in 
paragraph (b)(4)(i) of this section; or
    (ii) The amount of the adjustment agreed to by the taxpayer before 
the close of the merchandise return period.
    (2) Price adjustment in excess of legal obligation. The excess, if 
any, of the amount described in paragraph (c)(1)(ii) of this section 
over the amount described in paragraph (c)(1)(i) of this section should 
be excluded in the taxable year in which it is properly accruable under 
section 461.
    (d) Return of the merchandise--(1) In general. (i) The exclusion 
from gross income allowed by section 458 applies with respect to a 
qualified sale of merchandise only if the seller receives, before the 
close of the merchandise return period, either--
    (A) The physical return of the merchandise; or
    (B) Satisfactory evidence that the merchandise has not been and will 
not be resold (as defined in paragraph (d)(2) of this section).
    (ii) For purposes of this paragraph (d), evidence of a return 
received by an agent of the seller (other than the purchaser who 
purchased the merchandise from the seller) will be considered to be 
received by the seller at the time the agent receives the merchandise or 
evidence.
    (2) Satisfactory evidence. Evidence that merchandise has not been 
and will not be resold is satisfactory only if the seller receives--
    (i) Physical return of some portion of the merchandise (e.g., 
covers) provided under either the agreement between the seller and the 
purchaser or industry practice (such return evidencing the fact that the 
purchaser has not and will not resell the merchandise); or
    (ii) A written statement from the purchaser specifying the 
quantities of each title not resold, provided either--
    (A) The statement contains a representation that the items specified 
will not be resold by the purchaser; or
    (B) The past dealings, if any, between the parties and industry 
practice indicate that such statement constitutes a promise by the 
purchaser not to resell the items.
    (3) Retention of evidence. In the case of a return of merchandise 
(described in paragraph (d)(1)(i)(A) of this section) or portion thereof 
(described in paragraph (d)(2)(i) of this section), the seller has no 
obligation to retain physical evidence of the returned merchandise or 
portion thereof, provided the seller maintains documentary evidence that 
describes the quantity of physical items returned to the seller and 
indicates that the items were returned before the close of the 
merchandise return period.
    (e) Transitional adjustment--(1) In general. An election to change 
from some other method of accounting for the return of magazines, 
paperbacks, or records to the method of accounting described in section 
458 is a change in method of accounting that requires a transitional 
adjustment. Section 458 provides special rules for transitional 
adjustments that must be taken into account as a result of this change. 
See paragraph (e)(2) of this section for special rules applicable to 
magazines and paragraphs (e) (3) and (4) of this section for special 
rules applicable to paperbacks and records.
    (2) Magazines: 5-year spread of decrease in taxable income. For 
taxpayers who

[[Page 191]]

have elected to use the method of accounting described in section 458 to 
account for returned magazines for a taxable year, section 458(d) and 
this paragraph (e)(2) provide a special rule for taking into account any 
decrease in taxable income resulting from the adjustment required by 
section 481(a)(2). Under these provisions, one-fifth of the transitional 
adjustment must be taken into account in the taxable year of the change 
and in each of the 4 succeeding taxable years. For example, if the 
application of section 481(a)(2) would produce a decrease in taxable 
income of $50 for 1980, the year of change, then $10 (one-fifth of $50) 
must be taken into account as a decrease in taxable income for 1980, 
1981, 1982, 1983, and 1984.
    (3) Suspense account for paperbacks and records--(i) In general. For 
taxpayers who have elected to use the method of accounting described in 
section 458 to account for returned paperbacks and records for a taxable 
year, section 458(e) provides that, in lieu of applying section 481, an 
electing taxpayer must establish a separate suspense account for its 
paperback business and its record business. The initial opening balance 
of the suspense account is described in paragraph (e)(3)(ii)(A) of this 
section. An initial adjustment to gross income for the year of election 
is described in paragraph (e)(3)(ii)(B) of this section. Annual 
adjustments to the suspense account are described in paragraph 
(e)(3)(iii)(A) of this section. Gross income adjustments are described 
in paragraph (e)(3)(iii)(B) of this section. Examples are provided in 
paragraph (e)(4) of this section. The effect of the suspense account is 
to defer all, or some part, of the deduction of the transitional 
adjustment until the taxpayer is no longer engaged in the trade or 
business of selling paperbacks or records, whichever is applicable.
    (ii) Establishing a suspense account--(A) Initial opening balance. 
To compute the initial opening balance of the suspense account for the 
first taxable year for which an election is effective, the taxpayer must 
determine the section 458 amount (as defined in paragraph (e)(3)(ii)(C) 
of this section) for each of the three preceding taxable years. The 
initial opening balance of the account is the largest of the section 458 
amounts.
    (B) Initial year adjustment. If the initial opening balance in the 
suspense account exceeds the section 458 amount (as defined in paragraph 
(e)(3)(ii)(C) of this section) for the taxable year immediately 
preceding the year of election, the excess is included in the taxpayer's 
gross income for the first taxable year for which the election was made.
    (C) Section 458 amount. For purposes of paragraph (e)(3)(ii) of this 
section, the section 458 amount for a taxable year is the dollar amount 
of merchandise returns that would have been excluded from gross income 
under section 458(a) for that taxable year if the section 458 election 
had been in effect for that taxable year.
    (iii) Annual adjustments--(A) Adjustment to the suspense account. 
Adjustments are made to the suspense account each year to account for 
fluctuations in merchandise returns. To compute the annual adjustment, 
the taxpayer must determine the amount to be excluded under the election 
from gross income under section 458(a) for the taxable year. If the 
amount is less than the opening balance in the suspense account for the 
taxable year, the balance in the suspense account is reduced by the 
difference. Conversely, if the amount is greater than the opening 
balance in the suspense account for the taxable year, the account is 
increased by the difference, but not to an amount in excess of the 
initial opening balance described in paragraph (e)(3)(ii)(A) of this 
section. Therefore, the balance in the suspense account will never be 
greater than the initial opening balance in the suspense account 
determined in paragraph (e)(3)(ii)(A) of this section. However, the 
balance in the suspense account after adjustments may be less than this 
initial opening balance in the suspense account.
    (B) Gross income adjustments. Adjustments to the suspense account 
for years subsequent to the year of election also produce adjustments in 
the taxpayer's gross income. Adjustments which reduce the balance in the 
suspense account reduce gross income for the year in which the 
adjustment to

[[Page 192]]

the suspense account is made. Adjustments which increase the balance in 
the suspense account increase gross income for the year in which the 
adjustment to the suspense account is made.
    (4) Example. The provisions of paragraph (e)(3) of this section may 
be illustrated by the following example:

    Example: (i) X corporation, a paperback distributor, makes a timely 
section 458 election for its taxable year ending December 31, 1980. If 
the election had been in effect for the taxable years ending on December 
31, 1977, 1978, and 1979, the dollar amounts of the qualifying returns 
would have been $5, $8, and $6, respectively. The initial opening 
balance of X's suspense account on January 1, 1980, is $8, the largest 
of these amounts. Since the initial opening balance ($8), is larger than 
the qualifying returns for 1979 ($6), the initial adjustment to gross 
income for 1980 is $2 ($8-$6).
    (ii) X has $5 in qualifying returns for its taxable year ending 
December 31, 1980. X must reduce its suspense account by $3, which is 
the excess of the opening balance ($8) over the amount of qualifying 
returns for the 1980 taxable year ($5). X also reduces its gross income 
for 1980 by $3. Thus, the net amount excludable from gross income for 
the 1980 taxable year after taking into account the qualifying returns, 
the gross income adjustment, and the initial year adjustment is $6 
($3+$5-$2).
    (iii) X has qualifying returns of $7 for its taxable year ending 
December 31, 1981. X must increase its suspense account balance by $2, 
which is the excess of the amount of qualifying returns for 1981 ($7) 
over X's opening balance in the suspense account ($5). X must also 
increase its gross income by $2. Thus, the net income excludable from 
gross income for the 1981 taxable year after taking into account the 
qualifying returns and the gross income adjustment is $5 ($7-$2).
    (iv) X has qualifying returns of $10 for its taxable year ending 
December 31, 1982. The opening balance in X's suspense account of $7 
will not be increased in excess of the initial opening balance ($8). X 
must also increase gross income by $1. Thus, the net amount excludable 
from gross income for the 1982 taxable year is $9 ($10-$1).
    (v) This example is summarized by the following table:

----------------------------------------------------------------------------------------------------------------
                                                              Years Ending December 31
                                   -----------------------------------------------------------------------------
                                        1977         1978         1979       1980 \1\       1981         1982
----------------------------------------------------------------------------------------------------------------
Facts:
    Qualifying returns during                $5           $8           $6           $5           $7          $10
     merchandise return period for
     the taxable year.............
                                   =============================================================================
Adjustment to suspense account:
    Opening balance...............  ...........  ...........  ...........           $8           $5           $7
    Addition to account \2\.......  ...........  ...........  ...........  ...........            2            1
    Reduction to account \3\......  ...........  ...........  ...........          (3)
                                   -----------------------------------------------------------------------------
      Opening balance for next      ...........  ...........  ...........           $5           $7           $8
       year.......................
                                   =============================================================================
Amount excludable from income:
    Initial year adjustment.......  ...........  ...........  ...........         $(2)
    Amount excludable as            ...........  ...........  ...........            5           $7          $10
     qualifying returns in
     merchandise return period....
    Adjustment for increase in      ...........  ...........  ...........  ...........          (2)          (1)
     suspense account.............
    Adjustment for decrease in      ...........  ...........  ...........            3
     suspense account.............
                                   -----------------------------------------------------------------------------
      Net amount excludable for     ...........  ...........  ...........           $6           $5           $9
       the year...................
----------------------------------------------------------------------------------------------------------------
\1\ Year of Change.
\2\ Applies when qualifying returns during the merchandise return period exceed the opening balance; the
  addition is not to cause the suspense account to exceed the initial opening balance.
\3\ Applies when qualifying returns during the merchandise return period are less than the opening balance.

    (f) Subchapter C transactions--(1) General rule. If a transfer of 
substantially all the assets of a trade or business in which paperbacks 
or records are sold is made to an acquiring corporation, and if the 
acquiring corporation determines its basis in these assets, in whole or 
part, with reference to the basis of these assets in the hands of the 
transferor, then for the purposes of section

[[Page 193]]

458(e) the principles of section 381 and Sec. 1.381(c)(4)-1 will apply. 
The application of this rule is not limited to the transactions 
described in section 381(a). Thus, the rule also applies, for example, 
to transactions described in section 351.
    (2) Special rules. If, in the case of a transaction described in 
paragraph (f)(1) of this section, an acquiring corporation acquires 
assets that were used in a trade or business that was not subject to a 
section 458 election from a transferor that is owned or controlled 
directly (or indirectly through a chain of corporations) by the same 
interests, and if the acquiring corporation uses the acquired assets in 
a trade or business for which the acquiring corporation later makes an 
election to use section 458, then the acquiring corporation must 
establish a suspense account by taking into account not only its own 
experience but also the transferor's experience when the transferor held 
the assets in its trade or business. Furthermore, the transferor is not 
allowed a deduction or exclusion for merchandise returned after the date 
of the transfer attributable to sales made by the transferor before the 
date of the transfer. Such returns shall be considered to be received by 
the acquiring corporation.
    (3) Example. The provisions of paragraph (f)(2) of this section may 
be illustrated by the following example.

    Example. Corporation S, a calendar year taxpayer, is a wholly owned 
subsidiary of Corporation P, a calendar year taxpayer. On December 31, 
1982, S acquires from P substantially all of the assets used in a trade 
or business in which records are sold. P had not made an election under 
section 458 with respect to the qualified sale of records made in 
connection with that trade or business. S makes an election to use 
section 458 for its taxable year ending December 31, 1983, for the trade 
or business in which the acquired assets are used. P's qualified record 
returns within the 4 month and 15 day merchandise return period 
following the 1980 and 1981 taxable years were $150 and $170, 
respectively. S's qualified record returns during the merchandise return 
period following 1982 were $160. S must establish a suspense account by 
taking into account both P's and S's experience for the 3 immediately 
preceding taxable years. Thus, the initial opening balance of S's 
suspense account is $170. S must also make an initial year adjustment of 
$10 ($170--$160), which S must include in income for S's taxable year 
ending December 31, 1983. P is not entitled to a deduction or exclusion 
for merchandise received after the date of the transfer (December 31, 
1982) attributable to sales made by the transferor before the date of 
transfer. Thus, P is not entitled to a deduction or exclusion for the 
$160 of merchandise received by S during the first 4 months and 15 days 
of 1983.

    (g) Adjustment to inventory and cost of goods sold. (1) If a 
taxpayer makes adjustments to gross receipts for a taxable year under 
the method of accounting described in section 458, the taxpayer, in 
determining excludable gross income, is also required to make 
appropriate correlative adjustments to purchases or closing inventory 
and to cost of goods sold for the same taxable year. Adjustments are 
appropriate, for example, where the taxpayer holds the merchandise 
returned for resale or where the taxpayer is entitled to receive a price 
adjustment from the person or entity that sold the merchandise to the 
taxpayer. Cost of goods sold must be properly adjusted in accordance 
with the provisions of Sec. 1.61-3 which provides, in pertinent part, 
that gross income derived from a manufacturing or merchandising business 
equals total sales less cost of goods sold.
    (2) The provisions of this paragraph (g) may be illustrated by the 
following examples. These examples do not, however, reflect any required 
adjustments under paragraph (e)(3) of this section.

    Example 1. (i) In 1986, P, a publisher, properly elects under 
section 458 of the Code not to include in its gross income in the year 
of sale, income attributable to qualified sales of paperback books 
returned within the specified statutory merchandise return period of 4 
months and 15 days. P and D, a distributor, agree that P shall provide D 
with a full refund for paperback books that D purchases from P and is 
unable to resell, provided the merchandise is returned to P within four 
months following the original sale. The agreement constitutes a legal 
obligation. The agreement provides that D's return of the covers of 
paperback books within the first four months following their sale 
constitutes satisfactory evidence that D has not resold and will not 
resell the paperback books. During P's 1989 taxable year, pursuant to 
the agreement, P sells D 500 paperback books for $1 each. In 1990, 
during the merchandise return period, D returns covers from 100 unsold 
paperback books representing $100 of P's 1989 sales of paperback

[[Page 194]]

books. P's cost attributable to the returned books is $25. No adjustment 
to cost of goods sold is required under paragraph (g)(1) of this section 
because P is not holding returned merchandise for resale. P's proper 
amount excluded from its 1989 gross income under section 458 is $100.
    (ii) If D returns the paperback books, rather than the covers, to P 
and these same books are then held by P for resale to other customers, 
paragraph (g)(1) of this section applies. Under paragraph (g)(1), P is 
required to decrease its cost of goods sold by $25, the amount of P's 
cost attributable to the returned merchandise. The proper amount 
excluded from P's 1989 gross income under section 458 is $75, resulting 
from adjustments to sales and cost of sales [(100x$1)--$25].
    Example 2. (i) In 1986, D, a distributor, properly elects under 
section 458 of the Code not to include in its gross income in the year 
of sale, income attributable to qualified sales of paperback books 
returned within the specified statutory merchandise return period of 
four months and 15 days. D and R, a retailer, agree that D shall provide 
a full refund for paperback books that R purchases from it and is unable 
to resell. D and R also have agreed that the merchandise must be 
returned to D within four months following the original sale. The 
agreement constitutes a legal obligation. D is similarly entitled to a 
full refund from P, the publisher, for the same paperback books. In 
1990, during the merchandise return period, R returns paperback books to 
D representing $100 of 1989 sales. D's cost relating to these sales is 
$50. Under paragraph (g)(1) of this section, D must decrease its costs 
of goods sold by $50. D's proper amount excluded from its 1989 gross 
income under section 458 is $50 resulting from adjustments to sales and 
costs of sales ($100--$50).
    (ii) If D is instead only entitled to a 50 percent refund from P, D 
is required under paragraph (g)(1) of this section to decrease its costs 
of goods sold by $25, the amount of refund from P. D's proper amount 
excluded from its 1989 gross income under section 458 is $75, resulting 
from adjustments to sales and cost of sales ($100--$25).

[T.D. 8426, 57 FR 38596, Aug. 26, 1992; 57 FR 45879, Oct. 5, 1992]



Sec. 1.458-2  Manner of and time for making election.

    (a) Scope. For taxable years beginning after September 30, 1979, 
section 458 provides a special method of accounting for taxpayers who 
account for sales of magazines, paperbacks, or records using an accrual 
method of accounting. In order to use the special method of accounting 
under section 458, a taxpayer must make an election in the manner 
prescribed in this section. The election does not require the prior 
consent of the Internal Revenue Service. The election is effective for 
the taxable year for which it is made and for all subsequent taxable 
years, unless the taxpayer secures the prior consent of the Internal 
Revenue Service to revoke such election.
    (b) Separate election for each trade or business. An election is 
made with respect to each trade or business of a taxpayer in connection 
with which qualified sales (as defined in section 458(b)(5)) of a 
category of merchandise were made. Magazines, paperbacks, and records 
are each treated as a separate category of merchandise. If qualified 
sales of two or more categories of merchandise are made in connection 
with the same trade or business, then solely for purposes of section 
458, each category is treated as a separate trade or business. For 
example, if a taxpayer makes qualified sales of both magazines and 
paperbacks in the same trade or business, then solely for purposes of 
section 458, the qualified sales relating to magazines are considered 
one trade or business and the qualified sales relating to paperbacks are 
considered a separate trade or business. Thus, if the taxpayer wishes to 
account under section 458 for the qualified sales of both magazines and 
paperbacks, such taxpayer must make a separate election for each 
category.
    (c) Manner of, and time for, making election. An election is made 
under section 458 and this section by filing a statement of election 
containing the information described in paragraph (d) of this section 
with the taxpayer's income tax return for first taxable year for which 
the election is made. The election must be made no later than the time 
prescribed by law (including extensions) for filing the income tax 
return for the first taxable year for which the election is made. Thus, 
the election may not be filed with an amended income tax return after 
the prescribed date (including extensions) for filing the original 
return for such year.
    (d) Required information. The statement of election required by 
paragraph (c) of this section must indicate that an election is being 
made under section

[[Page 195]]

458(c) and must set forth the following information:
    (1) The taxpayer's name, address, and identification number;
    (2) A description of each trade or business for which an election is 
made;
    (3) The first taxable year for which an election is made for each 
trade or business;
    (4) The merchandise return period (as defined in section 458(b)(7)) 
for each trade or business for which an election is made;
    (5) With respect to an election that applies to magazines, the 
amount of the adjustment computed under section 481(a) resulting from 
the change to the method of accounting described in section 458; and
    (6) With respect to an election that applies to paperbacks or 
records, the initial opening balance (computed in accordance with 
section 458(e)) in the suspense account for each trade or business for 
which an election is made.

The statement of election should be made on a Form 3115 which need 
contain no information other than that required by this paragraph.

[T.D. 7628, 44 FR 33398, June 11, 1979. Redesignated by T.D. 8426, 57 FR 
38599, Aug. 26, 1992]



Sec. 1.460-0  Outline of regulations under section 460.

    This section lists the paragraphs contained in Sec. 1.460-1 through 
Sec. 1.460-6.

                   Sec. 1.460-1 Long-term contracts.

    (a) Overview.
    (1) In general.
    (2) Exceptions to required use of PCM.
    (i) Exempt construction contract.
    (ii) Qualified ship or residential construction contract.
    (b) Terms.
    (1) Long-term contract.
    (2) Contract for the manufacture, building, installation, or 
construction of property.
    (i) In general.
    (ii) De minimis construction activities.
    (3) Allocable contract costs.
    (4) Related party.
    (5) Contracting year.
    (6) Completion year.
    (7) Contract commencement date.
    (8) Incurred.
    (9) Independent research and development expenses.
    (10) Long-term contract methods of accounting.
    (c) Entering into and completing long-term contracts.
    (1) In general.
    (2) Date contract entered into.
    (i) In general.
    (ii) Options and change orders.
    (3) Date contract completed.
    (i) In general.
    (ii) Secondary items.
    (iii) Subcontracts.
    (iv) Final completion and acceptance.
    (A) In general.
    (B) Contingent compensation.
    (C) Assembly or installation.
    (D) Disputes.
    (d) Allocation among activities.
    (1) In general.
    (2) Non-long-term contract activity.
    (e) Severing and aggregating contracts.
    (1) In general.
    (2) Facts and circumstances.
    (i) Pricing.
    (ii) Separate delivery or acceptance.
    (iii) Reasonable businessperson.
    (3) Exceptions.
    (i) Severance for PCM.
    (ii) Options and change orders.
    (4) Statement with return.
    (f) Classifying contracts.
    (1) In general.
    (2) Hybrid contracts.
    (i) In general.
    (ii) Elections.
    (3) Method of accounting.
    (4) Use of estimates.
    (i) Estimating length of contract.
    (ii) Estimating allocable contract costs.
    (g) Special rules for activities benefitting long-term contracts of 
a related party.
    (1) Related party use of PCM.
    (i) In general.
    (ii) Exception for components and subassemblies.
    (2) Total contract price.
    (3) Completion factor.
    (h) Effective date.
    (1) In general.
    (2) Change in method of accounting.
    (i) [Reserved]
    (j) Examples.

            Sec. 1.460-2 Long-term manufacturing contracts.

    (a) In general.
    (b) Unique.
    (1) In general.
    (2) Safe harbors.
    (i) Short production period.
    (ii) Customized item.
    (iii) Inventoried item.
    (c) Normal time to complete.
    (1) In general.
    (2) Production by related parties.
    (d) Qualified ship contracts.
    (e) Examples.

             Sec. 1.460-3 Long-term construction contracts.

    (a) In general.
    (b) Exempt construction contracts.

[[Page 196]]

    (1) In general.
    (2) Home construction contract.
    (i) In general.
    (ii) Townhouses and rowhouses.
    (iii) Common improvements.
    (iv) Mixed use costs.
    (3) $10,000,000 gross receipts test.
    (i) In general.
    (ii) Single employer.
    (iii) Attribution of gross receipts.
    (c) Residential construction contracts.

      Sec. 1.460-4 Methods of accounting for long-term contracts.

    (a) Overview.
    (b) Percentage-of-completion method.
    (1) In general.
    (2) Computations.
    (3) Post-completion-year income.
    (4) Total contract price.
    (i) In general.
    (A) Definition.
    (B) Contingent compensation.
    (C) Non-long-term contract activities.
    (ii) Estimating total contract price.
    (5) Completion factor.
    (i) Allocable contract costs.
    (ii) Cumulative allocable contract costs.
    (iii) Estimating total allocable contract costs.
    (iv) Pre-contracting-year costs.
    (v) Post-completion-year costs.
    (6) 10-percent method.
    (i) In general.
    (ii) Election.
    (7) Terminated contract.
    (i) Reversal of income.
    (ii) Adjusted basis.
    (iii) Look-back method.
    (c) Exempt contract methods.
    (1) In general.
    (2) Exempt-contract percentage-of-completion method.
    (i) In general.
    (ii) Determination of work performed.
    (d) Completed-contract method.
    (1) In general.
    (2) Post-completion-year income and costs.
    (3) Gross contract price.
    (4) Contracts with disputed claims.
    (i) In general.
    (ii) Taxpayer assured of profit or loss.
    (iii) Taxpayer unable to determine profit or loss.
    (iv) Dispute resolved.
    (e) Percentage-of-completion/capitalized-cost method.
    (f) Alternative minimum taxable income.
    (1) In general.
    (2) Election to use regular completion factors.
    (g) Method of accounting.
    (h) Examples.
    (i) [Reserved]
    (j) Consolidated groups and controlled groups.
    (1) Intercompany transactions.
    (i) In general.
    (ii) Definitions and nomenclature.
    (2) Example.
    (3) Effective dates.
    (i) In general.
    (ii) Prior law.
    (4) Consent to change method of accounting.
    (k) Mid-contract change in taxpayer.
    (1) In general.
    (2) Constructive completion transactions.
    (i) Scope.
    (ii) Old taxpayer.
    (iii) New taxpayer.
    (iv) Special rules relating to distributions of certain contracts by 
a partnership.
    (A) In general.
    (B) Old taxpayer.
    (C) New taxpayer.
    (D) Basis rules.
    (E) Section 751.
    (1) In general.
    (2) Ordering rules.
    (3) Step-in-the-shoes transactions.
    (i) Scope.
    (ii) Old taxpayer.
    (A) In general.
    (B) Gain realized on the transaction.
    (iii) New taxpayer.
    (A) Method of accounting.
    (B) Contract price.
    (C) Contract costs.
    (iv) Special rules related to certain corporate and partnership 
transactions.
    (A) Old taxpayer--basis adjustment.
    (1) In general.
    (2) Basis adjustment in excess of stock or partnership interest 
basis.
    (3) Subsequent dispositions of certain contracts.
    (B) New taxpayer.
    (1) Contract price adjustment.
    (2) Basis in contract.
    (C) Definition of old taxpayer and new taxpayer for certain 
partnership transactions.
    (D) Exceptions to step-in-the-shoes rules for S corporations.
    (v) Special rules relating to certain partnership transactions.
    (A) Section 704(c).
    (1) Contributions of contracts.
    (2) Revaluations of partnership property.
    (3) Allocation methods.
    (B) Basis adjustments under sections 743(b) and 734(b).
    (C) Cross reference.
    (D) Exceptions to step-in-the-shoes rules.
    (4) Anti-abuse rule.
    (5) Examples.
    (6) Effective date.

                  Sec. 1.460-5 Cost allocation rules.

    (a) Overview.
    (b) Cost allocation method for contracts subject to PCM.
    (1) In general.
    (2) Special rules.

[[Page 197]]

    (i) Direct material costs.
    (ii) Components and subassemblies.
    (iii) Simplified production methods.
    (iv) Costs identified under cost-plus long-term contracts and 
federal long-term contracts.
    (v) Interest.
    (A) In general.
    (B) Production period.
    (C) Application of section 263A(f).
    (vi) Research and experimental expenses.
    (vii) Service costs.
    (A) Simplified service cost method.
    (1) In general.
    (2) Example.
    (B) Jobsite costs.
    (C) Limitation on other reasonable cost allocation methods.
    (c) Simplified cost-to-cost method for contracts subject to the PCM.
    (1) In general.
    (2) Election.
    (d) Cost allocation rules for exempt construction contracts reported 
using CCM.
    (1) In general.
    (2) Indirect costs.
    (i) Indirect costs allocable to exempt construction contracts.
    (ii) Indirect costs not allocable to exempt construction contracts.
    (3) Large homebuilders.
    (e) Cost allocation rules for contracts subject to the PCCM.
    (f) Special rules applicable to costs allocated under this section.
    (1) Nondeductible costs.
    (2) Costs incurred for non-long-term contract activities.
    (g) Method of accounting.

                     Sec. 1.460-6 Look-back method.

    (a) In general.
    (1) Introduction.
    (2) Overview.
    (b) Scope of look-back method.
    (1) In general.
    (2) Exceptions from section 460.
    (3) De minimis exception.
    (4) Alternative minimum tax.
    (5) Effective date.
    (c) Operation of the look-back method.
    (1) Overview.
    (i) In general.
    (ii) Post-completion revenue and expenses.
    (A) In general.
    (B) Completion.
    (C) Discounting of contract price and contract cost adjustments 
subsequent to completion; election not to discount.
    (1) General rule.
    (2) Election not to discount.
    (3) Year-end discounting convention.
    (D) Revenue acceleration rule.
    (2) Look-back Step One.
    (i) Hypothetical reallocation of income among prior tax years.
    (ii) Treatment of estimated future costs in year of completion.
    (iii) Interim reestimates not considered.
    (iv) Tax years in which income is affected.
    (v) Costs incurred prior to contract execution; 10-percent method.
    (A) General rule.
    (B) Example.
    (vi) Amount treated as contract price.
    (A) General rule.
    (B) Contingencies.
    (C) Change orders.
    (3) Look-back Step Two: Computation of hypothetical overpayment or 
underpayment of tax.
    (i) In general.
    (ii) Redetermination of tax liability.
    (iii) Hypothetical underpayment or overpayment.
    (iv) Cumulative determination of tax liability.
    (v) Years affected by look-back only.
    (vi) Definition of tax liability.
    (4) Look-back Step Three: Calculation of interest on underpayment or 
overpayment.
    (i) In general.
    (ii) Changes in the amount of a loss or credit carryback or 
carryover.
    (iii) Changes in the amount of tax liability that generated a 
subsequent refund.
    (d) Simplified marginal impact method.
    (1) Introduction.
    (2) Operation.
    (i) In general.
    (ii) Applicable tax rate.
    (iii) Overpayment ceiling.
    (iv) Example.
    (3) Anti-abuse rule.
    (4) Application.
    (i) Required use by certain pass-through entities.
    (A) General rule.
    (B) Closely held.
    (C) Examples.
    (D) Domestic contracts.
    (1) General rule.
    (2) Portion of contract income sourced.
    (E) Application to foreign contracts.
    (F) Effective date.
    (ii) Elective use.
    (A) General rule.
    (B) Election requirements.
    (C) Consolidated group consistency rule.
    (e) Delayed reapplication method.
    (1) In general.
    (2) Time and manner of making election.
    (3) Examples.
    (f) Look-back reporting.
    (1) Procedure.
    (2) Treatment of interest on return.
    (i) General rule.
    (ii) Timing of look-back interest.
    (3) Statutes of limitations and compounding of interest on look-back 
interest.
    (g) Mid-contract change in taxpayer.
    (1) In general.

[[Page 198]]

    (2) Constructive completion transactions.
    (3) Step-in-the-shoes transactions.
    (i) General rules.
    (ii) Application of look-back method to pre-transaction period.
    (A) Contract price
    (B) Method.
    (C) Interest accrual period.
    (D) Information old taxpayer must provide.
    (1) In general.
    (2) Special rules for certain pass-through entity transactions.
    (iii) Application of look-back method to post-transaction years.
    (iv) S corporation elections.
    (4) Effective date.
    (h) Examples.
    (1) Overview.
    (2) Step One.
    (3) Step Two.
    (4) Post-completion adjustments.
    (5) Alternative minimum tax.
    (6) Credit carryovers.
    (7) Net operating losses.
    (8) Alternative minimum tax credit.
    (9) Period for interest.
    (i) [Reserved]
    (j) Election not to apply look-back method in de minimis cases.

[T.D. 9315, 55 FR 41670, Oct. 15, 1990, as amended by T.D. 8597, 60 FR 
36683, July 18, 1995; T.D. 8756, 63 FR 1918, Jan. 13, 1998; T.D. 8775, 
63 FR 36181, July 2, 1998; T.D. 8929, 66 FR 2224, Jan. 11, 2001; T.D. 
8995, 67 FR 34605, May 15, 2002; T.D. 9137, 69 FR 42553, July 16, 2004]



Sec. 1.460-1  Long-term contracts.

    (a) Overview--(1) In general. This section provides rules for 
determining whether a contract for the manufacture, building, 
installation, or construction of property is a long-term contract under 
section 460 and what activities must be accounted for as a single long-
term contract. Specific rules for long-term manufacturing and 
construction contracts are provided in Sec. Sec. 1.460-2 and 1.460-3, 
respectively. A taxpayer generally must determine the income from a 
long-term contract using the percentage-of-completion method described 
in Sec. 1.460-4(b) (PCM) and the cost allocation rules described in 
Sec. 1.460-5(b) or (c). In addition, after a contract subject to the 
PCM is completed, a taxpayer generally must apply the look-back method 
described in Sec. 1.460-6 to determine the amount of interest owed on 
any hypothetical underpayment of tax, or earned on any hypothetical 
overpayment of tax, attributable to accounting for the long-term 
contract under the PCM.
    (2) Exceptions to required use of PCM--(i) Exempt construction 
contract. The requirement to use the PCM does not apply to any exempt 
construction contract described in Sec. 1.460-3(b). Thus, a taxpayer 
may determine the income from an exempt construction contract using any 
accounting method permitted by Sec. 1.460-4(c) and, for contracts 
accounted for using the completed-contract method (CCM), any cost 
allocation method permitted by Sec. 1.460-5(d). Exempt construction 
contracts that are not subject to the PCM or CCM are not subject to the 
cost allocation rules of Sec. 1.460-5 except for the production-period 
interest rules of Sec. 1.460-5(b)(2)(v). Exempt construction 
contractors that are large homebuilders described in Sec. 1.460-5(d)(3) 
must capitalize costs under section 263A. All other exempt construction 
contractors must account for the cost of construction using the 
appropriate rules contained in other sections of the Internal Revenue 
Code or regulations.
    (ii) Qualified ship or residential construction contract. The 
requirement to use the PCM applies only to a portion of a qualified ship 
contract described in Sec. 1.460-2(d) or residential construction 
contract described in Sec. 1.460-3(c). A taxpayer generally may 
determine the income from a qualified ship contract or residential 
construction contract using the percentage-of-completion/capitalized-
cost method (PCCM) described in Sec. 1.460-4(e), but must use a cost 
allocation method described in Sec. 1.460-5(b) for the entire contract.
    (b) Terms--(1) Long-term contract. A long-term contract generally is 
any contract for the manufacture, building, installation, or 
construction of property if the contract is not completed within the 
contracting year, as defined in paragraph (b)(5) of this section. 
However, a contract for the manufacture of property is a long-term 
contract only if it also satisfies either the unique item or 12-month 
requirements described in Sec. 1.460-2. A contract for the manufacture 
of personal property is a manufacturing contract. In contrast, a 
contract for the building, installation, or construction of real 
property is a construction contract.

[[Page 199]]

    (2) Contract for the manufacture, building, installation, or 
construction of property--(i) In general. A contract is a contract for 
the manufacture, building, installation, or construction of property if 
the manufacture, building, installation, or construction of property is 
necessary for the taxpayer's contractual obligations to be fulfilled and 
if the manufacture, building, installation, or construction of that 
property has not been completed when the parties enter into the 
contract. If a taxpayer has to manufacture or construct an item to 
fulfill its obligations under the contract, the fact that the taxpayer 
is not required to deliver that item to the customer is not relevant. 
Whether the customer has title to, control over, or bears the risk of 
loss from, the property manufactured or constructed by the taxpayer also 
is not relevant. Furthermore, how the parties characterize their 
agreement (e.g., as a contract for the sale of property) is not 
relevant.
    (ii) De minimis construction activities. Notwithstanding paragraph 
(b)(2)(i) of this section, a contract is not a construction contract 
under section 460 if the contract includes the provision of land by the 
taxpayer and the estimated total allocable contract costs, as defined in 
paragraph (b)(3) of this section, attributable to the taxpayer's 
construction activities are less than 10 percent of the contract's total 
contract price, as defined in Sec. 1.460-4(b)(4)(i). For the purposes 
of this paragraph (b)(2)(ii), the allocable contract costs attributable 
to the taxpayer's construction activities do not include the cost of the 
land provided to the customer. In addition, a contract's estimated total 
allocable contract costs include a proportionate share of the estimated 
cost of any common improvement that benefits the subject matter of the 
contract if the taxpayer is contractually obligated, or required by law, 
to construct the common improvement.
    (3) Allocable contract costs. Allocable contract costs are costs 
that are allocable to a long-term contract under Sec. 1.460-5.
    (4) Related party. A related party is a person whose relationship to 
a taxpayer is described in section 707(b) or 267(b), determined without 
regard to section 267(f)(1)(A) and determined by replacing ``at least 80 
percent'' with ``more than 50 percent'' for the purposes of determining 
the ownership of the stock of a corporation in sections 267(b)(2), (8), 
(10)(A), and (12).
    (5) Contracting year. The contracting year is the taxable year in 
which a taxpayer enters into a contract as described in paragraph (c)(2) 
of this section.
    (6) Completion year. The completion year is the taxable year in 
which a taxpayer completes a contract as described in paragraph (c)(3) 
of this section.
    (7) Contract commencement date. The contract commencement date is 
the date that a taxpayer or related party first incurs any allocable 
contract costs, such as design and engineering costs, other than 
expenses attributable to bidding and negotiating activities. Generally, 
the contract commencement date is relevant in applying Sec. 1.460-
6(b)(3) (concerning the de minimis exception to the look-back method 
under section 460(b)(3)(B)); Sec. 1.460-5(b)(2)(v)(B)(1)(i) (concerning 
the production period subject to interest allocation); Sec. 1.460-2(d) 
(concerning qualified ship contracts); and Sec. 1.460-3(b)(1)(ii) 
(concerning the construction period for exempt construction contracts).
    (8) Incurred. Incurred has the meaning given in Sec. 1.461-1(a)(2) 
(concerning the taxable year a liability is incurred under the accrual 
method of accounting), regardless of a taxpayer's overall method of 
accounting. See Sec. 1.461-4(d)(2)(ii) for economic performance rules 
concerning the PCM.
    (9) Independent research and development expenses. Independent 
research and development expenses are any expenses incurred in the 
performance of research or development, except that this term does not 
include any expenses that are directly attributable to a particular 
long-term contract in existence when the expenses are incurred and this 
term does not include any expenses under an agreement to perform 
research or development.
    (10) Long-term contract methods of accounting. Long-term contract 
methods of accounting, which include the PCM, the

[[Page 200]]

CCM, the PCCM, and the exempt-contract percentage-of-completion method 
(EPCM), are methods of accounting that may be used only for long-term 
contracts.
    (c) Entering into and completing long-term contracts--(1) In 
general. To determine when a contract is entered into under paragraph 
(c)(2) of this section and completed under paragraph (c)(3) of this 
section, a taxpayer must consider all relevant allocable contract costs 
incurred and activities performed by itself, by related parties on its 
behalf, and by the customer, that are incident to or necessary for the 
long-term contract. In addition, to determine whether a contract is 
completed in the contracting year, the taxpayer may not consider when it 
expects to complete the contract.
    (2) Date contract entered into--(i) In general. A taxpayer enters 
into a contract on the date that the contract binds both the taxpayer 
and the customer under applicable law, even if the contract is subject 
to unsatisfied conditions not within the taxpayer's control (such as 
obtaining financing). If a taxpayer delays entering into a contract for 
a principal purpose of avoiding section 460, however, the taxpayer will 
be treated as having entered into a contract not later than the contract 
commencement date.
    (ii) Options and change orders. A taxpayer enters into a new 
contract on the date that the customer exercises an option or similar 
provision in a contract if that option or similar provision must be 
severed from the contract under paragraph (e) of this section. 
Similarly, a taxpayer enters into a new contract on the date that it 
accepts a change order or other similar agreement if the change order or 
other similar agreement must be severed from the contract under 
paragraph (e) of this section.
    (3) Date contract completed--(i) In general. A taxpayer's contract 
is completed upon the earlier of--
    (A) Use of the subject matter of the contract by the customer for 
its intended purpose (other than for testing) and at least 95 percent of 
the total allocable contract costs attributable to the subject matter 
have been incurred by the taxpayer; or
    (B) Final completion and acceptance of the subject matter of the 
contract.
    (ii) Secondary items. The date a contract accounted for using the 
CCM is completed is determined without regard to whether one or more 
secondary items have been used or finally completed and accepted. If any 
secondary items are incomplete at the end of the taxable year in which 
the primary subject matter of a contract is completed, the taxpayer must 
separate the portion of the gross contract price and the allocable 
contract costs attributable to the incomplete secondary item(s) from the 
completed contract and account for them using a permissible method of 
accounting. A permissible method of accounting includes a long-term 
contract method of accounting only if a separate contract for the 
secondary item(s) would be a long-term contract, as defined in paragraph 
(b)(1) of this section.
    (iii) Subcontracts. In the case of a subcontract, a subcontractor's 
customer is the general contractor. Thus, the subject matter of the 
subcontract is the relevant subject matter under paragraph (c)(3)(i) of 
this section.
    (iv) Final completion and acceptance--(A) In general. Except as 
otherwise provided in this paragraph (c)(3)(iv), to determine whether 
final completion and acceptance of the subject matter of a contract have 
occurred, a taxpayer must consider all relevant facts and circumstances. 
Nevertheless, a taxpayer may not delay the completion of a contract for 
the principal purpose of deferring federal income tax.
    (B) Contingent compensation. Final completion and acceptance is 
determined without regard to any contractual term that provides for 
additional compensation that is contingent on the successful performance 
of the subject matter of the contract. A taxpayer must account for all 
contingent compensation that is not includible in total contract price 
under Sec. 1.460-4(b)(4)(i), or in gross contract price under Sec. 
1.460-4(d)(3), using a permissible method of accounting. For application 
of the look-back method for contracts accounted for using the PCM, see 
Sec. 1.460-6(c)(1)(ii) and (2)(vi).
    (C) Assembly or installation. Final completion and acceptance is 
determined without regard to whether the

[[Page 201]]

taxpayer has an obligation to assist or supervise assembly or 
installation of the subject matter of the contract where the assembly or 
installation is not performed by the taxpayer or a related party. A 
taxpayer must account for the gross receipts and costs attributable to 
such an obligation using a permissible method of accounting, other than 
a long-term contract method.
    (D) Disputes. Final completion and acceptance is determined without 
regard to whether a dispute exists at the time the taxpayer tenders the 
subject matter of the contract to the customer. For contracts accounted 
for using the CCM, see Sec. 1.460-4(d)(4). For application of the look-
back method for contracts accounted for using the PCM, see Sec. 1.460-
6(c)(1)(ii) and (2)(vi).
    (d) Allocation among activities--(1) In general. Long-term contract 
methods of accounting apply only to the gross receipts and costs 
attributable to long-term contract activities. Gross receipts and costs 
attributable to long-term contract activities means amounts included in 
total contract price or gross contract price, whichever is applicable, 
as determined under Sec. 1.460-4, and costs allocable to the contract, 
as determined under Sec. 1.460-5. Gross receipts and costs attributable 
to non-long-term contract activities (as defined in paragraph (d)(2) of 
this section) generally must be taken into account using a permissible 
method of accounting other than a long-term contract method. See section 
446(c) and Sec. 1.446-1(c). However, if the performance of a non-long-
term contract activity is incident to or necessary for the manufacture, 
building, installation, or construction of the subject matter of one or 
more of the taxpayer's long-term contracts, the gross receipts and costs 
attributable to that activity must be allocated to the long-term 
contract(s) benefitted as provided in Sec. Sec. 1.460-4(b)(4)(i) and 
1.460-5(f)(2), respectively. Similarly, if a single long-term contract 
requires a taxpayer to perform a non-long-term contract activity that is 
not incident to or necessary for the manufacture, building, 
installation, or construction of the subject matter of the long-term 
contract, the gross receipts and costs attributable to that non-long-
term contract activity must be separated from the contract and accounted 
for using a permissible method of accounting other than a long-term 
contract method. But see paragraph (g) of this section for related party 
rules.
    (2) Non-long-term contract activity. Non-long-term contract activity 
means the performance of an activity other than manufacturing, building, 
installation, or construction, such as the provision of architectural, 
design, engineering, and construction management services, and the 
development or implementation of computer software. In addition, 
performance under a guaranty, warranty, or maintenance agreement is a 
non-long-term contract activity that is never incident to or necessary 
for the manufacture or construction of property under a long-term 
contract.
    (e) Severing and aggregating contracts--(1) In general. After 
application of the allocation rules of paragraph (d) of this section, 
the severing and aggregating rules of this paragraph (e) may be applied 
by the Commissioner or the taxpayer as necessary to clearly reflect 
income (e.g., to prevent the unreasonable deferral (or acceleration) of 
income or the premature recognition (or deferral) of loss). Under the 
severing and aggregating rules, one agreement may be treated as two or 
more contracts, and two or more agreements may be treated as one 
contract. Except as provided in paragraph (e)(3)(ii) of this section, a 
taxpayer must determine whether to sever an agreement or to aggregate 
two or more agreements based on the facts and circumstances known at the 
end of the contracting year.
    (2) Facts and circumstances. Whether an agreement should be severed, 
or two or more agreements should be aggregated, depends on the following 
factors:
    (i) Pricing. Independent pricing of items in an agreement is 
necessary for the agreement to be severed into two or more contracts. In 
the case of an agreement for similar items, if the price to be paid for 
the items is determined under different terms or formulas (e.g., if some 
items are priced under a cost-plus incentive fee arrangement and later 
items are to be priced under a fixed-price arrangement), then

[[Page 202]]

the difference in the pricing terms or formulas indicates that the items 
are independently priced. Similarly, interdependent pricing of items in 
separate agreements is necessary for two or more agreements to be 
aggregated into one contract. A single price negotiation for similar 
items ordered under one or more agreements indicates that the items are 
interdependently priced.
    (ii) Separate delivery or acceptance. An agreement may not be 
severed into two or more contracts unless it provides for separate 
delivery or separate acceptance of items that are the subject matter of 
the agreement. However, the separate delivery or separate acceptance of 
items by itself does not necessarily require an agreement to be severed.
    (iii) Reasonable businessperson. Two or more agreements to perform 
manufacturing or construction activities may not be aggregated into one 
contract unless a reasonable businessperson would not have entered into 
one of the agreements for the terms agreed upon without also entering 
into the other agreement(s). Similarly, an agreement to perform 
manufacturing or construction activities may not be severed into two or 
more contracts if a reasonable businessperson would not have entered 
into separate agreements containing terms allocable to each severed 
contract. Analyzing the reasonable businessperson standard requires an 
analysis of all the facts and circumstances of the business arrangement 
between the taxpayer and the customer. For purposes of this paragraph 
(e)(2)(iii), a taxpayer's expectation that the parties would enter into 
another agreement, when agreeing to the terms contained in the first 
agreement, is not relevant.
    (3) Exceptions--(i) Severance for PCM. A taxpayer may not sever 
under this paragraph (e) a long-term contract that would be subject to 
the PCM without obtaining the Commissioner's prior written consent.
    (ii) Options and change orders. Except as provided in paragraph 
(e)(3)(i) of this section, a taxpayer must sever an agreement that 
increases the number of units to be supplied to the customer, such as 
through the exercise of an option or the acceptance of a change order, 
if the agreement provides for separate delivery or separate acceptance 
of the additional units.
    (4) Statement with return. If a taxpayer severs an agreement or 
aggregates two or more agreements under this paragraph (e) during the 
taxable year, the taxpayer must attach a statement to its original 
federal income tax return for that year. This statement must contain the 
following information--
    (i) The legend NOTIFICATION OF SEVERANCE OR AGGREGATION UNDER SEC. 
1.460-1(e);
    (ii) The taxpayer's name; and
    (iii) The taxpayer's employer identification number or social 
security number.
    (f) Classifying contracts--(1) In general. After applying the 
severing and aggregating rules of paragraph (e) of this section, a 
taxpayer must determine the classification of a contract (e.g., as a 
long-term manufacturing contract, long-term construction contract, non-
long-term contract) based on all the facts and circumstances known no 
later than the end of the contracting year. Classification is determined 
on a contract-by-contract basis. Consequently, a requirement to 
manufacture a single unique item under a long-term contract will subject 
all other items in that contract to section 460.
    (2) Hybrid contracts--(i) In general. A long-term contract that 
requires a taxpayer to perform both manufacturing and construction 
activities (hybrid contract) generally must be classified as two 
contracts, a manufacturing contract and a construction contract. A 
taxpayer may elect, on a contract-by-contract basis, to classify a 
hybrid contract as a long-term construction contract if at least 95 
percent of the estimated total allocable contract costs are reasonably 
allocable to construction activities. In addition, a taxpayer may elect, 
on a contract-by-contract basis, to classify a hybrid contract as a 
long-term manufacturing contract subject to the PCM.
    (ii) Elections. A taxpayer makes an election under this paragraph 
(f)(2) by using its method of accounting for similar construction 
contracts or for manufacturing contracts, whichever is applicable, to 
account for a hybrid contract entered into during the taxable

[[Page 203]]

year of the election on its original federal income tax return for the 
election year. If an electing taxpayer's method is the PCM, the taxpayer 
also must use the PCM to apply the look-back method under Sec. 1.460-6 
and to determine alternative minimum taxable income under Sec. 1.460-
4(f).
    (3) Method of accounting. Except as provided in paragraph (f)(2)(ii) 
of this section, a taxpayer's method of classifying contracts is a 
method of accounting under section 446 and, thus, may not be changed 
without the Commissioner's consent. If a taxpayer's method of 
classifying contracts is unreasonable, that classification method is an 
impermissible accounting method.
    (4) Use of estimates--(i) Estimating length of contract. A taxpayer 
must use a reasonable estimate of the time required to complete a 
contract when necessary to classify the contract (e.g., to determine 
whether the five-year completion rule for qualified ship contracts under 
Sec. 1.460-2(d), or the two-year completion rule for exempt 
construction contracts under Sec. 1.460-3(b), is satisfied, but not to 
determine whether a contract is completed within the contracting year 
under paragraph (b)(1) of this section). To be considered reasonable, an 
estimate of the time required to complete the contract must include 
anticipated time for delay, rework, change orders, technology or design 
problems, or other problems that reasonably can be anticipated 
considering the nature of the contract and prior experience. A contract 
term that specifies an expected completion or delivery date may be 
considered evidence that the taxpayer reasonably expects to complete or 
deliver the subject matter of the contract on or about the date 
specified, especially if the contract provides bona fide penalties for 
failing to meet the specified date. If a taxpayer classifies a contract 
based on a reasonable estimate of completion time, the contract will not 
be reclassified based on the actual (or another reasonable estimate of) 
completion time. A taxpayer's estimate of completion time will not be 
considered unreasonable if a contract is not completed within the 
estimated time primarily because of unforeseeable factors not within the 
taxpayer's control, such as third-party litigation, extreme weather 
conditions, strikes, or delays in securing permits or licenses.
    (ii) Estimating allocable contract costs. A taxpayer must use a 
reasonable estimate of total allocable contract costs when necessary to 
classify the contract (e.g., to determine whether a contract is a home 
construction contract under Sec. 1.460-(3)(b)(2)). If a taxpayer 
classifies a contract based on a reasonable estimate of total allocable 
contract costs, the contract will not be reclassified based on the 
actual (or another reasonable estimate of) total allocable contract 
costs.
    (g) Special rules for activities benefitting long-term contracts of 
a related party--(1) Related party use of PCM--(i) In general. Except as 
provided in paragraph (g)(1)(ii) of this section, if a related party and 
its customer enter into a long-term contract subject to the PCM, and a 
taxpayer performs any activity that is incident to or necessary for the 
related party's long-term contract, the taxpayer must account for the 
gross receipts and costs attributable to this activity using the PCM, 
even if this activity is not otherwise subject to section 460(a). This 
type of activity may include, for example, the performance of 
engineering and design services, and the production of components and 
subassemblies that are reasonably expected to be used in the production 
of the subject matter of the related party's contract.
    (ii) Exception for components and subassemblies. A taxpayer is not 
required to use the PCM under this paragraph (g) to account for a 
component or subassembly that benefits a related party's long-term 
contract if more than 50 percent of the average annual gross receipts 
attributable to the sale of this item for the 3-taxable-year-period 
ending with the contracting year comes from unrelated parties.
    (2) Total contract price. If a taxpayer is required to use the PCM 
under paragraph (g)(1)(i) of this section, the total contract price (as 
defined in Sec. 1.460-4(b)(4)(i)) is the fair market value of the 
taxpayer's activity that is incident to or necessary for the performance 
of the related party's long-term contract. The related party also must 
use the

[[Page 204]]

fair market value of the taxpayer's activity as the cost it incurs for 
the activity. The fair market value of the taxpayer's activity may or 
may not be the same as the amount the related party pays the taxpayer 
for that activity.
    (3) Completion factor. To compute a contract's completion factor (as 
described in Sec. 1.460-4(b)(5)), the related party must take into 
account the fair market value of the taxpayer's activity that is 
incident to or necessary for the performance of the related party's 
long-term contract when the related party incurs the liability to the 
taxpayer for the activity, rather than when the taxpayer incurs the 
costs to perform the activity.
    (h) Effective date--(1) In general. Except as otherwise provided, 
this section and Sec. Sec. 1.460-2 through 1.460-5 are applicable for 
contracts entered into on or after January 11, 2001.
    (2) Change in method of accounting. Any change in a taxpayer's 
method of accounting necessary to comply with this section and 
Sec. Sec. 1.460-2 through 1.460-5 is a change in method of accounting 
to which the provisions of section 446 and the regulations thereunder 
apply. For the first taxable year that includes January 11, 2001, a 
taxpayer is granted the consent of the Commissioner to change its method 
of accounting to comply with the provisions of this section and 
Sec. Sec. 1.460-2 through 1.460-5 for long-term contracts entered into 
on or after January 11, 2001. A taxpayer that wants to change its method 
of accounting under this paragraph (h)(2) must follow the automatic 
consent procedures in Rev. Proc. 99-49 (1999-52 I.R.B. 725) (see Sec. 
601.601(d)(2) of this chapter), except that the scope limitations in 
section 4.02 of Rev. Proc. 99-49 do not apply. Because a change under 
this paragraph (h)(2) is made on a cut-off basis, a section 481(a) 
adjustment is not permitted or required. Moreover, the taxpayer does not 
receive audit protection under section 7 of Rev. Proc. 99-49 for a 
change in method of accounting under this paragraph (h)(2). A taxpayer 
that wants to change its exempt-contract method of accounting is not 
granted the consent of the Commissioner under this paragraph (h)(2) and 
must file a Form 3115, ``Application for Change in Accounting Method,'' 
to obtain consent. See Rev. Proc. 97-27 (1997-1 C.B. 680) (see Sec. 
601.601(d)(2) of this chapter).
    (i) [Reserved]
    (j) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Contract for manufacture of property. B notifies C, an 
aircraft manufacturer, that it wants to purchase an aircraft of a 
particular type. At the time C receives the order, C has on hand several 
partially completed aircraft of this type; however, C does not have any 
completed aircraft of this type on hand. C and B agree that B will 
purchase one of these aircraft after it has been completed. C retains 
title to and risk of loss with respect to the aircraft until the sale 
takes place. The agreement between C and B is a contract for the 
manufacture of property under paragraph (b)(2)(i) of this section, even 
if labeled as a contract for the sale of property, because the 
manufacture of the aircraft is necessary for C's obligations under the 
agreement to be fulfilled and the manufacturing was not complete when B 
and C entered into the agreement.
    Example 2. De minimis construction activity. C, a master developer 
whose taxable year ends December 31, owns 5,000 acres of undeveloped 
land with a cost basis of $5,000,000 and a fair market value of 
$50,000,000. To obtain permission from the local county government to 
improve this land, a service road must be constructed on this land to 
benefit all 5,000 acres. In 2001, C enters into a contract to sell a 
1,000-acre parcel of undeveloped land to B, a residential developer, for 
its fair market value, $10,000,000. In this contract, C agrees to 
construct a service road running through the land that C is selling to B 
and through the 4,000 adjacent acres of undeveloped land that C has sold 
or will sell to other residential developers for its fair market value, 
$40,000,000. C reasonably estimates that it will incur allocable 
contract costs of $50,000 (excluding the cost of the land) to construct 
this service road, which will be owned and maintained by the county. C 
must reasonably allocate the cost of the service road among the 
benefitted parcels. The portion of the estimated total allocable 
contract costs that C allocates to the 1,000-acre parcel being sold to B 
(based upon its fair market value) is $10,000 ($50,000x($10,000,000/
$50,000,000)). Construction of the service road is finished in 2002. 
Because the estimated total allocable contract costs attributable to C's 
construction activities, $10,000, are less than 10 percent of the 
contract's total contract price, $10,000,000, C's contract with B is not 
a construction contract under paragraph (b)(2)(ii) of this section. 
Thus, C's contract with B is not a long-term contract under paragraph 
(b)(2)(i)

[[Page 205]]

of this section, notwithstanding that construction of the service road 
is not completed in 2001.
    Example 3. Completion--customer use. In 2002, C, whose taxable year 
ends December 31, enters into a contract to construct a building for B. 
In November of 2003, the building is completed in every respect 
necessary for its intended use, and B occupies the building. In early 
December of 2003, B notifies C of some minor deficiencies that need to 
be corrected, and C agrees to correct them in January 2004. C reasonably 
estimates that the cost of correcting these deficiencies will be less 
than five percent of the total allocable contract costs. C's contract is 
complete under paragraph (c)(3)(i)(A) of this section in 2003 because in 
that year, B used the building and C had incurred at least 95 percent of 
the total allocable contract costs attributable to the building. C must 
use a permissible method of accounting for any deficiency-related costs 
incurred after 2003.
    Example 4. Completion--customer use. In 2001, C, whose taxable year 
ends December 31, agrees to construct a shopping center, which includes 
an adjoining parking lot, for B. By October 2002, C has finished 
constructing the retail portion of the shopping center. By December 
2002, C has graded the entire parking lot, but has paved only one-fourth 
of it because inclement weather conditions prevented C from laying 
asphalt on the remaining three-fourths. In December 2002, B opens the 
retail portion of the shopping center and the paved portion of the 
parking lot to the general public. C reasonably estimates that the cost 
of paving the remaining three-fourths of the parking lot when weather 
permits will exceed five percent of C's total allocable contract costs. 
Even though B is using the subject matter of the contract, C's contract 
is not completed in December 2002 under paragraph (c)(3)(i)(A) of this 
section because C has not incurred at least 95 percent of the total 
allocable contract costs attributable to the subject matter.
    Example 5. Completion--customer use. In 2001, C, whose taxable year 
ends December 31, agrees to manufacture 100 machines for B. By December 
31, 2002, C has delivered 99 of the machines to B. C reasonably 
estimates that the cost of finishing the related work on the contract 
will be less than five percent of the total allocable contract costs. 
C's contract is not complete under paragraph (c)(3)(i)(A) of this 
section in 2002 because in that year, B is not using the subject matter 
of the contract (all 100 machines) for its intended purpose.
    Example 6. Non-long-term contract activity. On January 1, 2001, C, 
whose taxable year ends December 31, enters into a single long-term 
contract to design and manufacture a satellite and to develop computer 
software enabling B to operate the satellite. At the end of 2001, C has 
not finished manufacturing the satellite. Designing the satellite and 
developing the computer software are non-long-term contract activities 
that are incident to and necessary for the taxpayer's manufacturing of 
the subject matter of a long-term contract because the satellite could 
not be manufactured without the design and would not operate without the 
software. Thus, under paragraph (d)(1) of this section, C must allocate 
these non-long-term contract activities to the long-term contract and 
account for the gross receipts and costs attributable to designing the 
satellite and developing computer software using the PCM.
    Example 7. Non-long-term contract activity. C agrees to manufacture 
equipment for B under a long-term contract. In a separate contract, C 
agrees to design the equipment being manufactured for B under the long-
term contract. Under paragraph (d)(1) of this section, C must allocate 
the gross receipts and costs related to the design to the long-term 
contract because designing the equipment is a non-long-term contract 
activity that is incident to and necessary for the manufacture of the 
subject matter of the long-term contract.
    Example 8. Severance. On January 1, 2001, C, a construction 
contractor, and B, a real estate investor, enter into an agreement 
requiring C to build two office buildings in different areas of a large 
city. The agreement provides that the two office buildings will be 
completed by C and accepted by B in 2002 and 2003, respectively, and 
that C will be paid $1,000,000 and $1,500,000 for the two office 
buildings, respectively. The agreement will provide C with a reasonable 
profit from the construction of each building. Unless C is required to 
use the PCM to account for the contract, C is required to sever this 
contract under paragraph (e)(2) of this section because the buildings 
are independently priced, the agreement provides for separate delivery 
and acceptance of the buildings, and, as each building will generate a 
reasonable profit, a reasonable businessperson would have entered into 
separate agreements for the terms agreed upon for each building.
    Example 9. Severance. C, a large construction contractor whose 
taxable year ends December 31, accounts for its construction contracts 
using the PCM and has elected to use the 10-percent method described in 
Sec. 1.460-4(b)(6). In September 2001, C enters into an agreement to 
construct four buildings in four different cities. The buildings are 
independently priced and the contract provides a reasonable profit for 
each of the buildings. In addition, the agreement requires C to complete 
one building per year in 2002, 2003, 2004, and 2005. As of December 31, 
2001, C has incurred 25 percent of the estimated total allocable 
contract costs attributable to one of

[[Page 206]]

the buildings, but only five percent of the estimated total allocable 
contract costs attributable to all four buildings included in the 
agreement. C does not request the Commissioner's consent to sever this 
contract. Using the 10-percent method, C does not take into account any 
portion of the total contract price or any incurred allocable contract 
costs attributable to this agreement in 2001. Upon examination of C's 
2001 tax return, the Commissioner determines that C entered into one 
agreement for four buildings rather than four separate agreements each 
for one building solely to take advantage of the deferral obtained under 
the 10-percent method. Consequently, to clearly reflect the taxpayer's 
income, the Commissioner may require C to sever the agreement into four 
separate contracts under paragraph (e)(2) of this section because the 
buildings are independently priced, the agreement provides for separate 
delivery and acceptance of the buildings, and a reasonable 
businessperson would have entered into separate agreements for these 
buildings.
    Example 10. Aggregation. In 2001, C, a shipbuilder, enters into two 
agreements with the Department of the Navy as the result of a single 
negotiation. Each agreement obligates C to manufacture a submarine. 
Because the submarines are of the same class, their specifications are 
similar. Because C has never manufactured submarines of this class, 
however, C anticipates that it will incur substantially higher costs to 
manufacture the first submarine, to be delivered in 2007, than to 
manufacture the second submarine, to be delivered in 2010. If the 
agreements are treated as separate contracts, the first contract 
probably will produce a substantial loss, while the second contract 
probably will produce substantial profit. Based upon these facts, 
aggregation is required under paragraph (e)(2) of this section because 
the submarines are interdependently priced and a reasonable 
businessperson would not have entered the first agreement without also 
entering into the second.
    Example 11. Aggregation. In 2001, C, a manufacturer of aircraft and 
related equipment, agrees to manufacture 10 military aircraft for 
foreign government B and to deliver the aircraft by the end of 2003. 
When entering into the agreement, C anticipates that it might receive 
production orders from B over the next 20 years for as many as 300 more 
of these aircraft. The negotiated contract price reflects C's and B's 
consideration of the expected total cost of manufacturing the 10 
aircraft, the risks and opportunities associated with the agreement, and 
the additional factors the parties considered relevant. The negotiated 
price provides a profit on the sale of the 10 aircraft even if C does 
not receive any additional production orders from B. It is unlikely, 
however, that C actually would have wanted to manufacture the 10 
aircraft but for the expectation that it would receive additional 
production orders from B. In 2003, B accepts delivery of the 10 
aircraft. At that time, B orders an additional 20 aircraft of the same 
type for delivery in 2007. When negotiating the price for the additional 
20 aircraft, C and B consider the fact that the expected unit cost for 
this production run of 20 aircraft will be lower than the unit cost of 
the 10 aircraft completed and accepted in 2003, but substantially higher 
than the expected unit cost of future production runs. Based upon these 
facts, aggregation is not permitted under paragraph (e)(2) of this 
section. Because the parties negotiated the prices of both agreements 
considering only the expected production costs and risks for each 
agreement standing alone, the terms and conditions agreed upon for the 
first agreement are independent of the terms and conditions agreed upon 
for the second agreement. The fact that the agreement to manufacture 10 
aircraft provides a profit for C indicates that a reasonable 
businessperson would have entered into that agreement without entering 
into the agreement to manufacture the additional 20 aircraft.
    Example 12. Classification and completion. In 2001, C, whose taxable 
year ends December 31, agrees to manufacture and install an industrial 
machine for B. C elects under paragraph (f) of this section to classify 
the agreement as a long-term manufacturing contract and to account for 
it using the PCM. The agreement requires C to deliver the machine in 
August 2003 and to install and test the machine in B's factory. In 
addition, the agreement requires B to accept the machine when the tests 
prove that the machine's performance will satisfy the environmental 
standards set by the Environmental Protection Agency (EPA), even if B 
has not obtained the required operating permit. Because of technical 
difficulties, C cannot deliver the machine until December 2003, when B 
conditionally accepts delivery. C installs the machine in December 2003 
and then tests it through February 2004. B accepts the machine in 
February 2004, but does not obtain the operating permit from the EPA 
until January 2005. Under paragraph (c)(3)(i)(B) of this section, C's 
contract is finally completed and accepted in February 2004, even though 
B does not obtain the operating permit until January 2005, because C 
completed all its obligations under the contract and B accepted the 
machine in February 2004.

[T.D. 8929, 66 FR 2225, Jan. 11, 2001; 66 FR 18357, Apr. 6, 2001]



Sec. 1.460-2  Long-term manufacturing contracts.

    (a) In general. Section 460 generally requires a taxpayer to 
determine the

[[Page 207]]

income from a long-term manufacturing contract using the percentage-of-
completion method described in Sec. 1.460-4(b) (PCM). A contract not 
completed in the contracting year is a long-term manufacturing contract 
if it involves the manufacture of personal property that is--
    (1) A unique item of a type that is not normally carried in the 
finished goods inventory of the taxpayer; or
    (2) An item that normally requires more than 12 calendar months to 
complete (regardless of the duration of the contract or the time to 
complete a deliverable quantity of the item).
    (b) Unique--(1) In general. Unique means designed for the needs of a 
specific customer. To determine whether an item is designed for the 
needs of a specific customer, a taxpayer must consider the extent to 
which research, development, design, engineering, retooling, and similar 
activities (customizing activities) are required to manufacture the item 
and whether the item could be sold to other customers with little or no 
modification. A contract may require the taxpayer to manufacture more 
than one unit of a unique item. If a contract requires a taxpayer to 
manufacture more than one unit of the same item, the taxpayer must 
determine whether that item is unique by considering the customizing 
activities that would be needed to produce only the first unit. For the 
purposes of this paragraph (b), a taxpayer must consider the activities 
performed on its behalf by a subcontractor.
    (2) Safe harbors. Notwithstanding paragraph (b)(1) of this section, 
an item is not unique if it satisfies one or more of the safe harbors in 
this paragraph (b)(2). If an item does not satisfy one or more safe 
harbors, the determination of uniqueness will depend on the facts and 
circumstances. The safe harbors are:
    (i) Short production period. An item is not unique if it normally 
requires 90 days or less to complete. In the case of a contract for 
multiple units of an item, the item is not unique only if it normally 
requires 90 days or less to complete each unit of the item in the 
contract.
    (ii) Customized item. An item is not unique if the total allocable 
contract costs attributable to customizing activities that are incident 
to or necessary for the manufacture of the item do not exceed 10 percent 
of the estimated total allocable contract costs allocable to the item. 
In the case of a contract for multiple units of an item, this comparison 
must be performed on the first unit of the item, and the total allocable 
contract costs attributable to customizing activities that are incident 
to or necessary for the manufacture of the first unit of the item must 
be allocated to that first unit.
    (iii) Inventoried item. A unique item ceases to be unique no later 
than when the taxpayer normally includes similar items in its finished 
goods inventory.
    (c) Normal time to complete--(1) In general. The amount of time 
normally required to complete an item is the item's reasonably expected 
production period, as described in Sec. 1.263A-12, determined at the 
end of the contracting year. Thus, in general, the expected production 
period for an item begins when a taxpayer incurs at least five percent 
of the costs that would be allocable to the item under Sec. 1.460-5 and 
ends when the item is ready to be held for sale and all reasonably 
expected production activities are complete. In the case of components 
that are assembled or reassembled into an item or unit at the customer's 
facility by the taxpayer's employees or agents, the production period 
ends when the components are assembled or reassembled into an operable 
item or unit. To the extent that several distinct activities related to 
the production of the item are expected to occur simultaneously, the 
period during which these distinct activities occur is not counted more 
than once. Furthermore, when determining the normal time to complete an 
item, a taxpayer is not required to consider activities performed or 
costs incurred that would not be allocable contract costs under section 
460 (e.g., independent research and development expenses (as defined in 
Sec. 1.460-1(b)(9)) and marketing expenses). Moreover, the time 
normally required to design and manufacture the first unit of an item 
for which the taxpayer intends to produce multiple units generally does 
not indicate the normal time to complete the item.

[[Page 208]]

    (2) Production by related parties. To determine the time normally 
required to complete an item, a taxpayer must consider all relevant 
production activities performed and costs incurred by itself and by 
related parties, as defined in Sec. 1.460-1(b)(4). For example, if a 
taxpayer's item requires a component or subassembly manufactured by a 
related party, the taxpayer must consider the time the related party 
takes to complete the component or subassembly and, for purposes of 
determining the beginning of an item's production period, the costs 
incurred by the related party that are allocable to the component or 
subassembly. However, if both requirements of the exception for 
components and subassemblies under Sec. 1.460-1(g)(1)(ii) are 
satisfied, a taxpayer does not consider the activities performed or the 
costs incurred by a related party when determining the normal time to 
complete an item.
    (d) Qualified ship contracts. A taxpayer may determine the income 
from a long-term manufacturing contract that is a qualified ship 
contract using either the PCM or the percentage-of-completion/
capitalized-cost method (PCCM) of accounting described in Sec. 1.460-
4(e). A qualified ship contract is any contract entered into after 
February 28, 1986, to manufacture in the United States not more than 5 
seagoing vessels if the vessels will not be manufactured directly or 
indirectly for the United States Government and if the taxpayer 
reasonably expects to complete the contract within 5 years of the 
contract commencement date. Under Sec. 1.460-1(e)(3)(i), a contract to 
produce more than 5 vessels for which the PCM would be required cannot 
be severed in order to be classified as a qualified ship contract.
    (e) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Unique item and classification. In December 2001, C 
enters into a contract with B to design and manufacture a new type of 
industrial equipment. C reasonably expects the normal production period 
for this type of equipment to be eight months. Because the new type of 
industrial equipment requires a substantial amount of research, design, 
and engineering to produce, C determines that the equipment is a unique 
item and its contract with B is a long-term contract. After delivering 
the equipment to B in September 2002, C contracts with B to produce five 
additional units of that industrial equipment with certain different 
specifications. These additional units, which also are expected to take 
eight months to produce, will be delivered to B in 2003. C determines 
that the research, design, engineering, retooling, and similar 
customizing costs necessary to produce the five additional units of 
equipment does not exceed 10 percent of the first unit's share of 
estimated total allocable contract costs. Consequently, the additional 
units of equipment satisfy the safe harbor in paragraph (b)(2)(ii) of 
this section and are not unique items. Although C's contract with B to 
produce the five additional units is not completed within the 
contracting year, the contract is not a long-term contract since the 
additional units of equipment are not unique items and do not normally 
require more than 12 months to produce. C must classify its second 
contract with B as a non-long term contract, notwithstanding that it 
classified the previous contract with B for a similar item as a long-
term contract, because the determination of whether a contract is a 
long-term contract is made on a contract-by-contract basis. A change in 
classification is not a change in method of accounting because the 
change in classification results from a change in underlying facts.
    Example 2. 12-month rule--related party. C manufactures cranes. C 
purchases one of the crane's components from R, a related party under 
Sec. 1.460-1(b)(4). Less than 50 percent of R's gross receipts 
attributable to the sale of this component comes from sales to unrelated 
parties; thus, the exception for components and subassemblies under 
Sec. 1.460-1(g)(1)(ii) is not satisfied. Consequently, C must consider 
the activities of R as R incurs costs and performs the activities rather 
than as C incurs a liability to R. The normal time period between the 
time that both C and R incur five percent of the costs allocable to the 
crane and the time that R completes the component is five months. C 
normally requires an additional eight months to complete production of 
the crane after receiving the integral component from R. C's crane is an 
item of a type that normally requires more than 12 months to complete 
under paragraph (c) of this section because the production period from 
the time that both C and R incur five percent of the costs allocable to 
the crane until the time that production of the crane is complete is 
normally 13 months.
    Example 3. 12-month rule--duration of contract. The facts are the 
same as in Example 2, except that C enters into a sales contract with B 
on December 31, 2001 (the last day of C's taxable year), and delivers a 
completed crane to B on February 1, 2002. C's contract with B is a long-
term contract under paragraph (a)(2) of this section because the 
contract is not completed in the contracting

[[Page 209]]

year, 2001, and the crane is an item that normally requires more than 12 
calendar months to complete (regardless of the duration of the 
contract).
    Example 4. 12-month rule--normal time to complete. The facts are the 
same as in Example 2, except that C (and R) actually complete B's crane 
in only 10 calendar months. The contract is a long-term contract because 
the normal time to complete a crane, not the actual time to complete a 
crane, is the relevant criterion for determining whether an item is 
subject to paragraph (a)(2) of this section.
    Example 5. Normal time to complete. C enters into a multi-unit 
contract to produce four units of an item. C does not anticipate 
producing any additional units of the item. C expects to perform the 
research, design, and development that are directly allocable to the 
particular item and to produce the first unit in the first 24 months. C 
reasonably expects the production period for each of the three remaining 
units will be 3 months. This contract is not a contract that involves 
the manufacture of an item that normally requires more than 12 months to 
complete because the normal time to complete the item is 3 months. 
However, the contract does not satisfy the 90-day safe harbor for unique 
items because the normal time to complete the first unit of this item 
exceeds 90 days. Thus, the contract might involve the manufacture of a 
unique item depending on the facts and circumstances.

[T.D. 8929, 66 FR 2230, Jan. 11, 2001; 66 FR 18191, Apr. 6, 2001]



Sec. 1.460-3  Long-term construction contracts.

    (a) In general. Section 460 generally requires a taxpayer to 
determine the income from a long-term construction contract using the 
percentage-of-completion method described in Sec. 1.460-4(b) (PCM). A 
contract not completed in the contracting year is a long-term 
construction contract if it involves the building, construction, 
reconstruction, or rehabilitation of real property; the installation of 
an integral component to real property; or the improvement of real 
property (collectively referred to as construction). Real property means 
land, buildings, and inherently permanent structures, as defined in 
Sec. 1.263A-8(c)(3), such as roadways, dams, and bridges. Real property 
does not include vessels, offshore drilling platforms, or unsevered 
natural products of land. An integral component to real property 
includes property not produced at the site of the real property but 
intended to be permanently affixed to the real property, such as 
elevators and central heating and cooling systems. Thus, for example, a 
contract to install an elevator in a building is a construction contract 
because a building is real property, but a contract to install an 
elevator in a ship is not a construction contract because a ship is not 
real property.
    (b) Exempt construction contracts--(1) In general. The general 
requirement to use the PCM and the cost allocation rules described in 
Sec. 1.460-5(b) or (c) does not apply to any long-term construction 
contract described in this paragraph (b) (exempt construction contract). 
Exempt construction contract means any--
    (i) Home construction contract; and
    (ii) Other construction contract that a taxpayer estimates (when 
entering into the contract) will be completed within 2 years of the 
contract commencement date, provided the taxpayer satisfies the 
$10,000,000 gross receipts test described in paragraph (b)(3) of this 
section.
    (2) Home construction contract--(i) In general. A long-term 
construction contract is a home construction contract if a taxpayer 
(including a subcontractor working for a general contractor) reasonably 
expects to attribute 80 percent or more of the estimated total allocable 
contract costs (including the cost of land, materials, and services), 
determined as of the close of the contracting year, to the construction 
of--
    (A) Dwelling units, as defined in section 168(e)(2)(A)(ii)(I), 
contained in buildings containing 4 or fewer dwelling units (including 
buildings with 4 or fewer dwelling units that also have commercial 
units); and
    (B) Improvements to real property directly related to, and located 
at the site of, the dwelling units.
    (ii) Townhouses and rowhouses. Each townhouse or rowhouse is a 
separate building.
    (iii) Common improvements. A taxpayer includes in the cost of the 
dwelling units their allocable share of the cost that the taxpayer 
reasonably expects to incur for any common improvements (e.g., sewers, 
roads, clubhouses) that benefit the dwelling units and that the taxpayer 
is contractually

[[Page 210]]

obligated, or required by law, to construct within the tract or tracts 
of land that contain the dwelling units.
    (iv) Mixed use costs. If a contract involves the construction of 
both commercial units and dwelling units within the same building, a 
taxpayer must allocate the costs among the commercial units and dwelling 
units using a reasonable method or combination of reasonable methods, 
such as specific identification, square footage, or fair market value.
    (3) $10,000,000 gross receipts test--(i) In general. Except as 
otherwise provided in paragraphs (b)(3)(ii) and (iii) of this section, 
the $10,000,000 gross receipts test is satisfied if a taxpayer's (or 
predecessor's) average annual gross receipts for the 3 taxable years 
preceding the contracting year do not exceed $10,000,000, as determined 
using the principles of the gross receipts test for small resellers 
under Sec. 1.263A-3(b).
    (ii) Single employer. To apply the gross receipts test, a taxpayer 
is not required to aggregate the gross receipts of persons treated as a 
single employer solely under section 414(m) and any regulations 
prescribed under section 414.
    (iii) Attribution of gross receipts. A taxpayer must aggregate a 
proportionate share of the construction-related gross receipts of any 
person that has a five percent or greater interest in the taxpayer. In 
addition, a taxpayer must aggregate a proportionate share of the 
construction-related gross receipts of any person in which the taxpayer 
has a five percent or greater interest. For this purpose, a taxpayer 
must determine ownership interests as of the first day of the taxpayer's 
contracting year and must include indirect interests in any corporation, 
partnership, estate, trust, or sole proprietorship according to 
principles similar to the constructive ownership rules under sections 
1563(e), (f)(2), and (f)(3)(A). However, a taxpayer is not required to 
aggregate under this paragraph (b)(3)(iii) any construction-related 
gross receipts required to be aggregated under paragraph (b)(3)(i) of 
this section.
    (c) Residential construction contracts. A taxpayer may determine the 
income from a long-term construction contract that is a residential 
construction contract using either the PCM or the percentage-of-
completion/capitalized-cost method (PCCM) of accounting described in 
Sec. 1.460-4(e). A residential construction contract is a home 
construction contract, as defined in paragraph (b)(2) of this section, 
except that the building or buildings being constructed contain more 
than 4 dwelling units.

[T.D. 8929, 66 FR 2231, Jan. 11, 2001]



Sec. 1.460-4  Methods of accounting for long-term contracts.

    (a) Overview. This section prescribes permissible methods of 
accounting for long-term contracts. Paragraph (b) of this section 
describes the percentage-of-completion method under section 460(b) (PCM) 
that a taxpayer generally must use to determine the income from a long-
term contract. Paragraph (c) of this section lists permissible methods 
of accounting for exempt construction contracts described in Sec. 
1.460-3(b)(1) and describes the exempt-contract percentage-of-completion 
method (EPCM). Paragraph (d) of this section describes the completed-
contract method (CCM), which is one of the permissible methods of 
accounting for exempt construction contracts. Paragraph (e) of this 
section describes the percentage-of-completion/capitalized-cost method 
(PCCM), which is a permissible method of accounting for qualified ship 
contracts described in Sec. 1.460-2(d) and residential construction 
contracts described in Sec. 1.460-3(c). Paragraph (f) of this section 
provides rules for determining the alternative minimum taxable income 
(AMTI) from long-term contracts that are not exempted under section 56. 
Paragraph (g) of this section provides rules concerning consistency in 
methods of accounting for long-term contracts. Paragraph (h) of this 
section provides examples illustrating the principles of this section. 
Paragraph (j) of this section provides rules for taxpayers that file 
consolidated tax returns. Finally, paragraph (k) of this section 
provides rules relating to a mid-contract change in taxpayer of a 
contract accounted for using a long-term contract method of accounting.
    (b) Percentage-of-completion method--(1) In general. Under the PCM, 
a taxpayer generally must include in income the portion of the total 
contract

[[Page 211]]

price, as defined in paragraph (b)(4)(i) of this section, that 
corresponds to the percentage of the entire contract that the taxpayer 
has completed during the taxable year. The percentage of completion must 
be determined by comparing allocable contract costs incurred with 
estimated total allocable contract costs. Thus, the taxpayer includes a 
portion of the total contract price in gross income as the taxpayer 
incurs allocable contract costs.
    (2) Computations. To determine the income from a long-term contract, 
a taxpayer--
    (i) Computes the completion factor for the contract, which is the 
ratio of the cumulative allocable contract costs that the taxpayer has 
incurred through the end of the taxable year to the estimated total 
allocable contract costs that the taxpayer reasonably expects to incur 
under the contract;
    (ii) Computes the amount of cumulative gross receipts from the 
contract by multiplying the completion factor by the total contract 
price;
    (iii) Computes the amount of current-year gross receipts, which is 
the difference between the amount of cumulative gross receipts for the 
current taxable year and the amount of cumulative gross receipts for the 
immediately preceding taxable year (the difference can be a positive or 
negative number); and
    (iv) Takes both the current-year gross receipts and the allocable 
contract costs incurred during the current year into account in 
computing taxable income.
    (3) Post-completion-year income. If a taxpayer has not included the 
total contract price in gross income by the completion year, as defined 
in Sec. 1.460-1(b)(6), the taxpayer must include the remaining portion 
of the total contract price in gross income for the taxable year 
following the completion year. For the treatment of post-completion-year 
costs, see paragraph (b)(5)(v) of this section. See Sec. 1.460-
6(c)(1)(ii) for application of the look-back method as a result of 
adjustments to total contract price.
    (4) Total contract price--(i) In general--(A) Definition. Total 
contract price means the amount that a taxpayer reasonably expects to 
receive under a long-term contract, including holdbacks, retainages, and 
cost reimbursements. See Sec. 1.460-6(c)(1)(ii) and (2)(vi) for 
application of the look-back method as a result of changes in total 
contract price.
    (B) Contingent compensation. Any amount related to a contingent 
right under a contract, such as a bonus, award, incentive payment, and 
amount in dispute, is included in total contract price as soon as the 
taxpayer can reasonably predict that the amount will be earned, even if 
the all events test has not yet been met. For example, if a bonus is 
payable to a taxpayer for meeting an early completion date, the bonus is 
includible in total contract price at the time and to the extent that 
the taxpayer can reasonably predict the achievement of the corresponding 
objective. Similarly, a portion of the contract price that is in dispute 
is includible in total contract price at the time and to the extent that 
the taxpayer can reasonably predict that the dispute will be resolved in 
the taxpayer's favor (regardless of when the taxpayer actually receives 
payment or when the dispute is finally resolved). Total contract price 
does not include compensation that might be earned under any other 
agreement that the taxpayer expects to obtain from the same customer 
(e.g., exercised option or follow-on contract) if that other agreement 
is not aggregated under Sec. 1.460-1(e). For the purposes of this 
paragraph (b)(4)(i)(B), a taxpayer can reasonably predict that an amount 
of contingent income will be earned not later than when the taxpayer 
includes that amount in income for financial reporting purposes under 
generally accepted accounting principles. If a taxpayer has not included 
an amount of contingent compensation in total contract price under this 
paragraph (b)(4)(i) by the taxable year following the completion year, 
the taxpayer must account for that amount of contingent compensation 
using a permissible method of accounting. If it is determined after the 
taxable year following the completion year that an amount included in 
total contract price will not be earned, the taxpayer should deduct that 
amount in the year of the determination.

[[Page 212]]

    (C) Non-long-term contract activities. Total contract price includes 
an allocable share of the gross receipts attributable to a non-long-term 
contract activity, as defined in Sec. 1.460-1(d)(2), if the activity is 
incident to or necessary for the manufacture, building, installation, or 
construction of the subject matter of the long-term contract. Total 
contract price also includes amounts reimbursed for independent research 
and development expenses (as defined in Sec. 1.460-1(b)(9)), or for 
bidding and proposal costs, under a federal or cost-plus long-term 
contract (as defined in section 460(d)), regardless of whether the 
research and development, or bidding and proposal, activities are 
incident to or necessary for the performance of that long-term contract.
    (ii) Estimating total contract price. A taxpayer must estimate the 
total contract price based upon all the facts and circumstances known as 
of the last day of the taxable year. For this purpose, an event that 
occurs after the end of the taxable year must be taken into account if 
its occurrence was reasonably predictable and its income was subject to 
reasonable estimation as of the last day of that taxable year.
    (5) Completion factor--(i) Allocable contract costs. A taxpayer must 
use a cost allocation method permitted under either Sec. 1.460-5(b) or 
(c) to determine the amount of cumulative allocable contract costs and 
estimated total allocable contract costs that are used to determine a 
contract's completion factor. Allocable contract costs include a 
reimbursable cost that is allocable to the contract.
    (ii) Cumulative allocable contract costs. To determine a contract's 
completion factor for a taxable year, a taxpayer must take into account 
the cumulative allocable contract costs that have been incurred, as 
defined in Sec. 1.460-1(b)(8), through the end of the taxable year.
    (iii) Estimating total allocable contract costs. A taxpayer must 
estimate total allocable contract costs for each long-term contract 
based upon all the facts and circumstances known as of the last day of 
the taxable year. For this purpose, an event that occurs after the end 
of the taxable year must be taken into account if its occurrence was 
reasonably predictable and its cost was subject to reasonable estimation 
as of the last day of that taxable year. To be considered reasonable, an 
estimate of total allocable contract costs must include costs 
attributable to delay, rework, change orders, technology or design 
problems, or other problems that reasonably can be predicted considering 
the nature of the contract and prior experience. However, estimated 
total allocable contract costs do not include any contingency allowance 
for costs that, as of the end of the taxable year, are not reasonably 
predicted to be incurred in the performance of the contract. For 
example, estimated total allocable contract costs do not include any 
costs attributable to factors not reasonably predictable at the end of 
the taxable year, such as third-party litigation, extreme weather 
conditions, strikes, and delays in securing required permits and 
licenses. In addition, the estimated costs of performing other 
agreements that are not aggregated with the contract under Sec. 1.460-
1(e) that the taxpayer expects to incur with the same customer (e.g., 
follow-on contracts) are not included in estimated total allocable 
contract costs for the initial contract.
    (iv) Pre-contracting-year costs. If a taxpayer reasonably expects to 
enter into a long-term contract in a future taxable year, the taxpayer 
must capitalize all costs incurred prior to entering into the contract 
that will be allocable to that contract (e.g., bidding and proposal 
costs). A taxpayer is not required to compute a completion factor, or to 
include in gross income any amount, related to allocable contract costs 
for any taxable year ending before the contracting year or, if 
applicable, the 10-percent year defined in paragraph (b)(6)(i) of this 
section. In that year, the taxpayer is required to compute a completion 
factor that includes all allocable contract costs that have been 
incurred as of the end of that taxable year (whether previously 
capitalized or deducted) and to take into account in computing taxable 
income the related gross receipts and the previously capitalized 
allocable contract costs. If, however, a taxpayer determines in a 
subsequent year that it will not enter into the long-term contract, the 
taxpayer must account for these

[[Page 213]]

pre-contracting-year costs in that year (e.g., as a deduction or an 
inventoriable cost) using the appropriate rules contained in other 
sections of the Code or regulations.
    (v) Post-completion-year costs. If a taxpayer incurs an allocable 
contract cost after the completion year, the taxpayer must account for 
that cost using a permissible method of accounting. See Sec. 1.460-
6(c)(1)(ii) for application of the look-back method as a result of 
adjustments to allocable contract costs.
    (6) 10-percent method--(i) In general. Instead of determining the 
income from a long-term contract beginning with the contracting year, a 
taxpayer may elect to use the 10-percent method under section 460(b)(5). 
Under the 10-percent method, a taxpayer does not include in gross income 
any amount related to allocable contract costs until the taxable year in 
which the taxpayer has incurred at least 10 percent of the estimated 
total allocable contract costs (10-percent year). A taxpayer must treat 
costs incurred before the 10-percent year as pre-contracting-year costs 
described in paragraph (b)(5)(iv) of this section.
    (ii) Election. A taxpayer makes an election under this paragraph 
(b)(6) by using the 10-percent method for all long-term contracts 
entered into during the taxable year of the election on its original 
federal income tax return for the election year. This election is a 
method of accounting and, thus, applies to all long-term contracts 
entered into during and after the taxable year of the election. An 
electing taxpayer must use the 10-percent method to apply the look-back 
method under Sec. 1.460-6 and to determine alternative minimum taxable 
income under paragraph (f) of this section. This election is not 
available if a taxpayer uses the simplified cost-to-cost method 
described in Sec. 1.460-5(c) to compute the completion factor of a 
long-term contract.
    (7) Terminated contract--(i) Reversal of income. If a long-term 
contract is terminated before completion and, as a result, the taxpayer 
retains ownership of the property that is the subject matter of that 
contract, the taxpayer must reverse the transaction in the taxable year 
of termination. To reverse the transaction, the taxpayer reports a loss 
(or gain) equal to the cumulative allocable contract costs reported 
under the contract in all prior taxable years less the cumulative gross 
receipts reported under the contract in all prior taxable years.
    (ii) Adjusted basis. As a result of reversing the transaction under 
paragraph (b)(7)(i) of this section, a taxpayer will have an adjusted 
basis in the retained property equal to the cumulative allocable 
contract costs reported under the contract in all prior taxable years. 
However, if the taxpayer received and retains any consideration or 
compensation from the customer, the taxpayer must reduce the adjusted 
basis in the retained property (but not below zero) by the fair market 
value of that consideration or compensation. To the extent that the 
amount of the consideration or compensation described in the preceding 
sentence exceeds the adjusted basis in the retained property, the 
taxpayer must include the excess in gross income for the taxable year of 
termination.
    (iii) Look-back method. The look-back method does not apply to a 
terminated contract that is subject to this paragraph (b)(7).
    (c) Exempt contract methods--(1) In general. An exempt contract 
method means the method of accounting that a taxpayer must use to 
account for all its long-term contracts (and any portion of a long-term 
contract) that are exempt from the requirements of section 460(a). Thus, 
an exempt contract method applies to exempt construction contracts, as 
defined in Sec. 1.460-3(b); the non-PCM portion of a qualified ship 
contract, as defined in Sec. 1.460-2(d); and the non-PCM portion of a 
residential construction contract, as defined in Sec. 1.460-3(c). 
Permissible exempt contract methods include the PCM, the EPCM described 
in paragraph (c)(2) of this section, the CCM described in paragraph (d) 
of this section, or any other permissible method. See section 446.
    (2) Exempt-contract percentage-of-completion method--(i) In general. 
Similar to the PCM described in paragraph (b) of this section, a 
taxpayer using the EPCM generally must include in income the portion of 
the total contract

[[Page 214]]

price, as described in paragraph (b)(4) of this section, that 
corresponds to the percentage of the entire contract that the taxpayer 
has completed during the taxable year. However, under the EPCM, the 
percentage of completion may be determined as of the end of the taxable 
year by using any method of cost comparison (such as comparing direct 
labor costs incurred to date to estimated total direct labor costs) or 
by comparing the work performed on the contract with the estimated total 
work to be performed, rather than by using the cost-to-cost comparison 
required by paragraphs (b)(2)(i) and (5) of this section, provided such 
method is used consistently and clearly reflects income. In addition, 
paragraph (b)(3) of this section (regarding post-completion-year 
income), paragraph (b)(6) of this section (regarding the 10-percent 
method) and Sec. 1.460-6 (regarding the look-back method) do not apply 
to the EPCM.
    (ii) Determination of work performed. For purposes of the EPCM, the 
criteria used to compare the work performed on a contract as of the end 
of the taxable year with the estimated total work to be performed must 
clearly reflect the earning of income with respect to the contract. For 
example, in the case of a roadbuilder, a standard of completion solely 
based on miles of roadway completed in a case where the terrain is 
substantially different may not clearly reflect the earning of income 
with respect to the contract.
    (d) Completed-contract method--(1) In general. Except as otherwise 
provided in paragraph (d)(4) of this section, a taxpayer using the CCM 
to account for a long-term contract must take into account in the 
contract's completion year, as defined in Sec. 1.460-1(b)(6), the gross 
contract price and all allocable contract costs incurred by the 
completion year. A taxpayer may not treat the cost of any materials and 
supplies that are allocated to a contract, but actually remain on hand 
when the contract is completed, as an allocable contract cost.
    (2) Post-completion-year income and costs. If a taxpayer has not 
included an item of contingent compensation (i.e., amounts for which the 
all events test has not been satisfied) in gross contract price under 
paragraph (d)(3) of this section by the completion year, the taxpayer 
must account for this item of contingent compensation using a 
permissible method of accounting. If a taxpayer incurs an allocable 
contract cost after the completion year, the taxpayer must account for 
that cost using a permissible method of accounting.
    (3) Gross contract price. Gross contract price includes all amounts 
(including holdbacks, retainages, and reimbursements) that a taxpayer is 
entitled by law or contract to receive, whether or not the amounts are 
due or have been paid. In addition, gross contract price includes all 
bonuses, awards, and incentive payments, such as a bonus for meeting an 
early completion date, to the extent the all events test is satisfied. 
If a taxpayer performs a non-long-term contract activity, as defined in 
Sec. 1.460-1(d)(2), that is incident to or necessary for the 
manufacture, building, installation, or construction of the subject 
matter of one or more of the taxpayer's long-term contracts, the 
taxpayer must include an allocable share of the gross receipts 
attributable to that activity in the gross contract price of the 
contract(s) benefitted by that activity. Gross contract price also 
includes amounts reimbursed for independent research and development 
expenses (as defined in Sec. 1.460-1(b)(9)), or bidding and proposal 
costs, under a federal or cost-plus long-term contract (as defined in 
section 460(d)), regardless of whether the research and development, or 
bidding and proposal, activities are incident to or necessary for the 
performance of that long-term contract.
    (4) Contracts with disputed claims--(i) In general. The special 
rules in this paragraph (d)(4) apply to a long-term contract accounted 
for using the CCM with a dispute caused by a customer's requesting a 
reduction of the gross contract price or the performance of additional 
work under the contract or by a taxpayer's requesting an increase in 
gross contract price, or both, on or after the date a taxpayer has 
tendered the subject matter of the contract to the customer.
    (ii) Taxpayer assured of profit or loss. If the disputed amount 
relates to a customer's claim for either a reduction in

[[Page 215]]

price or additional work and the taxpayer is assured of either a profit 
or a loss on a long-term contract regardless of the outcome of the 
dispute, the gross contract price, reduced (but not below zero) by the 
amount reasonably in dispute, must be taken into account in the 
completion year. If the disputed amount relates to a taxpayer's claim 
for an increase in price and the taxpayer is assured of either a profit 
or a loss on a long-term contract regardless of the outcome of the 
dispute, the gross contract price must be taken into account in the 
completion year. If the taxpayer is assured a profit on the contract, 
all allocable contract costs incurred by the end of the completion year 
are taken into account in that year. If the taxpayer is assured a loss 
on the contract, all allocable contract costs incurred by the end of the 
completion year, reduced by the amount reasonably in dispute, are taken 
into account in the completion year.
    (iii) Taxpayer unable to determine profit or loss. If the amount 
reasonably in dispute affects so much of the gross contract price or 
allocable contract costs that a taxpayer cannot determine whether a 
profit or loss ultimately will be realized from a long-term contract, 
the taxpayer may not take any of the gross contract price or allocable 
contract costs into account in the completion year.
    (iv) Dispute resolved. Any part of the gross contract price and any 
allocable contract costs that have not been taken into account because 
of the principles described in paragraph (d)(4)(i), (ii), or (iii) of 
this section must be taken into account in the taxable year in which the 
dispute is resolved. If a taxpayer performs additional work under the 
contract because of the dispute, the term taxable year in which the 
dispute is resolved means the taxable year the additional work is 
completed, rather than the taxable year in which the outcome of the 
dispute is determined by agreement, decision, or otherwise.
    (e) Percentage-of-completion/capitalized-cost method. Under the 
PCCM, a taxpayer must determine the income from a long-term contract 
using the PCM for the applicable percentage of the contract and its 
exempt contract method, as defined in paragraph (c) of this section, for 
the remaining percentage of the contract. For residential construction 
contracts described in Sec. 1.460-3(c), the applicable percentage is 70 
percent, and the remaining percentage is 30 percent. For qualified ship 
contracts described in Sec. 1.460-2(d), the applicable percentage is 40 
percent, and the remaining percentage is 60 percent.
    (f) Alternative minimum taxable income--(1) In general. Under 
section 56(a)(3), a taxpayer (not exempt from the AMT under section 
55(e)) must use the PCM to determine its AMTI from any long-term 
contract entered into on or after March 1, 1986, that is not a home 
construction contract, as defined in Sec. 1.460-3(b)(2). For AMTI 
purposes, the PCM must include any election under paragraph (b)(6) of 
this section (concerning the 10-percent method) or under Sec. 1.460-
5(c) (concerning the simplified cost-to-cost method) that the taxpayer 
has made for regular tax purposes. For exempt construction contracts 
described in Sec. 1.460-3(b)(1)(ii), a taxpayer must use the simplified 
cost-to-cost method to determine the completion factor for AMTI 
purposes. Except as provided in paragraph (f)(2) of this section, a 
taxpayer must use AMTI costs and AMTI methods, such as the depreciation 
method described in section 56(a)(1), to determine the completion factor 
of a long-term contract (except a home construction contract) for AMTI 
purposes.
    (2) Election to use regular completion factors. Under this paragraph 
(f)(2), a taxpayer may elect for AMTI purposes to determine the 
completion factors of all of its long-term contracts using the methods 
of accounting and allocable contract costs used for regular federal 
income tax purposes. A taxpayer makes this election by using regular 
methods and regular costs to compute the completion factors of all long-
term contracts entered into during the taxable year of the election for 
AMTI purposes on its original federal income tax return for the election 
year. This election is a method of accounting and, thus, applies to all 
long-term contracts entered into during and after the taxable year of 
the election. Although a taxpayer may elect to compute the

[[Page 216]]

completion factor of its long-term contracts using regular methods and 
regular costs, an election under this paragraph (f)(2) does not 
eliminate a taxpayer's obligation to comply with the requirements of 
section 55 when computing AMTI. For example, although a taxpayer may 
elect to use the depreciation methods used for regular tax purposes to 
compute the completion factor of its long-term contracts for AMTI 
purposes, the taxpayer must use the depreciation methods permitted by 
section 56 to compute AMTI.
    (g) Method of accounting. A taxpayer that uses the PCM, EPCM, CCM, 
or PCCM, or elects the 10-percent method or special AMTI method (or 
changes to another method of accounting with the Commissioner's consent) 
must apply the method(s) consistently for all similarly classified long-
term contracts, until the taxpayer obtains the Commissioner's consent 
under section 446(e) to change to another method of accounting. A 
taxpayer-initiated change in method of accounting will be permitted only 
on a cut-off basis (i.e., for contracts entered into on or after the 
year of change), and thus, a section 481(a) adjustment will not be 
permitted or required.
    (h) Examples. The following examples illustrate the rules of this 
section:

    Example 1. PCM--estimating total contract price. C, whose taxable 
year ends December 31, determines the income from long-term contracts 
using the PCM. On January 1, 2001, C enters into a contract to design 
and manufacture a satellite (a unique item). The contract provides that 
C will be paid $10,000,000 for delivering the completed satellite by 
December 1, 2002. The contract also provides that C will receive a 
$3,000,000 bonus for delivering the satellite by July 1, 2002, and an 
additional $4,000,000 bonus if the satellite successfully performs its 
mission for five years. C is unable to reasonably predict if the 
satellite will successfully perform its mission for five years. If on 
December 31, 2001, C should reasonably expect to deliver the satellite 
by July 1, 2002, the estimated total contract price is $13,000,000 
($10,000,000 unit price + $3,000,000 production-related bonus). 
Otherwise, the estimated total contract price is $10,000,000. In either 
event, the $4,000,000 bonus is not includible in the estimated total 
contract price as of December 31, 2001, because C is unable to 
reasonably predict that the satellite will successfully perform its 
mission for five years.
    Example 2. PCM--computing income. (i) C, whose taxable year ends 
December 31, determines the income from long-term contracts using the 
PCM. During 2001, C agrees to manufacture for the customer, B, a unique 
item for a total contract price of $1,000,000. Under C's contract, B is 
entitled to retain 10 percent of the total contract price until it 
accepts the item. By the end of 2001, C has incurred $200,000 of 
allocable contract costs and estimates that the total allocable contract 
costs will be $800,000. By the end of 2002, C has incurred $600,000 of 
allocable contract costs and estimates that the total allocable contract 
costs will be $900,000. In 2003, after completing the contract, C 
determines that the actual cost to manufacture the item was $750,000.
    (ii) For each of the taxable years, C's income from the contract is 
computed as follows:

------------------------------------------------------------------------
                                              Taxable Year
                               -----------------------------------------
                                    2001          2002          2003
------------------------------------------------------------------------
(A) Cumulative incurred costs.     $200,000      $600,000      $750,000
(B) Estimated total costs.....      800,000       900,000       750,000
                               -----------------------------------------
(C) Completion factor: (A) /         25.00%        66.67%       100.00%
 (B)..........................
                               -----------------------------------------
(D) Total contract price......    1,000,000     1,000,000     1,000,000
                               -----------------------------------------
(E) Cumulative gross receipts:      250,000       666,667     1,000,000
 (C)x(D)......................
(F) Cumulative gross receipts            (0)     (250,000)     (666,667)
 (prior year).................
                               -----------------------------------------
(G) Current-year gross              250,000       416,667       333,333
 receipts.....................
                               -----------------------------------------
(H) Cumulative incurred costs.      200,000       600,000       750,000
(I) Cumulative incurred costs            (0)     (200,000)     (600,000)
 (prior year).................
                               -----------------------------------------
(J) Current-year costs........      200,000       400,000       150,000
                               -----------------------------------------
(K) Gross income: (G) - (J)...      $50,000       $16,667      $183,333
------------------------------------------------------------------------


[[Page 217]]

    Example 3. PCM--computing income with cost sharing. (i) C, whose 
taxable year ends December 31, determines the income from long-term 
contracts using the PCM. During 2001, C enters into a contract to 
manufacture a unique item. The contract specifies a target price of 
$1,000,000, a target cost of $600,000, and a target profit of $400,000. 
C and B will share the savings of any cost underrun (actual total 
incurred cost is less than target cost) and the additional cost of any 
cost overrun (actual total incurred cost is greater than target cost) as 
follows: 30 percent to C and 70 percent to B. By the end of 2001, C has 
incurred $200,000 of allocable contract costs and estimates that the 
total allocable contract costs will be $600,000. By the end of 2002, C 
has incurred $300,000 of allocable contract costs and estimates that the 
total allocable contract costs will be $400,000. In 2003, after 
completing the contract, C determines that the actual cost to 
manufacture the item was $700,000.
    (ii) For each of the taxable years, C's income from the contract is 
computed as follows (note that the sharing of any cost underrun or cost 
overrun is reflected as an adjustment to C's target price under 
paragraph (b)(4)(i) of this section):

------------------------------------------------------------------------
                                              Taxable Year
                               -----------------------------------------
                                    2001          2002          2003
------------------------------------------------------------------------
(A) Cumulative incurred costs.     $200,000      $300,000      $700,000
(B) Estimated total costs.....      600,000       400,000       700,000
                               -----------------------------------------
(C) Completion factor: (A) /         33.33%        75.00%       100.00%
 (B)..........................
                               =========================================
(D) Target price..............   $1,000,000    $1,000,000    $1,000,000
                               -----------------------------------------
(E) Estimated total costs.....      600,000       400,000       700,000
(F) Target costs..............      600,000       600,000       600,000
                               -----------------------------------------
(G) Cost (underrun)/overrun:              0      (200,000)      100,000
 (E) - (F)....................
(H) Adjustment rate...........          70%           70%           70%
                               -----------------------------------------
(I) Target price adjustment...            0      (140,000)       70,000
                               -----------------------------------------
(J) Total contract price: (D)    $1,000,000      $860,000    $1,070,000
 + (I)........................
                               =========================================
(K) Cumulative gross receipts:     $333,333      $645,000    $1,070,000
 (C)x(J)......................
(L) Cumulative gross receipts            (0)     (333,333)     (645,000)
 (prior year):................
                               -----------------------------------------
(M) Current-year gross              333,333       311,667       425,000
 receipts.....................
                               -----------------------------------------
(N) Cumulative incurred costs.      200,000       300,000       700,000
(O) Cumulative incurred costs            (0)     (200,000)     (300,000)
 (prior year):................
                               -----------------------------------------
(P) Current-year costs........      200,000       100,000       400,000
                               -----------------------------------------
(Q) Gross income: (M) - (P)...     $133,333      $211,667       $25,000
------------------------------------------------------------------------

    Example 4. PCM--10 percent method. (i) C, whose taxable year ends 
December 31, determines the income from long-term contracts using the 
PCM. In November 2001, C agrees to manufacture a unique item for 
$1,000,000. C reasonably estimates that the total allocable contract 
costs will be $600,000. By December 31, 2001, C has received $50,000 in 
progress payments and incurred $40,000 of costs. C elects to use the 10 
percent method effective for 2001 and all subsequent taxable years. 
During 2002, C receives $500,000 in progress payments and incurs 
$260,000 of costs. In 2003, C incurs an additional $300,000 of costs, C 
finishes manufacturing the item, and receives the final $450,000 
payment.
    (ii) For each of the taxable years, C's income from the contract is 
computed as follows:

------------------------------------------------------------------------
                                              Taxable Year
                               -----------------------------------------
                                    2001          2002          2003
------------------------------------------------------------------------
(A) Cumulative incurred costs.      $40,000      $300,000      $600,000
(B) Estimated total costs.....      600,000       600,000       600,000
                               -----------------------------------------
(C) Completion factor (A) /           6.67%        50.00%       100.00%
 (B)..........................
                               -----------------------------------------
(D) Total contract price......    1,000,000     1,000,000     1,000,000
                               -----------------------------------------
(E) Cumulative gross receipts:            0       500,000     1,000,000
 (C)x(D)*.....................

[[Page 218]]

 
(F) Cumulative gross receipts            (0)           (0)     (500,000)
 (prior year):................
                               -----------------------------------------
(G) Current-year gross                    0       500,000       500,000
 receipts.....................
                               -----------------------------------------
(H) Cumulative incurred costs.            0       300,000       600,000
(I) Cumulative incurred costs            (0)           (0)     (300,000)
 (prior year):................
                               -----------------------------------------
(J) Current-year costs........            0       300,000       300,000
                               -----------------------------------------
(K) Gross income: (G) - (J)...           $0      $200,000     $200,000
------------------------------------------------------------------------
*Unless (C) <10 percent.

    Example 5. PCM--contract terminated. C, whose taxable year ends 
December 31, determines the income from long-term contracts using the 
PCM. During 2001, C buys land and begins constructing a building that 
will contain 50 condominium units on that land. C enters into a contract 
to sell one unit in this condominium to B for $240,000. B gives C a 
$5,000 deposit toward the purchase price. By the end of 2001, C has 
incurred $50,000 of allocable contract costs on B's unit and estimates 
that the total allocable contract costs on B's unit will be $150,000. 
Thus, for 2001, C reports gross receipts of $80,000 ($50,000/
$150,000x$240,000), current-year costs of $50,000, and gross income of 
$30,000 ($80,000 - $50,000). In 2002, after C has incurred an additional 
$25,000 of allocable contract costs on B's unit, B files for bankruptcy 
protection and defaults on the contract with C, who is permitted to keep 
B's $5,000 deposit as liquidated damages. In 2002, C reverses the 
transaction with B under paragraph (b)(7) of this section and reports a 
loss of $30,000 ($50,000-$80,000). In addition, C obtains an adjusted 
basis in the unit sold to B of $70,000 ($50,000 (current-year costs 
deducted in 2001)- $5,000 (B's forfeited deposit) + $25,000 (current-
year costs incurred in 2002). C may not apply the look-back method to 
this contract in 2002.
    Example 6. CCM--contracts with disputes from customer claims. In 
2001, C, whose taxable year ends December 31, uses the CCM to account 
for exempt construction contracts. C enters into a contract to construct 
a bridge for B. The terms of the contract provide for a $1,000,000 gross 
contract price. C finishes the bridge in 2002 at a cost of $950,000. 
When B examines the bridge, B insists that C either repaint several 
girders or reduce the contract price. The amount reasonably in dispute 
is $10,000. In 2003, C and B resolve their dispute, C repaints the 
girders at a cost of $6,000, and C and B agree that the contract price 
is not to be reduced. Because C is assured a profit of $40,000 
($1,000,000 - $10,000 - $950,000) in 2002 even if the dispute is 
resolved in B's favor, C must take this $40,000 into account in 2002. In 
2003, C will earn an additional $4,000 profit ($1,000,000 - $956,000 - 
$40,000) from the contract with B. Thus, C must take into account an 
additional $10,000 of gross contract price and $6,000 of additional 
contract costs in 2003.
    Example 7. CCM--contracts with disputes from taxpayer claims. In 
2003, C, whose taxable year ends December 31, uses the CCM to account 
for exempt construction contracts. C enters into a contract to construct 
a building for B. The terms of the contract provide for a $1,000,000 
gross contract price. C finishes the building in 2004 at a cost of 
$1,005,000. B examines the building in 2004 and agrees that it meets the 
contract's specifications; however, at the end of 2004, C and B are 
unable to agree on the merits of C's claim for an additional $10,000 for 
items that C alleges are changes in contract specifications and B 
alleges are within the scope of the contract's original specifications. 
In 2005, B agrees to pay C an additional $2,000 to satisfy C's claims 
under the contract. Because the amount in dispute affects so much of the 
gross contract price that C cannot determine in 2004 whether a profit or 
loss will ultimately be realized, C may not taken any of the gross 
contract price or allocable contract costs into account in 2004. C must 
take into account $1,002,000 of gross contract price and $1,005,000 of 
allocable contract costs in 2005.
    Example 8. CCM--contracts with disputes from taxpayer and customer 
claims. C, whose taxable year ends December 31, uses the CCM to account 
for exempt construction contracts. C constructs a factory for B pursuant 
to a long-term contract. Under the terms of the contract, B agrees to 
pay C a total of $1,000,000 for construction of the factory. C finishes 
construction of the factory in 2002 at a cost of $1,020,000. When B 
takes possession of the factory and begins operations in December 2002, 
B is dissatisfied with the location and workmanship of certain heating 
ducts. As of the end of 2002, C contends that the heating ducts are 
constructed in accordance with contract specifications. The amount of 
the gross contract price reasonably in dispute with respect to the 
heating ducts is $6,000. As of this time, C is claiming $14,000 in 
addition to the original contract

[[Page 219]]

price for certain changes in contract specifications which C alleges 
have increased his costs. B denies that these changes have increased C's 
costs. In 2003, the disputes between C and B are resolved by performance 
of additional work by C at a cost of $1,000 and by an agreement that the 
contract price would be revised downward to $996,000. Under these 
circumstances, C must include in his gross income for 2002, $994,000 
(the gross contract price less the amount reasonably in dispute because 
of B's claim, or $1,000,000 - $6,000). In 2002, C must also take into 
account $1,000,000 of allocable contract costs (costs incurred less the 
amounts in dispute attributable to both B's and C's claims, or 
$1,020,000 - $6,000 - $14,000). In 2003, C must take into account an 
additional $2,000 of gross contract price ($996,000 - $994,000) and 
$21,000 of allocable contract costs ($1,021,000 - $1,000,000).

    (i) [Reserved]
    (j) Consolidated groups and controlled groups--(1) Intercompany 
transactions--(i) In general. Section 1.1502-13 does not apply to the 
income, gain, deduction, or loss from an intercompany transaction 
between members of a consolidated group, and section 267(f) does not 
apply to these items from an intercompany sale between members of a 
controlled group, to the extent--
    (A) The transaction or sale directly or indirectly benefits, or is 
intended to benefit, another member's long-term contract with a 
nonmember;
    (B) The selling member is required under section 460 to determine 
any part of its gross income from the transaction or sale under the 
percentage-of-completion method (PCM); and
    (C) The member with the long-term contract is required under section 
460 to determine any part of its gross income from the long-term 
contract under the PCM.
    (ii) Definitions and nomenclature. The definitions and nomenclature 
under Sec. 1.1502-13 and Sec. 1.267(f)-1 apply for purposes of this 
paragraph (j).
    (2) Example. The following example illustrates the principles of 
paragraph (j)(1) of this section.

    Example. Corporations P, S, and B file consolidated returns on a 
calendar-year basis. In 1996, B enters into a long-term contract with X, 
a nonmember, to manufacture 5 airplanes for $500 million, with delivery 
scheduled for 1999. Section 460 requires B to determine the gross income 
from its contract with X under the PCM. S enters into a contract with B 
to manufacture for $50 million the engines that B will install on X's 
airplanes. Section 460 requires S to determine the gross income from its 
contract with B under the PCM. S estimates that it will incur $40 
million of total contract costs during 1997 and 1998 to manufacture the 
engines. S incurs $10 million of contract costs in 1997 and $30 million 
in 1998. Under paragraph (j) of this section, S determines its gross 
income from the long-term contract under the PCM rather than taking its 
income or loss into account under section 267(f) or Sec. 1.1502-13. 
Thus, S includes $12.5 million of gross receipts and $10 million of 
contract costs in gross income in 1997 and includes $37.5 million of 
gross receipts and $30 million of contract costs in gross income in 
1998.

    (3) Effective dates--(i) In general. This paragraph (j) applies with 
respect to transactions and sales occurring pursuant to contracts 
entered into in years beginning on or after July 12, 1995.
    (ii) Prior law. For transactions and sales occurring pursuant to 
contracts entered into in years beginning before July 12, 1995, see the 
applicable regulations issued under sections 267(f) and 1502, including 
Sec. Sec. 1.267(f)-1T, 1.267(f)-2T, and 1.1502-13(n) (as contained in 
the 26 CFR part 1 edition revised as of April 1, 1995).
    (4) Consent to change method of accounting. For transactions and 
sales to which this paragraph (j) applies, the Commissioner's consent 
under section 446(e) is hereby granted to the extent any changes in 
method of accounting are necessary solely to comply with this section, 
provided the changes are made in the first taxable year of the taxpayer 
to which the rules of this paragraph (j) apply. Changes in method of 
accounting for these transactions are to be effected on a cut-off basis.
    (k) Mid-contract change in taxpayer--(1) In general. The rules in 
this paragraph (k) apply if prior to the completion of a long-term 
contract accounted for using a long-term contract method by a taxpayer 
(old taxpayer), there is a transaction that makes another taxpayer (new 
taxpayer) responsible for accounting for income from the same contract. 
For purposes of this paragraph (k) and Sec. 1.460-6(g), an old taxpayer 
also includes any old taxpayer(s) (e.g., predecessors) of the old 
taxpayer. In addition, a change in status from taxable to tax exempt or 
from domestic to foreign, or vice versa, will be

[[Page 220]]

considered a change in taxpayer. Finally, a contract will be treated as 
the same contract if the terms of the contract are not substantially 
changed in connection with the transaction, whether or not the customer 
agrees to release the old taxpayer from any or all of its obligations 
under the contract. The rules governing constructive completion 
transactions are provided in paragraph (k)(2) of this section, while the 
rules governing step-in-the-shoes transactions are provided in paragraph 
(k)(3) of this section. Special rules relating to the treatment of 
certain partnership transactions are provided in paragraphs (k)(2)(iv) 
and (k)(3)(v) of this section. For application of the look-back method 
to mid-contract changes in taxpayers for contracts accounted for using 
the PCM, see Sec. 1.460-6(g).
    (2) Constructive completion transactions--(i) Scope. The 
constructive completion rules in this paragraph (k)(2) apply to 
transactions (constructive completion transactions) that result in a 
change in the taxpayer responsible for reporting income from a contract 
and that are not described in paragraph (k)(3)(i) of this section. 
Constructive completion transactions generally include, for example, 
taxable sales under section 1001 and deemed asset sales under section 
338.
    (ii) Old taxpayer. The old taxpayer is treated as completing the 
contract on the date of the transaction. The total contract price (or, 
gross contract price in the case of a long-term contract accounted for 
under the CCM) for the old taxpayer is the sum of any amounts realized 
from the transaction that are allocable to the contract and any amounts 
the old taxpayer has received or reasonably expects to receive under the 
contract. Total contract price (or gross contract price) is reduced by 
any amount paid by the old taxpayer to the new taxpayer, and by any 
transaction costs, that are allocable to the contract. Thus, the old 
taxpayer's allocable contract costs determined under paragraph (b)(5) of 
this section do not include any consideration paid, or costs incurred, 
as a result of the transaction that are allocable to the contract. In 
the case of a transaction subject to section 338 or 1060, the amount 
realized from the transaction allocable to the contract is determined by 
using the residual method under Sec. Sec. 1.338-6 and 1.338-7.
    (iii) New taxpayer. The new taxpayer is treated as entering into a 
new contract on the date of the transaction. The new taxpayer must 
evaluate whether the new contract should be classified as a long-term 
contract within the meaning of Sec. 1.460-1(b) and account for the 
contract under a permissible method of accounting. For a new taxpayer 
who accounts for a contract using the PCM, the total contract price is 
any amount the new taxpayer reasonably expects to receive under the 
contract consistent with paragraph (b)(4) of this section. Total 
contract price is reduced by the amount of any consideration paid by the 
new taxpayer as a result of the transaction, and by any transaction 
costs, that are allocable to the contract and is increased by the amount 
of any consideration received by the new taxpayer as a result of the 
transaction that is allocable to the contract. Similarly, the gross 
contract price for a contract accounted for using the CCM is all amounts 
the new taxpayer is entitled by law or contract to receive consistent 
with paragraph (d)(3) of this section, adjusted for any consideration 
paid (or received) by the new taxpayer as a result of the transaction, 
and for any transaction costs, that are allocable to the contract. Thus, 
the new taxpayer's allocable contract costs determined under paragraph 
(b)(5) of this section do not include any consideration paid, or costs 
incurred, as a result of the transaction that are allocable to the 
contract. In the case of a transaction subject to sections 338 or 1060, 
the amount of consideration paid that is allocable to the contract is 
determined by using the residual method under Sec. Sec. 1.338-6 and 
1.338-7.
    (iv) Special rules relating to distributions of certain contracts by 
a partnership--(A) In general. The constructive completion rules of 
paragraph (k)(2) of this section apply both to the distribution of a 
contract accounted for under a long-term contract method of accounting 
by a partnership to a partner and to the distribution of an interest in 
a partnership (lower-tier partnership)

[[Page 221]]

holding (either directly or through other partnerships) one or more 
contracts accounted for under a long-term contract method of accounting 
by another partnership (upper-tier partnership). Notwithstanding the 
previous sentence, the constructive completion rules of paragraph (k)(2) 
of this section do not apply to a transfer by a partnership (transferor 
partnership) of all of its assets and liabilities to a second 
partnership (transferee partnership) in an exchange described in section 
721, followed by a distribution of the interest in the transferee 
partnership in liquidation of the transferor partnership, under Sec. 
1.708-1(b)(4) (relating to terminations under section 708(b)(1)(B)) or 
Sec. 1.708-1(c)(3)(i) (relating to certain partnership mergers). If a 
partnership that holds a contract accounted for under a long-term 
contract method of accounting terminates under section 708(b)(1)(A) 
because the number of its owners is reduced to one, the entire contract 
will be treated as being distributed from the partnership for purposes 
of the constructive completion rules, and the partnership must apply 
paragraph (k)(2) of this section immediately prior to the transaction or 
transactions resulting in the termination of the partnership.
    (B) Old taxpayer. The partnership that distributes the contract is 
treated as the old taxpayer for purposes of paragraph (k)(2)(ii) of this 
section. For purposes of determining the total contract price (or gross 
contract price) under paragraph (k)(2)(ii) of this section, the fair 
market value of the contract is treated as the amount realized from the 
transaction. For purposes of determining each partner's distributive 
share of partnership items, any income or loss resulting from the 
constructive completion must be allocated among the partners of the old 
taxpayer as though the partnership closed its books on the date of the 
distribution.
    (C) New taxpayer. The partner receiving the distributed contract is 
treated as the new taxpayer for purposes of paragraph (k)(2)(iii) of 
this section. For purposes of determining the total contract price (or 
gross contract price) under paragraph (k)(2)(iii) of this section, the 
new taxpayer's basis in the contract (including the uncompleted 
property, if applicable) after the distribution (as determined under 
section 732) is treated as consideration paid by the new taxpayer that 
is allocable to the contract. Thus, the total contract price (or gross 
contract price) of the new contract is reduced by the partner's basis in 
the contract (including the uncompleted property, if applicable) 
immediately after the distribution.
    (D) Basis rules. For purposes of determining the new taxpayer's 
basis in the contract (including the uncompleted property, if 
applicable) under section 732, and the amount of any basis adjustment 
under section 734(b), the partnership's basis in the contract (including 
the uncompleted property, if applicable) immediately prior to the 
distribution is equal to--
    (1) The partnership's allocable contract costs (including 
transaction costs);
    (2) Increased (or decreased) by the amount of cumulative taxable 
income (or loss) recognized by the partnership on the contract through 
the date of the distribution (including amounts recognized as a result 
of the constructive completion); and
    (3) Decreased by the amounts that the partnership has received or 
reasonably expects to receive under the contract.
    (E) Section 751--(1) In general. Contracts accounted for under a 
long-term contract method of accounting are unrealized receivables 
within the meaning of section 751(c). For purposes of section 751, the 
amount of ordinary income or loss attributable to a contract accounted 
for under a long-term contract method of accounting is the amount of 
income or loss that the partnership would take into account under the 
constructive completion rules of paragraph (k)(2) of this section if the 
contract were disposed of for its fair market value in a constructive 
completion transaction, adjusted to account for any income or loss from 
the contract that is allocated under section 706 to that portion of the 
taxable year of the partnership ending on the date of the distribution, 
sale, or exchange.
    (2) Ordering rules. Because the distribution of a contract accounted 
for under a long-term contract method of

[[Page 222]]

accounting is the distribution of an unrealized receivable, section 
751(b) may apply to the distribution. A partnership that distributes a 
contract accounted for under a long-term contract method of accounting 
must apply paragraph (k)(2)(ii) of this section before applying the 
rules of section 751(b) to the distribution.
    (3) Step-in-the-shoes transactions--(i) Scope. Except as otherwise 
provided in paragraph (k)(3)(v)(D) of this section, the step-in-the-
shoes rules in this paragraph (k)(3) apply to the following transactions 
that result in a change in the taxpayer responsible for reporting income 
from a contract accounted for using a long-term contract method of 
accounting (step-in-the-shoes transactions)--
    (A) Transfers to which section 361 applies if the transfer is in 
connection with a reorganization described in section 368(a)(1)(A), (C) 
or (F);
    (B) Transfers to which section 361 applies if the transfer is in 
connection with a reorganization described in section 368(a)(1)(D) or 
(G), provided the requirements of section 354(b)(1)(A) and (B) are met;
    (C) Distributions to which section 332 applies, provided the 
contract is transferred to an 80-percent distributee;
    (D) Transfers described in section 351;
    (E) Transfers to which section 361 applies if the transfer is in 
connection with a reorganization described in section 368(a)(1)(D) with 
respect to which the requirements of section 355 (or so much of section 
356 as relates to section 355) are met;
    (F) Transfers (e.g., sales) of S corporation stock;
    (G) Conversion to or from an S corporation;
    (H) Members joining or leaving a consolidated group;
    (I) Contributions of contracts accounted for under a long-term 
contract method of accounting to which section 721(a) applies;
    (J) Contributions of property (other than contracts accounted for 
under a long-term contract method of accounting) to a partnership that 
holds a contract accounted for under a long-term contract method of 
accounting;
    (K) Transfers of partnership interests (other than transfers which 
cause the partnership to terminate under section 708(b)(1)(A));
    (L) Distributions to which section 731 applies (other than the 
distribution of the contract); and
    (M) Any other transaction designated in the Internal Revenue 
Bulletin by the Internal Revenue Service. See Sec. 601.601(d)(2)(ii) of 
this chapter.
    (ii) Old taxpayer--(A) In general. The new taxpayer will ``step into 
the shoes'' of the old taxpayer with respect to the contract. Thus, the 
old taxpayer's obligation to account for the contract terminates on the 
date of the transaction and is assumed by the new taxpayer, as set forth 
in paragraph (k)(3)(iii) of this section. As a result, an old taxpayer 
using the PCM is required to recognize income from the contract based on 
the cumulative allocable contract costs incurred as of the date of the 
transaction. Similarly, an old taxpayer using the CCM is not required to 
recognize any revenue and may not deduct allocable contract costs 
incurred with respect to the contract.
    (B) Gain realized on the transaction. The amount of gain the old 
taxpayer realizes on the transfer of a contract in a step-in-the-shoes 
transaction must be determined after application of paragraph 
(k)(3)(ii)(A) of this section using the rules of paragraph (k)(2) of 
this section that apply to constructive completion transactions. (The 
amount of gain realized on a transfer of a contract is relevant, for 
example, in determining the amount of gain recognized with respect to 
the contract in a section 351 transaction in which the old taxpayer 
receives from the new taxpayer money or property other than stock of the 
transferee.)
    (iii) New taxpayer--(A) Method of accounting. Beginning on the date 
of the transaction, the new taxpayer must account for the long-term 
contract by using the same method of accounting used by the old taxpayer 
prior to the transaction. The same method of accounting must be used for 
such contract regardless of whether the old taxpayer's method is the new 
taxpayer's principal method of accounting under Sec. 1.381(c)(4)-
1(b)(3) or whether the new taxpayer is otherwise eligible to use the old 
taxpayer's method. Thus, if the old taxpayer uses the PCM to account

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for the contract, the new taxpayer steps into the shoes of the old 
taxpayer with respect to its completion factor and percentage of 
completion methods (such as the 10-percent method), even if the new 
taxpayer has not elected such methods for similarly classified 
contracts. Similarly, if the old taxpayer uses the CCM, the new taxpayer 
steps into the shoes of the old taxpayer with respect to the CCM, even 
if the new taxpayer is not otherwise eligible to use the CCM. However, 
the new taxpayer is not necessarily bound by the old taxpayer's method 
for similarly classified contracts entered into by the new taxpayer 
subsequent to the transaction and must apply general tax principles, 
including section 381, to determine the appropriate method to account 
for these subsequent contracts. To the extent that general tax 
principles allow the taxpayer to account for similarly classified 
contracts using a method other than the old taxpayer's method, the 
taxpayer is not required to obtain the consent of the Commissioner to 
begin using such other method.
    (B) Contract price. In the case of a long-term contract that has 
been accounted for under PCM, the total contract price for the new 
taxpayer is the sum of any amounts the old taxpayer or the new taxpayer 
has received or reasonably expects to receive under the contract 
consistent with paragraph (b)(4) of this section. Similarly, the gross 
contract price in the case of a long-term contract accounted for under 
the CCM includes all amounts the old taxpayer or the new taxpayer is 
entitled by law or by contract to receive consistent with paragraph 
(d)(3) of this section.
    (C) Contract costs. Total allocable contract costs for the new 
taxpayer are the allocable contract costs as defined under paragraph 
(b)(5) of this section incurred by either the old taxpayer prior to, or 
the new taxpayer after, the transaction. Thus, any payments between the 
old taxpayer and the new taxpayer with respect to the contract in 
connection with the transaction are not treated as allocable contract 
costs.
    (iv) Special rules related to certain corporate and partnership 
transactions--(A) Old taxpayer--basis adjustment--(1) In general. Except 
as provided in paragraph (k)(3)(iv)(A)(2) of this section, in the case 
of a transaction described in paragraph (k)(3)(i)(D), (E), or (I) of 
this section, the old taxpayer must adjust its basis in the stock or 
partnership interest of the new taxpayer by--
    (i) Increasing such basis by the amount of gross receipts the old 
taxpayer has recognized under the contract; and
    (ii) Reducing such basis by the amount of gross receipts the old 
taxpayer has received or reasonably expects to receive under the 
contract (except to the extent such gross receipts give rise to a 
liability other than a liability described in section 357(c)(3)).
    (2) Basis adjustment in excess of stock or partnership interest 
basis. If the old and new taxpayer do not join in the filing of a 
consolidated Federal income tax return, the old taxpayer may not adjust 
its basis in the stock or partnership interest of the new taxpayer under 
paragraph (k)(3)(iv)(A)(1) of this section below zero and the old 
taxpayer must recognize ordinary income to the extent the basis in the 
stock or partnership interest of the new taxpayer otherwise would be 
adjusted below zero. If the old and new taxpayer join in the filing of a 
consolidated Federal income tax return, the old taxpayer must create an 
(or increase an existing) excess loss account to the extent the basis in 
the stock of the new taxpayer otherwise would be adjusted below zero 
under paragraph (k)(3)(iv)(A)(1) of this section. See Sec. 1.1502-19 
and 1.1502-32(a)(3)(ii).
    (3) Subsequent dispositions of certain contracts. If the old 
taxpayer disposes of a contract in a transaction described in paragraph 
(k)(3)(i)(D), (E), or (I) of this section that the old taxpayer acquired 
in a transaction described in paragraph (k)(3)(i)(D), (E), or (I) of 
this section, the basis adjustment rule of this paragraph (k)(3)(iv)(A) 
is applied by treating the old taxpayer as having recognized the amount 
of gross receipts recognized by the previous old taxpayer under the 
contract and any amount recognized by the previous old taxpayer with 
respect to the contract in connection with the transaction in which the 
old taxpayer acquired the contract. In addition, the old taxpayer

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is treated as having received or as reasonably expecting to receive 
under the contract any amount the previous old taxpayer received or 
reasonably expects to receive under the contract. Similar principles 
will apply in the case of multiple successive transfers described in 
paragraph (k)(3)(i)(D), (E), or (I) of this section involving the 
contract.
    (B) New taxpayer--(1) Contract price adjustment. Generally, payments 
between the old taxpayer and the new taxpayer with respect to the 
contract in connection with the transaction do not affect the contract 
price. Notwithstanding the preceding sentence and paragraph 
(k)(3)(iii)(B) of this section, however, in the case of transactions 
described in paragraph (k)(3)(i)(B), (D), (E), or (I) of this section, 
the total contract price (or gross contract price) must be reduced to 
the extent of any amount recognized by the old taxpayer with respect to 
the contract in connection with the transaction (e.g., any amount 
recognized under section 351(b) or section 357 that is attributable to 
the contract and any income recognized by the old taxpayer pursuant to 
the basis adjustment rule of paragraph (k)(3)(iv)(A) of this section).
    (2) Basis in contract. The new taxpayer's basis in a contract 
(including the uncompleted property, if applicable) acquired in a 
transaction described in paragraphs (k)(3)(i)(A) through (E) or 
paragraph (k)(3)(i)(I) of this section will be computed under section 
362, section 334, or section 723, as applicable. Upon a new taxpayer's 
completion (actual or constructive) of a CCM or a PCM contract acquired 
in a transaction described in paragraphs (k)(3)(i)(A) through (E) or 
paragraph (k)(3)(i)(I) of this section, the new taxpayer's basis in the 
contract (including the uncompleted property, if applicable) is reduced 
to zero. The new taxpayer is not entitled to a deduction or loss in 
connection with any basis reduction pursuant to this paragraph 
(k)(3)(iv)(B)(2).
    (C) Definition of old taxpayer and new taxpayer for certain 
partnership transactions. For purposes of paragraphs (k)(3)(ii), (iii) 
and (iv) of this section, in the case of a transaction described in 
paragraph (k)(3)(i)(I) of this section, the partner contributing the 
contract to the partnership is treated as the old taxpayer, and the 
partnership receiving the contract from the partner is treated as the 
new taxpayer.
    (D) Exceptions to step-in-the-shoes rules for S corporations. Upon a 
transfer described in paragraph (k)(3)(i)(F) of this section or a 
conversion described in paragraph (k)(3)(i)(G) of this section, 
paragraphs (k)(3)(ii) and (iii) of this section apply to a contract 
accounted for under a long-term contract method of accounting only if 
the S corporation's books are closed under section 1362(e)(3), section 
1362(e)(6)(C), section 1362(e)(6)(D), section 1377(a)(2), or Sec. 
1.1502-76 on the date of the transfer or conversion. In these cases, the 
corporation is treated as both the old taxpayer and the new taxpayer for 
purposes of paragraphs (k)(3)(ii) and (iii) of this section. In all 
other cases involving these transfers, the corporation shall compute its 
income or loss from each contract accounted for under a long-term 
contract method of accounting for the period that includes the date of 
the transaction as though no change in taxpayer had occurred with 
respect to the contract, and must allocate the income or loss from the 
contract for that period in accordance with the rules generally 
applicable to transfers of S corporation stock and conversions to or 
from S corporation status. This paragraph (k)(3)(iv)(D) is applicable 
for transactions on or after July 16, 2004. In addition, this paragraph 
(k)(3)(iv)(D) may be relied upon for transactions on or after May 15, 
2002.
    (v) Special rules relating to certain partnership transactions--(A) 
Section 704(c)--(1) Contributions of contracts. The principles of 
section 704(c)(1)(A), section 737, and the regulations thereunder apply 
to income or loss with respect to a contract accounted for under a long-
term contract method of accounting that is contributed to a partnership. 
The amount of built-in income or built-in loss attributable to a 
contributed contract that is subject to section 704(c)(1)(A) is 
determined as follows. First, the contributing partner must take into 
account any income or loss required under paragraph

[[Page 225]]

(k)(3)(ii)(A) of this section for the period ending on the date of the 
contribution. Second, the partnership must determine the amount of 
income or loss that the contributing partner would take into account if 
the contract were disposed of for its fair market value in a 
constructive completion transaction. This calculation is treated as 
occurring immediately after the partner has applied paragraph 
(k)(3)(ii)(A) of this section, but before the contribution to the 
partnership. Finally, this amount is reduced by the amount of income, if 
any, that the contributing partner is required to recognize as a result 
of the contribution.
    (2) Revaluations of partnership property. The principles of section 
704(c) and Sec. 1.704-3 apply to allocations of income or loss with 
respect to a long-term contract that is revalued by a partnership under 
Sec. 1.704-1(b)(2)(iv)(f). The amount of built-in income or built-in 
loss attributable to such a contract is equal to the amount of income or 
loss that would be taken into account if, at the time of the 
revaluation, the contract were disposed of for its fair market value in 
a constructive completion transaction.
    (3) Allocation methods. In the case of a contract accounted for 
under the CCM, any built-in income or loss under section 704(c) is taken 
into account in the year the contract is completed. In the case of a 
contract accounted for under a long-term contract method of accounting 
other than the CCM, any built-in income or loss under section 704(c) 
must be taken into account in a manner that reasonably accounts for the 
section 704(c) income or loss over the remaining term of the contract.
    (B) Basis adjustments under sections 743(b) and 734(b). For purposes 
of Sec. Sec. 1.743-1(d), 1.755-1(b), and 1.755-1(c), the amount of 
ordinary income or loss attributable to a contract accounted for under a 
long-term contract method of accounting is the amount of income or loss 
that the partnership would take into account under the constructive 
completion rules of paragraph (k)(2) of this section if, at the time of 
the sale of a partnership interest or the distribution to a partner, the 
partnership disposed of the contract for its fair market value in a 
constructive completion transaction. If all or part of the transferee's 
basis adjustment under section 743(b) or the partnership's basis 
adjustment under section 734(b) is allocated to a contract accounted for 
under a long-term contract method of accounting, the basis adjustment 
shall reduce or increase, as the case may be, the affected party's 
income or loss from the contract. In the case of a contract accounted 
for under the CCM, the basis adjustment is taken into account in the 
year in which the contract is completed. In the case of a contract 
accounted for under a long-term contract method of accounting other than 
the CCM, the portion of that basis adjustment that is recovered in each 
taxable year of the partnership must be determined by the partnership in 
a manner that reasonably accounts for the adjustment over the remaining 
term of the contract.
    (C) Cross reference. See paragraph (k)(2)(iv)(E) of this section for 
rules relating to the application of section 751 to the transfer of an 
interest in a partnership holding a contract accounted for under a long-
term contract method of accounting.
    (D) Exceptions to step-in-the-shoes rules. Upon a contribution 
described in paragraph (k)(3)(i)(J) of this section, a transfer 
described in paragraph (k)(3)(i)(K) of this section, or a distribution 
described in paragraph (k)(3)(i)(L) of this section, paragraphs 
(k)(3)(ii) and (iii) of this section apply to a contract accounted for 
under a long-term contract method of accounting only if the 
partnership's books are properly closed with respect to that contract 
under section 706. In these cases, the partnership is treated as both 
the old taxpayer and the new taxpayer for purposes of paragraphs 
(k)(3)(ii) and (iii) of this section. In all other cases involving these 
transactions, the partnership shall compute its income or loss from each 
contract accounted for under a long-term contract method of accounting 
for the period that includes the date of the transaction as though no 
change in taxpayer had occurred with respect to the contract, and must 
allocate the income or loss from the contract for that period under a 
reasonable method complying with section 706.

[[Page 226]]

    (4) Anti-abuse rule. Notwithstanding this paragraph (k), in the case 
of a transaction entered into with a principal purpose of shifting the 
tax consequences associated with a long-term contract in a manner that 
substantially reduces the aggregate U.S. Federal income tax liability of 
the parties with respect to that contract, the Commissioner may allocate 
to the old (or new) taxpayer the income from that contract properly 
allocable to the old (or new) taxpayer. For example, the Commissioner 
may reallocate income from a long-term contract in a transaction in 
which a contract accounted for using the CCM, or using the PCM where the 
old taxpayer has received advance payments in excess of its contribution 
to the contract, is transferred to a tax indifferent party (e.g., a 
foreign person not subject to U.S. Federal income tax).
    (5) Examples. The following examples illustrate the rules of this 
paragraph (k). For purposes of these examples, it is assumed that the 
contract is a long-term construction contract accounted for using the 
PCM prior to the transaction unless stated otherwise and the contract is 
not transferred with a principal purpose of shifting the tax 
consequences associated with a long-term contract in a manner that 
substantially reduces the aggregate U.S. Federal income tax liability of 
the parties with respect to that contract. The examples are as follows:

    Example 1. Constructive completion--PCM--(i) Facts. In Year 1, X 
enters into a contract. The total contract price is $1,000,000 and the 
estimated total allocable contract costs are $800,000. In Year 1, X 
incurs costs of $200,000. In Year 2, X incurs additional costs of 
$400,000 before selling the contract as part of a taxable sale of its 
business in Year 2 to Y, an unrelated party. At the time of sale, X has 
received $650,000 in progress payments under the contract. The 
consideration allocable to the contract under section 1060 is $150,000. 
Pursuant to the sale, the new taxpayer Y immediately assumes X's 
contract obligations and rights. Y is required to account for the 
contract using the PCM. In Year 2, Y incurs additional allocable 
contract costs of $50,000. Y correctly estimates at the end of Year 2 
that it will have to incur an additional $75,000 of allocable contract 
costs in Year 3 to complete the contract.
    (ii) Old taxpayer. For Year 1, X reports receipts of $250,000 (the 
completion factor multiplied by total contract price ($200,000/
$800,000x$1,000,000)) and costs of $200,000, for a profit of $50,000. X 
is treated as completing the contract in Year 2 because it sold the 
contract. For purposes of applying the PCM in Year 2, the total contract 
price is $800,000 (the sum of the amounts received under the contract 
and the amount realized in the sale ($650,000 + $150,000)) and the total 
allocable contract costs are $600,000 (the sum of the costs incurred in 
Year 1 and Year 2 ($200,000 + $400,000)). Thus, in Year 2, X reports 
receipts of $550,000 (total contract price minus receipts already 
reported ($800,000 - $250,000)) and costs incurred in year 2 of 
$400,000, for a profit of $150,000.
    (iii) New taxpayer. Y is treated as entering into a new contract in 
Year 2. The total contract price is $200,000 (the amount remaining to be 
paid under the terms of the contract less the consideration paid 
allocable to the contract ($1,000,000 - $650,000 - $150,000)). The 
estimated total allocable contract costs at the end of Year 2 are 
$125,000 (the allocable contract costs that Y reasonably expects to 
incur to complete the contract ($50,000 + $75,000)). In Year 2, Y 
reports receipts of $80,000 (the completion factor multiplied by the 
total contract price [($50,000/$125,000)x$200,000] and costs of $50,000 
(the costs incurred after the purchase), for a profit of $30,000. For 
Year 3, Y reports receipts of $120,000 (total contract price minus 
receipts already reported ($200,000 - $80,000)) and costs of $75,000, 
for a profit of $45,000.
    Example 2. Constructive completion--CCM--(i) Facts. The facts are 
the same as in Example 1, except that X and Y properly account for the 
contract under the CCM.
    (ii) Old taxpayer. X does not report any income or costs from the 
contract in Year 1. In Year 2, the contract is deemed complete for X, 
and X reports its gross contract price of $800,000 (the sum of the 
amounts received under the contract and the amount realized in the sale 
($650,000 + $150,000)) and its total allocable contract costs of 
$600,000 (the sum of the costs incurred in Year 1 and Year 2 ($200,000 + 
$400,000)) in that year, for a profit of $200,000.
    (iii) New taxpayer. Y is treated as entering into a new contract in 
Year 2. Under the CCM, Y reports no gross receipts or costs in Year 2. Y 
reports its gross contract price of $200,000 (the amount remaining to be 
paid under the terms of the contract less the consideration paid 
allocable to the contract ($1,000,000 - $650,000 - $150,000)) and its 
total allocable contract costs of $125,000 (the allocable contract costs 
that Y incurred to complete the contract ($50,000 + $75,000)) in Year 3, 
the completion year, for a profit of $75,000.
    Example 3. Step-in-the-shoes--PCM--(i) Facts. The facts are the same 
as in Example 1, except that X transfers the contract (including the 
uncompleted property) to Y in exchange for stock of Y in a transaction 
that

[[Page 227]]

qualifies as a statutory merger described in section 368(a)(1)(A) and 
does not result in gain or loss to X under section 361(a).
    (ii) Old taxpayer. For Year 1, X reports receipts of $250,000 (the 
completion factor multiplied by total contract price ($200,000/
$800,000x$1,000,000)) and costs of $200,000, for a profit of $50,000. 
Because the mid-contract change in taxpayer results from a transaction 
described in paragraph (k)(3)(i) of this section, X is not treated as 
completing the contract in Year 2. In Year 2, X reports receipts of 
$500,000 (the completion factor multiplied by the total contract price 
and minus the Year 1 gross receipts [($600,000/$800,000x$1,000,000)-
$250,000]) and costs of $400,000, for a profit of $100,000.
    (iii) New taxpayer. Because the mid-contract change in taxpayer 
results from a step-in-the-shoes transaction, Y must account for the 
contract using the same methods of accounting used by X prior to the 
transaction. Total contract price is the sum of any amounts that X and Y 
have received or reasonably expect to receive under the contract, and 
total allocable contract costs are the allocable contract costs of X and 
Y. Thus, the estimated total allocable contract costs at the end of Year 
2 are $725,000 (the cumulative allocable contract costs of X and the 
estimated total allocable contract costs of Y ($200,000 + $400,000 + 
$50,000 + $75,000)). In Year 2, Y reports receipts of $146,552 (the 
completion factor multiplied by the total contract price minus receipts 
reported by the old taxpayer ([($650,000/$725,000)x$1,000,000]-$750,000) 
and costs of $50,000, for a profit of $96,552. For Year 3, Y reports 
receipts of $103,448 (the total contract price minus prior year receipts 
($1,000,000-$896,552)) and costs of $75,000, for a profit of $28,448.
    Example 4. Step-in-the-shoes--CCM--(i) Facts. The facts are the same 
as in Example 3, except that X properly accounts for the contract under 
the CCM.
    (ii) Old taxpayer. X reports no income or costs from the contract in 
Years 1, 2 or 3.
    (iii) New taxpayer. Because the mid-contract change in taxpayer 
results from a step-in-the-shoes transaction, Y must account for the 
contract using the same method of accounting used by X prior to the 
transaction. Thus, in Year 3, the completion year, Y reports receipts of 
$1,000,000 and total contract costs of $725,000, for a profit of 
$275,000.
    Example 5. Step in the shoes--PCM--basis adjustment. The facts are 
the same as in Example 3, except that X transfers the contract 
(including the uncompleted property) with a basis of $0 and $125,000 of 
cash to a new corporation, Z, in exchange for all of the stock of Z in a 
section 351 transaction. Thus, under section 358(a), X's basis in the Z 
stock is $125,000. Pursuant to paragraph (k)(3)(iv)(A)(1) of this 
section, X must increase its basis in the Z stock by the amount of gross 
receipts X recognized under the contract, $750,000 ($250,000 receipts in 
Year 1 + $500,000 receipts in Year 2), and reduce its basis by the 
amount of gross receipts X received under the contract, the $650,000 in 
progress payments. Accordingly, X's basis in the Z stock is $225,000. 
All other results are the same.
    Example 6. Step in the shoes--CCM--basis adjustment--(i) Facts. The 
facts are the same as in Example 4, except that X receives progress 
payments of $800,000 (rather than $650,000) and transfers the contract 
(including the uncompleted property) with a basis of $600,000 and 
$125,000 of cash to a new corporation, Z, in exchange for all of the 
stock of Z in a section 351 transaction. X and Z do not join in filing a 
consolidated Federal income tax return.
    (ii) Old taxpayer. X reports no income or costs under the contract 
in Years 1, 2, or 3. Under section 358(a), X's basis in Z is $725,000. 
Pursuant to paragraph (k)(3)(iv)(A)(1), X must reduce its basis in the 
stock of Z by $800,000, the progress payments received by X. However, X 
may not reduce its basis in the Z stock below zero pursuant paragraph 
(k)(3)(iv)(A)(2) of this section. Accordingly, X's basis in the Z stock 
is reduced by $725,000 to zero and X must recognize ordinary income of 
$75,000.
    (iii) New taxpayer. Upon completion of the contract in Year 3, Z 
reports gross receipts of $925,000 ($1,000,000 original contract price--
$75,000 income recognized by the old taxpayer pursuant to the basis 
adjustment rule of paragraph (k)(3)(iv)(A)) and total contract costs of 
$725,000, for a profit of $200,000.
    Example 7. Step in the shoes--PCM--gain recognized in transaction--
(i) Facts. The facts are the same as in Example 3, except that X 
transfers the contract (including the uncompleted property) with a basis 
of $0 and an unrelated capital asset with a value of $100,000 and a 
basis of $0 to a new corporation, Z, in exchange for stock of Z with a 
value of $200,000 and $50,000 of cash in a section 351 transaction.
    (ii) Old taxpayer. For year 1, X reports receipts of $250,000 
($200,000/$800,000x$1,000,000) and costs of $200,000, for a profit of 
$50,000. X is not treated as completing the contract in Year 2. In Year 
2, X reports receipts of $500,000 (($600,000/$800,000x$1,000,000 = 
$750,000 cumulative gross receipts)--$250,000 prior year cumulative 
gross receipts) and costs of $400,000, for a profit of $100,000. Under 
paragraph (k)(3)(ii)(B) of this section, X determines that the gain 
realized on the transfer of the contract to Z under the constructive 
completion rules of paragraph (k)(2)(ii) of this section is $50,000 
(total contract price of $800,000 ($150,000 value allocable to the 
contract + $650,000 progress payments)--$750,000 previously recognized 
cumulative gross receipts--$0 costs incurred but not recognized).

[[Page 228]]

The gain realized on the transfer of the unrelated capital asset to Z is 
$100,000. The amount of gain X must recognize due to the receipt of 
$50,000 cash in the exchange is $50,000, of which $30,000 is allocated 
to the contract ($150,000 value of contract/$250,000 total value of 
property transferred to Z x $50,000) and is treated as ordinary income, 
and $20,000 is allocated to the unrelated capital asset ($100,000 value 
of capital asset/$250,000 total value of property transferred to Z x 
$50,000). Under section 358(a), X's basis in the Z stock is $0. However, 
pursuant to paragraph (k)(3)(iv)(A)(1) of this section, X must increase 
its basis in the Z stock by $750,000, the amount of gross receipts 
recognized under the contract, and must reduce its basis in the Z stock 
by $650,000, the amount of gross receipts X received under the contract. 
Therefore, X's basis in the Z stock is $100,000.
    (iii) New taxpayer. Z must account for the contract using the same 
PCM method used by X prior to the transaction. Pursuant to paragraph 
(k)(3)(iv)(B)(1) of this section, the total contract price is $970,000 
($1,000,000 amount X and Z have received or reasonably expect to receive 
under the contract--$30,000 income recognized by X with respect to the 
contract as a result of the receipt of $50,000 cash in the transaction). 
In Year 2, Z reports gross receipts of $119,655 ($650,000/
$725,000x$970,000 = $869,655 current year cumulative gross receipts--
$750,000 cumulative gross receipts reported by the old taxpayer) and 
costs of $50,000, for a profit of $69,655. In Year 3, Z reports gross 
receipts of $100,345 ($970,000-$869,655) and costs of $75,000, for a 
profit of $25,345.
    Example 8. Step in the shoes--CCM--gain recognized in transaction--
(i) Facts. The facts are the same as in Example 4, except that X 
transfers the contract (including the uncompleted property) with a basis 
of $600,000 and an unrelated capital asset with a value of $125,000 and 
a basis of $0 to a new corporation, Z, in exchange for all the stock of 
Z with a value of $175,000 and $100,000 of cash in a section 351 
transaction. X and Z do not join in filing a consolidated Federal income 
tax return.
    (ii) Old taxpayer. X reports no income or costs under the contract 
in Years 1, 2, or 3. Under paragraph (k)(3)(ii)(B), X determines that 
the gain realized on the transfer of the contract to Z under the 
constructive completion rules of paragraph (k)(2)(ii) of this section is 
$200,000 ($800,000 total contract price ($150,000 value allocable to the 
contract + $650,000 progress payments)--$600,000 costs incurred but not 
recognized). The gain realized on the transfer of the unrelated capital 
asset to Z is $125,000. The amount of gain X must recognize due to the 
receipt of $100,000 of cash in the exchange is $100,000, of which 
$54,545 is allocated to the contract ($150,000 value of the contract/
$275,000 total value of property transferred to Zx$100,000) and is 
treated as ordinary income, and $45,455 is allocated to the unrelated 
capital asset ($125,000 value of capital asset/$275,000 total value of 
property transferred to Zx$100,000). Under section 358(a), X's basis in 
the Z stock is $600,000 ($600,000 basis in the contract and unrelated 
capital asset transferred--$100,000 cash received + $100,000 gain 
recognized). Pursuant to paragraph (k)(3)(iv)(A)(1) of this section, X 
must reduce its basis in the stock of Z by $650,000, the progress 
payments received under the contract. However, X may not reduce its 
basis in the Z stock below zero pursuant to paragraph (k)(3)(iv)(A)(2) 
of this section. Accordingly, X's basis in the Z stock is reduced by 
$600,000 to zero and X must recognize income of $50,000.
    (iii) New taxpayer. Z must account for the contract using the same 
CCM used by X prior to the transaction. Pursuant to paragraph 
(k)(3)(iv)(B)(1) of this section, the total contract price is $895,455 
($1,000,000 original contract price--$54,545 income recognized by old 
taxpayer with respect to the contract as a result of the receipt of cash 
in the transaction--$50,000 income recognized by the old taxpayer 
pursuant to the basis adjustment rule of paragraph (k)(3)(iv)(A)). 
Accordingly, upon completion of the contract in Year 3, Z reports gross 
receipts of $895,455 and total contract costs of $725,000, for a profit 
of $170,455.
    Example 9. Constructive completion--PCM--distribution of contract by 
partnership--(i) Facts. In Year 1, W, X, Y, and Z each contribute 
$100,000 to form equal partnership PRS. In Year 1, PRS enters into a 
contract. The total contract price is $1,000,000 and the estimated total 
allocable contract costs are $800,000. In Year 1, PRS incurs costs of 
$600,000 and receives $650,000 in progress payments under the contract. 
Under the contract, PRS performed all of the services required in order 
to be entitled to receive the progress payments, and there was no 
obligation to return the payments or perform any additional services in 
order to retain the payments. PRS properly accounts for the contract 
under the PCM. In Year 2, PRS distributes the contract to X in 
liquidation of X's interest. PRS incurs no costs and receives no 
progress payments in Year 2 prior to the distribution. At the time of 
the distribution, PRS's only asset other than the long-term contract and 
the partially constructed property is $450,000 cash ($400,000 initially 
contributed and $50,000 in excess progress payments). The fair market 
value of the contract is $150,000. Pursuant to the distribution, X 
assumes PRS's contract obligations and rights. In Year 2, X incurs 
additional allocable contract costs of $50,000. X correctly estimates at 
the end of Year 2 that X will have to incur an additional $75,000 of 
allocable contract costs in Year 3 to complete the contract (rather than 
$150,000 as originally estimated by PRS). Assume that

[[Page 229]]

X properly accounts for the contract under the PCM, that PRS has no 
income or loss other than income or loss from the contract, and that PRS 
has an election under section 754 in effect in Year 2.
    (ii) Tax consequences to PRS. For Year 1, PRS reports receipts of 
$750,000 (the completion factor multiplied by total contract price 
($600,000/$800,000 x $1,000,000)) and costs of $600,000, for a profit of 
$150,000, which is allocated equally among W, X, Y, and Z ($37,500 
each). Immediately prior to the distribution of the contract to X in 
Year 2, the contract is deemed completed. Under paragraph (k)(2)(iv)(B) 
of this section, the fair market value of the contract ($150,000) is 
treated as the amount realized from the transaction. For purposes of 
applying the PCM in Year 2, the total contract price is $800,000 (the 
sum of the amounts received under the contract and the amount treated as 
realized from the transaction ($650,000 + $150,000)) and the total 
allocable contract costs are $600,000. Thus, in Year 2 PRS reports 
receipts of $50,000 (total contract price minus receipts already 
reported ($800,000 - $750,000)), and costs incurred in Year 2 of $0, for 
a profit of $50,000. Under paragraph (k)(2)(iv)(B) of this section, this 
profit must be allocated among W, X, Y, and Z as though the partnership 
closed its books on the date of the distribution. Accordingly, each 
partner's distributive share of this income is $12,500.
    (iii) Tax consequences to X. X's basis in its interest in PRS 
immediately prior to the distribution is $150,000 (X's $100,000 initial 
contribution, increased by $37,500, X's distributive share of Year 1 
income, and $12,500, X's distributive share of Year 2 income). Under 
paragraph (k)(2)(iv)(D) of this section, PRS's basis in the contract 
(including the uncompleted property, if applicable) immediately prior to 
the distribution is equal to $150,000 (the partnership's allocable 
contract costs, $600,000, increased by the amount of income recognized 
by PRS on the contract through the date of the distribution (including 
amounts recognized as a result of the constructive completion), 
$200,000, decreased by the amounts that the partnership has received or 
reasonably expects to receive under the contract, $650,000). Under 
section 732, X's basis in the contract (including the uncompleted 
property) after the distribution is $150,000. Under paragraph 
(k)(2)(iv)(C) of this section, X's basis in the contract (including the 
uncompleted property) is treated as consideration paid by X that is 
allocable to the contract. X's total contract price is $200,000 (the 
amount remaining to be paid under the terms of the contract less the 
consideration allocable to the contract ($350,000-$150,000)). For Year 
2, X reports receipts of $80,000 (the completion factor multiplied by 
the total contract price [($50,000/$125,000)x$200,000]) and costs of 
$50,000 (the costs incurred after the distribution of the contract), for 
a profit of $30,000. For Year 3, X reports receipts of $120,000 (the 
total contract price minus receipts already reported ($200,000 - 
$80,000)) and costs of $75,000, for a profit of $45,000.
    (iv) Section 734(b). Because X's basis in the contract (including 
the uncompleted property) immediately after the distribution, $150,000, 
is equal to PRS's basis in the contract (including the uncompleted 
property) immediately prior to the distribution, there is no basis 
adjustment under section 734(b).
    Example 10. Constructive completion--CCM--distribution of contract 
by partnership--(i) Facts. The facts are the same as in Example 9, 
except that PRS and X properly account for the contract under the CCM.
    (ii) Tax consequences to PRS. PRS reports no income or costs from 
the contract in Year 1. Immediately prior to the distribution of the 
contract to X in Year 2, the contract is deemed completed. Under 
paragraph (k)(2)(iv)(B) of this section, the fair market value of the 
contract ($150,000) is treated as the amount realized from the 
transaction. For purposes of applying the CCM in Year 2, the gross 
contract price is $800,000 (the sum of the amounts received under the 
contract and the amount treated as realized from the transaction 
($650,000 + $150,000)) and the total allocable contract costs are 
$600,000. Thus, in Year 2 PRS reports profits of $200,000 ($800,000 - 
$600,000). This profit must be allocated among W, X, Y, and Z as though 
the partnership closed its books on the date of the distribution. 
Accordingly, each partner's distributive share of this income is 
$50,000.
    (iii) Tax consequences to X. X's basis in its interest in PRS 
immediately prior to the distribution is $150,000 ($100,000 initial 
contribution, increased by $50,000, X's distributive share of Year 2 
income). Under paragraph (k)(2)(iv)(D) of this section, PRS's basis in 
the contract (including the uncompleted property, if applicable) 
immediately prior to the distribution is equal to $150,000 (the 
partnership's allocable contract costs, $600,000, increased by the 
amount of cumulative taxable income recognized by PRS on the contract 
through the date of the distribution (including amounts recognized as a 
result of the constructive completion), $200,000, decreased by the 
amounts that the partnership has received or reasonably expects to 
receive under the contract, $650,000). Under section 732, X's basis in 
the contract (including the uncompleted property) after the distribution 
is $150,000. Under paragraph (k)(2)(iv)(C) of this section, X's basis in 
the contract is treated as consideration paid by X that is allocable to 
the contract. Under the CCM, X reports no gross receipts or costs in 
Year 2. For Year 3, the completion year, X reports its gross contract 
price of $200,000 (the amount remaining to be paid under the terms of 
the contract less the consideration allocable to the contract ($350,000 
- $150,000))

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and its total allocable contract costs of $125,000 (the allocable 
contract costs that X incurred to complete the contract ($50,000 + 
$75,000)), for a profit of $75,000.
    (iv) Section 734(b). The results under section 734(b) are the same 
as in Example 9.
    Example 11. Step-in-the-shoes--PCM--contribution of contract to 
partnership --(i) Facts. In Year 1, X enters into a contract that X 
properly accounts for under the PCM. The total contract price is 
$1,000,000 and the estimated total allocable contract costs are 
$800,000. In Year 1, X incurs costs of $600,000 and receives $650,000 in 
progress payments under the contract. Under the contract, X performed 
all of the services required in order to be entitled to receive the 
progress payments, and there was no obligation to return the payments or 
perform any additional services in order to retain the payments. In Year 
2, X contributes the contract (including the uncompleted property) with 
a basis of $0 and $125,000 of cash to partnership PRS in exchange for a 
one-fourth partnership interest. X incurs costs of $10,000, and receives 
no progress payments in Year 2 prior to the contribution of the 
contract. X and the other three partners of PRS share equally in its 
capital, profits, and losses. The parties determine that, at the time of 
the contribution, the fair market value of the contract is $160,000. 
Following the contribution in Year 2, PRS incurs additional allocable 
contract costs of $40,000. PRS correctly estimates at the end of Year 2 
that it will have to incur an additional $75,000 of allocable contract 
costs in Year 3 to complete the contract (rather than $150,000 as 
originally estimated by PRS).
    (ii) Tax consequences to X. For Year 1, X reports receipts of 
$750,000 (the completion factor multiplied by the total contract price 
($600,000/$800,000 x $1,000,000)) and costs of $600,000, for a profit of 
$150,000. Because the mid-contract change in taxpayer results from a 
transaction described in paragraph (k)(3)(i)(I) of this section, X is 
not treated as completing the contract in Year 2. Under paragraph 
(k)(3)(ii)(A) of this section, for Year 2, X reports receipts of $12,500 
(the completion factor multiplied by the total contract price ($610,000/
$800,000 x $1,000,000, or $762,500), decreased by receipts already 
reported, $750,000) and costs of $10,000, for a profit of $2,500. Under 
section 722, X's initial basis in its interest in PRS is $125,000. 
Pursuant to paragraph (k)(3)(iv)(A)(1) of this section, X must increase 
its basis in its interest in PRS by the amount of gross receipts X 
recognized under the contract, $762,500, and reduce its basis by the 
amount of gross receipts X received under the contract, the $650,000 in 
progress payments. Accordingly, X's basis in its interest in PRS is 
$237,500.
    (iii) Tax consequences to PRS. Because the mid-contract change in 
taxpayer results from a step-in-the-shoes transaction, PRS must account 
for the contract using the same methods of accounting used by X prior to 
the transaction. The total contract price is the sum of any amounts that 
X and PRS have received or reasonably expect to receive under the 
contract, and total allocable contract costs are the allocable contract 
costs of X and PRS. For Year 2, PRS reports receipts of $134,052 (the 
completion factor multiplied by the total contract price [($650,000/
$725,000) - $1,000,000], $896,552, decreased by receipts reported by X, 
$762,500) and costs of $40,000, for a profit of $94,052. For Year 3, PRS 
reports receipts of $103,448 (the total contract price minus prior year 
receipts ($1,000,000 x $896,552)) and costs of $75,000, for a profit of 
$28,448.
    (iv) Section 704(c). The principles of section 704(c) and Sec. 
1.704-3 apply to allocations of income or loss with respect to the 
contract contributed by X. In this case, the amount of built-in income 
that is subject to section 704(c) is the amount of income or loss that 
the contributing partner would take into account if the contract were 
disposed of for its fair market value in a constructive completion 
transaction. This calculation is treated as occurring immediately after 
the partner has applied paragraph (k)(3)(ii)(A) of this section, but 
before the contribution to the partnership. In a constructive completion 
transaction, the total contract price would be $810,000 (the sum of the 
amounts received under the contract and the amount realized in the 
deemed sale ($650,000 + $160,000)). X would report receipts of $47,500 
(total contract price minus receipts already reported ($810,000 - 
$762,500)) and costs of $0, for a profit of $47,500. Thus, the amount of 
built-in income that is subject to section 704(c) is $47,500. The 
partnership must apply section 704(c) to this income in a manner that 
reasonably accounts for the income over the remaining term of the 
contract. For example, in Year 2, PRS could allocate $26,810 to X under 
section 704(c) (the amount of built-in income, $47,500, multiplied by a 
fraction, the numerator of which is the completion factor for the year, 
$650,000/725,000, less the completion factor for the prior year, 
$610,000/$800,000, and the denominator of which is 100 percent reduced 
by the completion factor for the taxable year preceding the event 
creating the section 704(c) income or loss, $610,000/$800,000). The 
remaining $67,242 would be allocated equally among all of the partners. 
In Year 3, the completion year, PRS could allocate $20,690 to X under 
section 704(c) ($47,500 x [($725,000/$725,000 -$650,000/$725,000) / (100 
percent - $610,000/$800,000)]). The remaining $7,758 would be allocated 
equally among all the partners.
    Example 12. Step-in-the-shoes--CCM--contribution of contract to 
partnership --(i) Facts. The facts are the same as in Example 11, except 
that X and PRS properly account for the contract under the CCM, and X 
has a

[[Page 231]]

basis of $610,000 in the contract (including the uncompleted property).
    (ii) Tax consequences to X. X reports no income or costs from the 
contract in Years 1 or 2. X is not treated as completing the contract in 
Year 2. Under section 722, X's initial basis in its interest in PRS is 
$735,000 (the sum of $125,000 cash and X's basis of $610,000 in the 
contract (including the uncompleted property)). Pursuant to paragraph 
(k)(3)(iv)(A)(1)(ii) of this section, X must reduce its basis in its 
interest in PRS by the amount of gross receipts X received under the 
contract, or $650,000. Accordingly, X's basis in its interest in PRS is 
$85,000.
    (iii) Tax consequences to PRS. PRS must account for the contract 
using the same methods of accounting used by X prior to the transaction. 
Under the CCM, PRS reports no gross receipts or costs in Year 2. For 
Year 3, the completion year, PRS reports its gross contract price of 
$1,000,000 (the sum of any amounts that X and PRS have received or 
reasonably expect to receive under the contract), and total allocable 
contract costs of $725,000 (the allocable contract costs of X and PRS), 
for a profit of $275,000.
    (iv) Section 704(c). In this case, the amount of built-in income 
that is subject to section 704(c) is the amount of income or loss that 
the contributing partner would take into account if the contract were 
disposed of for its fair market value in a constructive completion 
transaction. This calculation is treated as occurring immediately after 
the partner has applied paragraph (k)(3)(ii)(A) of this section, but 
before the contribution to the partnership. In a constructive completion 
transaction, X would report its gross contract price of $810,000 (the 
sum of the amounts received under the contract and the amount realized 
in the deemed sale ($650,000 + $160,000)) and its total allocable 
contract costs of $610,000, for a profit of $200,000. Thus, the amount 
of built-in income that is subject to section 704(c) is $200,000. Out of 
PRS's income of $275,000, in Year 3, $200,000 must be allocated to X 
under section 704(c), and the remaining $75,000 is allocated equally 
among all of the partners.
    Example 13. Step-in-the-shoes--PCM--transfer of a partnership 
interest --(i) Facts. In Year 1, W, X, Y, and Z each contribute $100,000 
to form equal partnership PRS. In Year 1, PRS enters into a contract. 
The total contract price is $1,000,000 and the estimated total allocable 
contract costs are $800,000. In Year 1, PRS incurs costs of $600,000 and 
receives $650,000 in progress payments under the contract. Under the 
contract, PRS performed all of the services required in order to be 
entitled to receive the progress payments, and there was no obligation 
to return the payment or perform any additional services in order to 
retain the payments. PRS properly accounts for the contract under the 
PCM. In Year 2, W transfers W's interest in PRS to T for $150,000. 
Assume that $10,000 of PRS's Year 2 costs are incurred prior to the 
transfer, $40,000 are incurred after the transfer; and that PRS receives 
no progress payments in Year 2. Also assume that the fair market value 
of the contract on the date of the transfer is $160,000, that PRS closes 
its books with respect to the contract under section 706 on the date of 
the transfer, and that PRS correctly estimates at the end of Year 2 that 
it will have to incur an additional $75,000 of allocable contract costs 
in Year 3 to complete the contract (rather than $150,000 as originally 
estimated by PRS).
    (ii) Income reporting for period ending on date of transfer. For 
Year 1, PRS reports receipts of $750,000 (the completion factor 
multiplied by total contract price ($600,000/$800,000 x $1,000,000)) and 
costs of $600,000, for a profit of $150,000. This profit is allocated 
equally among W, X, Y, and Z ($37,500 each). Under paragraph 
(k)(3)(ii)(A) of this section, for the part of Year 2 ending on the date 
of the transfer of W's interest, PRS reports receipts of $12,500 (the 
completion factor multiplied by the total contract price ($610,000/
$800,000 x $1,000,000) minus receipts already reported ($750,000)) and 
costs of $10,000 for a profit of $2,500. This profit is allocated 
equally among W, X, Y, and Z ($625 each).
    (iii) Income reporting for period after transfer. PRS must continue 
to use the PCM. For the part of Year 2 beginning on the day after the 
transfer, PRS reports receipts of $134,052 (the completion factor 
multiplied by the total contract price decreased by receipts reported by 
PRS for the period ending on the date of the transfer [($650,000/
$725,000 x $1,000,000)--$762,500]) and costs of $40,000, for a profit of 
$94,052. This profit is shared equally among T, X, Y, and Z ($23,513 
each). For Year 3, PRS reports receipts of $103,448 (the total contract 
price minus prior year receipts ($1,000,000 - $896,552)) and costs of 
$75,000, for a profit of $28,448. The profit for Year 3 is shared 
equally among T, X, Y, and Z ($7,112 each).
    (iv) Tax Consequences to W. W's amount realized is $150,000. W's 
adjusted basis in its interest in PRS is $138,125 ($100,000 originally 
contributed, plus $37,500, W's distributive share of PRS's Year 1 
income, and $625, W's distributive share of PRS's Year 2 income prior to 
the transfer). Accordingly, W's income from the sale of W's interest in 
PRS is $11,875. Under paragraph (k)(2)(iv)(E) of this section, for 
purposes of section 751(a), the amount of ordinary income attributable 
to the contract is determined as follows. First, the partnership must 
determine the amount of income or loss from the contract that is 
allocated under section 706 to the period ending on the date of the sale 
($625). Second, the partnership must determine the amount of income or 
loss that the partnership would take into account under the constructive 
completion rules of paragraph (k)(2) of this

[[Page 232]]

section if the contract were disposed of for its fair market value in a 
constructive completion transaction. Because PRS closed its books under 
section 706 with respect to the contract on the date of the sale, this 
calculation is treated as occurring immediately after the partnership 
has applied paragraph (k)(3)(ii)(A) of this section on the date of the 
sale. In a constructive completion transaction, the total contract price 
would be $810,000 (the sum of the amounts received under the contract 
and the amount realized in the deemed sale ($650,000 + $160,000)). PRS 
would report receipts of $47,500 (total contract price minus receipts 
already reported ($810,000 - $762,500)) and costs of $0, for a profit of 
$47,500. Thus, the amount of ordinary income attributable to the 
contract is $47,500, and W's share of that income is $11,875. Thus, 
under Sec. 1.751-1(a), all of W's $11,875 of income from the sale of 
W's interest in PRS is ordinary income.
    (v) Tax Consequences to T. T's adjusted basis for its interest in 
PRS is $150,000. Under Sec. 1.743-1(d)(2), the amount of income that 
would be allocated to T if the contract were disposed of for its fair 
market value (adjusted to account for income from the contract for the 
portion of PRS's taxable year that ends on the date of the transfer) is 
$11,875. Under Sec. 1.743-1(b), the amount of T's basis adjustment 
under section 743(b) is $11,875. Under paragraph (k)(3)(v)(B) of this 
section, the portion of T's basis adjustment that is recovered in Year 2 
and Year 3 must be determined by PRS in a manner that reasonably 
accounts for the adjustment over the remaining term of the contract. For 
example, PRS could recover $6,703 of the adjustment in Year 2 (the 
amount of the basis adjustment, $11,875, multiplied by a fraction, the 
numerator of which is the excess of the completion factor for the year, 
$650,000/$725,000, less the completion factor for the prior year, 
$610,000/$800,000, and the denominator of which is 100 percent reduced 
by the completion factor for the taxable year preceding the transfer, 
$610,000/$800,000). T's distributive share of income in Year 2 from the 
contract would be adjusted from $23,513 to $16,810 as a result of the 
basis adjustment. In Year 3, the completion year, PRS could recover 
$5,172 of the adjustment ($11,875 x [($725,000/$725,000 -$650,000/
$725,000) / (100 percent - $610,000/$800,000)]). T's distributive share 
of income in Year 3, the completion year, from the contract would be 
adjusted from $7,112 to $1,940 as a result of the basis adjustment.

    (6) Effective date. Except as provided in paragraph (k)(3)(iv)(D) of 
this section, this paragraph (k) is applicable for transactions on or 
after May 15, 2002. Application of the rules of this paragraph (k) to a 
transaction that occurs on or after May 15, 2002 is not a change in 
method of accounting.

[T.D. 8597, 60 FR 36684, July 18, 1995, as amended by T.D. 8929, 66 FR 
2232, Jan. 11, 2001; 66 FR 18191, Apr. 6, 2001; T.D 8995, 67 FR 34605, 
May 15, 2002; T.D. 9137, 69 FR 42553, July 16, 2004]



Sec. 1.460-5  Cost allocation rules.

    (a) Overview. This section prescribes methods of allocating costs to 
long-term contracts accounted for using the percentage-of-completion 
method described in Sec. 1.460-4(b) (PCM), the completed-contract 
method described in Sec. 1.460-4(d) (CCM), or the percentage-of-
completion/capitalized-cost method described in Sec. 1.460-4(e) (PCCM). 
Exempt construction contracts described in Sec. 1.460-3(b) accounted 
for using a method other than the PCM or CCM are not subject to the cost 
allocation rules of this section (other than the requirement to allocate 
production-period interest under paragraph (b)(2)(v) of this section). 
Paragraph (b) of this section describes the regular cost allocation 
methods for contracts subject to the PCM. Paragraph (c) of this section 
describes an elective simplified cost allocation method for contracts 
subject to the PCM. Paragraph (d) of this section describes the cost 
allocation methods for exempt construction contracts reported using the 
CCM. Paragraph (e) of this section describes the cost allocation rules 
for contracts subject to the PCCM. Paragraph (f) of this section 
describes additional rules applicable to the cost allocation methods 
described in this section. Paragraph (g) of this section provides rules 
concerning consistency in method of allocating costs to long-term 
contracts.
    (b) Cost allocation method for contracts subject to PCM--(1) In 
general. Except as otherwise provided in paragraph (b)(2) of this 
section, a taxpayer must allocate costs to each long-term contract 
subject to the PCM in the same manner that direct and indirect costs are 
capitalized to property produced by a taxpayer under Sec. 1.263A-1(e) 
through (h). Thus, a taxpayer must allocate to each long-term contract 
subject to the PCM all direct costs and certain indirect costs properly 
allocable to the long-term contract (i.e., all costs that directly 
benefit or are incurred by reason

[[Page 233]]

of the performance of the long-term contract). However, see paragraph 
(c) of this section concerning an election to allocate contract costs 
using the simplified cost-to-cost method. As in section 263A, the use of 
the practical capacity concept is not permitted. See Sec. 1.263A-
2(a)(4).
    (2) Special rules--(i) Direct material costs. The costs of direct 
materials must be allocated to a long-term contract when dedicated to 
the contract under principles similar to those in Sec. 1.263A-11(b)(2). 
Thus, a taxpayer dedicates direct materials by associating them with a 
specific contract, including by purchase order, entry on books and 
records, or shipping instructions. A taxpayer maintaining inventories 
under Sec. 1.471-1 must determine allocable contract costs attributable 
to direct materials using its method of accounting for those inventories 
(e.g., FIFO, LIFO, specific identification).
    (ii) Components and subassemblies. The costs of a component or 
subassembly (component) produced by the taxpayer must be allocated to a 
long-term contract as the taxpayer incurs costs to produce the component 
if the taxpayer reasonably expects to incorporate the component into the 
subject matter of the contract. Similarly, the cost of a purchased 
component (including a component purchased from a related party) must be 
allocated to a long-term contract as the taxpayer incurs the cost to 
purchase the component if the taxpayer reasonably expects to incorporate 
the component into the subject matter of the contract. In all other 
cases, the cost of a component must be allocated to a long-term contract 
when the component is dedicated, under principles similar to those in 
Sec. 1.263A-11(b)(2). A taxpayer maintaining inventories under Sec. 
1.471-1 must determine allocable contract costs attributable to 
components using its method of accounting for those inventories (e.g., 
FIFO, LIFO, specific identification).
    (iii) Simplified production methods. A taxpayer may not determine 
allocable contract costs using the simplified production methods 
described in Sec. 1.263A-2(b) and (c).
    (iv) Costs identified under cost-plus long-term contracts and 
federal long-term contracts. To the extent not otherwise allocated to 
the contract under this paragraph (b), a taxpayer must allocate any 
identified costs to a cost-plus long-term contract or federal long-term 
contract (as defined in section 460(d)). Identified cost means any cost, 
including a charge representing the time-value of money, identified by 
the taxpayer or related person as being attributable to the taxpayer's 
cost-plus long-term contract or federal long-term contract under the 
terms of the contract itself or under federal, state, or local law or 
regulation.
    (v) Interest--(A) In general. If property produced under a long-term 
contract is designated property, as defined in Sec. 1.263A-8(b) 
(without regard to the exclusion for long-term contracts under Sec. 
1.263A-8(d)(2)(v)), a taxpayer must allocate interest incurred during 
the production period to the long-term contract in the same manner as 
interest is allocated to property produced by a taxpayer under section 
263A(f). See Sec. Sec. 1.263A-8 to 1.263A-12 generally.
    (B) Production period. Notwithstanding Sec. 1.263A-12(c) and (d), 
for purposes of this paragraph (b)(2)(v), the production period of a 
long-term contract--
    (1) Begins on the later of--
    (i) The contract commencement date, as defined in Sec. 1.460-
1(b)(7); or
    (ii) For a taxpayer using the accrual method of accounting for long-
term contracts, the date by which 5 percent or more of the total 
estimated costs, including design and planning costs, under the contract 
have been incurred; and
    (2) Ends on the date that the contract is completed, as defined in 
Sec. 1.460-1(c)(3).
    (C) Application of section 263A(f). For purposes of this paragraph 
(b)(2)(v), section 263A(f)(1)(B)(iii) (regarding an estimated production 
period exceeding 1 year and a cost exceeding $1,000,000) must be applied 
on a contract-by-contract basis; except that, in the case of a taxpayer 
using an accrual method of accounting, that section must be applied on a 
property-by-property basis.
    (vi) Research and experimental expenses. Notwithstanding Sec. 
1.263A-1(e)(3)(ii)(P) and (iii)(B), a taxpayer

[[Page 234]]

must allocate research and experimental expenses, other than independent 
research and development expenses (as defined in Sec. 1.460-1(b)(9)), 
to its long-term contracts.
    (vii) Service costs--(A) Simplified service cost method--(1) In 
general. To use the simplified service cost method under Sec. 1.263A-
1(h), a taxpayer must allocate the otherwise capitalizable mixed service 
costs among its long-term contracts using a reasonable method. For 
example, otherwise capitalizable mixed service costs may be allocated to 
each long-term contract based on labor hours or contract costs allocable 
to the contract. To be considered reasonable, an allocation method must 
be applied consistently and must not disproportionately allocate service 
costs to contracts expected to be completed in the near future.
    (2) Example. The following example illustrates the rule of this 
paragraph (b)(2)(vii)(A):

    Example. Simplified service cost method. During 2001, C, whose 
taxable year ends December 31, produces electronic equipment for 
inventory and enters into long-term contracts to manufacture specialized 
electronic equipment. C's method of allocating mixed service costs to 
the property it produces is the labor-based, simplified service cost 
method described in Sec. 1.263A-1(h)(4). For 2001, C's total mixed 
service costs are $100,000, C's section 263A labor costs are $500,000, 
C's section 460 labor costs (i.e., labor costs allocable to C's long-
term contracts) are $250,000, and C's total labor costs are $1,000,000. 
To determine the amount of mixed service costs capitalizable under 
section 263A for 2001, C multiplies its total mixed service costs by its 
section 263A allocation ratio (section 263A labor costs / total labor 
costs). Thus, C's capitalizable mixed service costs for 2001 are $50,000 
($100,000x$500,000/$1,000,000). Thereafter, C allocates its 
capitalizable mixed service costs to produced property remaining in 
ending inventory using its 263A allocation method (e.g., burden rate, 
simplified production). Similarly, to determine the amount of mixed 
service costs that are allocable to C's long-term contracts for 2001, C 
multiplies its total mixed service costs by its section 460 allocation 
ratio (section 460 labor / total labor costs). Thus, C's allocable mixed 
service contract costs for 2001 are $25,000 ($100,000x$250,000/
$1,000,000). Thereafter, C allocates its allocable mixed service costs 
to its long-term contracts proportionately based on its section 460 
labor costs allocable to each long-term contract.

    (B) Jobsite costs. If an administrative, service, or support 
function is performed solely at the jobsite for a specific long-term 
contract, the taxpayer may allocate all the direct and indirect costs of 
that administrative, service, or support function to that long-term 
contract. Similarly, if an administrative, service, or support function 
is performed at the jobsite solely for the taxpayer's long-term contract 
activities, the taxpayer may allocate all the direct and indirect costs 
of that administrative, service, or support function among all the long-
term contracts performed at that jobsite. For this purpose, jobsite 
means a production plant or a construction site.
    (C) Limitation on other reasonable cost allocation methods. A 
taxpayer may use any other reasonable method of allocating service 
costs, as provided in Sec. 1.263A-1(f)(4), if, for the taxpayer's long-
term contracts considered as a whole, the--
    (1) Total amount of service costs allocated to the contracts does 
not differ significantly from the total amount of service costs that 
would have been allocated to the contracts under Sec. 1.263A-1(f)(2) or 
(3);
    (2) Service costs are not allocated disproportionately to contracts 
expected to be completed in the near future because of the taxpayer's 
cost allocation method; and
    (3) Taxpayer's cost allocation method is applied consistently.
    (c) Simplified cost-to-cost method for contracts subject to the 
PCM--(1) In general. Instead of using the cost allocation method 
prescribed in paragraph (b) of this section, a taxpayer may elect to use 
the simplified cost-to-cost method, which is authorized under section 
460(b)(3)(A), to allocate costs to a long-term contract subject to the 
PCM. Under the simplified cost-to-cost method, a taxpayer determines a 
contract's completion factor based upon only direct material costs; 
direct labor costs; and depreciation, amortization, and cost recovery 
allowances on equipment and facilities directly used to manufacture or 
construct the subject matter of the contract. For this purpose, the

[[Page 235]]

costs associated with any manufacturing or construction activities 
performed by a subcontractor are considered either direct material or 
direct labor costs, as appropriate, and therefore must be allocated to 
the contract under the simplified cost-to-cost method. An electing 
taxpayer must use the simplified cost-to-cost method to apply the look-
back method under Sec. 1.460-6 and to determine alternative minimum 
taxable income under Sec. 1.460-4(f).
    (2) Election. A taxpayer makes an election under this paragraph (c) 
by using the simplified cost-to-cost method for all long-term contracts 
entered into during the taxable year of the election on its original 
federal income tax return for the election year. This election is a 
method of accounting and, thus, applies to all long-term contracts 
entered into during and after the taxable year of the election. This 
election is not available if a taxpayer does not use the PCM to account 
for all long-term contracts or if a taxpayer elects to use the 10-
percent method described in Sec. 1.460-4(b)(6).
    (d) Cost allocation rules for exempt construction contracts reported 
using the CCM--(1) In general. For exempt construction contracts 
reported using the CCM, other than contracts described in paragraph 
(d)(3) of this section (concerning contracts of homebuilders that do not 
satisfy the $10,000,000 gross receipts test described in Sec. 1.460-
3(b)(3) or will not be completed within two years of the contract 
commencement date), a taxpayer must annually allocate the cost of any 
activity that is incident to or necessary for the taxpayer's performance 
under a long-term contract. A taxpayer must allocate to each exempt 
construction contract all direct costs as defined in Sec. 1.263A-
1(e)(2)(i) and all indirect costs either as provided in Sec. 1.263A-
1(e)(3) or as provided in paragraph (d)(2) of this section.
    (2) Indirect costs--(i) Indirect costs allocable to exempt 
construction contracts. A taxpayer allocating costs under this paragraph 
(d)(2) must allocate the following costs to an exempt construction 
contract, other than a contract described in paragraph (d)(3) of this 
section, to the extent incurred in the performance of that contract--
    (A) Repair of equipment or facilities;
    (B) Maintenance of equipment or facilities;
    (C) Utilities, such as heat, light, and power, allocable to 
equipment or facilities;
    (D) Rent of equipment or facilities;
    (E) Indirect labor and contract supervisory wages, including basic 
compensation, overtime pay, vacation and holiday pay, sick leave pay 
(other than payments pursuant to a wage continuation plan under section 
105(d) as it existed prior to its repeal in 1983), shift differential, 
payroll taxes, and contributions to a supplemental unemployment benefits 
plan;
    (F) Indirect materials and supplies;
    (G) Noncapitalized tools and equipment;
    (H) Quality control and inspection;
    (I) Taxes otherwise allowable as a deduction under section 164, 
other than state, local, and foreign income taxes, to the extent 
attributable to labor, materials, supplies, equipment, or facilities;
    (J) Depreciation, amortization, and cost-recovery allowances 
reported for the taxable year for financial purposes on equipment and 
facilities to the extent allowable as deductions under chapter 1 of the 
Internal Revenue Code;
    (K) Cost depletion;
    (L) Administrative costs other than the cost of selling or any 
return on capital;
    (M) Compensation paid to officers other than for incidental or 
occasional services;
    (N) Insurance, such as liability insurance on machinery and 
equipment; and
    (O) Interest, as required under paragraph (b)(2)(v) of this section.
    (ii) Indirect costs not allocable to exempt construction contracts. 
A taxpayer allocating costs under this paragraph (d)(2) is not required 
to allocate the following costs to an exempt construction contract 
reported using the CCM--
    (A) Marketing and selling expenses, including bidding expenses;
    (B) Advertising expenses;
    (C) Other distribution expenses;
    (D) General and administrative expenses attributable to the 
performance of services that benefit the taxpayer's activities as a 
whole (e.g., payroll expenses, legal and accounting expenses);

[[Page 236]]

    (E) Research and experimental expenses (described in section 174 and 
the regulations thereunder);
    (F) Losses under section 165 and the regulations thereunder;
    (G) Percentage of depletion in excess of cost depletion;
    (H) Depreciation, amortization, and cost recovery allowances on 
equipment and facilities that have been placed in service but are 
temporarily idle (for this purpose, an asset is not considered to be 
temporarily idle on non-working days, and an asset used in construction 
is considered to be idle when it is neither en route to nor located at a 
job-site), and depreciation, amortization and cost recovery allowances 
under chapter 1 of the Internal Revenue Code in excess of depreciation, 
amortization, and cost recovery allowances reported by the taxpayer in 
the taxpayer's financial reports;
    (I) Income taxes attributable to income received from long-term 
contracts;
    (J) Contributions paid to or under a stock bonus, pension, profit-
sharing, or annuity plan or other plan deferring the receipt of 
compensation whether or not the plan qualifies under section 401(a), and 
other employee benefit expenses paid or accrued on behalf of labor, to 
the extent the contributions or expenses are otherwise allowable as 
deductions under chapter 1 of the Internal Revenue Code. Other employee 
benefit expenses include (but are not limited to): Worker's 
compensation; amounts deductible or for whose payment reduction in 
earnings and profits is allowed under section 404A and the regulations 
thereunder; payments pursuant to a wage continuation plan under section 
105(d) as it existed prior to its repeal in 1983; amounts includible in 
the gross income of employees under a method or arrangement of employer 
contributions or compensation which has the effect of a stock bonus, 
pension, profit-sharing, or annuity plan, or other plan deferring the 
receipt of compensation or providing deferred benefits; premiums on life 
and health insurance; and miscellaneous benefits provided for employees 
such as safety, medical treatment, recreational and eating facilities, 
membership dues, etc.;
    (K) Cost attributable to strikes, rework labor, scrap and spoilage; 
and
    (L) Compensation paid to officers attributable to the performance of 
services that benefit the taxpayer's activities as a whole.
    (3) Large homebuilders. A taxpayer must capitalize the costs of home 
construction contracts under section 263A and the regulations 
thereunder, unless the contract will be completed within two years of 
the contract commencement date and the taxpayer satisfies the 
$10,000,000 gross receipts test described in Sec. 1.460-3(b)(3).
    (e) Cost allocation rules for contracts subject to the PCCM. A 
taxpayer must use the cost allocation rules described in paragraph (b) 
of this section to determine the costs allocable to the entire qualified 
ship contract or residential construction contract accounted for using 
the PCCM and may not use the simplified cost-to-cost method described in 
paragraph (c) of this section.
    (f) Special rules applicable to costs allocated under this section--
(1) Nondeductible costs. A taxpayer may not allocate any otherwise 
allocable contract cost to a long-term contract if any section of the 
Internal Revenue Code disallows a deduction for that type of payment or 
expenditure (e.g., an illegal bribe described in section 162(c)).
    (2) Costs incurred for non-long-term contract activities. If a 
taxpayer performs a non-long-term contract activity, as defined in Sec. 
1.460-1(d)(2), that is incident to or necessary for the manufacture, 
building, installation, or construction of the subject matter of one or 
more of the taxpayer's long-term contracts, the taxpayer must allocate 
the costs attributable to that activity to such contract(s).
    (g) Method of accounting. A taxpayer that adopts or elects a cost 
allocation method of accounting (or changes to another cost allocation 
method of accounting with the Commissioner's consent) must apply that 
method consistently for all similarly classified contracts, until the 
taxpayer obtains the Commissioner's consent under section 446(e) to 
change to another cost allocation method. A taxpayer-initiated change in 
cost allocation method will be permitted only on a cut-off basis (i.e., 
for contracts entered into on or

[[Page 237]]

after the year of change) and thus, a section 481(a) adjustment will not 
be permitted or required.

[T.D. 8929, 66 FR 2237, Jan. 11, 2001]



Sec. 1.460-6  Look-back method.

    (a) In general--(1) Introduction. With respect to income from any 
long-term contract reported under the percentage of completion method, a 
taxpayer is required to pay or is entitled to receive interest under 
section 460(b) on the amount of tax liability that is deferred or 
accelerated as a result of overestimating or underestimating total 
contract price or contract costs. Under this look-back method, taxpayers 
are required to pay interest for any deferral of tax liability resulting 
from the underestimation of the total contract price or the 
overestimation of total contract costs. Conversely, if the total 
contract price is overestimated or the total contract costs are 
underestimated, taxpayers are entitled to receive interest for any 
resulting acceleration of tax liability. The computation of the amount 
of deferred or accelerated tax liability under the look-back method is 
hypothetical; application of the look-back method does not result in an 
adjustment to the taxpayer's tax liability as originally reported, as 
reported on an amended return, or as adjusted on examination. Thus, the 
look-back method does not correct for differences in tax liability that 
result from over- or under-estimation of contract price and costs and 
that are permanent because, for example, tax rates change during the 
term of the contract.
    (2) Overview. Paragraph (b) explains which situations require 
application of the look-back method to income from a long-term contract. 
Paragraph (c) explains the operation of the three computational steps 
for applying the look-back method. Paragraph (d) provides guidance 
concerning the simplified marginal impact method. Paragraph (e) provides 
an elective method to minimize the number of times the look-back method 
must be reapplied to a single long-term contract. Paragraph (f) 
describes the reporting requirements for the look-back method and the 
tax treatment of look-back interest. Paragraph (g) provides rules for 
applying the look-back method when there is a transaction that changes 
the taxpayer that reports income from a long-term contract prior to the 
completion of a contract. Paragraph (h) provides examples illustrating 
the three computational steps for applying the look-back method. 
Paragraph (j) of this section provides guidance concerning the election 
not to apply the look-back method in de minimis cases.
    (b) Scope of look-back method--(1) In general. The look-back method 
applies to any income from a long-term contract within the meaning of 
section 460(f) that is required to be reported under the percentage of 
completion method (as modified by section 460) for regular income tax 
purposes or for alternative minimum tax purposes. If a taxpayer uses the 
percentage of completion-capitalized cost method for long-term 
contracts, the look-back method applies for regular tax purposes only to 
the portion (40, 70, or 90 percent, whichever applies) of the income 
from the contract that is reported under the percentage of completion 
method. To the extent that the percentage-of-completion method is 
required to be used under Sec. 1.460-1(g) with respect to income and 
expenses that are attributable to activities that benefit a related 
party's long-term contract, the look-back method also applies to these 
amounts, even if those activities are not performed under a contract 
entered into directly by the taxpayer.
    (2) Exceptions from section 460. The look-back method generally does 
not apply to the regular taxable income from any long-term construction 
contract within the meaning of section 460(e)(4) that:
    (i) Is a home construction contract within the meaning of section 
460(e)(1)(A), or
    (ii) Is not a home construction contract but is estimated to be 
completed within a 2-year period by a taxpayer whose average annual 
gross receipts for the 3 tax years preceding the tax year the contract 
is entered into do not exceed $10,000,000 (as provided in section 
460(e)(1)(B)). These contracts are not subject to the look-back method 
for regular tax purposes, even if the taxpayer uses a version of the 
percentage

[[Page 238]]

of completion method permitted under Sec. 1.451-3, unless the taxpayer 
has properly changed its method of accounting for these contracts to the 
percentage of completion method as modified by section 460(b). The look-
back method, however, applies to the alternative minimum taxable income 
from a contract of this type, unless it is exempt from the required use 
of the percentage of completion method under section 56(a)(3).
    (3) De minimis exception. Notwithstanding that the percentage of 
completion method is otherwise required to be used, the look-back method 
does not apply to any long-term contract that:
    (i) Is completed within 2 years of the contract commencement date, 
and
    (ii) Has a gross contract price (as of the completion of the 
contract) that does not exceed the lesser of $1,000,000 or 1 percent of 
the average annual gross receipts of the taxpayer for the 3 tax years 
preceding the tax year in which the contract is completed.

This de minimis exception is mandatory and, therefore, precludes 
application of the look-back method to any contract that meets the 
requirements of the exception. The de minimis exception applies for 
purposes of computing both regular taxable income and alternative 
minimum taxable income. Solely for this purpose, the determination of 
whether a long-term contract meets the gross receipts test for both 
alternative minimum tax and regular tax purposes is made based only on 
the taxpayer's regular taxable income.
    (4) Alternative minimum tax. For purposes of computing alternative 
minimum taxable income, section 56(a)(3) generally requires long-term 
contracts within the meaning of section 460(f) (generally without regard 
to the exceptions in section 460(e)) to be accounted for using only the 
percentage of completion method as defined in section 460(b), including 
the look-back method of section 460(b), with respect to tax years 
beginning after December 31, 1986. However, section 56(a)(3) (and thus 
the look-back method) does not apply to any long-term contract entered 
into after June 20, 1988, and before the beginning of the first tax year 
that begins after September 30, 1990, that meets the conditions of both 
section 460(e)(1)(A) and clauses (i) and (ii) of section 460(e)(1)(B), 
and does not apply to any long-term contract entered into in a tax year 
that begins after September 30, 1990, that meets the conditions of 
section 460(e)(1)(A). A taxpayer that applies the percentage of 
completion method (and thus the look-back method) to income from a long-
term contract only for purposes of determining alternative minimum 
taxable income, and not regular taxable income, must apply the look-back 
method to the alternative minimum taxable income in the year of contract 
completion and other filing years whether or not the taxpayer was liable 
for the alternative minimum tax for the filing year or for any prior 
year. Interest is computed under the look-back method to the extent that 
the taxpayer's total tax liability (including the alternative minimum 
tax liability) would have differed if the percentage of completion 
method had been applied using actual, rather than estimated, contract 
price and contract costs.
    (5) Effective date. The look-back method, including the de minimis 
exception, applies to long-term contracts entered into after February 
28, 1986. With respect to activities that are subject to section 460 
solely because they benefit a long-term contract of a related party, the 
look-back method generally applies only if the related party's long-term 
contract was entered into after June 20, 1988, unless a principal 
purpose of the related-party arrangement is to avoid the requirements of 
section 460.
    (c) Operation of the look-back method--(1) Overview--(i) In general. 
The amount of interest charged or credited to a taxpayer under the look-
back method is computed in three steps. This paragraph (c) describes the 
three steps for applying the look-back method. These steps are 
illustrated by the examples in paragraph (h). The first step is to 
hypothetically reapply the percentage of completion method to all long-
term contracts that are completed or adjusted in the current year (the 
``filing year''), using the actual, rather than estimated, total 
contract price and contract costs. Based on this reapplication, the 
taxpayer determines the

[[Page 239]]

amount of taxable income (and alternative minimum taxable income) that 
would have been reported for each year prior to the filing year that is 
affected by contracts completed or adjusted in the filing year if the 
actual, rather than estimated, total contract price and costs had been 
used in applying the percentage of completion method to these contracts, 
and to any other contracts completed or adjusted in a year preceding the 
filing year. If the percentage of completion method only applies to 
alternative minimum taxable income for contracts completed or adjusted 
in the filing year, only alternative minimum taxable income is 
recomputed in the first step. The second step is to compare what the tax 
liability would have been under the percentage of completion method (as 
reapplied in the first step) for each tax year for which the tax 
liability is affected by income from contracts completed or adjusted in 
the filing year (a ``redetermination year'') with the most recent 
determination of tax liability for that year to produce a hypothetical 
underpayments or overpayment of tax. The third step is to apply the rate 
of interest on overpayments designated under section 6621 of the Code, 
compounded daily, to the hypothetical underpayment or overpayment of tax 
for each redetermination year to compute interest that runs, generally, 
from the due date (determined without regard to extensions) of the 
return for the redetermination year to the due date (determined without 
regard to extensions) of the return for the filing year. The net amount 
of interest computed under the third step is paid by or credited to the 
taxpayer for the filing year. Paragraph (d) provides a simplified 
marginal impact method that simplifies the second step--the computation 
of hypothetical underpayments or overpayments of tax liability for 
redetermination years--and, in some cases, the third step--the 
determination of the time period for computing interest.
    (ii) Post-completion revenue and expenses--(A) In general. Except as 
otherwise provided in section 460(b)(6) (see Sec. 1.460-6(j) for method 
of electing) or Sec. 1.460-6(e), a taxpayer must apply the look-back 
method to a long-term contract in the completion year and in any post-
completion year for which the taxpayer must adjust total contract price 
or total allocable contract costs, or both, under the PCM. Any year in 
which the look-back method must be reapplied is treated as a filing 
year. See Example (3) of paragraph (h)(4) for an illustration of how the 
look-back method is applied to post-completion adjustments.
    (B) Completion. A contract is considered to be completed for 
purposes of the look-back method in the year in which final completion 
and acceptance within the meaning of Sec. 1.460-1(c)(3) have occurred.
    (C) Discounting of contract price and contract cost adjustments 
subsequent to completion; election not to discount--(1) General rule. 
The amount of any post-completion adjustment to the total contract price 
or contract costs is discounted, solely for purposes of applying the 
look-back method, from its value at the time the amount is taken into 
account in computing taxable income to its value at the completion of 
the contract. The discount rate for this purpose is the Federal mid-term 
rate under section 1274(d) in effect at the time the amount is properly 
taken into account. For purposes of applying the look-back method for 
the completion year, no amounts are discounted, even if they are 
received after the completion year.
    (2) Election not to discount. Notwithstanding the general 
requirement to discount post-completion adjustments, a taxpayer may 
elect not to discount contract price and contract cost adjustments with 
respect to any contract. The election not to discount is to be made on a 
contract-by-contract basis and is binding with respect to all post-
completion adjustments that arise with respect to a contract for which 
an election has been made. An election not to discount with respect to 
any contract is made by stating that an election is being made on the 
taxpayer's timely filed Federal income tax return (determined with 
regard to extensions) for the first tax year after completion in which 
the taxpayer takes into account (i.e., includes in income or deducts) 
any adjustment to the contract price or contract costs. See Sec. 
301.9100-8 of this chapter.

[[Page 240]]

    (3) Year-end discounting convention. In the absence of an election 
not to discount, any revisions to the contract price and contract costs 
must be discounted to their value as of the completion of the contract 
in reapplying the look-back method. For this purpose, the period of 
discounting is the period between the completion date of the contract 
and the date that any adjustment is taken into account in computing 
taxable income. Although taxpayers may use the period between the months 
in which these two events actually occur, in many cases, these dates may 
not be readily identifiable. Therefore, for administrative convenience, 
taxpayers are permitted to use the period between the end of the tax 
years in which these events occur as the period of discounting provided 
that the convention is used consistently with respect to all post-
completion adjustments for all contracts of the taxpayer the adjustments 
to which are discounted. In that case, the taxpayer must use as the 
discount rate the Federal mid-term rate under section 1274(d) as of the 
end of the tax year in which any revision is taken into account in 
computing taxable income.
    (D) Revenue acceleration rule. Section 460(b)(1) imposes a special 
rule that requires a taxpayer to include in gross income, for the tax 
year immediately following the year of completion, any previously 
unreported portion of the total contract price (including amounts that 
the taxpayer expects to receive in the future) determined as of that 
year, even if the percentage of completion ratio is less than 100 
percent because the taxpayer expects to incur additional allocable 
contract costs in a later year. At the time any remaining portion of the 
contract price is includible in income under this rule, no offset 
against this income is permitted for estimated future contract costs. To 
achieve the requirement to report all remaining contract revenue without 
regard to additional estimated costs, a taxpayer must include only costs 
actually incurred through the end of the tax year in the denominator of 
the percentage of completion ratio in applying the percentage of 
completion method for any tax years after the year of completion. The 
look-back method also must be reapplied for the year immediately 
following the year of completion if any portion of the contract price is 
includible in income in that year by reason of section 460(b)(1). For 
purposes of reapplying the look-back method as a result of this 
inclusion in income, the taxpayer must only include in the denominator 
of the percentage of completion ratio the actual contract costs incurred 
as of the end of the year, even if the taxpayer reasonably expects to 
incur additional allocable contract costs. To the extent that costs are 
incurred in a subsequent tax year, the look-back method is reapplied in 
that year (or a later year if the delayed reapplication method is used), 
and the taxpayer is entitled to receive interest for the post-completion 
adjustment to contract costs. Because this reapplication occurs 
subsequent to the completion year, only the cumulative costs incurred as 
of the end of the reapplication year are includible in the denominator 
of the percentage of completion ratio.
    (2) Look-back Step One--(i) Hypothetical reallocation of income 
among prior tax years. For each filing year, a taxpayer must allocate 
total contract income among prior tax years, by hypothetically applying 
the percentage of completion method to all contracts that are completed 
or adjusted in the filing year using the rules of this paragraph (c)(2). 
The taxpayer must reallocate income from those contracts among all years 
preceding the filing year that are affected by those contracts using the 
total contract price and contract costs, as determined as of the end of 
the filing year (``actual contract price and costs''), rather than the 
estimated contract price and contract costs. The taxpayer then must 
determine the amount of taxable income and the amount of alternative 
minimum taxable income that would have been reported for each affected 
tax year preceding the filing year if the percentage of completion 
method had been applied on the basis of actual contract price and 
contract costs in reporting income from all contracts completed or 
adjusted in the filing year and in any preceding year. If the percentage 
of completion method only applies to alternative minimum taxable

[[Page 241]]

income from the contract, only alternative minimum taxable income is 
recomputed in the first step. For purposes of reallocating income (and 
costs if the 10-percent year changes for a taxpayer using the 10-percent 
method of section 460(b)(5)) under the look-back method, the method of 
computing the percentage of completion ratio is the same method used to 
report income from the contract on the taxpayer's return. (Thus, an 
election to use the 10-percent method or the simplified cost-to-cost 
method is taken into account). See Example (1) of paragraph (h)(2) for 
an illustration of Step One.
    (ii) Treatment of estimated future costs in year of completion. If a 
taxpayer reasonably expects to incur additional allocable contract costs 
in a tax year subsequent to the year in which the contract is completed, 
the taxpayer includes the actual costs incurred as of the end of the 
completion year plus the additional allocable contract costs that are 
reasonably expected to be incurred (to the extent includible under the 
taxpayer's percentage of completion method) in the denominator of the 
percentage of completion ratio. The completion year is the only filing 
year for which the taxpayer may include additional estimated costs in 
the denominator of the percentage of completion ratio in applying the 
look-back method. If the look-back method is reapplied in any year after 
the completion year, only the cumulative costs incurred as of the end of 
the year of reapplication are includible in the denominator of the 
percentage of completion ratio in reapplying the look-back method.
    (iii) Interim reestimates not considered. The look-back method 
cannot be applied to a contract before it is completed. Accordingly, for 
purposes of applying Step One, the actual total contract price and 
contract costs are substituted for the previous estimates of total 
contract price and contract costs only with respect to contracts that 
have been completed in the filing year and in a tax year preceding the 
filing year. No adjustments are made under Step One for contracts that 
have not been completed prior to the end of the current filing year, 
even if, as of the end of this year, the estimated total contract price 
or contract costs for these uncompleted contracts is different from the 
estimated amount that was used during any tax year for which taxable 
income is recomputed with respect to completed contracts under the look-
back method for the current filing year.
    (iv) Tax years in which income is affected. In general, because 
income under the percentage of completion method is generally reported 
as costs are incurred, the taxable income and alternative minimum 
taxable income are recomputed only for each year in which allocable 
contract costs were incurred. However, there will be exceptions to this 
general rule. For example, a taxpayer may be required to cumulatively 
adjust the income from a contract in a year in which no allocable 
contract costs are incurred if the estimated total contract price or 
contract costs was revised in that year. However, in applying the look-
back method, no contract income is allocated to that year. Thus, there 
may be a difference between the amount of contract income originally 
reported for that year and the amount of contract income as reallocated. 
Similarly, because of the revenue acceleration rule of section 
460(b)(1), income may be reported in the year immediately following the 
completion year even though no costs were incurred during that year and, 
in applying the look-back method in that year or another year, if 
additional costs are incurred or the contract price is adjusted in a 
later year, no income is allocated to the year immediately following the 
completion year.
    (v) Costs incurred prior to contract execution; 10-percent method--
(A) General rule. The look-back method does not require allocation of 
contract income to tax years before the contract was entered into. Costs 
incurred prior to the year a contract is entered into are first taken 
into account in the numerator of the percentage of completion ratio in 
the year the contract is entered into. A taxpayer using the 10-percent 
method must also use the 10-percent method in applying the look-back 
method, using actual total contract costs to determine the 10-percent 
year.

[[Page 242]]

Thus, contract income is never reallocated to a year before the 10-
percent year as determined on the basis of actual contract costs. If the 
10-percent year is earlier as a result of applying Step One of the look-
back method, contract costs incurred up to and including the new 10-
percent year (as determined based on actual contract costs), are 
reallocated from the original 10-percent year to the new 10-percent, and 
costs incurred in later years but before the old 10-percent year are 
reallocated to those years. If the 10-percent year is later as a result 
of applying Step One of the look-back method, contract costs incurred up 
to and including the new 10-percent year are reallocated from all prior 
years to the new 10-percent year. This is the only case in which costs 
are reallocated under the look-back method.
    (B) Example. The application of the look-back method by a taxpayer 
using the 10-percent method is illustrated by the following example:

    Example. Z elected to use the 10-percent method of section 460(b)(5) 
for reporting income under the percentage of completion method. Z 
entered into a contract in 1990 for a fixed price of $1,000x. During 
1990, Z incurred allocable contract costs of $80x and estimated that it 
would incur a total of $900x for the entire contract. Since $80x is less 
than 10 percent of total estimated contract costs, Z reported no revenue 
from the contract in 1990 and deferred the $80x of costs incurred. In 
1991, Z incurred an additional $620x of contract costs, and completed 
the contract. Accordingly, in its 1991 return, Z reported the entire 
contract price of $l,000x, and deducted the $620x of costs incurred in 
1991 and the $80x of costs incurred in 1990.
    Under section 460(b)(5), the 10-percent method applies both for 
reporting contract income and the look-back method. Under the look-back 
method, since the costs incurred in 1990 ($80x) exceed 10 percent of the 
actual total contract costs ($700x), Z is required to allocate $114x of 
contract revenue ($80x/$700xx$1,000x) and the $80x of costs incurred to 
1990. Thus, application of the 1ook-back method results in a net 
increase in taxable income for 1990 of $34x, solely for purposes of the 
look-back method.

    (vi) Amount treated as contract price--(A) General rule. The amount 
that is treated as total contract price for purposes of applying the 
percentage of completion method and reapplying the percentage of 
completion method under the look-back method under Step One includes all 
amounts that the taxpayer expects to receive from the customer. Thus, 
amounts are treated as part of the contract price as soon as it is 
reasonably estimated that they will be received, even if the all-events 
test has not yet been met.
    (B) Contingencies. Any amounts related to contingent rights or 
obligations, such as incentive fees or amounts in dispute, are not 
separated from the contract and accounted for under a non-long-term 
contract method of accounting, notwithstanding any provision in Sec. 
1.460-4(b)(4)(i), to the contrary. Instead, those amounts are treated as 
part of the total contract price in applying the look-back method. For 
example, if an incentive fee under a contract to manufacture a satellite 
is payable to the taxpayer after a specified period of successful 
performance, the incentive fee is includible in the total contract price 
at the time and to the extent that it can reasonably be predicted that 
the performance objectives will be met, . A portion of the contract 
price that is in dispute is included in the total contract price at the 
time and to the extent that the taxpayer can reasonably expect the 
dispute will be resolved in the taxpayer's favor (without regard to when 
the taxpayer receives payment for the amount in dispute or when the 
dispute is finally resolved).
    (C) Change orders. In applying the look-back method, a change order 
with respect to a contract is not treated as a separate contract unless 
the change order would be treated as a separate contract under the rules 
for severing and aggregating contracts provided in Sec. 1.460-1(e). 
Thus, if a change order is not treated as a separate contract, the 
contract price and contract costs attributable to the change order must 
be taken into account in allocating contract income to all tax years 
affected by the underlying contract.
    (3) Look-back Step Two: Computation of hypothetical overpayment or 
underpayment of tax--(i) In general. Step Two involves the computation 
of a hypothetical overpayment or underpayment of tax for each year in 
which the tax liability is affected by income from contracts that are 
completed or adjusted

[[Page 243]]

in the filing year (a ``redetermination year''). The application of Step 
Two depends on whether the taxpayer uses the simplified marginal impact 
method contained in paragraph (d) or the actual method described in this 
paragraph (c)(3). The remainder of this paragraph (c)(3) does not apply 
if a taxpayer uses the simplified marginal impact method.
    (ii) Redetermination of tax liability. Under the method described in 
this paragraph (c)(3) (the ``actual method''), a taxpayer, first, must 
determine what its regular and alternative minimum tax liability would 
have been for each redetermination year if the amounts of contract 
income allocated in Step One for all contracts completed or adjusted in 
the filing year and in any prior year were substituted for the amounts 
of contract income reported under the percentage of completion method on 
the taxpayer's original return (or as subsequently adjusted on 
examination, or by amended return). See Example (2) of paragraph (h)(3) 
for an illustration of Step Two.
    (iii) Hypothetical underpayment or overpayment. After redetermining 
the income tax liability for each tax year affected by the reallocation 
of contract income, the taxpayer then determines the amount, if any, of 
the hypothetical underpayment or overpayment of tax for each of these 
redetermination years. The hypothetical underpayment or overpayment for 
each affected year is the difference between the tax liability as 
redetermined under the look-back method for that year and the amount of 
tax liability determined as of the latest of the following:
    (A) The original return date;
    (B) The date of a subsequently amended or adjusted return (if, 
however, the amended return is due to a carryback described in section 
6611(f), see paragraph (c)(4)(iii)); or,
    (C) The last previous application of the look-back method (in which 
case, the previous hypothetical tax liability is used).
    (iv) Cumulative determination of tax liability. The redetermination 
of tax liability resulting from previous applications of the look-back 
method is cumulative. Thus, for example, in computing the amount of a 
hypothetical overpayment or underpayment of tax for a redetermination 
year, the current hypothetical tax liability is compared to the 
hypothetical tax liability for that year determined as of the last 
previous application of the look-back method.
    (v) Years affected by look-back only. A redetermination of income 
tax liability under Step Two is required for every tax year for which 
the tax liability would have been affected by a change in the amount of 
income or loss for any other year for which a redetermination is 
required. For example, if the allocation of contract income under Step 
One changed the amount of a net operating loss that was carried back to 
a year preceding the year the taxpayer entered into the contract, the 
tax liability for the earlier year must be redetermined.
    (vi) Definition of tax liability. For purposes of Step Two, the 
income tax liability must be redetermined by taking into account all 
applicable additions to tax, credits, and net operating loss carrybacks 
and carryovers. Thus, the tax, if any, imposed under section 55 
(relating to alternative minimum tax) must be taken into account. For 
example, if the taxpayer did not pay alternative minimum tax, but would 
have paid alternative minimum tax for that year if actual rather than 
estimated contract price and costs had been used in determining contract 
income for the year, the amount of any hypothetical overpayment or 
underpayment of tax must be determined by comparing the hypothetical 
total tax liability (including hypothetical alternative minimum tax 
liability) with the actual tax liability for that year. The effect of 
taking these items into account in applying the look-back method is 
illustrated in Examples (4) through (7) of paragraphs (h)(5) through 
(h)(8) below.
    (4) Look-back Step Three: Calculation of interest on underpayment or 
overpayment--(i) In general. After determining a hypothetical 
underpayment or overpayment of tax for each redetermination year, the 
taxpayer must determine the interest charged or credited on each of 
these amounts. Interest on the amount determined under Step Two is 
determined by applying the overpayment rate designated under section 
6621, compounded daily. In general, the

[[Page 244]]

time period over which interest is charged on hypothetical underpayments 
or credited on hypothetical overpayments begins at the due date (not 
including extensions) of the return for the redetermination year for 
which the hypothetical underpayment or overpayment determined in Step 
Two is computed. This time period generally ends on the earlier of:
    (A) The due date (not including extensions) of the return for the 
filing year, and
    (B) The date both
    (1) The income tax return for the filing year is filed, and
    (2) The tax for that year has been paid in full. If a taxpayer uses 
the simplified marginal impact method contained in paragraph (d), the 
remainder of this paragraph (c)(4) does not apply.
    (ii) Changes in the amount of a loss or credit carryback or 
carryover. The time period for determining interest may be different in 
cases involving loss or credit carrybacks or carryovers in order to 
properly reflect the time period during which the taxpayer (in the case 
of an underpayment) or the Government (in the case of an overpayment) 
had the use of the amount determined to be a hypothetical underpayment 
or overpayment. Thus, if a reallocation of contract income under Step 
One results in an increase or decrease to a net operating loss carryback 
(but not a carryforward), the interest due or to be refunded must be 
computed on the increase or decrease in tax attributable to the change 
to the carryback only from the due date (not including extensions) of 
the return for the redetermination year that generated the carryback and 
not from the due date of the return for the redetermination year in 
which the carryback was absorbed. In the case of a change in the amount 
of a carryover as a result of applying the lookback method, interest is 
computed from the due date of the return for the year in which the 
carryover was absorbed. See Examples (8) and (9) of paragraph (h)(9) for 
an illustration of these rules.
    (iii) Changes in the amount of tax liability that generated a 
subsequent refund. If the amount of tax liability for a redetermination 
year (as reported on the taxpayer's original return, as subsequently 
adjusted on examination, as adjusted by amended return, or as 
redetermined by the last previous application of the look-back method) 
is decreased by the application of the look-back method, and any portion 
of the redetermination year tax liability was absorbed by a loss or 
credit carryback arising in a year subsequent to the redetermination 
year, the look-back method applies as follows to properly reflect the 
time period of the use of the tax overpayment. To the extent the amount 
of tax absorbed because of the carryback exceeds the total hypothetical 
tax liability for the year (as redetermined under the look-back method) 
the taxpayer is entitled to receive interest only until the due date 
(not including extensions) of the return for the year in which the 
carryback arose.

    Example. Upon the completion of a long-term contract in 1990, the 
taxpayer redetermines its tax liability for 1988 under the look-back 
method. This redetermination results in a hypothetical reduction of tax 
liability from $1,500x (actual liability originally reported) to $1,200x 
(hypothetical liability). In addition, the taxpayer had already received 
a refund of some or all of the actual 1988 tax by carrying back a net 
operating loss (NOL) that arose in 1989. The time period over which 
interest would be computed on the hypothetical overpayment of $300x for 
1988 would depend on the amount of the refund generated by the 
carryback, as illustrated by the following three alternative situations:
    (A) If the amount refunded because of the NOL is $1,500x: interest 
is credited to the taxpayer on the entire hypothetical overpayment of 
$300x from the due date of the 1988 return, when the hypothetical 
overpayment occurred, until the due date of the 1989 return, when the 
taxpayer received a refund for the entire amount of the 1988 tax, 
including the hypothetical overpayment.
    (B) If the amount refunded because of the NOL is $1,000x: interest 
is credited to the taxpayer on the entire amount of the hypothetical 
overpayment of $300x from the due date of the 1988 return, when the 
hypothetical overpayment occurred, until the due date of the 1990 
return. In this situation interest is credited until the due date of the 
return for the completion year of the contract, rather than the due date 
of the return for the year in which the carryback arose, because the 
amount refunded was less than the redetermined tax liability. Therefore, 
no portion of the hypothetical overpayment is treated

[[Page 245]]

as having been refunded to the taxpayer before the filing year.
    (C) If the amount refunded because of the NOL is $1,300x-: interest 
is credited to the taxpayer on $100x ($1,300x-$1,200x) from the due date 
of the 1988 return until the due date of the 1989 return because only 
this portion of the total hypothetical overpayment is treated as having 
been refunded to the taxpayer before the filing year. However, the 
taxpayer did not receive a refund for the remaining $200x of the 
overpayment at that time and, therefore, is credited with interest on 
$200x through the due date of the tax return for 1990, the filing year. 
See Examples (10) and (11) of paragraph (h)(9) for a further 
illustration of this rule.

    (d) Simplified marginal impact method--(1) Introduction. This 
paragraph (d) provides a simplified method for calculating look-back 
interest. Any taxpayer may elect this simplified marginal impact method, 
except that pass-through entities described in paragraph (d)(4) of this 
section are required to apply the simplified marginal impact method at 
the entity level with respect to domestic contracts and the owners of 
those entities do not apply the look-back method to those contracts. 
Under the simplified marginal impact method, a taxpayer calculates the 
hypothetical underpayments or overpayments of tax for a prior year based 
on an assumed marginal tax rate. A taxpayer electing to use the 
simplified marginal impact method must use the method for each long-term 
contract for which it reports income (except with respect to domestic 
contracts if the taxpayer is an owner in a widely held pass-through 
entity that is required to use the simplified marginal impact method at 
the entity level for those contracts).
    (2) Operation--(i) In general. Under the simplified marginal impact 
method, income from those contracts that are completed or adjusted in 
the filing year is first reallocated in accordance with the procedures 
of Step One contained in paragraph (c)(2) of this section. Step Two is 
modified in the following manner. The hypothetical underpayment or 
overpayment of tax for each year of the contract (a ``redetermination 
year'') is determined by multiplying the applicable regular tax rate (as 
defined in paragraph (d)(2)(iii)) by the increase or decrease in regular 
taxable income (or, if it produces a greater amount, by multiplying the 
applicable alternative minimum tax rate by the increase or decrease in 
alternative minimum taxable income, whether or not the taxpayer would 
have been subject to the alternative minimum tax) that results from 
reallocating income to the tax year under Step One. Generally, the 
product of the alternative minimum tax rate and the increase or decrease 
in alternative minimum taxable income will be the greater of the two 
amounts described in the preceding sentence only with respect to 
contracts for which a taxpayer uses the full percentage of completion 
method only for alternative minimum tax purposes and uses the completed 
contract method, or the percentage of completion-capitalized cost 
method, for regular tax purposes. Step Three is then applied. Interest 
is credited to the taxpayer on the net overpayment and is charged to the 
taxpayer on the net underpayment for each redetermination year from the 
due date (determined without regard to extensions) of the return for the 
redetermination year until the earlier of
    (A) The due date (determined without regard to extensions) of the 
return for the filing year, and
    (B) The first date by which both the return is filed and the tax is 
fully paid.
    (ii) Applicable tax rate. For purposes of determining hypothetical 
underpayments or overpayments of tax under the simplified marginal 
impact method, the applicable regular tax rate is the highest rate of 
tax in effect for the redetermination year under section 1 in the case 
of an individual and under section 11 in the case of a corporation. The 
applicable alternative minimum tax rate is the rate of tax in effect for 
the taxpayer under section 55(b)(1). The highest rate is determined 
without regard to the taxpayer's actual rate bracket and without regard 
to any additional surtax imposed for the purpose of phasing out multiple 
tax brackets or exemptions.
    (iii) Overpayment ceiling. The net hypothetical overpayment of tax 
for any redetermination year is limited to the taxpayer's total federal 
income tax liability for the redetermination year reduced by the 
cumulative amount of net hypothetical overpayments of tax for that 
redetermination year resulting

[[Page 246]]

from earlier applications of the look-back method. If the reallocation 
of contract income results in a net overpayment of tax and this amount 
exceeds the actual tax liability (as of the filing year) for the 
redetermination year, as adjusted for past applications of the look-back 
method and taking into account net operating loss, capital loss, or 
credit carryovers and carrybacks to that year, the actual tax so 
adjusted is treated as the overpayment for the redetermination year. 
This overpayment ceiling does not apply when the simplified marginal 
impact method is applied at the entity level by a widely held pass-
through entity in accordance with paragraph (d)(4) of this section.
    (iv) Example. The application of the simplified marginal impact 
method is illustrated by the following example:

    Example. Corporation X, a calendar-year taxpayer, reports income 
from long-term contracts and elected the simplified marginal impact 
method when it filed its income tax return for 1989. X uses only the 
percentage of completion method for both regular taxable income and 
alternative minimum taxable income. X completed contracts A, B, and C in 
1989 and, therefore, was required to apply the look-back method in 1989. 
Income was actually reported for these contracts in 1987, 1988, and 
1989. X's applicable tax rate, as determined under section 11, for the 
redetermination years 1987 and 1988 was 40 percent and 34 percent, 
respectively. The amount of contract income originally reported and 
reallocated for contracts A, B, and C, and the net overpayments and 
underpayments for the redetermination years are as follows:

------------------------------------------------------------------------
                                                     1987        1988
------------------------------------------------------------------------
Contract A:
  Originally reported...........................    $5,000x     $4,000x
  Reallocated...................................     3,000x      5,000x
  Increase/(Decrease)...........................    (2,000x)     1,000x
Contract B:
  Originally reported...........................     6,000x      2,000x
  Reallocated...................................     7,000x      1,500x
  Increase/(Decrease)...........................     1,000x       (500x)
Contract C:
  Originally reported...........................     8,000x      5,000x
  Reallocated...................................     4,000x      7,000x
  Increase/(Decrease)...........................    (4,000x)     2,000x
Net Increase/(Decrease).........................    (5,000x)     2,500x
Tentative (Underpayment)/Overpayment:
    @ .40.......................................     2,000x   ..........
    @ .34.......................................  ..........      (850x)
Ceiling:
  Actual Tax Liability (After Carryovers and         1,500x        500x
   Carrybacks)..................................
Final (Underpayment)/Overpayment................     1,500x       (850x)
------------------------------------------------------------------------

    Under the simplified marginal impact method, X determined a 
tentative hypothetical net overpayment for 1987 and a net underpayment 
for 1988. X determined these amounts by first aggregating the difference 
for contracts A, B, and C between the amount of contract price 
originally reported and the amount of contract price as reallocated and, 
then, applying the highest regular tax rate to the aggregate decrease in 
income for 1987 and the aggregate increase in income for 1988.
    However, X's overpayment for 1987 is subject to a ceiling based on 
X's total tax liability. Because the tentative net overpayment of tax 
for 1987 exceeds the actual tax liability for that year after taking 
into account carryovers and carrybacks to that year, the final 
overpayment under the simplified marginal impact method is the amount of 
tax liability paid instead of the tentative net overpayment. Since 
application of the look-back method for 1988 results in a tentative 
underpayment of tax, it is not subject to a ceiling. If the look-back 
method is applied in 1991, the ceiling amount for 1987 will be zero and 
the ceiling amount for 1988 will be $1,350.
    X is entitled to receive interest on the hypothetical overpayment 
from March 15, 1988, to March 15, 1990. X is required to pay interest on 
the underpayment from March 15, 1989, to March 15, 1990.

    (3) Anti-abuse rule. If the simplified marginal impact method is 
used with respect to any long-term contract (including a contract of a 
widely held pass-through entity), the district director may recompute 
interest for the contract (including domestic contracts of widely held 
pass-through entities) under the look-back method using the actual 
method (and without regard to the simplified marginal impact method). 
The district director may make such a recomputation only if the amount 
of income originally reported with respect to the contract for any 
redetermination year exceeds the amount of income reallocated under the 
look-back method with respect to that contract for that year (using 
actual contract price and contract costs) by the lesser of $1,000,000 or 
20 percent of the amount of income as reallocated (i.e., based on actual 
contract price and contract costs) under the look-back method with 
respect to that contract for that year. In determining whether to 
exercise this authority upon examination of the Form 8697, the district 
director may take into account whether the taxpayer overreported income

[[Page 247]]

for a purpose of receiving interest under the look-back method on a 
hypothetical overpayment determined at the applicable tax rate. The 
district director also may take into account whether the taxpayer 
underreported income for the year in question with respect to other 
contracts. Notwithstanding the look-back method, the district director 
may require an adjustment to the tax liability for any open tax year if 
the taxpayer did not apply the percentage of completion method properly 
on its original return.
    (4) Application--(i) Required use by certain pass-through entities--
(A) General rule. The simplified marginal impact method is required to 
be used with respect to income reported from domestic contracts by a 
pass-through entity that is either a partnership, an S corporation, or a 
trust, and that is not closely held. With respect to contracts described 
in the preceding sentence, the simplified marginal impact method is 
applied by the pass-through entity at the entity level. For determining 
the amount of any hypothetical underpayment or overpayment, the 
applicable regular and alternative minimum tax rates, respectively, are 
generally the highest rates of tax in effect for corporations under 
section 11 and section 55 (b)(1). However, the applicable regular and 
alternative minimum tax rates are the highest rates of tax imposed on 
individuals under section 1 and section 55 (b)(1) if, at all times 
during the redetermination year involved (i.e., the year in which the 
hypothetical increase or decrease in income arises), more than 50 
percent of the interests in the entity were held by individuals directly 
or through 1 or more pass-through entities.
    (B) Closely held. A pass-through entity is closely held if, at any 
time during any redetermination year, 50 percent of more (by value) of 
the beneficial interests in that entity are held (directly or 
indirectly) by or for 5 or fewer persons. For this purpose, the term 
``person'' has the same meaning as in section 7701(a)(1), except that a 
pass-through entity is not treated as a person. In addition, the 
constructive ownership rules of section 1563(e) apply by substituting 
the term ``beneficial interest'' for the term ``stock'' and by 
substituting the term ``pass-through entity'' for the term, 
``corporation'' used in that section, as appropriate, for purposes of 
determining whether a beneficial interest in a pass-through entity is 
indirectly owned by any person.
    (C) Examples. The following examples illustrate the application of 
the rules of paragraph (d)(4)(i):

    Example (1). P, a partnership, began a long-term contract on March 
1, 1986, and completed this contract in its tax year ending December 31, 
1989. P used the percentage of completion method for all contract 
income. Substantially all of the income from the contract arose from 
U.S. sources. At all times during all of the years for which income was 
required to be reported under the contract, exactly 25 percent of the 
value of P's interests was owned by Corporation M. The remaining 75 
percent of the value of P's interests was owned in equal shares by 15 
unrelated individuals, who are also unrelated to Corporation M. M's 
ownership of P represents less than 50 percent of the value of the 
beneficial interests in P, and, therefore, viewed alone, is insufficient 
to make P a closely held partnership. In addition, because no 4 of the 
individual owners together own 25 percent or more of the remaining value 
of P's beneficial interests, there is no group of 5 owners that together 
own, directly or indirectly, 50 percent or more by value of the 
beneficial interests in P. Therefore, P is not closely held pass-through 
entity.
    Because P is not a closely held pass-through entity, and because P 
completed the contract after the effective date of section 460(b)(4), P 
is required to use the simplified marginal impact method. Any interest 
computed under the look-back method will be paid to, or collected from, 
P, rather than its partners, and must be reported to each of the 
partners on Form 1065 as interest income or expense. Further, assume 
that, for the redetermination years, Corporation M is subject to 
alternative minimum tax at the rate of 20 percent and 3 of the 
individuals who own interests in P are subject to the highest marginal 
tax rate of 33 percent in 1988. Regardless of the actual marginal tax 
rates of its partners, P is required to determine the underpayment or 
overpayment of tax for each redetermination year at the entity level by 
applying a single rate to the increase or decrease in income resulting 
from the reallocation of contract income under the look-back method. 
Because more than 50 percent of the interests in P are held by 
individuals, P must use the highest rate specified in section 1 for each 
redetermination year. Thus, the rate applied by P is 50 percent for 
1986, 38.5 percent for 1987, and 28 percent for 1988.

[[Page 248]]

    Example (2). Assume the same facts as in Example (1), except that 
one of the individuals, Individual I, who directly owns 5 percent of the 
value of the interests of P, also owns 100 percent of the stock of 
Corporation M. Section 1563(e)(4) of the Code provides that stock owned 
directly or indirectly by or for a corporation is considered to be owned 
by any person who owns 5 percent or more in value of its stock in that 
proportion which the value of the stock which that person so owns bears 
to the value of all the stock in that corporation. Because section 
460(b)(4)(C)(iii) and this paragraph (d)(4) provide that rules similar 
to the constructive ownership rules of section 1563(e) apply in 
determining whether a pass-through entity is closely held, all of M's 
interest in P is attributed to I because I owns 100 percent of the value 
of the stock in M. Accordingly, because I's direct 5 percent and 
constructive 25 percent ownership of P, plus the interests owned by any 
4 other individual partners, equals 50 percent or more of the value of 
the beneficial interests of P, P is a closely held pass-through entity 
within the meaning of section 460(b)(4)(C)(iii). Therefore, P cannot use 
the simplified marginal impact method at the entity level. Accordingly, 
each of the partners of P must separately apply the look-back method to 
their respective interests in the income and expenses attributable to 
the contract, but each partner may elect to use the simplified marginal 
impact method with respect to the partner's share of income from the 
contract.

    (D) Domestic contracts--(1) General rule. A domestic contract is any 
contract substantially all of the income of which is from sources in the 
United States. For this purpose, ``substantially all'' of the income 
from a long-term contract is considered to be from United States sources 
if 95 percent or more of the gross income from the contract is from 
sources within the United States as determined under the rules in 
sections 861 through 865.
    (2) Portion of contract income sourced. In determining whether 
substantially all of the gross income from a long-term contract is from 
United States sources, taxpayers must apply the allocation and 
apportionment principles of sections 861 through 865 only to the portion 
of the contract accounted for under the percentage of completion method. 
Under the percentage of completion method, gross income from a long-term 
contract includes all payments to be received under the contract (i.e., 
any amounts treated as contract price). Similarly, all costs taken into 
account in the computation of taxable income under the percentage of 
completion method are deducted from gross income rather than added to a 
cost of goods sold account that reduces gross income. Therefore, 
allocable contract costs are not considered in determining whether a 
long-term contract is a domestic contract or a foreign contract, even 
if, under the taxpayer's facts, the allocation of contract costs to any 
portion of a contract not accounted for under the percentage of 
completion method would affect the relative percentages of United States 
and foreign source gross income from the entire contract if this portion 
of the contract were taken into account in applying the 95-percent test.
    (E) Application to foreign contracts. If a widely held pass-through 
entity has some foreign contracts and some domestic contracts, the 
owners of the pass-through entity each apply the look-back method 
(using, if they elect, the simplified marginal impact method) to their 
respective share of the income and expense from foreign contracts. 
Moreover, in applying the look-back method to foreign contracts at the 
owner level, the owners do not take into account their share of 
increases or decreases in contract income resulting from the application 
of the simplified marginal impact method with respect to domestic 
contracts at the entity level.
    (F) Effective date. The simplified marginal impact method must be 
applied to pass-through entities described in paragraph (d)(4)(i) of 
this section with respect to domestic contracts completed or adjusted in 
tax years for which the due date of the return (determined with regard 
to extensions) of the pass-through entity is after November 9, 1988.
    (ii) Elective use--(A) General rule. As provided in paragraph 
(d)(4)(i) of this section, the simplified marginal impact method must be 
used by certain pass-through entities with respect to domestic 
contracts. C corporations, individuals, and owners of closely held pass-
through entities may elect the simplified marginal impact method. Owners 
of other pass-through entities may

[[Page 249]]

also elect the simplified marginal impact method with respect to all 
contracts other than those for which the simplified marginal impact 
method is required to be applied at the entity level. This rule applies 
to foreign contracts of widely held pass-through entities. In the case 
of an electing owner in a pass-through entity, the simplified marginal 
impact method is applied at the owner level, instead of at the entity 
level, with respect to the owner's share of the long-term contract 
income and expense reported by the pass-through entity.
    (B) Election requirements. A taxpayer elects the simplified marginal 
impact method by stating that the election is being made on a timely 
filed income tax return (determined with regard to extensions) for the 
first tax year the election is to apply. An election to use the 
simplified marginal impact method applies to all applications of the 
look-back method to all eligible long-term contracts for the tax year 
for which the election is made and for any subsequent tax year. The 
election may not be revoked without the consent of the Commissioner.
    (C) Consolidated group consistency rule. In the case of a 
consolidated group of corporations as defined in Sec. 1.1502-1(h), an 
election to use the simplified marginal impact method is made by the 
common parent of the group. The election is binding on all other 
affected members of the group (including members that join the group 
after the election is made with respect to all applications of the look-
back method after joining). If a member subsequently leaves the group, 
the election remains binding as to that member unless the Commissioner 
consents to a revocation of the election. If a corporation using the 
simplified marginal impact method joins a group that does not use the 
method, the election is automatically revoked with respect to all 
applications of the look-back method after it joins the group.
    (e) Delayed reapplication method--(1) In general. For purposes of 
reapplying the look-back method after the year of contract completion, a 
taxpayer may elect the delayed reapplication method to minimize the 
number of required reapplications of the look-back method. Under this 
method, the look-back method is reapplied after the year of completion 
of a contract (or after a subsequent application of the look-back 
method) only when the first one of the following conditions is met with 
respect to the contract:
    (i) The net undiscounted value of increases or decreases in the 
contract price occurring since the time of the last application of the 
look-back method exceeds the lesser of $1,000,000 or 10 percent of the 
total contract price as of that time,
    (ii) The net undiscounted value of increases or decreases in the 
contract costs occurring since the time of the last application of the 
look-back method exceeds the lesser of $1,000,000 or 10 percent of the 
total contract price as of that time,
    (iii) The taxpayer goes out of existence,
    (iv) The taxpayer reasonably believes the contract is finally 
settled and closed, or
    (v) Neither condition (e)(1) (i), (ii), (iii), nor (iv) above is met 
by the end of the fifth tax year that begins after the last previous 
application of the look-back method.
    (2) Time and manner of making election. An election to use the 
delayed reapplication method may be made for any filing year for which 
the due date of the return (determined with regard to extensions) is 
after June 12, 1990. The election is made by a statement to that effect 
on the taxpayer's timely filed Federal income tax return (determined 
with regard to extensions) for the first tax year the election is to be 
effective. An election to use the delayed reapplication method is 
binding with respect to all long-term contracts for which the look-back 
method would be reapplied without regard to the election in the year of 
election and any subsequent year unless the Commissioner consents to a 
revocation of the election. In the case of a consolidated group of 
corporations as defined in Sec. 1.1502-1(h), an election to use the 
delayed reapplication method is made by the common parent of the group. 
The election is binding on all other affected members of the group 
(including members that join the group after the election is made with 
respect to contracts

[[Page 250]]

adjusted after joining). If a member subsequently leaves the group, the 
election remains binding as to that member unless the Commissioner 
consents to a revocation of the election. If a corporation that has made 
the election joins a consolidated group that has not made the election, 
the election is treated as revoked with respect to contracts adjusted 
after joining.
    (3) Examples. The operation of this delayed reapplication method is 
illustrated by the following examples:

    Example (1). X completes a contract in 1987, and applies the look-
back method when its return for 1987 is filed. X properly uses $600,000 
as the actual contract price in applying the look-back method. In 1990, 
as a result of the settlement of a dispute with its customer, X 
redetermines total contract price to be $640,000, and includes $40,000 
in gross income. On its return for 1990, X states it is electing the 
delayed reapplication method. X is not required to reapply the look-back 
method at that time, because $40,000 does not exceed the lesser of 
$1,000,000 or 10 percent of the unadjusted contract price of $600,000, 
and 5 years have not passed since the last application of the look-back 
method.
    Example (2). Assume the same facts as in Example (1), except that at 
the end of 1992, the fifth year after completion of the contract, no 
other adjustments to contract price or contract costs have occurred. X 
is required to reapply the look-back method in 1992 and, accordingly, 
redetermine its tax liability for each redetermination year. After 
redetermining the underpayment of tax for those years, X must compute 
the amount of interest charged on the underpayments. Although 1992 is 
the filing year, interest is due on the amount of each underpayment 
resulting from the adjustment only from the due date of the return for 
each redetermination year to the due date of the return for 1990 because 
the tax liability for the adjustment was fully paid in 1990. However, 
from the due of the 1990 return until the due date of the 1992 return, 
when the look-back method is reapplied for the adjustment, interest is 
due on the amount of interest attributable to the underpayments.

    (f) Look-back reporting--(1) Procedure. The amount of any interest 
due from, or payable to, a taxpayer as a result of applying the look-
back method is computed on Form 8697 for any filing year. In general, 
the look-back method is applied by the taxpayer that reports income from 
a long-term contract. See paragraph (g) of this section to determine who 
is responsible for applying the look-back method when, prior to the 
completion of a long-term contract, there is a transaction that changes 
the taxpayer that reports income from the contract.
    (2) Treatment of interest on return--(i) General rule. The amount of 
interest required to be paid by a taxpayer is treated as an income tax 
under subtitle A, but only for purposes of subtitle F of the Code (other 
than sections 6654 and 6655), which addresses tax procedures and 
administration. Thus, a taxpayer that fails to pay the amount of 
interest due is subject to any applicable penalties under subtitle F, 
including, for example, an underpayment penalty under section 6651, and 
the taxpayer also is liable for underpayment interest under section 
6601. However, interest required to be paid under the look-back method 
is treated as interest expense for purposes of computing taxable income 
under subtitle A, even though it is treated as income tax liability for 
subtitle F purposes. Interest received under the look-back method is 
treated as taxable interest income for all purposes, and is not treated 
as a reduction in tax liability or a tax refund. The determination of 
whether or not interest computed under the look-back method is treated 
as tax is determined on a ``net'' basis for each filing year. Thus, if a 
taxpayer computes for the current filing year both hypothetical 
overpayments and hypothetical underpayments for prior years, the 
taxpayer has an increase in tax only if the interest computed on the 
underpayments for all those prior years exceeds the interest computed on 
the overpayments for all those prior years, for all contracts completed 
or adjusted for the year.
    (ii) Timing of look-back interest. For purposes of determining 
taxable income under subtitle A of the Code, any amount of interest 
payable to the taxpayer under the look-back method is includible in 
gross income as interest income in the tax year it is properly taken 
into account under the taxpayer's method of accounting for interest 
income. Any amount of interest required to be paid is taken into account 
as interest expense arising from an underpayment of income tax in the 
tax year it is properly taken into account under the taxpayer's method 
of accounting for interest expense. Thus,

[[Page 251]]

look-back interest required to be paid by an individual, or by a pass-
through entity on behalf of an individual owner (or beneficiary) under 
the simplified marginal impact method, is personal interest and, 
therefore, is disallowed in accordance with Sec. 1.163-9T(b)(2). 
Interest determined at the entity level under the simplified marginal 
impact method is allocated among the owners (or beneficiaries) for 
reporting purposes in the same manner that interest income and interest 
expense are allocated to owners (or beneficiaries) and subject to the 
requirements of section 704 and any other applicable rules.
    (3) Statute of limitations and compounding of interest on look-back 
interest. For guidance on the statute of limitations applicable to the 
assessment and collection of look-back interest owed by a taxpayer, see 
sections 6501 and 6502. A taxpayer's claim for credit or refund of look-
back interest previously paid by or collected from a taxpayer is a claim 
for credit or refund of an overpayment of tax and is subject to the 
statute of limitations provided in section 6511. A taxpayer's claim for 
look-back interest (or interest payable on look-back interest) that is 
not attributable to an amount previously paid by or collected from a 
taxpayer is a general, non-tax claim against the federal government. For 
guidance on the statute of limitations that applies to general, non-tax 
claims against the federal government, see 28 U.S.C. sections 2401 and 
2501. For guidance applicable to the compounding of interest when the 
look-back interest is not paid, see sections 6601 to 6622.
    (g) Mid-contract change in taxpayer--(1) In general. The rules in 
this paragraph (g) apply if, as described in Sec. 1.460-4(k), prior to 
the completion of a long-term contract accounted for using the PCM or 
the PCCM by a taxpayer (old taxpayer), there is a transaction that makes 
another taxpayer (new taxpayer) responsible for accounting for income 
from the same contract. The rules governing constructive completion 
transactions are provided in paragraph (g)(2) of this section, while the 
rules governing step-in-the-shoes transactions are provided in paragraph 
(g)(3) of this section. For purposes of this paragraph, pre-transaction 
years are all taxable years of the old taxpayer in which the old 
taxpayer accounted for (or should have accounted for) gross receipts 
from the contract, and post-transaction years are all taxable years of 
the new taxpayer in which the new taxpayer accounted for (or should have 
accounted for) gross receipts from the contract.
    (2) Constructive completion transactions. In the case of a 
transaction described in Sec. 1.460-4(k)(2)(i) (constructive completion 
transaction), the look-back method is applied by the old taxpayer with 
respect to pre-transaction years upon the date of the transaction and, 
if the new taxpayer uses the PCM or the PCCM to account for the 
contract, by the new taxpayer with respect to post-transaction years 
upon completion of the contract. The contract price and allocable 
contract costs to be taken into account by the old taxpayer or the new 
taxpayer in applying the look-back method are described in Sec. 1.460-
4(k)(2).
    (3) Step-in-the-shoes transactions--(i) General rules. In the case 
of a transaction described in Sec. 1.460-4(k)(3)(i) (step-in-the-shoes 
transaction), the look-back method is not applied at the time of the 
transaction, but is instead applied for the first time when the contract 
is completed by the new taxpayer. Upon completion of the contract, the 
look-back method is applied by the new taxpayer with respect to both 
pre-transaction years and post-transaction years, taking into account 
all amounts reasonably expected to be received by either the old or new 
taxpayer and all allocable contract costs incurred during both periods 
as described in Sec. 1.460-4(k)(3). The new taxpayer is liable for 
filing the Form 8697 and for interest computed on hypothetical 
underpayments of tax, and is entitled to receive interest with respect 
to hypothetical overpayments of tax, for both pre- and post-transaction 
years. The old taxpayer will be secondarily liable for any interest 
required to be paid with respect to pre-transaction years reduced by any 
interest on pre-transaction overpayments.
    (ii) Application of look-back method to pre-transaction period--(A) 
Contract price. The actual contract price for pre-

[[Page 252]]

transaction taxable years must be determined by the new taxpayer without 
regard to any contract price adjustment described in paragraph 
(k)(3)(iv)(B)(1) of this section.
    (B) Method. The new taxpayer may apply the look-back method to each 
pre-transaction taxable year that is a redetermination year using the 
simplified marginal impact method described in paragraph (d) of this 
section (regardless of whether or not the old taxpayer would have 
actually used that method and without regard to the tax liability 
ceiling). But see paragraph (d)(4) of this section, which requires use 
of the simplified marginal impact method by certain pass-through 
entities.
    (C) Interest accrual period. With respect to any hypothetical 
underpayment or overpayment of tax for a pre-transaction taxable year, 
interest accrues from the due date of the old taxpayer's tax return (not 
including extensions) for the taxable year of the underpayment or 
overpayment until the due date of the new taxpayer's return (not 
including extensions) for the completion year or the year of a post-
completion adjustment, whichever is applicable.
    (D) Information old taxpayer must provide--(1) In general. Except as 
provided in paragraph (g)(3)(ii)(D)(2) of this section, in order to help 
the new taxpayer to apply the look-back method with respect to pre-
transaction taxable years, any old taxpayer that accounted for income 
from a long-term contract under the PCM or PCCM for either regular or 
alternative minimum tax purposes is required to provide the information 
described in this paragraph to the new taxpayer by the due date (not 
including extensions) of the old taxpayer's income tax return for the 
first taxable year ending on or after a step-in-the-shoes transaction 
described in Sec. 1.460-4(k)(3)(i). The required information is as 
follows--
    (i) The portion of the contract reported by the old taxpayer under 
PCM for regular and alternative minimum tax purposes (i.e., whether the 
old taxpayer used PCM, the 40/60 PCCM method, or the 70/30 PCCM method);
    (ii) Any submethods used in the application of PCM (e.g., the 
simplified cost-to-cost method or the 10-percent method);
    (iii) The amount of total contract price reported by year;
    (iv) The numerator and the denominator of the completion factor by 
year;
    (v) The due date (not including extensions) of the old taxpayer's 
income tax returns for each taxable year in which income was required to 
be reported;
    (vi) Whether the old taxpayer was a corporate or a noncorporate 
taxpayer by year; and
    (vii) Any other information required by the Commissioner by 
administrative pronouncement.
    (2) Special rules for certain pass-through entity transactions. For 
purposes of paragraph (g)(3)(ii)(D)(1) of this section, in the case of a 
transaction described in Sec. 1.460-4(k)(3)(i)(I), the contributing 
partner is treated as the old taxpayer, and the partnership is treated 
as the new taxpayer. In the case of transactions described in Sec. 
1.460-4(k)(3)(i)(F), (G), (J), (K), or (L), the old taxpayer is not 
required to provide the information described in paragraph 
(g)(3)(ii)(D)(1) of this section, because information necessary for the 
new taxpayer to apply the look-back method is provided by the pass-
through entity. This paragraph (g)(3)(ii)(D) is applicable for 
transactions on or after August 6, 2003.
    (iii) Application of look-back method to post-transaction years. 
With respect to post-transaction taxable years, the new taxpayer must 
use the same look-back method it uses for other contacts (i.e., the 
simplified marginal impact method or the acutal method) to determine the 
amount of any hypothetical overpayment or underpayment of tax and the 
time period for computing interest on these amounts.
    (iv) S corporation elections. Following the conversion of a C 
corporation into an S corporation, the look-back method is applied at 
the entity level with respect to contracts entered into prior to the 
conversion, notwithstanding section 460(b)(4)(B)(i).
    (4) Effective date. Except as provided in paragraph (g)(3)(ii)(D) of 
this section, this paragraph (g) is applicable for transactions on or 
after May 15, 2002.

[[Page 253]]

    (h) Examples--(1) Overview. This paragraph provides computational 
examples of the rules of this section. Except as otherwise noted, the 
examples involve calendar-year taxpayers and involve long-term contracts 
subject to section 460 that are accounted for using the percentage of 
completion method, rather than the percentage of completion-capitalized 
cost method. If the percentage of completion-capitalized cost method 
were used by a taxpayer described in the examples, the amounts of 
contract income and expenses shown in the examples would be reduced, for 
purposes of determining regular taxable income, to the appropriate 
fraction (40, 70, or 90 percent) of contract items accounted for under 
the percentage of completion method. Tens of thousands of dollars ($ 
00,000's) are omitted from the figures in the examples. The contracts 
described in the examples are assumed to be the taxpayers' only 
contracts that are subject to the look-back method of section 460. 
Except as otherwise stated, the examples assume that the taxpayer has no 
adjustments and preferences for purposes of section 55, so that 
alternative minimum taxable income is the same as taxable income, and no 
alternative minimum tax is imposed for the years involved. The examples 
assume that the taxpayer does not elect the 10-percent method, the 
simplified marginal impact method, or the delayed reapplication method.
    (2) Step One. The following example illustrates the application of 
paragraph (c)(2):

    Example (1). In 1989, W completes three long-term contracts, A, B, 
and C, entered into on January 1 of 1986, 1987, and 1988, respectively. 
For Contract A, W used the completed contract method of accounting. For 
Contract B, W used the percentage of completion-capitalized cost method 
of accounting, taking into account 60 percent of contract income under 
W's normal method of accounting, which was the completed contract 
method. For Contract C, W used the percentage of completion method of 
accounting. The total price for each contract was $1,000. In computing 
alternative minimum taxable income, W is required to use the percentage 
of completion method for Contracts B and C. W used regular tax costs for 
purposes of determining the degree of contract completion under the 
alternative minimum tax.
    Contract A is not taken into account for purposes of applying the 
look-back method, because it is subject to neither section 460 nor 
section 56(a)(3). Thus, even if W had used the percentage of completion 
method as permitted under Sec. 1.451-3, instead of the completed 
contract method, the look-back method would not be applicable because 
the Contract A was entered into before the effective date of section 
460.
    The actual costs allocated to Contracts B and C under section 460(c) 
and incurred in each year of the contract were as follows:

------------------------------------------------------------------------
                 Contract                    1987   1988   1989   Total
------------------------------------------------------------------------
B.........................................   $200   $400   $200     $800
C.........................................    100    300    400      800
------------------------------------------------------------------------

    In applying the look-back method, the first step is to allocate the 
contract price among tax years preceding and including the completion 
year. That allocation would produce the following amounts of gross 
income for purposes of the regular tax. Note that no income from 
Contract C is allocated to 1987, the year before the contract was 
entered into, even though contract costs were incurred in 1987:

----------------------------------------------------------------------------------------------------------------
              Contract                           1987                              1988                    1989
----------------------------------------------------------------------------------------------------------------
B..................................              $100                              $200                     $700
                                            (40%X$200/$800X$1000)          ((40%X$600/$800X$1000)-$100)  .......
C..................................                0                                500                      500
                                     ............................                     ($400/$800X$1000)  .......
----------------------------------------------------------------------------------------------------------------

    Because the percentage of completion-capitalized cost method may not 
be used for alternative minimum tax purposes, the allocation of contract 
income would produce the following amounts of gross income for purposes 
of computing alternative minimum taxable income:

----------------------------------------------------------------------------------------------------------------
                     Contract                               1987                       1988                1989
----------------------------------------------------------------------------------------------------------------
B.................................................          $250                       $500                 $250
                                                       ($200/$800X$1000)       (($600/$800X$1000)-$250)  .......
C.................................................            0                        500                   500
----------------------------------------------------------------------------------------------------------------


[[Page 254]]

    (3) Step Two. The following example illustrates the application of 
paragraph (c)(3):

    Example (2). (i) X enters into two long-term contracts (D and E) in 
1988. X determines its tax liability for 1988 as follows:
    e=estimate
    a=amount originally reported (actual)
    h=hypothetical

------------------------------------------------------------------------
                                               1988
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1988 contract costs.................    $3,000a     $2,000a   ..........
Total contract costs................     8,000e      8,000e   ..........
Total contract price................    10,000e     10,000e   ..........
1988 completion %...................      37.5e         25e   ..........
1988 gross income...................     3,750a      2,500a   ..........
Less, 1988 costs....................    (3,000a)    (2,000a)  ..........
                                     -----------------------------------
      1988 net contract income......       750a        500a     $1,250a
Other 1988 net income (loss)........  ..........  ..........    (2,000a)
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........      (750a)
                                     -----------------------------------
      Tax...........................  ..........  ..........         0a
Refund from NOL carryback fully       ..........  ..........       345a
 absorbed in 1985, at 46%...........
------------------------------------------------------------------------

    (ii) X completes Contract D during 1989. X determines its taxable 
income for 1989 as follows:

------------------------------------------------------------------------
                                               1989
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1989 contract costs.................    $3,000a          0a   ..........
Total contract costs................     6,000a     $9,000e   ..........
Total contract price................    10,000a     10,000e   ..........
1989 completion %...................       100a       22.2e   ..........
1989 gross income/(loss)............     6,250a      (278a)   ..........
Less, 1989 costs....................   (3,000a)          0a   ..........
                                     -----------------------------------
      1989 net contract income......     3,250a      (278a)      $2,972a
Other 1989 net income (loss)........  ..........  ..........          0a
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........      2,972a
Tax at 34%..........................  ..........  ..........      1,011a
------------------------------------------------------------------------

    (iii) For purposes of the look-back method, X must reallocate the 
actual total contract D price between 1988 and 1989 based on the actual 
total contract D costs. This results in the following hypothetical 
underpayment of tax for 1988 for purposes of the look-back method. Note 
that X does not reallocate the contract E price in applying the look-
back method in 1989 because contract E has not been completed, even 
though X's estimate of contract E costs has changed. The following 
computation is only for purposes of applying the look-back method, and 
does not result in the assessment of a tax deficiency.

------------------------------------------------------------------------
                                               1988
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1988 contract costs.................    $3,000a     $2,000a   ..........
Total contract costs................     6,000a      8,000e   ..........
Total contract price................    10,000a     10,000e   ..........
1988 completion %...................        50a         25e   ..........
1988 gross income...................     5,000h      2,500a   ..........
Less, 1988 costs....................    (3,000a)    (2,000a)  ..........
                                     -----------------------------------
      1988 net contract income......     2,000h        500a     $2,500h
Other 1988 net income (loss)........  ..........  ..........    (2,000a)
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........       500h
Tax at 34%..........................  ..........  ..........       170h

[[Page 255]]

 
Less, previously computed tax.......  ..........  ..........        -0a
Underpayment of 1988 tax............  ..........  ..........       170h
Underpayment of 1985 tax from NOL     ..........  ..........       345h
 carryback refund in 1988...........
                                     -----------------------------------
      Total underpayment of tax.....  ..........  ..........       515h
------------------------------------------------------------------------

    For purposes of any subsequent application of the look-back method 
for which 1989 is a redetermination year, because the reallocation of 
contract income and redetermination of tax liability are cumulative, X 
will use for 1989 the amount of contract D income and the amount of tax 
liability that would have been reported in 1989 if X had used actual 
contract costs instead of the amounts that were originally reported 
using the estimate of $8,000. Assuming no subsequent revisions (due to, 
for example, adjustments to contract D price and costs determined after 
the end of 1989), this amount would be determined as follows:

------------------------------------------------------------------------
                                               1989
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1989 contract costs.................    $3,000a          0a   ..........
Total contract costs................     6,000a     $9,000e   ..........
Total contract price................    10,000a     10,000e   ..........
1989 completion %...................       100a       22.2e   ..........
1989 gross income...................     5,000h       (278a)  ..........
Less, 1989 costs....................    (3,000a)         0a   ..........
                                     -----------------------------------
      1989 net contract income......     2,000h       (278a)     $1,722h
Other 1989 net income (loss)........  ..........  ..........          0a
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........      1,722h
Tax at 34%..........................  ..........  ..........        585h
------------------------------------------------------------------------

    (iv) X completes contract E during 1990. X determines its taxable 
income for 1990 as follows:

------------------------------------------------------------------------
                                               1990
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1990 contract costs.................  ..........    $7,000a   ..........
Total contract costs................  ..........     9,000a   ..........
Total contract price................  ..........    10,000a   ..........
1990 completion %...................  ..........       100a   ..........
1990 gross income...................  ..........     7,778a   ..........
Less, 1990 costs....................  ..........    (7,000a)  ..........
                                     -----------------------------------
      1990 net contract income......  ..........       778a        $778a
Other 1990 net income (loss)........  ..........  ..........          0a
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........        778a
Tax at 34%..........................  ..........  ..........        265a
------------------------------------------------------------------------

    (v) For purposes of the look-back method, X must reallocate the 
actual total contract E price between the 1988, 1989, and 1990, based on 
the actual total contract E costs.

This results in the following hypothetical overpayment of tax for 1988. 
Note that X uses the amount of income for contract D determined in the 
last previous application of the look-back method, and not the amount of 
income actually reported:

[[Page 256]]


------------------------------------------------------------------------
                                               1988
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1988 contract costs.................    $3,000a     $2,000a   ..........
Total contract costs................    $6,000a     $9,000a   ..........
Total contract price................   $10,000a    $10,000a   ..........
1988 completion (%).................        50a       22.2a   ..........
1988 gross income...................    $5,000h     $2,222h   ..........
Less, 1988 costs....................   ($3,000a)   ($2,000a)  ..........
                                     -----------------------------------
      1988 net contract income......    $2,000h       $222h     $2,222h
Other 1988 net income (loss)........  ..........  ..........   ($2,000a)
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........      $222h
                                     -----------------------------------
      Tax at 34%....................  ..........  ..........       $75h
Less, previously computed tax (based  ..........  ..........      $170h
 on most recent application of the
 look-back method)..................
                                     -----------------------------------
      Overpayment of 1988 tax.......  ..........  ..........      ($95h)
------------------------------------------------------------------------

    In applying the look-back method to 1989, X again uses the amounts 
substituted as of the last previous application of the look-back method 
with respect to contract D. Thus, X computes its hypothetical 
underpayment for 1989 as follows:

------------------------------------------------------------------------
                                               1989
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1989 contract costs.................    $3,000a          0a   ..........
Total contract costs................    $6,000a     $9,000a   ..........
Total contract price................   $10,000a    $10,000a   ..........
1989 completion (%).................       100a       22.2a   ..........
1989 gross income...................    $5,000h         $0h   ..........
Less, 1989 costs....................   ($3,000a)       ($0a)  ..........
                                     -----------------------------------
      1989 net contract income......    $2,000h          0a     $2,000h
Other 1989 net income (loss)........  ..........  ..........       ($0a)
                                     -----------------------------------
Taxable income (NOL)................  ..........  ..........    $2,000h
Tax at 34%..........................  ..........  ..........      $680h
Less, previously computed tax.......  ..........  ..........      $585h
                                     -----------------------------------
      Underpayment of 1989 tax......  ..........  ..........       $95h
------------------------------------------------------------------------

    For purposes of any subsequent application of the look-back method 
for which 1990 is a redetermination year, X will use for 1990 the amount 
of Contract E income, and the amount of tax liability, that was 
originally reported in 1990 because X's estimate of the total contract 
costs from $8,000 to $9,000 did not change after 1989. Without regard to 
any subsequent revisions, these amounts are the same as in the table in 
paragraph (h)(3)(iv) above.

    (4) Post-completion adjustments. The following example illustrates 
the application of paragraph (c)(1)(ii):

    Example (3). The facts are the same as in Example (2). In 1991, X 
settles a lawsuit against its customer in Contract E. The customer pays 
X an additional $3,000, without interest, in 1991. Applying the Federal 
mid-term rate then in effect, this $3,000 has a discounted value at the 
time of contract completion in 1990 of $2,700. X is required to apply 
the look-back method for 1991 even though no contract was completed in 
1991. X must include the full $3,000 adjustment (which was not 
previously includible in total contract price) in gross income for 1991. 
X does not elect not to discount adjustments to the contract price or 
costs. Thus, X adjusts the contract price by the discounted amount of 
the adjustment and, therefore, uses $12,700 (not $13,000) for total 
Contract E price, rather than $10,000, which was used when the look-back 
method was first applied with respect to Contract E.
    For purposes of the look-back method, X must allocate the revised 
total Contract E price of $12,700 between 1988, 1989 and 1990 based on 
the actual total Contract E costs, and compare the resulting revised tax 
liability with the tax liability determined for the last previous 
application of the look-back method involving those years. This results 
in

[[Page 257]]

the following hypothetical underpayments of tax for purposes of the 
look-back method:
    r=revised

------------------------------------------------------------------------
                                               1988
                                    -------------------------    Total
                                          D           E
------------------------------------------------------------------------
1988 contract costs................     $3,000a     $2,000a   ..........
Total contract costs...............     $6,000a     $9,000a   ..........
Total contract price...............    $10,000a    $12,700r   ..........
1988 completion (%)................         50a       22.2a   ..........
1988 gross income..................     $5,000h    $2,822rh   ..........
Less, 1988 costs...................   ($3,000a)    ($2,000a)  ..........
                                    ------------------------------------
      1988 net contract income.....     $2,000h       822rh     $2,222rh
Other 1988 net income (loss).......  ..........  ...........   ($2,000a)
                                    ------------------------------------
      Taxable income...............  ..........  ...........      $822rh
      Tax at 34%...................  ..........  ...........      $279rh
Less, previously computed tax......  ..........  ...........        $75h
      Underpayment of 1988 tax.....  ..........  ...........      $204rh
------------------------------------------------------------------------

    No Contract E costs were incurred in 1989, and there is no 
hypothetical underpayment for 1989.

------------------------------------------------------------------------
                                                    1990
                                  --------------------------------------
                                        D            E          Total
------------------------------------------------------------------------
1990 contract costs..............  ...........     $7,000a   ...........
Total contract costs.............  ...........     $9,000a   ...........
Total contract price.............  ...........    $12,700r   ...........
1990 completion (%)..............  ...........        100a   ...........
1990 gross income................  ...........    $9,878rh   ...........
Less 1990 costs..................  ...........    ($7,000a)  ...........
                                  --------------------------------------
      1990 net contract income...  ...........    $2,878rh     $2,878rh
Other 1990 net income (loss).....  ...........  ...........          0a
                                  --------------------------------------
Taxable income (NOL).............  ...........  ...........    $2,878rh
Tax at 34%.......................  ...........  ...........      $978rh
Less, previously computed tax....  ...........  ...........       $265h
                                  --------------
      Underpayment of 1990 tax...  ...........  ...........      $713rh
------------------------------------------------------------------------

    In 1992, X incurs an additional cost of $1,000 allocable to the 
contract, which was not previously includible in total contract costs. 
Applying the Federal mid-term rate then in effect, the $1,000 has a 
discounted value at the time of contract completion of $800. X deducts 
this additional $1,000 in expenses in 1992. Based on this increase to 
contract costs, X reapplies the look-back method, and determines the 
following hypothetical underpayments for 1988, 1989 and 1990 for 
purposes of the look-back method:

------------------------------------------------------------------------
                                             1988
                                  --------------------------    Total
                                        D            E
------------------------------------------------------------------------
1988 contract costs..............     $3,000a      $2,000a   ...........
Total contract costs.............     $6,000a      $9,800r   ...........
Total contract price.............    $10,000a     $12,700r   ...........
1988 completion (%)..............         50a        20.4r   ...........
1988 gross income................     $5,000h     $2,592rh   ...........
Less, 1988 costs.................    ($3,000a)    ($2,000a)  ...........
                                  --------------------------------------
      1988 net contract income...     $2,000h        592rh     $2,592rh
Other 1988 net income (loss).....  ...........  ...........    ($2,000a)
                                  --------------------------------------
      Taxable income (NOL).......  ...........  ...........      $592rh
Tax at 34%.......................  ...........  ...........      $201rh
Less, previously computed tax....  ...........  ...........      $279rh
                                  --------------------------------------

[[Page 258]]

 
      Overpayment of 1988 tax....  ...........  ...........      ($78rh)
------------------------------------------------------------------------

    No Contract E costs were incured in 1989, and there is no 
hypothetical underpayment for 1989.

------------------------------------------------------------------------
                                              1990
                                   -------------------------    Total
                                         D           E
------------------------------------------------------------------------
1990 contract costs...............  ..........  ...........     $7,000a
Total contract costs..............  ..........      9,800r   ...........
Total contract price..............  ..........     12,700r   ...........
1990 completion (%)...............  ..........         92a   ...........
1990 gross income.................  ..........     9,071rh   ...........
Less, 1990 costs..................  ..........     (7,000a)  ...........
                                   -------------------------------------
1990 Net contract income..........  ..........     2,071rh     $2,071rh
Other 1990 net income (loss)......  ..........  ...........          0a
                                   -------------------------------------
      Taxable income (NOL)........  ..........  ...........     2,071rh
Tax at 34%........................  ..........  ...........       704rh
Less, previously computed tax.....  ..........  ...........       978rh
                                   -------------------------------------
      Overpayment of 1990 tax.....  ..........  ...........      (274rh)
------------------------------------------------------------------------

    (5) Alternative minimum tax. The operation of the look-back method 
in the case of a taxpayer liable for the alternative minimum tax as 
provided in paragraph (c)(3)(vi) is illustrated by the following 
examples:

    Example (4). Y enters into a long-term contract in 1988 that is 
completed in 1989. Y used regular tax costs for purposes of determining 
the degree of contract completion under the alternative minimum tax.

    (i) Y determines its tax liability for 1988 as follows:

1988 contract costs........................................     $4,000a
Total contract costs.......................................     $8,000e
Total contract price.......................................    $20,000e
1988 completion (%)........................................         50e
1988 gross income..........................................    $10,000a
Less, 1988 contract costs..................................    ($4,000a
                                                            ------------
      1988 net contract income.............................     $6,000a
Other 1988 net income/(loss)...............................    ($3,400a)
Taxable income.............................................     $2,600a
Regular tax at 34%.........................................        884a
Adjustments and preferences to produce alternative minimum        $600a
 taxable income............................................
Alternative minimum taxable income.........................     $3,200a
Tentative minimum tax at 20%...............................        640a
Tax liability..............................................       $884a
 

    In 1989, Y determines the following amounts:

1989 contract costs..........................................    $6,000a
Total contract costs.........................................   $10,000a
Total contract price.........................................   $20,000a
 

    (ii) For purposes of applying the look-back method, Y redetermines 
its tax liability for 1988, which results in a hypothetical overpayment 
of tax. This hypothetical overpayment is determined by comparing Y's 
original regular tax liability for 1988 with the hypothetical total tax 
liability (including alternative minimum tax liability) for that year 
because Y would have paid the alternative minimum tax if Y had used its 
actual contract costs to report income:

1988 contract costs.........................................    $4,000a
Total contract costs........................................   $10,000a
Total contract price........................................   $20,000a
1988 completion(%)..........................................        40a
1988 gross income...........................................    $8,000h
less, 1988 contract costs...................................   ($4,000a)
1988 net contract income....................................    $4,000h
Other 1988 net income/(loss)................................   ($3,400a)
Taxable income..............................................      $600h
Regular tax at 34%..........................................      $204h
Adjustments and preferences to produce alternative minimum        $600a
 taxable income.............................................
Alternative minimum taxable income..........................    $1,200h
Tentative minimum tax at 20%................................       240h
Alternative minimum tax.....................................       $36h
Total tax liability.........................................      $240h
less, previously computed tax...............................      $884a
Underpayment/(overpayment)..................................     ($644h)
 

    (6) Credit carryovers. The operation of the look-back method in the 
case of credit carryovers as provided in paragraph (c)(3)(v) is 
illustrated by the following example:

    Example (5). Z enters into a contract in 1986 that is completed in 
1987. Z determines its tax liability for 1986 as follows:

1986 contract costs..........................................     $400a
Total contract costs.........................................   $1,000e

[[Page 259]]

 
Total contract price.........................................   $2,000e
1986 completion (%)..........................................       40e
1986 gross income............................................     $800a
Less, 1986 costs.............................................    ($400a)
1986 net contract income.....................................     $400a
Other 1986 net income........................................       $0a
Taxable income...............................................     $400a
Tax at 46%...................................................     $184a
Unused tax credits carried forward from 1985 allowable in         $350a
 1986........................................................
Net tax due..................................................       $0a
 

    Z determines the following amounts for 1987:

1987 contract costs..........................................      $400a
Total contract price.........................................    $2,000a
Total contract costs.........................................      $800a
 

    If Z had used actual rather than estimated contract costs in 
determining gross income for 1986, Z would have reported tax liability 
of $276 (46%x$600) rather than $184. However, Z would have paid no 
additional tax for 1986 because its unused tax credits carried forward 
from 1985 would have been sufficient to offset this increased tax 
liability. Therefore, there is no hypothetical underpayment for 1986 for 
purposes of the look-back method. However, this hypothetical earlier use 
of the credit may increase the hypothetical tax liability for 1987 (or 
another subsequent year) for purposes of subsequent applications of the 
look-back method.

    (7) Net operating losses. The operation of the look-back method in 
the case of net operating loss (``NOL'') carryovers as provided in 
paragraph (c)(3)(v) is illustrated by the following example:

    Example (6). A entered into a long-term contract in 1986, which was 
completed in 1987. A determined its tax liability for 1986 as follows:

1986 contract costs.........................................      $400a
Total contract costs........................................    $1,000e
Total contract price........................................    $2,000e
1986 completion (%).........................................        40e
1986 gross income...........................................      $800a
Less, 1986 costs............................................     ($400a)
1986 net contract income....................................      $400a
Other 1986 net income/(loss)................................   ($1,000a)
Taxable income/(NOL)........................................     ($600a)
Tax.........................................................        $0a
 

    A elected to carry this loss forward to 1987 pursuant to section 
172(b)(3)(C).
    For 1987, A determined the following amounts:

1987 contract costs...........................................     $400a
Total contract costs..........................................     $800a
Total contract price..........................................   $2,000a
 

    If actual rather than estimated contract costs had been used in 
determining gross income for 1986, A would have reported $1,000 of gross 
income from the contract rather than $800, and thus would have reported 
a loss of $400 rather than $600. However, since A would have paid no tax 
for 1986 regardless of whether actual or estimated contract costs had 
been used, A does not have an underpayment for 1986 for purposes of the 
look-back method. If A had, instead, carried back the 1986 NOL, and this 
NOL had been absorbed in the tax years 1983 through 1985, it would have 
resulted in refunds of tax for those years in 1986. When A applies the 
look-back method, a hypothetical underpayment of tax would have resulted 
for those years due to a hypothetical reduction in the amount that would 
have been refunded if income had been reported on the basis of actual 
contract costs. See Example (2)(iii).

    (8) Alternative minimum tax credit. The following example 
illustrates the application of the look-back method if affected by the 
alternative minimum tax credit as provided in paragraph (c)(3)(vi):
    (i) Example (4), above illustrates that the reallocation of contract 
income under the look-back method can result in a hypothetical 
underpayment or overpayment determined using the alternative minimum tax 
rate, even though the taxpayer actually paid only the regular tax for 
that year. However, application of the look-back method had no effect on 
the difference between the amount of alternative minimum taxable income 
and the amount of regular taxable income taken into account in that year 
because the taxpayer was required to use the percentage of completion 
method for both regular and alternative minimum tax purposes and used 
the same version of the percentage of completion method for both regular 
and alternative minimum tax purposes (i.e., the taxpayer had made an 
election to use regular tax costs in determining the percentage of 
completion for purposes of computing alternative minimum taxable 
income).
    (ii) The following example illustrates the application of the look-
back method in the case of a taxpayer that does not use the percentage 
of completion method of accounting for long-term contracts in computing 
taxable income for regular tax purposes and thus must make an adjustment 
to taxable income to determine alternative minimum taxable income. The 
example also shows how interest is computed under the look-back method 
when the taxpayer is entitled to a credit under section 53 for minimum 
tax paid because of this adjustment.


[[Page 260]]


    Example (7). X is a taxpayer engaged in the construction of real 
property under contracts that are completed within a 24-month period and 
whose average annual gross receipts do not exceed $10,000,000. As 
permitted by section 460(e)(1)(B), X uses the completed contract method 
(``CCM'') for regular tax purposes. However, X is engaged in the 
construction of commercial real property and, therefore, is required to 
use the percentage of completion method (``PCM'') for alternative 
minimum tax (``AMT'') purposes.
    Assume that for 1988, 1989, and 1990, X has only one long-term 
contract, which is entered into in 1988 and completed in 1990. Assume 
further that X estimates gross income from the contract to be $2,000, 
total contract costs to be $1,000, and that the contract is 25 percent 
complete in 1988 and 75 percent complete in 1989. In 1990, the year of 
completion, the percentage of completion does not change but, upon 
completion, gross income from the contract is actually $3,000, instead 
of $2,000, and costs are actually $1,000.
    For 1988, 1989, and 1990, X's income and tax liability using 
estimated contract price and costs are as follows:

------------------------------------------------------------------------
            Estimates                  1988         1989         1990
------------------------------------------------------------------------
Regular tax:
    Long-term:
        Contract-CCM.............           0            0       $2,000
        Other Income.............           0       $5,000            0
            Total Income.........           0       $5,000       $2,000
Tax @ 34%........................           0       $1,700         $680
AMT
    Gross Income.................        $500       $1,000       $1,500
    Deductions...................       $(250)       $(500)       $(250)
    Total long-term:
        Contract-PCM.............        $250         $500       $1,250
        Other Income.............           0       $5,000            0
            Total Income.........        $250       $5,500       $1,250
Tax @ 20%........................         $50       $1,100         $250
Tentative Minimum Tax............         $50       $1,100         $250
Regular Tax......................           0       $1,700         $680
Minimum Tax Credit...............           0         $(50)           0
    Net Tax Liability............         $50       $1,650         $680
------------------------------------------------------------------------

    When X files its tax return for 1990, X applies the look-back method 
to the contract. For 1988, 1989, and 1990, X's income and tax liability 
using actual contract price and costs are as follows:

------------------------------------------------------------------------
              Actual                   1988         1989         1990
------------------------------------------------------------------------
Regular tax:
    Long-term:
        Contract-CCM.............           0            0       $2,000
        Other Income.............           0       $5,000            0
            Total Income.........           0       $5,000       $2,000
Tax @ 34%........................           0       $1,700         $680
AMT
    Gross Income.................        $750       $1,500         $750
    Deductions...................       $(250)       $(500)       $(250)
    Total long-term:
        Contract-PCM.............        $500       $1,000         $500
        Other Income.............           0       $5,000            0
            Total Income.........        $500       $6,000         $500
Tax @ 20%........................        $100       $1,200         $100
Tentative Minimum Tax............        $100       $1,200         $100
Regular Tax......................           0       $1,700         $680
Minimum Tax Credit...............           0        $(100)           0
    Net Tax Liability............        $100       $1,600         $680
Underpayment.....................         $50
Overpayment......................  ...........         $50
------------------------------------------------------------------------

    As shown above, application of the look-back method results in a 
hypothetical underpayment of $50 for 1988 because X was subject to the 
alternative minimum tax for that year. Interest is charged to X on this 
$50 underpayment from the due date of X's 1988 return until the due date 
of X's 1990 return.
    In 1989, although X was required to compute alternative minimum 
taxable income using the percentage of completion method,

[[Page 261]]

X was not required to pay alternative minimum tax. Nevertheless, the 
look-back method must be applied to 1989 because use of actual rather 
than estimated contract price in computing alternative minimum taxable 
income for 1988 would have changed the amount of the alternative minimum 
tax credit carried to 1989. Interest is paid to X on the resulting $50 
overpayment from the due date of X's 1989 return until the due date of 
X's 1990 return.

    (9) Period for interest. The following Examples (8) through (11) 
illustrate how to determine the period for computing interest as 
provided in paragraph (c)(4):

    Example (8). The facts are the same as in Example (6), except that 
the contract is completed in 1988, and A determined the following 
amounts for 1987 and 1988:

For 1987:
  1987 contract costs.......................................          0
  Total contract costs......................................    $1,000e
  Total contract price......................................    $2,000e
  1987 completion (%).......................................       $40e
  1987 gross income.........................................         0a
  Less, 1987 costs..........................................         0a
  Other 1987 net income.....................................      $600a
  Net operating loss carryforward from 1986.................     $(600a)
  Taxable income............................................         0a
  Tax.......................................................         0a
For 1988:
  1988 contract costs.......................................      $400a
  Total contract costs......................................      $800a
  Total contract price......................................    $2,000a
 

    If actual rather than estimated contract costs had been used in 
determining gross income for 1986, A would have reported $1,000 of gross 
income from the contract for 1986 rather than $800, and would have 
reported a net operating loss carryforward to 1987 of $400 rather than 
$600. Therefore, A would have reported taxable income of $200, and would 
have paid tax of $80 (i.e., $200x40%) for 1987. The due date for filing 
A's Federal income tax return for its 1988 taxable year is March 15. A 
obtains an extension and files its 1988 return on September 15, 1989. 
Under the look-back method, A is required to pay interest on the amount 
of this hypothetical underpayment ($80) computed from the due date 
(determined without regard to extensions) for A's return for 1987 (not 
1986, even though 1986 was the year in which the net operating loss 
arose) until March 15 (not September 15), the due date (without regard 
to extensions) of A's return for 1988. A is required to pay additional 
interest from March 15 until September 15 on the amount of interest 
outstanding as of March 15 with respect to the hypothetical underpayment 
of $80.
    Example (9). The facts are the same as in Example (6), except that A 
carries the net operating loss of $600 back to 1983 rather than forward 
to 1987, and receives a refund of $276 ($600 reduction in 1983 taxable 
income x 46% rate in effect in 1983). As in Example (6), if actual 
contract costs had been used, A would have reported a loss for 1986 of 
$400 rather than $600. Thus, A would have received a refund of 1983 tax 
of $184 ($400x46%) rather than $276. Under the look-back method A is 
required to pay interest on the difference in these two amounts ($92) 
computed from the due date (determined without regard to extensions) of 
A's return for 1986 (the year in which the carryback arose rather than 
1983, the year in which it was used) until the due date of A's return 
for 1988.
    Example (10). B enters into a long-term contract in 1986 that is 
completed in 1988. B determines its 1986 tax liability as follows:

1986 contract costs..........................................     $400a
Total contract costs.........................................   $1,000e
Total contract price.........................................   $2,000e
1986 completion (%)..........................................       40e
1986 gross income............................................     $800a
Less, 1986 costs.............................................    ($400a)
1986 net contract income.....................................     $400a
Other 1986 net income........................................   $2,000a
Taxable income...............................................   $2,400a
Tax at 46%...................................................   $1,104a
     B determines its tax liability for 1987 as follows:
1987 contract costs..........................................     $400a
Total contract costs.........................................   $1,600e
Total contract price.........................................   $2,000e
1987 completion (%)..........................................       50e
1987 gross income............................................     $200a
(=(50%x$2,000)-$800 previously reported) less, 1987 costs....    ($400a)
1987 net contract income.....................................    ($200a)
Other 1987 net income/(loss).................................  ($2,200a)
Taxable income (NOL).........................................  ($2,400a)
Tax..........................................................        0a
 

    Assume that B had no taxable income in either 1984 or 1985, so that 
the entire amount of the $2,400 net operating loss is carried back to 
1986, and B receives a refund, with interest from the due date of B's 
1987 return, of the entire $1,104 in tax that it paid for 1986.
    In 1988, B determines the following amounts:

1988 contract costs...........................................     $800a
Total contract costs..........................................   $1,600a
Total contract price..........................................   $2,000a
 

    If B had used actual contract costs rather than estimated costs in 
determining its gross income for 1986, B would have had gross income 
from the contract of $500 rather than $800, and thus would have had 
taxable income of $2,100 rather than $2,400, and would have paid tax of 
$966 rather than $1,104. B is entitled to receive interest on the 
difference between these two amounts, the hypothetical overpayment of 
tax of $138. Interest is computed from the due date (without regard to 
extensions) of B's return for 1986 until the due date for B's return for 
1987. Interest stops running at this date, because B's hypothetical 
overpayment of tax ended when B filed its original 1987 return and 
received a refund for the carryback to 1986, and interest on this refund 
began to run only from the

[[Page 262]]

due date of B's 1987 return. See section 6611(f).
    Example (11). C enters into a long-term contract in 1986, its first 
year in business, which is completed in 1988. C determines its tax 
liability for 1986 as follows:

1986 contract costs.........................................      $400a
Total contract costs........................................    $1,000e
Total contract price........................................    $2,000e
1986 completion (%).........................................        40e
1986 gross income...........................................      $800a
less, 1986 costs............................................     ($400a)
1986 net contract income....................................      $400a
Other 1986 net income.......................................    $2,000a
Taxable income (NOL)........................................    $2,400a
Tax at 46%..................................................    $1,104a
 

    C determines its tax liability for 1987 as follows:

1987 contract costs.........................................      $400a
Total contract costs........................................    $1,066e
Total contract price........................................    $2,000e
1987 completion (%).........................................        75e
1987 gross income...........................................      $700a
Less, 1987 costs............................................     ($400a)
1987 net contract income....................................      $300a
Other 1987 net income.......................................   ($2,450a)
Taxable income (NOL)........................................   ($2,150a)
Tax.........................................................       $10a
 

    C carries back the net operating loss to 1986, and files an amended 
return for 1986, showing taxable income of $250, and receives a refund 
of $989 (46%x$2,150). Interest on this refund begins to run only as of 
the due date of C's 1987 return. See section 6611(f).
    In 1988, when the contract is completed, C determines the following 
amounts:

1988 contract costs.........................................      $800a
Total contract costs........................................    $1,600a
Total contract price........................................    $2,000a
 

    If C had used actual contract price and contract costs in 
determining gross income for 1986, it would have reported gross income 
from the contract of $500 rather than $800, taxable income of $2,100 
rather than $2,400, and tax liability of $966 rather than $1,104.
    If C had used actual contract price and contract costs in 
determining gross income for 1987, it would have reported gross income 
from the contract of $500 rather than $700, and would have reported a 
net operating loss of $2,350, rather than $2,150, which would have been 
carried back to 1986.
    Under the look-back method, C receives interest with respect to a 
total 1986 hypothetical overpayment of $138 ($1,104 minus $966). C is 
credited with interest on $23 of this amount only from the due date of 
C's 1986 return until the due date of C's 1987 tax return, because this 
portion of C's total hypothetical overpayment for 1986 was refunded to C 
with interest computed from the due date of C's 1987 return and, 
therefore, was no longer held by the government. However, because the 
remainder of the total hypothetical overpayment of $115 was not refunded 
to C, C is credited with interest on this amount from the due date of 
C's 1986 return until the due date of C's 1988 tax return.
    Under the look-back method, C receives no interest with respect to 
1987, because C had no tax liability for 1987 using either estimated or 
actual contract price and costs.

    (i) [Reserved]
    (j) Election not to apply look-back method in de minimis cases. 
Section 460(b)(6) provides taxpayers with an election not to apply the 
look-back method to long-term contracts in de minimis cases, effective 
for contracts completed in taxable years ending after August 5, 1997. To 
make an election, a taxpayer must attach a statement to its timely filed 
original federal income tax return (including extensions) for the 
taxable year the election is to become effective or to an amended return 
for that year, provided the amended return is filed on or before March 
31, 998. This statement must have the legend ``NOTIFICATION OF ELECTION 
UNDER SECTION 460(b)(6)''; provide the taxpayer's name and identifying 
number and the effective date of the election; and identify the trades 
or businesses that involve long-term contracts. An election applies to 
all long-term contracts completed during and after the taxable year for 
which the election is effective. An election may not be revoked without 
the Commissioner's consent. For taxpayers who elected to use the delayed 
reapplication method under paragraph (e) of this section, an election 
under this paragraph (j) automatically revokes the election to use the 
delayed reapplication method for contracts subject to section 460(b)(6). 
A consolidated group of corporations, as defined in Sec. 1.1502-1(h), 
is subject to consistency rules analogous to those in paragraph (e)(2) 
of this section and in paragraph (d)(4)(ii)(C) of this section 
(concerning election to use simplified marginal impact method).

[T.D. 8315, 55 FR 41670, Oct. 15, 1990, as amended by T.D. 8775, 63 FR 
36181, July 2, 1998; T.D. 8929, 66 FR 2240, Jan. 11, 2001; T.D. 8995, 67 
FR 34609, May 15, 2002; T.D. 9137, 69 FR 42558, July 16, 2004]

[[Page 263]]

                 taxable year for which deductions taken



Sec. 1.461-0  Table of contents.

    This section lists the captions that appear in the regulations under 
section 461 of the Internal Revenue Code.

        Sec. 1.461-1 General rule for taxable year of deduction.

    (a) General rule.
    (1) Taxpayer using cash receipts and disbursements method.
    (2) Taxpayer using an accrual method.
    (3) Effect in current taxable year of improperly accounting for a 
liability in a prior taxable year.
    (4) Deductions attributable to certain foreign income.
    (b) Special rule in case of death.
    (c) Accrual of real property taxes.
    (1) In general.
    (2) Special rules.
    (3) When election may be made.
    (4) Binding effect of election.
    (5) Apportionment of taxes on real property between seller and 
purchaser.
    (6) Examples.
    (d) Limitation on acceleration of accrual of taxes.
    (e) Dividends or interest paid by certain savings institutions on 
certain deposits or withdrawable accounts.
    (1) Deduction not allowable.
    (2) Computation of amounts not allowed as a deduction.
    (3) When amounts allowable.

                  Sec. 1.461-2 Contested liabilities.

    (a) General rule.
    (1) Taxable year of deduction.
    (2) Exception.
    (3) Refunds includible in gross income.
    (4) Examples.
    (5) Liabilities described in paragraph (g) of Sec. 1.461-4. 
[Reserved]
    (b) Contest of asserted liability.
    (1) Asserted liability.
    (2) Definition of the term ``contest.''
    (3) Example.
    (c) Transfer to provide for the satisfaction of an asserted 
liability.
    (1) In general.
    (2) Examples.
    (d) Contest exists after transfer.
    (e) Deduction otherwise allowed.
    (1) In general.
    (2) Example.
    (f) Treatment of money or property transferred to an escrowee, 
trustee, or court and treatment of any income attributable thereto. 
[Reserved]
    (g) Effective dates.

               Sec. 1.461-3 Prepaid interest. [Reserved]

                   Sec. 1.461-4 Economic performance.

    (a) Introduction.
    (1) In general.
    (2) Overview.
    (b) Exceptions to the economic performance requirement.
    (c) Definitions.
    (1) Liability.
    (2) Payment.
    (d) Liabilities arising out of the provision of services, property, 
or the use of property.
    (1) In general.
    (2) Services or property provided to the taxpayer.
    (3) Use of property provided to the taxpayer.
    (4) Services or property provided by the taxpayer.
    (5) Liabilities that are assumed in connection with the sale of a 
trade or business.
    (6) Rules relating to the provision of services or property to a 
taxpayer.
    (7) Examples.
    (e) Interest.
    (f) Timing of deductions from notional principal contracts.
    (g) Certain liabilities for which payment is economic performance.
    (1) In general.
    (2) Liabilities arising under a workers compensation act or out of 
any tort, breach of contract, or violation of law.
    (3) Rebates and refunds.
    (4) Awards, prizes, and jackpots.
    (5) Insurance, warranty, and service contracts.
    (6) Taxes.
    (7) Other liabilities.
    (8) Examples.
    (h) Liabilities arising under the Nuclear Waste Policy Act of 1982.
    (i) [Reserved]
    (j) Contingent liabilities. [Reserved]
    (k) Special effective dates.
    (1) In general.
    (2) Long-term contracts.
    (3) Payment liabilities.
    (l) [Reserved]
    (m) Change in method of accounting required by this section.
    (1) In general.
    (2) Change in method of accounting for long-term contracts and 
payment liabilities.

                 Sec. 1.461-5 Recurring item exception.

    (a) In general.
    (b) Requirements for use of the exception.
    (1) General rule.
    (2) Amended returns.
    (3) Liabilities that are recurring in nature.
    (4) Materiality requirement.
    (5) Matching requirement.
    (c) Types of liabilities not eligible for treatment under the 
recurring item exception.

[[Page 264]]

    (d) Time and manner of adopting the recurring item exception.
    (1) In general.
    (2) Change to the recurring item exception method for the first 
taxable year beginning after December 31, 1991.
    (3) Retroactive change to the recurring item exception method.
    (e) Examples.

Sec. 1.461-6 Economic performance when certain liabilities are assigned 
           or are extinguished by the establishment of a fund.

    (a) Qualified assignments of certain personal injury liabilities 
under section 130.
    (b) Section 468B.
    (c) Payments to other funds or persons that constitute economic 
performance. [Reserved]
    (d) Effective dates.

[T.D. 8408, 57 FR 12420, Apr. 10, 1992, as amended by T.D. 8593, 60 FR 
18743, Apr. 13, 1995]



Sec. 1.461-1  General rule for taxable year of deduction.

    (a) General rule--(1) Taxpayer using cash receipts and disbursements 
method. Under the cash receipts and disbursements method of accounting, 
amounts representing allowable deductions shall, as a general rule, be 
taken into account for the taxable year in which paid. Further, a 
taxpayer using this method may also be entitled to certain deductions in 
the computation of taxable income which do not involve cash 
disbursements during the taxable year, such as the deductions for 
depreciation, depletion, and losses under sections 167, 611, and 165, 
respectively. If an expenditure results in the creation of an asset 
having a useful life which extends substantially beyond the close of the 
taxable year, such an expenditure may not be deductible, or may be 
deductible only in part, for the taxable year in which made. An example 
is an expenditure for the construction of improvements by the lessee on 
leased property where the estimated life of the improvements is in 
excess of the remaining period of the lease. In such a case, in lieu of 
the allowance for depreciation provided by section 167, the basis shall 
be amortized ratably over the remaining period of the lease. See section 
178 and the regulations thereunder for rules governing the effect to be 
given renewal options in determining whether the useful life of the 
improvements exceeds the remaining term of the lease where a lessee 
begins improvements on leased property after July 28, 1958, other than 
improvements which on such date and at all times thereafter, the lessee 
was under a binding legal obligation to make. See section 263 and the 
regulations thereunder for rules relating to capital expenditures. See 
section 467 and the regulations thereunder for rules under which a 
liability arising out of the use of property pursuant to a section 467 
rental agreement is taken into account.
    (2) Taxpayer using an accrual method--(i) In general. Under an 
accrual method of accounting, a liability (as defined in Sec. 1.446-
1(c)(1)(ii)(B)) is incurred, and generally is taken into account for 
Federal income tax purposes, in the taxable year in which all the events 
have occurred that establish the fact of the liability, the amount of 
the liability can be determined with reasonable accuracy, and economic 
performance has occurred with respect to the liability. (See paragraph 
(a)(2)(iii)(A) of this section for examples of liabilities that may not 
be taken into account until a taxable year subsequent to the taxable 
year incurred, and see Sec. Sec. 1.461-4 through 1.461-6 for rules 
relating to economic performance.) Applicable provisions of the Code, 
the Income Tax Regulations, and other guidance published by the 
Secretary prescribe the manner in which a liability that has been 
incurred is taken into account. For example, section 162 provides that 
the deductible liability generally is taken into account in the taxable 
year incurred through a deduction from gross income. As a further 
example, under section 263 or 263A, a liability that relates to the 
creation of an asset having a useful life extending substantially beyond 
the close of the taxable year is taken into account in the taxable year 
incurred through capitalization (within the meaning of Sec. 1.263A-
1(c)(3)), and may later affect the computation of taxable income through 
depreciation or otherwise over a period including subsequent taxable 
years, in accordance with applicable Internal Revenue Code sections and 
guidance published by the Secretary. The principles of this

[[Page 265]]

paragraph (a)(2) also apply in the calculation of earnings and profits 
and accumulated earnings and profits.
    (ii) Uncertainty as to the amount of a liability. While no liability 
shall be taken into account before economic performance and all of the 
events that fix the liability have occurred, the fact that the exact 
amount of the liability cannot be determined does not prevent a taxpayer 
from taking into account that portion of the amount of the liability 
which can be computed with reasonable accuracy within the taxable year. 
For example, A renders services to B during the taxable year for which A 
charges $10,000. B admits a liability to A for $6,000 but contests the 
remainder. B may take into account only $6,000 as an expense for the 
taxable year in which the services were rendered.
    (iii) Alternative timing rules. (A) If any provision of the Code 
requires a liability to be taken into account in a taxable year later 
than the taxable year provided in paragraph (a)(2)(i) of this section, 
the liability is taken into account as prescribed in that Code 
provision. See, for example, section 267 (transactions between related 
parties) and section 464 (farming syndicates).
    (B) If the liability of a taxpayer is subject to section 170 
(charitable contributions), section 192 (black lung benefit trusts), 
section 194A (employer liability trusts), section 468 (mining and solid 
waste disposal reclamation and closing costs), or section 468A (certain 
nuclear decommissioning costs), the liability is taken into account as 
determined under that section and not under section 461 or the 
regulations thereunder. For special rules relating to certain loss 
deductions, see sections 165(e), 165(i), and 165(l), relating to theft 
losses, disaster losses, and losses from certain deposits in qualified 
financial institutions.
    (C) Section 461 and the regulations thereunder do not apply to any 
amount allowable under a provision of the Code as a deduction for a 
reserve for estimated expenses.
    (D) Except as otherwise provided in any Internal Revenue 
regulations, revenue procedure, or revenue ruling, the economic 
performance requirement of section 461(h) and the regulations thereunder 
is satisfied to the extent that any amount is otherwise deductible under 
section 404 (employer contributions to a plan of deferred compensation), 
section 404A (certain foreign deferred compensation plans), or section 
419 (welfare benefit funds). See Sec. 1.461-4(d)(2)(iii).
    (E) Except as otherwise provided by regulations or other published 
guidance issued by the Commissioner (See Sec. 601.601(b)(2) of this 
chapter), in the case of a liability arising out of the use of property 
pursuant to a section 467 rental agreement, the all events test 
(including economic performance) is considered met in the taxable year 
in which the liability is to be taken into account under section 467 and 
the regulations thereunder.
    (3) Effect in current taxable year of improperly accounting for a 
liability in a prior taxable year. Each year's return should be complete 
in itself, and taxpayers shall ascertain the facts necessary to make a 
correct return. The expenses, liabilities, or loss of one year generally 
cannot be used to reduce the income of a subsequent year. A taxpayer may 
not take into account in a return for a subsequent taxable year 
liabilities that, under the taxpayer's method of accounting, should have 
been taken into account in a prior taxable year. If a taxpayer 
ascertains that a liability should have been taken into account in a 
prior taxable year, the taxpayer should, if within the period of 
limitation, file a claim for credit or refund of any overpayment of tax 
arising therefrom. Similarly, if a taxpayer ascertains that a liability 
was improperly taken into account in a prior taxable year, the taxpayer 
should, if within the period of limitation, file an amended return and 
pay any additional tax due. However, except as provided in section 
905(c) and the regulations thereunder, if a liability is properly taken 
into account in an amount based on a computation made with reasonable 
accuracy and the exact amount of the liability is subsequently 
determined in a later taxable year, the difference, if any, between such 
amounts shall be taken into account for the later taxable year.
    (4) Deductions attributable to certain foreign income. In any case 
in which,

[[Page 266]]

owing to monetary, exchange, or other restrictions imposed by a foreign 
country, an amount otherwise constituting gross income for the taxable 
year from sources without the United States is not includible in gross 
income of the taxpayer for that year, the deductions and credits 
properly chargeable against the amount so restricted shall not be 
deductible in such year but shall be deductible proportionately in any 
subsequent taxable year in which such amount or portion thereof is 
includible in gross income. See paragraph (b) of Sec. 1.905-1 for rules 
relating to credit for foreign income taxes when foreign income is 
subject to exchange controls.
    (b) Special rule in case of death. A taxpayer's taxable year ends on 
the date of his death. See section 443(a)(2) and paragraph (a)(2) of 
Sec. 1.443-1. In computing taxable income for such year, there shall be 
deducted only amounts properly deductible under the method of accounting 
used by the taxpayer. However, if the taxpayer used an accrual method of 
accounting, no deduction shall be allowed for amounts accrued only by 
reason of his death. For rules relating to the inclusion of items of 
partnership deduction, loss, or credit in the return of a decedent 
partner, see subchapter K, chapter 1 of the Code, and the regulations 
thereunder.
    (c) Accrual of real property taxes--(1) In general. If the accrual 
of real property taxes is proper in connection with one of the methods 
of accounting described in section 446(c), any taxpayer using such a 
method of accounting may elect to accrue any real property tax, which is 
related to a definite period of time, ratably over that period in the 
manner described in this paragraph. For example, assume that such an 
election is made by a calendar-year taxpayer whose real property taxes, 
applicable to the period from July 1, 1955, to June 30, 1956, amount to 
$1,200. Under section 461(c), $600 of such taxes accrue in the calendar 
year 1955, and the balance accrues in 1956. For special rule in the case 
of certain contested real property taxes in respect of which the 
taxpayer transfers money or other property to provide for the 
satisfaction of the contested tax, see Sec. 1.461-2. For general rules 
relating to deductions for taxes, see section 164 and the regulations 
thereunder.
    (2) Special rules--(i) Effective date. Section 461(c) and this 
paragraph do not apply to any real property tax allowable as a deduction 
under the Internal Revenue Code of 1939 for any taxable year beginning 
before January 1, 1954.
    (ii) If real property taxes which relate to a period prior to the 
taxpayer's first taxable year beginning on or after January 1, 1954, 
would, but for section 461(c), be deductible in such first taxable year, 
the portion of such taxes which applies to the prior period is 
deductible in such first taxable year (in addition to the amount 
allowable under section 461(c)(1)).
    (3) When election may be made--(i) Without consent. A taxpayer may 
elect to accrue real property taxes ratably in accordance with section 
461(c) and this paragraph without the consent of the Commissioner for 
his first taxable year beginning after December 31, 1953, and ending 
after August 16, 1954, in which the taxpayer incurs real property taxes. 
Such election must be made not later than the time prescribed by law for 
filing the return for such year (including extensions thereof). An 
election may be made by the taxpayer for each separate trade or business 
(and for nonbusiness activities, if accounted for separately). Such an 
election shall apply to all real property taxes of the trade, business, 
or nonbusiness activity for which the election is made. The election 
shall be made in a statement submitted with the taxpayer's return for 
the first taxable year to which the election is applicable. The 
statement should set forth:
    (a) The trades or businesses, or nonbusiness activity, to which the 
election is to apply, and the method of accounting used therein;
    (b) The period of time to which the taxes are related; and
    (c) The computation of the deduction for real property taxes for the 
first year of the election (or a summary of such computation).
    (ii) With consent. A taxpayer may elect with the consent of the 
Commissioner to accrue real property taxes ratably in accordance with 
section 461

[[Page 267]]

(c) and this paragraph. A written request for permission to make such an 
election shall be submitted to the Commissioner of Internal Revenue, 
Washington, D.C. 20224, within 90 days after the beginning of the 
taxable year to which the election is first applicable, or before March 
26, 1958, whichever date is later. The request for permission shall 
state:
    (a) The name and address of the taxpayer;
    (b) The trades or businesses, or nonbusiness activity, to which the 
election is to apply, and the method of accounting used therein;
    (c) The taxable year to which the election first applies;
    (d) The period to which the real property tax relate;
    (e) The computation of the deduction for real property taxes for the 
first year of election (or a summary of such computation); and
    (f) An adequate description of the manner in which all real property 
taxes were deducted in the year prior to the year of election.
    (4) Binding effect of election. An election to accrue real property 
taxes ratably under section 461(c) is binding upon the taxpayer unless 
the consent of the Commissioner is obtained under section 446(e) and 
paragraph (e) of Sec. 1.446-1 to change such method of deducting real 
property taxes. If the last day prescribed by law for filing a return 
for any taxable year (including extensions thereof) to which section 
461(c) is applicable falls before March 25, 1958, consent is hereby 
given for the taxpayer to revoke an election previously made to accrue 
real property taxes in the manner prescribed by section 461(c). If the 
taxpayer revokes his election under the preceding sentence, he must, on 
or before March 25, 1958, notify the district director for the district 
in which the return was filed of such revocation. For any taxable year 
for which such revocation is applicable, an amended return reflecting 
such revocation shall be filed on or before March 25, 1958.
    (5) Apportionment of taxes on real property between seller and 
purchaser. For apportionment of taxes on real property between seller 
and purchaser, see section 164(d) and the regulations thereunder.
    (6) Examples. The provisions of this paragraph are illustrated by 
the following examples:

    Example (1). A taxpayer on an accrual method reports his taxable 
income for the taxable year ending June 30. He elects to accrue real 
property taxes ratably for the taxable year ending June 30, 1955 (which 
is his first taxable year beginning on or after January 1, 1954). In the 
absence of an election under section 461(c), such taxes would accrue on 
January 1 of the calendar year to which they are related. The real 
property taxes are $1,200 for 1954; $1,600 for 1955; and $1,800 for 
1956. Deductions for such taxes for the fiscal years ending June 30, 
1955, and June 30, 1956, are computed as follows:

                    Fiscal year ending June 30, 1955
July through December 1954.....................................      \1\
                                                                    None
January through June 1955 (\6/12\ of $1,600)...................     $800
  Deduction for fiscal year ending June 30, 1955...............      800
 
\1\ The taxes for 1954 were deductible in the fiscal year ending June
  30, 1954, since such taxes accrued on January 1, 1954.


                    Fiscal year ending June 30, 1956
July through December 1955 (\6/12\ of $1,600)..................     $800
January through June 1956 (\6/12\ of $1,800)...................      900
                                                                --------
  Deduction for fiscal year ending June 30, 1956...............    1,700
 

    Example (2). A calendar-year taxpayer on an accrual method elects to 
accrue real property taxes ratably for 1954. In the absence of an 
election under section 461(c), such taxes would accrue on July 1 and are 
assessed for the 12-month period beginning on that date. The real 
property taxes assessed for the year ending June 30, 1954, are $1,200; 
$1,600 for the year ending June 30, 1955; and $1,800 for the year ending 
June 30, 1956. Deductions for such taxes for the calendar years 1954 and 
1955 are computed as follows:

                      Year ending December 31, 1954
January through June 1954......................................      \1\
                                                                    None
July through December 1954 (\6/12\ of $1,600)..................     $800
                                                                --------
  Deduction for year ending December 31, 1954..................      800
 
\1\ The entire tax of $1,200 for the year ended June 30, 1954, was
  deductible in the return for 1953, since such tax accrued on July 1,
  1953.


                      Year ending December 31, 1955
January through June 1955 (\6/12\ of $1,600)...................     $800
July through December 1955 (\6/12\ of $1,800)..................      900
                                                                --------
  Deduction for year ending December 31, 1955..................    1,700
 

    Example (3). A calendar-year taxpayer on an accrual method elects to 
accrue real property taxes ratably for 1954. In the absence of an 
election under section 461(c), such taxes, which relate to the calendar 
year 1954, are accruable on December 1 of the preceding calendar year. 
No deduction for real property

[[Page 268]]

taxes is allowable for the taxable year 1954 since such taxes accrued in 
the taxable year 1953 under section 23(c) of the Internal Revenue Code 
of 1939.
    Example (4). A taxpayer on an accrual method reports his taxable 
income for the taxable year ending March 31. He elects to accrue real 
property taxes ratably for the taxable year ending March 31, 1955. In 
the absence of an election under section 461(c), such taxes are 
accruable on June 1 of the calendar year to which they relate. The real 
property taxes are $1,200 for 1954; $1,600 for 1955; and $1,800 for 
1956. Deductions for such taxes for the taxable years ending March 31, 
1955, and March 31, 1956, are computed as follows:

                    Fiscal year ending March 31, 1955
April through December 1954 (\9/12\ of $1,200).................     $900
January through March 1955 (\3/12\ of $1,600)..................      400
                                                                --------
  Taxes accrued ratably in fiscal year ending March 31, 1955...    1,800
Tax relating to period January through March 1954, paid in June      300
 1954, and not deductible in prior taxable year (\9/12\ of
 $1,200).......................................................
                                                                --------
  Deduction for fiscal year ending March 31, 1955..............    1,600
                                                                ========
 


                    Fiscal year ending March 31, 1956
April through December 1955 (\9/12\ of $1,600).................   $1,200
January through March 1956 (\3/12\ of $1,800)..................      450
                                                                --------
  Deduction for fiscal year ending March 31, 1956..............    1,650
 

    Example (5). The facts are the same as in example (4) except that in 
June 1955, when the taxpayer pays his $1,600 real property taxes for 
1955, he pays $400 of such amount under protest. Deductions for taxes 
for the taxable years ending March 31, 1955, and March 31, 1956, are 
computed as follows:

                    Fiscal year ending March 31, 1955
April through December 1954 (\9/12\ of $1,200).................     $900
January through March 1955 (\3/12\ of $1,200, that is, $1,600        300
 minus $400 (the contested portion which is not properly
 accruable))...................................................
                                                                --------
  Taxes accrued ratably in fiscal year ending March 31, 1955...    1,200
 
Tax relating to period January through March 1954, paid in June      300
 1954, and not deductible in prior taxable years (\3/12\ of
 $1,200).......................................................
                                                                --------
  Deduction for fiscal year ending March 31, 1955..............    1,500
                                                                ========
 


                    Fiscal year ending March 31, 1956
April through December 1955 (\9/12\ of $1,200).................     $900
January through March 1956 (\3/12\ of $1,800)..................      450
                                                                --------
  Taxes accrued ratably in fiscal year ending March 31, 1956...    1,350
Contested portion of tax relating to period January through          400
 December 1955, paid in June 1955, and deductible, under
 section 461(f), for taxpayer's fiscal year ending March 31,
 1956..........................................................
                                                                --------
  Deduction for fiscal year ending March 31, 1956..............    1,750
                                                                ========
 

    (d) Limitation on acceleration of accrual of taxes. (1) Section 
461(d)(1) provides that, in the case of a taxpayer whose taxable income 
is computed under an accrual method of accounting, to the extent that 
the time for accruing taxes is earlier than it would be but for any 
action of any taxing jurisdiction taken after December 31, 1960, such 
taxes are to be treated as accruing at the time they would have accrued 
but for such action. Any such action which, but for the provisions of 
section 461(d) and this paragraph, would accelerate the time for 
accruing a tax is to be disregarded in determining the time for accruing 
such tax for purposes of the deduction allowed for such tax. Such action 
is to be disregarded not only with respect to a taxpayer (whose taxable 
income is computed under an accrual method of accounting) upon whom the 
tax is imposed at the time of the action, but also with respect to such 
a taxpayer upon whom the tax is imposed at any time subsequent to such 
action. Thus, in the case of a tax imposed on property, the acceleration 
of the time for accruing taxes is to be disregarded not only with 
respect to the taxpayer who owned the property at the time of such 
acceleration, but also with respect to any subsequent owner of the 
property whose taxable income is computed under an accrual method of 
accounting. Similarly, such action is to be disregarded with respect to 
all property subject to such tax, even if such property is acquired 
after the action. Whenever the time for accruing taxes is to be 
disregarded in accordance with the provisions of this paragraph, the 
taxpayer shall accrue the tax at the time (original accrual date) the 
tax would have accrued but for such action, and shall, in the absence of 
any action of the taxing jurisdiction placing the time for accruing such 
tax at a time subsequent to the original accrual date, continue to 
accrue the tax as of

[[Page 269]]

the original accrual date for all future taxable years.
    (2) For purposes of this paragraph--
    (i) The term ``a taxpayer whose taxable income is computed under an 
accrual method of accounting'' means a taxpayer who, for Federal income 
tax purposes, accounts for any tax which is the subject of ``any 
action'' (as defined in subdivision (iii) of this subparagraph) under an 
accrual method of accounting. See section 446 and the regulations 
thereunder. If a taxpayer uses an accrual method as his overall method 
of accounting, it shall be presumed that he is ``a taxpayer whose 
taxable income is computed under an accrual method of accounting.'' 
However, if the taxpayer establishes to the satisfaction of the district 
director that he has, for Federal income tax purposes, consistently 
accounted for such tax under the cash method of accounting, he shall be 
considered not to be ``a taxpayer whose taxable income is computed under 
an accrual method of accounting.''
    (ii) The time for accruing taxes shall be determined under section 
461 and the regulations in this section.
    (iii) The term ``any action'' includes the enactment or reenactment 
of legislation, the adoption of an ordinance, the exercise of any taxing 
or administrative authority, or the taking of any other step, the result 
of which is an acceleration of the accrual event of any tax. The term 
also applies to the substitution of a substantially similar tax by 
either the original taxing jurisdiction or a substitute jurisdiction. 
However, the term does not include either a judicial interpretation, or 
an administrative determination by the Internal Revenue Service, as to 
the event which fixes the accrual date for the tax.
    (iv) The term ``any taxing jurisdiction'' includes the District of 
Columbia, any State, possession of the United States, city, county, 
municipality, school district, or other political subdivision or 
authority, other than the United States, which imposes, assesses, or 
collects a tax.
    (3) The provisions of this paragraph may be illustrated by the 
following examples:

    Example (1). State X imposes a tax on intangible and tangible 
personal property used in a trade or business conducted in the State. 
The tax is assessed as of July 1, and becomes a lien as of that date. As 
a result of administrative and judicial decisions, July 1 is recognized 
as the proper date on which accrual method taxpayers may accrue their 
personal property tax for Federal income tax purposes. In 1961 State X, 
by legislative action, changes the assessment and lien dates from July 
1, 1962, to December 31, 1961, for the property tax year 1962. The 
action taken by State X is considered to be ``any action'' of a taxing 
jurisdiction which results in the time for accruing taxes being earlier 
than it would have been but for that action. Therefore, for purposes of 
the deduction allowed for such tax, the personal property tax imposed by 
State X, for the property tax year 1962, shall be treated as though it 
accrued on July 1, 1962.
    Example (2). Assume the same facts as in example (1) except that 
State X repeals the personal property tax and in lieu thereof enacts a 
franchise tax which is imposed on the privilege of conducting a trade or 
business within State X, and is based on the value of intangible and 
tangible personal property used in the trade or business. The franchise 
tax is to be assessed and will become a lien as of December 31, 1961, 
for the franchise tax year 1962, and on December 31 for all subsequent 
franchise tax years. Since the franchise tax is substantially similar to 
the former personal property tax and since the enactment of the 
franchise tax has the effect of accelerating the accrual date of the 
personal property tax from July 1, 1962, to December 31, 1961, the 
action taken by State X is considered to be ``any action'' of a taxing 
jurisdiction which results in the time for accruing taxes being earlier 
than it would have been but for that action. Therefore, for purposes of 
the deduction allowed for such tax, the franchise tax imposed by State X 
shall be treated as though it accrued on July 1, 1962, for the franchise 
tax year 1962, and on July 1 for all subsequent franchise tax years.
    Example (3). Assume the same facts as in example (1) except that 
State X repealed the personal property tax and empowered the counties 
within the State to impose a personal property tax. Assuming the 
counties in State X subsequently imposed a personal property tax and 
chose December 31 of the preceding year as the assessment and lien date, 
the action of each of the counties would be considered to be ``any 
action'' of a taxing jurisdiction which results in the time for accruing 
taxes being earlier than it would have been but for that action since it 
is immaterial whether the original taxing jurisdiction or a substitute 
jurisdiction took the action.

    (4) Section 461(d)(1) shall not be applicable to the extent that it 
would prevent the taxpayer and all other persons, including successors 
in interest,

[[Page 270]]

from ever taking into account, for Federal income tax purposes, any tax 
to which that section would otherwise apply. For example, assume that 
State Y imposes a personal property tax on tangible personal property 
used in a trade or business conducted in the State during a calendar 
year. The tax is assessed as of February 1 of the year following the 
personal property tax year, and becomes a lien as of that date. As a 
result of administrative and judicial decisions, February 1 of the 
following year is recognized as the proper date on which accrual method 
taxpayers may accrue the personal property tax for Federal income tax 
purposes. In 1962 State Y, by legislative action, changes the assessment 
and lien dates for the personal property tax year 1962 from February 1, 
1963, to December 1, 1962, and to December 1 of the personal property 
tax year for all subsequent years. Corporation A, an accrual method 
taxpayer which uses the calendar year as its taxable year, pays the tax 
for 1962 on December 10, 1962. On December 15, 1962, the property which 
was taxed is completely destroyed and, on December 20, 1962, corporation 
A transfers all of its remaining assets to its shareholders, and is 
dissolved. Since corporation A is not in existence in 1963, and 
therefore could not take the personal property tax into account in 
computing its 1963 Federal income tax if February 1, 1963, is considered 
to be the time for accruing the tax, and no other person could ever take 
such tax into account in computing his Federal income tax, such tax 
shall be treated as accruing as of December 1, 1962. To the extent that 
any person other than the taxpayer may at any time take such tax into 
account in computing his taxable income, the provisions of section 
461(d)(1) shall apply. Thus, upon the dissolution of a corporation or 
the termination of a partnership between the time which, but for the 
provisions of section 461(d)(1) and this paragraph, would be the time 
for accruing any tax which was the subject of ``any action'' (as defined 
in subdivision (iii) of subparagraph (2)), and the original accrual 
date, the corporation or the partnership would be entitled to a 
deduction for only that portion, if any, of such tax with respect to 
which it can establish, to the satisfaction of the district director, 
that no other taxpayer can properly take into account in computing his 
taxable income. However, to the extent that the corporation or 
partnership cannot establish, at the time of its dissolution or 
termination, as the case may be, that no other taxpayer would be 
entitled to take such tax into account in computing his taxable income, 
and it is subsequently determined that no other taxpayer is entitled to 
take such tax into account in computing his taxable income, the 
corporation or partnership may file a claim for refund for the year of 
its dissolution or termination (subject to the limitations prescribed in 
section 6511) and claim as a deduction therein the portion of such tax 
determined to be not deductible by any other taxpayer.
    (5) Section 461(d) and this paragraph shall apply to taxable years 
ending after December 31, 1960.
    (e) Dividends or interest paid by certain savings institutions on 
certain deposits or withdrawable accounts--(1) Deduction not allowable--
(i) In general. Except as otherwise provided in this paragraph, pursuant 
to section 461(e) amounts paid to, or credited to the accounts of, 
depositors or holders of accounts as dividends or interest on their 
deposits or withdrawable accounts (if such amounts paid or credited are 
withdrawable on demand subject only to customary notice to withdraw) by 
a mutual savings bank not having capital stock represented by shares, a 
domestic building and loan association, or a cooperative bank shall not 
be allowed as a deduction for the taxable year to the extent such 
amounts are paid or credited for periods representing more than 12 
months. The provisions of section 461(e) are applicable with respect to 
taxable years ending after December 31, 1962. Whether amounts are paid 
or credited for periods representing more than 12 months depends upon 
all the facts and circumstances in each case. For example, payments or 
credits which under all the facts and circumstances are in the nature of 
bona fide bonus interest or dividends paid or credited because a 
shareholder or depositor maintained a certain balance for more than 12

[[Page 271]]

months, will not be considered made for more than 12 months, providing 
the regular payments or credits represent a period of 12 months or less. 
The nonallowance of a deduction to the taxpayer under section 461(e) and 
this subparagraph has no effect either on the proper time for reporting 
dividends or interest by a depositor or holder of a withdrawable 
account, or on the obligation of the taxpayer to make a return setting 
forth, among other things, the aggregate amounts paid to a depositor or 
shareholder under section 6049 (relating to returns regarding payments 
of interest) and the regulations thereunder. With respect to a short 
period (a taxable year consisting of a period of less than 12 months), 
amounts of dividends or interest paid or credited shall not be allowed 
as a deduction to the extent that such amounts are paid or credited for 
a period representing more than the number of months in such short 
period. In such a case, the rules contained in section 461(e) and this 
paragraph apply to the short period in a manner consistent with the 
application of such rules to a 12-month taxable year. Subparagraph (2) 
of this paragraph provides rules for computing amounts not allowed in 
the taxable year and subparagraph (3) provides rules for determining 
when such amounts are allowed. See section 7701(a) (19) and (32) and the 
regulations thereunder for the definitions of domestic building and loan 
association and cooperative bank.
    (ii) Exceptions. The rule of nonallowance set forth in subdivision 
(i) of this subparagraph is not applicable to a taxpayer in the year in 
which it liquidates (other than following, or as part of, an acquisition 
of its assets in which the acquiring corporation, pursuant to section 
381(a), takes into account certain items of the taxpayer, which for 
purposes of this paragraph shall be referred to as an acquisition 
described in section 381(a)). In addition, such rule of nonallowance is 
not applicable to a taxpayer which pays or credits grace interest or 
dividends to terminating depositors or shareholders, provided the total 
amount of the grace interest or dividends paid or credited during the 
payment or crediting period (for example, a quarterly or semiannual 
period) does not exceed 10 percent of the total amount of the interest 
or dividends paid or credited during such period, computed without 
regard to the grace interest or dividends. For example, providing the 10 
percent limitation is met, the rule of nonallowance does not apply in a 
case in which a calendar year taxpayer, with regular interest payment 
dates of January 1, April 1, July 1, and October 1, pays grace interest 
for the period beginning October 1 to a depositor who terminates his 
account on December 10.
    (2) Computation of amounts not allowed as a deduction--(i) Method of 
computation. The amount of the dividends or interest to which 
subparagraph (1) of this paragraph applies, which is not allowed as a 
deduction, shall be computed under the rules of this subparagraph. The 
amount which is not allowed as a deduction is the difference between the 
total amount of dividends or interest paid or credited to that class of 
accounts with respect to which a deduction is not allowed under 
subparagraph (1) of this paragraph during the taxable year (or short 
period, if applicable) and an amount which bears the same ratio to such 
total as the number 12 (or number of months in the short period) bears 
to the number of months with respect to which such amounts of dividends 
or interest are paid or credited.
    (ii) Examples. The provisions of subdivision (i) of this 
subparagraph may be illustrated by the following examples:

    Example (1). X Association, a domestic building and loan association 
filing its return on the basis of a calendar year, regularly credits 
dividends on its withdrawable accounts quarterly on the first day of the 
quarter following the quarter with respect to which they are earned. X 
changes the time of crediting dividends commencing with the credit for 
the fourth quarter of 1964. Such credit and all subsequent credits are 
made on the last day of the quarter with respect to which they are 
earned. As a result of this change X's credits for the year 1964 are as 
follows:

------------------------------------------------------------------------
  Period with respect to which earned   Date credited in 1964     Amt.
------------------------------------------------------------------------
4th quarter, 1963.....................  Jan. 1                  $250,000
1st quarter, 1964.....................  Apr. 1                   300,000
2d quarter, 1964......................  July 1                   300,000
3d quarter, 1964......................  Oct. 1                   300,000
4th quarter, 1964.....................  Dec. 31                  350,000
                                       ---------------------------------

[[Page 272]]

 
   Total dividends credited...........  .....................  1,500,000
------------------------------------------------------------------------


Since the change in the time of crediting dividends results in the 
crediting in 1964 of amounts of dividends representing periods totaling 
15 months (October 1963 through December 1964), amounts shall not be 
allowed as a deduction in 1964 which are in excess of $1,200,000, which 
is the amount which bears the same ratio to the amounts of dividends 
credited during the year ($1,500,000) as the number 12 bears to the 
number of months (15) with respect to which such dividends are credited. 
Thus, $300,000 ($1,500,000 minus $1,200,000) is not allowed as a 
deduction in 1964.
    Example (2). Y Association, a domestic building and loan association 
filing its return on the basis of a calendar year, regularly credits 
dividends on its withdrawable accounts on the basis of a semiannual 
period on March 31 and September 30 of each year. Y changes the period 
with respect to which credits are made from the semiannual period to the 
quarterly basis, commencing with the last quarter in 1964. The credit 
for this last quarter and all subsequent credits are made on the last 
day of the quarter with respect to which they are earned. As a result of 
this change, Y's credits for the year 1964 are as follows:

------------------------------------------------------------------------
  Period with respect to which earned   Date credited in 1964     Amt.
------------------------------------------------------------------------
6-month period ending Mar. 31, 1964...  Mar. 31                 $300,000
6-month period ending Sept. 30, 1964..  Sept. 30                 400,000
4th quarter, 1964.....................  Dec. 31                  200,000
   Total dividends credited...........  .....................    900,000
------------------------------------------------------------------------


Since the change in the basis of crediting dividends results in a 
crediting in 1964 of dividends representing periods totaling 15 months 
(October 1963 through December 1964), amounts shall not be allowed as a 
deduction in 1964 which are in excess of $720,000, which is the amount 
which bears the same ratio to the amounts of dividends credited during 
the year ($900,000) as the number 12 bears to the number of months (15) 
with respect to which such dividends are credited. Thus, $180,000 
($900,000 minus $720,000) is not allowed as a deduction in 1964.
    Example (3). Z Association, a domestic building and loan association 
regularly files its return on the basis of a fiscal year ending on the 
last day of February and regularly credits dividends on its withdrawable 
accounts quarterly on the last day of the quarter with respect to which 
they are earned. Z receives approval from the Commissioner of Internal 
Revenue to change its accounting period to a calendar year and effects 
the change by filing a return for a short period ending on December 31, 
1964. Dividend credits for the short period beginning on March 1 and 
ending on December 31, 1964, are as follows:

------------------------------------------------------------------------
  Period with respect to which earned   Date credited in 1964     Amt.
------------------------------------------------------------------------
January-March 1964....................  Mar. 31                 $250,000
April-June 1964.......................  June 30                  300,000
July-September 1964...................  Sept. 30                 300,000
October-December 1964.................  Dec. 31                  350,000
   Total dividends credited...........  .....................  1,200,000
------------------------------------------------------------------------


Since the change of accounting period results in amounts of dividends 
credited ($1,200,000) representing periods totaling 12 months (January 
through December 1964), and such periods represent more than the number 
of months (10) in the short period, an amount shall not be allowed as a 
deduction in such short period which is in excess of $1,000,000, which 
is the amount which bears the same ratio to the amount of dividends 
credited in the short period ($1,200,000) as the number of months (10) 
in the short period bears to the number of months (12) with respect to 
which such dividends are credited. Thus, $200,000 ($1,200,000 minus 
$1,000,000) is not allowed as a deduction in the short period.

    (3) When amounts allowable. The amount of dividends or interest not 
allowed as a deduction under subparagraph (1) of this paragraph shall be 
allowed as follows (subject to the limitation that the total of the 
amounts so allowed shall not exceed the amount not allowed under 
subparagraph (1)):
    (i) Such amount shall be allowed as a deduction in a later taxable 
year or years subject to the limitation that, when taken together with 
the deductions otherwise allowable in the later taxable year or years, 
it does not bring the deductions for any later taxable year to a total 
representing a period of more than 12 months (or number of months in the 
short period, if applicable). However, in any event, an amount otherwise 
allowable under subdivision (ii) of this subparagraph shall be allowed 
notwithstanding the fact that it may bring the deductions allowable to a 
total representing a period of more than 12 months (or number of months 
in the short period, if applicable).
    (ii) In any case in which it is established to the satisfaction of 
the Commissioner that the taxpayer does not intend to avoid taxes, one-
tenth of

[[Page 273]]

such amount shall be allowed as a deduction in each of the 10 succeeding 
taxable years--
    (a) Commencing with the taxable year for which such amount is not 
allowed as a deduction under subparagraph (1), or
    (b) In the case of such amount not allowed for a taxable year ending 
before July 1, 1964, commencing with either the first or second taxable 
year after the taxable year for which such amount is not allowed as a 
deduction under subparagraph (1) if the taxpayer has not taken a 
deduction on his return, or filed a claim for credit or refund, in 
respect of such amount under (a).


Normally, if the deduction not allowed under subparagraph (1) is a 
result of a change, not requested by the taxpayer, in the taxpayer's 
annual accounting period or dividend or interest payment or crediting 
dates solely as a consequence of a requirement of a Federal or State 
regulatory authority, or if the deduction is not allowed solely as a 
result of the taxpayer being a party to an acquisition to which section 
381(a) applies, the Commissioner will permit the allowance of the amount 
not allowed in the manner provided in this subdivision. Nothing set 
forth in this subdivision shall be construed as permitting the allowance 
of a credit or refund for any year which is barred by the limitations on 
credit or refund provided by section 6511.
    (iii) If the total of the amounts, if any, allowed under 
subdivisions (i) and (ii) of this subparagraph before the taxable year 
in which the taxpayer liquidates or otherwise ceases to engage in trade 
or business is less than the amount not allowed under subparagraph (1), 
there shall be allowed a deduction in such taxable year for the 
difference between the amount not allowed under subparagraph (1) and the 
amounts allowed, if any, as deductions under subdivisions (i) and (ii) 
unless the circumstances under which the taxpayer ceased to do business 
constitute an acquisition described in section 381(a) (relating to 
carryovers in certain corporate acquisitions). If the circumstances 
under which the taxpayer ceased to do business constitute an acquisition 
described in section 381(a), the acquiring corporation shall succeed to 
and take into account the balance of the amounts not allowed on the same 
basis as the taxpayer, had it not ceased to engage in business.

[T.D. 6500, 25 FR 11720, Nov. 26, 1960, as amended by T.D. 6520, 25 FR 
13692, Dec. 24, 1960; T.D. 6710, 29 FR 3473, Mar. 18, 1964; T.D. 6735, 
29 FR 6494, May 19, 1964; T.D. 6772, 29 FR 15753, Nov. 24, 1964; T.D. 
6917, 32 FR 6682, May 2, 1967; T.D. 8408, 57 FR 12420, Apr. 10, 1992; 
T.D. 8482, 58 FR 42233, Aug. 9, 1993; T.D. 8554, 59 FR 36360, July 18, 
1994; T.D. 8820, 64 FR 26851, May 18, 1999]



Sec. 1.461-2  Contested liabilities.

    (a) General rule--(1) Taxable year of deduction. If--
    (i) The taxpayer contests an asserted liability,
    (ii) The taxpayer transfers money or other property to provide for 
the satisfaction of the asserted liability,
    (iii) The contest with respect to the asserted liability exists 
after the time of the transfer, and
    (iv) But for the fact that the asserted liability is contested, a 
deduction would be allowed for the taxable year of the transfer (or, in 
the case of an accrual method taxpayer, for an earlier taxable year for 
which such amount would be accruable),

then the deduction with respect to the contested amount shall be allowed 
for the taxable year of the transfer.
    (2) Exception. Subparagraph (1) of this paragraph shall not apply in 
respect of the deduction for income, war profits, and excess profits 
taxes imposed by the authority of any foreign country or possession of 
the United States, including a tax paid in lieu of a tax on income, war 
profits, or excess profits otherwise generally imposed by any foreign 
country or by any possession of the United States.
    (3) Refunds includible in gross income. If any portion of the 
contested amount which is deducted under subparagraph (1) of this 
paragraph for the taxable year of transfer is refunded when the contest 
is settled, such portion is includible in gross income except as 
provided in Sec. 1.111-1, relating to recovery of certain items 
previously deducted or credited. Such refunded amount is includible in 
gross income for the taxable

[[Page 274]]

year of receipt, or for an earlier taxable year if properly accruable 
for such earlier year.
    (4) Examples. The provisions of this paragraph are illustrated by 
the following examples:

    Example (1). X Corporation, which uses an accrual method of 
accounting, in 1964 contests $20 of a $100 asserted real property tax 
liability but pays the entire $100 to the taxing authority. In 1968, the 
contest is settled and X receives a refund of $5. X deducts $100 for the 
taxable year 1964, and includes $5 in gross income for the taxable year 
1968 (assuming Sec. 1.111-1 does not apply to such amount). If in 1964 
X pays only $80 to the taxing authority, X deducts only $80 for 1964. 
The result would be the same if X Corporation used the cash method of 
accounting.
    Example (2). Y Corporation makes its return on the basis of a 
calendar year and uses an accrual method of accounting. Y's real 
property taxes are assessed and become a lien on December 1, but are not 
payable until March 1 of the following year. On December 10, 1964, Y 
contests $20 of the $100 asserted real property tax which was assessed 
and became a lien on December 1, 1964. On March 1, 1965, Y pays the 
entire $100 to the taxing authority. In 1968, the contest is settled and 
Y receives a refund of $5. Y deducts $80 for the taxable year 1964, 
deducts $20 for the taxable year 1965, and includes $5 in gross income 
for the taxable year 1968 (assuming Sec. 1.111-1 does not apply to such 
amount).

    (b) Production costs--(1) In general; asserted liability. For 
purposes of paragraph (a)(1) of this section, the term ``asserted 
liability'' means an item with respect to which, but for the existence 
of any contest in respect of such item, a deduction would be allowable 
under an accrual method of accounting. For example, a notice of a local 
real estate tax assessment and a bill received for services may 
represent asserted liabilities.
    (2) Definition of the term ``contest''. Any contest which would 
prevent accrual of a liability under section 461(a) shall be considered 
to be a contest in determining whether the taxpayer satisfies paragraph 
(a)(1)(i) of this section. A contest arises when there is a bona fide 
dispute as to the proper evaluation of the law or the facts necessary to 
determine the existence or correctness of the amount of an asserted 
liability. It is not necessary to institute suit in a court of law in 
order to contest an asserted liability. An affirmative act denying the 
validity or accuracy, or both, of an asserted liability to the person 
who is asserting such liability, such as including a written protest 
with payment of the asserted liability, is sufficient to commence a 
contest. Thus, lodging a protest in accordance with local law is 
sufficient to contest an asserted liability for taxes. It is not 
necessary that the affirmative act denying the validity or accuracy, or 
both, of an asserted liability be in writing if, upon examination of all 
the facts and circumstances, it can be established to the satisfaction 
of the Commissioner that a liability has been asserted and contested.
    (3) Example. The provisions of this paragraph are illustrated by the 
following example:

    Example: O Corporation makes its return on the basis of a calendar 
year and uses an accrual method of accounting. O receives a large 
shipment of typewriter ribbons from S Company on January 30, 1964, which 
O pays for in full on February 10, 1964. Subsequent to their receipt, 
several of the ribbons prove defective because of inferior materials 
used by the manufacturer. On August 9, 1964, O orally notifies S and 
demands refund of the full purchase price of the ribbons. After 
negotiations prove futile and a written demand is rejected by S, O 
institutes an action for the full purchase price. For purposes of 
paragraph (a)(1)(i) of this section, S has asserted a liability against 
O which O contests on August 9, 1964. O deducts the contested amount for 
1964.

    (c) Transfer to provide for the satisfaction of an asserted 
liability--(1) In general. (i) A taxpayer may provide for the 
satisfaction of an asserted liability by transferring money or other 
property beyond his control to--
    (A) The person who is asserting the liability;
    (B) An escrowee or trustee pursuant to a written agreement (among 
the escrowee or trustee, the taxpayer, and the person who is asserting 
the liability) that the money or other property be delivered in 
accordance with the settlement of the contest;
    (C) An escrowee or trustee pursuant to an order of the United States 
or of any State or political subdivision thereof or any agency or 
instrumentality of the foregoing, or of a court, that the money or other 
property be

[[Page 275]]

delivered in accordance with the settlement of the contest; or
    (D) A court with jurisdiction over the contest.
    (ii) In order for money or other property to be beyond the control 
of a taxpayer, the taxpayer must relinquish all authority over the money 
or other property.
    (iii) The following are not transfers to provide for the 
satisfaction of an asserted liability--
    (A) Purchasing a bond to guarantee payment of the asserted 
liability;
    (B) An entry on the taxpayer's books of account;
    (C) A transfer to an account that is within the control of the 
taxpayer;
    (D) A transfer of any indebtedness of the taxpayer or of any promise 
by the taxpayer to provide services or property in the future; and
    (E) A transfer to a person (other than the person asserting the 
liability) of any stock of the taxpayer or of any stock or indebtedness 
of a person related to the taxpayer (as defined in section 267(b)).
    (2) Examples. The provisions of this paragraph are illustrated by 
the following examples:

    Example (1). M Corporation contests a $5,000 liability asserted 
against it by L Company for services rendered. To provide for the 
contingency that it might have to pay the liability, M establishes a 
separate bank account in its own name. M then transfers $5,000 from its 
general account to such separate account. Such transfer does not qualify 
as a transfer to provide for the satisfaction of an asserted liability 
because M has not transferred the money beyond its control.
    Example (2). M Corporation contests a $5,000 liability asserted 
against it by L Company for services rendered. To provide for the 
contingency that it might have to pay the liability, M transfers $5,000 
to an irrevocable trust pursuant to a written agreement among the 
trustee, M (the taxpayer), and L (the person who is asserting the 
liability) that the money shall be held until the contest is settled and 
then disbursed in accordance with the settlement. Such transfer 
qualifies as a transfer to provide for the satisfaction of an asserted 
liability.

    (d) Contest exists after transfer. In order for a contest with 
respect to an asserted liability to exist after the time of transfer, 
such contest must be pursued subsequent to such time. Thus, the contest 
must have been neither settled nor abandoned at the time of the 
transfer. A contest may be settled by a decision, judgment, decree, or 
other order of any court of competent jurisdiction which has become 
final, or by written or oral agreement between the parties. For example, 
Z Corporation, which uses an accrual method of accounting, in 1964 
contests a $100 asserted liability. In 1967 the contested liability is 
settled as being $80 which Z accrues and deducts for such year. In 1968 
Z pays the $80. Section 461(f) does not apply to Z with respect to the 
transfer because a contest did not exist after the time of such 
transfer.
    (e) Deduction otherwise allowed--(1) In general. The existence of 
the contest with respect to an asserted liability must prevent (without 
regard to section 461(f)) and be the only factor preventing a deduction 
for the taxable year of the transfer (or, in the case of an accrual 
method taxpayer, for an earlier taxable year for which such amount would 
be accruable) to provide for the satisfaction of such liability. Nothing 
in section 461(f) or this section shall be construed to give rise to a 
deduction since section 461(f) and this section relate only to the 
timing of deductions which are otherwise allowable under the Code.
    (2) Application of economic performance rules to transfers under 
section 461(f). (i) A taxpayer using an accrual method of accounting is 
not allowed a deduction under section 461(f) in the taxable year of the 
transfer unless economic performance has occurred.
    (ii) Economic performance occurs for liabilities requiring payment 
to another person arising out of any workers compensation act or any 
tort, or any other liability designated in Sec. 1.461-4(g), as payments 
are made to the person to which the liability is owed. Except as 
provided in section 468B or the regulations thereunder, economic 
performance does not occur when a taxpayer transfers money or other 
property to a trust, an escrow account, or a court to provide for the 
satisfaction of an asserted workers compensation, tort, or other 
liability designated under Sec. 1.461-4(g) that the taxpayer is 
contesting unless the trust, escrow account, or court is the person to 
which the liability is owed or the taxpayer's payment to the

[[Page 276]]

trust, escrow account, or court discharges the taxpayer's liability to 
the claimant. Rather, economic performance occurs in the taxable year 
the taxpayer transfers money or other property to the person that is 
asserting the workers compensation, tort, or other liability designated 
under Sec. 1.461-4(g) that the taxpayer is contesting or in the taxable 
year that payment is made from a trust, an escrow account, or a court 
registry funded by the taxpayer to the person to which the liability is 
owed.
    (3) Examples. The provisions of this paragraph are illustrated by 
the following examples:

    Example 1. A, an individual, makes a gift of certain property to B, 
an individual. A pays the entire amount of gift tax assessed against him 
but contests his liability for the tax. Section 275(a)(3) provides that 
gift taxes are not deductible. A does not satisfy the requirement of 
paragraph (a)(1)(iv) of this section because a deduction would not be 
allowed for the taxable year of the transfer even if A did not contest 
his liability to the tax.
    Example 2. Corporation X is a defendant in a class action suit for 
tort liabilities. In 2002, X establishes a trust for the purpose of 
satisfying the asserted liability and transfers $10,000,000 to the 
trust. The trust does not satisfy the requirements of section 468B or 
the regulations thereunder. In 2004, the trustee pays $10,000,000 to the 
plaintiffs in settlement of the litigation. Under paragraph (e)(2) of 
this section, economic performance with respect to X's liability to the 
plaintiffs occurs in 2004. X may deduct the $10,000,000 payment to the 
plaintiffs in 2004.

    (f) Treatment of money or property transferred to an escrowee, 
trustee, or court and treatment of any income attributable thereto. 
[Reserved]
    (g) Effective dates. (1) Except as otherwise provided, this section 
applies to transfers of money or other property in taxable years 
beginning after December 31, 1953, and ending after August 16, 1954.
    (2) Paragraph (c)(1)(iii)(E) of this section applies to transfers of 
any stock of the taxpayer or any stock or indebtedness of a person 
related to the taxpayer on or after November 19, 2003.
    (3) Paragraph (e)(2)(i) of this section applies to transfers of 
money or other property after July 18, 1984.
    (4) Paragraph (e)(2)(ii) and paragraph (e)(3) Example 2 of this 
section apply to--
    (i) Transfers after July 18, 1984, of money or other property to 
provide for the satisfaction of an asserted workers compensation or tort 
liability; and
    (ii) Transfers in taxable years beginning after December 31, 1991, 
of money or other property to provide for the satisfaction of asserted 
liabilities designated in Sec. 1.461-4(g) (other than liabilities for 
workers compensation or tort).

[T.D. 6772, 29 FR 15753, Nov. 24, 1964, as amended by T.D. 8408, 57 FR 
12421, Apr. 10, 1992; T.D. 9095, 68 FR 65636, Nov. 21, 2003; T.D. 9140, 
69 FR 43303, July 20, 2004]



Sec. 1.461-3  Prepaid interest. [Reserved]



Sec. 1.461-4  Economic performance.

    (a) Introduction--(1) In general. For purposes of determining 
whether an accrual basis taxpayer can treat the amount of any liability 
(as defined in Sec. 1.446-1(c)(1)(ii)(B)) as incurred, the all events 
test is not treated as met any earlier than the taxable year in which 
economic performance occurs with respect to the liability.
    (2) Overview. Paragraph (b) of this section lists exceptions to the 
economic performance requirement. Paragraph (c) of this section provides 
cross-references to the definitions of certain terms for purposes of 
section 461 (h) and the regulations thereunder. Paragraphs (d) through 
(m) of this section and Sec. 1.461-6 provide rules for determining when 
economic performance occurs. Section 1.461-5 provides rules relating to 
an exception under which certain recurring items may be incurred for the 
taxable year before the year during which economic performance occurs.
    (b) Exceptions to the economic performance requirement. Paragraph 
(a)(2)(iii)(B) of Sec. 1.461-1 provides examples of liabilities that 
are taken into account under rules that operate without regard to the 
all events test (including economic performance).
    (c) Definitions. The following cross-references identify certain 
terms defined for purposes of section 461(h) and the regulations 
thereunder:

[[Page 277]]

    (1) Liability. See paragraph (c)(1)(ii)(B)d of Sec. 1.446-1 for the 
definition of ``liability.''
    (2) Payment. See paragraph (g)(1)(ii) of this section for the 
definition of ``payment.''
    (d) Liabilities arising out of the provision of services, property, 
or the use of property--(1) In general. The principles of this paragraph 
(d) determine when economic performance occurs with respect to 
liabilities arising out of the performance of services, the transfer of 
property, or the use of property. This paragraph (d) does not apply to 
liabilities described in paragraph (e) (relating to interest expense) or 
paragraph (g) (relating to breach of contract, workers compensation, 
tort, etc.) of this section. In addition, except as otherwise provided 
in Internal Revenue regulations, revenue procedures, or revenue rulings 
this paragraph (d) does not apply to amounts paid pursuant to a notional 
principal contract. The Commissioner may provide additional rules in 
regulations, revenue procedures, or revenue rulings concerning the time 
at which economic performance occurs for items described in this 
paragraph (d).
    (2) Services or property provided to the Taxpayer--(i) In general. 
Except as otherwise provided in paragraph (d)(5) of this section, if the 
liability of a taxpayer arises out of the providing of services or 
property to the taxpayer by another person, economic performance occurs 
as the services or property is provided.
    (ii) Long-term contracts. In the case of any liability of a taxpayer 
described in paragraph (d)(2)(i) of this section that is an expense 
attributable to a long-term contract with respect to which the taxpayer 
uses the percentage of completion method, economic performance occurs--
    (A) As the services or property is provided; or, if earlier,
    (B) As the taxpayer makes payment (as defined in paragraph 
(g)(1)(ii) of this section) in satisfaction of the liability to the 
person providing the services or property. See paragraph (k)(2) of this 
section for the effective date of this paragraph (d)(2)(ii).
    (iii) Employee benefits--(A) In general. Except as otherwise 
provided in any Internal Revenue regulation, revenue procedure, or 
revenue ruling, the economic performance requirement is satisfied to the 
extent that any amount is otherwise deductible under section 404 
(employer contributions to a plan of deferred compensation), section 
404A (certain foreign deferred compensation plans), and section 419 
(welfare benefit funds). See Sec. 1.461-1(a)(2)(iii)(D).
    (B) Property transferred in connection with performance of services. 
[Reserved]
    (iv) Cross-references. See Examples 4 through 6 of paragraph (d)(7) 
of this section. See paragraph (d)(6) of this section for rules relating 
to when a taxpayer may treat services or property as provided to the 
taxpayer.
    (3) Use of property provided to the taxpayer--(i) In general. Except 
as otherwise provided in this paragraph (d)(3)d and paragraph (d)(5) of 
this section, if the liability of a taxpayer arises out of the use of 
property by the taxpayer, economic performance occurs ratably over the 
period of time the taxpayer is entitled to the use of the property 
(taking into account any reasonably expected renewal periods when 
necessary to carry out the purposes of section 461(h)). See Examples 6 
through 9 of paragraph (d)(7) of this section.
    (ii) Exceptions--(A) Volume, frequency of use, or income. If the 
liability of a taxpayer arises out of the use of property by the 
taxpayer and all or a portion of the liability is determined by 
reference to the frequency or volume of use of the property or the 
income from the property, economic performance occurs for the portion of 
the liability determined by reference to the frequency or volume of use 
of the property or the income from the property as the taxpayer uses the 
property or includes income from the property. See Examples 8 and 9 of 
paragraph (d)(7) of this section. This paragraph (d)(3)(ii) shall not 
apply if the District Director determines, that based on the substance 
of the transaction, the liability of the taxpayer for use of the 
property is more appropriately measured ratably over the period of time 
the taxpayer is entitled to the use of the property.
    (B) Section 467 rental agreements. In the case of a liability 
arising out of the use of property pursuant to a section

[[Page 278]]

467 rental agreement, economic performance occurs as provided in Sec. 
1.461-1(a)(2)(iii)(E).
    (4) Services or property provided by the taxpayer--(i) In general. 
Except as otherwise provided in paragraph (d)(5) of this section, if the 
liability of a taxpayer requires the taxpayer to provide services or 
property to another person, economic performance occurs as the taxpayer 
incurs costs (within the meaning of Sec. 1.446-1(c)(1)(ii)) in 
connection with the satisfaction of the liability. See Examples 1 
through 3 of paragraph (d)(7) of this section.
    (ii) Barter transactions. If the liability of a taxpayer requires 
the taxpayer to provide services, property, or the use of property, and 
arises out of the use of property by the taxpayer, or out of the 
provision of services or property to the taxpayer by another person, 
economic performance occurs to the extent of the lesser of--
    (A) The cumulative extent to which the taxpayer incurs costs (within 
the meaning of Sec. 1.446-1(c)(1)(ii)) in connection with its liability 
to provide the services of property; or
    (B) The cumulative extent to which the services or property is 
provided to the taxpayer.
    (5) Liabilities that are assumed in connection with the sale of a 
trade or business--(i) In general. If, in connection with the sale or 
exchange of a trade or business by a taxpayer, the purchaser expressly 
assumes a liability arising out of the trade or business that the 
taxpayer but for the economic performance requirement would have been 
entitled to incur as of the date of the sale, economic performance with 
respect to that liability occurs as the amount of the liability is 
properly included in the amount realized on the transaction by the 
taxpayer. See Sec. 1.1001-2 for rules relating to the inclusion in 
amount realized from a discharge of liabilities resulting from a sale or 
exchange.
    (ii) Trade or business. For purposes of this paragraph (d)(5), a 
trade or business is a specific group of activities carried on by the 
taxpayer for the purpose of earning income or profit if every operation 
that is necessary to the process of earning income or profit is included 
in the group. Thus, for example, the group of activities generally must 
include the collection of income and the payment of expenses.
    (iii) Tax avoidance. This paragraph (d)(5) does not apply if the 
District Director determines that tax avoidance is one of the taxpayer's 
principal purposes for the sale or exchange.
    (6) Rules relating to the provision of services or property to a 
taxpayer. The following rules apply for purposes of this paragraph (d):
    (i) Services or property provided to a taxpayer include services or 
property provided to another person at the direction of the taxpayer.
    (ii) A taxpayer is permitted to treat services or property as 
provided to the taxpayer as the taxpayer makes payment to the person 
providing the services or property (as defined in paragraph (g)(1)(ii) 
of this section), if the taxpayer can reasonably expect the person to 
provide the services or property within 3\1/2\ months after the date of 
payment.
    (iii) A taxpayer is permitted to treat property as provided to the 
taxpayer when the property is delivered or accepted, or when title to 
the property passes. The method used by the taxpayer to determine when 
property is provided is a method of accounting that must comply with the 
rules of Sec. 1.446-1(e). Thus, the method of determining when property 
is provided must be used consistently from year to year, and cannot be 
changed without the consent of the Commissioner.
    (iv) If different services or items of property are required to be 
provided to a taxpayer under a single contract or agreement, economic 
performance generally occurs over the time each service is provided and 
as each item of property is provided. However, if a service or item of 
property to be provided to the taxpayer is incidental to other services 
or property to be provided under a contract or agreement, the taxpayer 
is not required to allocate any portion of the total contract price to 
the incidental service or property. For purposes of this paragraph 
(d)(6)(iv), services or property is treated as incidental only if--
    (A) The cost of the services or property is treated on the 
taxpayer's books and records as part of the cost of the

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other services or property provided under the contract; and
    (B) The aggregate cost of the services or property does not exceed 
10 percent of the total contract price.
    (7) Examples. The following examples illustrate the principles of 
this paragraph (d). For purposes of these examples, it is assumed that 
the requirements of the all events test other than economic performance 
have been met, and that the recurring item exception is not used. Assume 
further that the examples do not involve section 467 rental agreements 
and, therefore, section 467 is not applicable. The examples are as 
follows:

    Example 1. Services or property provided by the taxpayer. (i) X 
corporation, a calendar year, accrual method taxpayer, is an oil 
company. During March 1990, X enters into an oil and gas lease with Y. 
In November 1990, X installs a platform and commences drilling. The 
lease obligates X to remove its offshore platform and well fixtures upon 
abandonment of the well or termination of the lease. During 1998, X 
removes the platform and well fixtures at a cost of $200,000.
    (ii) Under paragraph (d)(4)(i) of this section, economic performance 
with respect to X's liability to remove the offshore platform and well 
fixtures occurs as X incurs costs in connection with that liability. X 
incurs these costs in 1998 as, for example, X's employees provide X with 
removal services (see paragraph (d)(2) of this section). Consequently, X 
incurs $200,000 for the 1998 taxable year. Alternatively, assume that 
during 1990 X pays Z $130,000 to remove the platform and fixtures, and 
that Z performs these removal services in 1998. Under paragraph (d)(2) 
of this section, X does not incur this cost until Z performs the 
services. Thus, economic performance with respect to the $130,000 X pays 
Z occurs in 1998.
    Example 2. Services or property provided by the taxpayer. (i) W 
corporation, a calendar year, accrual method taxpayer, sells tractors 
under a three-year warranty that obligates W to make any reasonable 
repairs to each tractor it sells. During 1990, W sells ten tractors. In 
1992 W repairs, at a cost of $5,000, two tractors sold during 1990.
    (ii) Under paragraph (d)(4)(i) of this section, economic performance 
with respect to W's liability to perform services under the warranty 
occurs as W incurs costs in connection with that liability. W incurs 
these costs in 1992 as, for example, replacement parts are provided to W 
(see paragraph (d)(2) of this section). Consequently, $5,000 is incurred 
by W for the 1992 taxable year.
    Example 3. Services or property provided by the taxpayer; Long-term 
contracts. (i) W corporation, a calendar year, accrual method taxpayer, 
manufactures machine tool equipment. In November 1992, W contracts to 
provide X corporation with certain equipment. The contract is not a 
long-term contract under section 460 or Sec. 1.451-3. In 1992, W pays Z 
corporation $50,000 to lease from Z, for the one-year period beginning 
on January 1, 1993, testing equipment to perform quality control tests 
required by the agreement with X. In 1992, pursuant to the terms of a 
contract, W pays Y corporation $100,000 for certain parts necessary to 
manufacture the equipment. The parts are provided to W in 1993. W's 
employees provide W with services necessary to manufacture the equipment 
during 1993, for which W pays $150,000 in 1993.
    (ii) Under paragraph (d)(4) of this section, economic performance 
with respect to W's liability to provide the equipment to X occurs as W 
incurs costs in connection with that liability. W incurs these costs 
during 1993, as services, property, and the use of property necessary to 
manufacture the equipment are provided to W (see paragraphs (d)(2) and 
(d)(3) of this section). Thus, $300,000 is incurred by W for the 1993 
taxable year. See section 263A and the regulations thereunder for rules 
relating to the capitalization and inclusion in inventory of these 
incurred costs.
    (iii) Alternatively, assume that the agreement with X is a long-term 
contract as defined in section 460(f), and that W takes into account all 
items with respect to such contracts under the percentage of completion 
method as described in section 460(b)(1). Under paragraph (d)(2)(ii) of 
this section, the $100,000 W pays in 1992 for parts is incurred for the 
1992 taxable year, for purposes of determining the percentage of 
completion under section 460(b)(1)(A). W's other costs under the 
agreement are incurred for the 1993 taxable year for this purpose.
    Example 4. Services or property provided to the taxpayers. (i) LP1, 
a calendar year, accrual method limited partnership, owns the working 
interest in a parcel of property containing oil and gas. During December 
1990, LP1 enters into a turnkey contract with Z corporation pursuant to 
which LP1 pays Z $200,000 and Z is required to provide a completed well 
by the close of 1992. In May 1992, Z commences drilling the well, and, 
in December 1992, the well is completed.
    (ii) Under paragraph (d)(2) of this section, economic performance 
with respect to LP1's liability for drilling and development services 
provided to LP1 by Z occurs as the services are provided. Consequently, 
$200,000 is incurred by LP1 for the 1992 taxable year.
    Example 5. Services or property provided to the taxpayer. (i) X 
corporation, a calendar year, accrual method taxpayer, is an automobile 
dealer. On Jaunary 15, 1990, X agrees

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to pay an additional $10 to Y, the manufacturer of the automobiles, for 
each automobile purchased by X from Y. Y agrees to provide advertising 
and promotional activities to X.
    (ii) During 1990, X purchases from Y 1,000 new automobiles and pays 
to Y an additional $10,000 as provided in the agreement. Y, in turn, 
uses this $10,000 to provide advertising and promotional activities 
during 1992.
    (iii) Under paragraph (d)(2) of this section, economic performance 
with respect to X's liability for advertising and promotional services 
provided to X by Y occurs as the services are provided. Consequently, 
$10,000 is incurred by X for the 1992 taxable year.
    Example 6. Use of property provided to the taxpayer; services or 
property provided to the taxpayer. (i) V corporation, a calendar year, 
accrual method taxpayer, charters aircrafts. On December 20, 1990, V 
leases a jet aircraft from L for the four-year period that begins on 
January 1, 1991. The lease obligates V to pay L a base rental of 
$500,000 per year. In addition, the lease requires V to pay $25 to an 
escrow account for each hour that the aircraft is flown. The escrow 
account funds are held by V and are to be used by L to make necessary 
repairs to the aircraft. Any amount remaining in the escrow account upon 
termination of the lease is payable to V. During 1991, the aircraft is 
flown 1,000 hours and V pays $25,000 to the escrow account. The aircraft 
is repaired by L in 1993. In 1994, $20,000 is released from the escrow 
account to pay L for the repairs.
    (ii) Under paragraph (d)(3)(i) of this section, economic performance 
with respect to V's base rental liability occurs ratably over the period 
of time V is entitled to use the jet aircraft. Consequently, the 
$500,000 rent is incurred by V for the 1991 taxable year and for each of 
the next three taxable years. Under paragraph (d)(2) of this section, 
economic performance with respect to the liability to place amounts in 
escrow occurs as the aircraft is repaired. Consequently, V incurs $20,00 
for the 1993 taxable year.
    Example 7. Use of property provided to the taxpayer. (i) X 
corporation, a calendar year, accrual method taxpayer, manufactures and 
sells electronic circuitry. On November 15, 1990, X enters into a 
contract with Y that entitles X to the exclusive use of a product owned 
by Y for the five-year period beginning on January 1, 1991. Pursuant to 
the contract, X pays Y $100,000 on December 30, 1990.
    (ii) Under paragraph (d)(3)(i) of this section, economic performance 
with respect to X's liability for the use of property occurs ratably 
over the period of time X is entitled to use the product. Consequently, 
$20,000 is incurred by X for 1991 and for each of the succeeding four 
taxable years.
    Example 8. Use of property provided to the taxpayer. (i) Y 
corporation, a calendar year, accrual method taxpayer, enters into a 
five-year lease with Z for the use of a copy machine on July 1, 1991. Y 
also receives elivery of the copy machine on July 1, 1991. The lease 
obligates Y to pay Z a base rental payment of $6,000 per year at the 
beginning of each lease year and an additional charge of 5 cents per 
copy 30 days after the end of each lease year. The machine is used to 
make 50,000 copies during the first lease year: 20,000 copies in 1991 
and 30,000 copies from January 1, 1992, to July 1, 1992. Y pays the 
$6,000 base rental payment to Z on July 1, 1991, and the $2,500 variable 
use payment on July 30, 1992.
    (ii) under paragraph (d)(3)(i) of this section, economic performance 
with respect to Y's base rental liability occurs ratably over the period 
of time Y is entitled to use the copy machine. Consequently, $3,000 rent 
is incurred by Y for the 1991 taxable year. Under paragraph (d)(3)(ii) 
of this section, economic performance with respect to Y's variable use 
portion of the liability occurs as Y uses the machine. Thus, the $1,000 
of the $2,500 variable-use liability that relates to the 20,000 copies 
made in 1991 is incurred by Y for the 1991 taxable year.
    Example 9. Use of property provided to the taxpayer. (i) X 
corporation, a calendar year, accrual method taxpayer, enters into a 
five-year product distribution agreement with Y, on January 1, 1992. The 
agreement provides for a payment of $100,000 on January 1, 1992, plus 10 
percent of the gross profits earned by X from distribution of the 
product. The variable income portion of X's liability is payable on 
April 1 of each subsequent year. On January 1, 1992, X pays Y $100,000. 
On April 1, 1993, X pays Y $3 million representing 10 percent of X's 
gross profits from January 1 through December 31, 1992.
    (ii) Under paragraph (d)(3)(i) of this section, economic performance 
with respect to X's $100,000 payment occurs ratably over the period of 
time X is entitled to use the product. Consequently, $20,000 is incurred 
by X for each year of the agreement beginning with 1992. Under paragraph 
(d)(3)(ii) of this section, economic performance with respect to X's 
variable income portion of the liability occurs as the income is earned 
by X. Thus, the $3 million variable-income liability is incurred by X 
for the 1992 taxable year.

    (e) Interest. In the case of interest, economic performance occurs 
as the interest cost economically accrues, in accordance with the 
principles of relevant provisions of the Code.
    (f) Timing of deductions from notional principal contracts. Economic 
performance on a notional principal contract occurs as provided under 
Sec. 1.446-3.
    (g) Certain liabilities for which payment is economic performance--
(1) In general--(i) Person to which payment must be

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made. In the case of liabilities described in paragraphs (g) (2) through 
(7) of this section, economic performance occurs when, and to the extent 
that, payment is made to the person to which the liability is owed. 
Thus, except as otherwise provided in paragraph (g)(1)(iv) of this 
section and Sec. 1.461-6, economic performance does not occur as a 
taxpayer makes payments in connection with such a liability to any other 
person, including a trust, escrow account, court-administered fund, or 
any similar arrangement, unless the payments constitute payment to the 
person to which the liability is owed under paragraph (g)(1)(ii)(B) of 
this section. Instead, economic performance occurs as payments are made 
from that other person or fund to the person to which the liability is 
owed. The amount of economic performance that occurs as payment is made 
from the other person or fund to the person to which the liability is 
owed may not exceed the amount the taxpayer transferred to the other 
person or fund. For special rules relating to the taxation of amounts 
transferred to ``qualified settlement funds,'' see section 468B and the 
regulations thereunder. The Commissioner may provide additional rules in 
regulations, revenue procedures, and revenue rulings concerning the time 
at which economic performance occurs for items described in this 
paragraph (g).
    (ii) Payment to person to which liability is owed. Paragraph (d)(6) 
of this section provides that for purposes of paragraph (d) of this 
section (relating to the provision of services or property to the 
taxpayer) in certain cases a taxpayer may treat services or property as 
provided to the taxpayer as the taxpayer makes payments to the person 
providing the services or property. In addition, this paragraph (g) 
provides that in the case of certain liabilities of a taxpayer, economic 
performance occurs as the taxpayer makes payment to persons specified 
therein. For these and all other purposes of section 461(h) and the 
regulations thereunder:
    (A) Payment. The term payment has the same meaning as is used when 
determining whether a taxpayer using the cash receipts and disbursements 
method of accounting has made a payment. Thus, for example, payment 
includes the furnishing of cash or cash equivalents and the netting of 
offsetting accounts. Payment does not include the furnishing of a note 
or other evidence of indebtedness of the taxpayer, whether or not the 
evidence is guaranteed by any other instrument (including a standby 
letter of credit) or by any third party (including a government agency). 
As a further example, payment does not include a promise of the taxpayer 
to provide services or property in the future (whether or not the 
promise is evidenced by a contract or other witten agreement). In 
addition, payment does not include an amount transferred as a loan, 
refundable deposit, or contingent payment.
    (B) Person to which payment is made. Payment to a particular person 
is accomplished if paragraph (g)(1)(ii)(A) of this section is satisfied 
and a cash basis taxpayer in the position of that person would be 
treated as having actually or constructively received the amount of the 
payment as gross income under the principles of section 451 (without 
regard to section 104(a) or any other provision that specifically 
excludes the amount from gross income). Thus, for example, the purchase 
of an annuity contract or any other asset generally does not constitute 
payment to the person to which a liability is owed unless the ownership 
of the contract or other asset is transferred to that person.
    (C) Liabilities that are assumed in connection with the sale of a 
trade or business. Paragraph (d)(5) of this section provides rules that 
determine when economic performance occurs in the case of liabilities 
that are assumed in connection with the sale of a trade or business. The 
provisions of paragraph (d)(5) of this section also apply to any 
liability described in paragraph (g) (2) through (7) of this section 
that the purchaser expressly assumes in connection with the sale or 
exchange of a trade or business by a taxpayer, provided the taxpayer 
(but for the economic performance requirement) would have been entitled 
to incur the liability as of the date of the sale.
    (iii) Person. For purposes of this paragraph (g), ``person'' has the 
same meaning as in section 7701(a)(1), except that

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it also includes any foreign state, the United States, any State or 
political subdivision thereof, any possession of the United States, and 
any agency or instrumentality of any of the foregoing.
    (iv) Assignments. If a person that has a right to receive payment in 
satisfaction of a liability described in paragraphs (g) (2) through (7) 
of this section makes a valid assignment of that right to a second 
person, or if the right is assigned to the second person through 
operation of law, then payment to the second person in satisfaction of 
that liability constitutes payment to the person to which the liability 
is owed.
    (2) Liabilities arising under a workers compensation act or out of 
any tort, breach of contract, or violation of law. If the liability of a 
taxpayer requires a payment or series of payments to another person and 
arises under any workers compensation act or out of any tort, breach of 
contract, or violation of law, economic performance occurs as payment is 
made to the person to which the liability is owed. See Example 1 of 
paragraph (g)(8) of this section. For purposes of this paragraph 
(g)(2)--
    (i) A liability to make payments for services, property, or other 
consideration provided under a contract is not a liability arising out 
of a breach of that contract unless the payments are in the nature of 
incidental, consequential, or liquidated damages; and
    (ii) A liability arising out of a tort, breach of contract, or 
violation of law includes a liability arising out of the settlement of a 
dispute in which a tort, breach of contract, or violation of law, 
respectively, is alleged.
    (3) Rebates and refunds. If the liability of a taxpayer is to pay a 
rebate, refund, or similar payment to another person (whether paid in 
property, money, or as a reduction in the price of goods or services to 
be provided in the future by the taxpayer), economic performance occurs 
as payment is made to the person to which the liability is owed. This 
paragraph (g)(3) applies to all rebates, refunds, and payments or 
transfers in the nature of a rebate or refund regardless of whether they 
are characterized as a deduction from gross income, an adjustment to 
gross receipts or total sales, or an adjustment or addition to cost of 
goods sold. In the case of a rebate or refund made as a reduction in the 
price of goods or services to be provided in the future by the taxpayer, 
``payment'' is deemed to occur as the taxpayer would otherwise be 
required to recognize income resulting from a disposition at an 
unreduced price. See Example 2 of paragraph (g)(8) of this section. For 
purposes of determining whether the recurring item exception of Sec. 
1.461-5 applies, a liability that arises out of a tort, breach of 
contract, or violation of law is not considered a rebate or refund.
    (4) Awards, prizes, and jackpots. If the liability of a taxpayer is 
to provide an award, prize, jackpot, or other similar payment to another 
person, economic performance occurs as payment is made to the person to 
which the liability is owed. See Examples 3 and 4 of paragraph (g)(8) of 
this section.
    (5) Insurance, warranty, and service contracts. If the liability of 
a taxpayer arises out of the provision to the taxpayer of insurance, or 
a warranty or service contract, economic performance occurs as payment 
is made to the person to which the liability is owed. See Examples 5 
through 7 of paragraph (g)(8) of this section. For purposes of this 
paragraph (g)(5)--
    (i) A warranty or service contract is a contract that a taxpayer 
enters into in connection with property bought or leased by the 
taxpayer, pursuant to which the other party to the contract promises to 
replace or repair the property under specified circumstances.
    (ii) The term ``insurance'' has the same meaning as is used when 
determining the deductibility of amounts paid or incurred for insurance 
under section 162.
    (6) Taxes--(i) In general. Except as otherwise provided in this 
paragraph (g)(6), if the liability of a taxpayer is to pay a tax, 
economic performance occurs as the tax is paid to the governmental 
authority that imposed the tax. For purposes of this paragraph (g)(6), 
payment includes payments of estimated income tax and payments of tax 
where the taxpayer subsequently files a claim for credit or refund. In 
addition, for purposes of this paragraph (g)(6), a tax does not include 
a charge collected

[[Page 283]]

by a governmental authority for specific extraordinary services or 
property provided to a taxpayer by the governmental authority. Examples 
of such a charge include the purchase price of a parcel of land sold to 
a taxpayer by a governmental authority and a charge for labor engaged in 
by government employees to improve that parcel. In certain cases, a 
liability to pay a tax is permitted to be taken into account in the 
taxable year before the taxable year during which economic performance 
occurs under the recurring item exception of Sec. 1.461-5. See Example 
8 of paragraph (g)(8) of this section.
    (ii) Licensing fees. If the liability of a taxpayer is to pay a 
licensing or permit fee required by a governmental authority, economic 
performance occurs as the fee is paid to the governmental authority, or 
as payment is made to any other person at the direction of the 
governmental authority.
    (iii) Exceptions--(A) Real property taxes. If a taxpayer has made a 
valid election under section 461 (c), the taxpayer's accrual for real 
property taxes is determined under section 461 (c). Otherwise, economic 
performance with respect to a property tax liability occurs as the tax 
is paid, as specified in paragraph (g)(6)(i) of this section.
    (B) Certain foreign taxes. If the liability of a taxpayer is to pay 
an income, war profits, or excess profits tax that is imposed by the 
authority of any foreign country or possession of the United States and 
is creditable under section 901 (including a creditable tax described in 
section 903 that is paid in lieu of such a tax), economic performance 
occurs when the requirements of the all events test (as described in 
Sec. 1.446-1 (c)(1)(ii)) other than economic performance are met, 
whether or not the taxpayer elects to credit such taxes under section 
901 (a).
    (7) Other liabilities. In the case of a taxpayer's liability for 
which economic perfomance rules are not provided elsewhere in this 
section or in any other Internal Revenue regulation, revenue ruling or 
revenue procedure, economic performance occurs as the taxpayer makes 
payments in satisfaction of the liability to the person to which the 
liability is owed. This paragraph (g)(7) applies only if the liability 
cannot properly be characterized as a liability covered by rules 
provided elsewhere in this section. If a liability may properly be 
characterized as, for example, a liability arising from the provision of 
services or property to, or by, a taxpayer, the determination as to when 
economic performance occurs with respect to that liability is made under 
paragraph (d) of this section and not under this paragraph (g)(7).
    (8) Examples. The following examples illustrate the principles of 
this paragraph (g). For purposes of these examples, it is assumed that 
the requirements of the all events test other than economic performance 
have been met and, except as otherwise provided, that the recurring item 
exception is not used.

    Example 1. Liabilities arising out of a tort. (i) During the period 
1970 through 1975, Z corporation, a calendar year, accrual method 
taxpayer, manufactured and distributed industrial products that 
contained carcinogenic substances. In 1992, a number of lawsuits are 
filed against Z alleging damages due to exposure to these products. In 
settlement of a lawsuit maintained by A, Z agrees to purchase an annuity 
contract that will provide annual payments to A of $50,000 for a period 
of 25 years. On December 15, 1992, Z pays W, an unrelated life insurance 
company, $491,129 for such an annuity contract. Z retains ownership of 
the annuity contract.
    (ii) Under paragraph (g)(2) of this section, economic performance 
with respect to Z's liability to A occurs as each payment is made to A. 
Consequently, $50,000 is incurred by Z for each taxable year that a 
payment is made to A under the annuity contract. (Z must also include in 
income a portion of amounts paid under the annuity, pursuant to section 
72.) The result is the same if in 1992 Z secures its obligation with a 
standby letter of credit.
    (iii) If Z later transfers ownership of the annuity contract to A, 
an amount equal to the fair market value of the annuity on the date of 
transfer is incurred by Z in the taxable year of the transfer (see 
paragraph (g)(1)(ii)(B) of this section). In addition, the transfer 
constitutes a transaction to which section 1001 applies.
    Example 2. Rebates and refunds. (i) X corporation, a calendar year, 
accrual method taxpayer, manufactures and sells hardware products. X 
enters into agreements that entitle each of its distributors to a rebate 
(or discount on future purchases) from X based on the amount of 
purchases made by the distributor from X during any calendar year. 
During the 1992 calendar year, X becomes liable to pay a $2,000 rebate 
to distributor A. X

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pays A $1,200 of the rebate on January 15, 1993, and the remaining $800 
on October 15, 1993. Assume the rebate is deductible (or allowable as an 
adjustment to gross receipts or cost of goods sold) when incurred.
    (ii) If X does not adopt the recurring item exception described in 
Sec. 1.461-5 with respect to rebates and refunds, then under paragraph 
(g)(3) of this section, economic performance with respect to the $2,000 
rebate liability occurs in 1993. However, if X has made a proper 
election under Sec. 1.461-5, and as of December 31, 1992, all events 
have occurred that determine the fact of the rebate liability, X incurs 
$1,200 for the 1992 taxable year. Because economic performance (payment) 
with respect to the remaining $800 does not occur until October 15, 1993 
(more than 8\1/2\ months after the end of 1992), X cannot use the 
recurring item exception for this portion of the liability (see Sec. 
1.461-5). Thus, the $800 is not incurred by X until the 1993 taxable 
year. If, instead of making the cash payments to A during 1993, X 
adjusts the price of hardware purchased by A that is delivered to A 
during 1993, X's ``payment'' occurs as X would otherwise be required to 
recognize income resulting from a disposition at an unreduced price.
    Example 3. Awards, prizes, and jackpots. (i) W corporation, a 
calendar year, accrual method taxpayer, produces and sells breakfast 
cereal. W conducts a contest pursuant to which the winner is entitled to 
$10,000 per year for a period of 20 years. On December 1, 1992, A is 
declared the winner of the contest and is paid $10,000 by W. In 
addition, on December 1 of each of the next nineteen years, W pays 
$10,000 to A.
    (ii) Under paragraph (g)(4) of this section, economic performance 
with respect to the $200,000 contest liability occurs as each of the 
$10,000 payments is made by W to A. Consequently, $10,000 is incurred by 
W for the 1992 taxable year and for each of the succeeding nineteen 
taxable years.
    Example 4. Awards, prizes, and jackpots. (i) Y corporation, a 
calendar year, accrual method taxpayer, owns a casino that contains 
progressive slot machines. A progressive slot machine provides a 
guaranteed jackpot amount that increases as money is gambled through the 
machine until the jackpot is won or until a maximum predetermined amount 
is reached. On July 1, 1993, the guaranteed jackpot amount on one of Y's 
slot machines reaches the maximum predetermined amount of $50,000. On 
October 1, 1994, the $50,000 jackpot is paid to B.
    (ii) Under paragraph (g)(4) of this section, economic performance 
with respect to the $50,000 jackpot liability occurs on the date the 
jackpot is paid to B. Consequently, $50,000 is incurred by Y for the 
1994 taxable year.
    Example 5. Insurance, warranty, and service contracts. (i) V 
corporation, a calendar year, accrual method taxpayer, manufactures 
toys. V enters into a contract with W, an unrelated insurance company, 
on December 15, 1992. The contract obligates V to pay W a premium of 
$500,000 before the end of 1995. The contract obligates W to satisfy any 
liability of V resulting from claims made during 1993 or 1994 against V 
by any third party for damages attributable to defects in toys 
manufactured by V. Pursuant to the contract, V pays W a premium of 
$500,000 on October 1, 1995.
    (ii) Assuming the arrangement constitutes insurance, under paragraph 
(g)(5) of this section economic performance occurs as the premium is 
paid. Thus, $500,000 is incurred by V for the 1995 taxable year.
    Example 6. Insurance, warranty, and service contracts. (i) Y 
corporation, a calendar year, accrual method taxpayer, is a common 
carrier. On December 15, 1992, Y enters into a contract with Z, an 
unrelated insurance company, under which Z must satisfy any liability of 
Y that arises during the succeeding 5 years for damages under a workers 
compensation act or out of any tort, provided the event that causes the 
damages occurs during 1993 or 1994. Under the contract, Y pays $360,000 
to Z on December 31, 1993.
    (ii) Assuming the arrangement constitutes insurance, under paragraph 
(g)(5) of this section economic performance occurs as the premium is 
paid. Consequently, $360,000 is incurred by Y for the 1993 taxable year. 
The period for which the $360,000 amount is permitted to be taken into 
account is determined under the capitalization rules because the 
insurance contract is an asset having a useful life extending 
substantially beyond the close of the taxable year.
    Example 7. Insurance, warranty, and service contracts. Assume the 
same facts as in Example 6, except that Y is obligated to pay the first 
$5,000 of any damages covered by the arrangement with Z. Y is, in 
effect, self-insured to the extent of this $5,000 ``deductible.'' Thus, 
under paragraph (g)(2) of this section, economic performance with 
respect to the $5,000 liability does not occur until the amount is paid 
to the person to which the tort or workers compensation liability is 
owed.
    Example 8. Taxes. (i) The laws of State A provide that every person 
owning personal property located in State A on the first day of January 
shall be liable for tax thereon and that a lien for the tax shall attach 
as of that date. In addition, the laws of State A provide that 60% of 
the tax is due on the first day of December following the lien date and 
the remaining 40% is due on the first day of July of the succeeding 
year. On January 1, 1992, X corporation, a calendar year, accrual method 
taxpayer, owns personal property located in State A. State A imposes a 
$10,000 tax on S with respect to that property on January 1,

[[Page 285]]

1992. X pays State A $6,000 of the tax on December 1, 1992, and the 
remaining $4,000 on July 1, 1993.
    (ii) Under paragraph (g)(6) of this section, economic performance 
with respect to $6,000 of the tax liability occurs on December 1, 1992. 
Consequently, $6,000 is incurred by X for the 1992 taxable year. 
Economic performance with respect to the remaining $4,000 of the tax 
liability occurs on July 1, 1993. If X has adopted the recurring item 
exception described in Sec. 1.461-5 as a method of accounting for 
taxes, and as of December 31, 1992, all events have occurred that 
determine the liability of X for the remaining $4,000, X also incurs 
$4,000 for the 1992 taxable year. If X does not adopt the recurring item 
exception method, the $4,000 is not incurred by X until the 1993 taxable 
year.

    (h) Liabilities arising under the Nuclear Waste Policy Act of 1982. 
Notwithstanding the principles of paragraph (d) of this section, 
economic performance with respect to the liability of an owner or 
generator of nuclear waste to make payments to the Department of Energy 
(``DOE'') pursuant to a contract required by the Nuclear Waste Policy 
Act of 1982 (Pub. L. 97-425, 42 U.S.C. 10101-10226 (1982)) occurs as 
each payment under the contract is made to DOE and not when DOE 
satisfies its obligations under the contract. This rule applies to the 
continuing fee required by 42 U.S.C. 10222(a)(2) (1982), as well as the 
one-time fee required by 42 U.S.C. 10222 (a)(3) (1982). For rules 
relating to when economic performance occurs with respect to interest, 
see paragraph (e) of this section.
    (i) [Reserved]
    (j) Contingent liabilities. [Reserved]
    (k) Special effective dates--(1) In general. Except as otherwise 
provided in this paragraph (k), section 461(h) and this section apply to 
liabilities that would, under the law in effect before the enactment of 
section 461(h), be allowable as a deduction or otherwise incurred after 
July 18, 1984. For example, the economic performance requirement applies 
to all liabilities arising under a workers compensation act or out of 
any tort that would, under the law in effect before the enactment of 
section 461(h), be incurred after July 18, 1984. For taxable years 
ending before April 7, 1995, see Q&A-2 of Sec. 1.461-7T (as it appears 
in 26 CFR part 1 revised April 1, 1995), which provides an election to 
make this change in method of accounting applicable to either the 
portion of the first taxable year that occurs after July 18, 1984 (part-
year change method), or the entire first taxable year ending after July 
18, 1984 (full-year change method). With respect to the effective date 
rules for interest, section 461(h) applies to interest accruing under 
any obligation (whether or not evidenced by a debt instrument) if the 
obligation is incurred in any transaction occurring after June 8, 1984, 
and is not incurred under a written contract which was binding on March 
1, 1984, and at all times thereafter until the obligation is incurred. 
Interest accruing under an obligation described in the preceding 
sentence is subject to section 461(h) even if the interest accrues 
before July 19, 1984. Similarly, interest accruing under any obligation 
incurred in a transaction occurring before June 9, 1984, (or under a 
written contract which was binding on March 1, 1984, and at all times 
thereafter until the obligation is incurred) is not subject to section 
461(h) even to the extent the interest accrues after July 18, 1984.
    (2) Long-term contracts. Except as otherwise provided in paragraph 
(M)(2) of this section, in the case of liabilities described in 
paragraph (d)(2)(ii) of this section (relating to long-term contracts), 
paragraph (d)(2)(ii) of this section applies to liabilities that would, 
but for the enactment of section 461(h), be allowable as a deduction or 
otherwise incurred for taxable years beginning after December 31, 1991.
    (3) Payment liabilities. Except as otherwise provided in paragraph 
(m)(2) of this section, in the case of liabilities described in 
paragraph (g) of this section (other than liabilities arising under a 
workers compensation act or out of any tort described in paragraph 
(g)(2) of this section), paragraph (g) of this section applies to 
liabilities that would, but for the enactment of section 461(h), be 
allowable as a deduction or otherwise incurred for taxable years 
beginning after December 31, 1991.
    (l) [Reserved]
    (m) Change in method of accounting required by this section--(1) In 
general. For the first taxable year ending after July 18, 1984, a 
taxpayer is granted the consent of the Commissioner to change its

[[Page 286]]

method of accounting for liabilities to comply with the provisions of 
this section pursuant to any of the following procedures:
    (i) For taxable years ending before April 7, 1995, the part-year 
change in method election described in Q&A-2 through Q&A-6 and Q&A-8 
through Q&A-10 of Sec. 1.461-7T (as it appears in 26 CFR part 1 revised 
April 1, 1995);
    (ii) For taxable years ending before April 7, 1995, the full-year 
change in method election described in Q&A-2 through Q&A-6 and Q&A-8 
through Q&A-10 of Sec. 1.461-7T (as it appears in 26 CFR part 1 revised 
April 1, 1995); or
    (iii) For taxable years ending before April 7, 1995, if no election 
is made, the cut-off method described in Q&A-1 and Q&A-11 of Sec. 
1.461-7T (as it appears in 26 CFR part 1 revised April 1, 1995).
    (2) Change in method of accounting for long-term contracts and 
payment liabilities--(i) First taxable year beginning after December 31, 
1991. For the first taxable year beginning after December 31, 1991, a 
taxpayer is granted the consent of the Commissioner to change its method 
of accounting for long-term contract liabilities described in paragraph 
(D)(2)(ii) of this section and payment liabilities described in 
paragraph (g) of this section (other than liabilities arising under a 
workers compensation act or out of any tort described in paragraph 
(g)(2) of this section) to comply with the provisions of this section. 
The change must be made in accordance with paragraph (m)(1)(ii) or 
(m)(1)(iii) of this section, except the effective date is the first day 
of the first taxable year beginning December 31, 1991.
    (ii) Retroactive change in method of accounting for long-term 
contracts and payment liabilities. For the first taxable year beginning 
after December 31, 1989, or the first taxable year beginning after 
December 31, 1990, a taxpayer is granted the consent of the Commissioner 
to change its method of accounting for long-term contract liabilities 
described in paragraph (d)(2)(ii) of this section and payment 
liabilities described in paragraph (g) of this section (other than 
liabilities arising under a workers compensation act or out of any tort 
described in paragraph (g)(2) of this section) to comply with the 
provisions of this section. The change must be made in accordance with 
paragraph (m)(1)(ii) or (m)(1)(iii) of this section, except the 
effective date is the first day of the first taxable year beginning 
after December 31, 1989, or the first day of the first taxable year 
beginning after December 31, 1990. For taxable years ending before April 
7, 1995, the taxpayer may make the change in method of accounting, 
including a full-year change in method election under paragraph 
(m)(1)(ii) of this section and Q&A-5 of Sec. 1.461-7T (as it appears in 
26 CFR part 1 revised April 1, 1995), by filing an amended return for 
such year, provided the amended return is filed on or before October 7, 
1992.

[T.D. 8408, 57 FR 12421, Apr. 10, 1992, as amended by T.D. 8491, 58 FR 
53135, Oct. 14, 1993; T.D. 8593, 60 FR 18743, Apr. 13, 1995; T.D. 8820, 
64 FR 26851, May 18, 1999; T.D. 8408, 69 FR 44597, July 27, 2004]



Sec. 1.461-5  Recurring item exception.

    (a) In general. Except as otherwise provided in paragraph (c) of 
this section, a taxpayer using an accrual method of accounting may adopt 
the recurring item exception described in paragraph (b) of this section 
as method of accounting for one or more types of recurring items 
incurred by the taxpayer. In the case of the ``other payment 
liabilities'' described in Sec. 1.461-4(g)(7), the Commissioner may 
provide for the application of the recurring item exception by 
regulation, revenue procedure or revenue ruling.
    (b) Requirements for use of the exception--(1) General rule. Under 
the recurring item exception, a liability is treated as incurred for a 
taxable year if--
    (i) As of the end of that taxable year, all events have occurred 
that establish the fact of the liability and the amount of the liability 
can be determined with reasonable accuracy;
    (ii) Economic performance with respect to the liability occurs on or 
before the earlier of--
    (A) The date the taxpayer files a timely (including extensions) 
return for that taxable year; or
    (B) The 15th day of the 9th calendar month after the close of that 
taxable year;

[[Page 287]]

    (iii) The liability is recurring in nature; and
    (iv) Either--
    (A) The amount of the liability is not material; or
    (B) The accrual of the liability for that taxable year results in a 
better matching of the liability with the income to which it relates 
than would result from accruing the liability for the taxable year in 
which economic performance occurs.
    (2) Amended returns. A taxpayer may file an amended return treating 
a liability as incurred under the recurring item exception for a taxable 
year if economic performance with respect to the liability occurs after 
the taxpayer files a return for that year, but within 8\1/2\ months 
after the close of that year.
    (3) Liabilities that are recurring in nature. A liability is 
recurring if it can generally be expected to be incurred from one 
taxable year to the next. However, a taxpayer may treat such a liability 
as recurring in nature even if it is not incurred by the taxpayer in 
each taxable year. In addition, a liability that has never previously 
been incurred by a taxpayer may be treated as recurring if it is 
reasonable to expect that the liability will be incurred on a recurring 
basis in the future.
    (4) Materiality requirement. For purposes of this paragraph (b):
    (i) In determining whether a liability is material, consideration 
shall be given to the amount of the liability in absolute terms and in 
relation to the amount of other items of income and expense attributable 
to the same activity.
    (ii) A liability is material if it is material for financial 
statement purposes under generally acepted accounting principles.
    (iii) A liability that is immaterial for financial statement 
purposes under generally accepted accounting principles may be material 
for purposes of this paragraph (b).
    (5) Matching requirement. (i) In determining whether the matching 
requirement of paragraph (b)(1)(iv)(B) of this section is satisfied, 
generally accepted accounting principles are an important factor, but 
are not dispositive.
    (ii) In the case of a liability described in paragraph (g)(3) 
(rebates and refunds), paragraph (g)(4) (awards, prizes, and jackpots), 
paragraph (g)(5) (insurance, warranty, and service contracts), paragraph 
(g)(6) (taxes), or paragraph (h) (continuing fees under the Nuclear 
Waste Policy Act of 1982) of Sec. 1.461-4, the matching requirement of 
paragraph (b)(1)(iv)(B) of this section shall be deemed satisfied.
    (c) Types of liabilities not eligible for treatment under the 
recurring item exception. The recurring item exception does not apply to 
any liability of a taxpayer described in paragraph (e) (interest), 
paragraph (g)(2) (workers compensation, tort, breach of contract, and 
violation of law), or paragraph (g)(7) (other liabilities) of Sec. 
1.461-4. Moreover, the recurring item exception does not apply to any 
liability incurred by a tax shelter, as defined in section 461(i) and 
Sec. 1.448-1T(b).
    (d) Time and manner of adopting the recurring item exception--(1) In 
general. The recurring item exception is a method of accounting that 
must be consistently applied with respect to a type of item, or for all 
items, from one taxable year to the next in order to clearly reflect 
income. A taxpayer is permitted to adopt the recurring item exception as 
part of its method of accounting for any type of item for the first 
taxable year in which that type of item is incurred. Except as otherwise 
provided, the rules of section 446(e) and Sec. 1.446-1(e) apply to 
changes to or from the recurring item exception as a method of 
accounting. For taxable years ending before April 7, 1995, see Q&A-7 of 
Sec. 1.461-7T (as it appears in 26 CFR part 1 revised April 1, 1995) 
for rules concerning the time and manner of adopting the recurring item 
exception for taxable years that include July 19, 1984. For purposes of 
this section, items are to be classified by type in a manner that 
results in classifications that are no less inclusive than the 
classifications of production costs provided in the full-absorption 
regulations of Sec. 1.471-11(b) and(c), whether or not the taxpayer is 
required to maintain inventories.
    (2) Change to the recurring item exception method for the first 
taxable year beginning after December 31, 1991--(i) In

[[Page 288]]

general. For the first taxable year beginning after December 31, 1991, a 
taxpayer is granted the consent of the Commissioner to change to the 
recurring item exception method of accounting. A taxpayer is also 
granted the consent of the Commissioner to expand or modify its use of 
the recurring item exception method for the first taxable year beginning 
after December 31, 1991. For each trade or business for which a taxpayer 
elects to use the recurring item exception method, the taxpayer must use 
the same method of change (cut-off or full-year change) it is using for 
that trade or business under Sec. 1.461-4(m). For taxable year sending 
before April 7, 1995, see Q&A-11 of Sec. 1.461-7T (as it appears in 26 
CFR part 1 revised April 1, 1995) for an explanation of how amounts are 
taken into account under the cut-off method (except that, for purposes 
of this paragraph (d)(2), the change applies to all amounts otherwise 
incurred on or after the first day of the first taxable year beginning 
after December 31, 1991). For taxable years ending before April 7, 1995, 
see Q&A-6 of Sec. 1.461-7T (as it appears in 26 CFR part 1 revised 
April 1, 1995) for an explanation of how amounts are taken into account 
under the full-year change method (except that the change in method 
occurs on the first day of the first taxable year beginning after 
December 31, 1991). For taxable years ending before April 7, 1995, the 
full-year change in method may result in a section 481(a) adjustment 
that must be taken into account in the manner described in Q&A-8 and 
Q&A-9 of Sec. 1.461-7T (as it appears in 26 CFR part 1 revised April 1, 
1995) (except that the taxable year of change is the first taxable year 
beginning after December 31, 1991).
    (ii) Manner of changing to the recurring item exception method. For 
the first taxable year beginning after December 31, 1991, a taxpayer may 
change to the recurring item exception method by accounting for the item 
on its timely filed original return for such taxable year (including 
extensions). For taxable years ending before April 7, 1995, the 
automatic consent of the Commissioner is limited to those items 
accounted for under the recurring item exception method on the timely 
filed return, unless the taxpayer indicates a wider scope of change by 
filing the statement provided in Q&A-7(b)(2) of Sec. 1.461-7T (as it 
appears in 26 CFR part 1 revised April 1, 1995).
    (3) Retroactive change to the recurring item exception method. For 
the first taxable year beginning after December 31, 1989, or December 
31, 1990, a taxpayer is granted consent of the Commissioner to change to 
the recurring item exception method of accounting, provided the taxpayer 
complies with paragraph (d)(2) of this section on either the original 
return for such year or on an amended return for such year filed on or 
before October 7, 1991. For this purpose the effective date is the first 
day of the first taxable year beginning after December 31, 1989, or the 
first day of the first taxable year beginning after December 31, 1990. A 
taxpayer is also granted the consent of the Commissioner to expand or 
modify its use of the recurring item exception method for the first 
taxable year beginning after December 31, 1989, December 31, 1990, or 
December 31, 1991.
    (e) Examples. The following examples illustrate the principles of 
this section:

    Example 1. Requirements for use of the recurring item exception. (i) 
Y corporation, a calendar year, accrual method taxpayer, manufactures 
and distributes video cassette recorders. Y timely files its federal 
income tax return for each taxable year on the extended due date for the 
return (September 15, of the following taxable year). Y offers to refund 
the price of a recorder to any purchaser not satisfied with the 
recorder. During 1992, 100 purchasers request a refund of the $500 
purchase price. Y refunds $30,000 on or before September 15, 1993, and 
the remaining $20,000 after such date but before the end of 1993.
    (ii) Under paragraph (g)(3) of Sec. 1.461-4, economic performance 
with respect to $30,000 of the refund liability occurs on September 15, 
1993. Assume the refund is deductible (or allowable as an adjustment to 
gross receipts or cost of goods sold) when incurred. If Y does not adopt 
the recurring item exception with respect to rebates and refunds, the 
$30,000 refund is incurred by Y for the 1993 taxable year. However, if Y 
has properly adopted the recurring item exception method of accounting 
under this section, and as of December 31, 1992, all events have 
occurred that determine the fact of the liability for the $30,000 
refund, Y incurs that amount for the 1992 taxable year. Because economic 
performance (payment) with respect to the remaining $20,000 occurs after 
September 15, 1993 (more

[[Page 289]]

than 8\1/2\ months after the end of 1992), that amount is not eligible 
for recurring item treatment under this section. Thus, the $20,000 
amount is not incurred by Y until the 1993 taxable year.
    Example 2. Requirements for use of the recurring item exception; 
amended returns. The facts are the same as in Example 2, except that Y 
files its income tax return for 1992 on March 15, 1993, and Y does not 
refund the price of any recorder before that date. Under paragraph 
(b)(1) of this section, the refund liability is not eligible for the 
recurring item exception because economic performance with respect to 
the refund does not occur before Y files a return for the taxable year 
for which the item would have been incurred under the exception. 
However, since economic performance occurs within 8\1/2\ months after 
1992, Y may file an amended return claiming the $30,000 as incurred for 
its 1992 taxable year (see paragraph (b)(2) of this section).

[T.D. 8408, 57 FR 12427, Apr. 10, 1992, as amended by T.D. 8593, 60 FR 
18743, Apr. 13, 1995]



Sec. 1.461-6  Economic performance when certain liabilities are 
assigned or are extinguished by the establishment of a fund.

    (a) Qualified assignments of certain personal injury liabilities 
under section 130. In the case of a qualified assignment (within the 
meaning of section 130(c)), economic performance occurs as a taxpayer-
assignor makes payments that are excludible from the income of the 
assignee under section 130(a).
    (b) Section 468B. Economic performance occurs as a taxpayer makes 
qualified payments to a designated settlement fund under section 468B, 
relating to special rules for designated settlement funds.
    (c) Payments to other funds or persons that constitute economic 
performance. [Reserved]
    (d) Effective dates. The rules in paragraph (a) of this section 
apply to payments after July 18, 1984.

[T.D. 8408, 57 FR 12428, Apr. 10, 1992]



Sec. 1.465-1T  Aggregation of certain activities (temporary).

    (a) General rule. A partner in a partnership or an S corporation 
shareholder may aggregate and treat as a single activity--
    (1) The holding, production, or distribution of more than one motion 
picture film or video tape by the partnership or S corporation,
    (2) The farming (as defined in section 464 (e)) of more than one 
farm by the partnership or S corporation,
    (3) The exploration for, or exploitation of, oil and gas resources 
with respect to more than one oil and gas property by the partnership or 
S corporation, or
    (4) The exploration for, or exploitation of, geothermal deposits 
(within the meaning of section 613(e)(3)) with respect to more than one 
geothermal property by the partnership or S corporation.

Thus, for example, if a partnership or S corporation is engaged in the 
activity of exploring for, or exploiting, oil and gas resources with 
respect to 10 oil and gas properties, a partner or S corporation 
shareholder may aggregate those properties and treat the aggregated oil 
and gas activities as a single activity. If that partnership or S 
corporation also is engaged in the activity of farming with respect to 
two farms, the partner or shareholder may aggregate the farms and treat 
the aggregated farming activities as a single separate activity. Except 
as provided in section 465(c)(2)(B)(ii), the partner or shareholder 
cannot aggregate the farming activity with the oil and gas activity.
    (b) Effective date. This section shall apply to taxable years 
beginning after December 31, 1983 and before January 1, 1985.

(Secs. 465(c)(2)(B) and 7805 of the Internal Revenue Code of 1954 (98 
Stat. 814, 68A Stat. 917; 26 U.S.C. 465(c)(2)(B) and 7805))

[T.D. 8012, 50 FR 9614, Mar. 11, 1985]



Sec. 1.465-8  General rules; interest other than that of a creditor.

    (a) In general--(1) Amounts borrowed. This section applies to 
amounts borrowed for use in an activity described in section 465(c)(1) 
or (c)(3)(A). Amounts borrowed with respect to an activity will not 
increase the borrower's amount at risk in the activity if the lender has 
an interest in the activity other than that of a creditor or is related 
to a person (other than the borrower) who has an interest in the 
activity other than that of a creditor. This rule applies even if the 
borrower

[[Page 290]]

is personally liable for the repayment of the loan or the loan is 
secured by property not used in the activity. For additional rules 
relating to the treatment of amounts borrowed from these persons, see 
Sec. 1.465-20.
    (2) Certain borrowed amounts excepted. (i) For purposes of 
determining a corporation's amount at risk, an interest in the 
corporation as a shareholder is not an interest in any activity of the 
corporation. Thus, amounts borrowed by a corporation from a shareholder 
may increase the corporation's amount at risk.
    (ii) For purposes of determining a taxpayer's amount at risk in an 
activity of holding real property, paragraph (a)(1) of this section does 
not apply to financing that is secured by real property used in the 
activity and is either--
    (A) Qualified nonrecourse financing described in section 
465(b)(6)(B); or
    (B) Financing that, if it were nonrecourse, would be financing 
described in section 465(b)(6)(B).
    (b) Loans for which the borrower is personally liable for 
repayment--(1) General rule. If a borrower is personally liable for the 
repayment of a loan for use in an activity, a person shall be considered 
a person with an interest in the activity other than that of a creditor 
only if the person has either a capital interest in the activity or an 
interest in the net profits of the activity.
    (2) Capital interest. For the purposes of this section a capital 
interest in an activity means an interest in the assets of the activity 
which is distributable to the owner of the capital interest upon the 
liquidation of the activity. The partners of a partnership and the 
shareholders of an S corporation are considered to have capital 
interests in the activities conducted by the partnership or S 
corporation.
    (3) Interest in net profits. For the purposes of this section it is 
not necessary for a person to have any incidents of ownership in the 
activity in order to have an interest in the net profits of the 
activity. For example, an employee or independent contractor any part of 
whose compensation is determined with reference to the net profits of 
the activity will be considered to have an interest in the net profits 
of the activity.
    (4) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. A, the owner of a herd of cattle sells the herd to 
partnership BCD. BCD pays A $10,000 in cash and executes a note for 
$30,000 payable to A. Each of the three partners, B, C, and D, assumes 
personal liability for repayment of the amount owed A. In addition, BCD 
enters into an agreement with A under which A is to take care of the 
cattle for BCD in return for compensation equal to 6 percent of BCD's 
net profits from the activity. Because A has an interest in the net 
profits of BCD's farming activity, A is considered to have an interest 
in the activity other than that of a creditor. Accordingly, amounts 
payable to A for use in that activity do not increase the partners' 
amount at risk even though the partners assume personal liability for 
repayment.
    Example 2. Assume the same facts as in Example 1 except that instead 
of receiving compensation equal to 6 percent of BCD's net profits from 
the activity, A instead receives compensation equal to 1 percent of the 
gross receipts from the activity. A does not have a capital interest in 
BCD. A's interest in the gross receipts is not considered an interest in 
the net profits. Because B, C, and D assumed personal liability for the 
amounts payable to A, and A has neither a capital interest nor an 
interest in the net profits of the activity, A is not considered to have 
an interest in the activity other than that of a creditor with respect 
to the $30,000 loan. Accordingly, B, C, and D are at risk for their 
share of the loan if the other provisions of section 465 are met.
    Example 3. Assume the same facts as in Example 1 except that instead 
of receiving compensation equal to 6 percent of BCD's net profits from 
the activity, A instead receives compensation equal to 6 percent of the 
net profits from the activity or $15,000, whichever is greater. A is 
considered to have an interest in the net profits from the activity and 
accordingly will be treated as a person with an interest in the activity 
other than that of a creditor.

    (c) Nonrecourse loans secured by assets with a readily ascertainable 
fair market value--(1) General rule. This paragraph shall apply in the 
case of a nonrecourse loan for use in an activity where the loan is 
secured by property which has a readily ascertainable fair market value. 
In the case of such a loan a person shall be considered a person with an 
interest in the activity other than that of a creditor only if the 
person has either a capital interest in the activity

[[Page 291]]

or an interest in the net profits of the activity.
    (2) Example. The provisions of this paragraph (c) may be illustrated 
by the following example:

    Example. X is an investor in an activity described in section 
465(c)(1). In order to raise money for the investment, X borrows money 
from A, the promoter (the person who brought X together with other 
taxpayers for the purpose of investing in the activity). The loan is 
secured by stock unrelated to the activity which is listed on a national 
securities exchange. X's stock has a readily ascertainable fair market 
value. A does not have a capital interest in the activity or an interest 
in its net profits. Accordingly, with respect to the loan secured by X's 
stock, A does not have an interest in the activity other than that of a 
creditor.

    (d) Nonrecourse loans secured by assets without a readily 
ascertainable fair market value--(1) General rule. This paragraph shall 
apply in the case of a nonrecourse loan for use in an activity where the 
loan is secured by property which does not have a readily ascertainable 
fair market value. In the case of such a loan a person shall be 
considered a person with an interest in the activity other than that of 
a creditor if the person stands to receive financial gain (other than 
interest) from the activity or from the sale of interests in the 
activity. For the purposes of this section persons who stand to receive 
financial gain from the activity include persons who receive 
compensation for services rendered in connection with the organization 
or operation of the activity or for the sale of interests in the 
activity. Such a person will generally include the promoter of the 
activity who organizes the activity or solicits potential investors in 
the activity.
    (2) Example. The provisions of this paragraph (d) may be illustrated 
by the following example:

    Example. A is the promoter of an activity described in section 
465(c)(1). As the promoter, A organizes the activity and solicits 
potential investors. For these services A is paid a flat fee of $130x. 
This fee is paid out of the amounts contributed by the investors to the 
activity. X, one of the investors in the activity, borrows money from A 
for use in the activity. X is not personally liable for repayment to A 
of the amount borrowed. As security for the loan, X pledges an asset 
which does not have a readily ascertainable fair market value. A is 
considered a person with an interest in the activity other than that of 
a creditor with respect to this loan because the asset pledged as 
security does not have a readily ascertainable fair market value, X is 
not personally liable for repayment of the loan, and A received 
financial gain from the activity. Accordingly, X's amount at risk in the 
activity is not increased despite the fact that property was pledged as 
security.

    (e) Effective date. This section applies to amounts borrowed after 
May 3, 2004.

[T.D. 9124, 69 FR 24079, May 3, 2004; 69 FR 26305, May 12, 2004]



Sec. 1.465-20  Treatment of amounts borrowed from certain persons 
and amounts protected against loss.

    (a) General rule. The following amounts are treated in the same 
manner as borrowed amounts for which the taxpayer has no personal 
liability and for which no security is pledged--
    (1) Amounts that do not increase the taxpayer's amount at risk 
because they are borrowed from a person who has an interest in the 
activity other than that of a creditor or from a person who is related 
to a person (other than the taxpayer) who has an interest in the 
activity other than that of a creditor; and
    (2) Amounts (whether or not borrowed) that are protected against 
loss.
    (b) Interest other than that of a creditor; cross reference. See 
Sec. 1.465-8 for additional rules relating to amounts borrowed from a 
person who has an interest in the activity other than that of a creditor 
or is related to a person (other than the taxpayer) who has an interest 
in the activity other than that of a creditor.
    (c) Amounts protected against loss; cross reference. See Sec. 
1.465-6 for rules relating to amounts protected against loss.
    (d) Effective date. This section applies to amounts borrowed after 
May 3, 2004.

[T.D. 9124, 69 FR 24079, May 3, 2004]



Sec. 1.465-27  Qualified nonrecourse financing.

    (a) In general. Notwithstanding any provision of section 465(b) or 
the regulations under section 465(b), for an activity of holding real 
property, a taxpayer is considered at risk for the taxpayer's share of 
any qualified nonrecourse financing which is secured by real property 
used in such activity.

[[Page 292]]

    (b) Qualified nonrecourse financing secured by real property--(1) In 
general. For purposes of section 465(b)(6) and this section, the term 
qualified nonrecourse financing means any financing--
    (i) Which is borrowed by the taxpayer with respect to the activity 
of holding real property;
    (ii) Which is borrowed by the taxpayer from a qualified person or 
represents a loan from any federal, state, or local government or 
instrumentality thereof, or is guaranteed by any federal, state, or 
local government;
    (iii) For which no person is personally liable for repayment, taking 
into account paragraphs (b)(3), (4), and (5) of this section; and
    (iv) Which is not convertible debt.
    (2) Security for qualified nonrecourse financing--(i) Types of 
property. For a taxpayer to be considered at risk under section 
465(b)(6), qualified nonrecourse financing must be secured only by real 
property used in the activity of holding real property. For this 
purpose, however, property that is incidental to the activity of holding 
real property will be disregarded. In addition, for this purpose, 
property that is neither real property used in the activity of holding 
real property nor incidental property will be disregarded if the 
aggregate gross fair market value of such property is less than 10 
percent of the aggregate gross fair market value of all the property 
securing the financing.
    (ii) Look-through rule for partnerships. For purposes of paragraph 
(b)(2)(i) of this section, a borrower shall be treated as owning 
directly its proportional share of the assets in a partnership in which 
the borrower owns (directly or indirectly through a chain of 
partnerships) an equity interest.
    (3) Personal liability; partial liability. If one or more persons 
are personally liable for repayment of a portion of a financing, the 
portion of the financing for which no person is personally liable may 
qualify as qualified nonrecourse financing.
    (4) Partnership liability. For purposes of section 465(b)(6) and 
this paragraph (b), the personal liability of any partnership for 
repayment of a financing is disregarded and, provided the requirements 
contained in paragraphs (b)(1)(i), (ii), and (iv) of this section are 
satisfied, the financing will be treated as qualified nonrecourse 
financing secured by real property if--
    (i) The only persons personally liable to repay the financing are 
partnerships;
    (ii) Each partnership with personal liability holds only property 
described in paragraph (b)(2)(i) of this section (applying the 
principles of paragraph (b)(2)(ii) of this section in determining the 
property held by each partnership); and
    (iii) In exercising its remedies to collect on the financing in a 
default or default-like situation, the lender may proceed only against 
property that is described in paragraph (b)(2)(i) of this section and 
that is held by the partnership or partnerships (applying the principles 
of paragraph (b)(2)(ii) of this section in determining the property held 
by the partnership or partnerships).
    (5) Disregarded entities. Principles similar to those described in 
paragraph (b)(4) of this section shall apply in determining whether a 
financing of an entity that is disregarded for federal tax purposes 
under Sec. 301.7701-3 of this chapter is treated as qualified 
nonrecourse financing secured by real property.
    (6) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Personal liability of a partnership; incidental property. 
(i) X is a limited liability company that is classified as a partnership 
for federal tax purposes. X engages only in the activity of holding real 
property. In addition to real property used in the activity of holding 
real property, X owns office equipment, a truck, and maintenance 
equipment that it uses to support the activity of holding real property. 
X borrows $500 to use in the activity. X is personally liable on the 
financing, but no member of X and no other person is liable for 
repayment of the financing under local law. The lender may proceed 
against all of X's assets if X defaults on the financing.
    (ii) Under paragraph (b)(2)(i) of this section, the personal 
property is disregarded as incidental property used in the activity of 
holding real property. Under paragraph (b)(4) of this section, the 
personal liability of X for repayment of the financing is disregarded 
and, provided the requirements contained in paragraphs (b)(1)(i), (ii), 
and (iv) of this section are satisfied, the financing will be treated as 
qualified nonrecourse financing secured by real property.

[[Page 293]]

    Example 2. Bifurcation of a financing. The facts are the same as in 
Example 1, except that A, a member of X, is personally liable for 
repayment of $100 of the financing. If the requirements contained in 
paragraphs (b)(1)(i), (ii), and (iv) of this section are satisfied, then 
under paragraph (b)(3) of this section, the portion of the financing for 
which A is not personally liable for repayment ($400) will be treated as 
qualified nonrecourse financing secured by real property.
    Example 3. Personal liability; tiered partnerships. (i) UTP1 and 
UTP2, both limited liability companies classified as partnerships, are 
the only general partners in Y, a limited partnership. Y borrows $500 
with respect to the activity of holding real property. The financing is 
a general obligation of Y. UTP1 and UTP2, therefore, are personally 
liable to repay the financing. Under section 752, UTP1's share of the 
financing is $300, and UTP2's share is $200. No person other than Y, 
UTP1, and UTP2 is personally liable to repay the financing. Y, UTP1, and 
UTP2 each hold only real property.
    (ii) Under paragraph (b)(4) of this section, the personal liability 
of Y, UTP1, and UTP2 to repay the financing is disregarded and, provided 
the requirements of paragraphs (b)(1)(i), (ii), and (iv) of this section 
are satisfied, UTP1's $300 share of the financing and UTP2's $200 share 
of the financing will be treated as qualified nonrecourse financing 
secured by real property.
    Example 4. Personal liability; tiered partnerships. The facts are 
the same as in Example 3, except that Y's general partners are UTP1 and 
B, an individual. Because B, an individual, is also personally liable to 
repay the $500 financing, the entire financing fails to satisfy the 
requirement in paragraph (b)(1)(iii) of this section. Accordingly, 
UTP1's $300 share of the financing will not be treated as qualified 
nonrecourse financing secured by real property.
    Example 5. Personal liability; tiered partnerships. The facts are 
the same as in Example 3, except that Y is a limited liability company 
and UTP1 and UTP2 are not personally liable for the debt. However, UTP1 
and UTP2 each pledge property as security for the loan that is other 
than real property used in the activity of holding real property and 
other than property that is incidental to the activity of holding real 
property. The fair market value of the property pledged by UTP1 and UTP2 
is greater than 10 percent of the sum of the aggregate gross fair market 
value of the property held by Y and the aggregate gross fair market 
value of the property pledged by UTP1 and UTP2. Accordingly, the 
financing fails to satisfy the requirement in paragraph (b)(1)(iii) of 
this section by virtue of its failure to satisfy paragraph (b)(4)(iii) 
of this section. Therefore, the financing is not qualified nonrecourse 
financing secured by real property.
    Example 6. Personal liability; Disregarded entity. (i) X is a single 
member limited liability company that is disregarded as an entity 
separate from its owner for federal tax purposes under Sec. 301.7701-3 
of this chapter. X owns certain real property and property that is 
incidental to the activity of holding the real property. X does not own 
any other property. For federal tax purposes, A, the sole member of X, 
is considered to own all of the property held by X and is engaged in the 
activity of holding real property through X. X borrows $500 and uses the 
proceeds to purchase additional real property that is used in the 
activity of holding real property. X is personally liable to repay the 
financing, but A is not personally liable for repayment of the financing 
under local law. The lender may proceed against all of X's assets if X 
defaults on the financing.
    (ii) X is disregarded so that the assets and liabilities of X are 
treated as the assets and liabilities of A. However, A is not personally 
liable for the $500 liability. Provided that the requirements contained 
in paragraphs (b)(1)(i), (ii), and (iv) of this section are satisfied, 
the financing will be treated as qualified nonrecourse financing secured 
by real property with respect to A.

    (c) Effective date. This section is effective for any financing 
incurred on or after August 4, 1998. Taxpayers, however, may apply this 
section retroactively for financing incurred before August 4, 1998.

[T.D. 8777, 63 FR 41421, Aug. 4, 1998]



Sec. 1.466-1  Method of accounting for the redemption cost of qualified 
discount coupons.

    (a) Introduction. Section 466 permits taxpayers who elect to use the 
method of accounting description in section 466 to deduct the redemption 
cost (as defined in paragraph (b) of this section) of qualified discount 
coupons (as defined in paragraph (c) of this section) outstanding at the 
end of the taxable year and redeemed during the redemption period 
(within the meaning of paragraph (d)(2) of this section) in addition to 
the redemption cost of qualified discount coupons redeemed during the 
taxable year which were not deducted for a prior taxable year. For the 
taxable year in which the taxpayer first uses this method of accounting, 
the taxpayer is not allowed to deduct the redemption costs of qualified 
discount coupons redeemed during the taxable year that would have been 
deductible for the prior taxable year had

[[Page 294]]

the taxpayer used this method of accounting for such prior year. (See 
paragraph (e) of this section for rules describing how this amount 
should be taken into account.) A taxpayer must use the accrual method of 
accounting for any trade or business for which an election is made under 
section 466. Furthermore, the taxpayer must make an election in 
accordance with the rules in section 466(d) and Sec. 1.466-3 for that 
trade or business. The method of accounting in section 466 is applicable 
only to the taxpayer's redemption of qualified discount coupons. Section 
466 does not apply to trading stamps or premium coupons, which are 
subject to the method of accounting in Sec. 1.451-4, or to discount 
coupons that are not qualified discount coupons.
    (b) Redemption costs--(1) Costs deductible under section 466. The 
deduction allowed by section 466 applies only to the redemption cost of 
qualified discount coupons. The term ``redemption cost'' means an amount 
equal to:
    (i) The lesser of:
    (A) The amount of the discount stated on the coupon, or
    (B) The cost incurred by the taxpayer for paying the discount; plus
    (ii) The amount payable to the retailer (or other person redeeming 
the coupon from the person receiving the price discount) for services in 
redeeming the coupon.

The amount payable to the retailer or other person for services in 
redeeming the coupon is allowed only if the amount payable is stated on 
the coupon.
    (2) Costs not deductible under section 466. The term ``redemption 
cost'' includes only the amounts stated in paragraph (b)(1) of this 
section. Amounts other than those mentioned in paragraph (b)(1) of this 
section cannot be deducted under the method of accounting described in 
section 466 even though such amounts are incurred in relation to the 
redemption of qualified discount coupons. Therefore, those amounts must 
be taken into account as if section 466 did not apply. Examples of such 
amounts are fees paid to the redemption center or clearinghouse and 
amounts payable to the retailer in excess of the amount stated on the 
coupon.
    (c) Qualified discount coupons--(1) General rule. In order for a 
discount coupon (as defined in paragraph (c)(2)(i) of this section) to 
be considered a qualified discount coupon, all of the following 
requirements must be met:
    (i) The coupon must have been issued by and must be redeemable by 
the taxpayer;
    (ii) The coupon must allow a discount on the purchase price of 
merchandise or other tangible personal property;
    (iii) The face amount of the coupon must not exceed five dollars;
    (iv) The coupon, by its terms, may not be used with other coupons to 
bring about a price discount reimbursable by the issuer of more than 
five dollars with respect to any item; and
    (v) There must exist a redemption chain (as defined in paragraph 
(c)(2)(ii) of this section) with respect to the coupon.
    (2) Definitions--(i) Discount coupon. A discount coupon is a sales 
promotion device used to encourage the purchase of a specific product by 
allowing a purchaser of that product to receive a discount on its 
purchase price. The term ``discount coupon'' does not include trading 
stamps or premium coupons, which are subject to the method of accounting 
in Sec. 1.451-4. A discount coupon may or may not be issued as part of 
a prior purchase. A discount coupon normally entitles its holders to 
receive nothing more than a reduction in the sales price of one of the 
issuer's products. The discount may be stated in terms of a cash amount, 
a percentage or fraction of the purchase price, a ``two for the price of 
one'' deal, or any other similar provision. A discount coupon need not 
be printed on paper in the form usually associated with coupons; it may 
be a token or other object so long as it functions as a coupon.
    (ii) Redemption chain. A redemption chain exists when the issuer 
redeems the coupon from some person other than the customer who used the 
coupon to receive the price discount. Thus, in order to be treated as a 
qualified discount coupon, the coupon must not be issued by the person 
that initially redeems the coupon from the customer. For purposes of 
determining whether a redemption chain exists, corporations

[[Page 295]]

that are members of the same controlled group of corporations (as 
defined in section 1563(a)) as the issuer of the coupon shall be treated 
as the issuer. Thus, if the issuer of the coupon and the retailer that 
initially redeems the coupon from the customer are members of the same 
controlled group of corporations, the coupon shall not be treated as a 
qualified discount coupon.
    (d) Deduction for coupons redeemed during the redemption period--(1) 
General rule. Two special conditions must be met before the cost of 
redeeming qualified discount coupons during the redemption period can be 
deducted from the taxpayer's gross income for the taxable year preceding 
the redemption period. First, the qualified discount coupons must have 
been outstanding at the close of such taxable year. Second, the 
qualified discount coupons must have been received by the taxpayer 
before the close of the redemption period for that taxable year.
    (2) Redemption period. The taxpayer can select any redemption period 
so long as the period does not extend longer than 6 months after the 
close of the taxapayer's taxable year. A change in the redemption period 
so selected shall be treated as a change in method of accounting.
    (3) Coupons received. The deduction provided for in section 
466(a)(1) is limited to the redemption costs associated with coupons 
that are actually received by the taxpayer within the redemption period. 
For purposes of this paragraph, if the issuer uses a redemption agent or 
clearinghouse to group, count, and verify coupons after they have been 
redeemed by a retailer, the coupons received by the redemption agent or 
clearinghouse will be

considered to have been received by the issuer. Nothing in section 466, 
however, allows deductions to be made on the basis of estimated 
redemptions, whether such estimates are made by either the issuer or 
some other party.
    (e) Transitional adjustment--(1) In general. An election to change 
from some other method of accounting for the redemption of discount 
coupons to the method of accounting described in section 466 is a change 
in method of accounting that requires a transitional adjustment. Unless 
the taxpayer can qualify for a waiver of the suspense account 
requirement as provided for in section 373(c) of the Revenue Act of 1978 
(92 Stat. 2865), the taxpayer should compute the transitional adjustment 
described in section 481(a)(2) according to the rules contained in this 
section. This adjustment should be taken into account according to the 
special rules in subsections (e) and (f) of section 466.
    (2) Net increase in taxable income. In the case of a transitional 
adjustment that would result in a net increase in taxable income under 
section 481(a)(2) for the year of change, that increase should be taken 
into income over a ten-year period consisting of the year of change and 
the immediately succeeding nine taxable years. For example, assume that 
A, a calendar year taxpayer, makes an election to use the method of 
accounting described in section 466 for the year 1980 and for subsequent 
years. Assume further that the amount of the transitional adjustment 
computed under section 481(a)(2) would result in a net increase in 
taxable income of $100 for 1980. Under these facts, A should increase 
taxable income for 1980 and each of the next nine taxable years by $10.
    (3) Suspense account--(i) In general. In the case of a transitional 
adjustment that would result in a net decrease in taxable income under 
section 481(a)(2) for the year of change, in lieu of applying section 
481, the taxpayer must establish a separate suspense account for each 
trade or business for which the taxpayer has made an election to use 
section 466. The computation of the initial opening balance in the 
suspense account is described in paragraph (e)(3)(ii)(A) of this 
section. An initial adjustment to gross income for the year of election 
is described in paragaph (e)(3)(ii)(B) of this section. Annual 
adjustments to the suspense account are described in paragraph 
(e)(3)(iii)(A) of this section, and gross income adjustments are 
described in paragraph (e)(3)(iii)(B) of this section. Examples are 
provided in paragraph (e)(4) of this section. The effect of the suspense 
account is to defer some part of, or all of, the deduction of the 
transitional adjustment until the taxpayer no longer redeems discount 
coupons in

[[Page 296]]

connection with the trade or business to which the suspense account 
relates.
    (ii) Establishing a suspense account--(A) Initial opening balance. 
To compute the initial opening balance of the suspense account for the 
first taxable year for which the election to use section 466 is 
effective, the taxpayer must determine the dollar amount of the 
deduction that would have been allowed for qualified discount coupon 
redemption costs during the redemption period for each of the three 
immediately preceding taxable years had the election to use section 466 
been in effect for those years. The initial opening balance of the 
suspense account is the largest such dollar amount reduced by the sum of 
the adjustments attributable to the change in method of accounting that 
increase income for the year of change.
    (B) Initial year adjustment. If, in computing the initial opening 
balance, the largest dollar amount of deduction that would have been 
allowed in any of the three prior years exceeds the actual cost of 
redeeming qualified discount coupons received during the redemption 
period following the close of the year immediately preceding the year of 
election, the excess is included in income in the year of election. 
Section 481(b) does not apply to this increase in gross income.
    (iii) Annual adjustments--(A) Adjustment to the suspense account. 
Adjustments are made to the suspense account each year to account for 
fluctuations in coupon redemptions. To compute the annual adjustment, 
the taxpayer must determine the amount to be deducted under section 
466(a)(1) for the taxable year. If the amount is less than the opening 
balance in the suspense account for the taxable year, the balance in the 
suspense account is reduced by the difference. Conversely, if such 
amount is greater than the opening balance in the suspense account for 
the taxable year, the account is increased by the difference (but not to 
an amount in excess of the initial opening balance described in 
paragraph (e)(3)(ii) of this section). Therefore, the balance in the 
suspense account will never be greater than the initial opening balance 
in the suspense account determined in paragraph (e)(3)(ii) of this 
section. However, the balance in the suspense account after adjustments 
may be less than this initial opening balance in the suspense account.
    (B) Gross income adjustments. Adjustments to the suspense account 
for years subsequent to the year of the election also produce 
adjustments in the taxpayer's gross income. Adjustments which reduce the 
balance in the suspense account reduce gross income for the year in 
which the adjustment to the suspense account is made. Adjustments which 
increase the balance in the suspense account increase gross income for 
the year in which the adjustment to the suspense account is made.
    (4) Examples. (i) The provisions of paragraph (e)(3) of this section 
may be illustrated by the following examples:

    Example (1). Assume that the issuer of qualified discount coupons 
makes a timely election under section 466 for its taxable year ending 
December 31, 1979, and does not select a coupon redemption period 
shorter than the statutory period of 6 months. Assume further that the 
taxpayer's qualified discount coupon redemption costs in the first 6 
months of 1977, 1978, and 1979 were $7, $13, and $8 respectively, and 
that the accounting change adjustments that increase income for 1979 are 
$10. Since the accounting change adjustment that increases income for 
1979, ($10), is greater than the taxpayer's discount coupon redemptions 
during the first 6 months of 1979 ($8), the net section 481(a)(2) 
adjustment for the year of change results in a positive adjustment. 
Because of this, a suspense account is not required. The taxpayer should 
instead follow the rules in section 466(f) and in paragraph (e)(2) of 
this section in order to take this positive transitional adjustment into 
account.
    Example (2). Assume the same facts as in example (1), except that 
the sum of the accounting change adjustments that increase income for 
1979 is equal to $2. Under these facts the initial opening balance in 
the suspense account on January 1, 1979 would be $11 (that is, the 
largest dollar amount of qualified coupon redemption costs in the 
pertinent years ($13), reduced by the sum of the accounting change 
adjustments that increase income in the year of change ($2)). Since the 
coupon redemption costs taken into account in determining the initial 
opening balance ($13 in 1979) exceed the actual redemption costs in the 
first 6 months of the taxable year for which the election is first 
effective ($8 in 1979), the excess of $5 is added to gross income for 
the year of election (1979).
    Example (3). Assume, in addition to the facts of example (2), that 
coupon redemption

[[Page 297]]

costs during the redemption period for the 1979 taxable year are $7. 
Since the qualifying redemption costs ($7) during the redemption period 
for the taxable year are less than the opening balance in the suspense 
account ($11) the taxpayer must reduce the suspense account balance by 
the difference ($4). The taxpayer is also allowed to take a deduction 
equal to the amount of this adjustment to the suspense account. Thus, 
the net amount deductible for the 1979 taxable year after taking into 
account the coupon redemptions during the redemption period, the amount 
deductible because of the decrease in the suspense account, and the 
initial year adjustment determined in example (2) is $6 ($7+$4-$5).
    Example (4). Assume, in addition to the facts of example (3), that 
coupon redemption costs during the redemption period for the 1980 
taxable year are $10. Since the qualifying redemption costs during the 
redemption period for the taxable year ($10) exceed the opening balance 
of the suspense account at the beginning of the taxable year ($7), the 
suspense account must be increased by the difference ($3). The taxpayer 
must also include $3 in gross income for the taxable year. Thus, the net 
amount deductible for the 1980 taxable year is $7 ($10-$3).
    Example (5). Assume, in addition to the facts of example (4), that 
coupon redemption costs during the redemption period for the 1981 
taxable year are $12. Since the qualifying redemption costs for the 1961 
taxable year ($12) exceed the opening balance of the suspense account at 
the beginning of the taxable year ($10), the suspense account must be 
increased by the difference ($2) but not above the initial opening 
balance ($11). Thus, the taxpayer will increase the balance by $1. The 
taxpayer must also include $1 in gross income for the taxable year. 
Thus, the net amount deductible for the 1981 taxable year is $11 ($12-
$1).

    (ii) The following table summarizes examples (2) through (5):

------------------------------------------------------------------------
                                         Years ending Dec. 31--
                               -----------------------------------------
                                 1977   1978   1979   1980   1981   1982
------------------------------------------------------------------------
Facts:
    Actual coupon redemption       $7    $13     $8     $7    $10    $12
     costs in first six months
    Accounting change           .....  .....      2  .....  .....  .....
     adjustments that increase
     income in year of change.
                               -----------------------------------------
    Net adjustment decreasing   .....  .....      6  .....  .....  .....
     income in year of change
     under sec. 481(a)(2).....
                               -----------------------------------------
Adjustment to suspense
 account:
    Opening balance...........  .....  .....     11      7     10     11
    Addition to account.......  .....  .....  .....      3      1  .....
    Reduction to account......  .....  .....    (4)  .....  .....  .....
                               -----------------------------------------
        Opening balance for     .....  .....      7     10     11  .....
         next year............
                               -----------------------------------------
Amount deductible:
    Initial year adjustment...  .....  .....    (5)  .....  .....  .....
    Amount of deductible as     .....  .....      7     10     12  .....
     actual coupon redemptions
     during redemption period.
    Adjustment for increase in  .....  .....  .....    (3)    (1)  .....
     suspense account.........
    Adjustment for decrease in  .....  .....      4  .....  .....  .....
     suspense account.........
                               -----------------------------------------
        Net amount deductible   .....  .....      6      7     11  .....
         for the year for
         coupons redeemed
         during the redemption
         period...............
------------------------------------------------------------------------

    (f) Subchapter C transactions--(1) General rule. If a transfer of 
substantially all the assets of a trade or business in which discount 
coupons are redeemed is made to an acquiring corporation, and if the 
acquiring corporation determines its bases in these assets, in whole or 
part, with reference to the basis of these assets in the hands of the 
transferor, then for the purposes of section 466(e) the principles of 
section 381 and Sec. 1.381(c)(4)-1 will apply. The application of this 
rule is not limited to the transactions described in section 381(a). 
Thus, the rule also applies, for example, to transactions described in 
section 351.
    (2) Special rules. If, in the case of a transaction described in 
paragraph (f)(1) of this section, an acquiring corporation acquires 
assets that were used in a trade or business that was not subject to a 
section 466 election from a transferor that is owned or controlled 
directly (or indirectly through a chain of corporations) by the same 
interests, and if the acquiring corporation uses

[[Page 298]]

the acquired assets in a trade or business for which the acquiring 
corporation later makes an election to use section 466, then the 
acquiring corporation must establish a suspense account by taking into 
account not only its own experience but also the transferor's experience 
when the transferor held the assets in its trade or business. 
Furthermore, the transferor is not allowed a deduction for qualified 
discount coupons redeemed after the date of the transfer attributable to 
discount coupons issued by the transferor before the date of the 
transfer. Such redemptions shall be considered to be made by the 
acquiring corporation.
    (3) Example. The provisions of paragraph (f)(2) of this section may 
be illustrated by the following example:

    Example. Corporation S, a calendar year taxpayer, is a wholly owned 
subsidiary of Corporation P, a calendar year taxpayer. On December 31, 
1982, S acquires from P sustantially all of the assets used in a trade 
or business in which qualified disount coupons are redeemed. P had not 
made an election under section 466 with respect to the redemption costs 
of the qualified discount coupons issued in connection with that trade 
or business. S makes an election to use section 466 for its taxable year 
ending December 31, 1983, for the trade or business in which the 
acquired assets are used, and selects a redemption period of 6 months. 
Assume that P's qualified discount coupon redemption costs in the first 
6 months of 1981 and 1982 were $120 and $140 respectively. Assume 
further that S's qualified discount coupon redemption costs in the first 
6 months of 1983 were $130, and that there are no accounting change 
adjustments that increase income with respect to the election. S must 
establish a suspense account by taking into account the largest dollar 
amount of deductions that would have been allowed under section 
466(a)(1) for the 3 immediately preceding taxable years of P, including 
both P's and S's experience with respect to costs actually incurred 
during the redemption periods relating to those years. Thus, the initial 
opening balance of S's suspense account is $140. S must also make an 
initial year adjustment of $10 ($140-$130), which S must include in 
income for S's taxable year ending December 31, 1983. P may not take a 
deduction for the qualified coupon redemptions made after December 31, 
1982, that are attributable to coupons issued by P before December 31, 
1982. Thus, none of the $130 qualified discount coupon redemption costs 
incurred by S during the first six months of 1983 may be deducted by P.

[T.D. 8022, 50 FR 18474, May 1, 1985, as amended at 50 FR 21046, May 22, 
1985]



Sec. 1.466-2  Special protective election for certain taxpayers.

    (a) General rule. Section 373(c) of the Revenue Act of 1978 (92 
Stat. 2865) allows certain taxpayers, who in prior years have accounted 
for discount coupons under a method of accounting reasonably similar to 
the method described in Sec. 1.451-4, to elect to treat that method of 
accounting as a proper one for those prior years. There are several 
differences between this protective election and the section 466(d) 
election. First, the protective election applies only to a single 
continuous period of taxable years the last year of which ends before 
January 1, 1979. Second, an otherwise qualifying protective election may 
apply to coupons which are discount coupons but which would not be 
treated as qualified discount coupons under Code section 466. Third, 
certain expenses such as the cost of redemption center service fees, and 
amounts that are payable to the retailer (or other person redeeming the 
coupons from the person receiving the price discount) for services in 
redeeming the coupons but that are not stated on the coupon, can be 
subtracted from gross receipts for prior years covered by a protective 
election (if treated as deductible under the accounting method for such 
years), even though such expenses would not be deductible under Code 
section 466.
    (b) Requirements. In order to qualify for this special protective 
election, the following conditions must be met:
    (1) For a continuous period of one or more prior taxable years, (the 
last year of which ends before Jan. 1, 1979), the taxpayer must have 
used a method of accounting for discount coupons that is reasonably 
similar to the method provided in Sec. 1.451-4 or its predecessors 
under the Internal Revenue Code of 1954;
    (2) The taxpayer must make an election under section 466 of the 
Internal Revenue Code of 1954 according to the rules contained in Sec. 
1.466-3 for its first taxable year ending after December 31, 1978; and

[[Page 299]]

    (3) The taxpayer must make an election under section 373(c) of the 
Revenue Act of 1978 according to the rules contained in Sec. 1.466-4 
for its first taxable year ending after December 31, 1978.
    (c) Amount to be subtracted from gross receipts. The amount the 
taxpayer may subtract under this section for the redemption costs of 
coupons shall include only:
    (1) Costs of the type permitted by Sec. 1.451-4 to be included in 
the estimated average cost of redeeming coupons, plus
    (2) Any amount designated or referred to on the coupon payable by 
the taxpayer to the person who allowed the discount on a sale by such 
person to the user of the coupon.

Nothing in this paragraph shall allow an item to be deducted more than 
once.
    (d) Right to amend prior tax returns. This paragraph applies only to 
those taxpayers who have agreed in a prior year to discontinue the use 
of the method of accounting described in Sec. 1.451-4 for discount 
coupon redemptions. If the taxpayer used such method of accounting on 
the original return filed for the prior taxable year, and if any such 
year is not closed under the statute of limitations or by reason of a 
closing agreement with the Internal Revenue Service, a taxpayer who has 
made a protective election may file an amended return and a claim for 
refund for such years. In this amended return, the taxpayer should 
account for its discount coupon redemptions, according to the method of 
accounting described in Sec. 1.451-4. This is not to be construed, 
however, to abrogate in any way the rules regarding the close of taxable 
years due to the statute of limitations or a binding closing agreement 
between the Internal Revenue Service and the taxpayer.
    (e) Suspense account not required. If the following three conditions 
are satisfied, the taxpayer need not establish the suspense account 
otherwise required by section 466(e). First, the taxpayer must make a 
timely election under these rules to protect prior years. Second, the 
method of accounting used in those years must have been used for all 
discount coupons issued by the taxpayer in those years in all the 
taxpayer's separate trades or

businesses in which coupons were issued. Third, either before or after 
an amendment to the taxpayer's tax returns as described in paragraph (d) 
of this section, a method of accounting reasonably similar to the method 
of accounting described in Sec. 1.451-4 must have been used for the 
taxable year ending on or before December 31, 1978. If these conditions 
are met, the taxpayer will treat the election of the method under 
section 466 as a change in method of accounting to which the rules in 
section 481 and the regulations thereunder apply.
    (f) Definition: reasonably similar. For purposes of paragraphs 
(b)(1) and (e) of this section, a taxpayer will be considered to have 
used a method of accounting for discount coupons that is ``reasonably 
similar'' to the method of accounting provided in Sec. 1.451-4 if the 
taxpayer followed the method of accounting described in Sec. 1.451-4 as 
if that method were a valid method of accounting for discount coupon 
redemptions.

[T.D. 8022, 50 FR 18476, May 1, 1985]



Sec. 1.466-3  Manner of and time for making election under section 466.

    (a) In general. Section 466 provides a special method of accounting 
for accrual basis taxpayers who issue qualified discount coupons (as 
defined in section 466(b)). In order to use the special method under 
section 466, a taxpayer must make an election with respect to the trade 
or business in connection with which the qualified discount coupons are 
issued. If a taxpayer issues qualified discount coupons in connection 
with more than one trade or business, the taxpayer may use the special 
method of accounting under section 466 only with respect to the 
qualified discount coupons issued in connection with a trade or business 
for which an election is made. The election must be made in the manner 
prescribed in this section. The election does not require the prior 
consent of the Internal Revenue Service. An election under section 466 
is effective for the taxable year for which it is made and for all 
subsequent taxable years, unless the taxpayer secures the prior consent 
of

[[Page 300]]

the Internal Revenue Service to revoke such election.
    (b) Manner of and time for making election--(1) General rule. Except 
as provided in paragraph (b)(2) of this section, an election is made 
under section 466 and this section by filing a statement of election 
containing the information described in paragraph (c) of this section 
with the taxpayer's income tax return for the taxpayer's first taxable 
year for which the election is made. The election must be made not later 
than the time prescribed by law (including extensions thereof) for 
filing the income tax return for the first taxable year for which the 
election is made. Thus, the election may not be made for a taxable year 
by filing an amended income tax return after the time prescribed 
(including extensions) for filing the original return for such year.
    (2) Transitional rule. If the last day of the time prescribed by law 
(including extensions thereof) for filing a taxpayer's income tax return 
for the taxpayer's first taxable year ending after December 31, 1978, 
falls before December 3, 1979, and the taxpayer does not make an 
election under section 466 with respect to such taxable year in the 
manner prescribed by paragraph (b)(1) of this section, an election is 
made under section 466 and this section with respect to such taxable 
year if--
    (i) Within the time prescribed by law (including extensions thereof) 
for filing the taxpayer's income tax return for such taxable year, the 
taxpayer has made a reasonable effort to notify the Commissioner of the 
taxpayer's intent to make an election under section 466 with respect to 
such taxable year, and
    (ii) Before January 2, 1980, the taxpayer files a statement of 
election

containing the information described in paragraph (c) of this section to 
be associated with the taxpayer's income tax return for such taxable 
year.

For purposes of paragraph (b)(2)(i) of this section, a reasonable effort 
to notify the Commissioner of an intent to make an election under 
section 466 with respect to a taxable year includes the timely filing of 
an income tax return for such taxable year if the taxable income 
reported on the return reflects a deduction for the redemption costs of 
qualified discount coupons as determined under section 466(a).
    (c) Required information. The statement of election required by 
paragraph (b) of this section must indicate that the taxpayer 
(identified by name, address, and taxpayer identification number) is 
making an election under section 466 and must set forth the following 
information:
    (1) A description of each trade or business for which the election 
is made;
    (2) The first taxable year for which the election is made;
    (3) The redemption period (as defined in section 466(c)(2)) for each 
trade or business for which the election is made;
    (4) If the taxpayer is required to establish a suspense account 
under section 466(e) for a trade or business for which the election is 
made, the initial opening balance of such account (as defined in section 
466(e)(2)) for each such trade or business; and
    (5) In the case of an election under section 466 that results in a 
net increase in taxable income under section 481(a)(2), the amount of 
such net increase.

The statement of election should be made on a Form 3115, which need 
contain no information other than that required by this paragraph or 
paragraph (c) of Sec. 1.466-4.

[T.D. 8022, 50 FR 18477, May 1, 1985]



Sec. 1.466-4  Manner of and time for making election under section 
373(c) of the Revenue Act of 1978.

    (a) In general. Section 373(c)(2) of the Revenue Act of 1978 (92 
Stat. 2865) provides an election for taxpayers who satisfy the 
requirements of section 373(c)(2)(A) (i) and (ii) of the Act. The 
election is made with respect to a method of accounting for the 
redemption costs of discount coupons used by the electing taxpayer in a 
continuous period of one or more taxable years ending before January 1, 
1979. The election must be made in the manner prescribed by this 
section. The election does not require the prior consent of the Internal 
Revenue Service.

[[Page 301]]

    (b) Manner of and time for making election--(1) General rule. Except 
as provided in paragraph (b)(2) of this section, the election under 
section 373(c) of the Revenue Act of 1978 is made by filing a statement 
of election containing the information described in paragraph (c) of 
this section with the taxpayer's income tax return for the taxpayer's 
first taxable year ending after December 31, 1978. The election must be 
made not later than the time prescribed by law (including extensions 
thereof) for filing the income tax return for the taxpayer's first 
taxable year ending after December 31, 1978. Thus, the election may not 
be made with an amended income tax return for such year filed after the 
time prescribed (including extensions) for filing the original return.
    (2) Transitional rule. If the last day of the time prescribed by law 
(including extensions thereof) for filing a taxpayer's income tax return 
for the taxpayer's first taxable year ending after December 31, 1978, 
falls before December 3, 1979, and the taxpayer does not make an 
election in the manner prescribed by paragraph (b)(1) of this section, 
an election is made under section 373(c) of the Act and this section 
with respect to a continuous period if--
    (i) Within the time prescribed by law (including extensions thereof) 
for filing the taxpayer's income tax return for the taxpayer's first 
taxable year ending after December 31, 1978, the taxpayer has made a 
reasonable effort to notify the Commissioner of the taxpayer's intent to 
make election under section 373(c) of the Act with respect to the 
continuous period, and
    (ii) Before January 2, 1980, the taxpayer files a statement of 
election containing the information described in paragraph (c) of this 
section to be associated with the taxpayer's income tax return for the 
taxpayer's first taxable year ending after December 31, 1978.
    (c) Required information. The statement of election required by 
paragraph (b) of this section must indicate that the taxpayer 
(identified by name, address, and taxpayer identification number) is 
making an election under section 373(c) of the Revenue Act of 1978 and 
must set forth the taxable years in the continuous period for which the 
election is made. The statement of election should be made on the same 
form 3115 on which the taxpayer has made a statement of election under 
section 466. The Form 3115 need contain no information other than that 
required by this paragraph or paragraph (c) of Sec. 1466-3.

[T.D. 8022, 50 FR 18478, May 1, 1985]



Sec. 1.467-0  Table of contents.

    This section lists the captions that appear in Sec. Sec. 1.467-1 
through 1.467-9.

        Sec. 1.467-1 Treatment of lessors and lessees generally.

    (a) Overview.
    (1) In general.
    (2) Cases in which rules are inapplicable.
    (3) Summary of rules.
    (i) Basic rules.
    (ii) Special rules.
    (4) Scope of rules.
    (5) Application of other authorities.
    (b) Method of accounting for section 467 rental agreements.
    (c) Section 467 rental agreements.
    (1) In general.
    (2) Increasing or decreasing rent.
    (i) Fixed rent.
    (A) In general.
    (B) Certain rent holidays disregarded.
    (ii) Fixed rent allocated to a rental period.
    (A) Specific allocation.
    (1) In general.
    (2) Rental agreements specifically allocating fixed rent.
    (B) No specific allocation.
    (iii) Contingent rent.
    (A) In general.
    (B) Certain contingent rent disregarded.
    (3) Deferred or prepaid rent.
    (i) Deferred rent.
    (ii) Prepaid rent.
    (iii) Rent allocated to a calendar year.
    (iv) Examples.
    (4) Rental agreements involving total payments of $250,000 or less.
    (i) In general.
    (ii) Special rules in computing amount described in paragraph 
(c)(4)(i) of this section.
    (d) Section 467 rent.
    (1) In general.
    (2) Fixed rent for a rental period.
    (i) Constant rental accrual.
    (ii) Proportional rental accrual.
    (iii) Section 467 rental agreement accrual.
    (e) Section 467 interest.
    (1) In general.
    (2) Interest on fixed rent for a rental period.
    (i) In general.
    (ii) Section 467 rental agreements with adequate interest.

[[Page 302]]

    (3) Treatment of interest.
    (f) Substantial modification of a rental agreement.
    (1) Treatment as new agreement.
    (i) In general.
    (ii) Limitation.
    (2) Post-modification agreement; in general.
    (3) Other effects of a modification.
    (4) Special rules.
    (i) Carryover of character; leasebacks.
    (ii) Carryover of character; long-term agreements.
    (iii) Carryover of character; disqualified agreements.
    (iv) Allocation of rent.
    (v) Difference between aggregate rent and interest and aggregate 
payments.
    (A) In general.
    (B) Constant rental accrual prior to the modification.
    (C) Agreements described in this paragraph (f)(4)(v)(C).
    (vi) Principal purpose of tax avoidance.
    (5) Definitions.
    (6) Safe harbors.
    (7) Special rules for certain transfers.
    (i) In general.
    (ii) Exception.
    (g) Treatment of amounts payable by lessor to lessee.
    (1) Interest.
    (2) Other amounts. [Reserved]
    (h) Meaning of terms.
    (i) [Reserved]
    (j) Computational rules.
    (1) Counting conventions.
    (2) Conventions regarding timing of rent and payments.
    (i) In general.
    (ii) Time amount is payable.
    (3) Annualized fixed rent.
    (4) Allocation of fixed rent within a period.
    (5) Rental period length.

  Sec. 1.467-2 Rent accrual for section 467 rental agreements without 
                           adequate interest.

    (a) Section 467 rental agreements for which proportional rental 
accrual is required.
    (b) Adequate interest on fixed rent.
    (1) In general.
    (2) Section 467 rental agreements that provide for a variable rate 
of interest.
    (3) Agreements with both deferred and prepaid rent.
    (c) Computation of proportional rental amount.
    (1) In general.
    (2) Section 467 rental agreements that provide for a variable rate 
of interest.
    (d) Present value.
    (e) Applicable Federal rate.
    (1) In general.
    (2) Source of applicable Federal rates.
    (3) 110 percent of applicable Federal rate.
    (4) Term of the section 467 rental agreement.
    (i) In general.
    (ii) Section 467 rental agreements with variable interest.
    (f) Examples.

     Sec. 1.467-3 Disqualified leasebacks and long-term agreements.

    (a) General rule.
    (b) Disqualified leaseback or long-term agreement.
    (1) In general.
    (2) Leaseback.
    (3) Long-term agreement.
    (i) In general.
    (ii) Statutory recovery period.
    (A) In general.
    (B) Special rule for rental agreements relating to properties having 
different statutory recovery periods.
    (c) Tax avoidance as principal purpose for increasing or decreasing 
rent.
    (1) In general.
    (2) Tax avoidance.
    (i) In general.
    (ii) Significant difference in tax rates.
    (iii) Special circumstances.
    (3) Safe harbors.
    (4) Uneven rent test.
    (i) In general.
    (ii) Special rule for real estate.
    (iii) Operating rules.
    (d) Calculating constant rental amount.
    (1) In general.
    (2) Initial or final short periods.
    (3) Method to determine constant rental amount; no short periods.
    (i) Step 1.
    (ii) Step 2.
    (iii) Step 3.
    (e) Examples.

                     Sec. 1.467-4 Section 467 loan.

    (a) In general.
    (1) Overview.
    (2) No section 467 loan in the case of certain section 467 rental 
agreements.
    (3) Rental agreements subject to constant rental accrual.
    (4) Special rule in applying the provisions of Sec. 1.467-7 (e), 
(f), or (g).
    (b) Principal balance.
    (1) In general.
    (2) Section 467 rental agreements that provide for prepaid fixed 
rent and adequate interest.
    (3) Timing of payments.
    (c) Yield.
    (1) In general.
    (i) Method of determining yield.
    (ii) Method of stating yield.
    (iii) Rounding adjustments.
    (2) Yield of section 467 rental agreements for which constant rental 
amount or proportional rental amount is computed.
    (3) Yield for purposes of applying paragraph (a)(4) of this section.

[[Page 303]]

    (4) Determination of present values.
    (d) Contingent payments.
    (e) Section 467 rental agreements that call for payments before or 
after the lease term.
    (f) Examples.

   Sec. 1.467-5 Section 467 rental agreements with variable interest.

    (a) Variable interest on deferred or prepaid rent.
    (1) In general.
    (2) Exceptions.
    (b) Variable rate treated as fixed.
    (1) In general.
    (2) Variable interest adjustment amount.
    (i) In general.
    (ii) Positive or negative adjustment.
    (3) Section 467 loan balance.
    (c) Examples.

 Sec. 1.467-6 Section 467 rental agreements with contingent payments. 
                               [Reserved]

    Sec. 1.467-7 Section 467 recapture and other rules relating to 
                     dispositions and modifications.

    (a) Section 467 recapture.
    (b) Recapture amount.
    (1) In general.
    (2) Prior understated inclusion.
    (3) Section 467 gain.
    (i) In general.
    (ii) Certain dispositions.
    (c) Special rules.
    (1) Gifts.
    (2) Dispositions at death.
    (3) Certain tax-free exchanges.
    (i) In general.
    (ii) Dispositions covered.
    (A) In general.
    (B) Transfers to certain tax-exempt organizations.
    (4) Dispositions by transferee.
    (5) Like-kind exchanges and involuntary conversions.
    (6) Installment sales.
    (7) Dispositions covered by section 170(e), 341(e)(12), or 751(c).
    (d) Examples.
    (e) Other rules relating to dispositions.
    (1) In general.
    (2) Treatment of section 467 loan.
    (3) [Reserved]
    (4) Examples.
    (f) Treatment of assignments by lessee and lessee-financed renewals.
    (1) Substitute lessee use.
    (2) Treatment of section 467 loan.
    (3) Lessor use.
    (4) Examples.
    (g) Application of section 467 following a rental agreement 
modification.
    (1) Substantial modifications.
    (i) Treatment of pre-modification items.
    (ii) Computations with respect to post-modification items.
    (iii) Adjustments.
    (A) Adjustment relating to certain prepayments.
    (B) Adjustment relating to retroactive beginning of lease term.
    (iv) Coordination with rules relating to dispositions and 
assignments.
    (A) Dispositions.
    (B) Assignments.
    (2) Other modifications.
    (i) Computation of section 467 loan for modified agreement.
    (ii) Change in balance of section 467 loan.
    (iii) Section 467 rent and interest after the modification.
    (iv) Applicable Federal rate.
    (v) Modification effective within a rental period.
    (vi) Other adjustments.
    (vii) Coordination with rules relating to dispositions and 
assignments.
    (viii) Exception for agreements entered into prior to effective date 
of section 467.
    (3) Adjustment by Commissioner.
    (4) Effective date of modification.
    (5) Examples.
    (h) Omissions or duplications.
    (1) In general.
    (2) Example.

Sec. 1.467-8 Automatic consent to change to constant rental accrual for 
                       certain rental agreements.

    (a) General rule.
    (b) Agreements to which automatic consent applies.

 Sec. 1.467-9 Effective dates and automatic method changes for certain 
                               agreements.

    (a) In general.
    (b) Automatic consent for certain rental agreements.
    (c) Application of regulation project IA-292-84 to certain 
leasebacks and long-term agreements.
    (d) Entered into.
    (e) Change in method of accounting.
    (1) In general.
    (2) Application of regulation project IA-292-84.
    (3) Automatic change procedures.

[T.D. 8820, 64 FR 26851, May 18, 1999, as amended by T.D. 8917, 66 FR 
1039, Jan. 5, 2001]



Sec. 1.467-1  Treatment of lessors and lessees generally.

    (a) Overview--(1) In general. When applicable, section 467 requires 
a lessor and lessee of tangible property to treat rents consistently and 
to use the accrual method of accounting (and time value of money 
principles) regardless of their overall method of accounting. In 
addition, in certain cases involving tax avoidance, the lessor and 
lessee

[[Page 304]]

must take rent and stated or imputed interest into account under a 
constant rental accrual method, pursuant to which the rent is treated as 
accruing ratably over the entire lease term.
    (2) Cases in which rules are inapplicable. Section 467 applies only 
to leases (or other similar arrangements) that constitute section 467 
rental agreements as defined in paragraph (c) of this section. For 
example, a rental agreement is not a section 467 rental agreement, and, 
therefore, is not subject to the provisions of this section and 
Sec. Sec. 1.467-2 through 1.467-9 (the section 467 regulations), if it 
specifies equal amounts of rent for each month throughout the lease term 
and all payments of rent are due in the calendar year to which the rent 
relates (or in the preceding or succeeding calendar year). In addition, 
the section 467 regulations do not apply to a rental agreement that 
requires total rents of $250,000 or less. For purposes of determining 
whether the agreement has total rents of $250,000 or less, certain 
specified contingent rent is disregarded.
    (3) Summary of rules--(i) Basic rules. Paragraph (c) of this section 
provides rules for determining whether a rental agreement is a section 
467 rental agreement. Paragraphs (d) and (e) of this section provide 
rules for determining the amount of rent and interest, respectively, 
required to be taken into account by a lessor and lessee under a section 
467 rental agreement. Paragraphs (f) through (h) and (j) of this section 
provide various definitions and special rules relating to the 
application of the section 467 regulations. Paragraph (i) of this 
section is reserved.
    (ii) Special rules. Section 1.467-2 provides rules for section 467 
rental agreements that have deferred or prepaid rents without providing 
for adequate interest. Section 1.467-3 provides rules for application of 
the constant rental accrual method, including criteria for determining 
whether an agreement is subject to this method. Section 1.467-4 provides 
rules for establishing and adjusting a section 467 loan (the amount that 
a lessor is deemed to have loaned to the lessee, or vice versa, pursuant 
to the application of the section 467 regulations). Section 1.467-5 
provides rules for applying the section 467 regulations where a rental 
agreement requires payments of interest at a variable rate. Section 
1.467-6, relating to the treatment of certain section 467 rental 
agreements with contingent payments, is reserved. Section 1.467-7 
provides rules for the treatment of dispositions by a lessor of property 
subject to a section 467 rental agreement and the treatment of 
assignments by lessees and certain lessee-financed renewals of a section 
467 rental agreement. Section 1.467-7 also provides rules for the 
treatment of modified rental agreements. Section 1.467-8 provides 
special transitional rules relating to the method of accounting for 
certain rental agreements entered into on or before May 18, 1999. 
Finally, Sec. 1.467-9 provides the effective date rules for the section 
467 regulations.
    (4) Scope of rules. No inference should be drawn from any provision 
of this section or Sec. Sec. 1.467-2 through 1.467-9 concerning 
whether--
    (i) For Federal tax purposes, an arrangement constitutes a lease; or
    (ii) For Federal tax purposes, any obligation of the lessee under a 
rental agreement is treated as rent.
    (5) Application of other authorities. Notwithstanding section 467 
and the regulations thereunder, other authorities such as section 446(b) 
clear-reflection-of-income principles, section 482, and the substance-
over-form doctrine, may be applied by the Commissioner to determine the 
income and expense from a rental agreement (including the proper 
allocation of fixed rent under a rental agreement).
    (b) Method of accounting for section 467 rental agreements. If a 
rental agreement is a section 467 rental agreement, as described in 
paragraph (c) of this section, the lessor and lessee must each take into 
account for any taxable year the sum of--
    (1) The section 467 rent for the taxable year (as defined in 
paragraph (d) of this section); and
    (2) The section 467 interest for the taxable year (as defined in 
paragraph (e) of this section).
    (c) Section 467 rental agreements--(1) In general. Except as 
otherwise provided in paragraph (c)(4) of this section, the

[[Page 305]]

term section 467 rental agreement means a rental agreement, as defined 
in paragraph (h)(12) of this section, that has increasing or decreasing 
rents (as described in paragraph (c)(2) of this section), or deferred or 
prepaid rents (as described in paragraph (c)(3) of this section).
    (2) Increasing or decreasing rent--(i) Fixed rent--(A) In general. A 
rental agreement has increasing or decreasing rent if the annualized 
fixed rent, as described in paragraph (j)(3) of this section, allocated 
to any rental period exceeds the annualized fixed rent allocated to any 
other rental period in the lease term.
    (B) Certain rent holidays disregarded. Notwithstanding the 
provisions of paragraph (c)(2)(i)(A) of this section, a rental agreement 
does not have increasing or decreasing rent if the increasing or 
decreasing rent is solely attributable to a rent holiday provision 
allowing reduced rent (or no rent) for a period of three months or less 
at the beginning of the lease term.
    (ii) Fixed rent allocated to a rental period--(A) Specific 
allocation--(1) In general. If a rental agreement provides a specific 
allocation of fixed rent, as described in paragraph (c)(2)(ii)(A)(2) of 
this section, the amount of fixed rent allocated to each rental period 
during the lease term is the amount of fixed rent allocated to that 
period by the rental agreement.
    (2) Rental agreements specifically allocating fixed rent. A rental 
agreement specifically allocates fixed rent if the rental agreement 
unambiguously specifies, for periods no longer than a year, a fixed 
amount of rent for which the lessee becomes liable on account of the use 
of the property during that period, and the total amount of fixed rent 
specified is equal to the total amount of fixed rent payable under the 
lease. For example, a rental agreement providing that rent is $100,000 
per calendar year, and providing for total payments of fixed rent equal 
to the total amount specified, specifically allocates rent. A rental 
agreement stating only when rent is payable does not specifically 
allocate rent.
    (B) No specific allocation. If a rental agreement does not provide a 
specific allocation of fixed rent (for example, because the total amount 
of fixed rent specified is not equal to the total amount of fixed rent 
payable under the lease), the amount of fixed rent allocated to a rental 
period is the amount of fixed rent payable during that rental period. If 
an amount of fixed rent is payable before the beginning of the lease 
term, it is allocated to the first rental period in the lease term. If 
an amount of fixed rent is payable after the end of the lease term, it 
is allocated to the last rental period in the lease term.
    (iii) Contingent rent--(A) In general. A rental agreement has 
increasing or decreasing rent if it requires (or may require) the 
payment of contingent rent (as defined in paragraph (h)(2) of this 
section), other than contingent rent described in paragraph 
(c)(2)(iii)(B) of this section.
    (B) Certain contingent rent disregarded. For purposes of this 
paragraph (c)(2)(iii), rent is disregarded to the extent it is 
contingent as the result of one or more of the following provisions--
    (1) A qualified percentage rents provision, as defined in paragraph 
(h)(8) of this section;
    (2) An adjustment based on a reasonable price index, as defined in 
paragraph (h)(10) of this section;
    (3) A provision requiring the lessee to pay third-party costs, as 
defined in paragraph (h)(15) of this section;
    (4) A provision requiring the payment of late payment charges, as 
defined in paragraph (h)(4) of this section;
    (5) A loss payment provision, as defined in paragraph (h)(7) of this 
section;
    (6) A qualified TRAC provision, as defined in paragraph (h)(9) of 
this section;
    (7) A residual condition provision, as defined in paragraph (h)(13) 
of this section;
    (8) A tax indemnity provision, as defined in paragraph (h)(14) of 
this section;
    (9) A variable interest rate provision, as defined in paragraph 
(h)(16) of this section; or
    (10) Any other provision provided in regulations or other published 
guidance issued by the Commissioner, but only if the provision is 
designated as contingent rent to be disregarded for purposes of this 
paragraph (c)(2)(iii).

[[Page 306]]

    (3) Deferred or prepaid rent--(i) Deferred rent. A rental agreement 
has deferred rent under this paragraph (c)(3) if the cumulative amount 
of rent allocated as of the close of a calendar year (determined under 
paragraph (c)(3)(iii) of this section) exceeds the cumulative amount of 
rent payable as of the close of the succeeding calendar year.
    (ii) Prepaid rent. A rental agreement has prepaid rent under this 
paragraph (c)(3) if the cumulative amount of rent payable as of the 
close of a calendar year exceeds the cumulative amount of rent allocated 
as of the close of the succeeding calendar year (determined under 
paragraph (c)(3)(iii) of this section).
    (iii) Rent allocated to a calendar year. For purposes of this 
paragraph (c)(3), the rent allocated to a calendar year is the sum of--
    (A) The fixed rent allocated to any rental period (determined under 
paragraph (c)(2)(ii) of this section) that begins and ends in the 
calendar year;
    (B) A ratable portion of the fixed rent allocated to any other 
rental period that begins or ends in the calendar year; and (C) Any 
contingent rent that accrues during the calendar year.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (c)(3):

    Example 1. (i) A and B enter into a rental agreement that provides 
for the lease of property to begin on January 1, 2000, and end on 
December 31, 2003. The rental agreement provides that rent of $100,000 
accrues during each year of the lease term. Under the rental agreement, 
no rent is payable during calendar year 2000, a payment of $100,000 is 
to be made on December 31, 2001, and December 31, 2002, and a payment of 
$200,000 is to be made on December 31, 2003. A and B both select the 
calendar year as their rental period. Thus, the amount of rent allocated 
to each rental period under paragraph (c)(2)(ii) of this section is 
$100,000. Therefore, the rental agreement does not have increasing or 
decreasing rent as described in paragraph (c)(2)(i) of this section.
    (ii) Under paragraph (c)(3)(i) of this section, a rental agreement 
has deferred rent if, at the close of a calendar year, the cumulative 
amount of rent allocated under paragraph (c)(3)(iii) of this section 
exceeds the cumulative amount of rent payable as of the close of the 
succeeding year. In this example, there is no deferred rent: the rent 
allocated to 2000 ($100,000) does not exceed the cumulative rent payable 
as of December 31, 2001 ($100,000); the rent allocated to 2001 and 
preceding years ($200,000) does not exceed the cumulative rent payable 
as of December 31, 2002 ($200,000); the rent allocated to 2002 and 
preceding years ($300,000) does not exceed the cumulative rent payable 
as of December 31, 2003 ($400,000); and the rent allocated to 2003 and 
preceding years ($400,000) does not exceed the cumulative rent payable 
as of December 31, 2004 ($400,000). Therefore, because the rental 
agreement does not have increasing or decreasing rent and does not have 
deferred or prepaid rent, the rental agreement is not a section 467 
rental agreement.
    Example 2. (i) A and B enter into a rental agreement that provides 
for a 10-year lease of personal property, beginning on January 1, 2000, 
and ending on December 31, 2009. The rental agreement provides for 
accruals of rent of $10,000 during each month of the lease term. Under 
paragraph (c)(3)(iii) of this section, $120,000 is allocated to each 
calendar year. The rental agreement provides for a $1,200,000 payment on 
December 31, 2000.
    (ii) The rental agreement does not have increasing or decreasing 
rent as described in paragraph (c)(2)(i) of this section. The rental 
agreement, however, provides prepaid rent under paragraph (c)(3)(ii) of 
this section because the cumulative amount of rent payable as of the 
close of a calendar year exceeds the cumulative amount of rent allocated 
as of the close of the succeeding calendar year. For example, the 
cumulative amount of rent payable as of the close of 2000 ($1,200,000 is 
payable on December 31, 2000) exceeds the cumulative amount of rent 
allocated as of the close of 2001, the succeeding calendar year 
($240,000). Accordingly, the rental agreement is a section 467 rental 
agreement.

    (4) Rental agreements involving total payments of $250,000 or less--
(i) In general. A rental agreement is not a section 467 rental agreement 
if, as of the agreement date (as defined in paragraph (h)(1) of this 
section), it is not reasonably expected that the sum of the aggregate 
amount of rental payments under the rental agreement and the aggregate 
value of all other consideration to be received for the use of property 
(taking into account any payments of contingent rent, and any other 
contingent consideration) will exceed $250,000.
    (ii) Special rules in computing amount described in paragraph 
(c)(4)(i) of this section of this section. The following rules apply in 
determining the amount described in paragraph (c)(4)(i) of this section:
    (A) Stated interest on deferred rent is not taken into account. 
However,

[[Page 307]]

the Commissioner may recharacterize a portion of stated interest as 
additional rent if a rental agreement provides for interest on deferred 
rent at a rate that, in light of all of the facts and circumstances, is 
clearly greater than the arm's-length rate of interest that would have 
been charged in a lending transaction between the lessor and lessee.
    (B) Consideration that does not involve a cash payment is taken into 
account at its fair market value. A liability that is either assumed or 
secured by property acquired subject to the liability is taken into 
account at the sum of its remaining principal amount and accrued 
interest (if any) thereon or, in the case of an obligation originally 
issued at a discount, at the sum of its adjusted issue price and accrued 
qualified stated interest (if any), within the meaning of Sec. 1.1273-
1(c)(1).
    (C) All rental agreements that are part of the same transaction or a 
series of related transactions involving the same lessee (or any related 
person) and the same lessor (or any related person) are treated as a 
single rental agreement. Whether two or more rental agreements are part 
of the same transaction or a series of related transactions depends on 
all the facts and circumstances.
    (D) If an agreement includes a provision increasing or decreasing 
rent payable solely as a result of an adjustment based on a reasonable 
price index, the amount described in paragraph (c)(4)(i) of this section 
must be determined as if the applicable price index did not change 
during the lease term.
    (E) If an agreement includes a variable interest rate provision (as 
defined in paragraph (h)(16) of this section), the amount described in 
paragraph (c)(4)(i) of this section must be determined by using fixed 
rate substitutes (determined in the same manner as under Sec. 1.1275-
5(e), treating the agreement date as the issue date) for the variable 
rates of interest applicable to the lessor's indebtedness.
    (F) Contingent rent described in paragraphs (c)(2)(iii)(B)(3) 
through (8) of this section is not taken into account.
    (d) Section 467 rent--(1) In general. The section 467 rent for a 
taxable year is the sum of--
    (i) The fixed rent for any rental period (determined under paragraph 
(d)(2) of this section) that begins and ends in the taxable year;
    (ii) A ratable portion of the fixed rent for any other rental period 
beginning or ending in the taxable year; and
    (iii) In the case of a section 467 rental agreement that provides 
for contingent rent, the contingent rent that accrues during the taxable 
year.
    (2) Fixed rent for a rental period--(i) Constant rental accrual. In 
the case of a section 467 rental agreement that is a disqualified 
leaseback or long-term agreement (as described in Sec. 1.467-3(b)), the 
fixed rent for a rental period is the constant rental amount (as 
determined under Sec. 1.467-3(d)).
    (ii) Proportional rental accrual. In the case of a section 467 
rental agreement that is not described in paragraph (d)(2)(i) of this 
section, and does not provide adequate interest on fixed rent (as 
determined under Sec. 1.467-2(b)), the fixed rent for a rental period 
is the proportional rental amount (as determined under Sec. 1.467-
2(c)).
    (iii) Section 467 rental agreement accrual. In the case of a section 
467 rental agreement that is not described in either paragraph (d)(2)(i) 
or (ii) of this section, the fixed rent for a rental period is the 
amount of fixed rent allocated to the rental period under the rental 
agreement, as determined under paragraph (c)(2)(ii) of this section.
    (e) Section 467 interest--(1) In general. The section 467 interest 
for a taxable year is the sum of--
    (i) The interest on fixed rent for any rental period that begins and 
ends in the taxable year;
    (ii) A ratable portion of the interest on fixed rent for any other 
rental period beginning or ending in the taxable year; and
    (iii) In the case of a section 467 rental agreement that provides 
for contingent rent, any interest that accrues on the contingent rent 
during the taxable year.
    (2) Interest on fixed rent for a rental period--(i) In general. 
Except as provided in paragraph (e)(2)(ii) of this section and Sec. 
1.467-5(b)(1)(ii), the interest on

[[Page 308]]

fixed rent for a rental period is equal to the product of--
    (A) The principal balance of the section 467 loan (as described in 
Sec. 1.467-4(b)) at the beginning of the rental period; and
    (B) The yield of the section 467 loan (as described in Sec. 1.467-
4(c)).
    (ii) Section 467 rental agreements with adequate interest. Except in 
the case of a section 467 rental agreement that is a disqualified 
leaseback or long-term agreement, if a section 467 rental agreement 
provides adequate interest under Sec. 1.467-2(b)(1)(i) (agreements with 
no deferred or prepaid rent) or Sec. 1.467-2(b)(1)(ii) (agreements with 
adequate interest stated at a single fixed rate), the interest on fixed 
rent for a rental period is the amount of interest provided in the 
rental agreement for the period.
    (3) Treatment of interest. If the section 467 interest for a rental 
period is a positive amount, the lessor has interest income and the 
lessee has an interest expense. If the section 467 interest for a rental 
period is a negative amount, the lessee has interest income and the 
lessor has an interest expense. Section 467 interest is treated as 
interest for all purposes of the Internal Revenue Code.
    (f) Substantial modification of a rental agreement--(1) Treatment as 
new agreement--(i) In general. If a substantial modification of a rental 
agreement occurs after June 3, 1996, the post-modification agreement is 
treated as a new agreement and the date on which the modification occurs 
is treated as the agreement date in applying section 467 and the 
regulations thereunder to the post-modification agreement. Thus, for 
example, the post-modification agreement is treated as a new agreement 
entered into on the date the modification occurs for purposes of 
determining whether it is a section 467 rental agreement under this 
section, whether it is a disqualified leaseback or long-term agreement 
under Sec. 1.467-3, and whether it is entered into after the applicable 
effective date in Sec. 1.467-9.
    (ii) Limitation. In the case of a substantial modification of a 
rental agreement occurring on or before May 18, 1999, this paragraph (f) 
applies only if--
    (A) The rental agreement was a disqualified leaseback or long-term 
agreement before the modification and the agreement date, determined 
without regard to the modification, is after June 3, 1996; or
    (B) The post-modification agreement would, after application of the 
rules in this paragraph (f) (other than the special rule for 
disqualified agreements in paragraph (f)(4)(iii) of this section), be a 
disqualified leaseback or long-term agreement.
    (2) Post-modification agreement; in general. For purposes of 
determining whether a post-modification agreement is a section 467 
rental agreement or a disqualified leaseback or long-term agreement 
under paragraph (f)(1) of this section, the terms of the post-
modification agreement are, except as provided in paragraph (f)(4) of 
this section, only those terms that provide for rights and obligations 
relating to post-modification items (within the meaning of paragraph 
(f)(5)(iv) of this section).
    (3) Other effects of a modification. For rules relating to amounts 
that must be taken into account following certain modifications, see 
Sec. 1.467-7(g).
    (4) Special rules--(i) Carryover of character; leasebacks. If an 
agreement is a leaseback prior to its modification and the lessee prior 
to the modification (or a related person) is the lessee after the 
modification, the post-modification agreement is a leaseback even if the 
post-modification lessee did not have an interest in the property at any 
time during the two-year period ending on the date on which the 
modification occurs.
    (ii) Carryover of character; long-term agreements. If an agreement 
is a long-term agreement prior to its modification and the entire 
agreement (as modified) would be a long-term agreement, the post-
modification agreement is a long-term agreement.
    (iii) Carryover of character; disqualified agreements. If an 
agreement (as in effect before its modification) is a disqualified 
leaseback or long-term agreement as the result of a determination 
(whether occurring before or after the modification) under Sec. 1.467-
3(b)(1)(ii) and the post-modification agreement is a section 467 rental 
agreement (or the

[[Page 309]]

entire agreement (as modified) would be a section 467 rental agreement), 
the post-modification agreement will, notwithstanding its treatment as a 
new agreement under paragraph (f)(1)(i) of this section, be subject to 
constant rental accrual unless the Commissioner determines that, because 
of the absence of tax avoidance potential, the post-modification 
agreement should not be treated as a disqualified leaseback or long-term 
agreement.
    (iv) Allocation of rent. If the entire agreement (as modified) 
provides a specific allocation of fixed rent, as described in paragraph 
(c)(2)(ii)(A)(2) of this section, the post-modification agreement is 
treated as an agreement that provides a specific allocation of fixed 
rent. If the entire agreement (as modified) does not provide a specific 
allocation of fixed rent, the fixed rent allocated to rental periods 
during the lease term of the post-modification agreement is determined 
by applying the rules of paragraph (c)(2)(ii)(B) of this section to the 
entire agreement (as modified).
    (v) Difference between aggregate rent and interest and aggregate 
payments--(A) In general. Except as provided in paragraph (f)(4)(v)(B) 
of this section, a post-modification agreement described in paragraph 
(f)(4)(v)(C) of this section is treated as a section 467 rental 
agreement subject to proportional rental accrual (determined under Sec. 
1.467-2(c)).
    (B) Constant rental accrual prior to the modification. A post-
modification agreement described in paragraph (f)(4)(v)(C) of this 
section is treated as a section 467 rental agreement subject to constant 
rental accrual if--
    (1) Constant rental accrual is required under paragraph (f)(4)(iii) 
of this section; or
    (2) The post-modification agreement involves total payments of more 
than $250,000 (as described in paragraph (c)(4) of this section), and 
the Commissioner determines that the post-modification agreement is a 
disqualified leaseback or long-term agreement.
    (C) Agreements described in this paragraph (f)(4)(v)(C). A post-
modification agreement is described in this paragraph (f)(4)(v)(C) if 
the aggregate amount of fixed rent and stated interest treated as post-
modification items does not equal the aggregate amount of payments 
treated as post-modification items.
    (vi) Principal purpose of tax avoidance. If a principal purpose of a 
substantial modification is to avoid the purpose or intent of section 
467 or the regulations thereunder, the Commissioner may treat the entire 
agreement (as modified) as a single agreement for purposes of section 
467 and the regulations thereunder.
    (5) Definitions. The following definitions apply for purposes of 
this paragraph (f) and Sec. 1.467-7(g):
    (i) A modification of a rental agreement is any alteration, 
including any deletion or addition, in whole or in part, of a legal 
right or obligation of the lessor or lessee thereunder, whether the 
alteration is evidenced by an express agreement (oral or written), 
conduct of the parties, or otherwise.
    (ii) A modification is substantial only if, based on all of the 
facts and circumstances, the legal rights or obligations that are 
altered and the degree to which they are altered are economically 
substantial. A modification of a rental agreement will not be treated as 
substantial solely because it is not described in paragraph (f)(6) of 
this section.
    (iii) A modification occurs on the earlier of the first date on 
which there is a binding contract that substantially sets forth the 
terms of the modification or the date on which agreement to such terms 
is otherwise evidenced.
    (iv) Post-modification items with respect to any modification of a 
rental agreement are all items (other than pre-modification items) 
provided under the terms of the entire agreement (as modified).
    (v) Pre-modification items with respect to any modification of a 
rental agreement are pre-modification rent, interest thereon, and 
payments allocable thereto (whether payable before or after the 
modification.) For this purpose--
    (A) Pre-modification rent is rent allocable to periods before the 
effective date of the modification, but only to the extent such rent is 
payable under the entire agreement (as modified) at the time such rent 
was due under the

[[Page 310]]

agreement in effect before the modification; and
    (B) Pre-modification items are identified by applying payments, in 
the order payable under the entire agreement (as modified) unless the 
agreement specifies otherwise, to rent and interest thereon in the order 
in which amounts accrue.
    (vi) The entire agreement (as modified) with respect to any 
modification is the agreement consisting of pre-modification terms 
providing for rights and obligations that are not affected by the 
modification and post-modification terms providing for rights and 
obligations that differ from the rights and obligations under the 
agreement in effect before the modification. For example, if a 10-year 
rental agreement that provides for rent of $25,000 per year is modified 
at the end of the 5th year to provide for rent of $30,000 per year in 
subsequent years, the entire agreement (as modified) provides for a 10-
year lease term and provides for rent of $25,000 per year in years 1 
through 5 and rent of $30,000 per year in years 6 through 10. The result 
would be the same if the modification provided for both the increase in 
rent and the substitution of a new lessee.
    (6) Safe harbors. Notwithstanding the provisions of paragraph (f)(5) 
of this section, a modification of a rental agreement is not a 
substantial modification if the modification occurs solely as the result 
of one or more of the following--
    (i) The refinancing of any indebtedness incurred by the lessor to 
acquire the property subject to the rental agreement and secured by such 
property (or any refinancing thereof) but only if all of the following 
conditions are met--
    (A) Neither the amount, nor the time for payment, of the principal 
amount of the new indebtedness differs from the amount and time for 
payment of the remaining principal amount of the refinanced 
indebtedness, except for de minimis changes;
    (B) For each of the remaining rental periods, the rent allocation 
schedule, the payments of rent and interest, and the amount accrued 
under section 467 are changed only to the extent necessary to take into 
account the change in financing costs, and such changes are made 
pursuant to the terms of the rental agreement in effect before the 
modification;
    (C) The lessor and the lessee are not related persons to each other 
or to any lender to the lessor with respect to the property (whether 
under the refinanced indebtedness or the new indebtedness); and
    (D) With respect to the indebtedness being refinanced, the lessor 
was granted a unilateral option (within the meaning of Sec. 1.1001-
3(c)(3)) by the creditor to repay the refinanced indebtedness, 
exercisable with or without the lessee's consent;
    (ii) A change in the obligation of the lessee to make any of the 
contingent payments described in paragraphs (c)(2)(iii)(B)(3) through 
(8) of this section; or
    (iii) A change in the amount of fixed rent allocated to a rental 
period that, when combined with all previous changes in the amount of 
fixed rent allocated to the rental period, does not exceed one percent 
of the fixed rent allocated to that rental period prior to the 
modification.
    (7) Special rules for certain transfers--(i) In general. For 
purposes of this paragraph (f), a substitution of a new lessee or a 
sale, exchange, or other disposition by a lessor of property subject to 
a rental agreement will not, by itself, be treated as a substantial 
modification unless a principal purpose of the transaction giving rise 
to the modification is the avoidance of Federal income tax. In 
determining whether a principal purpose of the transaction giving rise 
to the modification is the avoidance of Federal income tax--
    (A) The safe harbors and other principles of Sec. 1.467-3(c) are 
taken into account; and
    (B) The Commissioner may treat the post-modification agreement as a 
new agreement or treat the entire agreement (as modified) as a single 
agreement.
    (ii) Exception. Notwithstanding the provisions of paragraph 
(f)(7)(i) of this section, the continuing lessor and the new lessee (in 
the case of a substitution of a new lessee) or the new lessor and the 
continuing lessee (in the

[[Page 311]]

case of a sale, exchange, or other disposition by a lessor of property 
subject to a rental agreement) may, in appropriate cases, request the 
Commissioner to treat the transaction as if it were a substantial 
modification in order to have the provisions of paragraph (f)(4)(iii) of 
this section and Sec. 1.467-7(g)(1) apply to the transaction.
    (g) Treatment of amounts payable by lessor to lessee--(1) Interest. 
For purposes of determining present value, any amounts payable by the 
lessor to the lessee as interest on prepaid rent are treated as negative 
amounts.
    (2) Other amounts. [Reserved]
    (h) Meaning of terms. The following meanings apply for purposes of 
this section and Sec. Sec. 1.467-2 through 1.467-9:
    (1) Agreement date means the earlier of the lease date or the first 
date on which there is a binding written contract that substantially 
sets forth the terms under which the property will be leased.
    (2) Contingent rent means any rent that is not fixed rent, including 
any amount reflecting an adjustment based on a reasonable price index 
(as defined in paragraph (h)(10) of this section) or a variable interest 
rate provision (as defined in paragraph (h)(16) of this section).
    (3) Fixed rent means any rent to the extent its amount and the time 
at which it is required to be paid are fixed and determinable under the 
terms of the rental agreement as of the lease date. The following rules 
apply for the purpose of determining the extent to which rent is fixed 
rent:
    (i) The possibility of a breach, default, or other early termination 
of the rental agreement and any adjustments based on a reasonable price 
index or a variable interest rate provision are disregarded.
    (ii) Rent will not fail to be treated as fixed rent merely because 
of the possibility of impairment by insolvency, bankruptcy, or other 
similar circumstances.
    (iii) If the lease term (as defined in paragraph (h)(6) of this 
section) includes one or more periods as to which either the lessor or 
the lessee has an option to renew or extend the term of the agreement, 
rent will not fail to be treated as fixed rent merely because the option 
has not been exercised.
    (iv) If the lease term includes one or more periods during which a 
substitute lessee or lessor may have use of the property, rent will not 
fail to be treated as fixed rent merely because the contingencies 
relating to the obligation of the lessee (or a related person) to make 
payments in the nature of rent have not occurred.
    (v) If either the lessor or the lessee has an unconditional option 
or options, exercisable on one or more dates during the lease term, 
that, if exercised, require payments of rent to be made under an 
alternative payment schedule or schedules, the amount of fixed rent and 
the dates on which such rent is required to be paid are determined on 
the basis of the payment schedule that, as of the agreement date, is 
most likely to occur. If payments of rent are made under an alternative 
payment schedule that differs from the payment schedule assumed in 
applying the preceding sentence, then, for purposes of paragraph (f) of 
this section, the rental agreement is treated as having been modified at 
the time the option to make payments on such alternative schedule is 
exercised.
    (4) Late payment charge means any amount required to be paid by the 
lessee to the lessor as additional compensation for the lessee's failure 
to make any payment of rent under a rental agreement when due.
    (5) Lease date means the date on which the lessee first has the 
right to use of the property that is the subject of the rental 
agreement.
    (6) Lease term means the period during which the lessee has use of 
the property subject to the rental agreement, including any option of 
the lessor to renew or extend the term of the agreement. An option of 
the lessee to renew or extend the term of the agreement is included in 
the lease term only if it is expected, as of the agreement date, that 
the option will be exercised. For this purpose, a lessee is generally 
expected to exercise an option if, for example, as of the agreement date 
the rent for the option period is less than the expected fair market 
value rental for such period. The lessor's or lessee's determination 
that an option period is

[[Page 312]]

either included in or excluded from the lease term is not binding on the 
Commissioner. If the lessee (or a related person) agrees that one or 
both of them will or could be obligated to make payments in the nature 
of rent (within the meaning of Sec. 1.168(i)-2(b)(2)) for a period when 
another lessee (the substitute lessee) or the lessor will have use of 
the property subject to the rental agreement, the Commissioner may, in 
appropriate cases, treat the period when the substitute lessee or lessor 
will have use of the property as part of the lease term. See Sec. 
1.467-7(f) for special rules applicable to the lessee, substitute 
lessee, and lessor. This paragraph (h)(6) applies to section 467 rental 
agreements entered into after March 6, 2001. However, taxpayers may 
choose to apply this paragraph (h)(6) to any rental agreement that is 
described in Sec. 1.467-9(a) and is entered into on or before March 6, 
2001.
    (7) A loss payment provision means a provision that requires the 
lessee to pay the lessor a sum of money (which may be either a 
stipulated amount or an amount determined by reference to a formula or 
other objective measure) if the property subject to the rental agreement 
is lost, stolen, damaged or destroyed, or otherwise rendered unsuitable 
for any use (other than for scrap purposes).
    (8) A qualified percentage rents provision means a provision 
pursuant to which the rent is equal to a fixed percentage of the 
lessee's receipts or sales (whether or not receipts or sales are 
adjusted for returned merchandise or Federal, state, or local sales 
taxes), but only if the percentage does not vary throughout the lease 
term. A provision will not fail to be treated as a qualified percentage 
rents provision solely by reason of one or more of the following 
additional terms:
    (i) Differing percentages of receipts or sales apply to different 
departments or separate floors of a retail store, but only if the 
percentage applicable to a particular department or floor does not vary 
throughout the lease term.
    (ii) The percentage is applied to receipts or sales in excess of 
determinable dollar amounts, but only if the determinable dollar amounts 
are fixed and do not vary throughout the lease term.
    (9) A qualified TRAC provision means a terminal rental adjustment 
clause (as defined in section 7701(h)(3)) contained in a qualified motor 
vehicle operating agreement (as defined in section 7701(h)(2)), but only 
if the adjustment to the rental price is based on a reasonable estimate, 
determined as of any date between the agreement date and the lease date 
(or, in the event the agreement date is the same as or later than the 
lease date, determined as of the agreement date), of the fair market 
value of the motor vehicle (including any trailer) at the end of the 
lease term.
    (10) An adjustment is based on a reasonable price index if the 
adjustment reflects inflation or deflation occurring over a period 
during the lease term and is determined consistently under a generally 
recognized index for measuring inflation or deflation (for example, the 
non-seasonally adjusted U.S. City Average All Items Consumer Price Index 
for All Urban Consumers (CPI-U), which is published by the Bureau of 
Labor Statistics of the Department of Labor). An adjustment will not 
fail to be treated as one that is based on a reasonable price index 
merely because the adjustment may be limited to a fixed percentage, but 
only if the parties reasonably expect, as of any date between the 
agreement date and the lease date (or, in the event the agreement date 
is the same as the lease date, as of such date), that the fixed 
percentage will actually limit the amount of the rent payable during 
less than 50 percent of the lease term.
    (11) For purposes of determining whether a section 467 rental 
agreement is a leaseback within the meaning of Sec. 1.467-3(b)(2), two 
persons are related persons if they are related persons within the 
meaning of section 465(b)(3)(C). In all other cases, two persons are 
related persons if they either have a relationship to each other that is 
specified in section 267(b) or section 707(b)(1) or are related entities 
within the meaning of sections 168(h)(4)(A), (B), or (C).
    (12) Rental agreement includes any agreement, whether written or 
oral, that provides for the use of tangible

[[Page 313]]

property and is treated as a lease for Federal income tax purposes.
    (13) A residual condition provision means a provision in a rental 
agreement that requires a payment to be made by either the lessor or the 
lessee to the other party based on the difference between the actual 
condition of the property subject to the agreement, determined as of the 
expiration of the lease term, and the expected condition of the property 
at the expiration of the lease term, as set forth in the rental 
agreement. The amount of any such payment may be determined by reference 
to any objective measure relating to the use or condition of the 
property, such as miles, hours or other duration of use, units of 
production, or similar measure. A provision will be treated as a 
residual condition provision only if the payment represents compensation 
for the use of, or wear and tear on, the property in excess of, or 
below, a standard set forth in the rental agreement, and the standard is 
reasonably expected, as of any date between the agreement date and the 
lease date (or, in the event the agreement date is the same as or later 
than the lease date, as of the agreement date), to be met at the 
expiration of the lease term.
    (14) A tax indemnity provision means a provision in a rental 
agreement that may require the lessee to make one or more payments to 
the lessor in the event that the Federal, foreign, state, or local 
income tax consequences actually realized by a lessor from owning the 
property subject to the rental agreement and leasing it to the lessee 
differ from the consequences reasonably expected by the lessor, but only 
if the differences in such consequences result from a misrepresentation, 
act, or failure to act on the part of the lessee, or any other factor 
not within the control of the lessor or any related person.
    (15) Third-party costs include any real estate taxes, insurance 
premiums, maintenance costs, and any other costs (excluding a debt 
service cost) that relate to the leased property and are not within the 
control of the lessor or lessee or any person related to the lessor or 
lessee.
    (16) A variable interest rate provision means a provision in a 
rental agreement that requires the rent payable by the lessee to the 
lessor to be adjusted by the dollar amount of changes in the amount of 
interest payable by the lessor on any indebtedness that was incurred to 
acquire the property subject to the rental agreement (or any refinancing 
thereof), but--
    (i) Only to the extent the changes are attributable to changes in 
the interest rate; and
    (ii) Only if the indebtedness provides for interest at one or more 
qualified floating rates (within the meaning of Sec. 1.1275-5(b)), or 
the changes are attributable to a refinancing at a fixed rate or one or 
more qualified floating rates.
    (i) [Reserved]
    (j) Computational rules. For purposes of this section and Sec. Sec. 
1.467-2 through 1.467-9, the following rules apply--
    (1) Counting conventions. Any reasonable counting convention may be 
used (for example, 30 days per month/360 days per year) to determine the 
length of a rental period or to perform any computation. Rental periods 
of the same descriptive length, for example annual, semiannual, 
quarterly, or monthly, may be treated as being of equal length.
    (2) Conventions regarding timing of rent and payments--(i) In 
general. For purposes of determining present values and yield only, 
except as otherwise provided in this section and Sec. Sec. 1.467-2 
through 1.467-8--
    (A) The rent allocated to a rental period is taken into account on 
the last day of the rental period;
    (B) Any amount payable during the first half of the first rental 
period is treated as payable on the first day of that rental period;
    (C) Any amount payable during the first half of any other rental 
period is treated as payable on the last day of the preceding rental 
period;
    (D) Any amount payable during the second half of a rental period is 
treated as payable on the last day of the rental period; and
    (E) Any amount payable at the midpoint of a rental period is 
treated, in applying this paragraph (j)(2), as an amount payable during 
the first half of the rental period.

[[Page 314]]

    (ii) Time amount is payable. For purposes of this section and 
Sec. Sec. 1.467-2 through 1.467-9, an amount is payable on the last day 
for timely payment (that is, the last day such amount may be paid 
without incurring interest, computed at an arm's-length rate, a 
substantial penalty, or other substantial detriment (such as giving the 
lessor the right to terminate the agreement, bring an action to enforce 
payment, or exercise other similar remedies under the terms of the 
agreement or applicable law)). This paragraph (j)(2)(ii) applies to 
section 467 rental agreements entered into after March 6, 2001. However, 
taxpayers may choose to apply this paragraph (j)(2)(ii) to any rental 
agreement that is described in Sec. 1.467-9(a) and is entered into on 
or before March 6, 2001.
    (3) Annualized fixed rent. Annualized fixed rent is determined by 
multiplying the fixed rent allocated to the rental period under 
paragraph (c)(2)(ii) of this section by the number of periods of the 
rental period's length in a calendar year. Thus, if the fixed rent 
allocated to a rental period is $10,000 and the rental period is one 
month, the annualized fixed rent for that rental period is $120,000 
($10,000 times 12).
    (4) Allocation of fixed rent within a period. A rental agreement 
that allocates fixed rent to any period is treated as allocating fixed 
rent ratably within that period. Thus, if a rental agreement provides 
that $120,000 is allocated to each calendar year in the lease term, 
$10,000 of rent is allocated to each calendar month.
    (5) Rental period length. Except as provided in Sec. 1.467-3(d)(1) 
(relating to agreements for which constant rental accrual is required), 
rental periods may be of any length, may vary in length, and may be 
different as between the lessor and the lessee as long as--
    (i) The rental periods are one year or less, cover the entire lease 
term, and do not overlap;
    (ii) Each scheduled payment under the rental agreement (other than a 
payment scheduled to occur before or after the lease term) occurs within 
30 days of the beginning or end of a rental period; and
    (iii) In the case of a rental agreement that does not provide a 
specific allocation of fixed rent, the rental periods selected do not 
cause the agreement to be treated as a section 467 rental agreement 
unless all alternative rental period schedules would result in such 
treatment.

[T.D. 8820, 64 FR 26853, May 18, 1999, as amended by T.D. 8917, 66 FR 
1039, Jan. 5, 2001]



Sec. 1.467-2  Rent accrual for section 467 rental agreements without 
adequate interest.

    (a) Section 467 rental agreements for which proportional rental 
accrual is required. Under Sec. 1.467-1(d)(2)(ii), the fixed rent for 
each rental period is the proportional rental amount, computed under 
paragraph (c) of this section, if--
    (1) The section 467 rental agreement is not a disqualified leaseback 
or long-term agreement under Sec. 1.467-3(b); and
    (2) The section 467 rental agreement does not provide adequate 
interest on fixed rent under paragraph (b) of this section.
    (b) Adequate interest on fixed rent--(1) In general. A section 467 
rental agreement provides adequate interest on fixed rent if, 
disregarding any contingent rent--
    (i) The rental agreement has no deferred or prepaid rent as 
described in Sec. 1.467-1(c)(3);
    (ii) The rental agreement has deferred or prepaid rent, and--
    (A) The rental agreement provides interest (the stated rate of 
interest) on deferred or prepaid fixed rent at a single fixed rate (as 
defined in Sec. 1.1273-1(c)(1)(iii));
    (B) The stated rate of interest on fixed rent is no lower than 110 
percent of the applicable Federal rate (as defined in paragraph (e)(3) 
of this section);
    (C) The amount of deferred or prepaid fixed rent on which interest 
is charged is adjusted at least annually to reflect the amount of 
deferred or prepaid fixed rent as of a date no earlier than the date of 
the preceding adjustment and no later than the date of the succeeding 
adjustment; and
    (D) The rental agreement requires interest to be paid or compounded 
at least annually;
    (iii) The rental agreement provides for deferred rent but no prepaid 
rent, and the sum of the present values

[[Page 315]]

(within the meaning of paragraph (d) of this section) of all amounts 
payable by the lessee as fixed rent (and interest, if any, thereon) is 
equal to or greater than the sum of the present values of the fixed rent 
allocated to each rental period; or
    (iv) The rental agreement provides for prepaid rent but no deferred 
rent, and the sum of the present values of all amounts payable by the 
lessee as fixed rent, plus the sum of the negative present values of all 
amounts payable by the lessor as interest, if any, on prepaid fixed 
rent, is equal to or less than the sum of the present values of the 
fixed rent allocated to each rental period.
    (2) Section 467 rental agreements that provide for a variable rate 
of interest. For purposes of the adequate interest test under paragraph 
(b)(1) of this section, if a section 467 rental agreement provides for 
variable interest, the rental agreement is treated as providing for 
fixed rates of interest on deferred or prepaid fixed rent equal to the 
fixed rate substitutes (determined in the same manner as under Sec. 
1.1275-5(e), treating the agreement date as the issue date) for the 
variable rates called for by the rental agreement. For purposes of this 
section, a rental agreement provides for variable interest if all stated 
interest provided by the agreement is paid or compounded at least 
annually at a rate or rates that meet the requirements of Sec. 1.1275-
5(a)(3)(i)(A) or (B) and (a)(4).
    (3) Agreements with both deferred and prepaid rent. If an agreement 
has both deferred and prepaid rent, the agreement provides adequate 
interest under paragraph (b)(1) of this section if the conditions set 
forth in paragraph (b)(1)(ii)(A) through (D) of this section are met for 
both the prepaid and the deferred rent. For purposes of this paragraph 
(b)(3), an agreement will be considered to meet the condition set forth 
in paragraph (b)(1)(ii)(A) of this section if the agreement provides a 
single fixed rate of interest on the deferred rent and a single fixed 
rate of interest on the prepaid rent, even if those rates are not the 
same. This paragraph (b)(3) applies to section 467 rental agreements 
entered into after March 6, 2001. However, taxpayers may choose to apply 
this paragraph (b)(3) to any rental agreement that is described in Sec. 
1.467-9(a) and is entered into on or before March 6, 2001.
    (c) Computation of proportional rental amount--(1) In general. The 
proportional rental amount for a rental period is the amount of fixed 
rent allocated to the rental period under Sec. 1.467-1(c)(2)(ii), 
multiplied by a fraction. The numerator of the fraction is the sum of 
the present values of the amounts payable under the terms of the section 
467 rental agreement as fixed rent and interest thereon. The denominator 
of the fraction is the sum of the present values of the fixed rent 
allocated to each rental period under the rental agreement.
    (2) Section 467 rental agreements that provide for a variable rate 
of interest. To calculate the proportional rental amount for a section 
467 rental agreement that provides for a variable rate of interest, see 
Sec. 1.467-5.
    (d) Present value. For purposes of determining adequate interest 
under paragraph (b) of this section or the proportional rental amount 
under paragraph (c) of this section, the present value of any amount is 
determined using a discount rate equal to 110 percent of the applicable 
Federal rate. In general, present values are determined as of the first 
day of the first rental period in the lease term. However, if a section 
467 rental agreement calls for payments of fixed rent prior to the lease 
term, present values are determined as of the first day a fixed rent 
payment is called for by the agreement. For purposes of the present 
value determination under paragraph (b)(1)(iv) of this section, the 
fixed rent allocated to a rental period must be discounted from the 
first day of the rental period. For other conventions and rules relating 
to the determination of present value, see Sec. 1.467-1(g) and (j).
    (e) Applicable Federal rate--(1) In general. The applicable Federal 
rate for a section 467 rental agreement is the applicable Federal rate 
in effect on the agreement date. The applicable Federal rate for a 
rental agreement means--
    (i) The Federal short-term rate if the term of the rental agreement 
is not over 3 years;

[[Page 316]]

    (ii) The Federal mid-term rate if the term of the rental agreement 
is over 3 years but not over 9 years; and
    (iii) The Federal long-term rate if the term of the rental agreement 
is over 9 years.
    (2) Source of applicable Federal rates. The Internal Revenue Service 
publishes the applicable Federal rates, based on annual, semiannual, 
quarterly, and monthly compounding, each month in the Internal Revenue 
Bulletin (see Sec. 601.601(d) of this chapter). However, the applicable 
Federal rates may be based on any compounding assumption. To convert a 
rate based on one compounding assumption to an equivalent rate based on 
a different compounding assumption, see Sec. 1.1272-1(j), Example 1.
    (3) 110 percent of applicable Federal rate. For purposes of Sec. 
1.467-1, this section and Sec. Sec. 1.467-3 through 1.467-9, 110 
percent of the applicable Federal rate means 110 percent of the 
applicable Federal rate based on semiannual compounding or any rate 
based on a different compounding assumption that is equivalent to 110 
percent of the applicable Federal rate based on semiannual compounding. 
The Internal Revenue Service publishes 110 percent of the applicable 
Federal rates, based on annual, semiannual, quarterly, and monthly 
compounding, each month in the Internal Revenue Bulletin (see Sec. 
601.601(d)(2) of this chapter).
    (4) Term of the section 467 rental agreement--(i) In general. For 
purposes of determining the applicable Federal rate under this paragraph 
(e), the term of the section 467 rental agreement includes the lease 
term, any period before the lease term beginning with the first day an 
amount of fixed rent is payable under the terms of the rental agreement, 
and any period after the lease term ending with the last day an amount 
of fixed rent or interest thereon is payable under the rental agreement.
    (ii) Section 467 rental agreements with variable interest. If a 
section 467 rental agreement provides variable interest on deferred or 
prepaid fixed rent, the term of the rental agreement for purposes of 
calculating the applicable Federal rate is the longest period between 
interest rate adjustment dates, or, if the rental agreement provides an 
initial fixed rate of interest on deferred or prepaid fixed rent, the 
period between the agreement date and the last day the fixed rate 
applies, if this period is longer. If, as described in Sec. 1.1274-
4(c)(2)(ii), the rental agreement provides for a qualified floating rate 
(as defined in Sec. 1.1275-5(b)) that in substance resembles a fixed 
rate, the applicable Federal rate is determined by reference to the 
lease term.
    (f) Examples. The following examples illustrate the 
application of this section. In each of these examples it is assumed 
that the rental agreement is not a disqualified leaseback or long-term 
agreement subject to constant rental accrual. The examples are as 
follows:

    Example 1. (i) C agrees to lease property from D for five years 
beginning on January 1, 2000, and ending on December 31, 2004. The 
section 467 rental agreement provides that rent of $100,000 accrues in 
each calendar year in the lease term and that rent of $500,000 plus 
$120,000 of interest is payable on December 31, 2004. Assume that the 
parties select the calendar year as the rental period and that 110 
percent of the applicable Federal rate is 10 percent, compounded 
annually.
    (ii) The rental agreement has deferred rent under Sec. 1.467-
1(c)(3)(i) because the fixed rent allocated to calendar years 2000, 
2001, and 2002 is not paid until 2004. In addition, because the rental 
agreement does not state an interest rate, the rental agreement does not 
satisfy the requirements of paragraph (b)(1)(ii) of this section.
    (iii)(A) Because the rental agreement has deferred fixed rent and no 
prepaid rent, the agreement has adequate interest only if the present 
value test provided in paragraph (b)(1)(iii) of this section is met. The 
present value of all fixed rent and interest payable under the rental 
agreement is $384,971.22, determined as follows: $620,000/(1.10) \5\ = 
$384,971.22. The present value of all fixed rent allocated under the 
rental agreement (discounting the amount of fixed rent allocated to a 
rental period from the last day of the rental period) is $379,078.68, 
determined as follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.000

    (B) The rental agreement provides adequate interest on fixed rent 
because the present value of the single amount payable under the section 
467 rental agreement exceeds the sum of the present values of fixed rent 
allocated.

[[Page 317]]

    (iv) For an example illustrating the computation of the yield on the 
rental agreement and the allocation of the interest and rent provided 
for under the rental agreement, see Sec. 1.467-4(f), Example 2.
    Example 2. (i) E and F enter into a section 467 rental agreement for 
the lease of equipment beginning on January 1, 2000, and ending on 
December 31, 2004. The rental agreement provides that rent of $100,000 
accrues for each calendar month during the lease term. All rent is 
payable on December 31, 2004, together with interest on accrued rent at 
a qualified floating rate set at a current value (as defined in Sec. 
1.1275-5(a)(4)) that is compounded at the end of each calendar month and 
adjusted at the beginning of each calendar month throughout the lease 
term. Therefore, the rental agreement provides for variable interest 
within the meaning of paragraph (b)(2) of this section.
    (ii) On the agreement date the qualified floating rate is 7.5 
percent, and 110 percent of the applicable Federal rate, as defined in 
paragraph (e)(3) of this section, based on monthly compounding, is 7 
percent. Under paragraph (b)(2) of this section, the fixed rate 
substitute for the qualified floating rate is 7.5 percent and the 
agreement is treated as providing for interest at this fixed rate for 
purposes of determining whether adequate interest is provided under 
paragraph (b) of this section. Accordingly, the requirements of 
paragraph (b)(1)(ii) of this section are satisfied, and the rental 
agreement has adequate interest.
    Example 3. (i) X and Y enter into a section 467 rental agreement for 
the lease of real property beginning on January 1, 2000, and ending on 
December 31, 2002. The rental agreement provides that rent of $800,000 
is allocable to 2000, $1,000,000 is allocable to 2001, and $1,200,000 is 
allocable to 2002. Under the rental agreement, Y must make a $3,000,000 
payment on December 31, 2002. Assume that both X and Y choose the 
calendar year as the rental period, X and Y are calendar year taxpayers, 
and 110 percent of the applicable Federal rate is 8.5 percent compounded 
annually.
    (ii) The rental agreement fails to provide adequate interest under 
paragraph (b)(1) of this section. Therefore, under Sec. 1.467-
1(d)(2)(ii), the fixed rent for each rental period is the proportional 
rental amount.
    (iii)(A) The proportional rental amount is computed under paragraph 
(c) of this section. Because the rental agreement does not call for any 
fixed rent payments prior to the lease term, under paragraph (d) of this 
section, the present value is determined as of the first day of the 
first rental period in the lease term. The present value of the single 
amount payable by the lessee under the rental agreement is computed as 
follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.001

    (B) The sum of the present values of the fixed rent allocated to 
each rental period (discounting the fixed rent allocated to a rental 
period from the last day of such rental period) is computed as follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.002

    (C) Thus, the fraction for determining the proportional rental 
amount is .9297194 ($2,348,724.30/$2,526,272.20). The section 467 
interest for each of the taxable years within the lease term is computed 
and taken into account as provided in Sec. 1.467-4. The section 467 
rent for each of the taxable years within the lease term is as follows:

------------------------------------------------------------------------
           Taxable year                       Section 467 rent
------------------------------------------------------------------------
2000.............................  $743,775.52
                                   ($ 800,000x.9297194).
2001.............................  929,719.40
                                   ($1,000,000x.9297194).
2002.............................  1,115,663.28
                                   ($1,200,000x.9297194).
------------------------------------------------------------------------


[T.D. 8820, 64 FR 26859, May 18, 1999, as amended by T.D. 8917, 66 FR 
1040, Jan. 5, 2001]



Sec. 1.467-3  Disqualified leasebacks and long-term agreements.

    (a) General rule. Under Sec. 1.467-1(d)(2)(i), constant rental 
accrual (as described under paragraph (d) of this section) must be used 
to determine the fixed rent for each rental period in the lease term if 
the section 467 rental agreement is a disqualified leaseback or long-
term agreement within the meaning of paragraph (b) of this section. 
Constant rental accrual may not be used in the absence of a 
determination by the Commissioner, pursuant to paragraph (b)(1)(ii) of 
this section, that the rental agreement is disqualified.

[[Page 318]]

Such determination may be made either on a case-by-case basis or in 
regulations or other guidance published by the Commissioner (see Sec. 
601.601(d)(2) of this chapter) providing that a certain type or class of 
leaseback or long-term agreement will be treated as disqualified and 
subject to constant rental accrual.
    (b) Disqualified leaseback or long-term agreement--(1) In general. A 
leaseback (as defined in paragraph (b)(2) of this section) or a long-
term agreement (as defined in paragraph (b)(3) of this section) is 
disqualified only if--
    (i) A principal purpose for providing increasing or decreasing rent 
is the avoidance of Federal income tax (as described in paragraph (c) of 
this section);
    (ii) The Commissioner determines that, because of the tax avoidance 
purpose, the agreement should be treated as a disqualified leaseback or 
long-term agreement; and
    (iii) For section 467 rental agreements entered into before July 19, 
1999, the amount determined with respect to the rental agreement under 
Sec. 1.467-1(c)(4) (relating to the exception for rental agreements 
involving total payments of $250,000 or less) exceeds $2,000,000.
    (2) Leaseback. A section 467 rental agreement is a leaseback if the 
lessee (or a related person) had any interest (other than a de minimis 
interest) in the property at any time during the two-year period ending 
on the agreement date. For this purpose, interests in property include 
options and agreements to purchase the property (whether or not the 
lessee or related person was considered the owner of the property for 
Federal income tax purposes) and, in the case of subleased property, any 
interest as a sublessor.
    (3) Long-term agreement--(i) In general. A section 467 rental 
agreement is a long-term agreement if the lease term exceeds 75 percent 
of the property's statutory recovery period.
    (ii) Statutory recovery period--(A) In general. The term statutory 
recovery period means--
    (1) In the case of property depreciable under section 168, the 
applicable period determined under section 467(e)(3)(A);
    (2) In the case of land, 19 years; and
    (3) In the case of any other tangible property, the period that 
would apply under section 467(e)(3)(A) if the property were property to 
which section 168 applied.
    (B) Special rule for rental agreements relating to properties having 
different statutory recovery periods. In the case of a rental agreement 
relating to two or more related properties that have different statutory 
recovery periods, the statutory recovery period for purposes of 
paragraph (b)(3)(ii)(A) of this section is the weighted average, based 
on the fair market values of the properties on the agreement date, of 
the statutory recovery periods of each of the properties.
    (c) Tax avoidance as principal purpose for increasing or decreasing 
rent--(1) In general. In determining whether a principal purpose for 
providing increasing or decreasing rent is the avoidance of Federal 
income tax, all relevant facts and circumstances are taken into account. 
However, an agreement will not be treated as a disqualified leaseback or 
long-term agreement if either of the safe harbors set forth in paragraph 
(c)(3) of this section is met. The mere failure of a leaseback or long-
term agreement to meet one of these safe harbors will not, by itself, 
cause the agreement to be treated as one in which tax avoidance was a 
principal purpose for providing increasing or decreasing rent.
    (2) Tax avoidance--(i) In general. If, as of the agreement date, a 
significant difference between the marginal tax rates of the lessor and 
lessee can reasonably be expected at some time during the lease term, 
the agreement will be closely scrutinized and clear and convincing 
evidence will be required to establish that tax avoidance is not a 
principal purpose for providing increasing or decreasing rent. The term 
``marginal tax rate'' means the percentage determined by dividing one 
dollar into the amount of the increase or decrease in the Federal income 
tax liability of the taxpayer that would result from an additional 
dollar of rental income or deduction.
    (ii) Significant difference in tax rates. A significant difference 
between the marginal tax rates of the lessor and lessee is reasonably 
expected if--

[[Page 319]]

    (A) The rental agreement has increasing rents and the lessor's 
marginal tax rate is reasonably expected to exceed the lessee's marginal 
tax rate by more than 10 percentage points during any rental period to 
which the rental agreement allocates annualized fixed rent that is less 
than the average rent allocated to all calendar years (determined by 
taking into account the rules set forth in paragraph (c)(4)(iii) of this 
section); or
    (B) The rental agreement has decreasing rents and the lessee's 
marginal tax rate is reasonably expected to exceed the lessor's marginal 
tax rate by more than 10 percentage points during any rental period to 
which the rental agreement allocates annualized fixed rent that is 
greater than the average rent allocated to all calendar years 
(determined by taking into account the rules set forth in paragraph 
(c)(4)(iii) of this section).
    (iii) Special circumstances. In determining the expected marginal 
tax rates of the lessor and lessee, net operating loss and credit 
carryovers and any other attributes or special circumstances reasonably 
expected to affect the Federal income tax liability of the taxpayer 
(including the alternative minimum tax) are taken into account. For 
example, in the case of a partnership or S corporation, the amount of 
rental income or deduction that would be allocable to the partners or 
shareholders, respectively, is taken into account.
    (3) Safe harbors. Tax avoidance will not be considered a principal 
purpose for providing increasing or decreasing rent if--
    (i) The uneven rent test (as defined in paragraph (c)(4) of this 
section) is met; or
    (ii) The increase or decrease in rent is wholly attributable to one 
or more of the following provisions--
    (A) A contingent rent provision set forth in Sec. 1.467-
1(c)(2)(iii)(B); or
    (B) A single rent holiday provision allowing reduced rent (or no 
rent) for one consecutive period during the lease term, but only if--
    (1) The rent holiday is for a period of three months or less at the 
beginning of the lease term and for no other period; or
    (2) The duration of the rent holiday is reasonable, determined by 
reference to commercial practice (as of the agreement date) in the 
locality where the use of the property occurs, and does not exceed the 
lesser of 24 months or 10 percent of the lease term.
    (4) Uneven rent test--(i) In general. The uneven rent test is met if 
the rent allocated to each calendar year does not vary from the average 
rent allocated to all calendar years (determined in accordance with the 
rules set forth in paragraph (c)(4)(iii) of this section) by more than 
10 percent.
    (ii) Special rule for real estate. Paragraph (c)(4)(i) of this 
section is applied by substituting ``15 percent'' for ``10 percent'' if 
the rental agreement is a long-term agreement and at least 90 percent of 
the property subject to the agreement (determined on the basis of fair 
market value as of the agreement date) consists of real property (as 
defined in Sec. 1.856-3(d)).
    (iii) Operating rules. In determining whether the uneven rent test 
has been met, the following rules apply:
    (A) Any contingent rent attributable to a provision set forth in 
Sec. 1.467-1(c)(2)(iii)(B)(3) through (9) is disregarded.
    (B) If the lease term includes one or more partial calendar years (a 
period less than a complete calendar year), the average rent allocated 
to each calendar year is the total rent allocated under the rental 
agreement, divided by the actual length (in years) of the lease term. 
The rent allocated to a partial calendar year is annualized by 
multiplying the allocated rent by the number of periods of the partial 
calendar year's length in a full calendar year and the annualized rent 
is treated as the amount of rent allocated to that year in determining 
whether the uneven rent test is met.
    (C) In the case of a rental agreement not described in paragraph 
(c)(4)(ii) of this section, an initial rent holiday period and any rent 
allocated to such period are disregarded for purposes of this paragraph 
(c)(4) if taking such period and rent into account would cause the 
agreement to fail to meet the uneven rent test. For purposes of this 
paragraph (c)(4), an initial rent holiday period is any period of three 
months or

[[Page 320]]

less at the beginning of the lease term during which annualized fixed 
rent (determined by treating such period as a rental period for purposes 
of Sec. 1.467-1(j)(3)) is less than the average rent allocated to all 
calendar years (determined before the application of this paragraph 
(c)(4)(iii)(C)).
    (D) In the case of a rental agreement described in paragraph 
(c)(4)(ii) of this section, one qualified rent holiday period and any 
rent allocated to such period are disregarded for purposes of this 
paragraph (c)(4) if taking such period and rent into account would cause 
the agreement to fail the uneven rent test. For this purpose, a 
qualified rent holiday period is a consecutive period that is an initial 
rent holiday period or that meets the following conditions:
    (1) The period does not exceed the lesser of 24 months or 10 percent 
of the lease term (determined before the application of this paragraph 
(c)(4)(iii)(D)).
    (2) Annualized fixed rent during the period (determined by treating 
the period as a rental period for purposes of Sec. 1.467-1(j)(3)) is 
less than the average rent allocated to all calendar years (determined 
before the application of this paragraph (c)(4)(iii)(D)).
    (3) Providing less than average rent for the period is reasonable, 
determined by reference to commercial practice (as of the agreement 
date) in the locality where the use of the property occurs.
    (E) If the rental agreement contains a variable interest rate 
provision, the uneven rent test is applied by treating the rent as 
having been fixed under the terms of the rental agreement for the entire 
lease term using fixed rate substitutes (determined in the same manner 
as Sec. 1.1275-5(e), treating the agreement date as the issue date) for 
the variable rates of interest provided under the terms of the lessor's 
indebtedness.
    (d) Calculating constant rental amount--(1) In general. Except as 
provided in paragraph (d)(2) of this section, the constant rental amount 
is the amount that, if paid at the end of each rental period, would 
result in a present value equal to the present value of all amounts 
payable under the disqualified leaseback or long-term agreement as rent 
and interest. In computing the constant rental amount, the rules for 
determining present value are the same as those provided in Sec. 1.467-
2(d) for computing the proportional rental amount. If constant rental 
accrual is required, all rental periods (other than an initial or final 
short period of not more than one month) must be equal in length and 
satisfy the requirements of Sec. 1.467-1(j)(5).
    (2) Initial or final short periods. If a disqualified leaseback or 
long-term agreement has an initial or final short rental period, the 
constant rental amount for the initial or final short period may be 
determined under any reasonable method. However, the sum of the present 
values of all the constant rental amounts must equal the present values 
of all amounts payable under the disqualified leaseback or long-term 
agreement as rent and interest. Any adjustment necessary to eliminate 
the section 467 loan balance because of the method used to determine the 
constant rental amount for short periods must be taken into account as 
section 467 rent for the final rental period.
    (3) Method to determine constant rental amount; no short periods--
(i) Step 1. Determine the present value of amounts payable under the 
disqualified leaseback or long-term agreement as rent or interest.
    (ii) Step 2. Determine the present value of $1 to be received at the 
end of each rental period during the lease term as of the first day of 
the first rental period during the lease term (or, if earlier, the first 
day a rent payment is required under the rental agreement).
    (iii) Step 3. Divide the amount determined in paragraph (d)(3)(i) of 
this section (Step 1) by the number of dollars determined in paragraph 
(d)(3)(ii) of this section (Step 2).
    (e) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i) K, lessor, and L, lessee, enter into a long-term 
agreement for a 10-year lease of personal property beginning on January 
1, 2000. K and L are C corporations that use the calendar year as their 
taxable year. K does not have any unused losses or credits from taxable 
years preceding 2000. In addition, as of the agreement date, K expects 
that it will be subject to the maximum rate

[[Page 321]]

of tax imposed by section 11 in 2000 and that it will not be limited in 
its ability to use any losses or credits. As of the agreement date, L 
expects that it will be subject to the alternative minimum tax imposed 
by section 55 in 2000. The rental agreement provides for rent 
allocations in each year of the lease term, as follows:

------------------------------------------------------------------------
                          Year                                Amount
------------------------------------------------------------------------
2000....................................................        $427,500
2001....................................................         442,500
2002....................................................         457,500
2003....................................................         472,500
2004....................................................         487,500
2005....................................................         502,500
2006....................................................         517,500
2007....................................................         532,500
2008....................................................         547,500
2009....................................................         562,500
------------------------------------------------------------------------

    (ii) As described in paragraph (c)(2) of this section, as of the 
agreement date, a significant difference between the marginal tax rates 
of the lessor and lessee can reasonably be expected at some time during 
the lease term. First, the rental agreement has increasing rents. 
Second, the lessor's marginal tax rate exceeds the lessee's marginal tax 
rate by more than 10 percentage points during a rental period to which 
the rental agreement allocates less than a ratable portion of the 
aggregate amount of rent payable under the agreement. For example, for 
the year 2000, the lessor's expected marginal tax rate is 35 percent, 
the percentage determined by dividing the increase in the Federal income 
tax liability of K that would result from an additional dollar of rental 
income ($.35) by $1. Because the lessee is subject to the alternative 
minimum tax, the lessee's expected marginal tax rate for 2000 is 20 
percent, the percentage determined by dividing the decrease in the 
Federal income tax liability (taking into account both the decrease in 
the lessee's regular tax and the increase in the lessee's alternative 
minimum tax) that would result from an additional dollar of rental 
deduction ($.20) by $1. Further, for the year 2000, the rent allocated 
in accordance with the rental agreement is $427,500, which is less than 
a ratable portion of the aggregate amount of rental payments, $495,000, 
determined by dividing the total rents payable under the agreement 
($4,950,000) by the number of years in the lease term (10). Thus, 
because a significant difference between the marginal tax rates of the 
lessor and lessee can reasonably be expected during the lease term, the 
agreement will be closely scrutinized and clear and convincing evidence 
will be required to establish that tax avoidance is not a principal 
purpose for providing increasing rent.
    Example 2. (i) A and B enter into a long-term agreement for a 5-year 
lease of personal property beginning on July 1, 2000, and ending on June 
30, 2005. The rental agreement provides that the rent is allocated to 
the calendar years in the lease term in accordance with the following 
schedule and is paid at successive six-month intervals (on December 31 
and June 30) during the lease term:

------------------------------------------------------------------------
                          Year                                Amount
------------------------------------------------------------------------
2000....................................................        $450,000
2001....................................................         900,000
2002....................................................         900,000
2003....................................................       1,100,000
2004....................................................       1,100,000
2005....................................................         550,000
------------------------------------------------------------------------

    (ii) In determining whether the uneven rent test described in 
paragraph (c)(4)(i) of this section is met, the total amount of rent 
allocated under the rental agreement is $5,000,000, and the lease term 
is five years. The average rent for each year is $1,000,000 (see 
paragraph (c)(4)(iii)(B) of this section), and the uneven rent test is 
met if the rent for each year is not less than $900,000 and not more 
than $1,100,000. The test is met for 2000 because the annualized rent 
for that year is $900,000. The test is met for 2005 because the 
annualized rent for that year is $1,100,000. The test is met for each of 
the years 2001 through 2004 because the rent for each of these years is 
not less than $900,000 and not more than $1,100,000. Accordingly, 
because the uneven rent test of paragraph (c)(4)(i) of this section is 
met, the long-term agreement will not be treated as disqualified.
    Example 3. (i) C and D enter into a long-term agreement for a lease 
of personal property beginning on October 1, 1999, and ending on 
December 31, 2005. The rental agreement provides that the rent is 
allocated to the calendar years in the lease term in accordance with the 
following schedule and is paid at successive six-month intervals (on 
December 31 and June 30) during the lease term:

                                  Year
------------------------------------------------------------------------
                         Amount
---------------------------------------------------------
1999....................................................              $0
2000....................................................         900,000
2001....................................................         900,000
2002....................................................         900,000
2003....................................................       1,100,000
2004....................................................       1,100,000
2005....................................................       1,100,000
------------------------------------------------------------------------

    (ii) The three-month rent holiday period at the beginning of the 
lease term is an initial rent holiday within the meaning of paragraph 
(c)(4)(iii)(C) of this section. Moreover, the agreement would fail the 
uneven rent test if the rent holiday period and the rent allocated to 
the period were taken into account. Thus, under paragraph (c)(4)(iii)(C) 
of this section, the period and the rent allocated to the period are 
disregarded for purposes of applying the uneven rent test. In

[[Page 322]]

that case, the lease term is six years, and the uneven rent test is met 
because the average rent for each year in the lease term is $1,000,000 
and the rent for each calendar year in the lease term is not less than 
$900,000 nor more than $1,100,000. Accordingly, the long-term agreement 
will not be treated as disqualified.
    Example 4. (i) E and F enter into a long-term agreement for a 6-year 
lease of personal property beginning on January 1, 2000, and ending on 
December 31, 2005. The rental agreement provides that the rent allocated 
to the calendar years in the lease term and paid at successive six-month 
intervals (on June 30 and December 31) during the lease term is the sum 
of the interest on the lessor's indebtedness, in the amount of 
$4,637,577, and an amount determined in accordance with the following 
schedule:

------------------------------------------------------------------------
                          Year                                Amount
------------------------------------------------------------------------
2000....................................................        $539,574
2001....................................................         583,603
2002....................................................         631,225
2003....................................................         886,733
2004....................................................         959,090
2005....................................................       1,037,352
------------------------------------------------------------------------

    (ii) Assume further that the lessor's indebtedness bears interest at 
the rate of 2 percent in excess of the 6-month London Interbank Offered 
Rate (LIBOR) in effect on the first day of the 6-month period for each 
rental period and that, on the agreement date, the interest rate under 
this formula would be 8 percent. If the interest rate remained fixed 
during the entire lease term, the formula for determining the rent 
payable by the lessee would result in payments of rent in the amount of 
$450,000 for each six-month period in 2000, 2001, and 2002, and $550,000 
for each six-month period in 2003, 2004, and 2005.
    (iii) Under paragraph (c)(4)(iii)(E) of this section, the fixed rate 
substitute for the variable interest rate provision produces a schedule 
of fixed rents that meets the uneven rent test of paragraph (c)(4)(i) of 
this section. Thus, even if the actual rents payable under the rental 
agreement do not meet the uneven rent test because of fluctuations in 
the 6-month LIBOR, the uneven rent test will be treated as having been 
met, and the long-term agreement will not be treated as disqualified.
    Example 5. (i) G and H enter into a long-term agreement for a 5-year 
lease of personal property beginning on January 1, 2000, and ending on 
December 31, 2004. The rental agreement provides that the rent is 
payable to G at the rate of $40,000 per month in arrears, subject to an 
adjustment based on changes in prevailing interest rates during the 
lease term. Under this adjustment, the lessor is entitled to receive an 
amount equal to the sum of a specified dollar amount, which increases 
each month as payments of rent are made, and interest on a notional 
principal amount (as defined in Sec. 1.446-3(c)(3)) at a qualified 
floating rate (as defined in Sec. 1.1275-5(b)). The notional principal 
amount is initially established at 80 percent of the cost of the 
property. As each payment of rent is made, the notional principal amount 
is reduced (but not below zero) to an amount that would represent the 
outstanding principal balance of a loan the payments on which are equal 
to the monthly payments of rent. As of the agreement date, the value of 
the qualified floating rate is 9 percent. Although G did not incur 
indebtedness specifically for the purpose of acquiring the property, the 
parties agreed to the adjustment provisions in order to compensate G for 
its general costs of borrowing.
    (ii) The adjustment provision produces a schedule of rent payments 
that is virtually identical to the schedule that would have resulted if 
G had actually borrowed money in an amount and on terms identical to the 
terms used in determining interest on the notional principal amount and 
the adjustment were based on that indebtedness. An adjustment based on 
actual indebtedness of the lessor would have been a variable interest 
rate provision eligible for a safe harbor under paragraph (c)(3)(ii)(A) 
of this section. Accordingly, based on all the facts and circumstances, 
the adjustment provision did not have as one of its principal purposes 
the avoidance of Federal income tax, and thus the long-term agreement 
will not be treated as disqualified.
    Example 6. (i) X and Y enter into a leaseback for a 5-year lease of 
personal property beginning on January 1, 1998, and ending on December 
31, 2002. The rental agreement provides that $0 of rent is allocated to 
years 1998, 1999, and 2000, and that rent of $17,500,000 is allocated to 
years 2001 and 2002. The rental agreement provides that the rent 
allocated to each year is payable on December 31 of that year. Assume 
all rental periods are the calendar year. Assume also that 110 percent 
of the applicable Federal rate based on annual compounding is 12 
percent.
    (ii)(A) If the Commissioner determines that the leaseback is 
disqualified, the constant rental amount is computed as follows:
    (B) Step 1 in calculating the constant rental amount is to determine 
the present value of the two payments due under the rental agreement as 
follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.003

    (iii) Because no amounts of rent are payable before the lease term, 
Step 2 in calculating the constant rental amount is to determine the 
present value as of the first day of the lease term of $1 to be received 
at the end of each rental period during the lease

[[Page 323]]

term. This results in a present value of $3.6047762. In Step 3 the 
amount determined in Step 1 is divided by the number of dollars 
determined in Step 2. Thus, the constant rental amount is $5,839,901 for 
each calendar year during the lease term computed as follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.004


[T.D. 8820, 64 FR 26860, May 18, 1999, as amended by T.D. 8917, 66 FR 
1040, Jan. 5, 2001]



Sec. 1.467-4  Section 467 loan.

    (a) In general--(1) Overview. Except as provided in paragraph (a)(2) 
of this section, the section 467 loan rules of this section apply to a 
section 467 rental agreement if, as of the first day of a rental period, 
there is a difference between the amount of fixed rent payable under the 
rental agreement on or before the first day and the amount of fixed rent 
required to be accrued in accordance with Sec. 1.467-1(d)(2) before the 
first day. Paragraph (b) of this section provides rules for computing 
the principal balance of a section 467 loan at the beginning of any 
rental period. The principal balance of a section 467 loan may be 
positive or negative. For Federal tax purposes, if the principal balance 
is positive, the amount represents a loan from the lessor to the lessee, 
and if the principal balance is negative, the amount represents a loan 
from the lessee to the lessor.
    (2) No section 467 loan in the case of certain section 467 rental 
agreements. Except as provided in paragraphs (a)(3) and (4) of this 
section, this section does not apply to section 467 rental agreements 
that provide adequate interest under Sec. 1.467-2(b)(1)(i) (agreements 
with no deferred or prepaid rent) or Sec. 1.467-2(b)(1)(ii) (agreements 
with deferred or prepaid rent that provide adequate stated interest at a 
single fixed rate).
    (3) Rental agreements subject to constant rental accrual. 
Notwithstanding the provisions of paragraph (a)(2) of this section, this 
section applies to rental agreements subject to constant rental accrual 
under Sec. 1.467-3 (relating to disqualified leasebacks or long-term 
agreements).
    (4) Special rule in applying the provisions of Sec. 1.467-7(e), 
(f), or (g). Notwithstanding the provisions of paragraph (a)(2) of this 
section, section 467 loan balances must be computed for section 467 
rental agreements that are not subject to constant rental accrual under 
Sec. 1.467-3 and that provide adequate interest under Sec. 1.467-
2(b)(1)(i) or (ii), but only for purposes of applying the provisions of 
Sec. 1.467-7(e) (relating to dispositions of property subject to a 
section 467 rental agreement), Sec. 1.467-7(f) (relating to assignments 
by lessees and lessee-financed renewals), and Sec. 1.467-7(g) (relating 
to modifications of rental agreements).
    (b) Principal balance--(1) In general. Except as provided in 
paragraph (b)(2) of this section or in Sec. 1.467-7(e), (f), or (g), 
the principal balance of the section 467 loan at the beginning of a 
rental period equals--
    (i) The fixed rent accrued in preceding rental periods;
    (ii) Increased by the sum of--
    (A) The interest on fixed rent includible in the gross income of the 
lessor for preceding rental periods; and
    (B) Any amount payable by the lessor on or before the first day of 
the rental period as interest on prepaid fixed rent; and
    (iii) Decreased by the sum of--
    (A) The interest on prepaid fixed rent includible in the gross 
income of the lessee for preceding rental periods; and
    (B) Any amount payable by the lessee on or before the first day of 
the rental period as fixed rent or interest thereon.
    (2) Section 467 rental agreements that provide for prepaid fixed 
rent and adequate interest. If a section 467 rental agreement calls for 
prepaid fixed rent and provides adequate interest under Sec. 1.467-
2(b)(1)(iv), the principal balance of the section 467 loan at the 
beginning of a rental period equals the principal balance determined 
under paragraph (b)(1) of this section, plus the fixed rent accrued for 
that rental period.
    (3) Timing of payments. For purposes of this paragraph (b), the day 
on which an amount is payable is determined under the rules of Sec. 
1.467-1(j)(2)(i)(B) through (E) and Sec. 1.467-1(j)(2)(ii).
    (c) Yield--(1) In general--(i) Method of determining yield. Except 
as provided in paragraphs (c)(2) and (3) of this section, the yield of a 
section 467 loan is the discount rate at which the sum of the present 
values of all amounts payable

[[Page 324]]

by the lessee as fixed rent and interest on fixed rent, plus the sum of 
the present values of all amounts payable by the lessor as interest on 
prepaid fixed rent, equals the sum of the present values of the fixed 
rent that accrues in accordance with Sec. 1.467-1(d)(2). The yield must 
be constant over the term of the section 467 rental agreement and, when 
expressed as a percentage, must be calculated to at least two decimal 
places.
    (ii) Method of stating yield. In determining the section 467 
interest for a rental period, the yield of the section 467 loan must be 
stated appropriately by taking into account the length of the rental 
period. Section 1.1272-1(j), Example 1, provides a formula for 
converting a yield based on a period of one length to an equivalent 
yield based on a period of a different length.
    (iii) Rounding adjustments. Any adjustment necessary to eliminate 
the section 467 loan because of rounding the yield to two or more 
decimal places must be taken into account as an adjustment to the 
section 467 interest for the final rental period determined as provided 
in paragraph (e) of this section.
    (2) Yield of section 467 rental agreements for which constant rental 
amount or proportional rental amount is computed. In the case of a 
section 467 rental agreement to which Sec. 1.467-1(d)(2)(i) or (ii) 
applies, the yield of the section 467 loan equals 110 percent of the 
applicable Federal rate (based on a compounding period equal to the 
length of the rental period).
    (3) Yield for purposes of applying paragraph (a)(4) of this section. 
For purposes of applying paragraph (a)(4) of this section, the yield of 
the section 467 loan balance of any party, or prior party, to a section 
467 rental agreement for a period is the same for all parties and is the 
yield that results in the net accrual of positive or negative interest 
for that period equal to the amount of such interest that accrues under 
the terms of the rental agreement for that period. For example, if 
property subject to a section 467 rental agreement is sold (transferred) 
and the beginning section 467 loan balance of the transferor (as 
described in Sec. 1.467-7(e)(2)(i)) is positive and the beginning 
section 467 loan balance of the transferee (as described in Sec. 1.467-
7(e)(2)(ii)) is negative, the yield on each of these loan balances for 
any period is the same for all parties and is the yield that results in 
the net accrual of positive or negative interest, taking into account 
the aggregate positive or negative interest on the section 467 loan 
balances of both the transferor and transferee, equal to the amount of 
such interest that accrues under the terms of the rental agreement for 
that period.
    (4) Determination of present values. The rules for determining 
present value in computing the yield of a section 467 loan are the same 
as those provided in Sec. 1.467-2(d) for computing the proportional 
rental amount.
    (d) Contingent payments. Except as otherwise required, contingent 
payments are not taken into account in calculating either the yield or 
the principal balance of a section 467 loan.
    (e) Section 467 rental agreements that call for payments before or 
after the lease term. If a section 467 rental agreement calls for the 
payment of fixed rent or interest thereon before the beginning of the 
lease term, this section is applied by treating the period beginning on 
the first day an amount is payable and ending on the day before the 
beginning of the first rental period of the lease term as one or more 
rental periods. If a rental agreement calls for the payment of fixed 
rent or interest thereon after the end of the lease term, this section 
is applied by treating the period beginning on the day after the end of 
the last rental period of the lease term and ending on the last day an 
amount of fixed rent or interest thereon is payable as one or more 
rental periods. Rental period length for the period before the lease 
term or after the lease term is determined in accordance with the rules 
of Sec. 1.467-1(j)(5).
    (f) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i)(A) A leases property to B for a three-year period 
beginning on January 1, 2000, and ending on December 31, 2002. The 
section 467 rental agreement has the following rent allocation schedule 
and payment schedule:

[[Page 325]]



------------------------------------------------------------------------
                                                    Rent
                                                 allocation    Payment
------------------------------------------------------------------------
2000..........................................     $400,000  ...........
2001..........................................      600,000  ...........
2002..........................................      800,000   $1,800,000
------------------------------------------------------------------------

    (B) The rental agreement requires a $1.8 million payment to be made 
on December 31, 2002, but does not provide for interest on deferred 
rent. Assume A and B choose the calendar year as the rental period 
length and that 110 percent of the applicable Federal rate based on 
annual compounding is 10 percent. Assume also that the agreement is not 
a leaseback or long-term agreement and, therefore, is not subject to 
constant rental accrual.
    (ii) Because the section 467 rental agreement does not provide 
adequate interest under Sec. 1.467-2(b) and is not subject to constant 
rental accrual, the fixed rent that accrues during each rental period is 
the proportional rental amount as described in Sec. 1.467-2(c). The 
proportional rental amounts for each rental period are as follows:

2000......................................................   $370,370.37
2001......................................................    555,555.56
2002......................................................    740,740.73
 

    (iii) A section 467 loan arises at the beginning of the second 
rental period because the rent payable on or before that day (zero) is 
less than the fixed rent accrued under Sec. 1.467-1(d)(2) in all 
preceding rental periods ($370,370.37). Under paragraph (c)(2) of this 
section, the yield of the loan is equal to 110 percent of the applicable 
Federal rate (10 percent compounded annually). Because no payments are 
treated as made on or before the first day of the second rental period, 
the principal balance of the loan at the beginning of the second rental 
period is $370,370.37. The interest for the second rental period on 
fixed rent is $37,037.04 (.10x$370,370.37) and, under Sec. 1.467-
1(e)(3), is treated as interest income of the lessor and as an interest 
expense of the lessee.
    (iv) Because no payments are made on or before the first day of the 
third rental period, the principal balance of the loan at the beginning 
of the third rental period is equal to the fixed rent accrued during the 
first and second rental periods plus the lessor's interest income on 
fixed rent for the second rental period ($962,962.97 = $370,370.37 + 
$555,555.56 + $37,037.04). The interest for the third rental period on 
fixed rent is $96,296.30 (.10x$962,962.97). Thus, the sum of the fixed 
rent and interest on fixed rent for the three rental periods is equal to 
the total amount paid over the lease term (first year fixed rent 
accrual, $370,370.37, plus second year fixed rent and interest accrual, 
$555,555.56 + $37,037.04, plus third year fixed rent and interest 
accrual, $740,740.73 + $96,296.30, equals $1,800,000). B takes the 
amounts of interest and rent into account as interest and rent expense, 
respectively, and A takes such amounts into account as interest and rent 
income, respectively, for the calendar years identified above, 
regardless of their respective overall methods of accounting.
    Example 2. (i) The facts are the same as in Example 1, Sec. 1.467-
2(f). C agrees to lease property from D for five years beginning on 
January 1, 2000, and ending on December 31, 2004. The section 467 rental 
agreement provides that rent of $100,000 accrues in each calendar year 
in the lease term and that rent of $500,000 plus $120,000 of interest is 
payable on December 31, 2004. The parties select the calendar year as 
the rental period, and 110 percent of the applicable Federal rate is 10 
percent, compounded annually. The rental agreement has deferred rent but 
provides adequate interest on fixed rent.
    (ii)(A) Pursuant to paragraph (c)(1) of this section, the yield of 
the section 467 loan is 10.775078%, compounded annually. The following 
is a schedule of the rent allocable to each rental period during the 
lease term, the balance of the section 467 loan as of the end of each 
rental period (determined, in the case of the calendar year 2004, 
without regard to the single payment of rent and interest in the amount 
of $620,000 payable on the last day of the lease term), and the interest 
on the section 467 loan allocable to each rental period:

----------------------------------------------------------------------------------------------------------------
                                                                    Section 467     Section 467     Section 467
                          Calendar year                              interest          rent        loan balance
----------------------------------------------------------------------------------------------------------------
2000............................................................              $0     $100,000.00     $100,000.00
2001............................................................       10,775.08      100,000.00      210,775.08
2002............................................................       22,711.18      100,000.00      333,486.26
2003............................................................       35,933.41      100,000.00      469,419.67
2004............................................................       50,580.33      100,000.00      620,000.00
----------------------------------------------------------------------------------------------------------------

    (B) C takes the amounts of interest and rent into account as expense 
and D takes such amounts into account as income for the calendar years 
identified above, regardless of their respective overall methods of 
accounting.

[T.D. 8820, 64 FR 26863, May 18, 1999]

[[Page 326]]



Sec. 1.467-5  Section 467 rental agreements with variable interest.

    (a) Variable interest on deferred or prepaid rent--(1) In general. 
This section provides rules for computing section 467 rent and interest 
in the case of section 467 rental agreements providing variable 
interest. For purposes of this section, a rental agreement provides for 
variable interest if the rental agreement provides for stated interest 
that is paid or compounded at least annually at a rate or rates that 
meet the requirements of Sec. 1.1275-5(a)(3)(i)(A) or (B) and (a)(4). 
If a section 467 rental agreement provides for interest that is neither 
variable interest nor fixed interest, the agreement provides for 
contingent payments.
    (2) Exceptions. This section is not applicable to section 467 rental 
agreements that provide adequate interest under Sec. 1.467-2(b)(1)(i) 
(agreements with no deferred or prepaid rent) or (b)(1)(ii) (rental 
agreements with stated interest at a single fixed rate). The exceptions 
in this paragraph (a)(2) do not apply to rental agreements subject to 
constant rental accrual under Sec. 1.467-3.
    (b) Variable rate treated as fixed--(1) In general. If a section 467 
rental agreement provides variable interest--
    (i) The fixed rate substitutes (determined in the same manner as 
under Sec. 1.1275-5(e), treating the agreement date as the issue date) 
for the variable rates of interest on deferred or prepaid fixed rent 
provided by the rental agreement must be used in computing the 
proportional rental amount under Sec. 1.467-2(c), the constant rental 
amount under Sec. 1.467-3(d), the principal balance of a section 467 
loan under Sec. 1.467-4(b), and the yield of a section 467 loan under 
Sec. 1.467-4(c); and
    (ii) The interest on fixed rent for any rental period is equal to 
the amount that would be determined under Sec. 1.467-1(e)(2) if the 
section 467 rental agreement did not provide variable interest, using 
the fixed rate substitutes determined under paragraph (b)(1)(i) of this 
section in place of the variable rates called for by the rental 
agreement, plus the variable interest adjustment amount provided in 
paragraph (b)(2) of this section.
    (2) Variable interest adjustment amount--(i) In general. The 
variable interest adjustment amount for a rental period equals the 
difference between--
    (A) The amount of interest that, without regard to section 467, 
would have accrued during the rental period under the terms of the 
section 467 rental agreement; and
    (B) The amount of interest that, without regard to section 467, 
would have accrued during the rental period under the terms of the 
section 467 rental agreement using the fixed rate substitutes determined 
under paragraph (b)(1)(i) of this section in place of the variable 
interest rates called for by the rental agreement.
    (ii) Positive or negative adjustment. If the amount determined under 
paragraph (b)(2)(i)(A) of this section is greater than the amount 
determined under paragraph (b)(2)(i)(B) of this section, the variable 
interest adjustment amount is positive. If the amount determined under 
paragraph (b)(2)(i)(A) of this section is less than the amount 
determined under paragraph (b)(2)(i)(B) of this section, the variable 
interest adjustment amount is negative.
    (3) Section 467 loan balance. The variable interest adjustment 
amount is not taken into account in determining the principal balance of 
a section 467 loan under Sec. 1.467-4(b). Instead, the section 467 loan 
balance is computed as if all amounts payable under the section 467 
rental agreement were based on the fixed rate substitutes determined 
under paragraph (b)(1)(i) of this section.
    (c) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i) X and Y enter into a section 467 rental agreement for 
the lease of personal property beginning on January 1, 2000, and ending 
on December 31, 2002. The rental agreement allocates $100,000 of rent to 
2000, $200,000 to 2001, and $100,000 to 2002, and requires the lessee to 
pay all $400,000 of rent on December 31, 2002. The rental agreement 
requires the accrual of interest on unpaid accrued rent at two different 
qualified floating rates (as defined in Sec. 1.1275-5(b)), one for 2001 
and the other for 2002, such interest to be paid on December 31 of the 
year it accrues. The rental agreement provides that the qualified 
floating rate is set at a current value within the meaning of Sec. 
1.1275-5(a)(4). Assume that on the agreement date, 110 percent of the 
applicable Federal rate is 10 percent, compounded annually. Assume also 
that the agreement is not a leaseback or

[[Page 327]]

long-term agreement and, therefore, is not subject to constant rental 
accrual.
    (ii) To determine if the section 467 rental agreement provides for 
adequate interest under Sec. 1.467-2(b), Sec. 1.467-2(b)(2) requires 
the use of fixed rate substitutes (in this example determined in the 
same manner as under Sec. 1.1275-5(e)(3)(i) treating the agreement date 
as the issue date) in place of the variable rates called for by the 
rental agreement. Assume that on the agreement date the qualified 
floating rates, and therefore the fixed rate substitutes, relating to 
2001 and 2002 are 10 and 15 percent compounded annually. Taking into 
account the fixed rate substitutes, the sum of the present values of all 
amounts payable by the lessee as fixed rent and interest thereon is 
greater than the sum of the present values of the fixed rent allocated 
to each rental period. Accordingly, the rental agreement provides 
adequate interest under Sec. 1.467-2(b)(1)(iii) and the fixed rent 
accruing in each calendar year during the rental agreement is the fixed 
rent allocated under the rental agreement.
    (iii) Because the section 467 rental agreement provides for variable 
interest on unpaid accrued fixed rent at qualified floating rates and 
the qualified floating rates are set at a current value, the 
requirements of Sec. 1.1275-5(a)(3)(i)(A) and (4) are met and the 
rental agreement provides for variable interest within the meaning of 
paragraph (a)(1) of this section. Therefore, under paragraph (b)(1)(i) 
of this section, the yield of the section 467 loan is computed based on 
the fixed rate substitutes. Under Sec. 1.467-4(c), the constant yield 
(rounded to two decimal places) equals 13.63 percent compounded 
annually. Based on the fixed rate substitutes, the fixed rent, interest 
on fixed rent, and the principal balance of the section 467 loan, for 
each calendar year during the lease term, are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                     Accrued        Projected       Cumulative
                                                  Accrued rent      interest         payment           loan
----------------------------------------------------------------------------------------------------------------
2000...........................................        $100,000              $0              $0         $100,000
2001...........................................         200,000          13,630         (10,000)         303,630
2002...........................................         100,000          41,370        (445,000)               0
----------------------------------------------------------------------------------------------------------------

    (iv) To compute the actual reported interest on fixed rent for each 
calendar year, the variable interest adjustment amount, as described in 
paragraph (b)(2) of this section, must be added to the accrued interest 
determined in paragraph (iii) of this Example 1. Assume that the 
variable rates for 2001 and 2002 are actually 11 and 14 percent, 
respectively. Without regard to section 467, the interest that would 
have accrued during each calendar year under the terms of the section 
467 rental agreement, and the interest that would have accrued under the 
terms of the rental agreement using the fixed rate substitutes 
determined under paragraph (b)(1)(i) of this section are as follows:

------------------------------------------------------------------------
                                            Accrued          Accrued
                                         interest under   interest using
                                             rental         fixed rate
                                           agreement       substitutes
------------------------------------------------------------------------
2000..................................               $0               $0
2001..................................           11,000           10,000
2002..................................           42,000           45,000
------------------------------------------------------------------------

    (v) Under paragraph (b)(2) of this section, the variable interest 
adjustment amount is $1,000 ($11,000-$10,000) for 2001 and is -$3,000 
($42,000-$45,000) for 2002. Thus, under paragraph (b)(1)(ii) of this 
section, the actual interest on fixed rent for 2001 is $14,630 ($13,630 
+ $1,000) and for 2002 is $38,370 ($41,370-$3,000).
    Example 2. (i) The facts are the same as in Example 1 except that 
110 percent of the applicable Federal rate is 15 percent compounded 
annually and the section 467 rental agreement does not provide adequate 
interest under Sec. 1.467-2(b). Consequently, the fixed rent for each 
calendar year during the lease is the proportional rental amount.
    (ii) The sum of the present values of the fixed rent provided for 
each calendar year during the lease term, discounted at 15 percent 
compounded annually, equals $303,936.87.
    (iii)(A) Paragraph (b)(1)(i) of this section requires the 
proportional rental amount to be computed based on the assumption that 
interest will accrue and be paid based on the fixed rate substitutes. 
Thus, the sum of the present values of the projected payments under the 
section 467 rental agreement equals $300,156.16, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.005

    (B) The fraction for computing the proportional rental amount equals 
.9875609 ($300,156.16/$303,936.87).
    (iv) Based on the fixed rate substitutes, the fixed rent, interest 
on fixed rent, and the balance of the section 467 loan for each calendar 
year during the lease term are as follows:

[[Page 328]]



----------------------------------------------------------------------------------------------------------------
                                                  Proportional       Accrued        Projected       Cumulative
                                                      rent          interest         payment           loan
----------------------------------------------------------------------------------------------------------------
2000...........................................      $98,756.09           $0.00              $0       $98,756.09
2001...........................................      197,512.18       14,813.41         (10,000)      301,081.68
2002...........................................       98,756.09       45,162.23        (445,000)            0.00
----------------------------------------------------------------------------------------------------------------

    (v) The variable interest adjustment amount in this example is the 
same as in Example 1. Under paragraph (b)(1)(ii) of this section, the 
actual interest on fixed rent for 2001 is $15,813.41 ($14,813.41 + 
$1,000) and for 2002 is $42,162.23 ($45,162.23-$3,000).

[T.D. 8820, 64 FR 26865, May 18, 1999]



Sec. 1.467-6  Section 467 rental agreements with contingent payments. 
[Reserved]



Sec. 1.467-7  Section 467 recapture and other rules relating to 
dispositions and modifications.

    (a) Section 467 recapture. Notwithstanding any other provision of 
the Internal Revenue Code, except as provided in paragraph (c) of this 
section, a lessor disposing of property in a transaction to which this 
paragraph (a) applies must recognize the recapture amount (determined 
under paragraph (b) of this section) and treat that amount as ordinary 
income. This paragraph (a) applies to any disposition of property 
subject to a section 467 rental agreement that--
    (1) Is a leaseback (as defined in Sec. 1.467-3(b)(2)) or a long-
term agreement (as defined in Sec. 1.467-3(b)(3));
    (2) Is not disqualified under Sec. 1.467-3(b)(1); and
    (3) Allocates to any rental period fixed rent that, when annualized, 
exceeds the annualized fixed rent allocated to any preceding rental 
period.
    (b) Recapture amount--(1) In general. The recapture amount for a 
disposition is the lesser of--
    (i) The prior understated inclusion (determined under paragraph 
(b)(2) of this section); or
    (ii) The section 467 gain (determined under paragraph (b)(3) of this 
section).
    (2) Prior understated inclusion. The prior understated inclusion is 
the excess (if any) of--
    (i) The aggregate amount of section 467 rent and section 467 
interest for the period during which the lessor held the property, 
determined as if the section 467 rental agreement were a disqualified 
leaseback or long-term agreement subject to constant rental accrual 
under Sec. 1.467-3; over
    (ii) The aggregate amount of section 467 rent and section 467 
interest accrued by the lessor during that period.
    (3) Section 467 gain--(i) In general. Except as otherwise provided 
in paragraph (b)(3)(ii) of this section, the section 467 gain is the 
excess (if any) of--
    (A) The amount realized from the disposition; over
    (B) The sum of the adjusted basis of the property and the amount of 
any gain from the disposition that is treated as ordinary income under 
any provision of subtitle A of the Internal Revenue Code other than 
section 467(c) (for example, section 1245 or 1250).
    (ii) Certain dispositions. In the case of a disposition that is not 
a sale or exchange, the section 467 gain is the excess (if any) of the 
fair market value of the property on the date of disposition over the 
amount determined under paragraph (b)(3)(i)(B) of this section.
    (c) Special rules--(1) Gifts. Paragraph (a) of this section does not 
apply to a disposition by gift. However, see paragraph (c)(4) of this 
section for dispositions by transferees. If a disposition is in part a 
sale or exchange and in part a gift, paragraph (a) of this section 
applies to the disposition but the prior understated inclusion is 
determined by taking into account only section 467 rent and section 467 
interest properly allocable to the portion of the property not disposed 
of by gift.
    (2) Dispositions at death. Paragraph (a) of this section does not 
apply to a disposition if the basis of the property in the hands of the 
transferee is determined under section 1014(a). This paragraph (c)(2) 
does not apply to property which constitutes a right to receive an item 
of income in respect of a decedent. See sections 691 and 1014(c).
    (3) Certain tax-free exchanges--(i) In general. The recapture amount 
in the case of a disposition to which this paragraph (c)(3) applies is 
limited to

[[Page 329]]

the amount of gain recognized to the transferor (determined without 
regard to paragraph (a) of this section), reduced by the amount of any 
gain from the disposition that is treated as ordinary income under any 
provision of subtitle A of the Internal Revenue Code other than section 
467(c). However, see paragraph (c)(4) of this section for dispositions 
by transferees.
    (ii) Dispositions covered--(A) In general. Except as provided in 
paragraph (c)(3)(ii)(B) of this section, this paragraph (c)(3) applies 
to a disposition of property if the basis of the property in the hands 
of the transferee is determined by reference to its basis in the hands 
of the transferor by reason of the application of section 332, 351, 361, 
721, or 731.
    (B) Transfers to certain tax-exempt organizations. This paragraph 
(c)(3) does not apply to a disposition to an organization (other than a 
cooperative described in section 521) which is exempt from tax imposed 
by chapter 1, subtitle A of the Internal Revenue Code (a tax-exempt 
entity) except to the extent the property is used in an activity the 
income from which is subject to tax under section 511(a) (a section 
511(a) activity). However, if assets used to any extent in a section 
511(a) activity are disposed of by the tax-exempt entity, then, 
notwithstanding any other provision of law (except section 1031 or 
section 1033) the recapture amount with respect to such disposition, to 
the extent attributable under paragraph (c)(4) of this section to the 
period of the transferor's ownership of the property prior to the first 
disposition, shall be included in the tax-exempt entity's unrelated 
business taxable income. To the extent that the tax-exempt entity ceases 
to use the property in a section 511(a) activity, the entity will be 
treated for purposes of this paragraph (c)(3) and paragraph (c)(4) of 
this section as having disposed of the property to such extent on the 
date of the cessation.
    (4) Dispositions by transferee. If the recapture amount with respect 
to a disposition of property (the first disposition) is limited under 
paragraph (c)(1) or (3) of this section and the transferee subsequently 
disposes of the property in a transaction to which paragraph (a) of this 
section applies, the prior understated inclusion determined under 
paragraph (b)(2) of this section is computed by taking into account the 
amounts attributable to the period of the transferor's ownership of the 
property prior to the first disposition. Thus, for example, the section 
467 rent and section 467 interest that would have been taken into 
account by the transferee if the section 467 rental agreement were a 
disqualified leaseback or long-term agreement subject to constant rental 
accrual include the amounts that would have been taken into account by 
the transferor, and the aggregate amount of section 467 rent and section 
467 interest accrued by the transferee includes the aggregate amount of 
section 467 rent and section 467 interest that was taken into account by 
the transferor. The prior understated inclusion determined under this 
paragraph (c)(4) must be reduced by any recapture amount taken into 
account under paragraph (a) of this section by the transferor.
    (5) Like-kind exchanges and involuntary conversions. If property is 
disposed of or converted and, before the application of paragraph (a) of 
this section, gain is not recognized in whole or in part under section 
1031 or 1033, then the amount of section 467 gain taken into account by 
the lessor is limited to the sum of--
    (i) The amount of gain recognized on the disposition or conversion 
of the property (determined without regard to paragraph (a) of this 
section); and
    (ii) The fair market value of property acquired that is not subject 
to the same section 467 rental agreement and that is not taken into 
account under paragraph (c)(5)(i) of this section.
    (6) Installment sales. In the case of an installment sale of 
property to which paragraph (a) of this section applies--
    (i) The recapture amount is recognized and treated as ordinary 
income in the year of the disposition; and
    (ii) Any gain in excess of the recapture amount is reported under 
the installment method of accounting if and to the extent that method is 
otherwise available under section 453.
    (7) Dispositions covered by section 170(e), 341(e)(12), or 751(c). 
For purposes of sections 170(e), 341(e)(12), and 751(c), amounts treated 
as ordinary income

[[Page 330]]

under paragraph (a) of this section must be treated in the same manner 
as amounts treated as ordinary income under section 1245 or 1250.
    (d) Examples. The following examples illustrate the application of 
paragraphs (a), (b), and (c) of this section. In each of these examples 
the transferor of property subject to a section 467 rental agreement is 
entitled to the rent for the day of the disposition. The examples are as 
follows:

    Example 1. (i)(A) X and Y enter into a section 467 rental agreement 
for a 5-year lease of personal property beginning on January 1, 2000, 
and ending on December 31, 2004. The rental agreement provides that the 
calendar year will be the rental period and that rents accrue and are 
paid in the following pattern:

------------------------------------------------------------------------
                                            Allocation        Payment
------------------------------------------------------------------------
2000....................................              $0              $0
2001....................................          87,500               0
2002....................................          87,500         175,000
2003....................................          87,500         175,000
2004....................................          87,500               0
------------------------------------------------------------------------

    (B) Assume that both X and Y are calendar year taxpayers and that 
110 percent of the applicable Federal rate is 11 percent, compounded 
annually. Assume also that the rental agreement is a long-term agreement 
(as defined in Sec. 1.467-3(b)(3)), but it is not a disqualified 
leaseback or long-term agreement. Further, because the agreement does 
not provide prepaid or deferred rent, proportional rental accrual is not 
applicable. (See Sec. 1.467-2(b)(1)(i)). Therefore, the rent taken into 
account under Sec. 1.467-1(d)(2) is the fixed rent allocated to the 
rental periods under Sec. 1.467-1(c)(2)(ii).
    (ii) On December 31, 2000, X sells the property subject to the 
section 467 rental agreement to an unrelated person for $575,000. At the 
time of the sale, X's adjusted basis in the property is $175,000. Thus, 
X's gain on the sale of the property is $400,000. Assume that $175,000 
of this gain would be treated as ordinary income under provisions of the 
Internal Revenue Code other than section 467(c). Under paragraph (a) of 
this section, X is required to take the recapture amount into account as 
ordinary income. Under paragraph (b) of this section, the recapture 
amount is the lesser of the prior understated inclusion or the section 
467 gain.
    (iii)(A) In computing the prior understated inclusion under 
paragraph (b)(2) of this section, assume that the section 467 rent and 
section 467 interest (based on constant rental accrual) would be taken 
into account as follows if the section 467 rental agreement were a 
disqualified long-term agreement:

------------------------------------------------------------------------
                                           Section 467     Section 467
                                              rent           interest
------------------------------------------------------------------------
2000...................................      $65,812.55              $0
2001...................................       65,812.55        7,239.38
2002...................................       65,812.55       15,275.09
2003...................................       65,812.55        4,944.73
2004...................................       65,812.55       (6,521.95)
------------------------------------------------------------------------

    (B) The total amount of section 467 rent and section 467 interest 
for 2000, based on constant rental accrual, is $65,812.55. Since X did 
not take any section 467 rent or section 467 interest into account in 
2000, the prior understated inclusion is also $65,812.55. X's section 
467 gain is $225,000, which is the excess of the gain realized 
($400,000) over the amount of that gain treated as ordinary income under 
non-section 467 provisions ($175,000). Accordingly, the recapture amount 
(the lesser of the prior understated inclusion or the section 467 gain) 
treated as ordinary income is $65,812.55.
    Example 2. (i) The facts are the same as in Example 1, except that 
the section 467 rental agreement specifies that rents accrue and are 
paid in the following pattern:

------------------------------------------------------------------------
                                            Allocation        Payment
------------------------------------------------------------------------
2000....................................         $60,000              $0
2001....................................          65,000               0
2002....................................          70,000         175,000
2003....................................          75,000         175,000
2004....................................          80,000               0
------------------------------------------------------------------------

    (ii)(A) Assume the section 467 rental agreement does not provide for 
adequate interest under Sec. 1.467-2(b), and, therefore, the fixed rent 
for a rental period is the proportional rental amount. See Sec. 1.467-
1(d)(2)(ii). Under Sec. 1.467-2(c), the following amounts would be 
required to be taken into account:

------------------------------------------------------------------------
                                           Section 467     Section 467
                                              rent           interest
------------------------------------------------------------------------
2000...................................      $57,260.43             $ 0
2001...................................       62,032.13        6,298.65
2002...................................       66,803.83       13,815.03
2003...................................       71,575.53        3,433.11
2004...................................       76,347.23       (7,565.94)
------------------------------------------------------------------------

    (B) The amount of section 467 rent and section 467 interest taken 
into account by X for 2000 is $57,260.43. Thus, the prior understated 
inclusion is $8,552.12 (the excess of the amount of section 467 rent and 
section 467 interest based on constant rental accrual for 2000, 
$65,812.55, over the amount of section 467 rent and section 467 interest 
actually taken into account, $57,260.43). Since the prior understated 
inclusion is less than the section 467 gain ($225,000, as determined in 
Example 1(iii)(B)), the recapture amount treated as ordinary income is 
also $8,552.12.
    Example 3. (i) The facts are the same as in Example 1, except that, 
instead of selling the property, X transfers the property to S on 
December 31, 2002, in exchange for stock of S

[[Page 331]]

in a transaction that meets the requirements of section 351(a). Under 
paragraph (c)(3) of this section, because of the application of section 
351, X is not required to take into account any section 467 recapture.
    (ii) On December 31, 2003, S sells the property subject to the 
section 467 rental agreement to an unrelated person for $450,000. At the 
time of the sale, S's adjusted basis in the property is $105,000. Thus, 
S's gain on the sale of the property is $345,000. Assume that $245,000 
of this gain would be treated as ordinary income under provisions of the 
Internal Revenue Code other than section 467(c). Under paragraph (a) of 
this section, S is required to take the recapture amount into account as 
ordinary income which, under paragraph (b) of this section, is the 
lesser of the prior understated inclusion or the section 467 gain.
    (iii) S owned the property in 2003 and, under paragraph (c)(4) of 
this section, for purposes of determining S's prior understated 
inclusion, S is treated as if it had owned the property during the years 
2000 through 2002. In computing S's prior understated inclusion under 
paragraph (b)(2) of this section, the section 467 rent and section 467 
interest based on constant rental accrual are the same as the amounts 
set forth in the schedule in Example 1(iii)(A). Thus, the constant 
rental amount for 2000, 2001, 2002, and 2003 is $290,709.40 
((4x$65,812.55) + $7,239.38 + $15,275.09 + $4,944.73). The section 467 
rent and section 467 interest actually taken into account prior to the 
disposition is $262,500. Thus, S's prior understated inclusion is 
$28,209.40 ($290,709.40 minus $262,500 (3x$87,500)). S's section 467 
gain is $100,000, the difference between the gain realized on the 
disposition ($345,000) and the amount of gain that is treated as 
ordinary income under non-section 467 Code provisions ($245,000). 
Accordingly, S's recapture amount, the lesser of the prior understated 
inclusion or the section 467 gain, is $28,209.40.

    (e) Other rules relating to dispositions--(1) In general. If there 
is a sale, exchange, or other disposition of property subject to a 
section 467 rental agreement (the transfer), the section 467 rent and, 
if applicable, section 467 interest for a period are taken into account 
by the owner of the property during the period. The following rules 
apply in determining the section 467 rent and section 467 interest for 
the portion of the rental period ending immediately prior to the 
transfer:
    (i) The section 467 rent and section 467 interest for the portion of 
the rental period ending immediately prior to the transfer are a pro 
rata portion of the section 467 rent and the section 467 interest, 
respectively, for the rental period. Such amounts are also taken into 
account in determining the transferor's section 467 loan balance, prior 
to any adjustment thereof that may be required under paragraph (h) of 
this section, immediately before the transfer.
    (ii) If the transferor of the property is entitled to the rent for 
the day of transfer, the transfer is treated as occurring at the end of 
the day of the transfer.
    (iii) If the transferee of the property is entitled to the rent for 
the day of transfer, the transfer is treated as occurring at the 
beginning of the day of the transfer.
    (2) Treatment of section 467 loan. If there is a transfer described 
in paragraph (e)(1) of this section, the following rules apply in 
determining the transferor's and the transferee's section 467 loans for 
the period after the transfer, the amount realized by the transferor, 
and the transferee's basis in the property:
    (i) The beginning balance of the transferor's section 467 loan is 
equal to the net present value at the time of the transfer (but after 
giving effect to the transfer) of all subsequent amounts payable as 
fixed rent and interest on fixed rent to the transferor and all 
subsequent amounts payable as interest on prepaid fixed rent by the 
transferor. The transferor must continue to take into account interest 
on the transferor's section 467 loan balance after the date of the 
transfer.
    (ii) The beginning balance of the transferee's section 467 loan is 
equal to the principal balance of the transferor's section 467 loan 
immediately before the transfer reduced (below zero, if appropriate) by 
the beginning balance of the transferor's section 467 loan. Amounts 
payable to the transferor are not taken into account in adjusting the 
transferee's section 467 loan balance.
    (iii) If the beginning balance of the transferee's section 467 loan 
is negative, the transferor and transferee must treat the balance as a 
liability that is either assumed in connection with the transfer of the 
property or secured by the property acquired subject to the liability. 
If the beginning balance of the transferee's section 467 loan

[[Page 332]]

is positive, the transferor and transferee must treat the balance as an 
additional asset acquired in connection with the transfer of the 
property. In the case of a positive beginning balance of the 
transferee's section 467 loan, the transferee will have an initial cost 
basis in the section 467 loan equal to the lesser of the beginning 
balance of the loan or the aggregate consideration for the transfer of 
the property subject to the section 467 rental agreement and the 
transfer of the transferor's interest in the section 467 loan.
    (3) [Reserved]
    (4) Examples. The following examples illustrate the application of 
this paragraph (e). In each of these examples the transferor of property 
subject to a section 467 rental agreement is entitled to the rent for 
the day of the transfer. The examples are as follows:

    Example 1. (i) Q and R enter into a section 467 rental agreement for 
a 5-year lease of personal property beginning on January 1, 2000, and 
ending on December 31, 2004. The rental agreement provides that $0 of 
rent is allocated to 2000, 2001, and 2002, and $1,750,000 is allocated 
to each of the years 2003 and 2004. The rental agreement provides that 
the calendar year will be the rental period and that the rent allocated 
to each calendar year is payable on the last day of that calendar year. 
Assume that both Q and R are calendar year taxpayers and that 110 
percent of the applicable Federal rate is 11 percent, compounded 
annually. Assume further that the rental agreement is a disqualified 
long-term agreement (as defined in Sec. 1.467-3(b)(3)) and that the 
section 467 rent, the section 467 interest, and the section 467 loan 
balance would be the following amounts:

----------------------------------------------------------------------------------------------------------------
                                                            Section 467                         Section 467 loan
            Calendar year                  Payment            interest       Section 467 rent       balance
----------------------------------------------------------------------------------------------------------------
2000................................                 $0                 $0        $592,905.87        $592,905.87
2001................................                  0          65,219.65         592,905.87       1,251,031.39
2002................................                  0         137,613.45         592,905.87       1,981,550.71
2003................................       1,750,000.00         217,970.58         592,905.87       1,042,427.16
2004................................       1,750,000.00         114,666.97         592,905.87                  0
----------------------------------------------------------------------------------------------------------------

    (ii) On December 31, 2002, Q sells the property subject to the 
section 467 rental agreement to P, an unrelated person, for $3,000,000. 
Q does not retain the right to receive any amounts payable by R under 
the rental agreement after the date of sale, but the agreement is not 
otherwise modified. At the time of the sale, Q's adjusted basis in the 
property is $975,000. Assume that, under Sec. 1.467-1(f)(7), the 
disposition is not a substantial modification. Further, the Commissioner 
does not determine that the treatment of the agreement as a disqualified 
long-term agreement should be changed and, under Sec. 1.467-
1(f)(4)(iii), the agreement remains subject to constant rental accrual. 
Thus, under paragraph (g)(2)(iii) of this section, section 467 rent and 
section 467 interest for periods after the disposition will be taken 
into account on the basis of constant rental accrual applied to the 
terms of the entire agreement (as modified).
    (iii) Under paragraph (e)(2)(ii) of this section, the beginning 
balance of P's section 467 loan is $1,981,550.71. P's section 467 loan 
balance is computed by reducing the balance of the section 467 loan 
immediately before the transfer ($1,981,550.71) by the beginning balance 
of the transferor's section 467 loan ($0 because Q does not retain the 
right to receive any amounts payable under the rental agreement 
subsequent to the transfer).
    (iv) Q will be treated as if it had received $1,981,550.71 from the 
disposition of the section 467 loan and $1,018,449.29 from the sale of 
the property subject to the rental agreement. Thus, Q's gain on the sale 
of the property is $43,449.29 ($1,018,449.29 amount realized less 
$975,000 adjusted basis). Q's gain is not subject to the recapture 
provisions of section 467(c) and paragraph (a) of this section because 
the rental agreement was disqualified under Sec. 1.467-3(b)(1) and, 
thus, the requirement of paragraph (a)(2) of this section is not met. Q 
recognizes no gain on the disposition of the section 467 loan because 
Q's basis in the loan equals the amount considered received for the 
loan. Further, Q does not take into account any of the section 467 rent 
or section 467 interest attributable to periods after the transfer of 
the property.
    (v) P is treated as if it had acquired the property and the positive 
balance in the transferee's section 467 loan. P's cost basis in the 
property is $1,018,449.29, and its cost basis in the section 467 loan 
immediately following the transfer is $1,981,550.71. P takes section 467 
rent and section 467 interest into account for the calendar years 2002 
and 2003 under the constant rental accrual method and, accordingly, 
treats payments received under the rental agreement as recoveries of the 
principal balance of the section 467 loan (as adjusted from time to 
time).

[[Page 333]]

    Example 2. (i) The facts are the same as Example 1, except that on 
December 31, 2002, Q transfers the property to P in exchange for stock 
of P having a fair market value of $3,000,000 and the transaction meets 
the requirements of section 351(a).
    (ii) Q is treated as having transferred two assets to P, the 
property subject to the rental agreement and the positive balance of the 
section 467 loan. Under section 351(a), because only stock of P is 
received by Q, Q does not recognize any of the gain realized on the 
transaction. Pursuant to section 358(a), the basis of Q in the P stock 
received in the exchange is the same as the aggregate basis of the 
property exchanged, or $2,956,550.71 (the sum of the balance of the 
section 467 loan, $1,981,550.71, and the adjusted basis of the property, 
$975,000). Q does not take into account any of the section 467 rent or 
section 467 interest attributable to periods after the transfer of the 
property.
    (iii) P is treated as if it had acquired the property and the 
positive balance in the transferee's section 467 loan in the 
transaction. Pursuant to section 362(a), P's basis in each asset is the 
same as the basis of Q immediately preceding the transfer. Thus, the 
basis of P in the property subject to the rental agreement is $975,000, 
and the basis of P in the section 467 loan immediately following the 
transfer is $1,981,550.71. P takes section 467 rent and section 467 
interest into account for the calendar years 2003 and 2004 under the 
constant rental accrual method and, accordingly, treats payments 
received under the rental agreement as recoveries of the principal 
balance of the section 467 loan (as adjusted from time to time).

    (f) Treatment of assignments by lessee and lessee-financed 
renewals--(1) Substitute lessee use. If a lessee assigns its interest in 
a section 467 rental agreement to a substitute lessee, or if a period 
when a substitute lessee has the use of property subject to a section 
467 rental agreement is otherwise included in the lease term under Sec. 
1.467-1(h)(6), the section 467 rent for a period is taken into account 
by the person having the use of the property during the period. The 
following rules apply in determining the section 467 rent and section 
467 interest for the portion of the rental period ending immediately 
prior to the assignment:
    (i) The section 467 rent and section 467 interest for the portion of 
the rental period ending immediately prior to the assignment are a pro 
rata portion of the section 467 rent and the section 467 interest, 
respectively, for the rental period. Such amounts are also taken into 
account in determining the lessee's section 467 loan balance, prior to 
any adjustment thereof that may be required under paragraph (h) of this 
section, immediately before the substitute lessee first has use of the 
property.
    (ii) If the lessee is liable for the rent for the day that the 
substitute lessee first has use of the property, the substitute lessee's 
use shall be treated as beginning at the end of that day.
    (iii) If the substitute lessee is liable for the rent for the day 
that the substitute lessee first has use of the property, the substitute 
lessee's use shall be treated as beginning at the beginning of that day.
    (2) Treatment of section 467 loan. If, as described in paragraph 
(f)(1) of this section, a lessee assigns its interest in a section 467 
rental agreement to a substitute lessee or a period when a substitute 
lessee has the use of property subject to a section 467 rental agreement 
is otherwise included in the lease term under Sec. 1.467-1(h)(6), the 
following rules apply in determining the amount of the lessee's and the 
substitute lessee's section 467 loans for the period when the substitute 
lessee has use of the property and in computing the taxable income of 
the lessee and substitute lessee:
    (i) The beginning balance of the lessee's section 467 loan is equal 
to the net present value, as of the time the substitute lessee first has 
use of the property (but after giving effect to the transfer of the 
right to use the property), of all amounts subsequently payable by the 
lessee as fixed rent and interest on fixed rent and all amounts 
subsequently payable as interest on prepaid fixed rent to the lessee. 
For purposes of this paragraph (f), any amount otherwise payable by the 
lessee is not treated as an amount subsequently payable by the lessee to 
the extent that such payment, if made by the lessee, would give rise to 
a right of contribution or other similar claim against the substitute 
lessee or any other person. The lessee must continue to take into 
account interest on the lessee's section 467 loan balance after the 
substitute lessee first has use of the property.
    (ii) The beginning balance of the substitute lessee's section 467 
loan is equal

[[Page 334]]

to the principal balance of the lessee's section 467 loan immediately 
before the substitute lessee first has use of the property reduced 
(below zero, if appropriate) by the beginning balance of the lessee's 
section 467 loan. Amounts payable by the lessee to any person other than 
the substitute lessee (or a related person) or payable to the lessee by 
any person other than the substitute lessee (or a related person) are 
not taken into account in adjusting the substitute lessee's section 467 
loan balance.
    (iii) If the beginning balance of the substitute lessee's section 
467 loan is positive, the beginning balance is treated as--
    (A) Gross receipts of the lessee for the taxable year in which the 
substitute lessee first has use of the property; and
    (B) A liability that is either assumed in connection with the 
transfer of the leasehold interest to the substitute lessee or secured 
by property acquired subject to the liability.
    (iv) If the beginning balance of the substitute lessee's section 467 
loan is negative, the following rules apply:
    (A) If the principal balance of the lessee's section 467 loan 
immediately before the substitute lessee first has use of the property 
was negative, any consideration paid by the substitute lessee to the 
lessee in conjunction with the transfer of the use of the property shall 
be treated as a nontaxable return of capital to the lessee to the extent 
that--
    (1) The consideration does not exceed the amount owed to the lessee 
under the lessee's section 467 loan balance immediately before the 
substitute lessee first has use of the property; and
    (2) The lessee has basis in the principal balance of the lessee's 
section 467 loan immediately before the substitute lessee first has use 
of the property.
    (B) Except as provided in paragraph (f)(2)(iv)(D) of this section, 
the excess, if any, of the beginning balance of the amount owed to the 
substitute lessee under the section 467 loan, over any consideration 
paid by the substitute lessee to the lessee in conjunction with the 
transfer of the use of the property, is treated as an amount incurred by 
the lessee for the taxable year in which the substitute lessee first has 
use of the property.
    (C) To the extent the beginning balance of the amount owed to the 
substitute lessee under the section 467 loan exceeds any consideration 
paid by the substitute lessee to the lessee in conjunction with the 
transfer of the use of the property, repayments of the beginning balance 
are items of gross income of the substitute lessee in the taxable year 
in which repayment occurs (determined by applying any repayment first to 
the beginning balance of the substitute lessee's section 467 loan).
    (D) Any amount incurred by the lessee under paragraph (f)(2)(iv)(B) 
of this section with respect to a transfer of the use of property (the 
current transfer) shall be reduced (but not below zero) to the extent 
that the lessee, in its capacity, if any, as a substitute lessee with 
respect to an earlier transfer of the use of the property would have 
recognized additional gross income under paragraph (f)(2)(iv)(C) of this 
section if the current transfer had not occurred.
    (v) For purposes of paragraph (f)(2)(iv)(C) of this section, 
repayments occur as the negative balance is amortized through the net 
accrual of rent and negative interest.
    (3) Lessor use. If a period when the lessor has the use of property 
subject to a section 467 rental agreement is included in the lease term 
under Sec. 1.467-1(h)(6), the section 467 rent for the period is not 
taken into account and the lessor is treated as a substitute lessee for 
purposes of this paragraph (f).
    (4) Examples. The following examples illustrate the application of 
this paragraph (f). In each of these examples, the substitute lessee is 
liable for the rent for the day on which the substitute lessee first has 
use of the property subject to the section 467 rental agreement. 
Further, assume that in each example the lessee assignment is not a 
substantial modification under Sec. 1.467-1(f). The examples are as 
follows:

    Example 1. (i) The facts are the same as in Example 1 of paragraph 
(e)(4) of this section, except that on December 31, 2001, R, the lessee, 
contracts to assign its entire remaining interest in the leasehold to S, 
a calendar

[[Page 335]]

year taxpayer. The assignment becomes effective at the beginning of 
January 1, 2002. Pursuant to the terms of the assignment, R agrees with 
S that R will make $1,400,000 of the $1,750,000 rental payment required 
on December 31, 2003.
    (ii) Under paragraph (f)(2)(i) of this section, R's section 467 loan 
balance as of the beginning of January 1, 2002, the time S first has use 
of the property, is $1,136,271.41 ($1,400,000/(1.11)2). Under paragraph 
(f)(2)(ii) of this section, S's section 467 loan balance as of the 
beginning of January 1, 2002, is $114,759.98 (the principal balance of 
R's section 467 loan immediately before S has use of the property 
($1,251,031.39), less R's section 467 loan balance at the beginning of 
January 1, 2002 ($1,136,271.41)).
    (iii) Because S's $114,759.98 section 467 loan balance is positive, 
under paragraph (f)(2)(iii)(A) of this section, such amount is treated 
as gross receipts of R for 2002, R's taxable year in which S first has 
use of the property. R will treat the $114,759.98 as an amount received 
in exchange for the transfer of the leasehold interest. Under paragraph 
(f)(2)(iii)(B) of this section, S will treat that amount as a liability 
assumed in acquiring the leasehold interest. Thus, S's cost basis in the 
leasehold interest is $114,759.98.
    (iv) Under paragraph (f)(1) of this section, S takes the section 467 
rent attributable to the property into account for the period beginning 
on January 1, 2002. For 2002, S takes section 467 interest into account 
based on S's section 467 loan balance at the beginning of 2002. S's 
amounts payable, section 467 rent, section 467 interest, and end-of-year 
section 467 loan balances for calendar years 2002 through 2004 are as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                            Section 467                         Section 467 loan
            Calendar year                  Payment            interest       Section 467 rent       balance
----------------------------------------------------------------------------------------------------------------
Beginning...........................  .................  .................  .................        $114,759.98
2002................................                 $0         $12,623.60        $592,905.87         720,289.45
2003................................         350,000.00          79,231.83         592,905.87       1,042,427.15
2004................................       1,750,000.00         114,666.98         592,905.87                  0
----------------------------------------------------------------------------------------------------------------

    (v) Under paragraph (f)(2)(i) of this section, R must continue to 
take into account section 467 interest on R's section 467 loan balance 
after S first has use of the property. R's section 467 loan balance 
beginning when S first has use of the property is $1,136,271.41. R's 
section 467 interest and end-of-year section 467 loan balances for 
calendar years 2002 through 2003 are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                               Section 467      Section 467 loan
                     Calendar year                            Payment            interest           balance
----------------------------------------------------------------------------------------------------------------
Beginning..............................................  .................  .................      $1,136,271.41
2002...................................................                 $0        $124,989.85       1,261,261.26
2003...................................................       1,400,000.00         138,738.74                  0
----------------------------------------------------------------------------------------------------------------

    Example 2. (i) On January 1, 2000, B leases tangible personal 
property from C for a period of five years. The rental agreement 
provides that the rental period is the calendar year and that rent 
payments are due at the end of the calendar year. The rental agreement 
does not provide for interest on prepaid rent. Assume that B and C are 
both calendar year taxpayers and that 110 percent of the applicable 
Federal rate is 10 percent, compounded annually. The rental agreement 
allocates rents and provides for payments of rent as follows:

------------------------------------------------------------------------
              Calendar year                    Rent          Payments
------------------------------------------------------------------------
2000....................................        $200,000        $400,000
2001....................................         200,000         300,000
2002....................................         200,000         200,000
2003....................................         200,000         100,000
2004....................................         200,000               0
------------------------------------------------------------------------

    (ii) The rental agreement has prepaid rent within the meaning of 
Sec. 1.467-1(c)(3)(ii) because the cumulative amount of rent payable 
through the end of 2001 ($700,000) exceeds the cumulative amount of rent 
allocated to calendar years 2000 through 2002 ($600,000). Because the 
rental agreement does not provide for adequate interest on prepaid fixed 
rent, the rent for each calendar year during the lease term is the 
proportional rental amount, as described in Sec. 1.467-2(c). The 
amounts payable, section 467 rent, section 467 interest, and end-of-year 
section 467 loan balances for each calendar year are as follows:

----------------------------------------------------------------------------------------------------------------
                                                           Section 467                         Section 467 loan
           Calendar year                 Payment            interest        Section 467 rent        balance
----------------------------------------------------------------------------------------------------------------
2000..............................           $400,000                 $0         $218,987.40       ($181,012.60)

[[Page 336]]

 
2001..............................            300,000         (18,101.26)         218,987.40        (280,126.46)
2002..............................            200,000         (28,012.64)         218,987.40        (289,151.70)
2003..............................            100,000         (28,915.17)         218,987.40        (199,079.47)
2004..............................                  0         (19,907.93)         218,987.40                  0
----------------------------------------------------------------------------------------------------------------

    (iii) On December 31, 2001, B contracts to assign its entire 
remaining interest in the leasehold to D, a calendar year taxpayer. The 
assignment becomes effective at the beginning of January 1, 2002. D pays 
B $278,000 on January 1, 2002, in conjunction with the assignment of the 
leasehold interest. Under the terms of the assignment, B is not 
obligated to make any rental payments due after the assignment.
    (iv) Under paragraph (f)(2)(i) of this section, B's section 467 loan 
balance as of the beginning of January 1, 2002, the time D first has use 
of the property, is zero because D is obligated to make all rent 
payments due after the assignment of the leasehold interest. Under 
paragraph (f)(2)(ii) of this section, D's section 467 loan balance as of 
the beginning of January 1, 2002, is negative $280,126.46 (the principal 
balance of B's section 467 loan immediately before D has use of the 
property (negative $280,126.46), less B's section 467 loan balance when 
D first has use of the property (zero)). Because D's beginning section 
467 loan balance is negative, paragraph (f)(2)(iv) of this section 
applies.
    (v) Because B's $280,126.46 section 467 loan balance at the end of 
2001 (that is, immediately before D has use of the property) is 
negative, paragraph (f)(2)(iv)(A) of this section applies. B's loan 
balance is the amount owed to B under the section 467 loan and consists 
of the excess of B's payments to C over the net amount of rent and 
negative interest B has taken into account through the end of 2001. 
Thus, B's basis in the negative section 467 loan balance at the end of 
2001 is $280,126.46. Because the $278,000 paid by D to B in conjunction 
with the transfer of the leasehold interest does not exceed the amount 
owed to B under the section 467 loan at the end of 2001, and does not 
exceed B's basis in that loan balance, under paragraph (f)(2)(iv)(A) of 
this section B treats the $278,000 payment from D as a nontaxable return 
of capital.
    (vi) The beginning balance of the amount owed to D under the section 
467 loan ($280,126.46) exceeds by $2,126.46 the $278,000 paid by D to B 
in conjunction with the transfer of the leasehold interest. Paragraph 
(f)(2)(iv)(B) of this section treats the $2,126.46 as an amount incurred 
by B in 2002, B's taxable year in which D first has use of the property. 
Paragraph (f)(2)(iv)(D) of this section does not apply to reduce the 
amount incurred by B because B is the original lessee under the section 
467 rental agreement.
    (vii) Under paragraph (f)(1) of this section, D takes the section 
467 rent into account for the period beginning when D first has use of 
the property. D takes section 467 interest into account based on a 
beginning section 467 loan balance of negative $280,126.46.
    (viii) The beginning balance of the amount owed to D under the 
section 467 loan ($280,126.46) exceeds by $2,126.46 the $278,000 paid by 
D to B in conjunction with the transfer of the leasehold interest. Under 
paragraph (f)(2)(iv)(C) of this section, D must include this amount in 
gross income in 2002, the year in which this amount of D's beginning 
section 467 loan balance is paid through the net accrual of rent and 
negative interest. This inclusion in gross income ensures that the 
reductions in D's taxable income attributable to the section 467 rental 
agreement will not exceed the actual amount of D's expenditures.

    (g) Application of section 467 following a rental agreement 
modification--(1) Substantial modifications. The following rules apply 
to any substantial modification of a rental agreement occurring after 
May 18, 1999 unless the entire agreement (as modified) is treated as a 
single agreement under Sec. 1.467-1(f)(4)(vi):
    (i) Treatment of pre-modification items. The lessor and lessee must 
take pre-modification items (within the meaning of Sec. 1.467-
1(f)(5)(v)) into account under their method of accounting used before 
the modification to report income and expense attributable to the rental 
agreement.
    (ii) Computations with respect to post-modification items. In 
computing section 467 rent, section 467 interest, and the amount of the 
section 467 loan with respect to post-modification items--
    (A) Post-modification items are treated as provided under a rental 
agreement (the post-modification agreement) separate from the agreement 
under which pre-modification items are provided;
    (B) The lease term of the post-modification agreement begins at the 
beginning of the first period for which rent

[[Page 337]]

other than pre-modification rent is provided; and
    (C) The applicable Federal rate for the post-modification agreement 
is the applicable Federal rate in effect on the day on which the 
modification occurs.
    (iii) Adjustments--(A) Adjustment relating to certain prepayments. 
If any payments before the beginning of the lease term of the post-
modification agreement are post-modification items, the lessor and 
lessee must take into account, in the taxable year in which the 
modification occurs, any adjustment necessary to prevent duplication 
with respect to such payments or the omission of interest thereon for 
periods before the beginning of the lease term.
    (B) Adjustment relating to retroactive beginning of lease term. If 
the lease term of a post-modification agreement begins before the date 
on which the modification occurs, the lessor and lessee must take into 
account in the taxable year in which the modification occurs any amount 
necessary to prevent the duplication or omission of rent or interest for 
the period after the beginning of the lease term of the post-
modification agreement and before the beginning of the taxable year in 
which the modification occurs. For this purpose, the amount necessary to 
prevent duplication or omission is determined after taking into account 
any adjustments required by the Commissioner for taxable years ending 
prior to the beginning of the taxable year in which the modification 
occurs. In determining any adjustments required by the Commissioner for 
taxable years ending prior to the beginning of the taxable year in which 
the modification occurs, the Commissioner will disregard the 
modification.
    (iv) Coordination with rules relating to dispositions and 
assignments--(A) Dispositions. If the modification involves a sale, 
exchange, or other disposition of the property subject to the rental 
agreement--
    (1) Adjustments required under this paragraph (g) are taken into 
account before applying paragraphs (a), (b), (c), and (e) of this 
section;
    (2) The prior understated inclusion for purposes of paragraph (b) of 
this section is the sum of the prior understated inclusion with respect 
to pre-modification items and the prior understated inclusion with 
respect to post-modification items; and
    (3) Paragraph (e) of this section applies separately with respect to 
pre-modification items and post-modification items.
    (B) Assignments. If the modification involves an assignment of the 
lessee's interest in the rental agreement to a substitute lessee or a 
substitute lessee having use of the property during a period otherwise 
included in the lease term--
    (1) Adjustments required under this paragraph (g) are taken into 
account before applying paragraph (f) of this section; and
    (2) Paragraph (f) of this section applies separately with respect to 
pre-modification items and post-modification items.
    (2) Other modifications. The following rules apply to a modification 
(other than a substantial modification) of a rental agreement occurring 
after May 18, 1999:
    (i) Computation of section 467 loan for modified agreement. The 
amount of the section 467 loan relating to the agreement is computed as 
of the effective date of the modification. The section 467 rent and 
section 467 interest for periods before the effective date of the 
modification are determined, solely for purposes of computing the amount 
of the section 467 loan, under the terms of the entire agreement (as 
modified).
    (ii) Change in balance of section 467 loan. (A) If the balance of 
the section 467 loan determined under paragraph (g)(2)(i) of this 
section is greater than the balance of the section 467 loan immediately 
before the effective date of the modification, the difference is taken 
into account, in the taxable year in which the modification occurs, as 
additional rent.
    (B) If the balance of the section 467 loan determined under 
paragraph (g)(2)(i) of this section is less than the balance of the 
section 467 loan immediately before the effective date of the 
modification, the difference is taken into account, in the taxable year 
in which the modification occurs, as a reduction of the rent previously 
taken into account by the lessor and lessee.

[[Page 338]]

    (C) For purposes of this paragraph (g)(2)(ii), a negative balance is 
less than a positive balance, a zero balance, or any other negative 
balance that is closer to a zero balance.
    (iii) Section 467 rent and interest after the modification. The 
section 467 rent and section 467 interest for periods after the 
effective date of the modification are determined under the terms of the 
entire agreement (as modified).
    (iv) Applicable Federal rate. The applicable Federal rate for the 
agreement does not change as a result of the modification.
    (v) Modification effective within a rental period. If the effective 
date of a modification does not coincide with the beginning or end of a 
rental period under the agreement in effect before the modification, the 
section 467 rent and section 467 interest for the portion of the rental 
period ending immediately prior to the effective date of the 
modification are a pro rata portion of the section 467 rent and the 
section 467 interest, respectively, for the rental period. Such amounts 
are also taken into account in determining the section 467 loan balance, 
prior to any adjustment thereof that may be required under paragraph (h) 
of this section, immediately before the effective date of the 
modification. Similar rules apply with respect to the section 467 rent 
and section 467 interest determined under the terms of the entire 
agreement (as modified) for purposes of computing the amount of the 
section 467 loan under paragraph (g)(2)(i) of this section and the 
section 467 rent and section 467 interest for a partial rental period 
beginning on the effective date of the modification.
    (vi) Other adjustments. The lessor and lessee must take into 
account, in the taxable year in which a retroactive modification occurs, 
any amount necessary to prevent the duplication or omission of rent or 
interest for the period before the beginning of the taxable year in 
which the modification occurs.
    (vii) Coordination with rules relating to dispositions and 
assignments. If the modification involves a sale, exchange, or other 
disposition of the property subject to the rental agreement, an 
assignment of the lessee's interest in the rental agreement to a 
substitute lessee or a substitute lessee having use of the property 
during a period otherwise included in the lease term, adjustments 
required under this paragraph (g) are taken into account before applying 
paragraphs (a), (b), (c), (e), and (f) of this section.
    (viii) Exception for agreements entered into prior to effective date 
of section 467. This paragraph (g)(2) does not apply to a modification 
of a rental agreement that is not subject to section 467 because of the 
effective date provisions of section 92(c) of the Tax Reform Act of 1984 
(Public Law 98-369 (98 Stat. 612)).
    (3) Adjustment by Commissioner. If the entire agreement (as 
modified) is treated as a single agreement under Sec. 1.467-
1(f)(4)(vi), the Commissioner may require adjustments to taxable income 
to reflect the effect of the modification, including adjustments that 
are similar to those required under paragraph (g)(2) of this section.
    (4) Effective date of modification. The effective date of a 
modification of a rental agreement occurs at the earliest of--
    (i) The date on which the modification occurs;
    (ii) The beginning of the first period for which the amount of rent 
or interest provided under the entire agreement (as modified) differs 
from the amount of rent or interest provided under the agreement in 
effect before the modification;
    (iii) The due date of the first payment, under either the entire 
agreement (as modified) or the agreement in effect before the 
modification, that is not identical, in due date and amount, under both 
such agreements;
    (iv) The date, in the case of a modification involving the 
substitution of a new lessor, on which the property subject to the 
rental agreement is transferred; or
    (v) The date, in the case of a modification involving the 
substitution of a new lessee, on which the substitute lessee first has 
use of the property subject to the rental agreement.
    (5) Examples. The following examples illustrate the application of 
this paragraph (g):

    Example 1. (i) F, a cash method lessor, and G, an accrual method 
lessee, agree to a 7-year lease of tangible personal property for

[[Page 339]]

the period beginning on January 1, 1998, and ending on December 31, 
2004. The rental agreement allocates $100,000 of rent to each calendar 
year during the lease term, such rent to be paid December 31 following 
the close of the calendar year to which it is allocated. Because the 
rental agreement does not provide for increasing rent, or deferred rent 
within the meaning of section 467(d)(1)(A), section 467 does not apply 
to the rental agreement.
    (ii) Prior to January 1, 2001, G timely makes the $100,000 rental 
payments required as of December 31, 1999, and December 31, 2000. On 
January 1, 2001, F and G modify the rental agreement payment schedule to 
provide for a single final payment of $500,000 on December 31, 2004. 
Assume that the change is a substantial modification within the meaning 
of Sec. 1.467-1(f)(5)(ii). Because the modification occurs after May 
18, 1999, the post-modification agreement is treated, under Sec. 1.467-
1(f)(1), as a new agreement for purposes of determining whether it is a 
section 467 rental agreement.
    (iii) Under Sec. 1.467-1(f)(5)(v), the $200,000 of rent allocated 
to calendar years 1998 and 1999 (periods prior to the modification) 
constitutes pre-modification rent, and the $100,000 rent payments made 
on December 31, 1999, and December 31, 2000, constitute pre-modification 
payments. Although calendar year 2000 is also prior to the modification, 
the rent allocated to calendar year 2000 is not pre-modification rent 
and the related payment is not a pre-modification payment because the 
modification changed the time at which that rent is payable. See Sec. 
1.467-1(f)(5)(v)(A).
    (iv) Under paragraph (g)(1)(i) of this section, F and G take pre-
modification rent and pre-modification payments into account under the 
method of accounting they used to report income and deductions 
attributable to the pre-modification agreement.
    (v) Under Sec. 1.467-1(f)(1)(i), the post-modification agreement 
providing rent for the period beginning on January 1, 2000, and ending 
on December 31, 2004, is treated as a new rental agreement. This rental 
agreement allocates $100,000 of rent to each of the calendar years 2000 
through 2004 and provides for a single rental payment of $500,000 on 
December 31, 2004. Because the post-modification agreement provides for 
deferred rent under Sec. 1.467-1(c)(3)(i), section 467 applies. 
Further, the post-modification agreement does not provide for adequate 
interest on fixed rent, and therefore F and G must account for fixed 
rent and interest on fixed rent using proportional rental accrual. Under 
paragraph (g)(1)(iii) of this section, for their taxable years which 
include January 1, 2001, F and G must adjust reported rent for the 
difference between the rent taken into account for the calendar year 
2000 under the unmodified agreement and the proportional rental amount 
for that year under the post-modification agreement.
    Example 2. (i) On January 1, 2000, X, lessee, and Y, lessor, enter 
into a rental agreement for a 6-year lease of tangible personal property 
beginning January 1, 2000, and endingDecember 31, 2005. The agreement 
provides that the calendar year is the rental period and all rent 
payments are due on July 15 of all years in which a payment is required. 
Assume the agreement is not a disqualified leaseback or long-term 
agreement within the meaning of Sec. 1.467-3(b), and has the following 
allocation schedule and payment schedule:

------------------------------------------------------------------------
                  Year                      Allocation        Payment
------------------------------------------------------------------------
2000....................................        $800,000              $0
2001....................................         900,000               0
2002....................................       1,000,000       1,500,000
2003....................................       1,000,000       1,500,000
2004....................................       1,100,000       1,500,000
2005....................................       1,200,000       1,500,000
------------------------------------------------------------------------

    (ii) The rental agreement has deferred rent within the meaning of 
Sec. 1.467-1(c)(3)(i) because the rent allocated to 2000 is not payable 
until 2002 and some of the rent allocable to 2001 is not payable until 
2003. Further, the rental agreement does not provide adequate interest 
on fixed rent within the meaning of Sec. 1.467-2(b). Therefore, the 
rent amount to be accrued by X and Y for each rental period is the 
proportional rental amount, as described in Sec. 1.467-2(c). Assuming 
110 percent of the applicableFederal rate is 10 percent compounded 
annually, the section 467 rent, interest, and loan balances are as 
follows:

----------------------------------------------------------------------------------------------------------------
                          Year                                  Rent             Interest         Loan balance
----------------------------------------------------------------------------------------------------------------
2000...................................................        $736,949.55                 $0        $736,949.55
2001...................................................         829,068.24          73,694.96       1,639,712.75
2002...................................................         921,186.94         163,971.28       1,224,870.97
2003...................................................         921,186.94         122,487.10         768,545.01
2004...................................................       1,013,305.63          76,854.50         358,705.14
2005...................................................       1,105,424.33          35,870.53                  0
----------------------------------------------------------------------------------------------------------------

    (iii)(A) On January 1, 2004, X and Y agree that the $1,500,000 
payment scheduled for July 15, 2005, will be made in three equal 
installments on June 15, 2005, July 15, 2005, and August 15, 2005. Under 
Sec. 1.467-1(j)(2)(i)(C) (relating to timing conventions), the payment 
to be made on June 15, 2005, is treated as if

[[Page 340]]

it were payable on December 31, 2004, for purposes of determining 
present values and yield of the section 467 loan. Assume that this 
change, which results in the following allocation schedule and payment 
schedule, is not a substantial modification within the meaning of Sec. 
1.467-1(f)(5)(ii):

------------------------------------------------------------------------
                  Year                      Allocation        Payment
------------------------------------------------------------------------
2000....................................        $800,000              $0
2001....................................         900,000               0
2002....................................       1,000,000       1,500,000
2003....................................       1,000,000       1,500,000
2004....................................       1,100,000       2,000,000
2005....................................       1,200,000       1,000,000
------------------------------------------------------------------------

    (B) The agreement remains subject to proportional rental accrual 
after the modification because it has deferred rent and does not provide 
adequate interest on fixed rent within the meaning of Sec. 1.467-2(b).
    (iv) Because the modification occurs after May 18, 1999, and is not 
substantial within the meaning of Sec. 1.467-1(f)(5)(ii), paragraph 
(g)(2) of this section applies. Under paragraph (g)(2)(i) of this 
section, the amount of the section 467 loan relating to the modified 
agreement is computed as of the effective date of the modification, and, 
solely for purposes of recomputing the amount of the section 467 loan, 
the section 467 rent and section 467 interest for periods before the 
modification are determined under the terms of the entire agreement (as 
modified). In addition, the applicable Federal rate does not change as a 
result of the modification. Thus, the recomputed section 467 rent, 
interest, and loan balances are as follows:

----------------------------------------------------------------------------------------------------------------
                         Year                                 Rent             Interest          Loan balance
----------------------------------------------------------------------------------------------------------------
2000.................................................       $ 742,242.59                $ 0        $ 742,242.59
2001.................................................         835,022.91          74,224.26        1,651,489.76
2002.................................................         927,803.24         165,148.98        1,244,441.98
2003.................................................         927,803.24         124,444.20          796,689.42
2004.................................................       1,020,583.56          79,668.94         (103,058.08)
2005.................................................       1,113,363.88         (10,305.80)                  0
----------------------------------------------------------------------------------------------------------------

    (v) Under paragraph (g)(2)(ii) of this section, the difference 
between the section 467 loan balance immediately before the effective 
date of the modification and the recomputed section 467 loan balance as 
of the effective date of the modification is taken into account. In this 
example, the loan balance immediately before the effective date of the 
modification is $768,545.01 and the recomputed loan balance as of the 
effective date of the modification is $796,689.42. Thus, because the 
recomputed loan balance exceeds the original loan balance, the 
difference ($28,144.41) is taken into account, in the taxable year in 
which the modification occurs, as additional rent. Beginning on January 
1, 2004, section 467 rent and interest are taken into account by X and Y 
in accordance with the recomputed rent schedule set forth in paragraph 
(iv) of this example.

    (h) Omissions or duplications--(1) In general. In applying the rules 
of this section in conjunction with the rules of Sec. Sec. 1.467-1 
through 1.467-5, adjustments must be made to the extent necessary to 
prevent the omission or duplication of items of income, deduction, gain, 
or loss. For example, if a transferee lessor acquires property subject 
to a section 467 rental agreement at other than the beginning or end of 
a rental period, and the transferee lessor's beginning section 467 loan 
balance differs from the transferor lessor's section 467 loan balance 
immediately prior to the transfer, it will be necessary to treat the 
rental period that includes the day of transfer as consisting of two 
rental periods, one beginning at the beginning of the rental period that 
includes the day of transfer and ending with or immediately prior to the 
transfer and one beginning with or immediately after the transfer and 
ending immediately prior to the beginning of the succeeding rental 
period. Because the substitution of two rental periods for one rental 
period may change the proportional rental amount or constant rental 
amount, the change in rental periods should be treated as a modification 
of the rental agreement that occurs immediately prior to the transfer. 
The change in rental periods, by itself, is not treated as a substantial 
modification of the rental agreement although the substitution of a new 
lessor may constitute a substantial modification of the rental 
agreement. Likewise, Sec. 1.467-1(j)(2), which provides rules regarding 
when amounts are treated as payable, is designed to simplify 
calculations of present values, section 467 loan balances, and 
proportional and constant rental amounts. These simplifying conventions 
assume that there will be no change in the lessor or lessee

[[Page 341]]

under a section 467 rental agreement and that the terms of the section 
467 rental agreement will not be modified. Therefore, as illustrated in 
the example in paragraph (h)(2) of this section, when actual events do 
not reflect these assumptions, it may be necessary to alter the 
application of these rules to properly reflect taxable income.
    (2) Example. The following example illustrates an application of 
this paragraph (h):

    Example. (i) J leases tangible personal property from K for five 
years beginning on January 1, 2000, and ending on December 31, 2004. 
Under the rental agreement, rent is payable on July 15 of the calendar 
year to which it is allocated. Both J and K treat the calendar year as 
the rental period. The allocation of rent and payments of rent required 
under the rental agreement are as follows:

------------------------------------------------------------------------
              Calendar year                    Rent          Payments
------------------------------------------------------------------------
2000....................................        $200,000        $450,000
2001....................................         200,000         250,000
2002....................................         200,000         200,000
2003....................................         200,000         100,000
2004....................................         200,000               0
------------------------------------------------------------------------

    (ii) The rental agreement does not provide for interest on prepaid 
rent. The rental agreement has prepaid rent under Sec. 1.467-
1(c)(3)(ii) because the rent payable at the end of 2000 exceeds the 
cumulative amount of rent allocated to 2000 and 2001. Therefore, J and K 
must take section 467 rent into account under the proportional rental 
method of Sec. 1.467-2(c). Assume that 110 percent of the applicable 
Federal rate is 10 percent, compounded annually. The section 467 rent, 
section 467 interest, amounts payable, and section 467 loan balances for 
each of the calendar years under the terms of the rental agreement are 
as follows:

----------------------------------------------------------------------------------------------------------------
                                                           Section 467                         Section 467 loan
           Calendar Year             Section 467 rent       interest            Payments            balance
----------------------------------------------------------------------------------------------------------------
2000..............................        $220,077.48                 $0            $450,000       $(229,922.52)
2001..............................         220,077.48         (22,992.25)            250,000        (282,837.29)
2002..............................         220,077.48         (28,283.73)            200,000        (291,043.54)
2003..............................         220,077.48         (29,104.35)            100,000        (200,070.41)
2004..............................         220,077.48         (20,007.07)                  0                  0
----------------------------------------------------------------------------------------------------------------

    (iii) On January 1, 2002, J and K amend the terms of the rental 
agreement to advance the due date of the $200,000 payment originally due 
on July 15, 2002, to June 15, 2002. This change in the payment schedule 
constitutes a modification of the terms of the rental agreement within 
the meaning of Sec. 1.467-1(f)(5)(i). Assume, however, that the change 
is not a substantial modification within the meaning of Sec. 1.467-
1(f)(5)(ii). Because the modification occurs after May 18, 1999, and is 
not substantial, paragraph (g)(2) of this section applies. Thus, the 
section 467 loan balance at the beginning of 2002 must be recomputed as 
if the June 15, 2002, payment date had been included in the terms of the 
pre-modification rental agreement. If this had been the case, the 
section 467 rent, section 467 interest, amounts payable, and section 467 
loan balances for each of the calendar years under the terms of the 
rental agreement would have been as follows:

----------------------------------------------------------------------------------------------------------------
                                                           Section 467                         Section 467 loan
             Calendar                Section 467 rent       interest            Payments            balance
----------------------------------------------------------------------------------------------------------------
2000..............................        $224,041.38                 $0            $450,000       $(225,958.62)
2001..............................         224,041.38         (22,595.86)            450,000        (474,513.10)
2002..............................         224,041.38         (47,451.31)                  0        (297,923.03)
2003..............................         224,041.38         (29,792.30)            100,000        (203,673.95)
2004..............................         224,041.38         (20,367.43)                  0                  0
----------------------------------------------------------------------------------------------------------------

    (iv) Section 1.467-4(b)(3) incorporates the conventions of Sec. 
1.467-1(j)(2) in determining when amounts are treated as payable for 
purposes of determining the section 467 loan balance. Section 1.467-
1(j)(2)(i)(C) treats amounts payable during the first half of any rental 
period except the first rental period as payable on the last day of the 
preceding rental period. Therefore, because June 15, 2002, occurs in the 
first half of 2002, in determining the section 467 loan balance at the 
beginning of 2002 under the amended terms of the rental agreement, the 
$200,000 payment due on June 15, 2002, is treated as payable on December 
31, 2001.
    (v) Under paragraph (g)(2)(ii)(B) of this section, if the recomputed 
section 467 loan balance is less than the section 467 loan balance 
immediately before the modification, the difference is taken into 
account as a reduction of the rent previously taken into account by the 
lessor and the lessee. In this example,

[[Page 342]]

the recomputed section 467 loan balance immediately after the 
modification is negative $474,513.10 and the section 467 loan balance 
immediately before the modification is negative $282,837.29. However, 
the section 467 loan balance immediately before the modification does 
not take into account the $200,000 payment originally payable on July 
15, 2002, whereas, under the conventions of Sec. 1.467-1(j)(2)(i)(C), 
the recomputed section 467 loan balance immediately after the 
modification takes into account that $200,000 payment because it is now 
payable in the first half of the rental period (June 15). Under these 
circumstances, if the recomputed section 467 loan balance immediately 
after the modification is treated as negative $474,513.10 for purposes 
of applying paragraph (g)(2)(ii)(B) of this section, K's gross income 
and J's deductions attributable to the section 467 rental agreement will 
be understated by $200,000. Therefore, under paragraph (h)(1) of this 
section, only for purposes of applying paragraph (g)(2)(ii)(B) of this 
section, the $200,000 payment due on June 15, 2002, should not be taken 
into account in determining the recomputed section 467 loan balance 
immediately after the modification.

[T.D. 8820, 64 FR 26867, May 18, 1999]



Sec. 1.467-8  Automatic consent to change to constant rental accrual 
for certain rental agreements.

    (a) General rule. For the first taxable year ending after May 18, 
1999, a taxpayer may change to the constant rental accrual method, as 
described in Sec. 1.467-3, for all of its section 467 rental agreements 
described in paragraph (b) of this section. A change to the constant 
rental accrual method is a change in method of accounting to which the 
provisions of sections 446 and 481 and the regulations thereunder apply. 
A taxpayer changing its method of accounting in accordance with this 
section must follow the automatic change in accounting method provisions 
of Rev. Proc. 98-60 (see Sec. 601.601(d)(2) of this chapter) except, 
for purposes of this paragraph (a), the scope limitations in section 
4.02 of Rev. Proc. 98-60 are not applicable. Taxpayers changing their 
method of accounting in accordance with this section must do so for all 
of their section 467 rental agreements described in paragraph (b) of 
this section.
    (b) Agreements to which automatic consent applies. A section 467 
rental agreement is described in this paragraph (b) if--
    (1) The property subject to the section 467 rental agreement is 
financed with an ``exempt facility bond'' within the meaning of section 
142;
    (2) The facility subject to the section 467 rental agreement is 
described in section 142(a)(1), (2), (3), or (12);
    (3) The section 467 rental agreement does not include a specific 
allocation of fixed rent within the meaning of Sec. 1.467-
1(c)(2)(ii)(A)(2); and
    (4) The section 467 rental agreement was entered into on or before 
May 18, 1999.

[T.D. 8820, 64 FR 26875, May 18, 1999]



Sec. 1.467-9  Effective dates and automatic method changes for certain 
agreements.

    (a) In general. Sections 1.467-1 through 1.467-7 are applicable 
for--
    (1) Disqualified leasebacks and long-term agreements entered into 
after June 3, 1996; and
    (2) Rental agreements not described in paragraph (a)(1) of this 
section that are entered into after May 18, 1999.
    (b) Automatic consent for certain rental agreements. Section 1.467-8 
applies only to rental agreements described in Sec. 1.467-8.
    (c) Application of regulation project IA-292-84 to certain 
leasebacks and long-term agreements. In the case of any leaseback or 
long-term agreement (other than a disqualified leaseback or long-term 
agreement) entered into after June 3, 1996, and on or before May 18, 
1999, a taxpayer may choose to apply the provisions of regulation 
project IA-292-84 (1996-2 C.B. 462)(see Sec. 601.601(d)(2) of this 
chapter).
    (d) Entered into. For purposes of this section and Sec. 1.467-8, a 
rental agreement is entered into on its agreement date (within the 
meaning of Sec. 1.467-1(h)(1) and, if applicable, Sec. 1.467-
1(f)(1)(i)).
    (e) Change in method of accounting--(1) In general. For the first 
taxable year ending after May 18, 1999, a taxpayer is granted consent of 
the Commissioner to change its method of accounting for rental 
agreements described in paragraph (a)(2) of this section to comply with 
the provisions of Sec. Sec. 1.467-1 through 1.467-7.

[[Page 343]]

    (2) Application of regulation project IA-292-84. For the first 
taxable year ending after May 18, 1999, a taxpayer is granted consent of 
the Commissioner to change its method of accounting for any rental 
agreement described in paragraph (c) of this section to comply with the 
provisions of regulation project IA-292-84 (1996-2 C.B. 462) (see Sec. 
601.601(d)(2) of this chapter).
    (3) Automatic change procedures. A taxpayer changing its method of 
accounting in accordance with this paragraph (e) must follow the 
automatic change in accounting method provisions of Rev. Proc. 98-60 
(see Sec. 601.601(d)(2) of this chapter) except, for purposes of this 
paragraph (e), the scope limitations in section 4.02 of Rev. Proc. 98-60 
are not applicable. A method change in accordance with paragraph (e)(1) 
of this section is made on a cut-off basis so no adjustment under 
section 481(a) is required.

[T.D. 8820, 64 FR 26875, May 18, 1999]



Sec. 1.468A-0  Nuclear decommissioning costs; table of contents.

    This section lists the paragraphs contained in Sec. Sec. 1.468A-1 
through 1.468A-8.

      Sec. 1.468A-1 Nuclear decommissioning costs; general rules.

    (a) Introduction.
    (b) Definitions.
    (c) Special rules applicable to certain experimental nuclear 
facilities.
    (d) Special rules for electing taxpayers whose rates are under the 
jurisdiction of the Rural Electrification Administration.

             Sec. 1.468A-2 Treatment of electing taxpayer.

    (a) In general.
    (b) Limitation on payments to a nuclear decommissioning fund.
    (1) In general.
    (2) Cost of service amount.
    (c) Deemed payment rules.
    (d) Treatment of distributions.
    (1) In general.
    (2) Exceptions to inclusion in gross income.
    (i) Payment of administrative costs and incidental expenses.
    (ii) Withdrawals of excess contributions.
    (iii) Actual distributions of amounts included in gross income as 
deemed distributions.
    (e) Deduction when economic performance occurs.
    (f) Effect of interim rate orders and retroactive adjustments to 
such orders.
    (1) In general.
    (2) Special rule permitting withdrawal of excess contribution that 
results from retroactive adjustment to interim rate order.
    (3) Revised schedule of ruling amounts.
    (4) Example.

                      Sec. 1.468A-3 Ruling amount.

    (a) In general.
    (b) Level funding limitation.
    (c) Funding period.
    (1) General rule.
    (2) Examples.
    (d) Decommissioning costs allocable to a fund.
    (1) General rule.
    (2) Total estimated cost of decommissioning.
    (3) Taxpayer's share.
    (4) Qualifying percentage.
    (e) Determination of estimated dates.
    (f) Special rules in the case of rates established or approved by 
two or more public utility commissions.
    (g) Requirement of determination by public utility commission of 
decommissioning costs to be included in cost of service.
    (h) Manner of requesting schedule of ruling amounts.
    (1) In general.
    (2) Information required.
    (3) Administrative procedures.
    (i) Review and revision of schedule of ruling amounts.
    (1) Mandatory review.
    (2) Elective review.
    (3) Determination of revised schedule of ruling amounts.
    (j) Special rule permitting payments to a nuclear decommissioning 
fund before receipt of an initial or revised ruling amount applicable to 
a taxable year.

        Sec. 1.468A-4 Treatment of nuclear decommissioning fund.

    (a) In general.
    (b) Modified gross income.
    (c) Special rules.
    (1) Period for computation of modified gross income.
    (2) Gain or loss upon distribution of property by a fund.
    (3) Denial of credits against tax.
    (4) Other corporate taxes inapplicable.
    (d) Treatment as corporation for purposes of subtitle F.

 Sec. 1.468A-5 Nuclear decommissioning fund--miscellaneous provisions.

    (a) Qualification requirements.
    (1) In general.
    (2) Limitation on contributions.
    (3) Limitation on use of fund.
    (i) In general.
    (ii) Definition of administrative costs and expenses.
    (4) Trust provisions.

[[Page 344]]

    (b) Prohibitions against self-dealing.
    (1) In general.
    (2) Self-dealing defined.
    (3) Disqualified person defined.
    (c) Disqualification of nuclear decommissioning fund.
    (1) In general.
    (2) Exception to disqualification.
    (i) In general.
    (ii) Excess contribution defined.
    (iii) Taxation of income attributable to an excess contribution.
    (3) Effect of disqualification.
    (d) Termination of nuclear decommissioning fund upon substantial 
completion of decommissioning.
    (1) In general.
    (2) Substantial completion of decommissioning defined.

   Sec. 1.468A-6 Disposition of an interest in a nuclear power plant.

    (a) In general.
    (b) Requirements.
    (c) Tax consequences.
    (1) The transferor and its Fund.
    (2) The transferee and its Fund.
    (3) Basis.
    (d) Determination of proportionate amount.
    (e) Calculation of schedule of ruling amounts for dispositions 
described in this section.
    (1) Transferor.
    (2) Transferee.
    (3) Example.
    (f) Calculation of the qualifying percentage after dispositions 
described in this section.
    (1) In general.
    (2) Special rule.
    (g) Other.
    (1) Anti-abuse provision.
    (2) Relief provision.
    (h) Effective date.

         Sec. 1.468A-7 Manner of and time for making election.

    (a) In general.
    (b) Required information.

          Sec. 1.468A-8 Effective date and transitional rules.

    (a) Effective date.
    (1) In general.
    (2) Cut-off method applicable to electing taxpayers.
    (b) Transitional rules.
    (1) Time for filing request for schedule of ruling amounts.
    (2) Manner of and time for making contributions to a nuclear 
decommissioning fund.
    (3) Manner of and time for making election.
    (4) Determination of cost of service limitation.
    (5) Assumptions and determinations to be used in determining ruling 
amounts.
    (6) Exception to level funding limitation.
    (7) Determination of qualifying percentage.
    (8) Limitation on payments to a nuclear decommissioning fund.
    (9) Denial of interest on overpayment.
    (10) Determination of addition to tax for failure to pay estimated 
tax.
    (11) Nuclear decommissioning fund qualification requirements.

[T.D. 8184, 53 FR 6804, Mar. 3, 1988, as amended by T.D. 8461, 57 FR 
62199, Dec. 30, 1992; T.D. 8580, 59 FR 66473, Dec. 27, 1994]



Sec. 1.468A-1  Nuclear decommissioning costs; general rules.

    (a) Introduction. Section 468A provides an elective method for 
taking into account nuclear decommissioning costs for Federal income tax 
purposes. In general, an eligible taxpayer that elects the application 
of section 468A pursuant to the rules contained in Sec. 1.468A-7 is 
allowed a deduction (as determined under Sec. 1.468A-2) for the taxable 
year in which the taxpayer makes a cash payment to a nuclear 
decommissioning fund. Taxpayers using an accrual method of accounting 
that do not elect the application of section 468A are not allowed a 
deduction for nuclear decommissioning costs prior to the taxable year in 
which economic performance occurs with respect to such costs (see 
section 461(h)).
    (b) Definitions. The following terms are defined for purposes of 
section 468A and the regulations thereunder:
    (1) The term eligible taxpayer means any taxpayer that possesses a 
qualifying interest in a nuclear power plant (including a nuclear power 
plant that is under construction).
    (2) The term qualifying interest means--
    (i) A direct ownership interest; and
    (ii) A leasehold interest in any portion of a nuclear power plant 
if--
    (A) The holder of the leasehold interest is subject to the 
jurisdiction of a public utility commission with respect to such portion 
of the nuclear power plant;
    (B) The holder of the leasehold interest is primarily liable under 
Federal or State law for decommissioning such portion of the nuclear 
power plant; and

[[Page 345]]

    (C) No other person establishes a nuclear decommissioning fund with 
respect to such portion of the nuclear power plant.

A direct ownership interest includes an interest held as a tenant in 
common or joint tenant, but does not include stock in a corporation that 
owns a nuclear power plant or an interest in a partnership that owns a 
nuclear power plant. Thus, in the case of a partnership that owns a 
nuclear power plant, the election under section 468A must be made by the 
partnership and not by the partners. In the case of an unincorporated 
organization described in Sec. 1.761-2(a)(3) that elects under section 
761(a) to be excluded from the application of subchapter K, each 
taxpayer that is a co-owner of the nuclear power plant is eligible to 
make a separate election under section 468A.
    (3) The terms nuclear decommissioning fund and qualified nuclear 
decommissioning fund mean a fund that satisfies the requirements of 
Sec. 1.468A-5. The term nonqualified decommissioning fund means a fund 
that does not satisfy those requirements.
    (4) The term nuclear power plant means any nuclear power reactor 
that is used predominantly in the trade or business of the furnishing or 
sale of electric energy, if the rates for the furnishing or sale, as the 
case may be, either have been established or approved by a public 
utility commission or are under the jurisdiction of the Rural 
Electrification Administration. Each unit (i.e., nuclear reactor) 
located on a multi-unit site is a separate nuclear power plant. The term 
nuclear power plant also includes the portion of the common facilities 
of a multi-unit site allocable to a unit on that site.
    (5) The term nuclear decommissioning costs or decommissioning costs 
means all otherwise deductible expenses to be incurred in connection 
with the entombment, decontamination, dismantlement, removal and 
disposal of the structures, systems and components of a nuclear power 
plant that has permanently ceased the production of electric energy. 
Such term includes all otherwise deductible expenses to be incurred in 
connection with the preparation for decommissioning, such as engineering 
and other planning expenses, and all otherwise deductible expenses to be 
incurred with respect to the plant after the actual decommissioning 
occurs, such as physical security and radiation monitoring expenses. 
Such term does not include otherwise deductible expenses to be incurred 
in connection with the disposal of spent nuclear fuel under the Nuclear 
Waste Policy Act of 1982 (Pub. L. 97-425). An expense is otherwise 
deductible for purposes of this paragraph (b)(5) if it would be 
deductible under chapter 1 of the Internal Revenue Code without regard 
to section 280B.
    (6) The term public utility commission means any State or political 
subdivision thereof, any agency, instrumentality or judicial body of the 
United States, or any judicial body, commission or other similar body of 
the District of Columbia or of any State or any political subdivision 
thereof that establishes or approves rates for the furnishing or sale of 
electric energy.
    (7) The term ratemaking proceeding means any proceeding before a 
public utility commission in which rates for the furnishing or sale of 
electric energy are established or approved. Such term includes a 
generic proceeding that applies to two or more taxpayers that are 
subject to the jurisdiction of a single public utility commission.
    (c) Special rules applicable to certain experimental nuclear 
facilities. (1) The owner of a qualifying interest in an experimental 
nuclear facility possesses a qualifying interest in a nuclear power 
plant for purposes of paragraph (b) of this section if--
    (i) Such person is engaged in the trade or business of the 
furnishing or sale of electric energy;
    (ii) The rates charged for electric energy furnished or sold by such 
person are established or approved by a public utility commission; and
    (iii) The cost of decommissioning the facility is included in the 
cost of service of such person.
    (2) An owner of stock in a corporation that owns an experimental 
nuclear facility possesses a qualifying interest in a nuclear power 
plant for purposes of paragraph (b)(1) of this section if--
    (i) Such stockholder satisfies the conditions of paragraph (c)(1) 
(i) through (iii) of this section; and

[[Page 346]]

    (ii) The corporation that directly owns the facility is not engaged 
in the trade or business of the furnishing or sale of electric energy.
    (3) For purposes of this paragraph (c), an experimental nuclear 
facility is a nuclear power reactor that is used predominantly for the 
purpose of conducting experimentation and research.
    (d) Special rules for electing taxpayers whose rates are under the 
jurisdiction of the Rural Electrification Administration. 
Notwithstanding any other provision of the regulations under section 
468A, a schedule of ruling amounts may be provided to a taxpayer with 
respect to a nuclear power plant if the rates for the furnishing or sale 
of the plant's electricity are under the jurisdiction of the Rural 
Electrification Administration. This schedule will be determined on the 
basis of all facts and circumstances in a manner consistent with section 
468A. No taxpayer will be provided a schedule of ruling amounts under 
section 468A for any taxable year unless the portion of the rates 
attributable to the decommissioning costs of that taxpayer with respect 
to such taxable year are treated by the taxpayer as though they were 
subject to section 88.

[T.D. 8184, 53 FR 6805, Mar. 3, 1988, as amended by T.D. 8461, 57 FR 
62199, Dec. 30, 1992; T.D. 8580, 59 FR 66473, Dec. 27, 1994]



Sec. 1.468A-2  Treatment of electing taxpayer.

    (a) In general. An eligible taxpayer that elects the application of 
section 468A pursuant to the rules contained in Sec. 1.468A-7 (an 
``electing taxpayer'') is allowed a deduction for the taxable year in 
which the taxpayer makes a cash payment (or is deemed to make a cash 
payment as provided in paragraph (c) of this section ) to a nuclear 
decommissioning fund. The amount of the deduction for any taxable year 
equals the total amount of cash payments made (or deemed made) by the 
electing taxpayer to a nuclear decommissioning fund (or nuclear 
decommissioning funds) during such taxable year. A payment may not be 
made (or deemed made) to a nuclear decommissioning fund before the first 
taxable year in which all of the following conditions are satisfied:
    (1) The construction of the nuclear power plant to which the nuclear 
decommissioning fund relates has commenced.
    (2) Nuclear decommissioning costs of the nuclear power plant to 
which the nuclear decommissioning fund relates are included in the 
taxpayer's cost of service for ratemaking purposes (see paragraph (b) of 
this section).
    (3) A ruling amount is applicable to the nuclear decommissioning 
fund (see Sec. 1.468A-3).
    (b) Limitation on payments to a nuclear decommissioning fund--(1) In 
general. For purposes of paragraph (a) of this section, the maximum 
amount of cash payments made (or deemed made) to a nuclear 
decommissioning fund during any taxable year shall not exceed the lesser 
of:
    (i) The cost of service amount applicable to the nuclear 
decommissioning fund for such taxable year (as defined in paragraph 
(b)(2) of this section); or
    (ii) The ruling amount applicable to the nuclear decommissioning 
fund for such taxable year (as determined under Sec. 1.468A-3).

If the amount of cash payments made (or deemed made) to a nuclear 
decommissioning fund during any taxable year exceeds the limitation of 
this paragraph (b)(1), the excess is not deductible by the electing 
taxpayer. In addition, see paragraph (c) of Sec. 1.468A-5 for rules 
which provide that the Internal Revenue Service may disqualify a nuclear 
decommissioning fund if the amount of cash payments made (or deemed 
made) to a nuclear decommissioning fund during any taxable year exceeds 
the limitation of this paragraph (b)(1).
    (2) Cost of service amount. (i) For purposes of section 468A and the 
regulations thereunder, the ``cost of service amount applicable to a 
nuclear decommissioning fund for a taxable year'' is the amount of 
decommissioning costs included in the electing taxpayer's cost of 
service for ratemaking purposes for such taxable year. Decommissioning 
costs are included in cost of service for a taxable year only to the 
extent such costs are directly or indirectly charged to customers of the 
taxpayer by reason of electric energy consumed during

[[Page 347]]

such taxable year or are otherwise required to be included in the 
taxpayer's income under section 88 and the regulations thereunder.
    (ii) Except as otherwise provided in paragraph (b)(4)(i) of Sec. 
1.468A-8 (relating to a special transitional rule), decommissioning 
costs shall generally not be considered included in cost of service for 
purposes of this section unless--
    (A) The order or opinion of the applicable public utility commission 
identifies the amount of decommissioning costs that is included in cost 
of service for ratemaking purposes; or
    (B) The written records of the ratemaking proceeding clearly and 
unambiguously indicate the amount of decommissioning costs that is 
included in cost of service for ratemaking purposes.
    (iii) Except as otherwise provided in paragraph (f)(2) of this 
section (relating to a special rule that applies to certain retroactive 
adjustments to interim rate orders), orders or opinions of a public 
utility commission that are issued after the close of any taxable year 
shall not be considered in determining the amount of decommissioning 
costs included in cost of service for such taxable year.
    (iv) If a taxpayer possesses a qualifying interest in two or more 
nuclear power plants that are the subject of a single ratemaking 
proceeding, the amount of decommissioning costs included in cost of 
service pursuant to such ratemaking proceeding must be allocated among 
such nuclear power plants. Such allocation must be reasonable and 
consistent, and must take into account the assumptions and 
determinations, if any, used by the public utility commission in 
establishing or approving the amount of decommissioning costs included 
in cost of service.
    (c) Deemed payment rules. (1) The amount of any cash payment made by 
an electing taxpayer to a nuclear decommissioning fund on or before the 
15th day of the third calendar month after the close of any taxable year 
(the ``deemed payment deadline date'') shall be deemed made during such 
taxable year if the electing taxpayer irrevocably designates the amount 
as relating to such taxable year on its timely filed Federal income tax 
return for such taxable year (see paragraph (b)(4)(iv) of Sec. 1.468A-7 
for rules relating to such designation).
    (2) The amount of any cash payment made by a customer of an electing 
taxpayer to a nuclear decommissioning fund of such electing taxpayer 
shall be deemed made by the electing taxpayer if the amount is included 
in the gross income of the electing taxpayer in the manner prescribed by 
section 88 and Sec. 1.88-1.
    (d) Treatment of distributions--(1) In general. Except as otherwise 
provided in paragraph (d)(2) of this section, the amount of any actual 
or deemed distribution from a nuclear decommissioning fund shall be 
included in the gross income of the electing taxpayer for the taxable 
year in which the distribution occurs. The amount of any distribution of 
property equals the fair market value of the property on the date of the 
distribution. A distribution from a nuclear decommissioning fund shall 
include an expenditure from the fund or the use of the fund's assets--
    (i) To satisfy, in whole or in part, the liability of the electing 
taxpayer for decommissioning costs of the nuclear power plant to which 
the fund relates; and
    (ii) To pay administrative costs and other incidental expenses of 
the fund.
    See paragraphs (c) and (d) of Sec. 1.468A-5 for rules relating to 
the deemed distribution of the assets of a nuclear decommissioning fund 
in the case of a disqualification or termination of the fund.
    (2) Exceptions to inclusion in gross income--(i) Payment of 
administrative costs and incidental expenses. The amount of any payment 
by a nuclear decommissioning fund for administrative costs or other 
incidental expenses of such fund (as defined in paragraph (a)(3)(ii) of 
Sec. 1.468A-5) shall not be included in the gross income of the 
electing taxpayer unless such amount is paid to the electing taxpayer 
(in which case the amount of the payment is included in the gross income 
of the electing taxpayer under section 61).
    (ii) Withdrawals of excess contributions. The amount of a withdrawal 
of an excess contribution (as defined in paragraph (c)(2)(ii) of Sec. 
1.468A-5) by an

[[Page 348]]

electing taxpayer pursuant to the rules of paragraph (c)(2) of Sec. 
1.468A-5 shall not be included in the gross income of the electing 
taxpayer. See paragraph (b)(1) of this section, which provides that the 
payment of such amount to the nuclear decommissioning fund is not 
deductible by the electing taxpayer.
    (iii) Actual distributions of amounts included in gross income as 
deemed distributions. If the amount of a deemed distribution is included 
in the gross income of the electing taxpayer for the taxable year in 
which the deemed distribution occurs, no further amount is required to 
be included in gross income when the amount of the deemed distribution 
is actually distributed by the nuclear decommissioning fund. The amount 
of a deemed distribution is actually distributed by a nuclear 
decommissioning fund as the first actual distributions are made by the 
nuclear decommissioning fund on or after the date of the deemed 
distribution.
    (e) Deduction when economic performance occurs. An electing taxpayer 
using an accrual method of accounting is allowed a deduction for nuclear 
decommissioning costs no earlier than the taxable year in which economic 
performance occurs with respect to such costs (see section 461 (h)(2)). 
The amount of nuclear decommissioning costs that is deductible under 
this paragraph (e) is determined without regard to section 280B (see 
paragraph (b)(5) of Sec. 1.468A-1). A deduction is allowed under this 
paragraph (e) whether or not a deduction was allowed with respect to 
such costs under section 468A(a) and paragraph (a) of this section for 
an earlier taxable year (see paragraph (a)(2) of Sec. 1.468A-8, 
however, for the effective date applicable to this paragraph (e)).
    (f) Effect of interim rate orders and retroactive adjustments to 
such orders--(1) In general. (i) The amount of decommissioning costs 
included in cost of service for any taxable year that ends before the 
date of a retroactive adjustment to an interim rate order or interim 
determination of a public utility commission shall include amounts 
authorized pursuant to such interim rate order or interim determination 
unless a taxpayer elects the application of paragraph (f)(2) of this 
section for such taxable year. For purposes of this paragraph (f), a 
retroactive adjustment occurs on the effective date of the revised rate 
schedule that implements the retroactive adjustment.
    (ii) If a retroactive adjustment to an interim rate order or interim 
determination reduces the amount of decommissioning costs included in 
cost of service for one or more taxable years ending before the date of 
the adjustment, the amount of such reduction must be subtracted from the 
amount of decommissioning costs included in cost of service (as 
determined under paragraph (b)(2) of this section) for one or more 
taxable years ending on or after the date of the adjustment. For this 
purpose, the amount of such reduction must be taken into account in the 
following manner:
    (A) If the retroactive adjustment reduces the amount of 
decommissioning costs included in cost of service for one taxable year 
ending before the date of the adjustment, the total amount of the 
reduction must be taken into account for the taxable year that includes 
the date of the adjustment.
    (B) If the retroactive adjustment reduces the amount of 
decommissioning costs included in cost of service for two taxable years 
ending before the date of the adjustment, at least one-half of the total 
amount of the reduction must be taken into account for the first taxable 
year ending on or after the date of the adjustment and the total amount 
of the reduction must be taken into account over the first two taxable 
years ending on or after the date of the adjustment.
    (C) If the retroactive adjustment reduces the amount of 
decommissioning costs included in cost of service for three or more 
taxable years ending before the date of the adjustment, at least one-
third of the total amount of the reduction must be taken into account 
for the first taxable year ending on or after the date of the 
adjustment, at least two-thirds of the total amount of the reduction 
must be taken into account over the first two taxable years ending on or 
after the date of the adjustment, and the total amount of the reduction 
must be taken into account

[[Page 349]]

over the first three taxable years ending on or after the date of the 
adjustment.
    (2) Special rule permitting withdrawal of excess contribution that 
results from retroactive adjustment to interim rate order. (i) If a 
retroactive adjustment that reduces the amount of decommissioning costs 
included in cost of service for a taxable year occurs on or before the 
date prescribed by law (including extensions) for filing the return of 
the nuclear decommissioning fund for such taxable year, a taxpayer may 
elect the application of this paragraph (f)(2) for such taxable year 
by--
    (A) Including in the amount of decommissioning costs included in 
cost of service for such taxable year only the amount of decommissioning 
costs authorized for such taxable year under the retroactive adjustment; 
and
    (B) Withdrawing any excess contribution that results from such 
treatment in accordance with the rules of paragraph (c)(2) of Sec. 
1.468A-5.
    (ii) If a taxpayer elects the application of this paragraph (f)(2) 
for any taxable year, the retroactive adjustment shall not be treated 
for purposes of paragraph (f)(1)(ii) of this section as a reduction in 
the amount of decommissioning costs included in cost of service for such 
taxable year.
    (3) Revised schedule of ruling amounts. (i) If the rules provided in 
this paragraph (f) result in a cost of service amount applicable to a 
nuclear decommissioning fund for any taxable year that is less than the 
cost of service amount applicable to the nuclear decommissioning fund 
for the immediately preceding taxable year, the taxpayer must request a 
revised schedule of ruling amounts on or before the deemed payment 
deadline date for the taxable year in which the retroactive adjustment 
occurs. The first taxable year to which the revised schedule of ruling 
amount applies shall be the taxable year in which the retroactive 
adjustment occurs.
    (ii) The requirement of this paragraph (f)(3) does not apply if the 
taxpayer determines its schedule of ruling amounts under a formula or 
method obtained under Sec. 1.468A-3(a)(4) and the cost of service 
amount is a variable element of that formula or method.
    (4) Example. The following example illustrates the application of 
the principles of this paragraph (f):

    Example. (i) X corporation is a calendar year, accrual method 
taxpayer engaged in the sale of electric energy generated by a nuclear 
power plant owned by X. During 1989, X is authorized pursuant to an 
interim rate order issued by the public utility commission of State A to 
collect nuclear decommissioning costs of $500,000 per year beginning on 
January 1, 1990. On May 1, 1992, the public utility commission of State 
A issues a final rate order that is effective on July 1, 1992. The final 
rate order authorizes X to collect decommissioning costs of $400,000 per 
year and requires X to refund to the ratepayers of State A excess 
decommissioning costs of $250,000 collected between January 1, 1990, and 
July 1, 1992.
    (ii) If X elects the application of paragraph (f)(2) of this section 
for the 1991 taxable year, the amount of decommissioning costs included 
in cost of service for such taxable year is $400,000. If X made a 
contribution of $500,000 to a nuclear decommissioning fund for the 1991 
taxable year, X must withdraw $100,000 from the nuclear decommissioning 
fund on or before the date prescribed by law (including extensions) for 
filing the return of the nuclear decommissioning fund for the 1991 
taxable year (see paragraph (c)(2) of Sec. 1.468A-5).
    (iii) In addition, under paragraph (f)(1)(i) of this section, the 
amount of decommissioning costs included in cost of service for the 1990 
taxable year is $500,000, and, under paragraph (f)(1)(ii) of this 
section, the amount of decommissioning costs included in cost of service 
for the 1992 taxable year is $300,000. Because the cost of service 
amount for the 1991 taxable year ($400,000) is less than the cost of 
service amount for the 1990 taxable year ($500,000), paragraph (f)(3) of 
this section applies and X must file a request for a revised schedule of 
ruling amounts for the period beginning with the 1992 taxable year on or 
before March 15, 1993.
    (iv) Alternatively, if X does not elect the application of paragraph 
(f)(2) section, the amount of decommissioning costs included in cost of 
service for the 1990 and 1991 taxable years is $500,000, and, under 
paragraph (f)(1)(ii) of this section, the amount of decommissioning 
costs included in cost of service for the 1992 taxable year may not 
exceed $300,000. Because the cost of service amount for the 1992 taxable 
year is less than the cost of service amount for the 1991 taxable year, 
paragraph (f)(3) of this section applies and X must file a request for a 
revised schedule of ruling amounts for the period beginning with

[[Page 350]]

the 1992 taxable year on or before March 15, 1993.

[T.D. 8184, 53 FR 6806, Mar. 3, 1988, as amended by T.D. 8461, 57 FR 
62199, Dec. 30, 1992; T.D. 8758, 63 FR 2894, Jan. 20, 1998]



Sec. 1.468A-3  Ruling amount.

    (a) In general. (1) Except as otherwise provided in paragraph (j) of 
this section, an electing taxpayer is allowed a deduction under section 
468A(a) for the taxable year in which the taxpayer makes a cash payment 
(or is deemed to make a cash payment) to a nuclear decommissioning fund 
only if the taxpayer has received a schedule of ruling amounts for the 
nuclear decommissioning fund that includes a ruling amount for such 
taxable year. Except as provided in paragraph (a) (4) or (5) of this 
section, a schedule of ruling amounts for a nuclear decommissioning fund 
(``schedule of ruling amounts'') is a ruling (within the meaning of 
paragraph (a)(2) of Sec. 601.201) specifying the annual payments 
(``ruling amounts'') that, over the taxable years remaining in the 
``funding period'' as of the date the schedule first applies, will 
result in a projected balance of the nuclear decommissioning fund as of 
the last day of the funding period equal to (and in no event greater 
than) the ``amount of decommissioning costs allocable to the fund.'' The 
projected balance of a nuclear decommissioning fund as of the last day 
of the funding period shall be calculated by taking into account the 
fair market value of the assets of the fund as of the first day of the 
first taxable year to which the schedule of ruling amounts applies and 
the estimated rate of return to be earned by the assets of the fund 
after payment of the estimated administrative costs and incidental 
expenses to be incurred by the fund (as defined in paragraph (a)(3)(ii) 
of Sec. 1.468A-5), including all Federal, State and local income taxes 
to be incurred by the fund (the ``after-tax rate of return''). See 
paragraph (c) of this section for a definition of funding period and 
paragraph (d) of this section for guidance with respect to the amount of 
decommissioning costs allocable to a fund.
    (2) To the extent consistent with the principles and provisions of 
this section, each schedule of ruling amounts shall be based on the 
reasonable assumptions and determinations used by the applicable public 
utility commission(s) in establishing or approving the amount of 
decommissioning costs to be included in cost of service for ratemaking 
purposes, taking into account amounts that are otherwise required to be 
included in the taxpayer's income under section 88 and the regulations 
thereunder. Thus, for example, each schedule of ruling amounts shall be 
based on the public utility commission's reasonable assumptions 
concerning--
    (i) The after-tax rate of return to be earned by the amounts 
collected for decommissioning;
    (ii) The total estimated cost of decommissioning the nuclear power 
plant (see paragraph (d)(2) of this section); and
    (iii) The frequency of contributions to a nuclear decommissioning 
fund for a taxable year (e.g., monthly, quarterly, semi-annual or annual 
contributions).
    (3) The Internal Revenue Service shall provide a schedule of ruling 
amounts that is identical to the schedule of ruling amounts proposed by 
the taxpayer in connection with the taxpayer's request for a schedule of 
ruling amounts (see paragraph (h)(2)(viii) of this section), but no 
schedule of ruling amounts shall be provided unless the taxpayer's 
proposed schedule of ruling amounts is consistent with the principles 
and provisions of this section. If a proposed schedule of ruling amounts 
is not consistent with the principles and provisions of this section, 
the taxpayer may propose an amended schedule of ruling amounts that is 
consistent with such principles and provisions.
    (4) The Internal Revenue Service will approve, at the request of the 
taxpayer, a formula or method for determining a schedule of ruling 
amounts (rather than a schedule specifying a dollar amount for each 
taxable year) that is consistent with the principles and provisions of 
this section. See paragraph (i)(1)(ii) of this section for a special 
rule relating to the mandatory review of ruling amounts that are 
determined pursuant to a formula or method.

[[Page 351]]

    (5) The Internal Revenue Service may, in its discretion, provide a 
schedule of ruling amounts that is determined on a basis other than the 
rules of paragraphs (a) through (g) of this section if--
    (i) In connection with its request for a schedule of ruling amounts, 
the taxpayer explains the need for special treatment and sets forth an 
alternative basis for determining the schedule of ruling amounts; and
    (ii) The Internal Revenue Service determines that special treatment 
is consistent with the purpose of section 468A.
    (b) Level funding limitation. (1) Except as otherwise provided in 
paragraph (b)(4) of this section and paragraph (b)(6) of Sec. 1.468A-8 
(relating to a special transitional rule), the ruling amount specified 
in a schedule of ruling amounts for any taxable year in the level 
funding limitation period shall not be less than the ruling amount 
specified in such schedule for any earlier taxable year.
    (2) For purposes of this section, the level funding limitation 
period for a nuclear decommissioning fund is the period that--
    (i) Begins on the first day of the first taxable year for which a 
deductible payment is made (or deemed made) to such nuclear 
decommissioning fund (see paragraph (a) of Sec. 1.468A-2 for rules 
relating to the first taxable year for which a payment may be made (or 
deemed made) to a nuclear decommissioning fund); and
    (ii) Ends on the last day of the taxable year that includes the 
estimated date on which the nuclear power plant to which the nuclear 
decommissioning fund relates will no longer be included in the 
taxpayer's rate base for ratemaking purposes (see paragraphs (e) (2) and 
(4) of this section).
    (3) The ruling amount specified in a schedule of ruling amounts for 
a taxable year after the end of the level funding limitation period may 
be less than the ruling amount specified in such schedule for an earlier 
taxable year.
    (4) The ruling amount specified in a schedule of ruling amounts for 
the last taxable year in the level funding limitation period may be less 
than the ruling amount specified in such schedule for any earlier 
taxable year if the applicable public utility commission assumes for 
cost of service purposes that decommissioning costs will be included in 
cost of service for only a portion of the last taxable year in the level 
funding limitation period. The ruling amount for the last taxable year 
in the level funding limitation period, however, may not be less than 
the amount that bears the same relationship to the ruling amount for the 
preceding taxable year as the period for which decommissioning costs 
will be included in cost of service for such last taxable year bears to 
one year.
    (c) Funding period--(1) General rule. For purposes of this section, 
the funding period for a nuclear decommissioning fund is the period 
that--
    (i) Begins on the first day of the first taxable year for which a 
deductible payment is made (or deemed made) to such nuclear 
decommissioning fund (see paragraph (a)(1) Sec. 1.468A-2 for rules 
relating to the first taxable year for which a payment may be made (or 
deemed made) to a nuclear decommissioning fund); and
    (ii) Ends on the later of--
    (A) The last day of the taxable year that includes the estimated 
date on which decommissioning costs of the nuclear power plant to which 
the nuclear decommissioning fund relates will no longer be included in 
the taxpayer's cost of service for ratemaking purposes (see paragraph 
(e)(1) of this section); or
    (B) The last day of the taxable year that includes the estimated 
date on which the nuclear power plant to which the nuclear 
decommissioning fund relates will no longer be included in the 
taxpayer's rate base for ratemaking purposes (see paragraph (e)(2) of 
this section).
    (2) Examples. The following examples illustrate the application of 
the principles of paragraphs (a), (b) and (c) of this section:

    Example (1). (i) X corporation is a calendar year, accrual method 
taxpayer engaged in the sale of electric energy generated by power 
plants owned by X. On March 15, 1995, X commences the construction of a 
nuclear power plant in State A. On May 15, 1995, the public utility 
commission of State A issues a

[[Page 352]]

final rate order for the four-year period beginning on January 1, 1995, 
that authorizes X to collect decommissioning costs from ratepayers 
residing in State A. For the 1995 taxable year, X is authorized to 
collect decommissioning costs of $500,000, and, for each taxable year 
during the remainder of the period to which the rate order applies, X is 
authorized to collect decommissioning costs in an amount equal to 105 
percent of the amount authorized to be collected for the preceding 
taxable year.
    (ii) In determining the amount of decommissioning costs to be 
collected from ratepayers residing in State A, the public utility 
commission assumes that (A) decommissioning costs will be included in 
cost of service for each taxable year in the period that begins with 
1995 and ends with 2025 and (B) decommissioning costs collected pursuant 
to subsequent rate orders will increase in the same manner as amounts 
collected pursuant to the rate order issued on May 15, 1995. In 
addition, in determining the rate of return to be earned by X with 
respect to the nuclear power plant, the public utility commission 
assumes that the nuclear power plant will be included in rate base for 
each year in the period that begins with 2000 and ends with 2025.
    (iii) X requests a schedule of ruling amounts in accordance with the 
rules of paragraph (h) of this section for the period beginning with the 
1995 taxable year. In determining the level funding limitation period 
and the funding period, the Internal Revenue Service shall assume that a 
deductible payment will be made to a nuclear decommissioning fund for 
the 1995 taxable year. Thus, under paragraph (b) of this section, the 
level funding limitation period begins on January 1, 1995, and ends on 
December 31, 2025. Under paragraph (c)(1) of this section, the funding 
period begins on January 1, 1995, and ends on December 31, 2025.
    (iv) In its request for a schedule or ruling amounts, X proposes a 
ruling amount for each taxable year in the funding period that 
corresponds to the projected cost of service amount for such taxable 
year. If (A) the assumptions and determinations used by the public 
utility commission in establishing the amount of decommissioning costs 
to be included in cost of service are reasonable and (B) the amounts 
collected pursuant to the proposed schedule, combined with the after-tax 
earnings on such amounts, will result in a projected balance of the 
nuclear decommissioning fund as of December 31, 2025, equal to the 
amount of decommissioning costs allocable to the fund, then, under 
paragraph (a)(3) of this section, each ruling amount in the initial 
schedule of ruling amounts shall equal the ruling amount proposed by X 
in connection with its request for a schedule of ruling amounts. Thus, 
the ruling amount for the 1995 taxable year would be $500,000, and the 
ruling amount for each subsequent taxable year would be 105 percent of 
the ruling amount for the preceding taxable year.
    Example (2). (i) Assume the same facts as in Example (1), except 
that on May 15, 1995, the public utility commission of State A issues a 
final rate order for the four-year period beginning on January 1, 1995, 
that authorizes X to collect decommissioning costs of $600,000 per year 
from ratepayers residing in State A. In determining the amount of 
decommissioning costs to be collected from ratepayers residing in State 
A, the public utility commission assumes that decommissioning costs of 
$600,000 will be collected for each taxable year in the period that 
begins with 1995 and ends with 2004 and that decommissioning costs of 
$200,000 will be collected for each taxable year in the period that 
begins with 2005 and ends with 2025.
    (ii) X requests a schedule of ruling amounts in accordance with the 
rules of paragraph (h) of this section for the period beginning with the 
1995 taxable year. In determining the level funding limitation period 
and the funding period, the Internal Revenue Service shall assume that a 
deductible payment will be made to a nuclear decommissioning fund for 
the 1995 taxable year. Thus, under paragraph (b) of this section, the 
level funding limitation period begins on January 1, 1995, and ends on 
December 31, 2025. Under paragraph (c)(1) of this section, the funding 
period begins on January 1, 1995, and ends on December 31, 2025.
    (iii) In its request for a schedule of ruling amounts, X proposes a 
ruling amount for each taxable year in the funding period that 
corresponds to the projected cost of service amount for such taxable 
year. A schedule of ruling amounts based on the projected cost of 
service amount would be inconsistent with the level funding limitation 
of paragraph (b) of this section because the projected cost of service 
amount for 2005 is less than the projected cost of service amount for 
2004. Consequently, under paragraph (a)(3) of this section, no schedule 
of ruling amounts shall be provided to X unless X proposes an amended 
schedule of ruling amounts that is consistent with the level funding 
limitation and the other principles and provisions of this section.
    (iv) Assume that X proposes an amended schedule of ruling amounts 
that provides for ruling amounts of $400,000 for each taxable year in 
the funding period. If (A) the schedule of ruling amounts proposed by X 
is based on the reasonable assumptions and determinations used by the 
public utility commission in establishing the amount of decommissioning 
costs to be included in cost of service and (B) the amounts collected 
pursuant to the proposed schedule, combined with the after-tax earnings 
on such amounts, will result in a projected balance of the nuclear 
decommissioning fund as of December 31,

[[Page 353]]

2025, equal to the amount of decommissioning costs allocable to the 
fund, then, under paragraph (a)(3) of this section, each ruling amount 
in the initial schedule of ruling amounts shall equal the ruling amount 
proposed by X in connection with its request for a schedule of ruling 
amounts. Thus, the ruling amount for the 1995 taxable year and for each 
subsequent taxable year through 2025 would be $400,000.
    (v) Under section 468A(b) and paragraph (b)(1) of Sec. 1.468A-2, 
the maximum amount of cash payments that X can make to a nuclear 
decommissioning fund for any taxable year shall not exceed the lesser of 
(A) the cost of service amount for such taxable year or (B) the ruling 
amount for such taxable year. If the projected cost of service amount 
that was assumed in determining rates under the rate order that was 
issued on May 15, 1995, is the actual cost of service amount for each 
taxable year in the funding period and the ruling amounts provided in 
the initial schedule of ruling amounts are not changed by a subsequent 
schedule of ruling amounts, then X would be allowed to make a deductible 
contribution of $400,000 to a nuclear decommissioning fund for each 
taxable year in the period that begins with 1995 and ends with 2004 and 
to make a deductible contribution of $200,000 to such nuclear 
decommissioning fund for each taxable year in the period that begins 
with 2005 and ends with 2025.
    Example (3). (i) Y corporation is a calendar year, accrual method 
taxpayer engaged in the sale of electric energy generated by power 
plants owned by Y. On June 1, 1990, a nuclear power plant owned by Y 
began commercial operations in State B. In the first ratemaking 
proceeding in which the nuclear power plant was included in rate base, 
the public utility commission of State B assumed that the nuclear power 
plant would be included in rate base for each year in the period that 
began with 1990 and ended with 2020. In addition, for each taxable year 
in the period that began with 1990 and ended with 2017, Y made a 
deductible contribution of $750,000 to a nuclear decommissioning fund 
established by Y. The $750,000 contribution equalled the cost of service 
amount and the ruling amount for each taxable year in the 28-year 
period.
    (ii) On August 30, 2017, the public utility commission of State B 
issues a final rate order for the six-year period beginning on January 
1, 2018, that authorizes Y to collect decommissioning costs of: (A) 
$500,000 for 2018, 2019 and 2020; (B) $1,500,000 for 2021; (C) 
$1,000,000 for 2022; and (D) $750,000 for 2023. In determining the 
amount of decommissioning costs to be collected from ratepayers residing 
in State B, the public utility commission assumes that decommissioning 
costs will no longer be included in cost of service after 2023. In 
addition, in determining the rate of return to be earned by Y with 
respect to the nuclear power plant, the public utility commission 
assumes that the nuclear power plant will no longer be included in rate 
base after 2020.
    (iii) Under paragraph (i)(1)(iii) of this section, Y is required to 
request a revised schedule of ruling amounts on or before March 15, 
2019. Assume that Y makes a timely request for a revised schedule of 
ruling amounts in accordance with the rules of paragraph (h) of this 
section. In its request, Y proposes a ruling amount for each taxable 
year in the period that begins with 2018 and ends with 2023 that 
corresponds to the amount of decommissioning costs to be included in 
cost of service under the rate order of August 30, 2017.
    (iv) Under paragraph (b) of this section, the level funding 
limitation period begins on January 1, 1990, and ends on December 31, 
2020. Under paragraph (c)(1) of this section, the funding period begins 
on January 1, 1990, and ends on December 31, 2023.
    (v) If (A) the assumptions and determinations used by the public 
utility commission in establishing the amount of decommissioning costs 
to be included in cost of service are reasonable and (B) the projected 
balance of the nuclear decommissioning fund as of December 31, 2023 
(taking into account the fair market value of the assets of the fund as 
of January 1, 2018, and the estimated after-tax rate of return to be 
earned by the assets of the fund) will equal the amount of 
decommissioning costs allocable to the fund, then, under paragraph 
(a)(3) of this section, each ruling amount in the revised schedule of 
ruling amounts shall equal the ruling amount proposed by Y in connection 
with its request for a schedule of ruling amounts. Thus, the ruling 
amount for 2018, 2019 and 2020 would be $500,000, the ruling amount for 
2021 would be $1,500,000, the ruling amount for 2022 would be $1,000,000 
and the ruling amount for 2023 would be $750,000.
    (vi) Although the ruling amount specified in the revised schedule of 
ruling amounts for 2018, 2019 and 2020 is less than a ruling amount 
specified in a prior schedule of ruling amounts for years prior to 2018, 
the revised schedule of ruling amounts is consistent with the level 
funding limitation. Under paragraph (i)(3) of this section, a ruling 
amount specified in a revised schedule of ruling amounts for any taxable 
year in level funding limitation period may be less than one or more 
ruling amounts specified in a prior schedule of ruling amounts for a 
prior taxable year. In addition, although the ruling amount specified in 
the revised schedule of ruling amounts for 2022 and 2023 is less than a 
ruling amount specified in such schedule for a prior taxable year, the 
revised schedule of ruling amounts is consistent with the level funding 
limitation because the level funding limitation period ends on December 
31, 2020.


[[Page 354]]


    (d) Decommissioning costs allocable to a fund. The amount of 
decommissioning costs allocable to a nuclear decommissioning fund is 
determined for purposes of this section by applying the following rules 
and definitions:
    (1) General rule. The amount of decommissioning costs allocable to a 
nuclear decommissioning fund is the taxpayer's share of the total 
estimated cost of decommissioning the nuclear power plant to which the 
fund relates, multiplied by the qualifying percentage.
    (2) Total estimated cost of decommissioning. (i) Except as otherwise 
provided in paragraph (d)(2)(ii) of this section, the total estimated 
cost of decommissioning a nuclear power plant is the reasonably 
estimated cost of decommissioning used by the applicable public utility 
commission in establishing or approving the amount of decommissioning 
costs to be included in cost of service for ratemaking purposes. If, in 
establishing or approving the amount of decommissioning costs to be 
included in cost of service, the public utility commission uses an 
estimated cost of decommissioning that is equal to a generic estimate of 
the cost of decommissioning as determined by the Nuclear Regulatory 
Commission (or an estimated cost that is based on the generic estimate 
adjusted for inflation), the Internal Revenue Service may, at its 
discretion, accept such amount as a reasonable estimate of the cost of 
decommissioning. In addition, if the estimated costs used by the 
applicable public utility commission are expected to be paid in any 
taxable year other than the taxable year that includes the last day of 
the funding period or the immediately succeeding taxable year, such 
costs must be adjusted (increased or decreased, as the case may be) by 
discounting or compounding such costs at the after-tax rate of return 
from the date such costs are expected to be paid to the last day of the 
funding period.
    (ii) If, in establishing or approving the amount of decommissioning 
costs to be included in cost of service, the applicable public utility 
commission assumes a projected balance of amounts set aside for 
decommissioning (whether or not such amounts are provided by a nuclear 
decommissioning fund) that is less than the total estimated cost of 
decommissioning assumed by the public utility commission, the total 
estimated cost of decommissioning for purposes of determining the 
schedule of ruling amounts shall equal the projected balance of amounts 
set aside for decommissioning that was assumed by the public utility 
commission.
    (3) Taxpayer's share. The taxpayer's share of the total estimated 
cost of decommissioning a nuclear power plant equals the total estimated 
cost of decommissioning such nuclear power plant multiplied by the 
percentage of such nuclear power plant that the qualifying interest of 
the taxpayer represents (see paragraph (b)(2) of Sec. 1.468A- 1 for 
circumstances in which a taxpayer possesses a qualifying interest in a 
nuclear power plant).
    (4) Qualifying percentage. (i) Except as otherwise provided in 
paragraph (b)(7)(iii) of Sec. 1.468A-8 (relating to a special 
transitional rule), the qualifying percentage for any nuclear 
decommissioning fund is equal to the fraction, the numerator of which is 
the number of taxable years in the estimated period for which the 
nuclear decommissioning fund is to be in effect and the denominator of 
which is the number of taxable years in the estimated useful life of the 
applicable nuclear power plant.
    (ii) Except as otherwise provided in paragraph (b)(7) (i) of (ii) of 
Sec. 1.468A-8 (relating to special transitional rules), the estimated 
period for which a nuclear decommissioning fund is to be in effect--
    (A) Begins on the later of--
    (1) The first day of the first taxable year for which a deductible 
payment is made (or deemed made) to such nuclear decommissioning fund; 
or
    (2) The first day of the taxable year that includes the date the 
nuclear power plant to which such nuclear decommissioning fund relates 
begins commercial operations; and
    (B) Ends on the last day of the taxable year that includes the 
estimated date on which the nuclear power plant to which such nuclear 
decommissioning fund relates will no longer be included in the 
taxpayer's rate base for

[[Page 355]]

ratemaking purposes (see paragraph (e) (3) and (4) of this section).
    (iii) Except as otherwise provided in paragraph (b)(7)(ii) of Sec. 
1.468A-8 (relating to a special transitional rule), the estimated useful 
life of a nuclear power plant.
    (A) Begins on the first day of the taxable year that includes the 
date that the nuclear power plant begins commercial operations; and
    (B) Ends on the last day of the taxable year that includes the 
estimated date on which the nuclear power plant will no longer be 
included in the taxpayer's rate base for ratemaking purposes (see 
paragraph (e) (3) and (4) of this section).
    (e) Determination of estimated dates. (1) For purposes of paragraph 
(c)(1)(ii)(A) of this section (relating to the funding period), the 
estimated date on which decommissioning costs of the nuclear power plant 
to which the nuclear decommissioning fund relates will no longer be 
included in the taxpayer's cost of service for ratemaking purposes is 
determined under the ratemaking assumptions that were used to determine 
the last rates (whether interim or final) that were established or 
approved by the applicable public utility commission prior to the filing 
of the current request for a schedule of ruling amounts.
    (2) For purposes of paragraphs (b)(2)(ii) and (c)(1)(ii)(B) of this 
section (relating to the level funding limitation period and the funding 
period), the estimated date on which the nuclear power plant to which 
the nuclear decommissioning fund relates will no longer be included in 
the taxpayer's rate base for ratemaking purposes is determined under the 
ratemaking assumptions that were used to determine the last rates 
(whether interim or final) that were established or approved by the 
applicable public utility commission prior to the filing of the current 
request for a schedule of ruling amounts.
    (3) For purposes of paragraph (d)(4) (ii)(B) and (iii)(B) of this 
section (relating to the qualifying percentage), the estimated date on 
which the nuclear power plant to which the nuclear decommissioning fund 
relates will no longer be included in the taxpayer's rate base for 
ratemaking purposes is determined under the ratemaking assumptions used 
by the applicable public utility commission in establishing or approving 
rates during the first ratemaking proceeding in which the nuclear power 
plant was included in the taxpayer's rate base.
    (4) For purposes of this section, in the case of a taxpayer whose 
interest in the nuclear power plant is described in paragraph (b)(2)(ii) 
of Sec. 1.468A-1, the date corresponding to ``the estimated date on 
which the nuclear power plant to which the nuclear decommissioning fund 
relates will no longer be included in the taxpayer's rate base'' will be 
determined upon the basis of all the facts and circumstances in a manner 
consistent with the provisions of this section and section 468A of the 
Code.
    (5) A formula or method obtained under paragraph (a)(4) of this 
section may provide for changes in an estimated date described in 
paragraph (e)(1) or (2) of this section to reflect changes in the 
ratemaking assumptions used to determine rates (whether interim or 
final) that are established or approved by the applicable public utility 
commission after the filing of the request for approval of a formula or 
method.
    (f) Special rules in the case of rates established or approved by 
two or more public utility commissions. If two or more public utility 
commissions establish or approve rates for electric energy generated by 
a single nuclear power plant, the following rules shall apply in 
determining the schedule of ruling amounts for the nuclear 
decommissioning fund that relates to such nuclear power plant.
    (1) A schedule of ruling amounts shall be separately determined 
pursuant to the rules of paragraphs (a) through (e) of this section for 
each public utility commission that has determined the amount of 
decommissioning costs to be included in cost of service for ratemaking 
purposes with respect to such nuclear power plant (see paragraph (g) of 
this section).
    (2) The separate determination with respect to a public utility 
commission shall be based on the reasonable assumptions and 
determinations used by such public utility commission and

[[Page 356]]

shall take into account only that portion of the total estimated cost of 
decommissioning the nuclear power plant that is properly allocable to 
the ratepayers whose rates are established or approved by such public 
utility commission.
    (3) The ruling amount applicable to the nuclear decommissioning fund 
for any taxable year is the sum of the ruling amounts for such taxable 
year determined under the separate schedules of ruling amounts.
    (4) The schedule of ruling amounts for the nuclear decommissioning 
fund is the schedule of the ruling amounts determined under paragraph 
(f)(3) of this section.
    (g) Requirement of determination by public utility commission of 
decommissioning costs to be included in cost of service. The Internal 
Revenue Service shall not provide a taxpayer with a schedule of ruling 
amounts for any nuclear decommissioning fund unless a public utility 
commission that establishes or approves rates for electric energy 
generated by the nuclear power plant to which the nuclear 
decommissioning fund relates has--
    (1) Determined the amount of decommissioning costs of such nuclear 
power plant to be included in the taxpayer's cost of service for 
ratemaking purposes; and
    (2) Disclosed the after-tax return and any other assumption and 
determinations used in establshing or approving such amount for any 
taxable year beginning on or after January 1, 1987.
    (h) Manner of requesting schedule of ruling amounts--(1) In general. 
(i) In order to receive a ruling amount for any taxable year, a taxpayer 
must file a request for a schedule of ruling amounts that complies with 
the requirements of this paragraph (h), the applicable procedural rules 
set forth in paragraph (e) of Sec. 601.201 (Statement of Procedural 
Rules) and the requirements of any applicable revenue procedure that is 
in effect on the date the request is filed.
    (ii) A separate request for a schedule of ruling amounts is required 
for each nuclear decommissioning fund established by a taxpayer (see 
paragraph (a) of Sec. 1.468A-5 for rules relating to the number of 
nuclear decommissioning funds that a taxpayer can establish).
    (iii) Except as provided by Sec. 1.468A-5 (a)(1)(iv) (relating to 
certain unincorporated organizations that may be taxable as 
corporations), a request for a schedule of ruling amounts must not 
contain a request for a ruling on any other issue, whether the issue 
involves section 468A or another section of the Internal Revenue Code.
    (iv) In the case of an affiliated group of corporations that join in 
the filing of a consolidated return, the common parent of the group may 
request a schedule of ruling amounts for each member of the group that 
possesses a qualifying interest in the same nuclear power plant by 
filing a single submission with the Internal Revenue Service.
    (v) Except as otherwise provided in paragraph (b)(1) of Sec. 
1.468A-8, the Internal Revenue Service shall not provide or revise a 
ruling amount applicable to a taxable year in response to a request for 
a schedule of ruling amounts that is filed after the deemed payment 
deadline date (as defined in paragraph (c)(1) of Sec. 1.468A-2) for 
such taxable year. In determining the date when a request is filed, the 
principles of sections 7502 and 7503 shall apply.
    (vi) Except as provided in paragraph (h)(1)(vii) of this section, a 
request for a schedule of ruling amounts shall be considered filed only 
if such request complies substantially with the requirements of this 
paragraph (h).
    (vii)(A) If a request does not comply substantially with the 
requirements of this paragraph (h), the Internal Revenue Service will 
notify the taxpayer of that fact. If the information or materials 
necessary to comply substantially with the requirements of this 
paragraph (h) are provided to the Internal Revenue Service within 30 
days after this notification, the request will be considered filed on 
the date of the original submission. If the information or materials 
necessary to comply substantially with the requirements of this 
paragraph (h) are not provided within 30 days after this notification, 
the request will be considered filed on

[[Page 357]]

the date that all information or materials necessary to comply with the 
requirements of this paragraph (h) are provided.
    (B) The Internal Revenue Service may waive the requirements of 
paragraph (h)(1)(vii)(A) of this section if the Service determines that 
the electing taxpayer is making a good faith effort to comply with the 
deadline and if the waiver is consistent with the purposes of section 
468A.
    (2) Information required. A request for a schedule of ruling amounts 
must contain the following information:
    (i) The taxpayer's name, address and taxpayer identification number.
    (ii) Whether the request is for an initial schedule of ruling 
amounts, a mandatory review of the schedule of ruling amounts (see 
paragraph (i)(1) of this section) or an elective review of the schedule 
of ruling amounts (see paragraph (i)(2) of this section).
    (iii) The name and location of the nuclear power plant with respect 
to which a schedule of ruling amounts is requested.
    (iv) A description of the taxpayer's qualifying interest in the 
nuclear power plant and the percentage of such nuclear power plant that 
the qualifying interest of the taxpayer represents.
    (v) An identification of each public utility commission that 
establishes or approves rates for the furnishing or sale by the taxpayer 
of electric energy generated by the nuclear power plant, and, for each 
public utility commission identified--
    (A) Whether the public utility commission has determined the amount 
of decommissioning costs to be included in the taxpayer's cost of 
service for ratemaking purposes; and
    (B) Whether a proceeding is pending before the public utility 
commission that may result in an increase or decrease in the amount of 
decommissioning costs to be included in cost of service.
    (vi) For each public utility commission that has determined the 
amount of decommissioning costs to be included in the taxpayer's cost of 
service for ratemaking purposes--
    (A) The amount of decommissioning costs that are to be included in 
the taxpayer's cost of service for each taxable year under the current 
determination and amounts that otherwise are required to be included in 
the taxpayer's income under section 88 and the regulations thereunder;
    (B) A description of the assumptions, estimates and other factors 
that were used in determining the amounts described in paragraph 
(h)(2)(vi)(A) of this section, including each of the following if 
applicable--
    (1) A description of the proposed method of decommissioning the 
nuclear power plant (for example, prompt removal/dismantlement, safe 
storage entombment with delayed dismantlement, or safe storage 
mothballing with delayed dismantlement);
    (2) The estimated year in which substantial decommissioning costs 
will first be incurred;
    (3) The estimated year in which the decommissioning of the nuclear 
power plant will be substantially complete (see paragraph (d)(2) of 
Sec. 1.468A-5 for a definition of substantial completion of 
decommissioning);
    (4) The total estimated cost of decommissioning expressed in current 
dollars (i.e., based on price levels in effect at the time of the 
current determination);
    (5) The total estimated cost of decommissioning expressed in future 
dollars (i.e., based on anticipated price levels when expenses are 
expected to be paid);
    (6) For each taxable year in the period that begins with the year 
specified in paragraph (h)(2)(vi)(B)(2) of this section (``the estimated 
year in which substantial decommissioning costs will first be 
incurred'') and ends with the year specified in paragraph 
(h)(2)(vi)(B)(3) of this section (``the estimated year in which the 
estimated year in which the decommissioning of the nuclear power plant 
will be substantially complete''), the estimated cost of decommissioning 
expressed in future dollars;
    (7) A description of the methodology used in converting the 
estimated cost of decommissioning expressed in current dollars to the 
estimated cost of decommissioning expressed in future dollars;

[[Page 358]]

    (8) The assumed after-tax rate of return to be earned by the amounts 
collected for decommissioning (if two or more after-tax rates of return 
are assumed by the public utility commission, each assumed after-tax 
rate of return and the amounts collected for decommissioning to which 
each assumed after-tax rate of return applies);
    (9) The proposed period over which decommissioning costs will be 
included in the cost of service of the taxpayer and the projected amount 
that will be included in cost of service for each taxable year in the 
proposed period;
    (10) The estimated date on which the nuclear power plant will no 
longer be included in the taxpayer's rate base for ratemaking purposes 
as determined under the ratemaking assumptions that were used to 
determine the last rates (whether interim or final) that were 
established or approved by the applicable public utility commission 
prior to the filing of the current request for a schedule of ruling 
amounts (or a corresponding date in the case of a taxpayer whose 
interest in the nuclear power plant is described in paragraph (b)(2)(ii) 
of Sec. 1.468A-1; see paragraph (e)(4) of this section); and
    (11) The estimated date on which the nuclear power plant will no 
longer be included in the taxpayer's rate base for ratemaking purposes 
as determined under the ratemaking assumptions that were used by the 
applicable public utility commission in establishing or approving rates 
during the first ratemaking proceeding in which the nuclear power plant 
was included in the taxpayer's rate base (or a corresponding date in the 
case of a taxpayer whose interest in the nuclear power plant is 
described in paragraph (b)(2)(ii) of Sec. 1.468A-1; see paragraph 
(e)(4) of this section);
    (C) A copy of such portions of any order or opinion of the public 
utility commission as pertain to the commission's most recent 
determination of the amount of decommissioning costs to be included in 
cost of service; and
    (D) A copy of each engineering or cost study that was relied on or 
used by the taxpayer or the public utility commission in determining the 
amount of decommissioning costs to be included in the taxpayer's cost of 
service under the current determination.
    (vii) For each proceeding pending before a public utility commission 
that may result in an increase or decrease in the amount of 
decommissioning costs to be included in the taxpayer's cost of service--
    (A) A description of the stage of the proceeding;
    (B) The amount of decommissioning costs that are proposed to be 
included in the taxpayer's cost of service for each taxable year;
    (C) A description of the assumptions, estimates and other factors 
that were used in determining the amount of decommissioning costs that 
are proposed to be included in the taxpayer's cost of service for each 
taxable year, including each of the items described in paragraph 
(h)(2)(vi)(B) of this section if applicable; and
    (D) A copy of each engineering or cost study that was relied on or 
used by the taxpayer or the public utility commission in determining the 
amount of decommissioning costs that are proposed to be included in the 
taxpayer's cost of service.
    (viii) A proposed schedule of ruling amounts for each taxable year 
remaining in the funding period as of the date the schedule of ruling 
amounts will first apply.
    (ix) A description of the assumptions, estimates and other factors 
that were used in determining the proposed schedule of ruling amounts, 
including each of the following if applicable--
    (A) The level funding limitation period (as such term is defined in 
paragraph (b)(2) of this section);
    (B) The funding period (as such term is defined in paragraph (c) of 
this section);
    (C) The assumed after-tax rate of return to be earned by the assets 
of the nuclear decommissioning fund;
    (D) The fair market value of the assets (if any) of the nuclear 
decommissioning fund as of the first day of the first taxable year to 
which the schedule of ruling amounts will apply;
    (E) The amount expected to be earned by the assets of the nuclear 
decommissioning fund (based on the after-tax rate of return applicable 
to the fund) over the period that begins

[[Page 359]]

on the first day of the first taxable year to which the schedule of 
ruling amounts will apply and ends on the last day of the funding 
period;
    (F) The amount of decommissioning costs allocable to the nuclear 
decommissioning fund (as determined under paragraph (d) of this 
section);
    (G) The total estimated cost of decommissioning (as such term is 
defined in paragraph (d)(2) of this section);
    (H) The taxpayer's share of the total estimated cost of 
decommissioning (as such term is defined in paragraph (d)(3) of this 
section);
    (I) The qualifying percentage (as such term is defined in paragraph 
(d)(4)(i) of this section);
    (J) The estimated period for which the nuclear decommissioning fund 
is to be in effect (as such term is defined in paragraph (d)(4)(ii) of 
this section); and
    (K) The estimated useful life of the nuclear power plant (as such 
term is defined in paragraph (d)(4)(iii) of this section).
    (x) If the request is for a revised schedule of ruling amounts, the 
after-tax rate of return earned by the assets of the nuclear 
decommissioning fund for each taxable year in the period that begins 
with the date of the inital contribution to the fund and ends with the 
first day of the first taxable year to which the revised schedule of 
ruling amounts applies.
    (xi) If applicable, an explanation of the need for a schedule of 
ruling amounts determined on a basis other than the rules of paragraphs 
(a) through (g) of this section and a description of an alternative 
basis for determining a schedule of ruling amounts (see paragraph (a)(5) 
of this section).
    (xii) A chart or table, based upon the assumed after-tax rate of 
return to be earned by the assets of the nuclear decommissioning fund, 
setting forth the years the fund will be in existence, the annual 
contribution to the fund, the estimated annual earnings of the fund and 
the cumulative total balance in the fund.
    (xiii) If the request is for a revised schedule of ruling amounts, a 
copy of the most recently issued schedule of ruling amounts for the 
nuclear power plant to which the request relates that has been issued to 
the taxpayer (or a predecessor in interest) making the request.
    (xiv) If the request for a schedule of ruling amounts contains a 
request, pursuant to Sec. 1.468A-5 (a)(1)(iv), that the Service rule 
whether an unincorporated organization through which the assets of the 
fund are invested is an association taxable as a corporation for federal 
tax purposes, a copy of the legal documents establishing or otherwise 
governing the organization.
    (xv) Any other information required by the Internal Revenue Service 
that may be necessary or useful in determining the schedule of ruling 
amounts.
    (3) Administrative procedures. The Internal Revenue Service may 
prescribe administrative procedures that supplement the provisions of 
paragraph (h) (1) and (2) of this section. In addition, the Internal 
Revenue Service may, in its discretion, waive the requirements of 
paragraph (h) (1) and (2) of this section under appropriate 
circumstances.
    (i) Review and revision of schedule of ruling amounts--(1) Mandatory 
review. (i) Any taxpayer that has obtained a schedule of ruling amounts 
pursuant to paragraph (h) of this section must file a request for a 
revised schedule of ruling amounts on or before the deemed payment 
deadline date for the 10th taxable year that begins after the taxable 
year in which the most recent schedule of ruling amounts was received. 
The first taxable year to which the revised schedule of ruling amounts 
applies shall be the 10th taxable year that begins after the taxable 
year in which the most recent schedule of ruling amounts was received.
    (ii)(A) Any taxpayer that has obtained a formula or method for 
determining a schedule of ruling amounts for any taxable year under 
paragraph (a)(4) of this section must file a request for a revised 
schedule on or before the earlier of the deemed payment deadline for the 
fifth taxable year that begins after its taxable year in which the most 
recent formula or method was approved or the deemed payment deadline for 
the first taxable year that begins after a taxable year in which there 
is a substantial variation in the ruling amount determined under the 
most recent formula or method. There is a substantial variation in the 
ruling amount

[[Page 360]]

determined under the formula or method in effect for a taxable year if 
the ruling amount for the year and the ruling amount for any earlier 
year since the most recent formula or method was approved differ by more 
than 50 percent of the smaller amount.
    (B) Any taxpayer that has determined its ruling amount for any 
taxable year under a formula prescribed by Sec. 1.468A-6 (which 
prescribes ruling amounts for the taxable year in which there is a 
disposition of a qualifying interest in a nuclear power plant) must file 
a request for a revised schedule of ruling amounts on or before the 
deemed payment deadline for its first taxable year that begins after the 
disposition.
    (iii) A taxpayer is required to request a revised schedule of ruling 
amounts for a nuclear decommissioning fund if--
    (A) Any public utility commission that establishes or approves rates 
for the furnishing or sale of electric energy generated by a nuclear 
power plant to which the nuclear decommissioning fund relates--
    (1) Increases the proposed period over which decommissioning costs 
of such nuclear power plant will be included in cost of service for 
ratemaking purposes;
    (2) Adjusts the estimated date on which such nuclear power plant 
will no longer be included in the taxpayer's rate base for ratemaking 
purposes; or
    (3) Reduces the amount of decommissioning costs to be included in 
cost of service for any taxable year;
    (B) The taxpayer's most recent request for a schedule of ruling 
amounts did not provide notice to the Internal Revenue Service of such 
action by the public utility commission; and
    (C) In the case of a taxpayer that determines its schedule of ruling 
amounts under a formula or method obtained under paragraph (a)(4) of 
this section, the item increased, adjusted, or reduced is a fixed 
(rather than a variable) element of that formula or method.
    (iv) If a taxpayer is required to request a revised schedule of 
ruling amounts by reason of an action described in paragraph (i)(1)(iii) 
of this section, the taxpayer must file the request for a revised 
schedule of ruling amounts on or before the deemed payment deadline date 
for the first taxable year in which rates that reflect such action 
become effective. The first taxable year to which the revised schedule 
of ruling amounts applies shall be the first taxable year in which such 
rates become effective.
    (v) A request for a schedule of ruling amounts required by this 
paragraph (i)(1) must be made in accordance with the rules of paragraph 
(h) of this section. If a taxpayer does not properly file a request for 
a revised schedule of ruling amounts by the date provided in paragraph 
(i)(1) (i), (ii) or (iv) of this section (whichever is applicable), the 
taxpayer's ruling amount for the first taxable year to which the revised 
schedule of ruling amounts would have applied and for all succeeding 
taxable years until a new schedule is obtained shall be zero, unless, in 
its discretion, the Internal Revenue Service provides otherwise in such 
new schedule of ruling amounts.
    (vi) See paragraph (f)(3) of Sec. 1.468A-2 for the application of 
the rules in paragraph (i)(1) (iii), (iv), and (v) of this section in 
the case of certain retroactive adjustments to interim rate orders.
    (2) Elective review. Any taxpayer that has obtained a schedule of 
ruling amounts pursuant to paragraph (h) of this section can request a 
revised schedule of ruling amounts. Such a request must be made in 
accordance with the rules of paragraph (h) of this section; thus, the 
Internal Revenue Service shall not provide a revised ruling amount 
applicable to a taxable year in response to a request for a schedule of 
ruling amounts that is filed after the deemed payment deadline date for 
such taxable year (see paragraph (h)(1)(vi) of this section).
    (3) Determination of revised schedule of ruling amounts. A revised 
schedule of ruling amounts for a nuclear decommissioning fund shall be 
determined under this section without regard to any schedule of ruling 
amounts for such nuclear decommissioning fund that was issued prior to 
such revised schedule. Thus, a ruling amount specified in a revised 
schedule of ruling amounts for any taxable year in the level funding 
limitation period can be

[[Page 361]]

less than one or more ruling amounts specified in a prior schedule of 
ruling amounts for a prior taxable year.
    (j) Special rule permitting payments to a nuclear decommissioning 
fund before receipt of an initial or revised ruling amount applicable to 
a taxable year. (1) If an electing taxpayer has filed a timely request 
for an initial or revised ruling amount for a taxable year beginning on 
or after January 1, 1987, and does not receive the ruling amount on or 
before the deemed payment deadline date for such taxable year, the 
taxpayer may make a payment to a nuclear decommissioning fund on the 
basis of the ruling amount proposed in the taxpayer's request. Thus, 
under the preceding sentence, an electing taxpayer may make a payment to 
a nuclear decommissioning fund for such taxable year that does not 
exceed the lesser of--
    (i) The cost of service amount applicable to the nuclear 
decommissioning fund for such taxable year; or
    (ii) The ruling amount proposed by the taxpayer for such taxable 
year in a timely filed request for a schedule of ruling amounts.
    (2) If an electing taxpayer makes a payment to a nuclear 
decommissioning fund for any taxable year pursuant to paragraph (j)(1) 
of this section and the ruling amount that is provided by the Internal 
Revenue Service is greater than the ruling amount proposed by the 
taxpayer for such taxable year, the taxpayer is not allowed to make an 
additional payment to the fund for such taxable year after the deemed 
payment deadline date for such taxable year.
    (3) If--(i) An electing taxpayer makes a payment to a nuclear 
decommissioning fund for any taxable year pursuant to paragraph (j)(1) 
of this section,
    (ii) The ruling amount that is provided by the Internal Revenue 
Service is less than the ruling amount proposed by the taxpayer for such 
taxable year, and
    (iii) As a result, there is an excess contribution (as defined in 
paragraph (c)(2)(ii) of Sec. 1.468A-5) for such taxable year,

Then the amount of the excess contribution is not deductible (see 
paragraph (b)(1) of Sec. 1.468A-2) and must be withdrawn by the 
taxpayer pursuant to the rules of paragraph (c)(2)(i) of Sec. 1.468A-5. 
Thus, an electing taxpayer that files a return based on a payment made 
pursuant to paragraph (j)(1) of this section should file an amended 
return if an excess contribution results when the ruling amount is 
issued for such taxable year.

[T.D. 8184, 53 FR 6808, Mar. 3, 1988, as amended by T.D. 8461, 57 FR 
62199, Dec. 30, 1992; T.D. 8580, 59 FR 66474, Dec. 27, 1994; 60 FR 8932, 
Feb. 16, 1995; T.D. 8758, 63 FR 2894, Jan. 20, 1998]



Sec. 1.468A-4  Treatment of nuclear decommissioning fund.

    (a) In general. A nuclear decommissioning fund is subject to tax on 
all of its modified gross income (as defined in paragraph (b) of this 
section). The rate of tax is 22 percent for taxable years beginning in 
calendar year 1994 or 1995, 20 percent for taxable years beginning after 
December 31, 1995, and the highest rate of tax specified by section 
11(b) for other years. This tax is in lieu of any other tax that may be 
imposed under subtitle A of the Internal Revenue Code on the income 
earned by the assets of the nuclear decommissioning fund.
    (b) Modified gross income. For purposes of this section, the term 
``modified gross income'' means gross income as defined under section 61 
computed with the following modifications:
    (1) The amount of any payment to the nuclear decommissioning fund 
with respect to which a deduction is allowed under section 468A(a) is 
excluded from gross income.
    (2) A deduction is allowed for the amount of administrative costs 
and other incidental expenses of the nuclear decommissioning fund 
(including taxes, legal expenses, accounting expenses, actuarial 
expenses and trustee expenses, but not including decommissioning costs) 
that are otherwise deductible and that are paid by the nuclear 
decommissioning fund to any person other than the electing taxpayer. An 
expense is otherwise deductible for purposes of this paragraph (b)(2) if 
it would be deductible under chapter 1 of the Internal Revenue Code in 
determining the taxable income of a corporation. For example, because 
Federal income taxes are not deductible under

[[Page 362]]

chapter 1 of the Internal Revenue Code in determining the taxable income 
of a corporation, the tax imposed by section 468A(e)(2) and paragraph 
(a) of this section is not deductible in determining the modified gross 
income of a nuclear decommissioning fund. Similarly, because certain 
expenses allocable to tax-exempt interest income are not deductible 
under section 265 of the Internal Revenue Code in determining the 
taxable income of a corporation, such expenses are not deductible in 
determining the modified gross income of a nuclear decommissioning fund.
    (3) A deduction is allowed for the amount of an otherwise deductible 
loss that is sustained by the nuclear decommissioning fund in connection 
with the sale, exchange or worthlessness of any investment. A loss is 
otherwise deductible for purposes of this paragraph (b)(3) if such loss 
would be deductible by a corporation under section 165 (f) or (g) and 
sections 1211(a) and 1212(a).
    (4) A deduction is allowed for the amount of an otherwise deductible 
net operating loss of the nuclear decommissioning fund. For purposes of 
this paragraph (b), the net operating loss of a nuclear decommissioning 
fund for a taxable year is the amount by which the deductions allowable 
under paragraph (b) (2) and (3) of this section exceed the gross income 
of the nuclear decommissioning fund computed with the modification 
described in paragraph (b)(1) of this section. A net operating loss is 
otherwise deductible for purposes of this paragraph (b)(4) if such a net 
operating loss would be deductible by a corporation under section 
172(a).
    (c) Special rules--(1) Period for computation of modified gross 
income. The modified gross income of a nuclear decommissioning fund must 
be computed on the basis of the taxable year of the electing taxpayer. 
If an electing taxpayer changes its taxable year, each nuclear 
decommissioning fund of the electing taxpayer must change to the new 
taxable year. See section 442 and Sec. 1.442-1 for rules relating to 
the change to a new taxable year.
    (2) Gain or loss upon distribution of property by a fund. A 
distribution of property by a nuclear decommissioning fund (whether an 
actual distribution or a deemed distribution) shall be considered a 
disposition of property by the nuclear decommissioning fund for purposes 
of section 1001. In determining the amount of gain or loss from such 
disposition, the amount realized by the nuclear decommissioning fund 
shall be the fair market value of the property on the date of 
disposition.
    (3) Denial of credits against tax. The tax imposed on the modified 
gross income of a nuclear decommissioning fund under paragraph (a) of 
this section is not to be reduced or offset by any credits against tax 
provided by part IV of subchapter A of chapter 1 of the Internal Revenue 
Code other than the credit provided by section 31(c) for amounts 
withheld under section 3406 (back-up withholding).
    (4) Other corporate taxes inapplicable. Although the modified gross 
income of a nuclear decommissioning fund is subject to tax at the rate 
specified by section 468A(e)(2) and paragraph (a) of this section, a 
nuclear decommissioning fund is not subject to the other taxes imposed 
on corporations under subtitle A of the Internal Revenue Code. For 
example, a nuclear decommissioning fund is not subject to the 
alternative minimum tax imposed by section 55, the accumulated earnings 
tax imposed by section 531, the personal holding company tax imposed by 
section 541, and the alternative tax imposed on a corporation under 
section 1201(a).
    (d) Treatment as corporation for purposes of subtitle F. For 
purposes of subtitle F of the Internal Revenue Code and the regulations 
thereunder, a nuclear decommissioning fund is to be treated as if it 
were a corporation and the tax imposed by section 468A(e)(2) and 
paragraph (a) of this section is to be treated as a tax imposed by 
section 11. Thus, for example, the following rules apply:
    (1) A nuclear decommissioning fund must file a return with respect 
to the tax imposed by section 468A(e)(2) and paragraph (a) of this 
section for each taxable year (or portion thereof) that the fund is in 
existence even though no amount is included in the gross income of the 
fund for such taxable year. The return is to be made on Form 1120-ND

[[Page 363]]

in accordance with the instructions relating to such form. For purposes 
of this paragraph (d)(1), a nuclear decommissioning fund is in existence 
for the period that--
    (i) Begins on the date that the first deductible payment is actually 
made to such nuclear decommissioning fund; and
    (ii) Ends on the date of termination (see paragraph (d) of Sec. 
1.468A-5), the date that the entire fund is disqualified (see paragraph 
(c) of Sec. 1.468A-5), or the date that the electing taxpayer disposes 
of its entire qualifying interest in the nuclear power plant to which 
the nuclear decommissioning fund relates, whichever is applicable.
    (2) For each taxable year of the nuclear decommissioning fund, the 
return described in paragraph (d)(1) of this section must be filed on or 
before the 15th day of the third month following the close of such 
taxable year unless the nuclear decommissioning fund is granted an 
extension of time for filing under section 6081. If such an extension is 
granted for any taxable year, the return for such taxable year must be 
filed on or before the extended due date for such taxable year. In no 
event will the filing of the initial return of a nuclear decommissioning 
fund be required before January 6, 1987.
    (3) A nuclear decommissioning fund must provide its employer 
identification number on returns, statements and other documents as 
required by the forms and instructions relating thereto. The employer 
identification number is obtained by filing a Form SS-4 in accordance 
with the instructions relating thereto.
    (4) A nuclear decommissioning fund must deposit all payments of tax 
imposed by section 468A(e)(2) and paragraph (a) of this section 
(including any payments of estimated tax) with an authorized government 
depositary in accordance with Sec. 1.6302-1.
    (5) A nuclear decommissioning fund is subject to the addition to tax 
imposed by section 6655 in case of a failure to pay estimated income 
tax. For purposes of section 6655 and this section--
    (i) The tax with respect to which the amount of the underpayment is 
computed in the case of a nuclear decommissioning fund is the tax 
imposed by section 468A(e)(2) and paragraph (a) of this section; and
    (ii) The taxable income with respect to which the nuclear 
decommissioning fund's status as a ``large corporation'' is measured is 
``modified gross income'' (as defined by paragraph (b) of this section).

[T.D. 8184, 53 FR 6814, Mar. 3, 1988, as amended by T.D. 8461, 57 FR 
62199, Dec. 30, 1992]



Sec. 1.468A-5  Nuclear decommissioning fund qualification requirements; 

prohibitions against self-dealing; disqualification of nuclear 
decommissioning fund; termination of fund upon substantial completion of 
          decommissioning.

    (a) Qualification requirements--(1) In general. (i) A nuclear 
decommissioning fund must be established and maintained at all times in 
the United States pursuant to an arrangement that qualifies as a trust 
under State law. Such trust must be established for the exclusive 
purpose of providing funds for the decommissioning of one or more 
nuclear power plants, but a single trust agreement may establish 
multiple funds for such purpose. Thus--
    (A) Two or more nuclear decommissioning funds can be established and 
maintained pursuant to a single trust agreement; and
    (B) One or more funds that are to be used for the decommissioning of 
a nuclear power plant and that do not qualify as nuclear decommissioning 
funds under this paragraph (a) can be established and maintained 
pursuant to a trust agreement that governs one or more nuclear 
decommissioning funds.
    (ii) A separate nuclear decommissioning fund is required for each 
electing taxpayer and for each nuclear power plant with respect to which 
an electing taxpayer possesses a qualifying interest. The Internal 
Revenue Service shall issue a separate schedule of ruling amounts with 
respect to each nuclear decommissioning fund and each nuclear 
decommissioning fund must file a separate income tax return even if 
other nuclear decommissioning funds or nonqualified decommissioning 
funds are established and maintained pursuant to the trust agreement 
governing such fund or the assets of other

[[Page 364]]

nuclear decommissioning funds or nonqualified decommissioning funds are 
pooled with the assets of such fund.
    (iii) An electing taxpayer can maintain only one nuclear 
decommissioning fund for each nuclear power plant with respect to which 
the taxpayer elects the application of section 468A. If a nuclear power 
plant is subject to the ratemaking jurisdiction of two or more public 
utility commissions and any such public utility commission requires a 
separate fund to be maintained for the benefit of ratepayers whose rates 
are established or approved by the public utility commission, the 
separate funds maintained for such plant (whether or not established and 
maintained pursuant to a single trust agreement) shall be considered a 
single nuclear decommissioning fund for purposes of section 468A and 
Sec. Sec. 1.468A-1 through 1.468A-5, 1.468A-7 and 1.468A-8. Thus, for 
example, the Internal Revenue Service shall issue one schedule of ruling 
amounts with respect to such nuclear power plant (see paragraph (f) of 
Sec. 1.468A-3), the nuclear decommissioning fund must file a single 
income tax return (see paragraph (d)(1) of Sec. 1.468A-4), and, if the 
Internal Revenue Service disqualifies the nuclear decommissioning fund, 
the assets of each separate fund are treated as distributed on the date 
of disqualification (see paragraph (c)(3) of this section).
    (iv) If assets of a nuclear decommissioning fund are (or will be) 
invested through an unincorporated organization, within the meaning of 
Sec. 301.7701-2 of this chapter, the Internal Revenue Service will 
rule, if requested, whether the organization is an association taxable 
as a corporation for federal tax purposes. A request for a ruling may be 
made by the electing taxpayer as part of its request for a schedule of 
ruling amounts.
    (2) Limitation on contributions. Except as otherwise provided in 
paragraph (b)(2)(ii) of Sec. 1.468A-8 (relating to a special 
transitional rule), a nuclear decommissioning fund is not permitted to 
accept any contributions in cash or property other than cash payments 
with respect to which a deduction is allowed under section 468A(a) and 
paragraph (a) of Sec. 1.468A-2. Thus, for example, unless the exception 
contained in paragraph (b)(2)(ii) of Sec. 1.468A-8 applies, securities 
may not be contributed to a nuclear decommissioning fund even if the 
taxpayer or a fund established by the taxpayer previously held such 
securities for the purpose of providing funds for the decommissioning of 
a nuclear power plant.
    (3) Limitation on use of fund--(i) In general. The assets of a 
nuclear decommissioning fund are to be used exclusively--
    (A) To satisfy, in whole or in part, the liability of the electing 
taxpayer for decommissioning costs of the nuclear power plant to which 
the nuclear decommissioning fund relates;
    (B) To pay administrative costs and other incidental expenses of the 
nuclear decommissioning fund; and
    (C) To the extent that the assets of the nuclear decommissioning 
fund are not currently required for the purposes described in paragraph 
(a)(3)(i) (A) or (B) of this section, to make investments.
    (ii) Definition of administrative costs and expenses. For purposes 
of paragraph (a)(3)(i) of this section, the term ``administrative costs 
and other incidental expenses of a nuclear decommissioning fund'' means 
all ordinary and necessary expenses incurred in connection with the 
operation of the nuclear decommissioning fund. Such term includes the 
tax imposed by section 468A(e)(2) and Sec. 1.468A-4(a), any State or 
local tax imposed on the income or the assets of the fund, legal 
expenses, accounting expenses, actuarial expenses and trustee expenses. 
Such term does not include decommissioning costs. Such term also does 
not include the excise tax imposed on the trustee or other disqualified 
person under section 4951 or the reimbursement of any expenses incurred 
in connection with the assertion of such tax unless such expenses are 
considered reasonable and necessary under section 4951(d)(2)(C) and it 
is determined that the trustee or other disqualified person is not 
liable for the excise tax.
    (4) Trust provisions. By December 31, 1996, each qualified nuclear 
decommissioning fund trust agreement must provide that assets in the 
fund must be used as authorized by section 468A and the regulations 
thereunder and that

[[Page 365]]

the agreement may not be amended so as to violate section 468A or the 
regulations thereunder.
    (b) Prohibitions against self-dealing--(1) In general. Except as 
otherwise provided in this paragraph (b), the excise taxes imposed by 
section 4951 shall apply to each act of self-dealing between a 
disqualified person and a nuclear decommissioning fund.
    (2) Self-dealing defined. For purposes of this paragraph (b), the 
term ``self-dealing'' means any act described in section 4951(d), 
except--
    (i) A payment by a nuclear decommissioning fund for the purpose of 
satisfying, in whole or in part, the liability of the electing taxpayer 
for decommissioning costs of the nuclear power plant to which the 
nuclear decommissioning fund relates;
    (ii) A withdrawal of an excess contribution by the electing taxpayer 
pursuant to the rules of paragraph (c)(2) of this section;
    (iii) A withdrawal by the electing taxpayer of amounts that have 
been treated as distributed under paragraph (c)(3) of this section;
    (iv) A payment of amounts remaining in a nuclear decommissioning 
fund to the electing taxpayer after the termination of such fund (as 
determined under paragraph (d) of this section);
    (v) Any act described in section 4951(d)(2) (B) or (C);
    (vi) Any act described in Sec. 53.4951-1(c) of this chapter only if 
undertaken to facilitate the temporary investment of assets or the 
payment of reasonable administrative expenses of the nuclear 
decommissioning fund; or
    (vii) A payment by a nuclear decommissioning fund for the 
performance of trust functions and certain general banking services by a 
bank or trust company which is a disqualified person, where the banking 
services are reasonable and necessary to carry out the purposes of the 
fund, if the compensation paid to the bank or trust company, taking into 
account the fair interest rate for the use of the funds by the bank or 
trust company, for such services is not excessive. The general banking 
services allowed by this paragraph (b)(2)(vii) are--
    (A) Checking accounts, as long as the bank does not charge interest 
on any overwithdrawals,
    (B) Savings accounts, as long as the fund may withdraw its funds on 
no more than 30 days' notice without subjecting itself to a loss of 
interest on its money for the time during which the money was on 
deposit, and
    (C) Safekeeping activities. (See example 3 of Sec. 53.4941(d)-
3(c)(2).)
    (3) Disqualified person defined. For purposes of this paragraph (b), 
the term ``disqualified person'' includes each person described in 
section 4951(e)(4) and paragraph (d) of Sec. 53.4951-1.
    (c) Disqualification of nuclear decommissioning fund--(1) In 
general. Except as otherwise provided in paragraph (c)(2) of this 
section, if at any time during a taxable year of a nuclear 
decommissioning fund--
    (i) The nuclear decommissioning fund does not satisfy the 
requirements of paragraph (a) of this section, or
    (ii) The nuclear decommissioning fund and a disqualified person 
engage in an act of self-dealing (as defined in paragraph (b)(2) of this 
section), the Internal Revenue Service may, in its discretion, 
disqualify all or any portion of the fund as of the date that the fund 
does not satisfy the requirements of paragraph (a) of this section or 
the date on which the act of self-dealing occurs, whichever is 
applicable, or as of any subsequent date (``date of disqualification''). 
The Internal Revenue Service shall notify the electing taxpayer of the 
disqualification of a nuclear decommissioning fund and the date of 
disqualification by registered or certified mail to the last known 
address of the electing taxpayer (the ``notice of disqualification''). 
For further guidance regarding the definition of last known address, see 
Sec. 301.6212-2 of this chapter.
    (2) Exception to disqualification--(i) In general. A nuclear 
decommissioning fund will not be disqualified under paragraph (c)(1) of 
this section by reason of an excess contribution or the withdrawal of 
such excess contribution by an electing taxpayer if the amount of the 
excess contribution is withdrawn by the electing taxpayer on or before 
the date prescribed by law (including

[[Page 366]]

extensions) for filing the return of the nuclear decommissioning fund 
for the taxable year to which the excess contribution relates. In the 
case of an excess contribution that is the result of a payment made 
pursuant to paragraph (j)(1) of Sec. 1.468A-3, a nuclear 
decommissioning fund will not be disqualified under paragraph (c)(1) of 
this section if the amount of the excess contribution is withdrawn by 
the electing taxpayer on or before the later of--
    (A) The date prescribed by law (including extensions) for filing the 
return of the nuclear decommissioning fund for the taxable year to which 
the excess contribution relates; or
    (B) The date that is 30 days after the date that the taxpayer 
receives the ruling amount for such taxable year.
    (ii) Excess contribution defined. For purposes of this section, an 
excess contribution is the amount by which cash payments made (or deemed 
made) to a nuclear decommissioning fund during any taxable year exceed 
the payment limitation contained in section 468A(b) and paragraph (b) of 
Sec. 1.468A-2.
    (iii) Taxation of income attributable to an excess contribution. The 
income of a nuclear decommissioning fund attributable to an excess 
contribution is required to be included in the gross income of the 
nuclear decommissioning fund under paragraph (b) of Sec. 1.468A-4.
    (3) Effect of disqualification. If all or any portion of a nuclear 
decommissioning fund is disqualified under paragraph (c)(1) of this 
section, the portion of the nuclear decommissioning fund that is 
disqualified is treated as distributed to the electing taxpayer on the 
date of disqualification. Such a distribution shall be treated for 
purposes of section 1001 as a disposition of property held by the 
nuclear decommissioning fund (see paragraph (c)(2) of Sec. 1.468A-4). 
In addition, the electing taxpayer must include in gross income for the 
taxable year that includes the date of disqualification an amount equal 
to the product of--
    (i) The fair market value of the assets of the fund determined as of 
the date of disqualification, reduced by--
    (A) The amount of any excess contribution that was not withdrawn 
before the date of disqualification if no deduction was allowed with 
respect to such excess contribution;
    (B) The amount of any deemed distribution that was not actually 
distributed before the date of disqualification (as determined under 
paragraph (d)(2)(iii) of Sec. 1.468A-2) if the amount of the deemed 
distribution was included in the gross income of the electing taxpayer 
for the taxable year in which the deemed distribution occurred; and
    (C) The amount of any tax that--
    (1) Is imposed on the income of the fund;
    (2) Is attributable to income taken into account before the date of 
disqualification or as a result of the disqualification; and
    (3) Has not been paid as of the date of disqualification; and
    (ii) The fraction of the nuclear decommissioning fund that was 
disqualified under paragraph (c)(1) of this section.

Contributions made to a disqualified fund after the date of 
disqualification are not deductible under section 468A(a) and paragraph 
(a) of Sec. 1.468A-2, or, if the fund is disqualified only in part, are 
deductible only to the extent provided in the notice of 
disqualification. In addition, if any assets of the fund that are deemed 
distributed under this paragraph (c)(3) are held by the fund after the 
date of disqualification (or if additional assets are acquired with 
nondeductible contributions made to the fund after the date of 
disqualification), the income earned by such assets after the date of 
disqualification must be included in the gross income of the electing 
taxpayer (see section 671) to the extent that such income is otherwise 
includible under chapter 1 of the Internal Revenue Code. An electing 
taxpayer can establish a nuclear decommissioning fund to replace a fund 
that has been disqualified in its entirety only if the Internal Revenue 
Service specifically consents to the establishment of a replacement fund 
in connection with the issuance of an initial schedule of ruling amounts 
for such replacement fund.
    (d) Termination of nuclear decommissioning fund upon substantial 
completion of decommissioning--(1) In general. Upon substantial 
completion of the decommissioning of a nuclear power plant to

[[Page 367]]

which a nuclear decommissioning fund relates, such nuclear 
decommissioning fund shall be considered terminated and treated as 
having distributed all of its assets on the date the termination occurs. 
Such a distribution shall be treated for purposes of section 1001 as a 
disposition of property held by the nuclear decommissioning fund (see 
paragraph (c)(2) of Sec. 1.468A-4). In addition, the electing taxpayer 
shall include in gross income for the taxable year in which the 
termination occurs an amount equal to the fair market value of the 
assets of the fund determined as of the date of termination, reduced 
by--
    (i) The amount of any deemed distribution that was not actually 
distributed before the date of termination if the amount of the deemed 
distribution was included in the gross income of the electing taxpayer 
for the taxable year in which the deemed distribution occurred; and
    (ii) The amount of any tax that--
    (A) Is imposed on the income of the fund;
    (B) Is attributable to income taken into account before the date the 
termination occurs or as a result of the termination; and
    (C) Has not been paid as of the date the termination occurs.

Contributions made to a nuclear decommissioning fund after the 
termination date are not deductible under section 468A(a) and paragraph 
(a) of Sec. 1.468A-2. In addition, if any assets are held by the fund 
after the termination date, the income earned by such assets after the 
termination date must be included in the gross income of the electing 
taxpayer (see section 671) to the extent that such income is otherwise 
includible under chapter 1 of the Internal Revenue Code. Finally, an 
electing taxpayer using an accrual method of accounting is allowed a 
deduction for nuclear decommissioning costs that are incurred during any 
taxable year (see paragraph (e) of Sec. 1.468A-2) even if such costs 
are incurred after substantial completion of decommissioning (e.g., 
expenses incurred to monitor or safeguard the plant site).
    (2) Substantial completion of decommissioning defined. (i) Except as 
otherwise provided in paragraph (d)(2)(ii) of this section, the 
substantial completion of the decommissioning of a nuclear power plant 
occurs on the date that the maximum acceptable radioactivity levels 
mandated by the Nuclear Regulatory Commission with respect to a 
decommissioned nuclear power plant are satisfied (the ``substantial 
completion date'').
    (ii) If a significant portion of the total estimated decommissioning 
costs with respect to a nuclear power plant are not incurred on or 
before the substantial completion date, an electing taxpayer may 
request, and the Internal Revenue Service shall issue, a ruling that 
designates the date on which substantial completion of decommissioning 
occurs. The date designated in the ruling shall not be later than the 
last day of the third taxable year after the taxable year that includes 
the substantial completion date. The request for a ruling under this 
paragraph (d)(2)(ii) must be filed during the taxable year that includes 
the substantial completion date and must comply with the procedural 
rules in effect at the time of the request.

[T.D. 8184, 53 FR 6815, Mar. 3, 1988, as amended by T.D. 8461, 57 FR 
62200, Dec. 30, 1992; T.D. 8580, 59 FR 66474, Dec. 27, 1994; 60 FR 8932, 
Feb. 16, 1995; T.D. 8939, 66 FR 2818, Jan. 12, 2001]



Sec. 1.468A-6  Disposition of an interest in a nuclear power plant.

    (a) In general. This section describes the federal income tax 
consequences of a transfer of the assets of a nuclear decommissioning 
fund (Fund) within the meaning of Sec. 1.468A-1(b)(3) in connection 
with a sale, exchange, or other disposition by a taxpayer (transferor) 
of all or a portion of its qualifying interest in a nuclear power plant 
to another taxpayer (transferee). This section also explains how a 
schedule of ruling amounts will be determined for the transferor and 
transferee.
    (b) Requirements. This section applies if--
    (1) Immediately before the disposition, the transferor maintained a 
Fund with respect to the interest disposed of; and
    (2) Immediately after the disposition--

[[Page 368]]

    (i) The transferee maintains a Fund with respect to the interest 
acquired;
    (ii) The interest acquired is a qualifying interest of the 
transferee in the nuclear power plant;
    (iii) Either a proportionate amount (which could include all) of the 
assets of the transferor's Fund is transferred to a Fund of the 
transferee, or the transferor's entire Fund is transferred to the 
transferee, provided in the latter case (or if the transferee receives 
all of the assets in the transferor's Fund, but not the transferor's 
Fund) that the transferee acquires the transferor's entire qualifying 
interest in the plant; and
    (iv) The transferee continues to satisfy the requirements of Sec. 
1.468A-5(a)(iii), which permits an electing taxpayer to maintain only 
one Fund for each plant.
    (c) Tax consequences. A disposition that satisfies the requirements 
of paragraph (b) of this section will have the following tax 
consequences at the time it occurs:
    (1) The transferor and its Fund. Neither the transferor nor the 
transferor's Fund will recognize gain or loss or otherwise take any 
income or deduction into account by reason of the transfer of a 
proportionate amount of the assets of the transferor's Fund to the 
transferee's Fund (or by reason of the transfer of the transferor's 
entire Fund to the transferee). For purposes of the regulations under 
section 468A, this transfer (or the transfer of the transferor's Fund) 
will not be considered a distribution of assets by the transferor's 
Fund.
    (2) The transferee and its Fund. Neither the transferee nor the 
transferee's Fund will recognize gain or loss or otherwise take any 
income or deduction into account by reason of the transfer of a 
proportionate amount of the assets of the transferor's Fund to the 
transferee's Fund (or by reason of the transfer of the transferor's Fund 
to the transferee). For purposes of the regulations under section 468A, 
this transfer (or the transfer of the transferor's Fund) will not 
constitute a payment or a contribution of assets by the transferee to 
its Fund.
    (3) Basis. Transfers of assets of a Fund to which this section 
applies do not affect basis. Thus, the transferee's Fund will have a 
basis in the assets received from the transferor's Fund that is the same 
as the basis of those assets in the transferor's Fund immediately before 
the disposition.
    (d) Determination of proportionate amount. For purposes of this 
section, a transferor of a qualifying interest in a nuclear power plant 
is considered to transfer a proportionate amount of the assets of its 
Fund to a Fund of a transferee of the interest if, on the date of the 
transfer of the interest, the percentage of the fair market value of the 
Fund's assets that are transferred equals the percentage of the 
transferor's qualifying interest that is transferred.
    (e) Calculation of schedule of ruling amounts for dispositions 
described in this section--(1) Transferor. If a transferor disposes of 
all or a portion of its qualifying interest in a nuclear power plant in 
accordance with this section, the transferor's schedule of ruling 
amounts with respect to the interests disposed of and retained (if any) 
will be determined in accordance with paragraphs (e)(1) (i) and (ii) of 
this section.
    (i) Taxable year of disposition. If a transferor does not file a 
request for a revised schedule of ruling amounts on or before the deemed 
payment deadline for the taxable year of the transferor in which the 
disposition of its interest in the nuclear power plant occurs (that is, 
the date that is two and one-half months after the close of that year), 
the transferor's ruling amount with respect to that plant for that year 
will equal the sum of--
    (A) The ruling amount contained in the transferor's current schedule 
of ruling amounts with respect to that plant for that taxable year 
multiplied by the portion of the qualifying interest that is retained 
(if any); and
    (B) The ruling amount contained in the transferor's current schedule 
of ruling amounts with respect to that plant for that taxable year 
multiplied by the product of--
    (1) The portion of the transferor's qualifying interest that is 
disposed of; and
    (2) A fraction, the numerator of which is the number of days in that 
taxable year that precede the date of

[[Page 369]]

disposition, and the denominator of which is the number of days in that 
taxable year.
    (ii) Taxable years after the year of disposition. A transferor that 
retains a qualifying interest in a nuclear power plant must file a 
request for a revised schedule of ruling amounts with respect to that 
interest on or before the deemed payment deadline for the first taxable 
year of the transferor beginning after the disposition. See Sec. 
1.468A-3(i)(1)(ii)(B). If the transferor does not timely file such a 
request, the transferor's ruling amount with respect to that interest 
for the affected year or years will be zero, unless the Internal Revenue 
Service waives the application of this paragraph (e)(1)(ii) upon a 
showing of good cause for the delay.
    (2) Transferee. If a transferee acquires all or a portion of a 
transferor's qualifying interest in a nuclear power plant under this 
section, the transferee's schedule of ruling amounts with respect to the 
interest acquired will be determined under paragraphs (e)(2) (i) and 
(ii) of this section.
    (i) Taxable year of disposition. If a transferee does not file a 
request for a schedule of ruling amounts on or before the deemed payment 
deadline for the taxable year of the transferee in which the disposition 
occurs (that is, the date that is two and one-half months after the 
close of that year), the transferee's ruling amount with respect to the 
interest acquired in the nuclear power plant for that year is the amount 
described in the following sentence. This amount is the amount contained 
in the transferor's current schedule of ruling amounts for that plant 
for the taxable year of the transferor in which the disposition 
occurred, multiplied by the product of--
    (A) The portion of the transferor's qualifying interest that is 
transferred; and
    (B) A fraction, the numerator of which is the number of days in the 
taxable year of the transferor including and following the date of 
disposition, and the denominator of which is the number of days in that 
taxable year.
    (ii) Taxable years after the year of disposition. A transferee of a 
qualifying interest in a nuclear power plant must file a request for a 
revised schedule of ruling amounts with respect to that interest on or 
before the deemed payment deadline for the first taxable year of the 
transferee beginning after the disposition. See Sec. 1.468A-
3(i)(1)(ii)(B). If the transferee does not timely file such a request, 
the transferee's ruling amount with respect to that interest for the 
affected year or years will be zero, unless the Internal Revenue Service 
waives the application of this paragraph (e)(2)(ii) upon a showing of 
good cause for the delay.
    (3) Example. The following example illustrates the provisions of 
this paragraph (e).

    Example. (i) X Corporation is a calendar year taxpayer engaged in 
the sale of electric energy generated by a nuclear power plant. The 
plant is owned entirely by X. On May 27, 1995, X transfers a 60 percent 
qualifying interest in the plant to Y Corporation, a calendar year 
taxpayer. Before the transfer, X had received a schedule of ruling 
amounts containing an annual ruling amount of $10 million for the 
taxable years 1993 through 2013. For 1995, neither X nor Y files a 
request for a revised schedule of ruling amounts.
    (ii) Under paragraph (e)(1)(i) of this section, X's ruling amount 
for 1995 is calculated as follows: ($10,000,000x40%) + 
($10,000,000x60%x146/365)=$6,400,000. Under paragraph (e)(2)(i) of this 
section, Y's ruling amount for 1995 is calculated as follows: 
$10,000,000x60%x219/365=$3,600,000. Under paragraphs (e)(1)(ii) and 
(e)(2)(ii) of this section, X and Y must file requests for revised 
schedules of ruling amounts by March 15, 1997.

    (f) Calculation of the qualifying percentage after dispositions 
described in this section--(1) In general. If a transferee acquires an 
interest in a nuclear power plant in a transaction that satisfies the 
requirements of this section, the transferee's qualifying percentage 
(within the meaning of Sec. 1.468A-3(d)(4)) for the interest acquired 
is the transferor's qualifying percentage for that interest immediately 
before the disposition. If the Internal Revenue Service has not approved 
a qualifying percentage for the transferor with respect to the interest 
transferred, the qualifying percentage for that interest is determined 
under Sec. 1.468A-3(d)(4).
    (2) Special rule. The Internal Revenue Service may, in its 
discretion, determine a qualifying percentage for an interest in a 
nuclear power plant acquired by a transferee on a basis other

[[Page 370]]

than the rule set forth in paragraph (f)(1) of this section if--
    (i) In connection with its first request for a schedule of ruling 
amounts after the disposition, the transferee requests special 
treatment, explains the need for such treatment, and sets forth an 
alternative basis for determining the qualifying percentage; and
    (ii) The Internal Revenue Service determines that the special 
treatment is consistent with the purposes of section 468A.
    (g) Other--(1) Anti-abuse provision. The Internal Revenue Service 
may treat a disposition occurring on or after December 27, 1994 as 
satisfying the requirements of this section if the Internal Revenue 
Service determines that this treatment is necessary or appropriate to 
carry out the purposes of section 468A and the regulations thereunder.
    (2) Relief provision. Upon request of the electing taxpayer, the 
Internal Revenue Service may treat a disposition occurring after July 
17, 1984, and before December 27, 1994 as satisfying the requirements of 
this section if the Internal Revenue Service determines that this 
treatment is necessary or appropriate to carry out the purposes of 
section 468A and the regulations thereunder.
    (h) Effective date. Section 1.468A-6 is effective for a disposition 
of an interest in a nuclear power plant on or after December 27, 1994.

[T.D. 8580, 59 FR 66474, Dec. 27, 1994]



Sec. 1.468A-7  Manner of and time for making election.

    (a) In general. An eligible taxpayer is allowed a deduction for the 
taxable year in which the taxpayer makes a cash payment (or is deemed to 
make a cash payment) to a nuclear decommissioning fund only if the 
taxpayer elects the application of section 468A. A separate election is 
required for each nuclear decommissioning fund and for each taxable year 
with respect to which payments are to be deducted under section 468A. In 
the case of an affiliated group of corporations that join in the filing 
of a consolidated return for a taxable year, the common parent must make 
a separate election on behalf of each member whose payments to a nuclear 
decommissioning fund during such taxable year are to be deducted under 
section 468A. The election under section 468A for any taxable year is 
irrevocable and must be made by attaching a statement (``Election 
Statement'') and a copy of the schedule of ruling amounts provided 
pursuant to the rules of Sec. 1.468A-3 to the taxpayer's Federal income 
tax return (or, in the case of an affiliated group of corporations that 
join in the filing of a consolidated return, the consolidated return) 
for such taxable year. Except as otherwise provided in paragraph (b)(3) 
of Sec. 1.468A-8, the return to which the Election Statement and a copy 
of the schedule of ruling amounts is attached must be filed on or before 
the time prescribed by law (including extensions) for filing the return 
for the taxable year with respect to which payments are to be deducted 
under section 468A.
    (b) Required information. The Election Statement must include the 
following information:
    (1) The legend ``Election Under Section 468A'' typed or legibly 
printed at the top of the first page.
    (2) The electing taxpayer's name, address and taxpayer 
identification number (or, in the case of an affiliated group of 
corporations that join in the filing of a consolidated return, the name, 
address and taxpayer identification number of each electing taxpayer).
    (3) The taxable year for which the election is made.
    (4) For each nuclear decommissioning fund for which an election is 
made--
    (i) The name and location of the nuclear power plant to which the 
fund relates;
    (ii) The name and employer identification number of the nuclear 
decommissioning fund;
    (iii) The total amount of actual cash payments made to the nuclear 
decommissioning fund during the taxable year that were not treated as 
deemed cash payments under paragraph (c)(1) of Sec. 1.468A-2 for a 
prior taxable year;
    (iv) The total amount of cash payments deemed made to the nuclear 
decommissioning fund under paragraph (c)(1) of Sec. 1.468A-2 for the 
taxable year; and

[[Page 371]]

    (v) The cost of service amount for the taxable year (see paragraph 
(b)(2) of Sec. 1.468A-2).

[T.D. 8184, 53 FR 6818, Mar. 3, 1988]



Sec. 1.468A-8  Effective date and transitional rules.

    (a) Effective date--(1) In general. Section 468A and Sec. Sec. 
1.468A-1 through 1.468A-5, 1.468A-7 and 1.468A-8 are effective on July 
18, 1984, and apply with respect to taxable years ending on or after 
such date.
    (2) Cut-off method applicable to electing taxpayers. Any amount of 
nuclear decommissioning costs taken into account before July 18, 1984, 
for a taxable year beginning before such date, is not allowable as a 
deduction after July 17, 1984, under section 468A(c)(2) and paragraph 
(e) of Sec. 1.468A-2.
    (b) Transitional rules--(1) Time for filing request for schedule of 
ruling amounts. The Internal Revenue Service shall provide a ruling 
amount for any taxable year that ends on or after July 18, 1984, and 
begins before January 1, 1987, if--
    (i) Paragraph (g) of Sec. 1.468A-3 is satisfied for the taxable 
year; and
    (ii) The taxpayer files a request for a schedule of ruling amounts 
that includes a proposed ruling amount for the taxable year on or before 
June 1, 1988.
    (2) Manner of and time for making contributions to a nuclear 
decommissioning fund. (i) The amount of any contribution (including a 
contribution of property allowed under paragraph (b)(2)(ii) of this 
section) to a nuclear decommissioning fund that relates to a taxable 
year that ends on or after July 18, 1984, and begins before January 1, 
1987, shall be deemed made during such taxable year if--
    (A) The taxpayer makes such contribution on or before the 30th day 
after the date the taxpayer receives a ruling amount applicable to such 
taxable year; and
    (B) The taxpayer irrevocably designates the amount of such 
contribution as relating to such taxable year on the Election Statement 
attached to its Federal income tax return (or amended return) for such 
taxable year.
    (ii)(A) An electing taxpayer may contribute property to a nuclear 
decommissioning fund if the property--
    (1) Is described in paragraph (a)(3)(i)(C) of Sec. 1.468-5;
    (2) Was acquired after July 18, 1984, and before March 3, 1988; and
    (3) Is contributed for any taxable year ending after July 18, 1984, 
and beginning before March 3, 1988.
    (B) If a taxpayer contributes property to a nuclear decommissioning 
fund under this paragraph (b)(2)(ii)--
    (1) The amount of the contribution (and the basis of the property to 
the nuclear decommissioning fund) shall equal the fair market value of 
the property on the date the property is contributed to the nuclear 
decommissioning fund;
    (2) The contribution of the property to the nuclear decommissioning 
fund shall be considered a sale or exchange of the property by the 
taxpayer for purposes of section 1001; and
    (3) For purposes of section 1001, the amount realized by the 
taxpayer shall be the fair market value of the property on the date the 
property was contributed to the nuclear decommissioning fund.
    (iii) A fund established by a taxpayer for the purpose of paying the 
decommissioning costs of a nuclear power plant is not treated as a 
nuclear decommissioning fund before the earlier of--
    (A) The date the taxpayer receives an initial schedule of ruling 
amounts with respect to the fund, or
    (B) The first day of the first taxable year of the taxpayer that 
begins on or after January 1, 1987,

even if the taxpayer elects the application of section 468A for a 
taxable year that begins before such date. Any income earned before such 
date by the assets of a fund that satisfies the requirements of Sec. 
1.468A-5 must be included in the gross income of the taxpayer treated 
under section 671 as the owner of such assets.
    (iv) If a fund is first treated as a nuclear decommissioning fund on 
the date described in paragraph (b)(2)(iii) of this section--
    (A) The assets held in the fund on such date shall be treated for 
purposes

[[Page 372]]

of this paragraph (b)(2) as assets contributed to the nuclear 
decommissioning fund on such date; and
    (B) The withdrawal of any such assets on or before the date 
prescribed by law (including extensions) for filing the return of the 
nuclear decommissioning fund for the taxable year that includes such 
date shall be treated in the same manner as the withdrawal of an excess 
contribution (see paragraph (c)(2) of Sec. 1.468A-5).
    (3) Manner of and time for making election. A taxpayer may elect the 
application of section 468A for a taxable year that ends on or after 
July 18, 1984, and begins before January 1, 1987, by attaching the 
Election Statement and a copy of the schedule of ruling amounts to--
    (i) A return that is filed on or before the time prescribed by law 
(including extensions) for filing to return for such taxable year; or
    (ii) An amended return for such taxable year that is filed on or 
before the 90th day after the date that the taxpayer receives a ruling 
amount for such table year.
    (4) Determination of cost of service limitation. (i) For purposes of 
section 468A(b)(1) and paragraph (b)(2)(ii) of Sec. 1.468A-2, 
decommissioning costs included in cost of service for any taxable year 
beginning before January 1, 1987, shall include decommissioning costs 
that can be accurately determined from information contained in the 
regulated books of account or other written records of the taxpayer.
    (ii) For purposes of section 468A(b)(1) and paragraph (b)(2) of 
Sec. 1.468A-2, the cost of service amount applicable to a nuclear 
decommissioning fund for the taxable year that includes July 18, 1984, 
is the amount determined under paragraph (b)(2) of Sec. 1.468A-2 
multiplied by a fraction, the numerator of which is the amount of 
nuclear decommissioning costs that is directly or indirectly charged to 
customers in such taxable year and that is included in the taxable 
income of the taxpayer for such taxable year and the denominator of 
which is the amount of nuclear decommissioning costs that is directly or 
indirectly charged to customers in such taxable year and that would have 
been included in the gross income of the taxpayer if such costs were 
taken into account by the taxpayer in the same manner as amounts charged 
for electric energy (see Sec. 1.88-1). Under the preceding sentence, an 
amount of decommissioning costs is included in the taxable income of a 
taxpayer for the taxable year that includes July 18, 1984, if the amount 
is included in gross income for such taxable year and no deduction 
(other than a deduction allowed under section 468A(a) and paragraph (a) 
of Sec. 1.468A-2) is claimed with respect to such amount for such 
taxable year.
    (5) Assumptions and determinations to be used in determining ruling 
amounts. (i) To the extent consistent with the principles and provisions 
of Sec. 1.468A-3, a ruling amount for any taxable year beginning before 
January 1, 1987, shall be based on the reasonable assumptions and 
determinations used by the applicable public utility commission(s) in 
establishing or approving the amount of decommissioning costs included 
in cost of service for ratemaking purposes for such taxable year.
    (ii) If the applicable public utility commission(s) did not disclose 
the after-tax rate of return used in establishing or approving the 
amount of decommissioning costs included in cost of service for any 
period during a taxable year that ends on or after July 18, 1984, and 
begins before January 1, 1987, the after-tax rate of return during such 
period is equal to 54 percent of the overpayment rate in effect under 
section 6621 during such period.
    (iii) If the applicable public utility commission(s) did not 
disclose the other assumptions and determinations used in establishing 
or approving the amount of decommissioning costs included in cost of 
service for any taxable year that ends on or after July 18, 1984, and 
begins before January 1, 1987, ruling amount for each such taxable year 
shall be determined by taking into account--
    (A) The amount of decommissioning costs included in cost of service 
for such taxable year;
    (B) The qualifying percentage (as determined under paragraph (d)(4) 
of Sec. 1.468A-3 and paragraph (b)(7) of this section); and

[[Page 373]]

    (C) The amount of decommissioning costs included in cost of service 
for any earlier taxable year.
    (6) Exception to level funding limitation. Notwithstanding paragraph 
(b) of Sec. 1.468A-3, the Internal Revenue Service may, in its 
discretion, provide a schedule of ruling amounts specifying a ruling 
amount for a taxable year that ends on or after July 18, 1984, and 
begins before January 1, 1987, that is greater than the ruling amount 
specified in such scedule for a later taxable year.
    (7) Determination of qualifying percentage. (i)(A) The qualifying 
percentage shall be determined under this paragraph (b)(7)(i) if a 
nuclear power plant began commercial operations on or before July 10, 
1986, and a taxpayer--
    (1) Files a request for a schedule of ruling amounts for the nuclear 
decommissioning fund maintained with respect to such nuclear power plant 
on or before June 1, 1988; and
    (2) Elects the application of this paragraph (b)(7)(i) in its 
request for a schedule of ruling amounts.
    (B) If the qualifying percentage is determined under this paragraph 
(b)(7)(i), the estimated period for which the nuclear decommissioning 
fund is to be in effect for purposes of paragraph (d)(4)(ii) of Sec. 
1.468A-3 begins on the later of--
    (1) The first day of the taxable year that includes the date that 
the nuclear power plant began commercial operations; or
    (2) The first day of the taxable year that includes July 18, 1984.
    (ii)(A) The qualifying percentage shall be determined under this 
paragraph (b)(7)(ii) if a nuclear power plant began commercial 
operations before July 18, 1984, and a taxpayer--
    (1) Files a request for a schedule of ruling amounts for the nuclear 
decommissioning fund maintained with respect to such nuclear power plant 
on or before June 1, 1988; and
    (2) Elects the application of this paragraph (b)(7)(ii) in its 
request for a schedule of ruling amounts.
    (B) If the qualifying percentage is determined under this paragraph 
(b)(7)(ii), the estimated period for which the nuclear decommissioning 
fund is to be in effect for purposes of paragraph (d)(4)(ii) of Sec. 
1.468A-3 and the estimated useful life of the nuclear power plant for 
purposes of paragraph (d)(4)(iii) of Sec. 1.468A-3 shall end on the 
earlier of--
    (1) The last day of the taxable year in which it is estimated that 
decommissioning will begin; or
    (2) The last day of the taxable year that includes the expiration 
date of the Nuclear Regulatory Commission operating license as in effect 
on July 18, 1984, without regard to any extensions or amendments 
thereto.
    (iii) In the case of a nuclear power plant that began commercial 
operations before July 18, 1984, and whose estimated useful life for 
ratemaking purposes was adjusted by a public utility commission before 
July 18, 1984, a taxpayer may elect in its request for a schedule of 
ruling amounts to compute the qualifying percentage in accordance with 
the following rules:
    (A) If the taxpayer files a request for a schedule of ruling amounts 
for the nuclear decommissioning fund maintained with respect to such 
nuclear power plant on or before June 1, 1988, the qualifying percentage 
equals the percentage of original depreciation costs (determined without 
regard to capitalized decommissioning costs) with respect to the nuclear 
power plant that remains to be recovered for ratemaking purposes as of 
the first day of the taxable year that includes July 18, 1984.
    (B) If a taxpayer does not file a request for a schedule of ruling 
amounts for the nuclear decommissioning fund maintained with respect to 
such nuclear power plant on or before June 1, 1988, the qualifying 
percentage equals the percentage of original depreciation costs 
(determined without regard to capitalized decommissioning costs) with 
respect to the nuclear power plant that remains to be recovered for 
ratemaking purposes as of the first day of the first taxable year for 
which a deductible payment is made to the nuclear decommissioning fund 
that relates to such nuclear power plant.
    (C) For purposes of this paragraph (b)(7)(iii), original 
depreciation costs with respect to a nuclear power plant include only 
those costs that were taken into account in determining the

[[Page 374]]

amount of depreciation with respect to such plant in the first 
ratemaking proceeding in which such depreciation was treated as a cost 
of service.
    (8) Limitation on payments to a nuclear decommissioning fund--(i) 
The limitation on payments to a nuclear decommissioning fund (see 
section 468A(b) and paragraph (b) of Sec. 1.468A-2) for a taxable year 
that ends on or after July 18, 1984, and begin before January 1, 1987, 
shall be determined under paragraph (b)(8)(ii) of this section if--
    (A) The electing taxpayer receives a ruling amount applicable to 
such taxable year after the deemed payment deadline date for such 
taxable year; and
    (B) The requirements of paragraph (b)(8)(iii) of this section are 
satisfied.
    (ii) If the limitation on payments to a nuclear decommissioning fund 
for a taxable year is determined under this paragraph (b)(8)(ii), the 
maximum amount of payments made (or deemed made) to the nuclear 
decommissioning fund during such taxable year shall not exceed the sum 
of--
    (A) The amount determined under section 468A(b) and paragraph (b) of 
Sec. 1.468A-2 (i.e., the lesser of the cost of service amount or the 
ruling amount) after application of the transitional rules contained in 
paragraph (b)(4), (5), (6) and (7) of this section; and
    (B) The amount of after-tax earnings that would have accumulated to 
the date of actual payment to the nuclear decommissioning fund if the 
amount described in paragraph (b)(8)(ii)(A) of this section had been 
contributed to the nuclear decommissioning fund on the deemed payment 
deadline date for such taxable year.

In determining the after-tax earnings that would have accumulated to the 
date of payment, an electing taxpayer must use the after-tax rate of 
return of the nuclear decommissioning fund that was used in determining 
the initial schedule of ruling amounts.
    (iii) In order to compute the payment limitation under paragraph 
(b)(8)(ii) of this section for any taxable year, an electing taxpayer 
must--
    (A) Indicate on the Election Statement for the taxable year that the 
amount of the deductible payment is greater than the amount determined 
under section 468A(b) and paragraph (b) of Sec. 1.468A-2 because 
paragraph (b)(8) of Sec. 1.468A-8 applies;
    (B) Not have claimed a deduction for the taxable year under section 
468A(a) or paragraph (a) of Sec. 1.468A-2 on any return that is filed 
before the date that a ruling amount is received for the taxable year;
    (C) Not have taken a deduction under section 468A (a) or paragraph 
(a) of Sec. 1.468A-2 into account in determining the amount properly 
estimated as tax for the taxable year under section 6081 (b) (relating 
to the automatic extension for filing corporate income tax returns); and
    (D) Not take the deduction allowed with respect to such payment into 
account in determining the amount of any overpayment of tax (within the 
meaning of section 6611) or underpayment of tax (within the meaning of 
section 6601) for the period ending on the date of such payment (see 
paragraph (b)(9) of this section).
    (iv) The following example illustrates the application of the 
principles of paragraph (b)(8) of this section:

    Example. X corporation is a calendar year, accrual method taxpayer 
engaged in the sale of electric energy generated by a nuclear power 
plant owned by X. On September 15, 1987, X receives a schedule of ruling 
amounts from the Internal Revenue Service that includes a ruling amount 
of $1,000,000 for the 1986 taxable year. For purposes of this example, 
assume that the cost of service amount applicable to the nuclear 
decommissioning fund for the 1986 taxable year is also $1,000,000 and 
that the after-tax rate of return of the nuclear decommissioning fund 
that was used in determining the schedule of ruling amounts is 10 
percent compounded semi-annually. On September 15, 1987, X makes a 
contribution of $1,050,000 to a nuclear decommissioning fund established 
by X. Under paragraph (b)(8)(ii) of this section, this contribution does 
not exceed the limitation on payments for the 1986 taxable year and the 
entire amount of the contribution is deductible for such year. The 
additional $50,000 deductible payment that is allowed under this 
paragraph (b)(8) reflects the foregone earnings of the fund for the six-
month period beginning on the deemed payment deadline date for the 1986 
taxable year (March 15, 1987) and ending on the date of the contribution 
(September 15, 1987).

    (9) Denial of interest on overpayment. If a deduction is allowed by 
reason of paragraph (b)(2) of this section for the

[[Page 375]]

amount of any payment made after the 15th day of the third calendar 
month after the close of the taxable year to which such payment relates, 
such deduction shall not be taken into account in determining the amount 
of any overpayment of tax (within the meaning of section 6611) or 
underpayment of tax (within the meaning of section 6601) for the period 
ending on the date of such payment.
    (10) Determination of addition to tax for failure to pay estimated 
tax. In the case of any taxable year that ends on or after July 18, 
1984, and begins before January 1, 1987, the tax shown on the return for 
such taxable year for purposes of section 6655(b) shall equal the tax 
that would be shown on the return if a deduction were allowed for the 
lesser of--
    (i) The amount of the payment made to the nuclear decommissioning 
fund for such taxable year; or
    (ii) The amount determined under section 468A(b) and paragraph (b) 
of Sec. 1.468A-2 (i.e., the lesser of the cost of service amount or the 
ruling amount) after application of the transitional rules contained in 
paragraph (b)(4), (5), (6) and (7) of this section but without regard to 
the transitional rule contained in paragraph (b)(8) of this section.
    (11) Nuclear decommissioning fund qualification requirements. For 
tax years beginning prior to January 1, 1995, the Service will not 
assert that an unincorporated organization referred to in Sec. 1.468A-
5(a)(1)(iv), established prior to January 1, 1993, through which the 
assets of a nuclear decommissioning fund are invested, is an association 
taxable as a corporation for federal tax purposes.
    (12) Use of formula or method. Section 1.468A-2(f)(3)(ii) and Sec. 
1.468A-3(a)(4) (to the extent it permits a formula or method when the 
applicable public utility commission estimates the cost of 
decommissioning in future dollars), (e)(5), (i)(1)(ii)(A) (to the extent 
it requires the taxpayer to file a request for a revised schedule 
because of a substantial variation in ruling amounts), and 
(i)(1)(iii)(C) apply only to requests for a formula or method submitted 
on or after January 20, 1998 and to formulas and methods obtained in 
response to those requests.

[T.D. 8184, 53 FR 6818, Mar. 3, 1988; 53 FR 9276, Mar. 24, 1988, as 
amended by T.D. 8461, 57 FR 62200, Dec. 30, 1992; T.D. 8758, 63 FR 2894, 
Jan. 20, 1998]



Sec. 1.468B  Designated settlement funds.

    A designated settlement fund, as defined in section 468B(d)(2), is 
taxed in the manner described in Sec. 1.468B-2. The rules for 
transferors to a qualified settlement fund described in Sec. 1.468B-3 
apply to transferors to a designated settlement fund. Similarly, the 
rules for claimants of a qualified settlement fund described in Sec. 
1.468B-4 apply to claimants of a designated settlement fund. A fund, 
account, or trust that does not qualify as a designated settlement fund 
is, however, a qualified settlement fund if it meets the requirements of 
a qualified settlement fund described in Sec. 1.468B-1.

[T.D. 8459, 57 FR 60988, Dec. 23, 1992]



Sec. 1.468B-0  Table of contents.

    This section lists the table of contents for Sec. Sec. 1.468B-1 
through 1.468B-9.

               Sec. 1.468B-1 Qualified settlement funds.

    (a) In general.
    (b) Coordination with other entity classifications.
    (c) Requirements.
    (d) Definitions.
    (1) Transferor.
    (2) Related person.
    (e) Governmental order or approval requirement.
    (1) In general.
    (2) Arbitration panels.
    (f) Resolve or satisfy requirement.
    (1) Liabilities to provide property or services.
    (2) CERCLA liabilities.
    (g) Excluded liabilities.
    (h) Segregation requirement.
    (1) In general.
    (2) Classification of fund established to resolve or satisfy 
allowable and non-allowable claims.
    (i) [Reserved]
    (j) Classification of fund prior to satisfaction of requirements in 
paragraph (c) of this section.
    (1) In general.
    (2) Relation-back rule.
    (i) In general.
    (ii) Relation-back election.
    (k) Election to treat a qualified settlement fund as a subpart E 
trust.

[[Page 376]]

    (1) In general.
    (2) Manner of making grantor trust election.
    (i) In general.
    (ii) Requirements for election statement.
    (3) Effect of making the election.
    (l) Examples.

   Sec. 1.468B-2 Taxation of qualified settlement funds and related 
                      administrative requirements.

    (a) In general.
    (b) Modified gross income.
    (c) Partnership interests held by a qualified settlement fund on 
February 14, 1992.
    (1) In general.
    (2) Limitation on changes in partnership agreements and capital 
contributions.
    (d) Distributions to transferors and claimants.
    (e) Basis of property transferred to a qualified settlement fund.
    (f) Distribution of property.
    (g) Other taxes.
    (h) Denial of credits against tax.
    (i) [Reserved]
    (j) Taxable year and accounting method.
    (k) Treatment as corporation for purposes of subtitle F.
    (l) Information reporting withholding requirements.
    (1) Payments to a qualified settlement fund.
    (2) Payments and distributions by a qualified settlement fund.
    (i) In general.
    (ii) Special rules.
    (m) Request for prompt assessment.
    (n) Examples.

           Sec. 1.468B-3 Rules applicable to the transferor.

    (a) Transfer of property.
    (1) In general.
    (2) Anti-abuse rule.
    (b) Qualified appraisal requirement for transfers of certain 
property.
    (1) In general.
    (2) Provision of copies.
    (3) Qualified appraisal.
    (4) Information included in a qualified appraisal.
    (5) Effect of signature of the qualified appraiser.
    (c) Economic performance.
    (1) In general.
    (2) Right to a refund or reversion.
    (i) In general.
    (ii) Right extinguished.
    (3) Obligations of a transferor.
    (d) Payment of insurance amounts.
    (e) Statement to the qualified settlement fund and the Internal 
Revenue Service.
    (1) In general.
    (2) Required statement.
    (i) In general.
    (ii) Combined statements.
    (f) Distributions to transferors.
    (1) In general.
    (2) Deemed distributions.
    (i) Other liabilities.
    (ii) Constructive receipt.
    (3) Tax benefit rule.
    (g) Example.

        Sec. 1.468B-4 Taxability of distributions to claimants.

   Sec. 1.468B-5 Effective dates and transition rules applicable to 
                       qualified settlement funds.

    (a) In general.
    (b) Taxation of certain pre-1996 fund income.
    (1) Reasonable method.
    (i) In general.
    (ii) Qualified settlement funds established after February 14, 1992, 
but before January 1, 1993.
    (iii) Use of cash method of accounting.
    (iv) Unreasonable position.
    (v) Waiver of penalties.
    (2) Election to apply qualified settlement fund rules.
    (i) In general.
    (ii) Election statement.
    (iii) Due date of returns and amended returns.
    (iv) Computation of interest and waiver of penalties.
    (c) Grantor trust elections under Sec. 1.468B-1(k).
    (1) In general.
    (2) Transition rules.
    (3) Qualified settlement funds established by the U.S. government on 
or before February 3, 2006.

Sec. 1.468B-6 Escrow accounts, trusts, and other funds used in deferred 
  exchanges of like-kind property under section 1031(a)(3). [Reserved]

                   Sec. 1.468B-7 Pre-closing escrows.

    (a) Scope.
    (b) Definitions.
    (c) Taxation of pre-closing escrows.
    (d) Reporting obligations of the administrator.
    (e) Examples.
    (f) Effective dates.
    (1) In general.
    (2) Transition rule.

        Sec. 1.468B-8 Contingent-at-closing escrows. [Reserved]

                Sec. 1.468B-9 Disputed ownership funds.

    (a) Scope.
    (b) Definitions.
    (c) Taxation of a disputed ownership fund.
    (1) In general.
    (2) Exceptions.
    (3) Property received by the disputed ownership fund.
    (i) Generally excluded from income.
    (ii) Basis and holding period.

[[Page 377]]

    (4) Property distributed by the disputed ownership fund.
    (i) Computing gain or loss.
    (ii) Denial of deduction.
    (5) Taxable year and accounting method.
    (6) Unused carryovers.
    (d) Rules applicable to transferors that are not transferor-
claimants.
    (1) Transfer of property.
    (2) Economic performance.
    (i) In general.
    (ii) Obligations of the transferor.
    (3) Distributions to transferors.
    (i) In general.
    (ii) Exception.
    (iii) Deemed distributions.
    (e) Rules applicable to transferor-claimants.
    (1) Transfer of property.
    (2) Economic performance.
    (i) In general.
    (ii) Obligations of the transferor-claimant.
    (3) Distributions to transferor-claimants.
    (i) In general.
    (ii) Deemed distributions.
    (f) Distributions to claimants other than transferor-claimants.
    (g) Statement to the disputed ownership fund and the Internal 
Revenue Service with respect to transfers of property other than cash.
    (1) In general.
    (2) Combined statements.
    (3) Information required on the statement.
    (h) Examples.
    (i) [Reserved]
    (j) Effective dates.
    (1) In general.
    (2) Transition rule.

[T.D. 8459, 57 FR 60988, Dec. 23, 1992, as amended by T.D. 8495, 58 FR 
58787, Nov. 4, 1993; T.D. 9249, 71 FR 6200, Feb. 7, 2006]



Sec. 1.468B-1  Qualified settlement funds.

    (a) In general. A qualified settlement fund is a fund, account, or 
trust that satisfies the requirements of paragraph (c) of this section.
    (b) Coordination with other entity classifications. If a fund, 
account, or trust that is a qualified settlement fund could be 
classified as a trust within the meaning of Sec. 301.7701-4 of this 
chapter, it is classified as a qualified settlement fund for all 
purposes of the Internal Revenue Code (Code). If a fund, account, or 
trust, organized as a trust under applicable state law, is a qualified 
settlement fund, and could be classified as either an association 
(within the meaning of Sec. 301.7701-2 of this chapter) or a 
partnership (within the meaning of Sec. 301.7701-3 of this chapter), it 
is classified as a qualified settlement fund for all purposes of the 
Code. If a fund, account, or trust, established for contested 
liabilities pursuant to Sec. 1.461-2(c)(1) is a qualified settlement 
fund, it is classified as a qualified settlement fund for all purposes 
of the Code.
    (c) Requirements. A fund, account, or trust satisfies the 
requirements of this paragraph (c) if--
    (1) It is established pursuant to an order of, or is approved by, 
the United States, any state (including the District of Columbia), 
territory, possession, or political subdivision thereof, or any agency 
or instrumentality (including a court of law) of any of the foregoing 
and is subject to the continuing jurisdiction of that governmental 
authority;
    (2) It is established to resolve or satisfy one or more contested or 
uncontested claims that have resulted or may result from an event (or 
related series of events) that has occurred and that has given rise to 
at least one claim asserting liability--
    (i) Under the Comprehensive Environmental Response, Compensation and 
Liability Act of 1980 (hereinafter referred to as CERCLA), as amended, 
42 U.S.C. 9601 et seq.; or
    (ii) Arising out of a tort, breach of contract, or violation of law; 
or
    (iii) Designated by the Commissioner in a revenue ruling or revenue 
procedure; and
    (3) The fund, account, or trust is a trust under applicable state 
law, or its assets are otherwise segregated from other assets of the 
transferor (and related persons).
    (d) Definitions. For purposes of this section--
    (1) Transferor. A ``transferor'' is a person that transfers (or on 
behalf of whom an insurer or other person transfers) money or property 
to a qualified settlement fund to resolve or satisfy claims described in 
paragraph (c)(2) of this section against that person.
    (2) Related person. A ``related person'' is any person who is 
related to the transferor within the meaning of sections 267(b) or 
707(b)(1).
    (e) Governmental order or approval requirement--(1) In general. A 
fund, account, or trust is ``ordered by'' or ``approved by'' a 
governmental authority described in paragraph (c)(1) of this

[[Page 378]]

section when the authority issues its initial or preliminary order to 
establish, or grants its initial or preliminary approval of, the fund, 
account, or trust, even if that order or approval may be subject to 
review or revision. Except as otherwise provided in paragraph (j)(2) of 
this section, the governmental authority's order or approval has no 
retroactive effect and does not permit a fund, account, or trust to be a 
qualified settlement fund prior to the date the order is issued or the 
approval is granted.
    (2) Arbitration panels. An arbitration award that orders the 
establishment of, or approves, a fund, account, or trust is an order or 
approval of a governmental authority described in paragraph (c)(1) of 
this section if--
    (i) The arbitration award is judicially enforceable;
    (ii) The arbitration award is issued pursuant to a bona fide 
arbitration proceeding in accordance with rules that are approved by a 
governmental authority described in paragraph (c)(1) of this section 
(such as self-regulatory organization-administered arbitration 
proceedings in the securities industry); and
    (iii) The fund, account, or trust is subject to the continuing 
jurisdiction of the arbitration panel, the court of law that has 
jurisdiction to enforce the arbitration award, or the governmental 
authority that approved the rules of the arbitration proceeding.
    (f) Resolve or satisfy requirement--(1) Liabilities to provide 
services or property. Except as otherwise provided in paragraph (f)(2) 
of this section, a liability is not described in paragraph (c)(2) of 
this section if it is a liability for the provision of services or 
property, unless the transferor's obligation to provide services or 
property is extinguished by a transfer or transfers to the fund, 
account, or trust.
    (2) CERCLA liabilities. A transferor's liability under CERCLA to 
provide services or property is described in paragraph (c)(2) of this 
section if following its transfer to a fund, account, or trust the 
transferor's only remaining liability to the Environmental Protection 
Agency (if any) is a remote, future obligation to provide services or 
property.
    (g) Excluded liabilities. A liability is not described in paragraph 
(c)(2) of this section if it--
    (1) Arises under a workers compensation act or a self-insured health 
plan;
    (2) Is an obligation to refund the purchase price of, or to repair 
or replace, products regularly sold in the ordinary course of the 
transferor's trade or business;
    (3) Is an obligation of the transferor to make payments to its 
general trade creditors or debtholders that relates to a title 11 or 
similar case (as defined in section 368(a)(3)(A)), or a workout; or
    (4) Is designated by the Commissioner in a revenue ruling or a 
revenue procedure (see Sec. 601.601(d)(2)(ii)(b) of this chapter).
    (h) Segregation requirement--(1) In general. If it is not a trust 
under applicable state law, a fund, account, or trust satisfies the 
requirements of paragraph (c)(3) of this section if its assets are 
physically segregated from other assets of the transferor (and related 
persons). For example, cash held by a transferor in a separate bank 
account satisfies the segregation requirement of paragraph (c)(3) of 
this section.
    (2) Classification of fund established to resolve or satisfy 
allowable and non-allowable claims. If a fund, account, or trust is 
established to resolve or satisfy claims described in paragraph (c)(2) 
of this section as well as other types of claims (i.e., non-allowable 
claims) arising from the same event or related series of events, the 
fund is a qualified settlement fund. However, under Sec. 1.468B-3(c), 
economic performance does not occur with respect to transfers to the 
qualified settlement fund for non-allowable claims.
    (i) [Reserved]
    (j) Classification of fund prior to satisfaction of requirements in 
paragraph (c) of this section--(1) In general. If a fund, account, or 
trust is established to resolve or satisfy claims described in paragraph 
(c)(2) of this section, the assets of the fund, account, or trust are 
treated as owned by the transferor of those assets until the fund, 
account, or trust also meets the requirements of paragraphs (c) (1) and 
(3) of this section. On the date the fund, account, or trust satisfies 
all the requirements of

[[Page 379]]

paragraph (c) of this section, the transferor is treated as transferring 
the assets to a qualified settlement fund.
    (2) Relation-back rule--(i) In general. If a fund, account, or trust 
meets the requirements of paragraphs (c)(2) and (c)(3) of this section 
prior to the time it meets the requirements of paragraph (c)(1) of this 
section, the transferor and administrator (as defined in Sec. 1.468B-
2(k)(3)) may jointly elect (a relation-back election) to treat the fund, 
account, or trust as coming into existence as a qualified settlement 
fund on the later of the date the fund, account, or trust meets the 
requirements of paragraphs (c)(2) and (c)(3) of this section or January 
1 of the calendar year in which all the requirements of paragraph (c) of 
this section are met. If a relation-back election is made, the assets 
held by the fund, account, or trust on the date the qualified settlement 
fund is treated as coming into existence are treated as transferred to 
the qualified settlement fund on that date.
    (ii) Relation-back election. A relation-back election is made by 
attaching a copy of the election statement, signed by each transferor 
and the administrator, to (and as part of) the timely filed income tax 
return (including extensions) of the qualified settlement fund for the 
taxable year in which the fund is treated as coming into existence. A 
copy of the election statement must also be attached to (and as part of) 
the timely filed income tax return (including extensions), or an amended 
return that is consistent with the requirements of Sec. Sec. 1.468B-1 
through 1.468B-4, of each transferor for the taxable year of the 
transferor that includes the date on which the qualified settlement fund 
is treated as coming into existence. The election statement must 
contain--
    (A) A legend, ``Sec. 1.468B-1 Relation-Back Election'', at the top 
of the first page;
    (B) Each transferor's name, address, and taxpayer identification 
number;
    (C) The qualified settlement fund's name, address, and employer 
identification number;
    (D) The date as of which the qualified settlement fund is treated as 
coming into existence; and
    (E) A schedule describing each asset treated as transferred to the 
qualified settlement fund on the date the fund is treated as coming into 
existence. The schedule of assets does not have to identify the amount 
of cash or the property treated as transferred by a particular 
transferor. If the schedule does not identify the transferor of each 
asset, however, each transferor must include with the copy of the 
election statement that is attached to its income tax return (or amended 
return) a schedule describing each asset the transferor is treated as 
transferring to the qualified settlement fund.
    (k) Election to treat a qualified settlement fund as a subpart E 
trust--(1) In general. If a qualified settlement fund has only one 
transferor (as defined in paragraph (d)(1) of this section), the 
transferor may make an election (grantor trust election) to treat the 
qualified settlement fund as a trust all of which is owned by the 
transferor under section 671 and the regulations thereunder. A grantor 
trust election may be made whether or not the qualified settlement fund 
would be classified, in the absence of paragraph (b) of this section, as 
a trust all of which is treated as owned by the transferor under section 
671 and the regulations thereunder. A grantor trust election may be 
revoked only for compelling circumstances upon consent of the 
Commissioner by private letter ruling.
    (2) Manner of making grantor trust election--(i) In general. To make 
a grantor trust election, a transferor must attach an election statement 
satisfying the requirements of paragraph (k)(2)(ii) of this section to a 
timely filed (including extensions) Form 1041, ``U.S. Income Tax Return 
for Estates and Trusts,'' that the administrator files on behalf of the 
qualified settlement fund for the taxable year in which the qualified 
settlement fund is established. However, if a Form 1041 is not otherwise 
required to be filed (for example, because the provisions of Sec. 
1.671-4(b) apply), then the transferor makes a grantor trust election by 
attaching an election statement satisfying the requirements of paragraph 
(k)(2)(ii) of this section to a timely filed (including extensions) 
income tax return of the transferor for the taxable

[[Page 380]]

year in which the qualified settlement fund is established. See Sec. 
1.468B-5(c)(2) for transition rules.
    (ii) Requirements for election statement. The election statement 
must include a statement by the transferor that the transferor will 
treat the qualified settlement fund as a grantor trust. The election 
statement must include the transferor's name, address, taxpayer 
identification number, and the legend, ``Sec. 1.468B-1(k) Election.'' 
The election statement and the statement described in Sec. 1.671-4(a) 
may be combined into a single statement.
    (3) Effect of making the election. If a grantor trust election is 
made--
    (i) Paragraph (b) of this section, and Sec. Sec. 1.468B-2, 1.468B-
3, and 1.468B-5(a) and (b) do not apply to the qualified settlement 
fund. However, this section (except for paragraph (b) of this section) 
and Sec. 1.468B-4 apply to the qualified settlement fund;
    (ii) The qualified settlement fund is treated, for Federal income 
tax purposes, as a trust all of which is treated as owned by the 
transferor under section 671 and the regulations thereunder;
    (iii) The transferor must take into account in computing the 
transferor's income tax liability all items of income, deduction, and 
credit (including capital gains and losses) of the qualified settlement 
fund in accordance with Sec. 1.671-3(a)(1); and
    (iv) The reporting obligations imposed by Sec. 1.671-4 on the 
trustee of a trust apply to the administrator.
    (l) Examples. The following examples illustrate the rules of this 
section:

    Example 1. In a class action brought in a United States federal 
district court, the court holds that the defendant, Corporation X, 
violated certain securities laws and must pay damages in the amount of 
$150 million. Pursuant to an order of the court, Corporation X transfers 
$50 million in cash and transfers property with a fair market value of 
$75 million to a state law trust. The trust will liquidate the property 
and distribute the cash proceeds to the plaintiffs in the class action. 
The trust is a qualified settlement fund because it was established 
pursuant to the order of a federal district court to resolve or satisfy 
claims against Corporation X for securities law violations that have 
occurred.
    Example 2. (i) Assume the same facts as in Example 1, except that 
Corporation X and the class of plaintiffs reach an out-of-court 
settlement that requires Corporation X to establish and fund a state law 
trust before the settlement agreement is submitted to the court for 
approval.
    (ii) The trust is not a qualified settlement fund because it neither 
is established pursuant to an order of, nor has it been approved by, a 
governmental authority described in paragraph (c)(1) of this section.
    Example 3. On June 1, 1994, Corporation Y establishes a fund to 
resolve or satisfy claims against it arising from the violation of 
certain securities laws. On that date, Corporation Y transfers $10 
million to a segregated account. On December 1, 1994, a federal district 
court approves the fund. Assuming Corporation Y and the administrator of 
the qualified settlement fund do not make a relation-back election, 
Corporation Y is treated as the owner of the $10 million, and is taxable 
on any income earned on that money, from June 1 through November 30, 
1994. The fund is a qualified settlement fund beginning on December 1, 
1994.
    Example 4. (i) On September 1, 1993, Corporation X, which has a 
taxable year ending on October 31, enters into a settlement agreement 
with a plaintiff class for asserted tort liabilities. Under the 
settlement agreement, Corporation X makes two $50 million payments into 
a segregated fund, one on September 1, 1993, and one on October 1, 1993, 
to resolve or satisfy the tort liabilities. A federal district court 
approves the settlement agreement on November 1, 1993.
    (ii) The administrator of the fund and Corporation X elect to treat 
the fund as a qualified settlement fund prior to governmental approval 
under the relation-back rule of paragraph (j)(2) of this section. The 
administrator must attach the relation-back election statement to the 
fund's income tax return for calendar year 1993, and Corporation X must 
attach the election to its original or amended income tax return for its 
taxable year ending October 31, 1993.
    (iii) Pursuant to the relation-back election, the fund begins its 
existence as a qualified settlement fund on September 1, 1993, and 
Corporation X is treated as transferring $50 million to the qualified 
settlement fund on September 1, 1993, and $50 million on October 1, 
1993.
    (iv) With respect to these transfers, Corporation X must provide the 
statement described in Sec. 1.468B-3(e) to the administrator of the 
qualified settlement fund by February 15, 1994, and must attach a copy 
of this statement to its original or amended income tax return for its 
taxable year ending October 31, 1993.
    Example 5. Assume the same facts as in Example 4, except that the 
court approves the settlement on May 1, 1994. The administrator must 
attach the relation-back election statement to the fund's income tax 
return

[[Page 381]]

for calendar year 1994, and Corporation X must attach the election 
statement to its original or amended income tax return for its taxable 
year ending October 31, 1994. Pursuant to this election, the fund begins 
its existence as a qualified settlement fund on January 1, 1994. In 
addition, Corporation X is treated as transferring to the qualified 
settlement fund all amounts held in the fund on January 1, 1994. With 
respect to the transfer, Corporation X must provide the statement 
described in Sec. 1.468B-3(e) to the administrator of the qualified 
settlement fund by February 15, 1995, and must attach a copy of this 
statement to its income tax return for its taxable year ending October 
31, 1994.
    Example 6. Corporation Z establishes a fund that meets all the 
requirements of section 468B(d)(2) for a designated settlement fund, 
except that Corporation Z does not make the election under section 
468B(d)(2)(F). Although the fund does not qualify as a designated 
settlement fund, it is a qualified settlement fund because the fund 
meets the requirements of paragraph (c) of this section.
    Example 7. Corporation X owns and operates a landfill in State A. 
State A requires Corporation X to transfer money to a trust annually 
based on the total tonnage of material placed in the landfill during the 
year. Under the laws of State A, Corporation X will be required to 
perform (either itself or through contractors) specified closure 
activities when the landfill is full, and the trust assets will be used 
to reimburse Corporation X for those closure costs. The trust is not a 
qualified settlement fund because it is established to secure the 
liability of Corporation X to perform the closure activities.

[T.D. 8459, 57 FR 60989, Dec. 23, 1992; 58 FR 7865, Feb. 10, 1993, as 
amended by T.D. 9249, 71 FR 6201, Feb. 7, 2006]



Sec. 1.468B-2  Taxation of qualified settlement funds and related 
administrative requirements.

    (a) In general. A qualified settlement fund is a United States 
person and is subject to tax on its modified gross income for any 
taxable year at a rate equal to the maximum rate in effect for that 
taxable year under section 1(e).
    (b) Modified gross income. The ``modified gross income'' of a 
qualified settlement fund is its gross income, as defined in section 61, 
computed with the following modifications--
    (1) In general, amounts transferred to the qualified settlement fund 
by, or on behalf of, a transferor to resolve or satisfy a liability for 
which the fund is established are excluded from gross income. However, 
dividends on stock of a transferor (or a related person), interest on 
debt of a transferor (or a related person), and payments in compensation 
for late or delayed transfers, are not excluded from gross income.
    (2) A deduction is allowed for administrative costs and other 
incidental expenses incurred in connection with the operation of the 
qualified settlement fund that would be deductible under chapter 1 of 
the Internal Revenue Code in determining the taxable income of a 
corporation. Administrative costs and other incidental expenses include 
state and local taxes, legal, accounting, and actuarial fees relating to 
the operation of the qualified settlement fund, and expenses arising 
from the notification of claimants and the processing of their claims. 
Administrative costs and other incidental expenses do not include legal 
fees incurred by, or on behalf of, claimants.
    (3) A deduction is allowed for losses sustained by the qualified 
settlement fund in connection with the sale, exchange, or worthlessness 
of property held by the fund to the extent the losses would be 
deductible in determining the taxable income of a corporation under 
section 165 (f) or (g), and sections 1211(a) and 1212(a).
    (4) A deduction is allowed for the amount of a net operating loss of 
the qualified settlement fund to the extent the loss would be deductible 
in determining the taxable income of a corporation under section 172(a). 
For purposes of this paragraph (b)(4), the net operating loss of a 
qualified settlement fund for a taxable year is the amount by which the 
deductions allowed under paragraphs (b)(2) and (b)(3) of this section 
exceed the gross income of the fund computed with the modification 
described in paragraph (b)(1) of this section.
    (c) Partnership interests held by a qualified settlement fund on 
February 14, 1992--(1) In general. For taxable years ending prior to 
January 1, 2003, a qualified settlement fund that holds a partnership 
interest it acquired prior to February 15, 1992, is allowed a deduction 
for its distributive share of that partnership's items of loss, 
deduction, or credit described in section 702(a) that would be 
deductible in determining the taxable income (or in the

[[Page 382]]

case of a credit, the income tax liability) of a corporation to the 
extent of the fund's distributive share of that partnership's items of 
income and gain described in section 702(a) for the same taxable year. 
For purposes of this paragraph (c)(1), a distributive share of a 
partnership credit is treated as a deduction in an amount equal to the 
amount of the credit divided by the rate described in paragraph (a) of 
this section.
    (2) Limitation on changes in partnership agreements and capital 
contributions. For purposes of paragraph (c)(1) of this section, changes 
in a qualified settlement fund's distributive share of items of income, 
gain, loss, deduction, or credit are disregarded if--
    (i) They result from a change in the terms of the partnership 
agreement on or after December 18, 1992, or a capital contribution to 
the partnership on or after December 18, 1992, unless the partnership 
agreement as in effect prior to December 18, 1992, requires the 
contribution; and
    (ii) A principal purpose of the change in the terms of the 
partnership agreement or the capital contribution is to circumvent the 
limitation described in paragraph (c)(1) of this section.
    (d) Distributions to transferors and claimants. Amounts that are 
distributed by a qualified settlement fund to, or on behalf of, a 
transferor or a claimant are not deductible by the fund.
    (e) Basis of property transferred to a qualified settlement fund. A 
qualified settlement fund's initial basis in property it receives from a 
transferor (or from an insurer or other person on behalf of a 
transferor) is the fair market value of that property on the date of 
transfer to the fund.
    (f) Distribution of property. A qualified settlement fund must treat 
a distribution of property as a sale or exchange of that property for 
purposes of section 1001(a). In computing gain or loss, the amount 
realized by the qualified settlement fund is the fair market value of 
the property on the date of distribution.
    (g) Other taxes. The tax imposed under paragraph (a) of this section 
is in lieu of any other taxation of the income of a qualified settlement 
fund under subtitle A of the Internal Revenue Code. Thus, a qualified 
settlement fund is not subject to the alternative minimum tax of section 
55, the accumulated earnings tax of section 531, the personal holding 
company tax of section 541, or the maximum capital gains rate of section 
1(h). A qualified settlement fund is, however, subject to taxes that are 
not imposed on the income of a taxpayer, such as the tax on transfers of 
property to foreign entities under section 1491.
    (h) Denial of credits against tax. The tax imposed on the modified 
gross income of a qualified settlement fund under paragraph (a) of this 
section may not be reduced or offset by any credits against tax provided 
by part IV of subchapter A of chapter 1 of the Internal Revenue Code.
    (i) [Reserved]
    (j) Taxable year and accounting method. The taxable year of a 
qualified settlement fund is the calendar year. A qualified settlement 
fund must use an accrual method of accounting within the meaning of 
section 446(c).
    (k) Treatment as corporation for purposes of subtitle F. Except as 
otherwise provided in Sec. 1.468B-5(b), for purposes of subtitle F of 
the Internal Revenue Code, a qualified settlement fund is treated as a 
corporation and any tax imposed under paragraph (a) of this section is 
treated as a tax imposed by section 11. Subtitle F rules that apply to 
qualified settlement funds include, but are not limited to--
    (1) A qualified settlement fund must file an income tax return with 
respect to the tax imposed under paragraph (a) of this section for each 
taxable year that the fund is in existence, whether or not the fund has 
gross income for that taxable year.
    (2) A qualified settlement fund is in existence for the period 
that--
    (i) Begins on the first date on which the fund is treated as a 
qualified settlement fund under Sec. 1.468B-1; and
    (ii) Ends on the earlier of the date the fund--
    (A) No longer satisfies the requirements of Sec. 1.468B-1; or
    (B) No longer has any assets and will not receive any more 
transfers. (See paragraph (m) of this section for procedures for the 
prompt assessment of tax.)

[[Page 383]]

    (3) The income tax return of the qualified settlement fund must be 
filed on or before March 15 of the year following the close of the 
taxable year of the qualified settlement fund unless the fund is granted 
an extension of time for filing under section 6081. The return must be 
made by the administrator of the qualified settlement fund. The 
``administrator'' (which may include a trustee if the qualified 
settlement fund is a trust) of a qualified settlement fund is, in order 
of priority--
    (i) The person designated, or approved, by the governmental 
authority that ordered or approved the fund for purposes of Sec. 
1.468B-1(c)(1);
    (ii) The person designated in the escrow agreement, settlement 
agreement, or other similar agreement governing the fund;
    (iii) The escrow agent, custodian, or other person in possession or 
control of the fund's assets; or
    (iv) The transferor or, if there are multiple transferors, all the 
transferors, unless an agreement signed by all the transferors 
designates a single transferor as the administrator.
    (4) The administrator of a qualified settlement fund must obtain an 
employer identification number for the fund.
    (5) A qualified settlement fund must deposit all payments of tax 
imposed under paragraph (a) of this section (including any payments of 
estimated tax) with an authorized government depositary in accordance 
with Sec. 1.6302-1.
    (6) A qualified settlement fund is subject to the addition to tax 
imposed by section 6655 in the case of an underpayment of estimated tax 
computed with respect to the tax imposed under paragraph (a) of this 
section. For purposes of section 6655(g)(2), a qualified settlement 
fund's taxable income is its modified gross income and a transferor is 
not considered a predecessor of a qualified settlement fund.
    (l) Information reporting and withholding requirements--(1) Payments 
to a qualified settlement fund. Payments to a qualified settlement fund 
are treated as payments to a corporation for purposes of the information 
reporting requirements of part III of subchapter A of chapter 61 of the 
Internal Revenue Code.
    (2) Payments and distributions by a qualified settlement fund--(i) 
In general. Payments and distributions by a qualified settlement fund 
are subject to the information reporting requirements of part III of 
subchapter A of chapter 61 of the Internal Revenue Code (Code), and the 
withholding requirements of subchapter A of chapter 3 of subtitle A and 
subtitle C of the Code.
    (ii) Special rules. The following rules apply with respect to 
payments and distributions by a qualified settlement fund--
    (A) A qualified settlement fund must make a return for, or must 
withhold tax on, a distribution to a claimant if one or more transferors 
would have been required to make a return or withhold tax had that 
transferor made the distribution directly to the claimant;
    (B) For purposes of sections 6041(a) and 6041A, if a qualified 
settlement fund makes a payment or distribution to a transferor, the 
fund is deemed to make the payment or distribution to the transferor in 
the course of a trade or business;
    (C) For purposes of sections 6041(a) and 6041A, if a qualified 
settlement fund makes a payment or distribution on behalf of a 
transferor or a claimant, the fund is deemed to make the payment or 
distribution to the recipient of that payment or distribution in the 
course of a trade or business;
    (D) With respect to a distribution or payment described in paragraph 
(1)(2)(ii)(C) of this section and the information reporting requirements 
of part III of subchapter A of chapter 61 of the Internal Revenue Code, 
the qualified settlement fund is also deemed to have made the 
distribution or payment to the transferor or claimant.
    (m) Request for prompt assessment. A qualified settlement fund is 
eligible to request the prompt assessment of tax under section 6501(d). 
For purposes of section 6501(d), a qualified settlement fund is treated 
as dissolving on the date the fund no longer has any assets (other than 
a reasonable reserve for potential tax liabilities and related 
professional fees) and will not receive any more transfers.
    (n) Examples. The following examples illustrate the rules of this 
section:


[[Page 384]]


    Example 1. On June 30, 1993, a United States federal district court 
approves the settlement of a lawsuit under which Corporation X must 
transfer $10,833,000 to a qualified settlement fund on August 1, 1993. 
The $10,833,000 includes $10 million of damages incurred by plaintiffs 
on October 1, 1992, and $833,000 of interest calculated at 10 percent 
annually from October 1, 1992, to August 1, 1993. The $833,000 of 
interest is not a payment to the qualified settlement fund in 
compensation for a late or delayed transfer to the fund within the 
meaning of paragraph (b)(1) of this section because the payment of 
$10,833,000 to the fund is not due until August 1, 1993.
    Example 2. Assume the same facts as in Example 1 except that the 
settlement agreement also provides for interest to accrue at a rate of 
12 percent annually on any amount not transferred to the qualified 
settlement fund on August 1, 1993, and the only transfer Corporation X 
makes to the fund is $11,374,650 on January 1, 1994. The additional 
payment of $541,650 ($11,374,650 paid on January 1, 1994, less 
$10,833,000 due on August 1, 1993) is a payment to the qualified 
settlement fund in compensation for a late or delayed transfer to the 
fund within the meaning of paragraph (b)(1) of this section.

[T.D. 8459, 57 FR 60991, Dec. 23, 1992; 58 FR 7865, Feb. 10, 1993]



Sec. 1.468B-3  Rules applicable to the transferor.

    (a) Transfer of property--(1) In general. A transferor must treat a 
transfer of property to a qualified settlement fund as a sale or 
exchange of that property for purposes of section 1001(a). In computing 
the gain or loss, the amount realized by the transferor is the fair 
market value of the property on the date the transfer is made (or is 
treated as made under Sec. 1.468B-1(g)) to the qualified settlement 
fund. Because the issuance of a transferor's debt, obligation to provide 
services or property in the future, or obligation to make a payment 
described in Sec. 1.461-4(g), is generally not a transfer of property 
by the transferor, it generally does not result in gain or loss to the 
transferor under this paragraph (a)(1). If a person other than the 
transferor transfers property to a qualified settlement fund, there may 
be other tax consequences as determined under general federal income tax 
principles.
    (2) Anti-abuse rule. The Commissioner may disallow a loss resulting 
from the transfer of property to a qualified settlement fund if the 
Commissioner determines that a principal purpose for the transfer was to 
claim the loss and--
    (i) The transferor places significant restrictions on the fund's 
ability to use or dispose of the property; or
    (ii) The property (or substantially similar property) is distributed 
to the transferor (or a related person).
    (b) Qualified appraisal requirement for transfers of certain 
property--(1) In general. A transferor must obtain a qualified appraisal 
to support a loss or deduction it claims with respect to a transfer to a 
qualified settlement fund of the following types of property--
    (i) Nonpublicly traded securities (as defined in Sec. 1.170A-
13(c)(7)(ix)) issued by the transferor (or a related person); and
    (ii) Interests in the transferor (if the transferor is a 
partnership) and in a partnership in which the transferor (or a related 
person) is a direct or indirect partner.
    (2) Provision of copies. The transferor must provide a copy of the 
qualified appraisal to the administrator of the qualified settlement 
fund no later than February 15 of the year following the calendar year 
in which the property is transferred. The transferor also must attach a 
copy of the qualified appraisal to (and as part of) its timely filed 
income tax return (including extensions) for the taxable year of the 
transferor in which the transfer is made.
    (3) Qualified appraisal. A ``qualified appraisal'' is a written 
appraisal that--
    (i) Is made within 60 days before or after the date the property is 
transferred to the qualified settlement fund;
    (ii) Is prepared, signed, and dated by an individual who is a 
qualified appraiser within the meaning of Sec. 1.170A-13(c)(5);
    (iii) Includes the information required by paragraph (b)(4) of this 
section; and
    (iv) Does not involve an appraisal fee of the type prohibited by 
Sec. 1.170A-13(c)(6).
    (4) Information included in a qualified appraisal. A qualified 
appraisal must include the following information--
    (i) A description of the appraised property;

[[Page 385]]

    (ii) The date (or expected date) of the property's transfer to the 
qualified settlement fund;
    (iii) The appraised fair market value of the property on the date 
(or expected date) of transfer;
    (iv) The method of valuing the property, such as the comparable 
sales approach;
    (v) The specific basis for the valuation, such as specific 
comparable sales or statistical sampling, including a justification for 
using comparable sales or statistical sampling and an explanation of the 
procedure employed;
    (vi) The terms of any agreement or understanding entered into (or 
expected to be entered into) by or on behalf of the transferor (or a 
related person) or the qualified settlement fund that relates to the 
use, sale, or other disposition of the transferred property, including, 
for example, the terms of any agreement or understanding that 
temporarily or permanently--
    (A) Restricts the qualified settlement fund's right to use or 
dispose of the property; or
    (B) Reserves to, or confers upon, any person other than the 
qualified settlement fund any right (including designating another 
person as having the right) to income from the property, to possess the 
property (including the right to purchase or otherwise acquire the 
property), or to exercise any voting rights with respect to the 
property;
    (vii) The name, address, and taxpayer identification number of the 
qualified appraiser; and if the qualified appraiser is acting in his or 
her capacity as a partner in a partnership, an employee of any person, 
or an independent contractor engaged by a person other than the 
transferor, the name, address, and taxpayer identification number of the 
partnership or the person who employs or engages the qualified 
appraiser;
    (viii) The qualifications of the qualified appraiser, including the 
appraiser's background, experience, education, and membership, if any, 
in professional appraisal associations; and
    (ix) A statement that the appraisal was prepared for income tax 
purposes.
    (5) Effect of signature of the qualified appraiser. Any appraiser 
who falsely or fraudulently overstates the value of the transferred 
property referred to in a qualified appraisal may be subject to a civil 
penalty under section 6701 for aiding and abetting an understatement of 
tax liability and may have appraisals disregarded pursuant to 31 U.S.C. 
330(c).
    (c) Economic performance--(1) In general. Except as otherwise 
provided in this paragraph (c), for purposes of section 461(h), economic 
performance occurs with respect to a liability described in Sec. 
1.468B-1(c)(2) (determined with regard to Sec. 1.468B-1(f) and (g)) to 
the extent the transferor makes a transfer to a qualified settlement 
fund to resolve or satisfy the liability.
    (2) Right to a refund or reversion--(i) In general. Economic 
performance does not occur to the extent--
    (A) The transferor (or a related person) has a right to a refund or 
reversion of a transfer if that right is exercisable currently and 
without the agreement of an unrelated person that is independent or has 
an adverse interest (e.g., the court or agency that approved the fund, 
or the fund claimants); or
    (B) Money or property is transferred under conditions that allow its 
refund or reversion by reason of the occurrence of an event that is 
certain to occur, such as the passage of time, or if restrictions on its 
refund or reversion are illusory.
    (ii) Right extinguished. With respect to a transfer described in 
paragraph (c)(2)(i) of this section, economic performance is deemed to 
occur on the date, and to the extent, the transferor's right to a refund 
or reversion is extinguished.
    (3) Obligations of a transferor. Economic performance does not occur 
when a transferor transfers to a qualified settlement fund its debt (or 
the debt of a related person). Instead, economic performance occurs as 
the transferor (or related person) makes principal payments on the debt. 
Similarly, economic performance does not occur when a transferor 
transfers to a qualified settlement fund its obligation (or the 
obligation of a related person) to provide services or property in the 
future, or to make a payment described in Sec. 1.461-4(g). Instead, 
economic performance with respect to such an obligation occurs as 
services, property or

[[Page 386]]

payments are provided or made to the qualified settlement fund or a 
claimant.
    (d) Payment of insurance amounts. No deduction is allowed to a 
transferor for a transfer to a qualified settlement fund to the extent 
the transferred amounts represent amounts received from the settlement 
of an insurance claim and are excludable from gross income. If the 
settlement of an insurance claim occurs after a transferor makes a 
transfer to a qualified settlement fund for which a deduction has been 
taken, the transferor must include in income the amounts received from 
the settlement of the insurance claim to the extent of the deduction.
    (e) Statement to the qualified settlement fund and the Internal 
Revenue Service--(1) In general. A transferor must provide the statement 
described in paragraph (e)(2) of this section to the administrator of a 
qualified settlement fund no later than February 15 of the year 
following each calendar year in which the transferor (or an insurer or 
other person on behalf of the transferor) makes a transfer to the fund. 
The transferor must attach a copy of the statement to (and as part of) 
its timely filed income tax return (including extensions) for the 
taxable year of the transferor in which the transfer is made.
    (2) Required statement--(i) In general. The statement required by 
this paragraph (e) must provide the following information--
    (A) A legend, ``Sec. 1.468B-3 Statement'', at the top of the first 
page;
    (B) The transferor's name, address, and taxpayer identification 
number;
    (C) The qualified settlement fund's name, address, and employer 
identification number;
    (D) The date of each transfer;
    (E) The amount of cash transferred; and
    (F) A description of property transferred and its fair market value 
on the date of transfer.
    (ii) Combined statements. If a qualified settlement fund has more 
than one transferor, any two or more of the transferors may provide a 
combined statement to the administrator that does not identify the 
amount of cash or the property transferred by a particular transferor. 
If a combined statement is used, however, each transferor must include 
with its copy of the statement that is attached to its income tax return 
a schedule describing each asset that the transferor transferred to the 
qualified settlement fund.
    (f) Distributions to transferors--(1) In general. A transferor must 
include in gross income any distribution (including a deemed 
distribution described in paragraph (f)(2) of this section) it receives 
from a qualified settlement fund. If property is distributed, the amount 
includible in gross income and the basis in that property, is the fair 
market value of the property on the date of the distribution.
    (2) Deemed distributions--(i) Other liabilities. If a qualified 
settlement fund makes a distribution on behalf of a transferor to a 
person that is not a claimant, or to a claimant to resolve or satisfy a 
liability of the transferor (or a related person) other than a liability 
described in Sec. 1.468B-1(c)(2) for which the fund was established, 
the distribution is deemed made by the fund to the transferor. The 
transferor, in turn, is deemed to have made a payment to the actual 
recipient.
    (ii) Constructive receipt. To the extent a transferor acquires a 
right to a refund or reversion described in paragraph (c)(2) of this 
section of all or a portion of the assets of a qualified settlement fund 
subsequent to the transfer of those assets to the fund, the fund is 
deemed to distribute those assets to the transferor on the date the 
right is acquired.
    (3) Tax benefit rule. A distribution described in paragraph (f)(1) 
or (f)(2) of this section is excluded from the gross income of a 
transferor to the extent provided by section 111(a).
    (g) Example. The following example illustrates the rules of this 
section:

    Example. On March 1, 1993, Individual A transfers $1 million to a 
qualified settlement fund to resolve or satisfy claims against him 
resulting from certain violations of securities laws. Individual A uses 
the cash receipts and disbursements method of accounting. Since 
Individual A does not use the accrual method of accounting, the economic 
performance rules of paragraph (c) of this section are not applicable. 
Therefore, whether, when, and to what extent Individual A can

[[Page 387]]

deduct the transfer is determined under applicable provisions of the 
Internal Revenue Code, such as sections 162 and 461.

[T.D. 8459, 57 FR 60992, Dec. 23, 1992]



Sec. 1.468B-4  Taxability of distributions to claimants.

    Whether a distribution to a claimant is includible in the claimant's 
gross income is generally determined by reference to the claim in 
respect of which the distribution is made and as if the distribution 
were made directly by the transferor. For example, to the extent a 
distribution is in satisfaction of damages on account of personal injury 
or sickness, the distribution may be excludable from gross income under 
section 104(a)(2). Similarly, to the extent a distribution is in 
satisfaction of a claim for foregone taxable interest, the distribution 
is includible in the claimant's gross income under section 61(a)(4).

[T.D. 8459, 57 FR 60994, Dec. 23, 1992]



Sec. 1.468B-5  Effective dates and transition rules applicable to 
qualified settlement funds.

    (a) In general. Section 468B, including section 468B(g), is 
effective as provided in the Tax Reform Act of 1986 and the Technical 
and Miscellaneous Revenue Act of 1988. Except as otherwise provided in 
this section, Sec. Sec. 1.468B-1 through 1.468-4 are effective on 
January 1, 1993. Thus, the regulations apply to income of a qualified 
settlement fund earned after December 31, 1992, transfers to a fund 
after December 31, 1992, and distributions from a fund after December 
31, 1992. For purposes of Sec. 1.468B-3(c) (relating to economic 
performance), previously transferred assets held by a qualified 
settlement fund on the date these regulations first apply to the fund 
(i.e., January 1, 1993, or the earlier date provided under paragraph 
(b)(2) of this section) are treated as transferred to the fund on that 
date, to the extent no taxpayer has previously claimed a deduction for 
the transfer.
    (b) Taxation of certain pre-1996 fund income--(1) Reasonable 
method--(i) In general. With respect to a fund, account, or trust 
established after August 16, 1986, but prior to February 15, 1992, that 
satisfies (or, if it no longer exists, would have satisfied) the 
requirements of Sec. 1.468B-1(c), the Internal Revenue Service will not 
challenge a reasonable, consistently applied method of taxation for 
transfers to the fund, income earned by the fund, and distributions made 
by the fund after August 16, 1986, but prior to January 1, 1996. A 
method is generally considered reasonable if, depending on the facts and 
circumstances, all transferors and the administrator of the fund have 
consistently treated transfers to the fund, income earned by the fund, 
and distributions made by the fund after August 16, 1986, as if the fund 
were--
    (A) A grantor trust and the transferors are the grantors;
    (B) A complex trust and the transferors are the grantors; or
    (C) A designated settlement fund.
    (ii) Qualified settlement funds established after February 14, 1992, 
but before January 1, 1993. With respect to a fund, account, or trust 
established after February 14, 1992, but prior to January 1, 1993, that 
satisfies the requirements of Sec. 1.468B-1(c), the Internal Revenue 
Service will not challenge a reasonable, consistently applied method of 
taxation as described in paragraph (b)(1)(i) of this section for 
transfers to, income earned by, and distributions made by the fund prior 
to January 1, 1993. However, pursuant to paragraph (a) of this section, 
sections 1.468B-1 through 1.468B-4 apply to transfers to, income earned 
by, and distributions made by the qualified settlement fund after 1992.
    (iii) Use of cash method of accounting. For purposes of paragraphs 
(b)(i) and (b)(ii) of this section, for taxable years beginning prior to 
January 1, 1996, the Internal Revenue Service will not challenge the use 
of the cash receipts and disbursement method of accounting by a fund, 
account, or trust.
    (iv) Unreasonable position. In no event is it a reasonable position 
to assert, pursuant to Rev. Rul. 71-119 (see Sec. 601.601(d)(2)(ii)(b) 
of this chapter), that there is no current taxation of the income of a 
fund established after August 16, 1986.
    (v) Waiver of penalties. For taxable years beginning prior to 
January 1, 1993, if a fund, account or trust is subject to section 
468B(g) and the Internal

[[Page 388]]

Revenue Service does not challenge the method of taxation for transfers 
to, income earned by, and distributions made by, the fund pursuant to 
paragraph (b)(1)(i) or (b)(1)(ii) of this section, penalties will not be 
imposed in connection with the use of such method. For example, the 
penalties under section 6655 for failure to pay estimated tax, section 
6651(a)(1) for failure to file a return, section 6651(a)(2) for failure 
to pay tax, section 6656 for failure to make deposit of taxes, and 
section 6662 for accuracy-related underpayments will generally not be 
imposed.
    (2) Election to apply qualified settlement fund rules--(i) In 
general. The person that will be the administrator of a qualified 
settlement fund may elect to apply Sec. Sec. 1.468B-1 through 1.468B-4 
to transfers to, income earned by, and distributions made by, the fund 
in taxable years ending after August 16, 1986. The election is effective 
beginning on the first day of the earliest open taxable year of the 
qualified settlement fund. For purposes of this paragraph (b)(2), a 
taxable year is considered open if the period for assessment and 
collection of tax has not expired pursuant to the rules of section 6501. 
The election statement must provide the information described in 
paragraph (b)(2)(ii) of this section and must be signed by the person 
that will be the administrator. Such person must also provide each 
transferor of the qualified settlement fund with a copy of the election 
statement on or before March 15, 1993.
    (ii) Election statement. The election statement must provide the 
following information--
    (A) A legend, ``Sec. 1.468B-5(b)(2) Election'', at the top of the 
first page;
    (B) Each transferor's name, address, and taxpayer identification 
number;
    (C) The qualified settlement fund's name, address, and employer 
identification number; and
    (D) The date the qualified settlement fund was established within 
the meaning of Sec. 1.468B-1(j).
    (iii) Due date of returns and amended returns. The election 
statement described in paragraph (b)(2)(ii) of this section must be 
filed with, and as part of, the qualified settlement fund's timely filed 
tax return for the taxable year ended December 31, 1992. In addition, 
the qualified settlement fund must file an amended return that is 
consistent with the requirements of Sec. Sec. 1.468B-1 through 1.468B-4 
for any taxable year to which the election applies in which the fund 
took a position inconsistent with those requirements. Any such amended 
return must be filed no later than March 15, 1993, and must include a 
copy of the election statement described in paragraph (b)(2)(ii) of this 
section.
    (iv) Computation of interest and waiver of penalties. For purposes 
of section 6601 and section 6611, the income tax return for each taxable 
year of the qualified settlement fund to which the election applies is 
due on March 15 of the year following the taxable year of the fund. For 
taxable years of a qualified settlement fund ending prior to January 1, 
1993, the income earned by the fund is deemed to have been earned on 
December 31 of each taxable year for purposes of section 6655. Thus, the 
addition to tax for failure to pay estimated tax under section 6655 will 
not be imposed. The penalty for failure to file a return under section 
6651(a)(1), the penalty for failure to pay tax under section 6651(a)(2), 
the penalty for failure to make deposit of taxes under section 6656, and 
the accuracy-related penalty under section 6662 will not be imposed on a 
qualified settlement fund if the fund files its tax returns for taxable 
years ending prior to January 1, 1993, and pays any tax due for those 
taxable years, on or before March 15, 1993.
    (c) Grantor trust elections under Sec. 1.468B-1(k)--(1) In general. 
A transferor may make a grantor trust election under Sec. 1.468B-1(k) 
if the qualified settlement fund is established after February 3, 2006.
    (2) Transition rules. A transferor may make a grantor trust election 
under Sec. 1.468B-1(k) for a qualified settlement fund that was 
established on or before February 3, 2006, if the applicable period of 
limitation on filing an amended return has not expired for both the 
qualified settlement fund's first taxable year and all subsequent 
taxable years and the transferor's corresponding taxable year or years. 
A grantor trust election under this paragraph (c)(2) requires that the 
returns of

[[Page 389]]

the qualified settlement fund and the transferor for all affected 
taxable years are consistent with the grantor trust election. This 
requirement may be satisfied by timely filed original returns or amended 
returns filed before the applicable period of limitation expires.
    (3) Qualified settlement funds established by the U.S. government on 
or before February 3, 2006. If the U.S. government, or any agency or 
instrumentality thereof, established a qualified settlement fund on or 
before February 3, 2006, and the fund would have been classified as a 
trust all of which is treated as owned by the U.S. government under 
section 671 and the regulations thereunder without regard to the 
regulations under section 468B, then the U.S. government is deemed to 
have made a grantor trust election under Sec. 1.468B-1(k), and the 
election is applicable for all taxable years of the fund.

[T.D. 8459, 57 FR 60994, Dec. 23, 1992, as amended by T.D. 9249, 71 FR 
6201, Feb. 7, 2006]



Sec. 1.468B-6  Escrow accounts, trusts, and other funds used in 
deferred exchanges of like-kind property under section 1031(a)(3). 
[Reserved]



Sec. 1.468B-7  Pre-closing escrows.

    (a) Scope. This section provides rules under section 468B(g) for the 
current taxation of income of a pre-closing escrow.
    (b) Definitions. For purposes of this section--
    (1) A pre-closing escrow is an escrow account, trust, or fund--
    (i) Established in connection with the sale or exchange of real or 
personal property;
    (ii) Funded with a down payment, earnest money, or similar payment 
that is deposited into the escrow prior to the sale or exchange of the 
property;
    (iii) Used to secure the obligation of the purchaser to pay the 
purchase price for the property;
    (iv) The assets of which, including any income earned thereon, will 
be paid to the purchaser or otherwise distributed for the purchaser's 
benefit when the property is sold or exchanged (for example, by being 
distributed to the seller as a credit against the purchase price); and
    (v) Which is not an escrow account or trust established in 
connection with a deferred exchange under section 1031(a)(3).
    (2) Purchaser means, in the case of an exchange, the intended 
transferee of the property whose obligation to pay the purchase price is 
secured by the pre-closing escrow;
    (3) Purchase price means, in the case of an exchange, the required 
consideration for the property; and
    (4) Administrator means the escrow agent, escrow holder, trustee, or 
other person responsible for administering the pre-closing escrow.
    (c) Taxation of pre-closing escrows. The purchaser must take into 
account in computing the purchaser's income tax liability all items of 
income, deduction, and credit (including capital gains and losses) of 
the pre-closing escrow. In the case of an exchange with a single pre-
closing escrow funded by two or more purchasers, each purchaser must 
take into account in computing the purchaser's income tax liability all 
items of income, deduction, and credit (including capital gains and 
losses) earned by the pre-closing escrow with respect to the money or 
property deposited in the pre-closing escrow by or on behalf of that 
purchaser.
    (d) Reporting obligations of the administrator. For each calendar 
year (or portion thereof) that a pre-closing escrow is in existence, the 
administrator must report the income of the pre-closing escrow on Form 
1099 to the extent required by the information reporting provisions of 
subpart B, Part III, subchapter A, chapter 61, Subtitle F of the 
Internal Revenue Code and the regulations thereunder. See Sec. 1.6041-
1(f) for rules relating to the amount to be reported when fees, 
expenses, or commissions owed by a payee to a third party are deducted 
from a payment.
    (e) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. P enters into a contract with S for the purchase of 
residential property owned by S for the price of $200,000. P is required 
to deposit $10,000 of earnest money into an escrow. At closing, the 
$10,000 and the interest earned thereon will be credited against the 
purchase price of the property.

[[Page 390]]

The escrow is a pre-closing escrow. P is taxable on the interest earned 
on the pre-closing escrow prior to closing.
    Example 2. X and Y enter into a contract in which X agrees to 
exchange certain construction equipment for residential property owned 
by Y. The contract requires X and Y to each deposit $10,000 of earnest 
money into an escrow. At closing, $10,000 and the interest earned 
thereon will be paid to X and $10,000 and the interest earned thereon 
will be paid to Y. The escrow is a pre-closing escrow. X is taxable on 
the interest earned prior to closing on the $10,000 of funds X deposited 
in the pre-closing escrow. Similarly, Y is taxable on the interest 
earned prior to closing on the $10,000 of funds Y deposited in the pre-
closing escrow.

    (f) Effective dates--(1) In general. This section applies to pre-
closing escrows established after February 3, 2006.
    (2) Transition rule. With respect to a pre-closing escrow 
established after August 16, 1986, but on or before February 3, 2006, 
the Internal Revenue Service will not challenge a reasonable, 
consistently applied method of taxation for income earned by the escrow 
or a reasonable, consistently applied method for reporting the income.

[T.D. 9249, 71 FR 6202, Feb. 7, 2006]



Sec. 1.468B-8  Contingent-at-closing escrows. [Reserved]



Sec. 1.468B-9  Disputed ownership funds.

    (a) Scope. This section provides rules under section 468B(g) 
relating to the current taxation of income of a disputed ownership fund.
    (b) Definitions. For purposes of this section--
    (1) Disputed ownership fund means an escrow account, trust, or fund 
that--
    (i) Is established to hold money or property subject to conflicting 
claims of ownership;
    (ii) Is subject to the continuing jurisdiction of a court;
    (iii) Requires the approval of the court to pay or distribute money 
or property to, or on behalf of, a claimant, transferor, or transferor-
claimant; and
    (iv) Is not a qualified settlement fund under Sec. 1.468B-1, a 
bankruptcy estate (or part thereof) resulting from the commencement of a 
case under title 11 of the United States Code, or a liquidating trust 
under Sec. 301.7701-4(d) of this chapter (except as provided in 
paragraph (c)(2)(ii) of this section);
    (2) Administrator means a person designated as such by a court 
having jurisdiction over a disputed ownership fund, however, if no 
person is designated, the administrator is the escrow agent, escrow 
holder, trustee, receiver, or other person responsible for administering 
the fund;
    (3) Claimant means a person who claims ownership of, in whole or in 
part, or a legal or equitable interest in, money or property immediately 
before and immediately after that property is transferred to a disputed 
ownership fund;
    (4) Court means a court of law or equity of the United States or of 
any state (including the District of Columbia), territory, possession, 
or political subdivision thereof;
    (5) Disputed property means money or property held in a disputed 
ownership fund subject to the claimants' conflicting claims of 
ownership;
    (6) Related person means any person that is related to a transferor 
within the meaning of section 267(b) or 707(b)(1);
    (7) Transferor means, in general, a person that transfers disputed 
property to a disputed ownership fund, except that--
    (i) If disputed property is transferred by an agent, fiduciary, or 
other person acting in a similar capacity, the transferor is the person 
on whose behalf the agent, fiduciary, or other person acts; and
    (ii) A payor of interest or other income earned by a disputed 
ownership fund is not a transferor within the meaning of this section 
(unless the payor is also a claimant);
    (8) Transferor-claimant means a transferor that claims ownership of, 
in whole or in part, or a legal or equitable interest in, the disputed 
property immediately before and immediately after that property is 
transferred to the disputed ownership fund. Because a transferor-
claimant is both a transferor and a claimant, generally the terms 
transferor and claimant also include a transferor-claimant. See 
paragraph (d) of this section for rules applicable only to transferors 
that are not transferor-claimants and paragraph (e)

[[Page 391]]

of this section for rules applicable only to transferors that are also 
transferor-claimants.
    (c) Taxation of a disputed ownership fund--(1) In general. For 
Federal income tax purposes, a disputed ownership fund is treated as the 
owner of all assets that it holds. A disputed ownership fund is treated 
as a C corporation for purposes of subtitle F of the Internal Revenue 
Code, and the administrator of the fund must obtain an employer 
identification number for the fund, make all required income tax and 
information returns, and deposit all tax payments. Except as otherwise 
provided in this section, a disputed ownership fund is taxable as--
    (i) A C corporation, unless all the assets transferred to the fund 
by or on behalf of transferors are passive investment assets. For 
purposes of this section, passive investment assets are assets of the 
type that generate portfolio income within the meaning of Sec. 1.469-
2T(c)(3)(i); or
    (ii) A qualified settlement fund, if all the assets transferred to 
the fund by or on behalf of transferors are passive investment assets. A 
disputed ownership fund taxable as a qualified settlement fund under 
this section is subject to all the provisions contained in Sec. 1.468B-
2, except that the rules contained in paragraphs (c)(3), (4), and 
(c)(5)(i) of this section apply in lieu of the rules in Sec. 1.468B-
2(b)(1), (d), (e), (f) and (j).
    (2) Exceptions. (i) The claimants to a disputed ownership fund may 
submit a private letter ruling request proposing a method of taxation 
different than the method provided in paragraph (c)(1) of this section.
    (ii) The trustee of a liquidating trust established pursuant to a 
plan confirmed by the court in a case under title 11 of the United 
States Code may, in the liquidating trust's first taxable year, elect to 
treat an escrow account, trust, or fund that holds assets of the 
liquidating trust that are subject to disputed claims as a disputed 
ownership fund. Pursuant to this election, creditors holding disputed 
claims are not treated as transferors of the money or property 
transferred to the disputed ownership fund. A trustee makes the election 
by attaching a statement to the timely filed Federal income tax return 
of the disputed ownership fund for the taxable year for which the 
election becomes effective. The election statement must include a 
statement that the trustee will treat the escrow account, trust, or fund 
as a disputed ownership fund and must include a legend, ``Sec. 1.468B-
9(c) Election,'' at the top of the page. The election may be revoked 
only upon consent of the Commissioner by private letter ruling.
    (3) Property received by the disputed ownership fund--(i) Generally 
excluded from income. In general, a disputed ownership fund does not 
include an amount in income on account of a transfer of disputed 
property to the disputed ownership fund. However, the accrual or receipt 
of income from the disputed property in a disputed ownership fund is not 
a transfer of disputed property to the fund. Therefore, a disputed 
ownership fund must include in income all income received or accrued 
from the disputed property, including items such as--
    (A) Payments to a disputed ownership fund made in compensation for 
late or delayed transfers of money or property;
    (B) Dividends on stock of a transferor (or a related person) held by 
the fund; and
    (C) Interest on debt of a transferor (or a related person) held by 
the fund.
    (ii) Basis and holding period. In general, the initial basis of 
property transferred by, or on behalf of, a transferor to a disputed 
ownership fund is the fair market value of the property on the date of 
transfer to the fund, and the fund's holding period begins on the date 
of the transfer. However, if the transferor is a transferor-claimant, 
the fund's initial basis in the property is the same as the basis of the 
transferor-claimant immediately before the transfer to the fund, and the 
fund=s holding period for the property is determined under section 
1223(2).
    (4) Property distributed by the disputed ownership fund--(i) 
Computing gain or loss. Except in the case of a distribution or deemed 
distribution described in paragraph (e)(3) of this section, a disputed 
ownership fund must treat a distribution of disputed property as a sale 
or exchange of that property for

[[Page 392]]

purposes of section 1001(a). In computing gain or loss, the amount 
realized by the disputed ownership fund is the fair market value of that 
property on the date of distribution.
    (ii) Denial of deduction. A disputed ownership fund is not allowed a 
deduction for a distribution of disputed property or of the net after-
tax income earned by the disputed ownership fund made to or on behalf of 
a transferor or claimant.
    (5) Taxable year and accounting method. (i) A disputed ownership 
fund taxable as a C corporation under paragraph (c)(1)(i) of this 
section may compute taxable income under any accounting method allowable 
under section 446 and is not subject to the limitations contained in 
section 448. A disputed ownership fund taxable as a C corporation may 
use any taxable year allowable under section 441.
    (ii) A disputed ownership fund taxable as a qualified settlement 
fund under paragraph (c)(1)(ii) of this section may compute taxable 
income under any accounting method allowable under section 446 and may 
use any taxable year allowable under section 441.
    (iii) Appropriate adjustments must be made by a disputed ownership 
fund or transferors to the fund to prevent the fund and the transferors 
from taking into account the same item of income, deduction, gain, loss, 
or credit (including capital gains and losses) more than once or from 
omitting such items. For example, if a transferor that is not a 
transferor-claimant uses the cash receipts and disbursements method of 
accounting and transfers an account receivable to a disputed ownership 
fund that uses an accrual method of accounting, at the time of the 
transfer of the account receivable to the disputed ownership fund, the 
transferor must include in its gross income the value of the account 
receivable because, under paragraph (c)(3)(ii) of this section, the 
disputed ownership fund will take a fair market value basis in the 
receivable and will not include the fair market value in its income when 
received from the transferor or when paid by the customer. If the 
account receivable were transferred to the disputed ownership fund by a 
transferor-claimant using the cash receipts and disbursements method, 
however, the disputed ownership fund would take a basis in the 
receivable equal to the transferor's basis, or $0, and would be required 
to report the income upon collection of the account.
    (6) Unused carryovers. Upon the termination of a disputed ownership 
fund, if the fund has an unused net operating loss carryover under 
section 172, an unused capital loss carryover under section 1212, or an 
unused tax credit carryover, or if the fund has, for its last taxable 
year, deductions in excess of gross income, the claimant to which the 
fund's net assets are distributable will succeed to and take into 
account the fund's unused net operating loss carryover, unused capital 
loss carryover, unused tax credit carryover, or excess of deductions 
over gross income for the last taxable year of the fund. If the fund's 
net assets are distributable to more than one claimant, the unused net 
operating loss carryover, unused capital loss carryover, unused tax 
credit carryover, or excess of deductions over gross income for the last 
taxable year must be allocated among the claimants in proportion to the 
value of the assets distributable to each claimant from the fund. Unused 
carryovers described in this paragraph (c)(6) are not money or other 
property for purposes of paragraph (e)(3)(ii) of this section and thus 
are not deemed transferred to a transferor-claimant before being 
transferred to the claimants described in this paragraph (c)(6).
    (d) Rules applicable to transferors that are not transferor-
claimants. The rules in this paragraph (d) apply to transferors (as 
defined in paragraph (b)(7) of this section) that are not transferor-
claimants (as defined in paragraph (b)(8) of this section).
    (1) Transfer of property. A transferor must treat a transfer of 
property to a disputed ownership fund as a sale or other disposition of 
that property for purposes of section 1001(a). In computing the gain or 
loss on the disposition, the amount realized by the transferor is the 
fair market value of the property on the date the transfer is made to 
the disputed ownership fund.
    (2) Economic performance--(i) In general. For purposes of section 
461(h), if a

[[Page 393]]

transferor using an accrual method of accounting has a liability for 
which economic performance would otherwise occur under Sec. 1.461-4(g) 
when the transferor makes payment to the claimant or claimants, economic 
performance occurs with respect to the liability when and to the extent 
that the transferor makes a transfer to a disputed ownership fund to 
resolve or satisfy that liability.
    (ii) Obligations of the transferor. Economic performance does not 
occur when a transferor using an accrual method of accounting issues to 
a disputed ownership fund its debt (or provides the debt of a related 
person). Instead, economic performance occurs as the transferor (or 
related person) makes principal payments on the debt. Economic 
performance does not occur when the transferor provides to a disputed 
ownership fund its obligation (or the obligation of a related person) to 
provide property or services in the future or to make a payment 
described in Sec. 1.461-4(g)(1)(ii)(A). Instead, economic performance 
occurs with respect to such an obligation as property or services are 
provided or payments are made to the disputed ownership fund or a 
claimant. With regard to interest on a debt issued or provided to a 
disputed ownership fund, economic performance occurs as determined under 
Sec. 1.461-4(e).
    (3) Distributions to transferors--(i) In general. Except as provided 
in section 111(a) and paragraph (d)(3)(ii) of this section, the 
transferor must include in gross income any distribution to the 
transferor (including a deemed distribution described in paragraph 
(d)(3)(iii) of this section) from the disputed ownership fund. If 
property is distributed, the amount includible in gross income and the 
basis in that property are generally the fair market value of the 
property on the date of distribution.
    (ii) Exception. A transferor is not required to include in gross 
income a distribution of money or property that it previously 
transferred to the disputed ownership fund if the transferor did not 
take into account, for example, by deduction or capitalization, an 
amount with respect to the transfer either at the time of the transfer 
to, or while the money or property was held by, the disputed ownership 
fund. The transferor's gross income does not include a distribution of 
money from the disputed ownership fund equal to the net after-tax income 
earned on money or property transferred to the disputed ownership fund 
by the transferor while that money or property was held by the fund. 
Money distributed to a transferor by a disputed ownership fund will be 
deemed to be distributed first from the money or property transferred to 
the disputed ownership fund by that transferor, then from the net after-
tax income of any money or property transferred to the disputed 
ownership fund by that transferor, and then from other sources.
    (iii) Deemed distributions. If a disputed ownership fund makes a 
distribution of money or property on behalf of a transferor to a person 
that is not a claimant, the distribution is deemed made by the fund to 
the transferor. The transferor, in turn, is deemed to make a payment to 
the actual recipient.
    (e) Rules applicable to transferor-claimants. The rules in this 
paragraph (e) apply to transferor-claimants (as defined in paragraph 
(b)(8) of this section).
    (1) Transfer of property. A transfer of property by a transferor-
claimant to a disputed ownership fund is not a sale or other disposition 
of the property for purposes of section 1001(a).
    (2) Economic performance--(i) In general. For purposes of section 
461(h), if a transferor-claimant using an accrual method of accounting 
has a liability for which economic performance would otherwise occur 
under Sec. 1.461-4(g) when the transferor-claimant makes payment to 
another claimant, economic performance occurs with respect to the 
liability when and to the extent that the disputed ownership fund 
transfers money or property to the other claimant to resolve or satisfy 
that liability.
    (ii) Obligations of the transferor-claimant. Economic performance 
does not occur when a disputed ownership fund transfers the debt of a 
transferor-claimant (or of a person related to the transferor-claimant) 
to another claimant. Instead, economic performance occurs as principal 
payments on the debt are made to the other claimant. Economic 
performance does not occur

[[Page 394]]

when a disputed ownership fund transfers to another claimant the 
obligation of a transferor-claimant (or of a person related to the 
transferor-claimant) to provide property or services in the future or to 
make a payment described in Sec. 1.461-4(g)(1)(ii)(A). Instead, 
economic performance occurs with respect to such an obligation as 
property or services are provided or payments are made to the other 
claimant. With regard to interest on a debt issued or provided to a 
disputed ownership fund, economic performance occurs as determined under 
Sec. 1.461-4(e).
    (3) Distributions to transferor-claimants--(i) In general. The gross 
income of a transferor-claimant does not include a distribution to the 
transferor-claimant (including a deemed distribution described in 
paragraph (e)(3)(ii) of this section) of money or property from a 
disputed ownership fund that the transferor-claimant previously 
transferred to the fund, or the net after-tax income earned on that 
money or property while it was held by the fund. If such property is 
distributed to the transferor-claimant by the disputed ownership fund, 
then the transferor-claimant's basis in the property is the same as the 
disputed ownership fund's basis in the property immediately before the 
distribution.
    (ii) Deemed distributions. If a disputed ownership fund makes a 
distribution of money or property to a claimant or makes a distribution 
of money or property on behalf of a transferor-claimant to a person that 
is not a claimant, the distribution is deemed made by the fund to the 
transferor-claimant. The transferor-claimant, in turn, is deemed to make 
a payment to the actual recipient.
    (f) Distributions to claimants other than transferor-claimants. 
Whether a claimant other than a transferor-claimant must include in 
gross income a distribution of money or property from a disputed 
ownership fund generally is determined by reference to the claim in 
respect of which the distribution is made.
    (g) Statement to the disputed ownership fund and the Internal 
Revenue Service with respect to transfers of property other than cash--
(1) In general. By February 15 of the year following each calendar year 
in which a transferor (or other person acting on behalf of a transferor) 
makes a transfer of property other than cash to a disputed ownership 
fund, the transferor must provide a statement to the administrator of 
the fund setting forth the information described in paragraph (g)(3) of 
this section. The transferor must attach a copy of this statement to its 
return for the taxable year of transfer.
    (2) Combined statements. If a disputed ownership fund has more than 
one transferor, any two or more transferors may provide a combined 
statement to the administrator. If a combined statement is used, each 
transferor must attach a copy of the combined statement to its return 
and maintain with its books and records a schedule describing each asset 
that the transferor transferred to the disputed ownership fund.
    (3) Information required on the statement. The statement required by 
paragraph (g)(1) of this section must include the following 
information--
    (i) A legend, ``Sec. 1.468B-9 Statement,'' at the top of the first 
page;
    (ii) The transferor's name, address, and taxpayer identification 
number;
    (iii) The disputed ownership fund's name, address, and employer 
identification number;
    (iv) A statement declaring whether the transferor is a transferor-
claimant;
    (v) The date of each transfer;
    (vi) A description of the property (other than cash) transferred; 
and
    (vii) The disputed ownership fund's basis in the property and 
holding period on the date of transfer as determined under paragraph 
(c)(3)(ii) of this section.
    (h) Examples. The following examples illustrate the rules of this 
section:

    Example 1. (i) X Corporation petitions the United States Tax Court 
in 2006 for a redetermination of its tax liability for the 2003 taxable 
year. In 2006, the Tax Court determines that X Corporation is liable for 
an income tax deficiency for the 2003 taxable year. X Corporation files 
an appellate bond in accordance with section 7485(a) and files a notice 
of appeal with the appropriate United States Court of Appeals. In 2006, 
the Court of Appeals affirms the decision of the Tax Court and the 
United States Supreme Court denies X Corporation's petition for a writ 
of certiorari.

[[Page 395]]

    (ii) The appellate bond that X Corporation files with the court for 
the purpose of staying assessment and collection of deficiencies pending 
appeal is not an escrow account, trust or fund established to hold 
property subject to conflicting claims of ownership. Although X 
Corporation was found liable for an income tax deficiency, ownership of 
the appellate bond is not disputed. Rather, the bond serves as security 
for a disputed liability. Therefore, the bond is not a disputed 
ownership fund.
    Example 2. (i) The facts are the same as Example 1, except that X 
Corporation deposits United States Treasury bonds with the Tax Court in 
accordance with section 7845(c)(2) and 31 U.S.C. 9303.
    (ii) The deposit of United States Treasury bonds with the court for 
the purpose of staying assessment and collection of deficiencies while X 
Corporation prosecutes an appeal does not create a disputed ownership 
fund because ownership of the bonds is not disputed.
    Example 3. (i) Prior to A's death, A was the insured under a life 
insurance policy issued by X, an insurance company. X uses an accrual 
method of accounting. Both A's current spouse and A's former spouse 
claim to be the beneficiary under the policy and entitled to the policy 
proceeds ($1 million). In 2005, X files an interpleader action and 
deposits $1 million into the registry of the court. On June 1, 2006, a 
final determination is made that A's current spouse is the beneficiary 
under the policy and entitled to the money held in the registry of the 
court. The interest earned on the registry account is $12,000. The money 
in the registry account is distributed to A's current spouse.
    (ii) The money held in the registry of the court consisting of the 
policy proceeds and the earnings thereon are a disputed ownership fund 
taxable as if it were a qualified settlement fund. See paragraphs (b)(1) 
and (c)(1)(ii) of this section. The fund's gross income does not include 
the $1 million transferred to the fund by X, however, the $12,000 
interest is included in the fund's gross income in accordance with its 
method of accounting. See paragraph (c)(3)(i) of this section. Under 
paragraph (c)(4)(ii) of this section, the fund is not allowed a 
deduction for a distribution to A's current spouse of the $1 million or 
the interest income earned by the fund.
    (iii) X is a transferor that is not a transferor-claimant. See 
paragraphs (b)(7) and (b)(8) of this section.
    (iv) Whether A's current spouse must include in income the $1 
million insurance proceeds and the interest received from the fund is 
determined under other provisions of the Internal Revenue Code. See 
paragraph (f) of this section.
    Example 4. (i) Corporation B and unrelated individual C claim 
ownership of certain rental property. B uses an accrual method of 
accounting. The rental property is property used in a trade or business. 
B claims to have purchased the property from C's father. However, C 
asserts that the purported sale to B was ineffective and that C acquired 
ownership of the property through intestate succession upon the death of 
C's father. For several years, B has maintained and received the rent 
from the property.
    (ii) Pending the resolution of the title dispute between B and C, 
the title to the rental property is transferred to a court-supervised 
registry account on February 1, 2005. On that date the court appoints R 
as receiver for the property. R collects the rent earned on the property 
and hires employees necessary for the maintenance of the property. The 
rents paid to R cannot be distributed to B or C without the court's 
approval.
    (iii) On June 1, 2006, the court makes a final determination that 
the rental property is owned by C. The court orders C to refund to B the 
purchase price paid by B to C's father plus interest on that amount from 
February 1, 2005. The court also orders that a distribution be made to C 
of all funds held in the court registry consisting of the rent collected 
by R and the income earned thereon. C takes title to the rental 
property.
    (iv) The rental property and the funds held by the court registry 
are a disputed ownership fund under paragraph (b)(1) of this section. 
The fund is taxable as if it were a C corporation because the rental 
property is not a passive investment asset within the meaning of 
paragraph (c)(1)(i) of this section.
    (v) The fund's gross income does not include the value of the rental 
property transferred to the fund by B. See paragraph (c)(3)(i) of this 
section. Under paragraph (c)(3)(ii) of this section, the fund's initial 
basis in the property is the same as B's adjusted basis immediately 
before the transfer to the fund and the fund's holding period is 
determined under section 1223(2). The fund's gross income includes the 
rents collected by R and any income earned thereon. For the period 
between February 1, 2005, and June 1, 2006, the fund may be allowed 
deductions for depreciation and for the costs of maintenance of the 
property because the fund is treated as owning the property during this 
period. See sections 162, 167, and 168. Under paragraph (c)(4)(ii) of 
this section, the fund may not deduct the distribution to C of the 
property, or the rents (or any income earned thereon) collected from the 
property while the fund holds the property. No gain or loss is 
recognized by the fund from this distribution or from the fund's 
transfer of the rental property to C pursuant to the court's 
determination that C owns the property. See paragraphs (c)(4)(i) and 
(e)(3) of this section.
    (vi) B is the transferor to the fund. Under paragraphs (b)(8) and 
(e)(1) of this section, B

[[Page 396]]

is a transferor-claimant and does not recognize gain or loss under 
section 1001(a) on transfer of the property to the disputed ownership 
fund. The money and property distributed from the fund to C is deemed to 
be distributed first to B and then transferred from B to C. See 
paragraph (e)(3)(ii) of this section. Under paragraph (e)(2)(i) of this 
section, economic performance occurs when the disputed ownership fund 
transfers the property and any earnings thereon to C. The income tax 
consequences of the deemed transfer from B to C as well as the income 
tax consequences of C's refund to B of the purchase price paid to C's 
father and interest thereon are determined under other provisions of the 
Internal Revenue Code.

    (i) [Reserved]
    (j) Effective dates--(1) In general. This section applies to 
disputed ownership funds established after February 3, 2006.
    (2) Transition rule. With respect to a disputed ownership fund 
established after August 16, 1986, but on or before February 3, 2006, 
the Internal Revenue Service will not challenge a reasonable, 
consistently applied method of taxation for income earned by the fund, 
transfers to the fund, and distributions made by the fund.

[T.D. 9249, 71 FR 6202, Feb. 7, 2006]



Sec. 1.469-0  Table of contents.

    This section lists the captions that appear in the regulations under 
section 469.

                      Sec. 1.469-1 General rules.

    (a)-(c)(7) [Reserved]
    (c)(8) Consolidated groups.
    (c)(9)-(d)(1) [Reserved]
    (2) Coordination with sections 613A(d) and 1211.
    (d)(3)-(e)(1) [Reserved]
    (2) Trade or business activity.
    (e)(3)(i)-(e)(3)(ii) [Reserved]
    (iii) Average period of customer use.
    (A) In general.
    (B) Average use factor.
    (C) Average period of customer use for class of property.
    (D) Period of customer use.
    (E) Class of property.
    (F) Gross rental income and daily rent.
    (e)(3)(iv)-(e)(3)(vi)(C) [Reserved]
    (D) Lodging rented for convenience of employer.
    (E) Unadjusted basis.
    (e)(3)(vii)-(e)(4)(iii) [Reserved]
    (iv) Definition of ``working interest.''
    (e)(4)(v)-(vi) [Reserved]
    (5) Rental of dwelling unit.
    (e)(6)-(f)(3)(iii) [Reserved]
    (4) Carryover of disallowed deductions and credits.
    (i) In general.
    (ii) Operations continued through C corporations or similar 
entities.
    (iii) Examples.
    (g)(1)-(g)(4)(ii)(B) [Reserved]
    (4)(ii)(C) (no paragraph heading)
    (5) [Reserved]
    (h)(1) In general.
    (2) Definitions.
    (3) [Reserved]
    (4) Status and participation of members.
    (i) Determination by reference to status and participation of group.
    (ii) Determination of status and participation of consolidated 
group.
    (5) [Reserved]
    (6) Intercompany transactions.
    (i) In general.
    (ii) Example.
    (iii) Effective dates.
    (h)(7)-(k) [Reserved]

                Sec. 1.469-1T General rules (temporary).

    (a) Passive activity loss and credit disallowed.
    (1) In general.
    (2) Exceptions.
    (b) Taxpayers to whom these rules apply.
    (c) Cross references.
    (1) Definition of passive activity.
    (2) Passive activity loss.
    (3) Passive activity credit.
    (4) Effect of rules for other purposes.
    (5) Special rule for oil and gas working interests.
    (6) Treatment of disallowed losses and credits.
    (7) Corporations subject to section 469.
    (8) [Reserved]
    (9) Joint returns.
    (10) Material participation.
    (11) Effective date and transition rules.
    (12) Future regulations.
    (d) Effect of section 469 and the regulations thereunder for other 
purposes.
    (1) Treatment of items of passive activity income and gain.
    (2) Coordination with sections 613A(d) and 1211. [Reserved]
    (3) Treatment of passive activity losses.
    (e) Definition of ``passive activity.''
    (1) In general.
    (2) Trade or business activity. [Reserved]
    (3) Rental Activity.
    (i) In general.
    (ii) Exceptions.
    (iii) Average period of customer use. [Reserved]
    (A) In general. [Reserved]
    (B) Average use factor. [Reserved]
    (C) Average period of customer use for class of property. [Reserved]
    (D) Period of Customer use. [Reserved]
    (E) Class of property. [Reserved]

[[Page 397]]

    (F) Gross rental income and daily rent. [Reserved]
    (iv) Significant personal services.
    (A) In general.
    (B) Excluded services.
    (v) Extraordinary personal services.
    (vi) Rental of property incidental to a nonrental activity of the 
taxpayer.
    (A) In general.
    (B) Property held for investment.
    (C) Property used in a trade or business.
    (D) Lodging rented for convenience of employer. [Reserved]
    (E) Unadjusted basis. [Reserved]
    (vii) Property made available for use in a nonrental activity 
conducted by a partnership, S corporation or joint venture in which the 
taxpayer owns an interest.
    (viii) Examples.
    (4) Special rules for oil and gas working interests.
    (i) In general.
    (ii) Exception for deductions attributable to a period during which 
liability is limited.
    (A) In general.
    (B) Coordination with rules governing the identification of 
disallowed passive activity deductions.
    (C) Meaning of certain terms.
    (1) Allocable deductions.
    (2) Disqualified deductions.
    (3) Net loss.
    (4) Ratable portion.
    (iii) Examples.
    (iv) Definition of ``working interest.'' [Reserved]
    (v) Entities that limit liability.
    (A) General rule.
    (B) Other limitations disregarded.
    (C) Examples.
    (vi) Cross reference to special rule for income from certain oil or 
gas properties.
    (5) Rental of dwelling unit. [Reserved]
    (6) Activity of trading personal property.
    (i) In general.
    (ii) Personal property.
    (iii) Example.
    (f) Treatment of disallowed passive activity losses and credits.
    (1) Scope of this paragraph.
    (2) Identification of disallowed passive activity deductions.
    (i) Allocation of disallowed passive activity deductions.
    (A) General rule.
    (B) Loss from an activity.
    (C) Significant participation passive activities.
    (D) Examples.
    (ii) Allocation with loss activities.
    (A) In general.
    (B) Excluded deductions.
    (iii) Separately identified deductions.
    (3) Identification of disallowed credits from passive activities.
    (i) General rule.
    (ii) Coordination rule.
    (iii) Separately identified credits.
    (4) Carryover of disallowed deductions and credits. [Reserved]
    (i) In general.
    (ii) Operations continued through C corporations or similar 
entities.
    (iii) Examples.
    (g) Application of these rules to C corporations.
    (1) In general.
    (2) Definitions.
    (3) Participation of corporations.
    (i) Material participation.
    (ii) Significant participation.
    (iii) Participation of individual.
    (4) Modified computation of passive activity loss in the case of 
closely held corporations.
    (i) In general.
    (ii) Net active income.
    (iii) Examples.
    (5) Allowance of passive activity credit of closely held 
corporations to extent of net active income tax liability.
    (i) In general.
    (ii) Net active income tax liability.
    (h) Special rules for affiliated group filing consolidated return.
    (1)-(2) [Reserved]
    (3) Disallowance of consolidated group's passive activity loss or 
credit.
    (4) Status and participation of members. [Reserved]
    (i) Determination by reference to status and participation of group. 
[Reserved]
    (ii) Determination of status and participation of consolidated 
group. [Reserved]
    (5) Modification of rules for identifying disallowed passive 
activity deductions and credits.
    (i) Identification of disallowed deductions.
    (ii) Ratable portion of disallowed passive activity losses.
    (iii) Identification of disallowed credits.
    (6) [Reserved]
    (7) Disposition of stock of a member of an affiliated group.
    (8) Dispositions of property used in multiple activities.
    (i) [Reserved]
    (j) Spouses filing joint returns.
    (1) In general.
    (2) Exceptions of treatment as one taxpayer.
    (i) Identification of disallowed deductions and credits.
    (ii) Treatment of deductions disallowed under sections 704(d), 
1366(d) and 465.
    (iii) Treatment of losses from working interests.
    (3) Joint return no longer filed.
    (4) Participation of spouses.
    (k) Former passive activities and changes in status of corporations. 
[Reserved]

                  Sec. 1.469-2 Passive activity loss.

    (a)-(c)(2)(ii) [Reserved]

[[Page 398]]

    (iii) Disposition of substantially appreciated property formerly 
used in a nonpassive activity.
    (A) In general.
    (B) Date of disposition.
    (C) Substantially appreciated property.
    (D) Investment property.
    (E) Coordination with Sec. l.469-2T(c)(2)(ii).
    (F) Coordination with section 163(d).
    (G) Examples.
    (iv) Taxable acquisitions.
    (v) Property held for sale to customers.
    (A) Sale incidental to another activity.
    (1) Applicability.
    (i) In general.
    (ii) Principal purpose.
    (2) Dealing activity not taken into account.
    (B) Use in a nondealing activity incidental to sale.
    (C) Examples.
    (c)(3)-(c)(5) [Reserved]
    (6) Gross income from certain oil or gas properties.
    (i) In general.
    (ii) Gross and net passive income from the property.
    (iii) Property.
    (iv) Examples 1 and 2.
    (c)(6)(iv) Example 3-(c)(7)(iii) [Reserved]
    (c)(7)(iv) through (vi) (no paragraph headings)
    (d)(1)-(d)(2)(viii) [Reserved]
    (d)(2)(ix) through (d)(2)(xii) (no paragraph headings)
    (d)(3)-(d)(5)(ii) [Reserved]
    (d)(5)(iii)(A) Applicability of rules in Sec. 1.469-2T(c)(2).
    (d)(5)(iii)(B)-(d)(6)(v)(D) [Reserved]
    (d)(6)(v)(E) (no paragraph heading)
    (d)(6)(v)(F)-(d)(7) [Reserved]
    (8) Taxable year in which item arises.
    (e)(1)-(e)(2)(i) [Reserved]
    (ii) Section 707(c).
    (iii) Payments in liquidation of a partner's interest in partnership 
property.
    (A) In general.
    (B) Payments in liquidation of a partner's interest in unrealized 
receivables and goodwill under section 736(a).
    (e)(3)(i)-(iii)(A) [Reserved]
    (e)(3)(iii)(B) (no paragraph heading)
    (e)(3)(iii)(C)-(f)(4) [Reserved]
    (5) Net income from certain property rented incidental to 
development activity.
    (i) In general.
    (ii) Commencement of use.
    (iii) Services performed for the purpose of enhancing the value of 
property.
    (iv) Examples.
    (6) Property rented to a nonpassive activity.
    (f)(7)-(f)(9)(ii) [Reserved]
    (f)(9)(iii) through (f)(9)(iv) (no paragraph heading).
    (10) Coordination with section 163(d).
    (f)(11) [Reserved]

            Sec. 1.469-2T Passive activity loss (temporary).

    (a) Scope of this section.
    (b) Definition of passive activity loss.
    (1) In general.
    (2) Cross reference.
    (c) Passive activity group income.
    (1) In general.
    (2) Treatment of gain from disposition of an interest in an activity 
or an interest in property used in an activity.
    (i) In general.
    (A) Treatment of gain.
    (B) Dispositions of partnership interest and S corporation stock.
    (C) Interest in property.
    (D) Examples.
    (ii) Disposition of property used in more than one activity in 12-
month period preceding disposition.
    (iii) Disposition of substantially appreciated property used in 
nonpassive activity. [Reserved]
    (A) In general. [Reserved]
    (B) Date of disposition. [Reserved]
    (C) Substantially appreciated property. [Reserved]
    (D) Investment property. [Reserved]
    (E) Coordination with paragraph (c)(2)(ii) of this section. 
[Reserved]
    (F) Coordination with section 163(d). [Reserved]
    (G) Examples. [Reserved]
    (iv) Taxable acquisitions. [Reserved]
    (v) Property held for sale to customers. [Reserved]
    (A) Sale incidental to another activity. [Reserved]
    (1) Applicability. [Reserved]
    (i) In general. [Reserved]
    (ii) Principal purpose. [Reserved]
    (2) Dealing activity not taken into account. [Reserved]
    (B) Use in a nondealing activity incidental to sale. [Reserved]
    (C) Examples. [Reserved]
    (3) Items of portfolio income specifically excluded.
    (i) In general.
    (ii) Gross income derived in the ordinary course of a trade or 
business.
    (iii) Special rules.
    (A) Income from property held for investment by dealer.
    (B) Royalties derived in the ordinary course of the trade or 
business of licensing intangible property.
    (1) In general.
    (2) Substantial services or costs.
    (i) In general.
    (ii) Exception.
    (iii) Expenditures taken into account.
    (3) Passthrough entities.
    (4) Cross reference.
    (C) Mineral production payments.
    (iv) Examples.
    (4) Items of personal service income specifically excluded.

[[Page 399]]

    (i) In general.
    (ii) Example.
    (5) Income from section 481 adjustments.
    (i) In general.
    (ii) Positive section 481 adjustments.
    (iii) Ratable portion.
    (6) Gross income from certain oil or gas properties. [Reserved]
    (i) In general. [Reserved]
    (ii) Gross and net passive income from the properties. [Reserved]
    (iii) Property. [Reserved]
    (iv) Examples.
    (7) Other items specifically excluded.
    (d) Passive activity deductions.
    (1) In general.
    (2) Exceptions.
    (3) Interest expense.
    (4) Clearly and directly allocable expenses.
    (5) Treatment of loss from disposition.
    (i) In general.
    (ii) Disposition of property used in more than one activity in 12-
month period preceding disposition.
    (iii) Other applicable rules.
    (A) Applicability or rules in paragraph (c)(2).
    (B) Dispositions of partnership interest and S corporation stock.
    (6) Coordination with other limitations on deductions that apply 
before section 469.
    (i) In general.
    (ii) Proration of deductions disallowed under basis limitations.
    (A) Deductions disallowed under section 704(d).
    (B) Deductions disallowed under section 1366(d).
    (iii) Proration of deductions disallowed under at-risk limitations.
    (iv) Coordination of basis and at-risk limitations.
    (v) Separately identified items of deduction and loss.
    (7) Deductions from section 481 adjustment.
    (i) In general.
    (ii) Negative section 481 adjustment.
    (iii) Ratable portion.
    (8) Taxable year in which item arises.
    (e) Special rules for partners and S corporation shareholders.
    (1) In general.
    (2) Payments under sections 707(a), 707(c), and 736(b).
    (i) Section 707(a).
    (ii) Section 707(c).
    (iii) Payments in liquidation of a partner's interest in partnership 
property.
    (A) In general.
    (B) Payments in liquidation of a partner's interest of a partnership 
property.
    (3) Sale or exchange of interest in passthrough entity.
    (i) Application of this paragraph (e)(3).
    (ii) General rule.
    (A) Allocation among activities.
    (B) Ratable portions.
    (1) Disposition on which gain is recognized.
    (2) Disposition on which loss is recognized.
    (C) Default rule.
    (D) Special rules.
    (1) Applicable valuation date.
    (i) In general.
    (ii) Exception.
    (2) Basis adjustment.
    (3) Tiered passthrough entities.
    (E) Meaning of certain terms.
    (iii) Treatment of gain allocated to certain passive activities as 
not from a passive activity.
    (iv) Dispositions occurring in taxable years beginning before 
February 19, 1988.
    (A) In general.
    (B) Exceptions.
    (v) Treatment of portfolio assets.
    (vi) Definitions.
    (vii) Examples.
    (f) Recharacterization of passive income in certain situations.
    (1) In general.
    (2) Special rule for significant participation.
    (i) In general.
    (ii) Significant participation passive activity.
    (iii) Example.
    (3) Rental of nondepreciable property.
    (4) Net interest income from passive equity-financed lending 
activity.
    (i) In general.
    (ii) Equity-financed lending activity.
    (A) In general.
    (B) Certain liabilities not taken into account.
    (iii) Equity-financed interest income.
    (iv) Net interest income.
    (v) Interest-bearing assets.
    (vi) Liabilities incurred in the activity.
    (vii) Average outstanding balance.
    (viii) Example.
    (5) Net income from certain property rented incidental to 
development activity.
    (i) In general. [Reserved]
    (ii) Commencement of use. [Reserved]
    (iii) Services performed for the purpose of enhancing the value of 
property. [Reserved]
    (iv) Examples. [Reserved]
    (6) Property rented to a nonpassive activity.
    (7) Special rules applicable to the acquisition of an interest of a 
passthrough entity engaged in the trade or business of licensing 
intangible property.
    (i) In general.
    (ii) Royalty income from property.
    (iii) Exceptions.
    (iv) Capital expenditures.
    (v) Example.
    (8) Limitation on recharacterized income.
    (9) Meaning of certain terms.
    (10) Coordination with section 163(d).
    (11) Effective date.

[[Page 400]]

                 Sec. 1.469-3 Passive activity credit.

    (a)-(d) [Reserved]
    (e) Coordination with section 38(b).
    (f) Coordination with section 50.
    (g) [Reserved]

           Sec. 1.469-3T Passive activity credit (temporary).

    (a) Computation of passive activity credit.
    (b) Credits subject to section 469.
    (1) In general.
    (2) Treatment of credits attributed to qualified progress 
expenditures.
    (3) Special rule for partners and S corporations shareholders.
    (4) Exception for pre-1987 credits.
    (c) Taxable year to which credit is attributable.
    (d) Regular tax liability allocable to passive activities.
    (1) In general.
    (2) Regular tax liability.
    (e) Coordination with section 38(b). [Reserved]
    (f) Coordination with section 47. [Reserved]
    (g) Examples.

                  Sec. 1.469-4 Definition of activity.

    (a) Scope and purpose.
    (b) Definitions.
    (1) Trade or business activities.
    (2) Rental activities.
    (c) General rules for grouping activities.
    (1) Appropriate economic unit.
    (2) Facts and circumstances test.
    (3) Examples.
    (d) Limitation on grouping certain activities.
    (1) Grouping rental activities with other trade or business 
activities.
    (i) Rule.
    (ii) Examples.
    (2) Grouping real property rentals and personal property rentals 
prohibited.
    (3) Certain activities of limited partners and limited 
entrepreneurs.
    (i) In general.
    (ii) Example.
    (4) Other activities identified by the Commissioner.
    (5) Activities conducted through section 469 entities.
    (i) In general.
    (ii) Cross reference.
    (e) Disclosure and consistency requirements.
    (1) Original groupings.
    (2) Regroupings.
    (f) Grouping by Commissioner to prevent tax avoidance.
    (1) Rule.
    (2) Example.
    (g) Treatment of partial dispositions.
    (h) Rules for grouping rental real estate activities for taxpayers 
qualifying under section 469(c)(7).

                  Sec. 1.469-5 Material participation.

    (a)-(e) [Reserved]
    (f) Participation.
    (1) In general.
    (f)(2)-(h)(2) [Reserved]
    (3) Coordination with rules governing the treatment of passthroughs 
entities.
    (i) [Reserved]
    (j) Material participation for preceding taxable years.
    (1) In general.
    (2) Material participation test for taxable years beginning before 
January 1, 1987
    (k) Examples (1)-(4). [Reserved]
    (k) Example (5).
    (k) Examples (6)-(8). [Reserved]

           Sec. 1.469-5T Material participation (temporary).

    (a) In general.
    (b) Facts and circumstances.
    (1) In general. [Reserved]
    (2) Certain participation insufficient to constitute material 
participation under this paragraph (b).
    (i) Participation satisfying standards not contained in section 469.
    (ii) Certain management activities.
    (iii) Participation less than 100 hours.
    (c) Significant participation activity.
    (1) In general.
    (2) Significant participation.
    (d) Personal service activity.
    (e) Treatment of limited partners.
    (1) General rule.
    (2) Exceptions.
    (3) Limited partnership interest.
    (i) In general.
    (ii) Limited partner holding general partner interest.
    (f) Participation. [Reserved]
    (1) In general. [Reserved]
    (2) Exceptions.
    (i) Certain work not customarily done by owners.
    (ii) participation as an investor.
    (A) In general.
    (B) Work done in individual's capacity as an investor.
    (3) Participation of spouses.
    (4) Methods of proof.
    (g) Material participation of trust and estates. [Reserved]
    (h) Miscellaneous rules.
    (1) Participation of corporations.
    (2) Treatment of certain retired farmers and surviving spouses of 
retired or disabled farmers.
    (3) Coordination with rules governing the treatment of passthroughs 
entities. [Reserved]
    (i) [Reserved]
    (j) Material participation for preceding taxable years. [Reserved]
    (1) In general. [Reserved]
    (2) Material participation for taxable years beginning before 
January 1, 1987. [Reserved]

[[Page 401]]

    (k) Examples.

 Sec. 1.469-6 Treatment of losses upon certain dispositions. [Reserved]

  Sec. 1.469-7 Treatment of self-charged items of interest income and 
                               deduction.

    (a) In general.
    (1) Applicability and effect of rules.
    (2) Priority of rules in this section.
    (b) Definitions.
    (1) Passthrough entity.
    (2) Taxpayer's share.
    (3) Taxpayer's indirect interest.
    (4) Entity taxable year.
    (5) Deductions for a taxable year.
    (c) Taxpayer loans to passthrough entity.
    (1) Applicability.
    (2) General rule.
    (3) Applicable percentage.
    (d) Passthrough entity loans to taxpayer.
    (1) Applicability.
    (2) General rule.
    (3) Applicable percentage.
    (e) Identically-owned passthrough entities.
    (1) Applicability.
    (2) General rule.
    (1) Example.
    (f) Identification of properly allocable deductions.
    (g) Election to avoid application of the rules of this section.
    (1) In general.
    (2) Form of election.
    (3) Period for which election applies.
    (4) Revocation.
    (h) Examples.

 Sec. 1.469-8 Application of section 469 to trust, estates, and their 
                        beneficiaries. [Reserved]

     Sec. 1.469-9 Rules for certain rental real estate activities.

    (a) Scope and purpose.
    (b) Definitions.
    (1) Trade or business.
    (2) Real property trade or business.
    (3) Rental real estate.
    (4) Personal services.
    (5) Material participation.
    (6) Qualifying taxpayer.
    (c) Requirements for qualifying taxpayers.
    (1) In general.
    (2) Closely held C corporations.
    (3) Requirement of material participation in the real property 
trades or businesses.
    (4) Treatment of spouses.
    (5) Employees in real property trades or businesses.
    (d) General rule for determining real property trades or businesses.
    (1) Facts and circumstances.
    (2) Consistency requirement.
    (e) Treatment of rental real estate activities of a qualifying 
taxpayer.
    (1) In general.
    (2) Treatment as a former passive activity.
    (3) Grouping rental real estate activities with other activities.
    (i) In general.
    (ii) Special rule for certain management activities.
    (4) Example.
    (f) Limited partnership interests in rental real estate activities.
    (1) In general.
    (2) De minimis exception.
    (g) Election to treat all interests in rental real estate as a 
single rental real estate activity.
    (1) In general.
    (2) Certain changes not material.
    (3) Filing a statement to make or revoke the election.
    (h) Interests in rental real estate held by certain passthrough 
entities.
    (1) General rule.
    (2) Special rule if a qualifying taxpayer holds a fifty-percent or 
greater interest in a passthrough entity.
    (3) Special rule for interests held in tiered passthrough entities.
    (i) [Reserved]
    (j) $25,000 offset for rental real estate activities of qualifying 
taxpayers.
    (1) In general.
    (2) Example.

      Sec. 1.469-10 Application of section 469 to publicly traded 
                        partnerships. [Reserved]

           Sec. 1.469-11 Effective date and transition rules.

    (a) Generally applicable effective dates.
    (b) Additional effective dates.
    (1) Application of 1992 amendments for taxable years beginning 
before October 4, 1994.
    (2) Additional transition rule for 1992 amendments.
    (3) Fresh starts under consistency rules.
    (i) Regrouping when tax liability is first determined under Project 
PS-1-89.
    (ii) Regrouping when tax liability is first determined under Sec. 
1.469-4.
    (iii) Regrouping when taxpayer is first subject to section 
469(c)(7).
    (4) Certain investment credit property.
    (c) Special rules.
    (1) Application of certain income recharacterization rules and self-
charged rules.
    (i) Certain recharacterization rules inapplicable in 1987.
    (ii) Property rented to a nonpassive activity.
    (iii) Self-charged rules.
    (2) Qualified low-income housing projects.
    (3) Effect of events occurring in years prior to 1987.

[[Page 402]]

    (d) Examples.

[T.D. 8417, 57 FR 20748, May 15, 1992, as amended by T.D. 8477, 58 FR 
11538, Feb. 26, 1993; T.D. 8495, 58 FR 58787, Nov. 4, 1993; T.D. 8565, 
59 FR 50487, Oct. 4, 1994; T.D. 8597, 60 FR 36684, July 18, 1995; T.D. 
8645, 60 FR 66498, Dec. 22, 1995; T.D. 9013, 67 FR 54089, Aug. 21, 2002]



Sec. 1.469-1  General rules.

    (a)-(c)(7) [Reserved]
    (c)(8) Consolidated groups. Rules relating to the application of 
section 469 to consolidated groups are contained in paragraph (h) of 
this section.
    (c)(9)-(d)(1) [Reserved]
    (d)(2) Coordination with sections 613A (d) and 1211. A passive 
activity deduction that is not disallowed for the taxable year under 
section 469 and the regulations thereunder may nonetheless be disallowed 
for the taxable year under section 613A(d) or 1211. The following 
example illustrates the application of this paragraph (d)(2):

    Example. In 1993, an individual derives $10,000 of ordinary income 
from passive activity X, no gains from the sale or exchange of capital 
assets or assets used in a trade or business, $12,000 of capital loss 
from passive activity Y, and no income, gain, deductions, or losses from 
any other passive activity. The capital loss from activity Y is a 
passive activity deduction (within the meaning of Sec. 1.469-2T(d)). 
Under section 469 and the regulations thereunder, the taxpayer is 
allowed $10,000 of the $12,000 passive activity deduction and has a 
$2,000 passive activity loss for the taxable year. Since the $10,000 
passive activity deduction allowed under section 469 is a capital loss, 
such deduction is allowable for the taxable year only to the extent 
provided under section 1211. Therefore, the taxpayer is allowed $3,000 
of the $10,000 capital loss under section 1211 and has a $7,000 capital 
loss carryover (within the meaning of section 1212(b)) to the succeeding 
taxable year.

    (d)(3)-(e)(1) [Reserved]
    (e)(2) Trade or business activities. Trade or business activities 
are activities that constitute trade or business activities within the 
meaning of Sec. 1.469-4(b)(1).
    (e)(3)(i)-(e)(3)(ii) [Reserved]
    (e)(3)(iii) Average period of customer use--(A) In general. For 
purposes of this paragraph (e)(3), the average period of customer use 
for property held in connection with an activity (the activity's average 
period of customer use) is the sum of the average use factors for each 
class of property held in connection with the activity.
    (B) Average use factor. The average use factor for a class of 
property held in connection with an activity is the average period of 
customer use for that class of property multiplied by the fraction 
obtained by dividing--
    (1) The activity's gross rental income attributable to that class of 
property; by
    (2) The activity's gross rental income.
    (C) Average period of customer use for class of property. In 
determining an activity's average period of customer use for a taxable 
year, the average period of customer use for a class of property held in 
connection with an activity is determined by dividing--
    (1) The aggregate number of days in all periods of customer use for 
property in the class (taking into account only periods that end during 
the taxable year or that include the last day of the taxable year); by
    (2) The number of those periods of customer use.
    (D) Period of customer use. Each period during which a customer has 
a continuous or recurring right to use an item of property held in 
connection with the activity (without regard to whether the customer 
uses the property for the entire period or whether the right to use the 
property is pursuant to a single agreement or to renewals thereof) is 
treated for purposes of this paragraph (e)(3)(iii) as a separate period 
of customer use. The duration of a period of customer use that includes 
the last day of a taxable year may be determined on the basis of 
reasonable estimates.
    (E) Class of property. Taxpayers may organize property into classes 
for purposes of this paragraph (e)(3)(iii) using any method under which 
items of property for which the amount of the daily rent differs 
significantly are not included in the same class.
    (F) Gross rental income and daily rent. In determining an activity's 
average period of customer use for a taxable year--
    (1) The activity's gross rental income is the gross income from the 
activity for the taxable year taking into account only income that is 
attributable

[[Page 403]]

to amounts paid for the use of property;
    (2) The activity's gross rental income attributable to a class of 
property is the gross income from the activity for the taxable year 
taking into account only income that is attributable to amounts paid for 
the use of property in that class; and
    (3) The daily rent for items of property may be determined on any 
basis that reasonably reflects differences during the taxable year in 
the amounts ordinarily paid for one day's use of those items of 
property.
    (e)(3)(iv)-(e)(3)(vi)(C) [Reserved]
    (e)(3)(vi)(D) Lodging rented for convenience of employer. The 
provision of lodging to an employee or to an employee's spouse or 
dependents is treated as incidental to the activity (or activities) of 
the taxpayer in which the employee performs services if the lodging is 
furnished for the taxpayer's convenience (within the meaning of section 
119).
    (E) Unadjusted basis. For purposes of this paragraph (e)(3)(vi), the 
term unadjusted basis means adjusted basis determined without regard to 
any adjustment described in section 1016 that decreases basis.
    (e)(3)(vii)-(e)(4)(iii) [Reserved]
    (e)(4)(iv) Definition of ``working interest.'' For purposes of 
section 469 and the regulations thereunder, the term working interest 
means a working or operating mineral interest in any tract or parcel of 
land (within the meaning of Sec. 1.612-4(a)).
    (e)(4)(v)-(f)(3) [Reserved]
    (f)(4) Carryover of disallowed deductions and credits--(i) In 
general. In the case of an activity of a taxpayer with respect to which 
any deductions or credits are disallowed for a taxable year under Sec. 
1.469-1T (f)(2) or (f)(3) (the loss activity)--
    (A) The disallowed deductions or credits is allocated among the 
taxpayer's activities for the succeeding taxable year in a manner that 
reasonably reflects the extent to which each activity continues the loss 
activity; and
    (B) The disallowed deductions or credits allocated to an activity 
under paragraph (f)(4)(i)(A) of this section shall be treated as 
deductions or credits from the activity for the succeeding taxable year.
    (ii) Business continued through C corporations or similar entities. 
If a taxpayer continues part or all of a loss activity through a C 
corporation or similar entity (C corporation entity), the taxpayer's 
interest in the C corporation entity shall be treated for purposes of 
this paragraph (f)(4) as an interest in a passive activity that 
continues that loss activity in whole or part. An entity is similar to a 
C corporation for this purpose if the owners of interests in the entity 
derive only portfolio income (within the meaning of Sec. 1.469-
2T(c)(3)(i)) from the interests.
    (iii) Examples. The following examples illustrate the application of 
this paragraph (f)(4). In each example, the taxpayer is an individual 
whose taxable year is the calendar year.

    Example 1. (i) The taxpayer owns interests in a convenience store 
and an apartment building. In each taxable year, the taxpayer's 
interests in the convenience store and the apartment building are 
treated under Sec. 1.469-4 as interests in two separate passive 
activities of the taxpayer. A $5,000 loss from the convenience-store 
activity and a $3,000 loss from the apartment-building activity are 
disallowed under Sec. 1.469-1T(f)(2) for 1993. Under Sec. 1.469-
1T(f)(2), the $5,000 loss from the convenience-store activity is 
allocated among the passive activity deductions from that activity for 
1993, and the $3,000 loss from the apartment-building activity is 
treated similarly.
    (ii) In 1994, the convenience store is continued in a single 
activity, and the section 469 activities that constituted the apartment 
building is similarly continued in a separate activity. Thus, the 
disallowed deductions from the convenience-store activity for 1993 must 
be allocated under paragraph (f)(4)(i)(A) of this section to the 
taxpayer's convenience-store activity in 1994. Similarly, the disallowed 
deductions from the apartment-building activity for 1993 must be 
allocated to the taxpayer's apartment-building activity in 1994. Under 
paragraph (f)(4)(i)(B) of this section, the disallowed deductions 
allocated to the convenience-store activity in 1994 are treated as 
deductions from that activity for 1994, and the disallowed deductions 
allocated to the apartment-building activity for 1994 are treated as 
deductions from the apartment-building activity for 1994.
    Example 2. (i) In 1993, the taxpayer acquires a restaurant and a 
catering business. Assume that in 1993 and 1994 the restaurant and the 
catering business are treated under Sec. 1.469-4 as an interest in a 
single passive activity of

[[Page 404]]

the taxpayer (the restaurant and catering activity). A $10,000 loss from 
the activity is disallowed under Sec. 1.469-1T(f)(2) for 1994. Assume 
that in 1995, the taxpayer's interests in the restaurant and the 
catering business are treated under Sec. 1.469-4 as interests in two 
separate passive activities of the taxpayer.
    (ii) Under Sec. 1.469-1T(f)(2), the $10,000 loss from the 
restaurant and catering activity is allocated among the passive activity 
deductions from that activity for 1994. In 1995, the businesses that 
constituted the restaurant and catering activity are continued, but are 
treated as two separate activities under Sec. 1.469-4. Thus, the 
disallowed deductions from the restaurant and catering activity for 1994 
must be allocated under paragraph (f)(4)(i)(A) of this section between 
the restaurant activity and the catering activity in 1995 in a manner 
that reasonably reflects the extent to which each of the activities 
continues the single restaurant and catering activity. Under paragraph 
(f)(4)(i)(B) of this section, the disallowed deductions allocated to the 
restaurant activity in 1995 are treated as deductions from the 
restaurant activity for 1995, and the disallowed deductions allocated to 
the catering activity in 1995 are treated as deductions from the 
catering activity for 1995.
    Example 3. (i) In 1993, the taxpayer acquires a restaurant and a 
catering business. Assume that in 1993 and 1994 the restaurant and the 
catering business are treated underSec. 1.469-4 as an interest in a 
single passive activity of the taxpayer (the restaurant and catering 
activity). A $10,000 loss from the activity is disallowed under Sec. 
1.469-1T(f)(2) for 1994. Assume that in 1995, the taxpayer's interests 
in the restaurant and the catering business are treated under Sec. 
1.469-4 as interestes in two separate passive activities of the 
taxpayer. In addition, a $20,000 loss from the activity was disallowed 
under Sec. 1.469-1T(f)(2) for 1993, and the gross income and deductions 
(including deductions that were disallowed for 1993 under Sec. 1.469-
1T(f)(2)) from the restaurant and catering business for 1993 and 1994 
are as follows:

------------------------------------------------------------------------
                                                               Catering
                                                 Restaurant    business
------------------------------------------------------------------------
1993:
  Gross income................................      $20,000      $60,000
  Deductions..................................       40,000       60,000
                                               --------------
      Net income (loss).......................     (20,000)  ...........
1994:
  Gross income................................       40,000       50,000
  Deductions..................................   \1\ 30,000   \2\ 70,000
                                               --------------
      Net income (loss).......................       10,000     (20,000)
------------------------------------------------------------------------
\1\ Includes $8,000 of deductions that were disallowed for 1993
  ($20,000x$40,000/$100,000).
\2\ Includes $12,000 of deductions that were disallowed for 1993
  ($20,000x$60,000/$100,000).

    (ii) Under paragraph (f)(4)(i)(A) of this section, the disallowed 
deductions from the restaurant and catering activity must be allocated 
among the taxpayer's activities for the succeeding year in a manner that 
reasonably reflects the extent to which those activities continue the 
restaurant and catering activity. The remainder of this example 
describes a number of allocation methods that will ordinarily satisfy 
the requirement of paragraph (f)(4)(i)(A) of this section. The 
description of specific allocation methods in this example does not 
preclude the use of other reasonable allocation methods for purposes of 
paragraph (f)(4)(i)(A) of this section.
    (iii) Ordinarily, an allocation of disallowed deductions from the 
restaurant to the restaurant activity and disallowed deductions from the 
catering business to the catering activity would satisfy the requirement 
of paragraph (f)(4)(i)(A) of this section. Under Sec. 1.469-1T 
(f)(2)(ii), a ratable portion of each deduction from the restaurant and 
catering activity is disallowed for 1994. Thus, $3,000 of the 1994 
deductions from the restaurant are disallowed ($10,000x$30,000/
$100,000), and $7,000 of the 1994 deductions from the catering business 
are disallowed ($10,000x$70,000/$100,000). Thus, the taxpayer can 
ordinarily treat $3,000 of the disallowed deductions as deductions from 
the restaurant activity for 1995, and $7,000 of the disallowed 
deductions as deductions from the catering activity for 1995.
    (iv) Ordinarily, an allocation of disallowed deductions between the 
restaurant activity and catering activity in proportion to the losses 
from the restaurant and from the catering business for 1994 would also 
satisfy the requirement of paragraph (f)(4)(i)(A) of this section. If 
the restaurant and the catering business had been treated as separate 
activities in 1994, the restaurant activity would have had net income of 
$10,000 and the catering activity would have had a $20,000 loss. Thus, 
the taxpayer can ordinarily treat all $10,000 of disallowed deductions 
as deductions from the catering activity for 1995.
    (v) Ordinarily, an allocation of disallowed deductions between the 
restaurant activity and catering activity in proportion to the losses 
from the restaurant and from the catering business for 1994 (determined 
as if the restaurant and the catering business had been separate 
activities for all taxable years) would also satisfy the requirement of 
paragraph (f)(4)(i)(A) of this section. If the restaurant and the 
catering business had been treated as separate activities for all 
taxable years, the entire $20,000 loss from the restaurant in 1993 would 
have been allocated to the restaurant activity in 1994, and the gross 
income and deductions from the separate activities for 1994 would be as 
follows:

------------------------------------------------------------------------
                                                               Catering
                                                 Restaurant    business
------------------------------------------------------------------------
Gross income..................................      $40,000      $50,000
Deductions....................................       42,000       58,000
                                               -------------------------

[[Page 405]]

 
      Net income (loss).......................      (2,000)      (8,000)
------------------------------------------------------------------------

    Thus, the taxpayer can ordinarily treat $2,000 of the disallowed 
deductions as deductions from the restaurant activity for 1995, and 
$8,000 of the disallowed deductions as deductions from the catering 
activity for 1995.
    Example 4. (i) The taxpayer is a partner in a law partnership that 
acquires a building in December 1993 for use in the partnership's law 
practice. In taxable year 1993, four floors that are not needed in the 
law practice are leased to tenants; in taxable year 1994, two floors are 
leased to tenants; in taxable years after 1994, only one floor is leased 
to tenants and the rental operations are insubstantial. Assume that 
under Sec. 1.469-4, the law practice and the rental property are 
treated as a trade or business activity and a separate rental activity 
for taxable years 1993 and 1994. Assume further that the law practice 
and the rental operations are a single trade or business activity for 
taxable years after 1994 under Sec. 1.469-4. The trade or business 
activity is not a passive activity of the taxpayer. The rental activity, 
however, is a passive activity. Under Sec. 1.469-T(f)(2), a $12,000 
loss from the rental activity is disallowed for 1993 and a $9,000 loss 
from the rental activity is disallowed for 1994.
    (ii) Under Sec. 1.469-1T(f)(2), the $12,000 loss from the rental 
activity for 1993 is allocated among the passive activity deductions 
from that activity for 1993. In 1994, the business of the rental 
activity is continued in two separate activities. Only two floors of the 
building remain in the rental activity, and the other two floors (i.e., 
the floors that were leased to tenants in 1993, but not in 1994) are 
used in the taxpayer's law-practice activity. Thus, the disallowed 
deductions from the rental activity for 1993 must be allocated under 
paragraph (f)(4)(i)(A) of this section between the rental activity and 
the law-practice activity in a manner that reasonably reflects the 
extent to which each of the activities continues business on the four 
floors that were leased to tenants in 1993. In these circumstances, the 
requirement of paragraph (f)(4)(i)(A) of this section would ordinarily 
be satisfied by any of the allocation methods illustrated in Example 3 
or by an allocation of 50 percent of the disallowed deductions to each 
activity. Under paragraph (f)(4)(i)(B) of this section, the disallowed 
deductions allocated to the rental activity in 1994 are treated as 
deductions from the rental activity for 1994, and the disallowed 
deductions ($6,000) allocated to the law-practice activity in 1994 are 
treated as deductions from the law-practice activity for 1994.
    (iii) Under Sec. 1.469-1T(f)(2), the $9,000 loss from the rental 
activity for 1994 is allocated among the passive activity deductions 
from that activity for 1994. In 1995, the rental activity is continued 
in the taxpayer's law-practice activity. Thus, the disallowed deductions 
from the rental activity for 1994 must be allocated under paragraph 
(f)(4)(ii) of this section to the taxpayer's law-practice activity in 
1995. Under paragraph (f)(4)(i)(B) of this section, the disallowed 
deductions allocated to the law-practice activity are treated as 
deductions from the law-practice activity for 1995.
    (iv) Rules relating to former passive activities will be contained 
in paragraph (k) of this section. Under those rules, any disallowed 
deductions from the rental activity that are treated as deductions from 
the law-practice activity will be treated as unused deductions that are 
allocable to a former passive activity.
    Example 5. (i) The taxpayer owns stock in a corporation that is an S 
corporation for the taxpayer's 1993 taxable year and a C coporation 
thereafter. The only activity of the corporation is a rental activity. 
For 1993, the taxpayer's pro rata share of the corporation's loss from 
the rental activity is $5,000, and the entire loss is disallowed under 
Sec. 1.469-1T(f)(2) of this section.
    (ii) Under Sec. 1.469-1T(f)(2), the taxpayer's $5,000 loss from the 
rental activity is allocated among the taxpayer's deductions from that 
activity for 1993. In 1994, the rental activity is continued through a C 
corporation, and the taxpayer's interest in the C corporation is treated 
under paragraph (f)(4)(ii) of this section as a passive activity that 
continues the rental activity (the C corporation activity) for purposes 
of allocating the previously disallowed loss. Thus, the disallowed 
deductions from the rental activity for 1993 must be allocated under 
paragraph (f)(4)(i)(A) of this section to the taxpayer's C corporation 
activity in 1994, and are treated under paragraph (f)(4)(i)(B) of this 
section as deductions from the C corporation activity for 1994.
    (iii) Treating the taxpayer's interest in the C corporation as an 
interest in a passive activity that continues the business of the rental 
activity does not change the character of the taxpayer's dividend income 
from the C corporation. Thus, the taxpayer's dividend income is 
portfolio income (within the meaning of Sec. 1.469-2T(c)(3)(i)) and is 
not included in passive activity gross income. Accordingly, the 
taxpayer's loss from the C corporation activity for 1994 is $5,000.
    Example 6. (i) The taxpayer owns stock in a corporation that is an S 
corporation for the taxpayer's 1993 taxable year and a C corporation 
thereafter. The only activity of the corporation is a rental activity. 
For 1993, the taxpayer's pro rata share of the corporation's loss from 
the rental activity is $5,000, and the entire loss is disallowed under 
Sec. 1.469-1T(f)(2). The taxpayer has $2,000 in income from other 
passive activities for 1994,

[[Page 406]]

and as a result, only 60% of the taxpayer's loss from the C corporation 
activity ($3,000) is disallowed for 1994 under Sec. 1.469-1T(f)(2).
    (ii) Under Sec. 1.469-1T(f)(2), the $3,000 disallowed loss from the 
C corporation activity is allocated among the passive activity 
deductions from that activity for 1994. In effect, therefore, 60 percent 
of each disallowed deduction from the rental activity for 1993 is again 
disallowed for 1994.
    (iii) Under paragraph (f)(4) of this section, the taxpayer's 
interest in the C corporation is treated as a loss activity and as an 
interest in a passive activity that continues the business of that loss 
activity for 1995. Thus, the disallowed deductions from the C 
corporation activity for 1994 must be allocated under paragraph 
(f)(4)(i)(A) of this section to the taxpayer's C corporation activity in 
1995, and are treated under paragraph (f)(4)(i)(B) of this section as 
deductions from that activity for 1995.

    (g)(1)-(g)(4)(ii)(B) [Reserved]
    (g)(4)(ii)(C) Portfolio income (within the meaning of Sec. 1.469-
2T(c)(3)(i)), including any gross income that is treated as portfolio 
income under any other provision of the regulations (See, e.g., Sec. 
1.469-2(c)(2)(iii)(F) (relating to gain from the disposition of 
substantially appreciated property formerly held for investment) and 
Sec. 1.469-2(f)(10) (relating to certain recharacterized passive 
activity gross income))
    (5) [Reserved]
    (h)(1) In general. This paragraph (h) provides rules for applying 
section 469 in computing a consolidated group's consolidated taxable 
income and consolidated tax liability (and the separate taxable income 
and tax liability of each member).
    (2) Definitions. The definitions and nomenclature in the regulations 
under section 1502 apply for purposes of this paragraph (h). See, e.g., 
Sec. Sec. 1.1502-1 (definitions of group, consolidated group, member, 
subsidiary, and consolidated return year), 1.1502-2 (consolidated tax 
liability), 1.1502-11 (consolidated taxable income), 1.1502-12 (separate 
taxable income), 1.1502-13 (intercompany transactions), 1.1502-21 (net 
operating losses, and 1.1502-22 (consolidated net capital gain and 
loss).
    (3) [Reserved]
    (4) Status and participation of members--(i) Determination by 
reference to status and participation of group. For purposes of section 
469 and the regulations thereunder--
    (A) Each member of a consolidated group shall be treated as a 
closely held corporation or personal service corporation, respectively, 
for the taxable year, if and only if the consolidated group is treated 
(under the rules of paragraph (h)(4)(ii) of this section) as a closely 
held corporation or personal service corporation for that year; and
    (B) The determination of whether a trade or business activity 
(within the meaning of paragraph (e)(2) of this section) conducted by 
one or more members of a consolidated group is a passive activity of the 
members is made by reference to the consolidated group's participation 
in the activity.
    (ii) Determination of status and participation of consolidated 
group. For purposes of determining under Sec. 1.469-1T(g)(2) whether a 
consolidated group is treated as a closely held corporation or a 
personal service corporation, and determining under Sec. 1.469-1T(g)(3) 
whether the consolidated group materially or significantly participates 
in any activity conducted by one or more members of the group--
    (A) The members of the consolidated group shall be treated as one 
corporation;
    (B) Only the outstanding stock of the common parent shall be treated 
as outstanding stock of the corporation;
    (C) An employee of any member of the group shall be treated as an 
employee of the corporation; and
    (D) An activity is treated as the principal activity of the 
corporation if and only if it is the principal activity (within the 
meaning of Sec. 1.441-3(e)) of the consolidated group.
    (5) [Reserved]
    (6) Intercompany transactions--(i) In general. Section 1.1502-13 
applies to determine the treatment under section 469 of intercompany 
items and corresponding items from intercompany transactions between 
members of a consolidated group. For example, the matching rule of Sec. 
1.1502-13(c) treats the selling member (S) and the buying member (B) as 
divisions of a single corporation for purposes of determining whether 
S's intercompany items and B's corresponding items are from a passive 
activity. Thus, for purposes of applying Sec. 1.469-2(c)(2)(iii) and 
Sec. 1.469-

[[Page 407]]

2T(d)(5)(ii) to property sold by S to B in an intercompany transaction--
    (A) S and B are treated as divisions of a single corporation for 
determining the uses of the property during the 12-month period 
preceding its disposition to a nonmember, and generally have an 
aggregate holding period for the property; and
    (B) Sec. 1.469-2(c)(2)(iv) does not apply.
    (ii) Example. The following example illustrates the application of 
this paragraph (h)(6).

    Example. (i) P, a closely held corporation, is the common parent of 
the P consolidated group. P owns all of the stock of S and B. X is a 
person unrelated to any member of the P group. S owns and operates 
equipment that is not used in a passive activity. On January 1 of Year 
1, S sells the equipment to B at a gain. B uses the equipment in a 
passive activity and does not dispose of the equipment before it has 
been fully depreciated.
    (ii) Under the matching rule of Sec. 1.1502-13(c), S's gain taken 
into account as a result of B's depreciation is treated as gain from a 
passive activity even though S used the equipment in a nonpassive 
activity.
    (iii) The facts are the same as in paragraph (a) of this Example, 
except that B sells the equipment to X on December 1 of Year 3 at a 
further gain. Assume that if S and B were divisions of a single 
corporation, gain from the sale to X would be passive income 
attributable to a passive activity. To the extent of B's depreciation 
before the sale, the results are the same as in paragraph (ii) of this 
Example. B's gain and S's remaining gain taken into account as a result 
of B's sale are treated as attributable to a passive activity.
    (iv) The facts are the same as in paragraph (iii) of this Example, 
except that B recognizes a loss on the sale to X. B's loss and S's gain 
taken into account as a result of B's sale are treated as attributable 
to a passive activity.

    (iii) Effective dates. This paragraph (h)(6) applies with respect to 
transactions occurring in years beginning on or after July 12, 1995. For 
transactions occurring in years beginning before July 12, 1995, see 
Sec. 1.469-1T(h)(6) (as contained in the 26 CFR part 1 edition revised 
as of April 1, 1995).
    (h)(7)-(k) [Reserved]

[T.D. 8417, 57 FR 20750, May 15, 1992; 57 FR 28612, June 26, 1992, as 
amended by T.D. 8417, 59 FR 45623, Sept. 2, 1994; T.D. 8597, 60 FR 
36684, July 18, 1995; T.D. 8677, 61 FR 33322, June 27, 1996; T.D. 8823, 
64 FR 36099, July 2, 1999; T.D. 8996, 67 FR 35012, May 17, 2002]



Sec. 1.469-1T  General rules (temporary).

    (a) Passive activity loss and credit disallowed--(1) In general. 
Except as otherwise provided in paragraph (a)(2) of this section--
    (i) The passive activity loss for the taxable year shall not be 
allowed as a deduction; and
    (ii) The passive activity credit for the taxable year shall not be 
allowed.
    (2) Exceptions. Paragraph (a)(1) of this section shall not apply to 
the passive activity loss or the passive activity credit for the taxable 
year to the extent provided in--
    (i) Section 469(i) and the rules to be contained in Sec. 1.469-9T 
(relating to losses and credits attributable to certain rental real 
estate activities); and
    (ii) Section 1.469-11T (relating to losses and credits attributable 
to certain pre-enactment interests in activities).
    (b) Taxpayers to whom these rules apply. The rules of section 469 
and the regulations thereunder generally apply to--
    (1) Individuals;
    (2) Trusts (other than trusts (or portions of trusts) described in 
section 671);
    (3) Estates;
    (4) Personal service corporations (within the meaning of paragraph 
(g)(2)(i) of this section); and
    (5) Closely held corporations (within the meaning of paragraph 
(g)(2)(ii) of this section).
    (c) Cross references--(1) Definition of ``passive activity.'' Rules 
relating to the definition of the term ``passive activity'' are 
contained in paragraph (e) of this section.
    (2) Passive activity loss. Rules relating to the computation of the 
passive activity loss for the taxable year are contained in Sec. 1.469-
2T.
    (3) Passive activity credit. Rules relating to the computation of 
the passive activity credit for the taxable year are contained in Sec. 
1.469-3T.
    (4) Effect of rules for other purposes. Rules relating to the effect 
of section 469 and the regulations thereunder for other purposes under 
the Code are contained in paragraph (d) of this section.
    (5) Special rule for oil and gas working interests. Rules relating 
to the treatment of losses and credits from certain

[[Page 408]]

interests in oil and gas wells are contained in paragraph (e)(4) of this 
section
    (6) Treatment of disallowed losses and credits. Paragraph (f) of 
this section contains rules relating to--
    (i) The treatment of deductions from passive activities in taxable 
years in which the passive activity loss is disallowed in whole or in 
part under paragraph (a)(1)(i) of this section; and
    (ii) The treatment of credits from passive activities in taxable 
years in which the passive activity credit is disallowed in whole or in 
part under paragraph (a)(1)(ii) of this section.
    (7) Corporation subject to section 469. Rules relating to the 
application of section 469 and regulations thereunder to C corporations 
are contained in paragraph (g) of this section.
    (8) [Reserved]
    (9) Joint returns. Rules relating to the application of section 469 
and the regulations thereunder to spouses filing a joint return for the 
taxable year are contained in paragraph (j) of this section.
    (10) Material participation. Rules defining the term ``material 
participation'' are contained in Sec. 1.469-5T.
    (11) Effective date and transition rules. Rules relating to the 
effective date of section 469 and the regulations thereunder and 
transition rules applicable to pre-enactment interests in activities are 
contained in Sec. 1.469-11T.
    (12) Future regulations. (i) Rules relating to former passive 
activities and changes in corporate status will be contained in 
paragraph (k) of this section.
    (ii) Rules relating to the definition of ``activity'' will be 
contained in Sec. 1.469-4T.
    (iii) Rules relating to the treatment of deductions from activities 
that are disposed of in certain transactions will be contained in Sec. 
1.469-6T.
    (iv) Rules relating to the treatment of self-charged items of income 
and expense will be contained in Sec. 1.469-7T.
    (v) Rules relating to the application of section 469 and the 
regulations thereunder to trusts, estates, and their beneficiaries will 
be contained in Sec. 1.469-8T.
    (vi) Rules relating to the treatment of income, deductions, and 
credits from certain rental real estate activities of individuals and 
certain estates will be contained in Sec. 1.469-9T.
    (vii) Rules relating to the application of section 469 to publicly 
traded partnerships will be contained in Sec. 1.469-10T.
    (d) Effect of section 469 and the regulations thereunder for other 
purposes--(1) Treatment of items of passive activity income and gain. 
Neither the provisions of section 469 (a)(1) and paragraph (a)(1) of 
this section nor the characterization of items of income or deduction as 
passive activity gross income (within the meaning of Sec. 1.469-2T (c)) 
or passive activity deductions (within the meaning of Sec. 1.469-2T 
(d)) affects the treatment of any item of income or gain under any 
provision of the Internal Revenue Code other than section 469. The 
following example illustrates the application of this paragraph (d)(1):

    Example. (i) In 1991, an individual's only income and loss from 
passive activities are a $10,000 capital gain from passive activity X 
and a $12,000 ordinary loss from passive activity Y. The taxpayer also 
has a $10,000 capital loss that is not derived from a passive activity.
    (ii) Under Sec. 1.469-2T (b), the taxpayer has a $2,000 passive 
activity loss for the taxable year. The only effect of section 469 and 
the regulations thereunder is to disallow a deduction for the taxpayer's 
$2,000 passive activity loss for the taxable year. Thus, the taxpayer's 
capital loss for the taxable year is allowed because the $10,000 capital 
gain from passive activity X is taken into account under section 1211 
(b) in computing the taxpayer's allowable capital loss for the year.

    (2) Coordination with sections 613A(d) and 1211. [Reserved]. See 
Sec. 1.469-1(d)(2) for rules relating to this paragraph.
    (3) Treatment of passive activity losses. Except as otherwise 
provided by regulations, a deduction that is disallowed for a taxable 
year under section 469 and the regulations thereunder is not taken into 
account as a deduction that is allowed for the taxable year in computing 
the amount subject to any tax imposed by subtitle A of the Internal 
Revenue Code. The following example illustrates the application of this 
paragraph (d)(3):

    Example. An individual has a $5,000 passive activity loss for a 
taxable year, all of which is disallowed under paragraph (a)(1) of this

[[Page 409]]

section. All of the disallowed loss is allocated under paragraph (f) of 
this section to activities that are trades or businesses (within the 
meaning of section 1402(c)). Such loss is not taken into account for the 
taxable year in computing the taxpayer's taxable income subject to tax 
under section 1. In addition, under this paragraph (d)(3), such loss is 
not taken into account for the taxable year in computing the taxpayer's 
net earnings from self-employment subject to tax under section 1401.

    (e) Definition of ``passive activity''--(1) In general. Except as 
otherwise provided in this paragraph (e), an activity is a passive 
activity of the taxpayer for a taxable year if and only if the 
activity--
    (i) Is a trade or business activity (within the meaning of paragraph 
(e)(2) of this section) in which the taxpayer does not materially 
participate for such taxable year; or
    (ii) Is a rental activity (within the meaning of paragraph (e)(3) of 
this section), without regard to whether or to what extent the taxpayer 
participates in such activity.
    (2) Trade or business activity. [Reserved]. See Sec. 1.469-1(e)(2) 
for rules relating to this paragraph.
    (3) Rental activity--(i) In general. Except as otherwise provided in 
this paragraph (e)(3), an activity is a rental activity for a taxable 
year if--
    (A) During such taxable year, tangible property held in connection 
with the activity is used by customers or held for use by customers; and
    (B) The gross income attributable to the conduct of the activity 
during such taxable year represents (or, in the case of an activity in 
which property is held for use by customers, the expected gross income 
from the conduct of the activity will represent) amounts paid or to be 
paid principally for the use of such tangible property (without regard 
to whether the use of the property by customers is pursuant to a lease 
or pursuant to a service contract or other arrangement that is not 
denominated a lease).
    (ii) Exceptions. For purposes of this paragraph (e)(3), an activity 
involving the use of tangible property is not a rental activity for a 
taxable year if for such taxable year--
    (A) The average period of customer use for such property is seven 
days or less;
    (B) The average period of customer use for such property is 30 days 
or less, and significant personal services (within the meaning of 
paragraph (e)(3)(iv) of this section) are provided by or on behalf of 
the owner of the property in connection with making the property 
available for use by customers;
    (C) Extraordinary personal services (within the meaning of paragraph 
(e)(3)(v) of this section) are provided by or on behalf of the owner of 
the property in connection with making such property available for use 
by customers (without regard to the average period of customer use);
    (D) The rental of such property is treated as incidental to a 
nonrental activity of the taxpayer under paragraph (e)(3)(vi) of this 
section;
    (E) The taxpayer customarily makes the property available during 
defined business hours for nonexclusive use by various customers; or
    (F) The provision of the property for use in an activity conducted 
by a partnership, S corporation, or joint venture in which the taxpayer 
owns an interest is not a rental activity under paragraph (e)(3)(vii) of 
this section.
    (iii) Average period of customer use. [Reserved]. See Sec. 1.469-
1(e)(3)(iii) for rules relating to this paragraph.
    (iv) Significant personal services--(A) In general. For purposes of 
paragraph (e)(3)(ii)(B) of this section, personal services include only 
services performed by individuals, and do not include excluded services 
(within the meaning of paragraph (e)(3)(iv)(B) of this section). In 
determining whether personal services provided in connection with making 
property available for use by customers are significant, all of the 
relevant facts and circumstances shall be taken into account. Relevant 
facts and circumstances include the frequency with which such services 
are provided, the type and amount of labor required to perform such 
services, and the value of such services relative to the amount charged 
for the use of the property.
    (B) Excluded services. For purposes of paragraph (e)(3)(iv)(A) of 
this section, the term ``excluded services'' means,

[[Page 410]]

with respect to any property made available for use by customers--
    (1) Services necessary to permit the lawful use of the property;
    (2) Services performed in connection with the construction of 
improvements to the property, or in connection with the performance of 
repairs that extend the property's useful life for a period 
substantially longer than the average period for which such property is 
used by customers; and
    (3) Services, provided in connection with the use of any improved 
real property, that are similar to those commonly provided in connection 
with long-term rentals of high-grade commercial or residential real 
property (e.g., cleaning and maintenance of common areas, routine 
repairs, trash collection, elevator service, and security at entrances 
or perimeters).
    (v) Extraordinary personal services. For purposes of paragraph 
(e)(3)(ii)(C) of this section, extraordinary personal services are 
provided in connection with making property available for use by 
customers only if the services provided in connection with the use of 
the property are performed by individuals, and the use by customers of 
the property is incidental to their receipt of such services. For 
example, the use by patients of a hospital's boarding facilities 
generally is incidental to their receipt of the personal services 
provided by the hospital's medical and nursing staff. Similarly, the use 
by students of a boarding school's dormitories generally is incidental 
to their receipt of the personal services provided by the school's 
teaching staff.
    (vi) Rental of property incidental to a nonrental activity of the 
taxpayer--(A) In general. For purposes of paragraph (e)(3)(ii)(D) of 
this section, the rental of property shall be treated as incidental to a 
nonrental activity of the taxpayer only to the extent provided in this 
paragraph (e)(3)(vi).
    (B) Property held for investment. The rental of property during a 
taxable year shall be treated as incidental to an activity of holding 
such property for investment if and only if--
    (1) The principal purpose for holding the property during such 
taxable year is to realize gain from the appreciation of the property 
(without regard to whether it is expected that such gain will be 
realized from the sale or exchange of the property in its current state 
of development); and
    (2) The gross rental income from the property for such taxable year 
is less than two percent of the lesser of--
    (i) The unadjusted basis of such property; and
    (ii) The fair market value of such property.
    (C) Property used in a trade or business. The rental of property 
during a taxable year shall be treated as incidental to a trade or 
business activity (within the meaning of paragraph (e)(2) of this 
section) if and only if--
    (1) The taxpayer owns an interest in such trade or business activity 
during the taxable year;
    (2) The property was predominantly used in such trade or business 
activity during the taxable year or during at least two of the five 
taxable years that immediately precede the taxable year; and
    (3) The gross rental income from such property for the taxable year 
is less than two percent of the lesser of--
    (i) The unadjusted basis of such property; and
    (ii) The fair market value of such property.
    (D) Lodging for convenience of employer. [Reserved]. See Sec. 
1.469-1(e)(3)(vi)(D) for rules relating to this paragraph.
    (E) Unadjusted basis. [Reserved]. See Sec. 1.469-1(e)(3)(vi)(E) for 
rules relating to this paragraph.
    (vii) Property made available for use in a nonrental activity 
conducted by a partnership, S corporation, or joint venture in which the 
taxpayer owns an interest. If the taxpayer owns an interest in a 
partnership, S corporation, or joint venture conducting an activity 
other than a rental activity, and the taxpayer provides property for use 
in the activity in the taxpayer's capacity as an owner of an interest in 
such partnership, S corporation, or joint venture, the provision of such 
property is not a rental activity. Thus, if a partner contributes the 
use of property to a partnership, none of the partner's distributive 
share of partnership income is income from a rental activity unless the 
partnership is engaged in a rental

[[Page 411]]

activity. In addition, a partner's gross income attributable to a 
payment described in section 707(c) is not income from a rental activity 
under any circumstances (see Sec. 1.469-2T (e)(2)). The determination 
of whether property used in an activity is provided by the taxpayer in 
the taxpayer's capacity as an owner of an interest in a partnership, S 
corporation, or joint venture shall be made on the basis of all of the 
facts and circumstances.
    (viii) Examples. The following examples illustrate the application 
of this paragraph (e)(3):

    Example (1). The taxpayer is engaged in an activity of leasing 
photocopying equipment. The average period of customer use for the 
equipment exceeds 30 days. Pursuant to the lease agreements, skilled 
technicians employed by the taxpayer maintain the equipment and service 
malfunctioning equipment for no additional charge. Service calls occur 
frequently (three times per week on average) and require substantial 
labor. The value of the maintenance and repair services (measured by the 
cost to the taxpayer of employees performing these services) exceeds 50 
percent of the amount charged for the use of the equipment. Under these 
facts, services performed by individuals are provided in connection with 
the use of the photocopying equipment, but the customers' use of the 
photocopying equipment is not incidental to their receipt of the 
services. Therefore, extraordinary personal services (within the meaning 
of paragraph (e)(3)(v) of this section) are not provided in connection 
with making the photocopying equipment available for use by customers, 
and the activity is a rental activity.
    Example (2). The facts are the same as in example (1), except that 
the average period of customer use for the photocopying equipment 
exceeds seven days but does not exceed 30 days. Under these facts, 
significant personal services (within the meaning of paragraph 
(e)(3)(iv) of this section) are provided in connection with making the 
photocopying equipment available for use by customers and, under 
paragraph (e)(3)(ii)(B) of this section, the activity is not a rental 
activity.
    Example (3). The taxpayer is engaged in an activity of transporting 
goods for customers. In conducting the activity, the taxpayer provides 
tractor-trailers to transport goods for customers pursuant to 
arrangements under which the tractor-trailers are selected by the 
taxpayer, may be replaced at the sole option of the taxpayer, and are 
operated and maintained by drivers and mechanics employed by the 
taxpayer. The average period of customer use for the tractor-trailers 
exceeds 30 days. Under these facts, the use of tractor-trailers by the 
taxpayer's customers is incidental to their receipt of personal services 
provided by the taxpayer. Accordingly, the services performed in the 
activity are extraordinary personal services (within the meaning of 
paragraph (e)(3)(v) of this section) and, under paragraph (e)(3)(ii)(C) 
of this section, the activity is not a rental activity.
    Example (4). The taxpayer is engaged in an activity of owning and 
operating a residential apartment hotel. For the taxable year, the 
average period of customer use for apartments exceeds seven days but 
does not exceed 30 days. In addition to cleaning public entrances, 
exists, stairways, and lobbies, and collecting and removing trash, the 
taxpayer provides a daily maid and linen service at no additional 
charge. All of the services other than maid and linen service are 
excluded services (within the meaning of paragraph (e)(3)(iv)(B) of this 
section), because such services are similar to those commonly provided 
in connection with long-term rentals of high-grade residential real 
property. The value of the maid and linen services (measured by the cost 
to the taxpayer of employees performing such services) is less than 10 
percent of the amount charged to tenants for occupancy of apartments. 
Under these facts, neither significant personal services (within the 
meaning of paragraph (e)(3)(iv) of this section) nor extraordinary 
personal services (within the meaning of paragraph (e)(3)(v) of this 
section) are provided in connection with making apartments available for 
use by customers. Accordingly, the activity is a rental activity.
    Example (5). The taxpayer owns 1,000 acres of unimproved land with a 
fair market value of $350,000 and an unadjusted basis of $210,000. The 
taxpayer holds the land for the principal purpose of realizing gain from 
appreciation. In order to defray the cost of carrying the land, the 
taxpayer leases the land to a rancher, who uses the land to graze cattle 
and pays rent of $4,000 per year. Thus, the gross rental income from the 
land is less than two percent of the lesser of the fair market value and 
the unadjusted basis of the land (.02 x $210,000=$4,200). Accordingly, 
under paragraph (e)(3)(ii)(D) of this section, the rental of the land is 
not a rental activity because the rental is treated under paragraph 
(e)(3)(vi)(B) of this section as incidental to an activity of holding 
the property for investment.
    Example (6). (i) A calendar year taxpayer owns an interest in a 
farming activity which is a trade or business activity (within the 
meaning of paragraph (e)(2) of this section) and owns farmland which was 
used in the farming activity in 1985 and 1986. The fair market value of 
the farmland is $350,000 and its unadjusted basis is $210,000. In 1987, 
1988, and 1989, the taxpayer continues to own an interest in the farming 
activity but does not

[[Page 412]]

use the land in the activity. In 1987, the taxpayer leases the land for 
$4,000 to a rancher, who uses the land to graze cattle. In 1988, the 
taxpayer leases the land for $10,000 to a film production company, which 
uses the land to film scenes for a movie. In 1989, the taxpayer again 
leases the land for $4,000 to the rancher.
    (ii) For 1987 and 1989, the taxpayer owns an interest in a trade or 
business activity, and the farmland which the taxpayer leases to the 
rancher was used in such activity for two out of the five immediately 
preceding taxable years. In addition, the gross rental income from the 
land ($4,000) is less than two percent of the lesser of the fair market 
value and the unadjusted basis of the land (.02x$210,000=$4,200). 
Accordingly, the taxpayer's rental of the land is treated under 
paragraph (e)(3)(vi)(C) of this section as incidental to the taxpayer's 
farming activity, and is not a rental activity.
    (iii) Because the taxpayer's gross rental income from the land for 
1988 ($10,000) is not less than two percent of the lesser of the fair 
market value and the unadjusted basis of the land, the requirement of 
paragraph (e)(3)(vi)(C)(3) of this section is not met. Therefore, the 
taxpayer's rental of the land in 1988 is not treated as incidental to 
the taxpayer's farming activity and is a rental activity.
    Example (7). (i) In 1988, the taxpayer acquires vacant land for the 
purpose of constructing a shopping mall. Before commencing construction, 
the taxpayer leases the land under a one-year lease to an automobile 
dealer, who uses the land to park cars held in its inventory. The 
taxpayer commences construction of the shopping mall in 1989.
    (ii) The taxpayer acquired the land for the principal purpose of 
constructing the shopping mall, not for the principal purpose of 
realizing gain from the appreciation of the property. Therefore, the 
rental of the property in 1988 is not treated under paragraph 
(e)(3)(vi)(B) of this section as incidental to an activity of holding 
the property for investment.
    (iii) The land has not been used in any taxable year in any trade or 
business of the taxpayer. Therefore, the rental of the property in 1988 
is not treated under paragraph (e)(3)(vi)(C) of this section as 
incidental to a trade or business activity.
    (iv) Since the rental of the land in 1988 is not treated under 
paragraph (e)(3)(vi) of this section as incidental to a nonrental 
activity of the taxpayer, the rental of the land in 1988 is a rental 
activity. See Sec. 1.469-2T(f)(3) for a special rule relating to the 
treatment of gross income from the rental of nondepreciable property.
    Example (8). The taxpayer makes farmland available to a tenant 
farmer pursuant to an arrangement designated a ``crop-share lease.'' 
Under the arrangement, the tenant is required to use the tenant's best 
efforts to farm the land and produce marketable crops. The taxpayer is 
obligated to pay 50 percent of the costs incurred in the activity 
(without regard to whether any crops are successfully produced or 
marketed), and is entitled to 50 percent of the crops produced (or 50 
percent of the proceeds from marketing the crops). For purposes of 
paragraph (e)(3)(vii) of this section, the taxpayer is treated as 
providing the farmland for use in a farming activity conducted by a 
joint venture in the taxpayer's capacity as an owner of an interest in 
the joint venture. Accordingly, under paragraph (e)(3)(ii)(F) of this 
section, the taxpayer is not engaged in a rental activity, without 
regard to whether the taxpayer performs any services in the farming 
activity.
    Example (9). The taxpayer owns a taxicab which the taxpayer operates 
during the day and leases to another driver for use at night under a 
one-year lease. Under the terms of the lease, the other driver is 
charged a fixed rental for use of the taxicab. Assume that, under the 
rules to be contained in Sec. 1.469-4T, the taxpayer is engaged in two 
separate activities, an activity of operating the taxicab and an 
activity of making the taxicab available for use by the other driver. 
Under these facts, the period for which the other driver uses the 
taxicab exceeds 30 days, and the taxpayer does not provide extraordinary 
personal services in connection with making the taxicab available to the 
other driver. Accordingly, the lease of the taxicab is a rental 
activity.
    Example (10). The taxpayer operates a golf course. Some customers of 
the golf course pay green fees upon each use of the golf course, while 
other customers purchase weekly, monthly, or annual passes. The golf 
course is open to all customers from sunrise to sunset every day of the 
year except certain holidays and days on which the taxpayer determines 
that the course is too wet for play. The taxpayer thus makes the golf 
course available during prescribed hours for nonexclusive use by various 
customers. Accordingly, under paragraph (e)(3)(ii)(E) of this section, 
the taxpayer is not engaged in a rental activity, without regard to the 
average period of customer use for the golf course.

    (4) Special rule for oil and gas working interests--(i) In general. 
Except as otherwise provided in paragraph (e)(4)(ii) of this section, an 
interest in an oil or gas well drilled or operated pursuant to a working 
interest (within the meaning of paragraph (e)(4)(iv) of this section) of 
a taxpayer is not an interest in a passive activity for the taxpayer's 
taxable year (without regard to whether the taxpayer materially 
participates in

[[Page 413]]

such activity) if at any time during such taxable year the taxpayer 
holds such working interest either--
    (A) Directly; or
    (B) Through an entity that does not limit the liability of the 
taxpayer with respect to the drilling or operation of such well pursuant 
to such working interest.
    (ii) Exception for deductions attributable to a period during which 
liability is limited--(A) In general. If paragraph (e)(4)(i) of this 
section applies for a taxable year to the taxpayer's interest in an oil 
or gas well that would, but for the application of paragraph (e)(4)(i) 
of this section, by an interest in a passive activity for the taxable 
year, and the taxpayer has a net loss (within the meaning of paragraph 
(e)(4)(ii)(C)(3) of this section) from the well for the taxable year--
    (1) The taxpayer's disqualified deductions (within the meaning of 
paragraph (e)(4)(ii)(C)(2) of this section) from such oil or gas well 
for such year shall be treated as passive activity deductions for such 
year (within the meaning of Sec. 1.469-2T(d)); and
    (2) A ratable portion (within the meaning of paragraph 
(e)(4)(ii)(C)(4) of this section) of the taxpayer's gross income from 
such oil or gas well for such year shall be treated as passive activity 
gross income for such year (within the meaning of Sec. 1.469-2T(c)).
    (B) Coordination with rules governing the identification of 
disallowed passive activity deductions. If gross income and deductions 
from an activity for a taxable year are treated as passive activity 
gross income and passive activity deductions under paragraph 
(e)(4)(ii)(A) of this section, such activity shall be treated as a 
passive activity for such year for purposes of applying paragraph (f) 
(2) and (4) of this section.
    (C) Meaning of certain terms. For purposes of this paragraph 
(e)(4)(ii), the following terms shall have the meanings set forth below:
    (1) Allocable deductions. The deductions allocable to a taxable year 
are any deductions that arise in such year (within the meaning of Sec. 
1.469-2T (d)(8)) and any deductions that are treated as deductions for 
such year under paragraph (f)(4) of this section.
    (2) Disqualified deductions. The taxpayer's ``disqualified 
deductions'' from an oil or gas well for a taxable year are the 
taxpayer's deductions--
    (i) That are attributable to such well and allocable to the taxable 
year; and
    (ii) With respect to which economic performance (within the meaning 
of section 461(h), without regard to section 461 (h)(3) or (i)(2)) 
occurs at a time during which the taxpayer's only interest in the 
working interest is held through an entity that limits the taxpayer's 
liability with respect to the drilling or operation of such well.
    (3) Net loss. The ``net loss'' of a taxpayer from an oil or gas well 
for a taxable year equals the amount by which the taxpayer's deductions 
that are attributable to such oil or gas well and allocable to such year 
exceeds the gross income of the taxpayer from such well for such year.
    (4) Ratable portion. The ``ratable portion'' of the taxpayer's gross 
income from an oil or gas well for a taxable year equals the total 
amount of such gross income multiplied by the fraction obtained by 
dividing--
    (i) The disqualified deductions from such oil or gas well for the 
taxable year; by
    (ii) The total amount of the deductions that are attributable to 
such oil or gas well and allocable to the taxable year.
    (iii) Examples. The following examples illustrate the application of 
paragraphs (e)(4) (i) and (ii) of this section:

    Example (1). (i) A, a calendar year individual, acquires on January 
1, 1987, a general partnership interest in P, a calendar year 
partnership that holds a working interest in an oil or gas property. 
Pursuant to the partnership agreement, A is entitled to convert the 
general partnership interest into a limited partnership interest at any 
time. On December 1, 1987, pursuant to a contract with D, an independent 
drilling contractor, P commences drilling a single well pursuant to the 
working interest. Under the drilling contract, P pays D for the drilling 
only as the work is performed. All drilling costs are deducted by P in 
the year in which they are paid. At the end of 1987, A converts the 
general partnership interest into a limited partnership interest, 
effective immediately. The drilling of the well is completed on February 
28, 1988. A's interest in the well would but for this paragraph (e)(4) 
be an interest in a passive activity.

[[Page 414]]

    (ii) Throughout 1987, A holds the working interest through an entity 
that does not limit A's liability with respect to the drilling of the 
well pursuant to the working interest. In 1988, however, A holds the 
working interest through an entity that limits A's liability with 
respect to the drilling and operation of the well throughout such year. 
Accordingly, under paragraph (e)(4)(i) of this section, A's interest in 
P's well is not an interest in a passive activity for 1987 but is an 
interest in a passive activity for 1988. Moreover, since economic 
performance occurs in 1987 with respect to all items of deduction for 
drilling costs that are allocable to 1987, A has no disqualified 
deductions for 1987.
    Example (2). The facts are the same as in example (1), except that 
all costs of drilling under the contract with D (including costs of 
drilling performed after 1987) are paid before the end of 1987 and A has 
a net loss for 1987. In addition, A has $15,000 of total deductions that 
are attributable to the well and allocable to 1987, but economic 
performance (as that term is used in paragraph (e)(4)(ii)(C)(2)(ii) of 
this section) does not occur with respect to $5,000 of those deductions 
until 1988. Under paragraph (e)(4)(ii) of this section, the $5,000 of 
deductions with respect to which economic performance occurs in 1988 are 
disqualified deductions and are treated as passive activity deductions 
for 1987. In addition, one-third ($5,000/$15,000) of A's gross income 
from the well for 1987 is treated as passive activity gross income.

    (iv) Definition of ``working interest.'' [Reserved]. See Sec. 
1.469-1(e)(4)(iv) for rules relating to this paragraph.
    (v) Entities that limit liability--(A) General rule. For purposes of 
paragraph (e)(4)(i)(B) of this section, an entity limits the liability 
of the taxpayer with respect to the drilling or operation of a well 
pursuant to a working interest held through such entity if the 
taxpayer's interest in the entity is in the form of--
    (1) A limited partnership interest in a partnership in which the 
taxpayer is not a general partner;
    (2) Stock in a corporation; or
    (3) An interest in any entity (other than a limited partnership or 
corporation) that, under applicable State law, limits the potential 
liability of a holder of such an interest for all obligations of the 
entity to a determinable fixed amount (for example, the sum of the 
taxpayer's capital contributions).
    (B) Other limitations disregarded. For purposes of this paragraph 
(e)(4), protection against loss through any of the following is not 
taken into account in determining whether a taxpayer holds a working 
interest through an entity that limits the taxpayer's liability:
    (1) An indemnification agreement;
    (2) A stop loss arrangement;
    (3) Insurance;
    (4) Any similar arrangement; or
    (5) Any combination of the foregoing.
    (C) Examples. The following examples illustrate the application of 
this paragraph (e)(4)(v):

    Example (1). A owns a 20 percent interest as a general partner in 
the capital and profits of P, a partnership which owns oil or gas 
working interests. The other partners of P agree to indemnify A against 
liability in excess of A's capital contribution for any of P's costs and 
expenses with respect to P's working interests. As a general partner, 
however, A is jointly and severally liable for all of P's liabilities 
and, under paragraph (e)(4)(v)(B)(1) of this section, the 
indemnification agreement is not taken into account in determining 
whether A holds the working interests through an entity that limits A's 
liability. Accordingly, the partnership does not limit A's liability 
with respect to the drilling or operation of wells pursuant to the 
working interests.
    Example (2). B owns a 10 percent interest in X, an entity (other 
than a limited partnership or corporation) created under applicable 
State law to hold working interests in oil or gas properties. Under 
applicable State law, B is liable without limitation for 10 percent of 
X's costs and expenses with respect to X's working interests but is not 
liable for the remaining 90 percent of such costs and expenses. Since 
B's liability for the obligations of X is not limited to a determinable 
fixed amount (within the meaning of paragraph (e)(4)(v)(A)(3) of this 
section), the entity does not limit B's liability with respect to the 
drilling or operation of wells pursuant to the working interests.
    Example (3). C is both a general partner and a limited partner in a 
partnership that owns a working interest in oil or gas property. Because 
C owns an interest as a general partner in each well drilled pursuant to 
the working interest, C's entire interest in each well drilled pursuant 
to the working interest is treated under paragraph (e)(4)(i) of this 
section as an interest in an activity that is not a passive activity 
(without regard to whether C materially participates in such activity).

    (vi) Cross reference to special rule for income from certain oil or 
gas properties. A special rule relating to the treatment of income from 
certain interests in oil or gas properties is contained in Sec. 1.469-
2T(c)(6).

[[Page 415]]

    (5) Rental of dwelling unit. [Reserved]. See Sec. 1.469-
2(d)(2)(xii) for rules relating to this paragraph.
    (6) Activity of trading personal property--(i) In general. An 
activity of trading personal property for the account of owners of 
interests in the activity is not a passive activity (without regard to 
whether such activity is a trade or business activity (within the 
meaning of paragraph (e)(2) of this section)).
    (ii) Personal property. For purposes of this paragraph (e)(6), the 
term ``personal property'' means personal property (within the meaning 
of section 1092(d), without regard to paragraph (3) thereof).
    (iii) Example. The following example illustrates the application of 
this paragraph (e)(6):

    Example. A partnership is a trader of stocks, bonds, and other 
securities (within the meaning of section 1236(c)). The capital employed 
by the partnership in the trading activity consists of amounts 
contributed by the partners in exchange for their partnership interests, 
and funds borrowed by the partnership. The partnership derives gross 
income from the activity in the form of interest, dividends, and capital 
gains. Under these facts, the partnership is treated as conducting an 
activity of trading personal property for the account of its partners. 
Accordingly, under this paragraph (e)(6), the activity is not a passive 
activity.

    (f) Treatment of disallowed passive activity losses and credits--(1) 
Scope of this paragraph. The rules in this paragraph (f)--
    (i) Identify the passive activity deductions that are disallowed for 
any taxable year in which all or a portion of the taxpayer's passive 
activity loss is disallowed under paragraph (a)(1)(i) of this section;
    (ii) Identify the credits from passive activities that are 
disallowed for any taxable year in which all or a portion of the 
taxpayer's passive activity credit is disallowed under paragraph 
(a)(1)(i) of this section; and
    (iii) Provide for the carryover of disallowed deductions and 
credits.
    (2) Identification of disallowed passive activity deductions--(i) 
Allocation of disallowed passive activity loss among activities--(A) 
General rule. If all or any portion of the taxpayer's passive activity 
loss is disallowed for the taxable year under paragraph (a)(1)(i) of 
this section, a ratable portion of the loss (if any) from each passive 
activity of the taxpayer is disallowed. For purposes of the preceding 
sentence, the ratable portion of a loss from an activity is computed by 
multiplying the passive activity loss that is disallowed for the taxable 
year by the fraction obtained by dividing--
    (1) The loss from the activity for the taxable year; by
    (2) The sum of the losses for the taxable year from all activities 
having losses for such year.
    (B) Loss from an activity. For purposes of this paragraph (f)(2)(i), 
the term ``loss from an activity'' means--
    (1) The amount by which the passive activity deductions from the 
activity for the taxable year (within the meaning of Sec. 1.469-2T(d)) 
exceed the passive activity gross income from the activity for the 
taxable year (within the meaning of Sec. 1.469-2T(c)); reduced by
    (2) Any part of such amount that is allowed under section 469(i) and 
the rules to be contained in Sec. 1.469-9T (relating to the $25,000 
allowance for certain rental real estate activities).
    (C) Significant participation passive activities. If the taxpayer's 
passive activity gross income from significant participation passive 
activities (within the meaning of Sec. 1.469-2T(f)(2)(ii)) for the 
taxable year (determined without regard to Sec. 1.469-2T(f)(2) through 
(4)) exceeds the taxpayer's passive activity deductions from such 
activities for the taxable year, such activities shall be treated, 
solely for purposes of applying this paragraph (f)(2)(i) for the taxable 
year, as a single activity that does not have a loss for such taxable 
year.
    (D) Examples. The following examples illustrate the application of 
this paragraph (f)(2)(i):

    Example (1). An individual holds interests in three passive 
activities, A, B, and C. The gross income and deductions from these 
activities for the taxable year are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                   A            B            C          Total
----------------------------------------------------------------------------------------------------------------
Gross income................................................      $7,000       $4,000      $12,000      $23,000

[[Page 416]]

 
Deductions..................................................     (16,000)     (20,000)      (8,000)     (44,000)
                                                             ---------------------------------------------------
    Net income (loss).......................................     ($9,000)    ($16,000)      $4,000     ($21,000)
----------------------------------------------------------------------------------------------------------------

    The taxpayer's $21,000 passive activity loss for the taxable year is 
disallowed under paragraph (a)(1)(i) of this section. Therefore, a 
ratable portion of the losses from activities A and B is disallowed. The 
disallowed portion of each loss is determined as follows:

A: $21,000x$9,000/$25,000.....................................    $7,560
B: $21,000x$16,000/$25,000....................................   $13,440
                                                               ---------
    Total.....................................................   $21,000
 

    Example (2). An individual holds interests in four passive 
activities, A, B, C, and D. The results of operations of these 
activities for the taxable year are as follows:

----------------------------------------------------------------------------------------------------------------
                                                      A            B            C            D          Total
----------------------------------------------------------------------------------------------------------------
Gross income...................................      15,000        5,000       10,000       10,000       40,000
Deductions.....................................      (5,000)     (10,000)     (20,000)      (8,000)     (43,000)
    Net income (loss)..........................      10,000       (5,000)     (10,000)       2,000       (3,000)
----------------------------------------------------------------------------------------------------------------

    Activities A and B are significant participation passive activities 
(within the meaning of Sec. 1.469-2T(f)(2)(ii)). The gross income from 
these activities for the taxable year ($20,000) exceeds the passive 
activity deductions from those activities for the taxable year ($15,000) 
by $5,000 and, under Sec. 1.469-2T(f)(2), $5,000 of gross income from 
those activities is treated as not from a passive activity. Therefore, 
solely for purposes of applying this paragraph (f)(2)(i) for the taxable 
year, activities A and B are treated as a single activity that does not 
have a loss for the taxable year. Under Sec. 1.469-2T(b), the 
taxpayer's passive activity loss for the taxable year is $8,000 ($43,000 
of passive activity deductions minus $35,000 of passive activity gross 
income). The results of treating activities A and B as a single activity 
that does not have a loss for the taxable year is that none of the 
$8,000 passive activity loss is allocated under this paragraph (f)(2)(i) 
to activity B for the taxable year, even though the taxpayer incurred a 
loss in that activity for the taxable year.

    (ii) Allocation within loss activities--(A) In general. If all or 
any portion of a taxpayer's loss from an activity is disallowed under 
paragraph (f)(2)(i) of this section for the taxable year, a ratable 
portion of each passive activity deduction (other than an excluded 
deduction (within the meaning of paragraph (f)(2)(ii)(B) of this 
section)) of the taxpayer from such activity is disallowed. For purposes 
of the preceding sentence, the ratable portion of a passive activity 
deduction of a taxpayer is the amount of the disallowed portion of the 
taxpayer's loss from the activity (within the meaning of paragraph 
(f)(2)(i)(B) of this section) for the taxable year multiplied by the 
fraction obtained by dividing--
    (1) The amount of such deduction; by
    (2) The sum of all passive activity deductions (other than excluded 
deductions (within the meaning of paragraph (f)(2)(ii)(B) of this 
section)) of the taxpayer from such activity from the taxable year.
    (B) Excluded deductions. The term ``excluded deduction'' means any 
passive activity deduction of a taxpayer that is taken into account in 
computing the taxpayer's net income from an item of property for a 
taxable year in which an amount of the taxpayer's gross income from such 
item of property is treated as not from a passive activity under Sec. 
1.469-2T(c)(6) or Sec. 1.469-2T(f) (5), (6), or (7).
    (iii) Separately identified deductions. In identifying the 
deductions from an activity that are disallowed under this paragraph 
(f)(2), the taxpayer need not account separately for a deduction unless 
such deduction may, if separately taken into account, result in an 
income tax liability for any taxable year different from that which 
would result were such deduction not taken into account separately. For 
related rules applicable to partnerships and S corporations, see Sec. 
1.702-1(a)(8)(ii) and section 1366(a)(1)(A), respectively. Deductions 
that must be accounted for separately include (but are not limited to) 
deductions that--
    (A) Arise in a rental real estate activity (within the meaning of 
section

[[Page 417]]

469(i) and the rules to be contained in Sec. 1.469-9T) in taxable years 
in which the taxpayer actively participates (within the meaning of 
section 469(i) and the rules to be contained in Sec. 1.469-9T) in such 
activity;
    (B) Arise in a rental real estate activity (within the meaning of 
section 469(i) and the rules to be contained in Sec. 1.469-9T) in 
taxable years in which the taxpayer does not actively participate 
(within the meaning of section 469(i) and the rules to be contained in 
Sec. 1.469-9T) in such activity; or
    (C) Are taken into account under section 1211 (relating to the 
limitation on capital losses) or section 1231 (relating to property used 
in a trade or business and involuntary conversions).
    (3) Identification of disallowed credits from passive activities--
(i) General rule. If all or any portion of the taxpayer's passive 
activity credit is disallowed for the taxable year under paragraph 
(a)(1)(ii) of this section, a ratable portion of each credit from each 
passive activity of the taxpayer is disallowed. For purposes of the 
preceding sentence, the ratable portion of a credit of a taxpayer is 
computed by multiplying the portion of the taxpayer's passive activity 
credit that is disallowed for the taxable year by the fraction obtained 
by dividing--
    (A) The amount of the credit; by
    (B) The sum of all of the taxpayer's credits from passive activities 
for the taxable year.
    (ii) Coordination rule. For purposes of paragraph (f)(3)(i) of this 
section, the credits from a passive activity do not include any credit 
or portion of a credit that--
    (A) Is allowed for the taxable year under section 469(i) and the 
rules to be contained in Sec. 1.469-9T (relating to the $25,000 
allowance for certain rental real estate activities); or
    (B) Increases the basis of property during the taxable year under 
section 469(j)(9) and the rules to be contained in Sec. 1.469-6T 
(relating to the election to increase the basis of certain property by 
disallowed credits).
    (iii) Separately identified credits. In identifying the credits from 
an activity that are disallowed under this paragraph (f)(3), the 
taxpayer need not account separately for any credit unless such credit 
may, if separately taken into account, result in an income tax liability 
for any taxable year different from that which would result were such 
credit not taken into account separately. For related rules applicable 
to partnerships and S corporations, see Sec. 1.702-1(a)(8)(ii) and 
section 1366(a)(1)(A), respectively. Credits that must be accounted for 
separately include (but are not limited to)--
    (A) Credits (other than the low-income housing and rehabilitation 
investment credits) from a rental real estate activity (within the 
meaning of section 469(i) and the rules to be contained in Sec. 1.469-
9T) that arise in a taxable year in which the taxpayer actively 
participates (within the meaning of section 469(i) and the rules to be 
contained in Sec. 1.469-9T) in such activity;
    (B) Credits (other than the low-income housing and rehabilitation 
investment credits) from a rental real estate activity (within the 
meaning of section 469(i) and the rules to be contained in Sec. 1.469-
9T) that arise in a taxable year in which the taxpayer does not actively 
participate (within the meaning of section 469(i) and the rules to be 
contained in Sec. 1.469-9T) in such activity;
    (C) Low-income housing and rehabilitation investment credits from a 
rental real estate activity (within the meaning of section 469(i) and 
the rules to be contained in Sec. 1.469-9T); and
    (D) Any credit that is subject to the limitations of sections 26(a), 
28(d)(2), 29(b)(5), or 38(c) in a manner that differs from the manner in 
which any other credit is subject to such limitations.
    (4) Carryover of disallowed deductions and credits. [Reserved]. See 
Sec. 1.469-1(f)(4) for rules relating to this paragraph.
    (g) Application of these rules to C corporations--(1) In general. 
Except as otherwise provided in the rules to be contained in paragraph 
(k) of this section, section 469 and the regulations thereunder do not 
apply to any corporation that is not a personal service corporation or a 
closely held corporation for the taxable year. See paragraphs (g) (4) 
and (5) of this section for special rules for computing the passive 
activity loss and passive activity credit, respectively, of a closely 
held corporation.

[[Page 418]]

    (2) Definitions. For purposes of section 469 and the regulations 
thereunder--
    (i) The term personal service corporation means a C corporation that 
is a personal service corporation for the taxable year (within the 
meaning of Sec. 1.441-3(c)); and
    (ii) The term closely held corporation means a C corporation that 
meets the stock ownership requirements of section 542(a)(2) (taking into 
account the modifications in section 465(a)(3)) for the taxable year and 
is not a personal service corporation for such year.
    (3) Participation of corporations--(i) Material participation. For 
purposes of section 469 and the regulations thereunder, a corporation 
described in paragraph (g)(2) of this section shall be treated as 
materially participating in an activity for a taxable year if and only 
if--
    (A) One or more individuals, each of whom is treated under paragraph 
(g)(3)(iii) of this section as materially participating in such activity 
for the taxable year, directly or indirectly hold (in the aggregate) 
more than 50 percent (by value) of the outstanding stock of such 
corporation; or
    (B) In the case of a closely held corporation (within the meaning of 
paragraph (g)(2)(ii) of this section), the requirements of section 
465(c)(7)(C) (without regard to clause (iv) thereof and taking into 
account section 465(c)(7)(D)) are met with respect to such activity.
    (ii) Significant participation. For purposes of Sec. 1.469-
2T(f)(2), an activity of a corporation described in paragraph (g)(2) of 
this section shall be treated as a significant participation passive 
activity for a taxable year if and only if--
    (A) The corporation is not treated as materially participating in 
such activity for the taxable year; and
    (B) One or more individuals, each of whom is treated under paragraph 
(g)(3)(iii) of this section as significantly participating in such 
activity, directly or indirectly hold (in the aggregate) more than 50 
percent (by value) of the outstanding stock of such corporation.
    (iii) Participation of individual. Whether an individual is treated 
for purposes of this paragraph (g)(3) as materially participating or 
significantly participating in an activity of a corporation shall be 
determined under the rules of Sec. 1.469-5T, except that in applying 
such rules--
    (A) All activities of the corporation shall be treated as activities 
in which the individual holds an interest in determining whether the 
individual participates (within the meaning of Sec. 1.469-5T(f)) in an 
activity of the corporation; and
    (B) The individual's participation in all activities other than 
activities of the corporation shall be disregarded in determining 
whether the individual's participation in an activity of the corporation 
is treated as material participation under Sec. 1.469-5T(a)(4) 
(relating to material participation in significant participation 
activities).
    (4) Modified computation of passive activity loss in the case of 
closely held corporations--(i) In general. A closely held corporation's 
passive activity loss for the taxable year is the amount, if any, by 
which the corporation's passive activity deductions for the taxable year 
(within the meaning of Sec. 1.469-2T(d)) exceed the sum of--
    (A) The corporation's passive activity gross income for the taxable 
year (within the meaning of Sec. 1.469-2T(c)); and
    (B) The corporation's net active income for the taxable year.
    (ii) Net active income. For purposes of this paragraph (g)(4), a 
corporation's net active income for the taxable year is such 
corporation's taxable income for the taxable year, determined without 
regard to the following items for the year:
    (A) Passive activity gross income;
    (B) Passive activity deductions;
    (C) [Reserved]. See Sec. 1.469-1(g)(4)(ii)(C) for rules relating to 
this paragraph.
    (D) Gross income that is treated under Sec. 1.469-2T(c)(6) 
(relating to gross income from certain oil or gas properties) as not 
from a passive activity;
    (E) Gross income and deductions from any trade or business activity 
(within the meaning of paragraph (e)(2) of this section) that is 
described in

[[Page 419]]

paragraph (e)(6) of this section (relating to certain activities of 
trading personal property) but only if the corporation did not 
materially participate in such activity for the taxable year;
    (F) Deductions described in Sec. 1.469-2T(d)(2)(i), (ii), and (iv) 
(relating to certain deductions attributable to portfolio income); and
    (G) Interest expense allocated under Sec. 1.163-8T to a portfolio 
expenditure (within the meaning of Sec. 1.163-8T(b)(6)).
    (iii) Examples. The following examples illustrate the application of 
this paragraph (g)(4):

    Example (1). (i) For 1987, X, a closely held corporation, is engaged 
in two activities, a trade or business activity in which X materially 
participates for 1987 and a rental activity. X also holds portfolio 
investments. For 1987, X has the following gross income and deductions:

Gross income:
  Rents....................................................      $60,000
  Gross income from business...............................      100,000
  Portfolio income.........................................       35,000
                                                            ------------
    Total..................................................     $195,000
                                                            ============
Deductions:
  Rental deductions........................................   ($100,000)
  Business deductions (80,000).............................
  Interest expense allocable to portfolio expenditures          (10,000)
   under Sec.  1.163-8T...................................
  Deductions (other than interest expense) clearly and           (5,000)
   directly allocable to portfolio income..................
                                                            ------------
    Total..................................................   ($195,000)
                                                            ============
 

    (ii) The corporation's net active income for 1987 is $20,000, 
computed as follows:

Gross income.....................  ...........     $195,000
Amounts not taken into account in
 computing net active income:
  Rents (see paragraph                 $60,000
   (g)(4)(ii)(A) of this section)
  Portfolio income (see paragraph      $35,000
   (g)(4)(ii)(C) of this section)
                                  --------------
                                       $95,000    ($95,000)
                                  --------------------------
Gross income taken into account    ...........     $100,000     $100,000
 in computing net active income..
                                               =============
Deductions.......................  ...........   ($195,000)
Amounts not taken into account in
 computing net active income:
  Rental deductions (see            ($100,000)
   paragraph (g)(4)(ii)(B) of
   this section).................
  Interest expense allocated to      ($10,000)
   portfolio expenditures (see
   paragraph (g)(4)(ii)(G) of
   this section).................
Other deductions clearly and          ($5,000)
 directly allocable to portfolio
 income (see paragraph
 (g)(4)(ii)(F) of this section)..
                                               -------------
                                    ($115,000)     $115,000
                                               -------------
Deductions taken into account in   ...........    ($80,000)    ($80,000)
 computing net active income.....
                                               =============
Net active income................  ...........  ...........      $20,000
                                                            ============
 

    (iii) Under paragraph(g)(4)(i) of this section, X's passive activity 
loss for 1987 is $20,000, the amount by which the passive activity 
deductions for the taxable year ($100,000) exceed the sum of (a) the 
passive activity gross income for the taxable year ($60,000) and (b) the 
net active income for the taxable year ($20,000). Under paragraph (f)(4) 
of this section, the $20,000 of deductions from X's rental activity that 
are disallowed for 1987 are treated as deductions from the rental 
activity for 1988. If computed without regard to the net active income 
for the taxable year, X's passive activity loss would be $40,000 
($100,000 of rental deductions minus $60,000 of rental income). Thus, 
the effect of the rule in paragraph (g)(4)(i) of this section is to 
reduce the corporation's passive activity loss for the taxable year by 
the amount of the corporation's net active income for such year.
    (iv) Under these facts, X's taxable income for 1987 is $20,000, 
computed as follows:

Gross income..................................  ...........     $195,000
Deductions:
  Total deductions............................   ($195,000)
  Passive activity loss.......................      $20,000
                                               --------------
  Allowable deductions........................   ($175,000)   ($175,000)
                                                            ------------
Taxable income................................  ...........      $20,000
                                                            ============
 

    Example (2). (i) The facts are the same as in example (1), except 
that, in 1988, X has a loss from the trade or business activity, and a 
net operating loss (``NOL'') of $15,000 that is carried back under 
section 172(b) to 1987. Since NOL carrybacks are taken into account in 
computing net active income, X's net active income for 1987 must be 
recomputed as follows:

Net active income before NOL carryback.....................      $20,000
NOL carryback..............................................    ($15,000)
                                                            ------------

[[Page 420]]

 
Net active income..........................................       $5,000
                                                            ============
 

    (ii) Under these facts, X's disallowed passive activity loss for 
1987 is $35,000, the amount by which the passive activity deductions for 
the taxable year ($100,000) exceed the sum of (a) the passive activity 
gross income for the taxable year ($60,000) and (b) the net active 
income for the taxable year ($5,000).
    (iii) Under paragraph (f)(4) of this section, the $35,000 of 
deductions from X's rental activity that are disallowed for 1987 are 
treated as deductions from the rental activity for 1988. X's taxable 
income for 1987 is $20,000, computed as follows:

Gross income..................................  ...........     $195,000
Deductions:
  Total deductions............................   ($210,000)
  Passive activity loss.......................      $35,000
  Allowable deductions........................   ($175,000)   ($175,000)
                                                            ------------
Taxable income................................  ...........      $20,000
                                                            ============
 


Thus, taking the NOL carryback into account in computing net active 
income for 1987 does not affect X's taxable income for 1987, but 
increases the deductions treated under paragraph (f)(4) as deductions 
from X's rental activity for 1988 and decreases X's NOL carryover to 
years other than 1987.

    (5) Allowance of passive activity credit of closely held 
corporations to extent of net active income tax liability--(i) In 
general. Solely for purposes of determining the amount disallowed under 
paragraph (a)(1)(ii) of this section, a closely held corporation's 
passive activity credit for the taxable year shall be reduced by such 
corporation's net active income tax liability for such year.
    (ii) Net active income tax liability. For purposes of paragraph 
(g)(5)(i) of this section, a corporation's net active income tax 
liability for a taxable year is the amount (if any) by which--
    (A) The corporation's regular tax liability (within the meaning of 
section 26(b)) for the taxable year, determined by reducing the 
corporation's taxable income for such year by an amount equal to the 
excess (if any) of the corporation's passive activity gross income for 
such year over the corporation's passive activity deductions for such 
year; exceeds
    (B) The sum of--
    (1) The corporation's regular tax liability for the taxable year, 
determined by reducing the corporation's taxable income for such year by 
an amount equal to the excess (if any) of the sum of the corporation's 
net active income (within the meaning of paragraph (g)(4)(ii) of this 
section) and passive activity gross income for such year over the 
corporation's passive activity deductions for such year; and
    (2) The corporation's credits (other than credits from passive 
activities) that are allowable for the taxable year (without regard to 
the limitations contained in sections 26(a), 28(d)(2), 29(b)(5), 38(c), 
and 469).
    (h) Special rules for affiliated group filing consolidated return.--
(1)-(2) [Reserved]
    (3) Disallowance of consolidated group's passive activity loss or 
credit. A consolidated group's passive activity loss or passive activity 
credit for the taxable year shall be disallowed to the extent provided 
in paragraph (a) of this section. For purposes of the preceding 
sentence, a consolidated group's passive activity loss and passive 
activity credit shall be determined by taking into account the following 
items of each member of such group:
    (i) Passive activity gross income;
    (ii) Passive activity deductions;
    (iii) Net active income (in the case of a consolidated group treated 
as a closely held corporation under paragraph (h)(4)(ii) of this 
section); and
    (iv) Credits from passive activities.
    (4) [Reserved]. See Sec. 1.469-1(h)(4) for rules relating to this 
paragraph.
    (5) Modification of rules for identifying disallowed passive 
activity deductions and credits--(i) Identification of disallowed 
deductions. In applying paragraphs (f) (2) and (4) of this section to a 
consolidated group for purposes of identifying the passive activity 
deductions of such consolidated group and of each member of such 
consolidated group that are disallowed for the taxable year and treated 
as deductions from activities for the succeeding taxable year, the 
following rules shall apply:
    (A) A ratable portion (within the meaning of paragraph (h)(5)(ii) of 
this section) of the passive activity loss of the consolidated group 
that is disallowed for the taxable year shall be allocated to each 
member of the group;
    (B) Pararaph (f)(2) of this section shall then be applied to each 
member of the group as if--

[[Page 421]]

    (1) Such member were a separate taxpayer; and
    (2) The amount allocated to such member under paragraph (h)(5)(i)(A) 
of this section were the amount of such member's passive activity loss 
that is disallowed for the taxable year; and
    (C) Paragraph (f)(4) of this section shall be applied to each member 
of the group as if it were a separate taxpayer.
    (ii) Ratable portion of disallowed passive activity loss. For 
purposes of paragraph (h)(5)(i)(A) of this section, a member's ratable 
portion of the disallowed passive activity loss of the consolidated 
group is the amount of such disallowed loss multiplied by the fraction 
obtained by dividing--
    (A) The amount of the passive activity loss of such member of the 
consolidated group that would be disallowed for the taxable year if the 
items of gross income and deduction of such member were the only items 
of the group for such year; by
    (B) The sum of the amounts described in paragraph (h)(5)(ii)(A) of 
this section for all members of the group.
    (iii) Identification of disallowed credits. In applying paragraph 
(f)(3) of this section to a consolidated group for purposes of 
identifying the credits from passive activities of members of such 
consolidated group that are disallowed for the taxable year, the 
consolidated group shall be treated as one taxpayer. Thus, a ratable 
portion of each of the group's credits from passive activities is 
disallowed.
    (6) [Reserved]
    (7) Disposition of stock of a member of an affiliated group. Any 
gain recognized by a member on the disposition of stock of a subsidiary 
(including income resulting from the recognition of an excess loss 
account under Sec. 1.1502-19) shall be treated as portfolio income 
(within the meaning of Sec. 1.469-2T (c)(3)(i)).
    (8) Dispositions of property used in multiple activities. The 
determination of whether Sec. 1.469-2T(c)(2)(ii) or (iii) or (d)(5)(ii) 
applies to a disposition (including a deemed disposition described in 
paragraph (h)(6)(iii)(C)(1) of this section) of property by a member of 
a consolidated group shall be made by treating such member as having 
held the property for the entire period that the group has owned such 
property and as having used the property in all of the activities in 
which the group has used such property
    (i) [Reserved]
    (j) Spouses filing joint return--(1) In general. Except as otherwise 
provided in the regulations under section 469, spouses filing a joint 
return for a taxable year shall be treated for such year as one taxpayer 
for purposes of section 469 and the regulations thereunder Thus, for 
example, spouses filing a joint return are treated as one taxpayer for 
purposes of--
    (i) Section 1.469-2T (relating generally to the computation of such 
taxpayer's passive activity loss); and
    (ii) Paragraph (f) of this section (relating to the allocation of 
such taxpayer's disallowed passive activity loss and passive activity 
credit among activities and the identification of disallowed passive 
activity deductions and credits from passive activities).
    (2) Exceptions to treatment as one taxpayer--(i) Identification of 
disallowed deductions and credits. For purposes of paragraphs 
(f)(2)(iii) and (3)(iii) of this section, spouses filing a joint return 
for the taxable year must account separately for the deductions and 
credits attributable to the interests of each spouse in any activity.
    (ii) Treatment of deductions disallowed under sections 704(d), 
1366(d), and 465. Notwithstanding any other provision of this section or 
Sec. 1.469-2T, this paragraph (j) shall not affect the application of 
section 704(d), section 1366(d), or section 465 to taxpayers filing a 
joint return for the taxable year.
    (iii) Treatment of losses from working interests. Paragraph (e)(4) 
of this section (relating to losses and credits from certain interests 
in oil and gas wells) shall be applied by treating a husband and wife 
(whether or not filing a joint return) as separate taxpayers.
    (3) Joint return no longer filed. If an individual--
    (A) Does not file a joint return for the taxable years; and
    (B) Filed a joint return for the immediately preceding taxable year;


then the passive activity deductions and credits allocable to such 
individual's activities for the taxable year under paragraph (f)(4) of 
this section

[[Page 422]]

shall be determined by taking into account the items of deduction and 
credit attributable to such individual's interests in passive activities 
for the immediately preceding taxable year. See paragraph (j)(2)(i) of 
this section.
    (4) Participation of spouses. Rules treating an individual's 
participation in an activity as participation of such individual's 
spouse in such activity (without regard to whether the spouses file a 
joint return) are contained in Sec. 1.469-5T(f)(3).
    (k) Former passive activities and changes in status of corporations. 
[Reserved]

[T.D. 8175, 53 FR 5700, Feb. 25, 1988, as amended by T.D. 8253, 54 FR 
20535, May 12, 1989; T.D. 8319, 55 FR 49038, Nov. 26, 1990; T.D. 8417, 
57 FR 20753, May 15, 1992; 58 FR 29536, May 21, 1993; 58 FR 45059, Aug. 
26, 1993; 59 FR 17478, Apr. 13, 1994; T.D. 8560, 59 FR 41674, Aug. 15, 
1994; T.D. 8597, 60 FR 36685, July 18, 1995; T.D. 8996, 67 FR 35012, May 
17, 2002]



Sec. 1.469-2  Passive activity loss.

    (a)-(c)(2)(ii) [Reserved]
    (c)(2)(iii) Disposition of substantially appreciated property 
formerly used in nonpassive activity--(A) In general. If an interest in 
property used in an activity is substantially appreciated at the time of 
its disposition, any gain from the disposition shall be treated as not 
from a passive activity unless the interest in property was used in a 
passive activity for either--
    (1) 20 percent of the period during which the taxpayer held the 
interest in property; or
    (2) The entire 24-month period ending on the date of the 
disposition.
    (B) Date of disposition. For purposes of this paragraph (c)(2)(iii), 
a disposition of an interest in property is deemed to occur on the date 
that the interest in property becomes subject to an oral or written 
agreement that either requires the owner or gives the owner an option to 
transfer the interest in property for consideration that is fixed or 
otherwise determinable on that date.
    (C) Substantially appreciated property. For purposes of this 
paragraph (c)(2)(iii), an interest in property is substantially 
appreciated if the fair market value of the interest in property exceeds 
120 percent of the adjusted basis of the interest.
    (D) Investment property. For purposes of this paragraph (c)(2)(iii), 
an interest in property is treated as an interest in property used in an 
activity other than a passive activity and as an interest in property 
held for investment for any period during which the interest is held 
through a C corporation or similar entity. An entity is similar to a C 
corporation for this purpose if the owners of interests in the entity 
derive only portfolio income (within the meaning of Sec. 1.469-2T) from 
the interests.
    (E) Coordination with Sec. 1.469-2T(c)(2)(ii). If Sec. 1.469-
2T(c)(2)(ii) applies to the disposition of an interest in property, this 
paragraph (c)(2)(iii) applies only to that portion of the gain from the 
disposition of the interest in property that is characterized as gain 
from a passive activity after the application of Sec. 1.469-
2T(c)(2)(ii).
    (F) Coordination with section 163(d). Gain that is treated as not 
from a passive activity under this paragraph (c)(2)(iii) is treated as 
income described in section 469(e)(1)(A) and Sec. 1.469-2T(c)(3)(i) if 
and only if the gain is from the disposition of an interest in property 
that was held for investment for more than 50 percent of the period 
during which the taxpayer held that interest in property in activities 
other than passive activities.
    (G) Examples. The following examples illustrate the application of 
this paragraph (c)(2)(iii):

    Example 1. A acquires a building on January 1, 1993, and uses the 
building in a trade or business activity in which A materially 
participates until March 31, 2004. On April 1, 2004, A leases the 
building to B. On December 31, 2005, A sells the building. At the time 
of the sale, A's interest in the building is substantially appreciated 
(within the meaning of paragraph (c)(2)(iii)(C) of this section). 
Assuming A's lease of the building to B constitutes a rental activity 
(within the meaning of Sec. 1.469-1T(e)(3)), the building is used in a 
passive activity for 21 months (April 1, 2004, through December 31, 
2005). Thus, the building was not used in a passive activity for the 
entire 24-month period ending on the date of the sale. In addition, the 
21-month period during which the building was used in a passive activity 
is less than 20 percent of A's holding period for the building (13 
years). Therefore, the gain from the sale is treated under this 
paragraph (c)(2)(iii) as not from a passive activity.

[[Page 423]]

    Example 2. (i) A, an individual, is a stockholder of corporation X. 
X is a C corporation until December 31, 1993, and is an S corporation 
thereafter. X acquires a building on January 1, 1993, and sells the 
building on March 1, 1994. At the time of the sale, A's interest in the 
building held through X is substantially appreciated (within the meaning 
of paragraph (c)(2)(iii)(C) of this section). The building is leased to 
various tenants at all times during the period in which it is held by X. 
Assume that the lease of the building would constitute a rental activity 
(within the meaning of Sec. 1.469-1T(e)(3)) with respect to a person 
that holds the building directly or through an S corporation.
    (ii) Paragraph (c)(2)(iii)(D) of this section provides that an 
interest in property is treated for purposes of this paragraph 
(c)(2)(iii) as used in an activity other than a passive activity and as 
held for investment for any period during which the interest is held 
through a C corporation. Thus, for purposes of determining the character 
of A's gain from the sale of the building, A's interest in the building 
is treated as an interest in property held for investment for the period 
from January 1, 1993, to December 31, 1993, and as an interest in 
property used in a passive activity for the period from January 1, 1994, 
to February 28, 1994.
    (iii) A's interest in the building was not used in a passive 
activity for the entire 24-month period ending on the date of the sale. 
In addition, the 2-month period during which A's interest in the 
building was used in a passive activity is less than 20 percent of the 
period during which A held an interest in the building (14 months). 
Therefore, the gain from the sale is treated under this paragraph 
(c)(2)(iii) as not from a passive activity.
    (iv) Under paragraph (c)(2)(iii)(F) of this section, gain that is 
treated as nonpassive under this paragraph (c)(2)(iii) is treated as 
portfolio income (within the meaning of Sec. 1.469-2T(c)(3)(i)) if the 
gain is from the disposition of an interest in property that was held 
for investment for more than 50 percent of the period during which the 
taxpayer held the interest in activities other than passive activities. 
In this case, A's interest in the building was treated as held for 
investment for the entire period during which it was used in activities 
other than passive activities (i.e., the 12-month period from January 1, 
1993, to December 31, 1993). Accordingly, A's gain from the sale is 
treated under this paragraph (c)(2)(iii) as portfolio income.

    (iv) Taxable acquisitions. If a taxpayer acquires an interest in 
property in a transaction other than a nonrecognition transaction 
(within the meaning of section 7701(a)(45)), the ownership and use of 
the interest in property before the transaction is not taken into 
account for purposes of applying this paragraph (c)(2) to any subsequent 
disposition of the interest in property by the taxpayer.
    (v) Property held for sale to customers--(A) Sale incidental to 
another activity--(1) Applicability--(i) In general. This paragraph 
(c)(2)(v)(A) applies to the disposition of a taxpayer's interest in 
property if and only if--
    (A) At the time of the disposition, the taxpayer holds the interest 
in property in an activity that, for purposes of section 1221(1), 
involves holding the property or similar property primarily for sale to 
customers in the ordinary course of a trade or business (a dealing 
activity);
    (B) One or more other activities of the taxpayer do not involve 
holding similar property for sale to customers in the ordinary course of 
a trade or business (nondealing activities) and the interest in property 
was used in the nondealing activity or activities for more than 80 
percent of the period during which the taxpayer held the interest in 
property; and
    (C) The interest in property was not acquired and held by the 
taxpayer for the principal purpose of selling the interest to customers 
in the ordinary course of a trade or business.
    (ii) Principal purpose. For purposes of this paragraph (c)(2)(v)(A), 
a taxpayer is rebuttably presumed to have acquired and held an interest 
in property for the principal purpose of selling the interest to 
customers in the ordinary course of a trade or business if--
    (A) The period during which the interest in property was used in 
nondealing activities of the taxpayer does not exceed the lesser of 24 
months or 20 percent of the recovery period (within the meaning of 
section 168) applicable to the property; or
    (B) The interest in property was simultaneously offered for sale to 
customers and used in a nondealing activity of the taxpayer for more 
than 25 percent of the period during which the interest in property was 
used in nondealing activities of the taxpayer.
    For purposes of the preceding sentence, an interest in property is 
not considered to be offered for sale to customers solely because a 
lessee of the

[[Page 424]]

property has been granted an option to purchase the property.
    (2) Dealing activity not taken into account. If paragraph 
(c)(2)(v)(A) applies to the disposition of a taxpayer's interest in 
property, holding the interest in the dealing activity is treated, for 
purposes of Sec. 1.469-2T(c)(2), as the use of the interest in the last 
nondealing activity of the taxpayer in which the interest in property 
was used prior to its disposition.
    (B) Use in a nondealing activity incidental to sale. If paragraph 
(c)(2)(v)(A) of this section does not apply to the disposition of a 
taxpayer's interest in property that is held in a dealing activity of 
the taxpayer at the time of disposition, the use of the interest in 
property in a nondealing activity of the taxpayer for any period during 
which the interest in property is also offered for sale to customers is 
treated, for purposes of Sec. 1.469-2T(c)(2), as the use of the 
interest in property in the dealing activity of the taxpayer.
    (C) Examples. The following examples illustrate the application of 
this paragraph (c)(2)(v):

    Example 1. (i) The taxpayer acquires a residential apartment 
building on January 1, 1993, and uses the building in a rental activity. 
In January 1996, the taxpayer converts the apartments into condominium 
units. After the conversion, the taxpayer holds the condominium units 
for sale to customers in the ordinary course of a trade or business of 
dealing in condominium units. (Assume that these are dealing operations 
treated as separate activities under Sec. 1.469-4, and that the 
taxpayer materially participates in the activity.) In addition, the 
taxpayer continues to use the units in the rental activity until they 
are sold. The units are first held for sale on January 1, 1996, and the 
last unit is sold on December 31, 1996.
    (ii) This paragraph (c)(2)(v) provides that holding an interest in 
property in a dealing activity (the marketing of the property) is 
treated for purposes of Sec. 1.469-2T(c)(2) as the use of the interest 
in a nondealing activity if the marketing of the property is incidental 
to the nondealing use. Under paragraph (c)(2)(v)(A)(2) of this section, 
the interests in property are treated as used in the last nondealing 
activity in which they were used prior to their disposition. In 
addition, paragraph (c)(2)(v)(A)(1) of this section provides rules for 
determining whether the marketing of the property is incidental to the 
use of an interest in property in a nondealing activity. Under these 
rules, the marketing of the property is treated as incidental to the use 
in a nondealing activity if the interest in property was used in 
nondealing activities for more than 80 percent of the taxpayer's holding 
period in the property (the holding period requirement) and the taxpayer 
did not acquire and hold the interest in property for the principal 
purpose of selling it to customers in the ordinary course of a trade or 
business (a dealing purpose).
    (iii) In this case, the apartments were used in a rental activity 
for the entire period during which they were held by the taxpayer. Thus, 
the apartments were used in a nondealing activity for more than 80 
percent of the taxpayer's holding period in the property, and the 
marketing of the property satisfies the holding period requirement.
    (iv) Paragraph (c)(2)(v)(A)(1)(ii) of this section provides that a 
taxpayer is rebuttably presumed to have a dealing purpose unless the 
interest in property was used in nondealing activities for more than 24 
months or 20 percent of the property's recovery period (whichever is 
less). The same presumption applies if the interest in property was 
offered for sale to customers during more than 25 percent of the period 
in which the interest was held in nondealing activities. In this case, 
the taxpayer used each apartment in a nondealing activity (the rental 
activity) for a period of 36 to 48 months (i.e., from January 1, 1993, 
to the date of sale in the period from January through December 1996). 
Thus, the apartments were used in nondealing activities for more than 24 
months, and the first of the rebuttable presumptions described above 
does not apply. In addition, the apartments were offered for sale to 
customers for up to 12 months (depending on the month in which the 
apartment was sold) during the period in which the apartments were used 
in a nondealing activity. The percentage obtained by dividing the period 
during which an apartment was held for sale to customers by the period 
during which the apartment was used in nondealing activities ranges from 
zero in the case of apartments sold on January 1, 1996, to 25 percent 
(i.e., 12 months/48 months) in the case of apartments sold on December 
31, 1996. Thus, no apartment was offered for sale to customers during 
more than 25 percent of the period in which it was used in nondealing 
activities, and the second rebuttable presumption does not apply.
    (v) Because neither of the rebuttable presumptions in paragraph 
(c)(2)(v)(A)(1)((ii) of this section applies in this case, the taxpayer 
will not be treated as having a dealing purpose unless other facts and 
circumstances establish that the taxpayer acquired and held the 
apartments for the principal purpose of selling the apartments to 
customers in the ordinary course of a trade or business. Assume that 
none of the facts and circumstances suggest that the taxpayer had

[[Page 425]]

such a purpose. If that is the case, the taxpayer does not have a 
dealing purpose.
    (vi) The marketing of the property satisfies the holding period 
requirement, and the taxpayer does not have a dealing purpose. Thus, 
holding the apartments in the taxpayer's dealing activity is treated for 
purposes of this paragraph (c)(2) as the use of the apartments in a 
nondealing activity. In this case, the rental activity is the only 
nondealing activity in which the apartments were used prior to their 
disposition. Thus, the apartments are treated under paragraph 
(c)(2)(v)(A)(2) of this section as interests in property that were used 
only in the rental activity for the entire period during which the 
taxpayer held the interests. Accordingly, the rules in Sec. 1.469-
2T(c)(2)(ii) and paragraph (c)(2)(iii) of this section do not apply, and 
all gain from the sale of the apartments is treated as passive activity 
gross income.
    Example 2. (i) The taxpayer acquires a residential apartment 
building on January 1, 1993, and uses the building in a rental activity. 
The taxpayer converts the apartments into condominium units on July 1, 
1993. After the conversion, the taxpayer holds the condominium units for 
sale to customers in the ordinary course of a trade or business of 
dealing in condominium units. (Assume that these are dealing operations 
treated as separate activities under Sec. 1.469-4, and that the 
taxpayer materially participates in the activities.) In addition, the 
taxpayer continues to use the units in the rental activity until they 
are sold. The first unit is sold on January 1, 1994, and the last unit 
is sold on December 31, 1996.
    (ii) In this case, all of the apartments were simultaneously offered 
for sale to customers and used in a nondealing activity of the taxpayer 
for more than 25 percent of the period during which the apartments were 
used in nondealing activities. Thus, the taxpayer is rebuttably presumed 
to have acquired the apartments (including apartments that are used in 
the rental activity for at least 24 months) for the principal purpose of 
selling them to customers in the ordinary course of a trade or business. 
Assume that the facts and circumstances do not rebut this presumption. 
If that is the case, the taxpayer has a dealing purpose, and paragraph 
(c)(2)(v)(A) of this section does not apply to the disposition of the 
apartments.
    (iii) Paragraph (c)(2)(v)(B) of this section provides that if 
paragraph (c)(2)(v)(A) of this section does not apply to the disposition 
of a taxpayer's interest in property that is held in a dealing activity 
of the taxpayer at the time of the disposition, the use of the interest 
in property in any nondealing activity of the taxpayer for any period 
during which the interest is also offered for sale to customers is 
treated as incidental to the use of the interest in the dealing 
activity. Accordingly, for purposes of applying the rules of Sec. 
1.469-2T(c)(2) to the disposition of the apartments, the rental of the 
apartments after July 1, 1993, is treated as the use of the apartments 
in the taxpayer's dealing activity.
    Example 3. (i) The taxpayer acquires a residential apartment 
building on January 1, 1993, and uses the building in a rental activity. 
In January 1996, the taxpayer converts the apartments into condominium 
units. After the conversion, the taxpayer holds the condominium units 
for sale to customers in the ordinary course of a trade or business of 
dealing in condominium units. (Assume that these are dealing operations 
treated as separate activities under Sec. 1.469-4, and that the 
taxpayer materially participates in the activities.) In addition, the 
taxpayer continues to use the units in the rental activity until they 
are sold. The units are first held for sale on January 1, 1996, and the 
last unit is sold in 1997.
    (ii) The treatment of apartments sold in 1996 is the same as in 
Example 1. The apartments sold in 1997, however, were simultaneously 
offered for sale to customers and used in a nondealing activity for more 
than 25 percent of the period during which the apartments were used in 
nondealing activities. (For example, an apartment that is sold on 
January 31, 1997, has been offered for sale for 13 months or 26.1 
percent of the 49-month period during which it was used in nondealing 
activities.) Thus, the taxpayer is rebuttably presumed to have acquired 
the apartments sold in 1997 for the principal purpose of selling them to 
customers in the ordinary course of a trade of business. Assume that the 
facts and circumstances do not rebut this presumption. In that case, the 
marketing of the apartments sold in 1997 does not satisfy the principal 
purpose requirement, and paragraph (c)(2)(v)(A) of this section does not 
apply to the disposition of those apartments. Accordingly, for purposes 
of applying the rules of Sec. 1.469-2T(c)(2) to the disposition of the 
apartments sold in 1997, the rental of the apartments after January 1, 
1996, is treated, under paragraph (c)(2)(v)(B) of this section, as the 
use of the apartments in the taxpayer's dealing activity.

    (c)(3)-(c)(5) [Reserved]
    (c)(6) Gross income from certain oil or gas properties--(i) In 
general. Notwithstanding any other provision of the regulations under 
section 469, passive activity gross income for any taxable year does not 
include an amount of the taxpayer's gross passive income for the year 
from a property described in this paragraph (c)(6)(i) equal to the 
taxpayer's net passive income from the property for the year. Property 
is described in this paragraph (c)(6)(i) if the property is--

[[Page 426]]

    (A) An oil or gas property that includes an oil or gas well if, for 
any prior taxable year beginning after December 31, 1986, any of the 
taxpayer's loss from the well was treated, solely by reason of Sec. 
1.469-1T(e)(4) (relating to a special rule for losses from oil and gas 
working interests), and not by reason of the taxpayer's material 
participation in the activity, as a loss that is not from a passive 
activity; or
    (B) Any property the basis of which is determined in whole or in 
part by reference to the basis of property described in paragraph 
(c)(6)(i)(A) of this section.
    (ii) Gross and net passive income from the property. For purposes of 
this paragraph (c)(6)--
    (A) The taxpayer's gross passive income for any taxable year from 
any property described in paragraph (c)(6)(i) of this section is any 
passive activity gross income for the year (determined without regard to 
this paragraph (c)(6) and Sec. 1.469-2T(f)) from the property;
    (B) The taxpayer's net passive income for any taxable year from any 
property described in paragraph (c)(6)(i) of this section is the excess, 
if any, of--
    (1) The taxpayer's gross passive income for the taxable year from 
the property; over
    (2) Any passive activity deductions for the taxable year (including 
any deduction treated as a deduction for the year under Sec. 1.469-
1T(f)(4)) that are reasonably allocable to the income; and
    (C) if any oil or gas well or other item of property (the item) is 
included in two or more properties described in paragraph (c)(6)(i) of 
this section (the properties), the taxpayer must allocate the passive 
activity gross income (determined without regard to this paragraph 
(c)(6) and Sec. 1.469-2T(f) from the item and the passive activity 
deductions reasonably allocable to the item among the properties.
    (iii) Property. For purposes of paragraph (c)(6)(i)(A) of this 
section, the term ``property'' does not have the meaning given the term 
by section 614(a) or the regulations thereunder, and an oil or gas 
property that includes an oil or gas well is--
    (A) The well; and
    (B) Any other item of property (including any oil or gas well) the 
value of which is directly enhanced by any drilling, logging, seismic 
testing, or other activities the costs of which were taken into account 
in determining the amount of the taxpayer's income or loss from the 
well.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (c)(6):

    Example 1. A is a general partner in partnership P and a limited 
partner in partnership R. P and R own oil and gas working interests in 
two separate tracts of land acquired from two separate landowners. In 
1993, P drills a well on its tract, and A's distributive share of P's 
losses from drilling the well are treated under Sec. 1.469-1T(e)(4) as 
not from a passive activity. In the course of selecting the drilling 
site and drilling the well, P develops information indicating that the 
reservior in which the well was drilled underlies R's tract as well as 
P's. Under these facts, P's and R's tracts are treated as one property 
for purposes of this paragraph (c)(6), even if A's interests in the 
mineral deposits in the tracts are treated as separate properties under 
section 614(a). Accordingly, in 1994 and subsequent years, A's 
distributive share of both P's and R's income and expenses from their 
respective tracts is taken into account in computing A's net passive 
income from the property for purposes of this paragraph (c)(6).
    Example 2. B is a general partner in partnership S. S owns an oil 
and gas working interest in a single tract of land. In 1993, S drills a 
well, and B's distributive share of S's losses from drilling the well is 
treated under Sec. 1.469-1T(e)(4) as not from a passive activity. In 
the course of drilling the well, S discovers two oil-bearing formations, 
one underlying the other. On December 1, 1993, S completes the well in 
the underlying formation. On January 1, 1994, B converts B's entire 
general partnership interest in S into a limited partnership interest. 
In 1994, S completes in, and commences production from, the shallow 
formation. Under these facts, the two mineral deposits in S's tract are 
treated as one property for purposes of this paragraph (c)(6), even if 
they are treated as separate properties under section 614(a). 
Accordingly, B's distributive share of S's income and expenses from both 
the underlying formation and from recompletion in and production from 
the shallow formation is taken into account in computing B's net passive 
income from the property for purposes of this paragraph (c)(6).

    (c)(6)(iv) Example 3--(c)(7)(iii) [Reserved]

[[Page 427]]

    (c)(7)(iv) Gross income of an individual from a covenant by such 
individual not to compete;
    (v) Gross income that is treated as not from a passive activity 
under any provision of the regulations under section 469, including but 
not limited to Sec. 1.469-1T(h)(6) (relating to income from 
intercompany transactions of members of an affiliated group of 
corporations filing a consolidated return) and Sec. 1.469-2T(f) and 
paragraph (f) of this section (relating to recharacterized passive 
income);
    (vi) Gross income attributable to the reimbursement of a loss from 
fire, storm, shipwreck, or other casualty, or from theft (as such terms 
are used in section 165(c)(3)) if--
    (A) The reimbursement is included in gross income under Sec. 1.165-
1(d)(2)(iii) (relating to reimbursements of losses that the taxpayer 
deducted in a prior taxable year); and
    (B) The deduction for the loss was not a passive activity deduction; 
and
    (c)(7)(vii) Gross income or gain allocable to business or rental use 
of a dwelling unit for any taxable year in which section 280A(c)(5) 
applies to such business or rental use.
    (d)(1)-(d)(2)(viii) [Reserved]
    (ix) An item of loss or deduction that is carried to the taxable 
year under section 172(a), section 613A(d), section 1212(a)(1) (in the 
case of corporations), or section 1212(b) (in the case of taxpayers 
other than corporations);
    (x) An item of loss or deduction that would have been allowed for a 
taxable year beginning before January 1, 1987, but for section 704(d), 
1366, or 465;
    (xi) A deduction for a loss from fire, storm, shipwreck, or other 
casualty, or from theft (as such terms are used in section 165(c)(3)) if 
losses that are similar in cause and severity do not recur regularly in 
the conduct of the activity; and
    (xii) A deduction or loss allocable to business or rental use of a 
dwelling unit for any taxable year in which section 280A(c)(5) applies 
to such business or rental use.
    (d)(3)-(d)(5)(ii) [Reserved]
    (d)(5)(iii) Other applicable rules--(A) Applicability of rules in 
Sec. 1.469-2T(c)(2). For purposes of this paragraph (d)(5), a 
taxpayer's interests in property used in an activity and the amounts 
allocated to the interests shall be determined under Sec. 1.469-
2T(c)(2)(i)(C). In addition, the rules contained in paragraph (c)(2)(iv) 
and (v) of this section apply in determining for purposes of this 
paragraph (d)(5) the activity (or activities) in which an interest in 
property is used at the time of its disposition and during the 12-month 
period ending on the date of its disposition.
    (d)(5)(iii)(B)-(d)(6)(v)(D) [Reserved]
    (d)(6)(v)(E) Are taken into account under section 613A(d) (relating 
to limitations on certain depletion deductions), section 1211 (relating 
to the limitation on capital losses), or section 1231 (relating to 
property used in a trade or business and involuntary conversions); or
    (d)(6)(v)(F)-(d)(7) [Reserved]
    (d)(8) Taxable year in which item arises. For purposes of Sec. 
1.469-2T(d), an item of deduction arises in the taxable year in which 
the item would be allowable as a deduction under the taxpayer's method 
of accounting if taxable income for all taxable years were determined 
without regard to sections 469, 613A(d) and 1211.
    (e)(1)-(e)(2)(i) [Reserved]
    (e)(2)(ii) Section 707(c). Except as provided in paragraph 
(e)(2)(iii)(B) of this section, any payment to a partner for services or 
the use of capital that is described in section 707(c), including any 
payment described in section 736(a)(2) (relating to guaranteed payments 
made in liquidation of the interest of a retiring or deceased partner), 
is characterized as a payment for services or as the payment of 
interest, respectively, and not as a distributive share of partnership 
income.
    (iii) Payments in liquidation of a partner's interest in partnership 
property--(A) In general. If any gain or loss is taken into account by a 
retiring partner (or any other person that owns (directly or indirectly) 
an interest in the partner if the partner is a passthrough entity) or a 
deceased partner's successor in interest as a result of a payment to 
which section 736(b) (relating to payments made in exchange for a 
retired or deceased partner's interest in partnership property) applies, 
the gain or loss is treated as passive activity gross income or a 
passive activity deduction only to the extent that the gain or loss

[[Page 428]]

would have been passive activity gross income or a passive activity 
deduction of the retiring or deceased partner (or the other person) if 
it had been recognized at the time the liquidation of the partner's 
interest commenced.
    (B) Payments in liquidation of a partner's interest in unrealized 
receivables and goodwill under section 736(a). (1) If a payment is made 
in liquidation of a retiring or deceased partner's interest, the payment 
is described in section 736(a), and any income--
    (i) Is taken into account by the retiring partner (or any other 
person that owns (directly or indirectly) an interest in the partner if 
the partner is a passthrough entity) or the deceased partner's successor 
in interest as a result of the payment; and
    (ii) Is attributable to the portion (if any) of the payment that is 
allocable to the unrealized receivables (within the meaning of section 
751(c)) and goodwill of the partnership;

the percentage of the income that is treated as passive activity gross 
income shall not exceed the percentage of passive activity gross income 
that would be included in the gross income that the retiring or deceased 
partner (or the other person) would have recognized if the unrealized 
receivables and goodwill had been sold at the time that the liquidation 
of the partner's interest commenced.
    (2) For purposes of this paragarph (e)(2)(iii)(B), the portion (if 
any) of a payment under section 736(a) that is allocable to unrealized 
receivables and goodwill of a partnership shall be determined in 
accordance with the principles employed under Sec. 1.736-1(b) for 
determining the portion of a payment made under section 736 that is 
treated as a distribution under section 736(b).
    (e)(3)(i)-(iii)(A) [Reserved]
    (B) An amount of gain that would have been treated as gain that is 
not from a passive activity under paragraph (c)(2)(iii) of this section 
(relating to substantially appreciated property formerly used in a 
nonpassive activity), paragraph (c)(6) of this section (relating to 
certain oil or gas properties), Sec. 1.469-2T(f)(5) (relating to 
certain property rented incidental to development), paragraph (f)(6) of 
this section (relating to property rented to a nonpassive activity), or 
Sec. 1.469-2T(f)(7) (relating to certain interests in a passthrough 
entity engaged in the trade or business of licensing intangible 
property) would have been allocated to the holder (or such other person) 
with respect to the interest if all of the property used in the passive 
activity had been sold immediately prior to the disposition for its fair 
market value on the applicable valuation date (within the meaning of 
Sec. 1.469-2T(e)(3)(ii)(D)(1)); and
    (e)(3)(iii)(C)-(f)(4) [Reserved]
    (f)(5) Net income from certain property rented incidental to 
development activity--(i) In general. An amount of the taxpayer's gross 
rental activity income for the taxable year from an item of property 
equal to the net rental activity income for the year from the item of 
property shall be treated as not from a passive activity if--
    (A) Any gain from the sale, exchange, or other disposition of the 
item of property is included in the taxpayer's income for the taxable 
year;
    (B) The taxpayer's use of the item of property in an activity 
involving the rental of the property commenced less than 12 months 
before the date of the disposition (within the meaning of paragraph 
(c)(2)(iii)(B) of this section) of such property; and
    (C) The taxpayer materially participated (within the meaning of 
Sec. 1.469-5T) or significantly participated (within the meaning of 
Sec. 1.469-5T(c)(2)) for any taxable year in an activity that involved 
for such year the performance of services for the purpose of enhancing 
the value of such item of property (or any other item of property if the 
basis of the item of property that is sold, exchanged, or otherwise 
disposed of is determined in whole or in part by reference to the basis 
of such other item of property).
    (ii) Commencement of use--(A) In general. For purposes of paragraph 
(f)(5)(i)(B) of this section, a taxpayer's use of an item of property in 
an activity involving the rental of the property commences on the first 
date on which--
    (1) The taxpayer owns an interest in the property;
    (2) Substantially all of the property is rented (or is held out for 
rent and is in a state of readiness for rental); and

[[Page 429]]

    (3) No significant value-enhancing services (within the meaning of 
paragraph (f)(5)(ii)(B) of this section) remain to be performed.
    (B) Value-enhancing services. For purposes of this paragraph 
(f)(5)(ii), the term value-enhancing services means the services 
described in paragraphs (f)(5) (i)(C) and (iii) of this section, except 
that the term does not include lease-up. Thus, in cases in which this 
paragraph (f)(5) applies solely because substantial lease-up remains to 
be performed (see paragraph (f)(5)(iii)(C) of this section), the twelve 
month period described in paragraph (f)(5)(i)(B) of this section will 
begin when the taxpayer acquires an interest in the property if 
substantially all of the property is held out for rent and is in a state 
of readiness for rental on that date.
    (iii) Services performed for the purpose of enhancing the value of 
property. For purposes of paragraph (f)(5)(i)(C) of this section, 
services that are treated as performed for the purpose of enhancing the 
value of an item of property include but are not limited to--
    (A) Construction;
    (B) Renovation; and
    (C) Lease-up (unless more than 50 percent of the property is leased 
on the date that the taxpayer acquires an interest in the property).
    (iv) Examples. The following examples illustrate the application of 
this paragraph (f)(5):

    Example 1. (i) A, a calendar year individual, is a partner in P, a 
calendar year partnership, which develops real estate. In 1993, P 
acquires an interest in undeveloped land and arranges for the financing 
and construction of an office building on the land. Construction is 
completed in February 1995, and substantially all of the building is 
either rented or held out for rent and in a state of readiness for 
rental beginning on March 1, 1995. Twenty percent of the building is 
leased as of March 1, 1995.
    (ii) P rents the building (or holds it out for rent) for the 
remainder of 1995 and all of 1996, and sells the building on February 1, 
1997, pursuant to a contract entered into on January 15, 1996. P did not 
hold the building (or any other buildings) for sale to customers in the 
ordinary course of P's trade or business (see paragraph (c)(2)(v) of 
this section). A's distributive share of P's taxable losses from the 
rental of the building is $50,000 for 1995 and $30,000 for 1996. All of 
A's losses from the rental of the building are disallowed under 1.469-
1(a)(1)(i) (relating to the disallowance of the passive activity loss 
for the taxable year). A's distributive share of P's gain from the sale 
of the building is $150,000. A has no other gross income or deductions 
from the activity of renting the building.
    (iii) The real estate development activity that A holds through P in 
1993, 1994, and 1995 involves the performance of services (e.g., 
construction) for the purpose of enhancing the value of the building. 
Accordingly, an amount equal to A's net rental activity income from the 
building may be treated as gross income that is not from a passive 
activity if A's use of the building in an activity involving the rental 
of the building commenced less that 12 months before the date of the 
disposition of the building. In this case, the date of the disposition 
of the building is January 15, 1996, the date of the binding contract 
for its sale.
    (iv)(A) A taxpayer's use of an item of property in an activity 
involving the rental of the property commences on the first date on 
which--
    (1) The taxpayer owns an interest in the item of property;
    (2) Substantially all of the property is rented (or is held out for 
rent and is in a state of readiness for rental); and
    (3) No significant value-enhancing services (within the meaning of 
paragraph (f)(5)(ii)(B) of this section) remain to be performed.
    (B) In this case, A's use of the building in an activity involving 
the rental of the building commenced on March 1, 1995, less than 12 
months before January 15, 1996, the date of disposition. Accordingly, if 
A materially (or significantly) participated in the real estate 
development activity in 1993, 1994, or 1995 (without regard to whether A 
materially participated in the activity in more than one of those 
years), an amount of A's gross rental activity income from the building 
for 1997 equal to A's net rental activity income from the building for 
1997 is treated under this paragraph (f)(5) as gross income that is not 
from a passive activity. Under paragraph (f)(9)(iv) of this section, A's 
net rental activity income from the building for 1997 is $70,000 
($150,000 distributive share of gain from the disposition of the 
building minus $80,000 of reasonably allocable passive activity 
deductions).
    Example 2. (i) X, a calendar year taxpayer subject to section 469, 
acquires a building on February 1, 1994, when the building is 25 percent 
leased. During 1994, X rents the building (or holds it out for rent) and 
materially participates in an activity that involves the lease-up of the 
building. X's activities do not otherwise involve the performance of 
construction or other services for the purpose of enhancing the value of 
the building, and X does not hold the building (or any other

[[Page 430]]

building) for sale to customers in the ordinary course of X's trade or 
business. X sells the building on December 1, 1994.
    (ii)(A) Under paragraph (f)(5)(iii)(C) of this section, lease-up is 
considered a service performed for the purpose of enhancing the value of 
property unless more than 50 percent of the property is leased on the 
date the taxpayer acquires an interest in the property. Under paragraph 
(f)(5)(ii)(B) of this section, however, lease-up is not considered a 
value-enhancing service for purposes of determining when the taxpayer 
commences using an item of property in an activity involving the rental 
of the property. Accordingly, X's acquisition of the building 
constitutes a commencement of X's use of the building in a rental 
activity, because February 1, 1994, is the first date on which--
    (1) The taxpayer owns an interest in the item of property;
    (2) Substantially all of the property is held out for rent; and
    (3) No significant value-enhancing services (within the meaning of 
paragraph (f)(5)(ii)(B) of this section) remain to be performed.
    (B) In this case, X disposes of the property within 12 months of the 
date X commenced using the building in a rental activity. Accordingly, 
an amount of X's gross rental activity income for 1994 equal to X's net 
rental activity income from the building for 1994 is treated under this 
paragraph (f)(5) as gain that is not from a passive activity.
    Example 3. The facts are the same as in Example 2, except that at 
the time X acquires the building it is 60 percent leased. Under 
paragraph (f)(5)(iii)(C) of this section, lease-up is not considered a 
service performed for the purpose of enhancing the value of property if 
more than 50 percent of the property is leased on the date the taxpayer 
acquires an interest in the property. Therefore, additional lease-up 
performed by X is not taken into account under this paragraph (f)(5). 
Since X's activities do not otherwise involve the performance of 
services for the purpose of enhancing the value of the building, none of 
X's gross rental activity income from the building will be treated as 
income that is not from a passive activity under this paragraph (f)(5).

    (f)(6) Property rented to a nonpassive activity. An amount of the 
taxpayer's gross rental activity income for the taxable year from an 
item of property equal to the net rental activity income for the year 
from that item of property is treated as not from a passive activity if 
the property--
    (i) Is rented for use in a trade or business activity (within the 
meaning of paragraph (e)(2) of this section) in which the taxpayer 
materially participates (within the meaning of Sec. 1.469-5T) for the 
taxable year; and
    (ii) Is not described in Sec. 1.469-2T(f)(5).
    (f)(7)-(f)(9)(ii) [Reserved]
    (f)(9)(iii) The gross rental activity income for a taxable year from 
an item of property is any passive activity gross income (determined 
without regard to Sec. 1.469-2T(f)(2) through (f)(6)) that--
    (A) Is income for the year from the rental or disposition of such 
item of property; and
    (B) In the case of income from the disposition of such item of 
property, is income from an activity that involved the rental of such 
item of property during the 12-month period ending on the date of the 
disposition (see Sec. 1.469-2T(c)(2)(ii)); and
    (iv) The net rental activity income from an item of property for the 
taxable year is the excess, if any, of--
    (A) The gross rental activity income from the item of property for 
the taxable year; over
    (B) Any passive activity deductions for the taxable year (including 
any deduction treated as a deduction for the year under Sec. 1.469-
1(f)(4)) that are reasonably allocable to the income.
    (10) Coordination with section 163(d). Gross income that is treated 
as not from a passive activity under Sec. 1.469-2T(f)(3), (4), or (7) 
is treated as income described in section 469(e)(1)(A) and Sec. 1.469-
2T(c)(3)(i) except in determining whether--
    (i) Any property is treated for purposes of section 
469(e)(1)(A)(ii)(I) and Sec. 1.469-2T(c)(3)(i)(C) as property that 
produces income of a type described in Sec. 1.469-2T(c)(3)(i)(A);
    (ii) Any property is treated for purposes of section 
469(e)(1)(A)(ii)(II) and Sec. 1.469-2T(c)(3)(i)(D) as property held for 
investment;
    (iii) An expense (other than interest expense) is treated for 
purposes of section 469(e)(1)(A)(i)(II) and Sec. 1.469-2T(d)(4) as 
clearly and directly allocable to portfolio income (within the meaning 
of Sec. 1.469-2T(c)(3)(i); and
    (iv) Interest expense is allocated under Sec. 1.163-8T to an 
investment expenditure (within the meaning of Sec. 1.163-8T(b)(3)) or 
to a passive activity expenditure (within the meaning of Sec. 1.163-
8T(b)(4)).

[[Page 431]]

    (11) [Reserved]

[T.D. 8417, 57 FR 20754, May 15, 1992, as amended by T.D. 8477, 58 FR 
11538, Feb. 26, 1993; 58 FR 13706, Mar. 15, 1993; 58 FR 29536, May 21, 
1993; T.D. 8495, 58 FR 58787, Nov. 4, 1993; T.D. 8417, 59 FR 45623, 
Sept. 2, 1994]



Sec. 1.469-2T  Passive activity loss (temporary).

    (a) Scope of this section. This section contains rules for 
determining the amount of the taxpayer's passive activity loss for the 
taxable year for purposes of section 469 and the regulations thereunder. 
The rules contained in this section--
    (1) Provide general guidance for identifying items of income and 
deduction that are taken into account in determining the amount of the 
passive activity loss for the taxable year;
    (2) Specify particular items of income and deduction that are not 
taken into account in determining the amount of the passive activity 
loss for the taxable year; and
    (3) Specify the manner in which provisions of the Internal Revenue 
Code and the regulations, other than section 469 and the regulations 
thereunder, are applied for purposes of determining the extent to which 
items of deduction are taken into account for a taxable year in 
computing the amount of the passive activity loss for such year.
    (b) Definition of passive activity loss--(1) In general. In the case 
of a taxpayer other than a closely held corporation (within the meaning 
of Sec. 1.469-1T(g)(2)(ii)), the passive activity loss for the taxable 
year is the amount, if any, by which the passive activity deductions for 
the taxable year exceed the passive activity gross income for the 
taxable year.
    (2) Cross references. See paragraph (c) of this section for the 
definition of ``passive activity gross income,'' paragraph (d) of this 
section for the definition of ``passive activity deduction,'' and Sec. 
1.469-1T(g)(4) for the computation of the passive activity loss of a 
closely held corporation.
    (c) Passive activity gross income--(1) In general. Except as 
otherwise provided in the regulations under section 469, passive 
activity gross income for a taxable year includes an item of gross 
income if and only if such income is from a passive activity.
    (2) Treatment of gain from disposition of an interest in an activity 
or an interest in property used in an activity--(i) In general--(A) 
Treatment of gain. Except as otherwise provided in the regulations under 
section 469, any gain recognized upon the sale, exchange or other 
disposition (a ``disposition'') of an interest in property used in an 
activity at the time of the disposition or of an interest in an activity 
held through a partnership or S corporation is treated in the following 
manner:
    (1) The gain is treated as gross income from such activity for the 
taxable year or years in which it is recognized;
    (2) If the activity is a passive activity of the taxpayer for the 
taxable year of the disposition, the gain is treated as passive activity 
gross income for the taxable year or years in which it is recognized; 
and
    (3) If the activity is not a passive activity of the taxpayer for 
the taxable year of the disposition, the gain is treated as not from a 
passive activity.
    (B) Dispositions of partnership interests and S corporation stock. A 
partnership interest or S corporation stock is not property used in an 
activity for purposes of this paragraph (c)(2). See paragraph (e)(3) of 
this section for rules treating the gain recognized upon the disposition 
of a partnership interest or S corporation stock as gain from the 
disposition of interests in the activities in which the partnership or S 
corporation has an interest.
    (C) Interest in property. For purposes of applying this paragraph 
(c)(2) to a disposition of property--
    (1) Any material portion of the property that was used, at any time 
before the disposition, in any activity at a time when the remainder of 
the property was not used in such activity shall be treated as a 
separate interest in property; and
    (2) The amount realized from the disposition and the adjusted basis 
of the property must be allocated among the separate interests in a 
reasonable manner.
    (D) Examples. The following examples illustrate the application of 
this paragraph (c)(2)(i):


[[Page 432]]


    Example (1). A owns an interest in a trade or business activity in 
which A has never materially partcipated. In 1987, A sells equipment 
that was used exclusively in the activity and realizes a gain on the 
sale. Under paragraph (c)(2)(i)(A)(2) of this section, the gain is 
passive activity gross income.
    Example (2). B owns an interest in a trade or business activity in 
which B materially participates for 1987. In 1987, B sells a building 
used in the activity in an installment sale and realizes a gain on the 
sale. B does not materially participate in the activity for 1988 or any 
subsequent year. Under paragraph (c)(2)(i)(A)(3) of this section, none 
of B's gain from the sale (including gain taken into account after 1987) 
is passive activity gross income.
    Example (3). C enters into a contract to acquire property used by 
the seller in a rental activity. Before acquiring the property pursuant 
to the contract, C sells all rights under the contract and realizes a 
gain on the sale. Since C's rights under the contract are not property 
used in a rental activity, the gain is not income from a rental 
activity. The result would be the same if C owned an option to acquire 
the property and sold the option.
    Example (4). D sells a ten-floor office building. D owned the 
building for three years preceding the sale and at all times during that 
period used seven floors of the building in a trade or business activity 
and three floors in a rental activity. The fair market value per square 
foot is substantially the same throughout the building, and D did not 
maintain a separate adjusted basis for any part of the building. Under 
paragraph (c)(2)(i)(C)(1) of this section, the seven floors used in the 
trade or business activity and the three floors used in the rental 
activity are treated as separate interests in property. Under paragraph 
(c)(2)(i)(C)(2) of this section, the amount realized and the adjusted 
basis of the building must be allocated between the separate interests 
in a reasonable manner. Under these facts, an allocation based on the 
square footage of the parts of the building used in each activity would 
be reasonable.
    Example (5). The facts are the same as in example (4), except that 
two of the seven floors used in the trade or business activity were used 
in the rental activity until five months before the sale. Under 
paragraph (c)(2)(i)(C)(1) of this section, the five floors used 
exclusively in the trade or business activity and the two floors used 
first in the rental activity and then in the trade or business activity 
are treated as separate interests in property. See paragraph (c)(2)(ii) 
of this section for rules for allocating amount realized and adjusted 
basis upon a disposition of an interest in property used in more than 
one activity during the 12-month period ending on the date of the 
disposition.

    (ii) Disposition of property used in more than one activity in 12-
month period preceding disposition. In the case of a disposition of an 
interest in property that is used in more than one activity during the 
12-month period ending on the date of the disposition, the amount 
realized from the disposition and the adjusted basis of such interest 
must be allocated among such activities on a basis that reasonably 
reflects the use of such interest in property during such 12-month 
period. For purposes of this paragraph (c)(2)(ii), an allocation of the 
amount realized and adjusted basis solely to the activity in which an 
iterest in property is predominantly used during the 12-month period 
ending on the date of the disposition reasonably reflects the use of 
such interest in property if the fair market value of such interest does 
not exceed the lesser of--
    (A) $10,000; and
    (B) 10 percent of the sum of the fair market value of such interest 
and the fair market value of all other property used in such activity 
immediately before the disposition.

The following examples illustrate the application of this paragraph 
(c)(2)(ii):

    Example (1). The facts are the same as in example (5) of paragraph 
(c)(2)(i)(D) of this section. Under paragraph (c)(2)(i)(C)(2) of this 
section, D allocates the amount realized and adjusted basis of the 
building 30 percent to the three floors used exclusively in the rental 
activity, 50 percent to the five floors used exclusively in the trade or 
business activity, and 20 percent to the two floors used first in the 
rental activity and then in the trade or business activity. Under this 
paragraph (c)(2)(ii), the amount realized and adjusted basis allocated 
to the two floors that were used in both activities during the 12-month 
period ending on the date of the disposition must also be allocated 
between such activities. Under these facts, an allocation of 7/12 of 
such amounts to the rental activity and 5/12 of such amounts to the 
trade or business activity would reasonably reflect the use of the two 
floors during the 12-month period ending on the date of the disposition.
    Example (2). B is a limited partner in a partnership that sells a 
tractor-trailer. During the 12-month period ending on the date of the 
sale, the tractor-trailer was used in several activities, and the 
partnership allocates the amount realized from the disposition and the 
adjusted basis of the tractor-trailer among the activities based on the 
number of days during the 12-month period

[[Page 433]]

that the partnership used the tractor-trailer in each activity. Under 
these facts, the partnership's allocation reasonably reflects the use of 
the tractor-trailer during the 12-month period ending on the date of the 
sale.
    Example (3). C sells a personal computer for $8,000. During the 12-
month period ending on the date of the sale, 70 percent of C's use of 
the computer was in a passive activity. Immediately before the sale, the 
fair market value of all property used in the passive activity 
(including the personal computer) was $200,000. Under these facts, the 
computer was predominatly used in the passive activity during the 12-
month period ending on the date of the sale, and the value of the 
computer, as measured by its sale price ($8,000), does not exceed the 
lesser of (a) $10,000, and (b) 10 percent of the value of all property 
used in the activity immediately before the sale ($20,000). C allocates 
the amount realized and the adjusted basis solely to the passive 
activity. Under this paragraph (c)(2)(ii), C's allocation reasonably 
reflects the use of the computer during the 12-month period ending on 
the date of the sale.

    (iii) Disposition of substantially appreciated property formerly 
used in nonpassive activity. [Reserved]. See Sec. 1.469-4(c)(2)(iii) 
for rules relating to this paragraph.
    (iv) Taxable acquisitions. [Reserved]. See Sec. 1.469-2(c)(iv) for 
rules relating to this paragraph.
    (v) Property held for sale to customers. [Reserved]. See Sec. 
1.469-2(c)(v) for rules relating to this paragraph.

    (3) Items of portfolio income specifically excluded--(i) In general. 
Passive activity gross income does not include portfolio income. For 
purposes of the preceding sentence, portfolio income includes all gross 
income, other than income derived in the ordinary course of a trade or 
business (within the meaning of paragraph (c)(3)(ii) of this section), 
that is attributable to--
    (A) Interest (including amounts treated as interest under paragraph 
(e)(2)(ii) of this section, relating to certain payments to partners for 
the use of capital); annuities; royalties (including fees and other 
payments for the use of intangible property); dividends on C corporation 
stock; and income (including dividends) from a real estate investment 
trust (within the meaning of section 856), regulated investment company 
(within the meaning of section 851), real estate mortgage investment 
conduit (within the meaning of section 860D), common trust fund (within 
the meaning of section 584), controlled foreign corporation (within the 
meaning of section 957), qualified electing fund (within the meaning of 
section 1295(a)), or cooperative (within the meaning of section 
1381(a));
    (B) Dividends on S corporation stock (within the meaning of section 
1368(c)(2);
    (C) The disposition of property that produces income of a type 
described in paragraph (c)(3)(i)(A) of this section; and
    (D) The disposition of property held for investment (within the 
meaning of section 163 (d)).
    (ii) Gross income derived in the ordinary course of a trade or 
business. Solely for purposes of paragraph (c)(3)(i) of this section, 
gross income derived in the ordinary course of a trade or business 
includes only--
    (A) Interest income on loans and investments made in the ordinary 
course of a trade or business of lending money;
    (B) Interest on accounts receivable arising from the performance of 
services or the sale of property in the ordinary course of a trade or 
business of performing such services or selling such property, but only 
if credit is customarily offered to customers of the business;
    (C) Income from investments made in the ordinary course of a trade 
or business of furnishing insurance or annuity contracts or reinsuring 
risks underwritten by insurance companies;
    (D) Income or gain derived in the ordinary course of an activity of 
trading or dealing in any property if such activity constitutes a trade 
or business (but see paragraph (c)(3)(iii)(A) of this section);
    (E) Royalties derived by the taxpayer in the ordinary course of a 
trade or business of licensing intangible property (within the meaning 
of paragraph (c)(3)(iii)(B) of this section);
    (F) Amount included in the gross income of a patron of a cooperative 
(within the meaning of section 1381(a), without regard to paragraph 
(2)(A) or (C) thereof) by reason of any payment or allocation to the 
patron based on patronage occurring with respect to a trade or business 
of the patron; and

[[Page 434]]

    (G) Other income identified by the Commissioner as income derived by 
the taxpayer in the ordinary course of a trade or business.
    (iii) Special rules--(A) Income from property held for investment by 
dealer. For purposes of paragraph (c)(3)(i) of this section, a dealer's 
income or gain from an item of property is not dervied by the dealer in 
the ordinary course of a trade or business of dealing in such property 
if the dealer held the property for investment at any time before such 
income or gain is recognized.
    (B) Royalties derived in the ordinary course of the trade or 
business of licensing intangible property--(1) In general. Royalties 
received by any person with respect to a license or other transfer of 
any rights in intangible property shall be considered to be derived in 
the ordinary course of the trade or business of licensing such property 
only if such person--
    (i) Created such property; or
    (ii) Performed substantial services or incurred substantial costs 
with respect to the development or marketing of such property.
    (2) Substantial services or costs--(i) In general. Except as 
provided in paragraph (c)(3)(iii)(B)(2)(ii) of this section, the 
determination of whether a person has performed substantial services or 
incurred substantial costs with respect to the development or marketing 
of an item of intangible property shall be made on the basis of all the 
facts and circumstances.
    (ii) Exception. A person has performed substantial services or 
incurred substantial costs for a taxable year with respect to the 
development or marketing of an item of intangible property if--
    (a) The expenditures reasonably incurred by such person in such 
taxable year with respect to the development or marketing of the 
property exceed 50 percent of the gross royalties from licensing such 
property that are includible in such person's gross income for the 
taxable year; or
    (b) The expenditures reasonably incurred by such person in such 
taxable year and all prior taxable years with respect to the development 
or marketing of the property exceed 25 percent of the aggregate capital 
expenditures (without any adjustment of amortization) made by such 
person with respect to the property in all such taxable years.
    (iii) Expenditures taken into account. For purposes of paragraph 
(c)(3)(iii)(B)(2)(ii) of this section, expenditures in a taxable year 
include amounts chargeable to capital account for such year without 
regard to the year or years (if any) in which any deduction for such 
expenditure is allowed.
    (3) Passthrough entities. For purposes of this paragraph 
(c)(3)(iii)(B), in the case of any intangible property held by a 
partnership, S corporation, estate, or trust, the determination of 
whether royalties from such property are derived in the ordinary course 
of a trade or business shall be made by applying the rules of this 
paragraph (c)(3)(iii)(B) to such entity and not to any holder of an 
interest in such entity.
    (4) Cross reference. For special rules applicable to certain gross 
income from a trade or business of licensing intangible property, see 
paragraph (f)(7) of this section.
    (C) Mineral production payments. For purposes of section 469 and the 
regulations thereunder--
    (1) If a mineral production payment is treated as a loan under 
section 636, the portion of any payment in discharge of the production 
payment that is the equivalent of interest shall be treated as interest; 
and
    (2) If a mineral production payment is not treated as a loan under 
section 636, payments in discharge of the production payment shall be 
treated as royalties.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (c)(3):

    Example (1). A, an individual engaged in the trade or business of 
farming, disposes of farmland in an installment sale. A is not engaged 
in a trade or business of selling farmland. Therefore, A's interest 
income from the installment note is not gross income derived in the 
ordinary course of a trade or business.
    Example (2). P, a partnership, operates a rental apartment building 
for low-income tenants in City Y. Under Y's laws relating to the 
operation of low-income housing, P is required to maintain a reserve 
fund to pay for the maintenance and repair of the building.

[[Page 435]]

P invests the reserve fund in short-term interest-bearing deposits. 
Because P's interest income from the investment of the reserve fund is 
not interest income described in paragraph (c)(3)(ii) of this section, 
such income is not treated as derived in the ordinary course of a trade 
or business. Accordingly, P's interest income from the deposits is 
portfolio income (within the meaning of paragraph (c)(3)(i) of this 
section).
    Example (3). (i) B is a partner in a partnership that is engaged in 
an activity involving the conduct of a trade or business of dealing in 
securities. On February 1, the partnership acquires certain securities 
for investment (within the meaning of section 163(d)). On February 2, 
before recognizing any income with respect to the securities, the 
partnership determines that it would be advisable to hold the securities 
primarily for sale to customers and subsequently sells them to customers 
in the ordinary course of its business.
    (ii) Under paragraph (c)(3)(iii)(A) of this section, income or gain 
from any security (including any security acquired pursuant to an 
investment of working capital) held by a dealer for investment at any 
time before such income or gain is recognized is not treated for 
purposes of paragraph (c)(3)(i) of this section as derived by the dealer 
in the ordinary course of its trade or business of dealing in 
securities. Accordingly, B's distributive share of the partnership's 
interest, dividends, or gains from the securities acquired by the 
partnership for investment on February 1 is portfolio income of B, 
notwithstanding that such securities were held by the partnership, 
subsequent to February 1, primarily for sale to customers in the 
ordinary course of the partnership's trade or business of dealing in 
securities.
    Example (4). C is a partner in a partnership that is engaged in an 
activity of trading or dealing in royalty interests in mineral 
properties. The partnership derives royalty income from royalty 
interests held in the activity. If the activity is a trade or business 
activity, C's distributive share of the partnership's royalty income 
from such royalty interests is treated under paragraph (c)(3)(ii)(D) of 
this section as derived in the ordinary course of the partnership's 
trade or business.
    Example (5). (i) D, a calendar year individual, is a partner in a 
calendar year partnership that is engaged in an activity of developing 
and marketing a design for a system that reduces air pollution in office 
buildings. D has a 10 percent distributive share of all items of 
partnership income, gain, loss, deduction, and credit. In 1987, the 
partnership acquired the rights to the design for $100,000. In 1987, 
1988, and 1989, the partnership incurs expenditures with respect to the 
development and marketing of the design, and derives gross royalties 
from licensing the design, in the amounts set forth in the table below. 
The expenditures incurred in 1987 and 1988 are currently deductible 
expenses. The expenditures incurred in 1989 are capitalized and may be 
deducted only in subsequent taxable years.

------------------------------------------------------------------------
                                                            Cumulative
              Year                 Gross    Expenditures      capital
                                 royalties                 expenditures
------------------------------------------------------------------------
1987...........................    $20,000      $8,000          $100,000
1988...........................     20,000      12,000           100,000
1989...........................     60,000      15,000           115,000
1990...........................    120,000           0           115,000
------------------------------------------------------------------------

    (ii) Under paragraph (c)(3)(iii)(B)(3) of this section, the 
determination of whether royalties from intangible property are derived 
in the ordinary course of a trade or business of a partnership is made 
by applying the rules of paragraph (c)(3)(iii)(B) of this section to the 
partnership rather than the partners. The expenditures reasonably 
incurred by the partnership in 1987 with respect to the development or 
marketing of the design ($8,000) do not exceed 50 percent of the 
partnership's gross royalties for such year from licensing the design 
($20,000). In addition, the sum of such expenditures incurred in 1987 
and all prior taxable years ($8,000) does not exceed 25 percent of the 
aggregate capital expenditures made by the partnership in all such 
taxable years with respect to the design ($100,000). Accordingly, for 
1987, the partnership is not treated under paragraph 
(c)(3)(iii)(B)(2)(ii) of this section as performing substantial services 
or incurring substantial costs with respect to the development or 
marketing of the design. Therefore, unless all of the facts and 
circumstances indicate that the partnership performed substantial 
services or incurred substantial costs with respect to the development 
or marketing of the design, D's distributive share of the partnership's 
royalty income for 1987 is portfolio income.
    (iii) As of the end of 1988, the sum of the expenditures reasonably 
incurred by the partnership during such taxable year and all prior 
taxable years with respect to the development or marketing of the design 
($20,000) does not exceed 25 percent of the aggregate capital 
expenditures made by the partnership in all such years with respect to 
the design ($100,000). However, the amount of such expenditures incurred 
by the partnership in 1988 ($12,000) exceeds 50 percent of the 
partnership's gross royalties for such year from licensing the design 
($20,000). Accordingly, for 1988, under paragraph 
(c)(3)(iii)(B)(2)(ii)(a) of this section, the partnership is treated as 
performing substantial services or incurring substantial costs with 
respect to the development or marketing of the design, and D's 
distributive share of the partnership's royalty income for 1988 is 
considered for purposes of paragraph (c)(3)(i) of this section to be 
derived in the ordinary course of a trade

[[Page 436]]

or business and therefore is not portfolio income.
    (iv) The expenditures reasonably incurred by the partnership in 1989 
with respect to the development or marketing of the design ($15,000) do 
not exceed 50 percent of the partnership's gross royalties for such year 
from licensing the design ($60,000). However, the sum of such 
expenditures incurred by the partnership in 1989 and all prior taxable 
years ($35,000) exceeds 25 percent of the partnership's aggregate 
capital expenditures made in all such years with respect to the design 
($115,000). Accordingly, for 1989, under paragraph 
(c)(3)(iii)(B)(2)(ii)(b) of this section, the partnership is treated as 
performing substantial services or incurring substantial costs with 
respect to the development or marketing of the design, and D's 
distributive share of the partnership's royalty income in 1989 is 
considered for purposes of paragraph (c)(3)(i) of this section to be 
derived in the ordinary course of a trade or business and therefore is 
not portfolio income.
    (v) The result for 1990 is the same as for 1989, notwithstanding 
that the partnership incurs no expenditures in 1990 with respect to the 
development or marketing of the design.
    Example (6). The facts are the same as in example (5), except that, 
for 1987, D's distributive share of the partnership's development and 
marketing costs is 15 percent, while D's distributive share of the 
partnership's gross royalties is 10 percent. Although D's distributive 
share of the expenditures reasonably incurred by the partnership during 
1987 with respect to the development and marketing of the design 
($1,200) is more than 50 percent of D's distributive share of the 
partnership's gross royalties from licensing the design ($2,000), D is 
not treated as performing substantial services or incurring substantial 
costs with respect to the development or marketing of the design for 
1987 under paragraph (c)(3)(iii)(B)(2)(ii)(a) of this section. This is 
because, under paragraph (c)(3)(iii)(B)(3) of this section, the 
determination of whether the royalties are derived in the ordinary 
course of a trade or business is made by applying paragraph 
(c)(3)(iii)(B) of this section to the partnership, and not to D.

    (4) Items of personal service income specifically excluded--(i) In 
general. Passive activity gross income does not include compensation 
paid to or on behalf of an individual for personal services performed or 
to be performed by such individual at any time. For purposes of this 
paragraph (c)(4), compensation for personal services includes only--
    (A) Earned income (within the meaning of section 911(d)(2)(A)), 
including gross income from a payment described in paragraph (e)(2) of 
this section that represents compensation for the performance of 
services by a partner;
    (B) Amounts includible in gross income under section 83;
    (C) Amounts includible in gross income under sections 402 and 403;
    (D) Amounts (other than amounts described in paragraph (c)(4)(i)(C) 
of this section) paid pursuant to retirement, pension, and other 
arrangements for deferred compensation for services;
    (E) Social security benefits (within the meaning of section 86(d)) 
includible in gross income under section 86; and
    (F) Other income identified by the Commissioner as income derived by 
the taxpayer from personal services;

provided, however, that no portion of a partner's distributive share of 
partnership income (within the meaning of section 704(b)) or a 
shareholder's pro rata share of income from an S corporation (within the 
meaning of section 1377(a)) shall be treated as compensation for 
personal services.
    (ii) Example. The following example illustrates the application of 
this paragraph (c)(4):

    Example. C owns 50 percent of the stock of X, an S corporation. X 
owns rental real estate, which it manages. X pays C a salary for 
services performed by C on behalf of X in connection with the management 
of X's rental properties. Under this paragraph (c)(4), although C's pro 
rata share of X's gross rental income is passive activity gross income 
(even if the salary paid to C is less than the fair market value of C's 
services), the salary paid to C does not constitute passive activity 
gross income.

    (5) Income from section 481 adjustment--(i) In general. If a change 
in accounting method results in a positive section 481 adjustment with 
respect to an activity, a ratable portion (within the meaning of 
paragraph (c)(5)(iii) of this section) of the amount taken into account 
for a taxable year as a net positive section 481 adjustment by reason of 
such change shall be treated as gross income from the activity for such 
taxable year, and such gross income shall be treated as passive activity 
gross income if and only if such activity is a passive activity for the 
year of the change (within the meaning of section 481(a)).

[[Page 437]]

    (ii) Positive section 481 adjustments. For purposes of applying this 
paragraph (c)(5)--
    (A) The term ``net positive section 481 adjustment'' means the 
increase (if any) in taxable income taken into account under section 
481(a) to prevent amounts from being duplicated or omitted by reason of 
a change in accounting method; and
    (B) The term ``positive section 481 adjustment with respect to an 
activity'' means the increase (if any) in taxable income that would be 
taken into account under section 481(a) to prevent only the duplication 
or omission of amounts from such activity by reason of the change in 
accounting method.
    (iii) Ratable portion. The ratable portion of the amount taken into 
account as a net positive section 481 adjustment for a taxable year by 
reason of a change in accounting method is determined with respect to an 
activity by multiplying such amount by the fraction obtained by 
dividing--
    (A) The positive section 481 adjustment with respect to the 
activity; by
    (B) The sum of the positive section 481 adjustments with respect to 
all of the activities of the taxpayer.
    (6) Gross income from certain oil or gas properties--(i) In general. 
[Reserved]. See Sec. 1.469-2(c)(6)(i) for rules relating to this 
paragraph.
    (ii) Gross and net passive income from the property. [Reserved]. See 
Sec. 1.469-2(c)(6)(ii) for rules relating to this paragraph.
    (iii) Property. [Reserved]. See 1.469-2(c)(6)(iii) for rules 
relating to this paragraph.
    (iv) Examples. The following examples illustrate the application of 
this (c)(6):

    Example 1. [Reserved]. See Sec. 1.469-2(c)(6)(iv) Example 1.
    Example 2. [Reserved]. See Sec. 1.469-2(c)(6)(iv) Example 2.
    Example (3). C is a general partner in partnership T and a limited 
partner in partnership U. T and U both own oil and gas working interests 
in tracts of land in County X. In 1987, T drills a well, and C's 
distributive share of T's losses from drilling the well is treated under 
Sec. 1.469-1T(e)(4) as not from a passive activity. In the course of 
selecting the drilling site and drilling the well, T develops 
information indicating a significant probability that substantial oil 
and gas reserves underlie most portions of County X. As a result, the 
value of all oil and gas properties in County X is enhanced. The 
information developed by T does not, however, indicate that the 
reservoir in which T's well is drilled underlies U's tract. Under these 
facts, T's and U's tracts are not treated as one property for purposes 
of this paragraph (c)(6), because the value of U's tract is not directly 
enhanced by T's activities.

    (7) Other items specifically excluded. Notwithstanding any other 
provision of the regulations under section 469, passive activity gross 
income does not include the following:
    (i) Gross income of an individual from intangible property, such as 
a patent, copyright, or literary, musical, or artistic composition, if 
the taxpayer's personal efforts significantly contributed to the 
creation of such property;
    (ii) Gross income from a qualified low-income housing project 
(within the meaning of section 502 of the Tax Reform Act of 1986) for 
any taxable year in the relief period (within the meaning of section 
502(b) of such Act;
    (iii) Gross income attributable to a refund of any state, local, or 
foreign income, war profits, or excess profits tax;
    (iv) [Reserved]. See Sec. 1.469-2(c)(7)(iv) for rules relating to 
this paragraph (c)(7)(iv).
    (v) [Reserved]. See Sec. 1.469-2(c)(7)(v) for rules relating to 
this paragraph (c)(7)(v).
    (vi) [Reserved]. See Sec. 1.469-2(c)(7)(vi) for rules relating to 
this paragraph (c)(7)(vi).
    (d) Passive activity deductions--(1) In general. Except as otherwise 
provided in section 469 and the regulations thereunder, a deduction is a 
passive activity deduction for a taxable year if and only if such 
deduction--
    (i) Arises (within the meaning of paragraph (d)(8) of this section) 
in connection with the conduct of an activity that is a passive activity 
for the taxable year; or
    (ii) Is treated as a deduction from an activity under Sec. 1.469-
1T(f)(4) for the taxable year.

The following example illustrates the application of this paragraph 
(d)(1):

    Example. (i) In 1987, A, a calendar year individual, acquires a 
partnership interest in R, a calendar year partnership. R's only 
activity is a trade or business activity in which A materially 
participates for 1987. R incurs a loss in 1987. A's distributive share 
of R's 1987

[[Page 438]]

loss is $1,000. However, A's basis in the partnership interest at the 
end of 1987 (without regard to A's distributive share of partnership 
loss) is $600; accordingly, section 704(d) disallows any deduction in 
1987 for $400 of A's distributive share of R's loss. The remainder of 
A's distributive share of R's loss would be allowed as a deduction for 
1987 if taxable income for all taxable years were determined without 
regard to sections 469, 613A(d), and 1211. See paragraph (d)(8) of this 
section.
    (ii) A does not materially participate in R's activity for 1988. In 
1988, R again incurs a loss, and A's distributive share of the loss is 
again $1,000. At the end of 1988, A's basis in the partnership interest 
(without regard to A's distributive share of partnership loss) is 
$2,000; accordingly, in 1988 section 704(d) does not limit A's deduction 
for either A's $1,000 distributive share of R's 1988 loss or the $400 
loss carried over from 1987 under the second sentence of section 704(d). 
These losses would be allowed as a deduction for 1988 if taxable income 
for all taxable years were determined without regard to sections 469, 
613A(d) and 1211. See paragraph (d)(8) of this section.
    (iii) Under these facts, only $400 of A's distributive share of R's 
deductions from the activity are disallowed under section 704(d) in 
1987. A's remaining deductions from the activity are treated as 
deductions that arise in connection with the activity for 1987 under 
paragraph (d)(8) of this section. Because A materially participates in 
the activity for 1987, the activity is not a passive activity (within 
the meaning of Sec. 1.469-1T(e)(1)) of A for such year. Accordingly, 
the deductions that are not disallowed in 1987 are not passive activity 
deductions.
    (iv) A does not materially participate in R's activity for 1988. 
Accordingly, the activity is a passive activity of A for such year. No 
portion of A's distributive share of R's deductions from the activity is 
disallowed under section 704(d) in 1988. Accordingly, A's distributive 
share of R's deductions for 1988 and the $400 of deductions carried over 
from 1987 are both treated under paragraph (d)(8) of this section as 
deductions that arise in 1988. Since the activity is a passive activity 
for 1988, such deductions are passive activity deductions.

    (2) Exceptions. Passive activity deductions do not include--
    (i) A deduction for an item of expense (other than interest) that is 
clearly and directly allocable (within the meaning of paragraph (d)(4) 
of this section) to portfolio income (within the meaning of paragraph 
(c)(3)(i) of this section);
    (ii) A deduction allowed under section 243, 244, or 245 with respect 
to any dividend that is not included in passive activity gross income;
    (iii) Interest expense (other than interest expense described in 
paragraph (d)(3) of this section);
    (iv) A deduction for a loss from the disposition of property of a 
type that produces portfolio income (within the meaning of paragraph 
(c)(3)(i) of this section);
    (v) A deduction that, under section 469(g) and Sec. 1.469-6T 
(relating to the allowance of passive activity losses upon certain 
dispositions of interests in passive activities), is treated as a 
deduction that is not a passive activity deduction;
    (vi) A deduction for any state, local, or foreign income, war 
profits, or excess profits tax;
    (vii) A miscellaneous itemized deduction (within the meaning of 
section 67(b)) that is subject to disallowance in whole or in part under 
section 67(a) (without regard to whether any amount of such deduction is 
disallowed under section 67);
    (viii) A deduction allowed under section 170 for a charitable 
contribution;
    (ix) [Reserved]. See Sec. 1.469-2(d)(2)(ix) for rules relating to 
this paragraph.
    (x) [Reserved]. See Sec. 1.469-2(d)(2)(x) for rules relating to 
this paragraph (d)(2)(x).
    (xi) [Reserved]. See Sec. 1.469-2(d)(2)(xi) for rules relating to 
this paragraph (d)(2)(xi).
    (xii) [Reserved]. See Sec. 1.469-2(d)(2)(xii) for rules relating to 
this paragraph (d)(2)(xii).
    (3) Interest expense. Except as otherwise provided in the 
regulations under section 469, interest expense is taken into account as 
a passive activity deduction if and only if such interest expense--
    (i) Is allocated under Sec. 1.163-8T to a passive activity 
expenditure (within the meaning of Sec. 1.163-8T(b)(4)); and
    (ii) Is not--
    (A) Qualified residence interest (within the meaning of Sec. 1.163-
10T); or
    (B) Capitalized pursuant to a capitalization provision (within the 
meaning of Sec. 1.163-8T(m)(7)(i)).
    (4) Clearly and directly allocable expenses. For purposes of section 
469 and the regulations thereunder, an expense (other than interest 
expense) is clearly and directly allocable to portfolio income (within 
the meaning of paragraph

[[Page 439]]

(c)(3)(i) of this section) if and only if such expense is incurred as a 
result of, or incident to, an activity in which such gross income is 
derived or in connection with property from which such gross income is 
derived. For example, general and administrative expenses and 
compensation paid to officers attributable to the performance of 
services that do not directly benefit or are not incurred by reason of a 
particular activity or particular property are not clearly and directly 
allocable to portfolio income (within the meaning of paragraph (c)(3)(i) 
of this section).
    (5) Treatment of loss from disposition--(i) In general. Except as 
otherwise provided in the regulations under section 469--
    (A) Any loss recognized in any year upon the sale, exchange, or 
other disposition (a ``disposition'') of an interest in property used in 
an activity at the time of the disposition or of an interest in an 
activity held through a partnership or S corporation and any deduction 
allowed on account of the abandonment or worthlessness of such an 
interest is treated as a deduction from such activity; and
    (B) Any such deduction is a passive activity deduction if and only 
if the activity is a passive activity of the taxpayer for the taxable 
year of the disposition (or other event giving rise to the deduction).
    (ii) Disposition of property used in more than one activity in 12-
month period preceding disposition. In the case of a disposition of an 
interest in property that is used in more than one activity during the 
12-month period ending on the date of the disposition, the amount 
realized from the disposition and the adjusted basis of such interest 
must be allocated among such activities in the manner described in 
paragraph (c)(2)(ii) of this section.
    (iii) Other applicable rules--(A) Applicability of rules in 
paragraph (c)(2). [Reserved]. See Sec. 1.469-2(d)(5)(iii)(A) for rules 
relating to this paragraph.
    (B) Dispositions of partnership interests and S corporation stock. A 
partnership interest or S corporation stock is not property used in an 
activity for purposes of this paragraph (d)(5). See paragraph (e)(3) of 
this section for rules treating the loss recognized upon the disposition 
of a partnership interest or S corporation stock as loss from the 
disposition of interests in the activities in which the partnership or S 
corporation has an interest.
    (6) Coordination with other limitations on deductions that apply 
before section 469--(i) In general. An item of deduction from a passive 
activity that is disallowed for a taxable year under section 704(d), 
1366(d), or 465 is not a passive activity deduction for the taxable 
year. Paragraphs (d)(6) (ii) and (iii) of this section provide rules for 
determining the extent to which items of deduction from a passive 
activity are disallowed for a taxable year under sections 704(d), 
1366(d), and 465.
    (ii) Proration of deductions disallowed under basis limitations--(A) 
Deductions disallowed under section 704(d). If any amount of a partner's 
distributive share of a partnership's loss for the taxable year is 
disallowed under section 704(d), a ratable portion of the partner's 
distributive share of each item of deduction or loss of the partnership 
is disallowed for the taxable year. For purposes of the preceding 
sentence, the ratable portion of an item of deduction or loss is the 
amount of such item multiplied by the fraction obtained by dividing--
    (1) The amount of the partner's distributive share of partnership 
loss that is disallowed for the taxable year; by
    (2) The sum of the partner's distributive shares of all items of 
deduction and loss of the partnership for the taxable year.
    (B) Deductions disallowed under section 1366(d). If any amount of an 
S corporation shareholder's pro rata share of an S corporation's loss 
for the taxable year is disallowed under section 1366(d), a ratable 
portion of the taxpayer's pro rata share of each item of deduction or 
loss of the S corporation is disallowed for the taxable year. For 
purposes of the preceding sentence, the ratable portion of an item of 
deduction or loss is the amount of such item multiplied by the fraction 
obtained by dividing--
    (1) The amount of the shareholder's pro rata share of S corporation 
loss that is disallowed for the taxable year; by
    (2) The sum of the shareholder's pro rata shares of all items of 
deduction

[[Page 440]]

and loss of the corporation for the taxable year.
    (iii) Proration of deductions disallowed under at-risk limitation. 
If any amount of the taxpayer's loss from an activity (within the 
meaning of section 465(c)) is disallowed under section 465 for the 
taxable year, a ratable portion of each item of deduction or loss from 
the activity is disallowed for the taxable year. For purposes of the 
preceding sentence, the ratable portion of an item of deduction or loss 
is the amount of such item multiplied by the fraction obtained by 
dividing--
    (1) The amount of the loss from the activity that is disallowed for 
the taxable year; by
    (2) The sum of all deductions from the activity for the taxable 
year.
    (iv) Coordination of basis and at-risk limitations. The portion of 
any item of deduction or loss that is disallowed for the taxable year 
under section 704(d) or 1366(d) is not taken into account for the 
taxable year in determining the loss from an activity (within the 
meaning of section 465(c)) for purposes of applying section 465.
    (v) Separately identified items of deduction and loss. In 
identifying the items of deduction and loss from an activity that are 
not disallowed under sections 704(d), 1366(d), and 465 (and that 
therefore may be treated as passive activity deductions), the taxpayer 
need not account separately for any item of deduction or loss unless 
such item may, if separately taken into account, result in an income tax 
liability different from that which would result were such item of 
deduction or loss taken into account separately. For related rules 
applicable to partnerships and S corporations, see Sec. 1.702-
1(a)(8)(ii) and section 1366(a)(1)(A), respectively. Items of deduction 
or loss that must be accounted for separately include (but are not 
limited to) items of deduction or loss that--
    (A) Are attributable to separate activities (within the meaning of 
the rules to be contained in Sec. 1.469-4T);
    (B) Arise in a rental real estate activity (within the meaning of 
section 469(i) and the rules to be contained in Sec. 1.469-9T) in 
taxable years in which the taxpayer activity participates (within the 
meaning of section 469(i) and the rules to be contained in Sec. 1.469-
9T) in such activity;
    (C) Arise in a rental real estate activity (within the meaning of 
section 469(i) and the rules to be contained in Sec. 1.469-9T) in 
taxable years in which the taxpayer does not actively participate 
(within the meaning of section 469(i) and the rules to be contained in 
Sec. 1.469-9T) in such activity;
    (D) Arose in a taxable year beginning before 1987 and were not 
allowed for such taxable year under section 704(d), 1366(d), or 
465(a)(2);
    (E) [Reserved]. See Sec. 1.469-2(d)(6)(v)(E) for rules relating to 
this paragraph.
    (F) Are attributable to pre-enactment interests in activities 
(within the meaning of Sec. 1.469-11T(c)).
    (7) Deductions from section 481 adjustment--(i) In general. If a 
change in accounting method results in a negative section 481 adjustment 
with respect to an activity, a ratable portion (within the meaning of 
paragraph (d)(7)(iii) of this section) of the amount taken into account 
for a taxable year as a net negative section 481 adjustment by reason of 
such change shall be treated as a deduction from the activity for such 
taxable year, and such deduction shall be treated as a passive activity 
deduction if and only if such activity is a passive activity for the 
year of the change (within the meaning of section 481(a)). See the rules 
to be contained in Sec. 1.469-1T(k) for the treatment of passive 
activity deductions from an activity in taxable years in which the 
activity is a former passive activity.
    (ii) Negative section 481 adjustments. For purposes of applying this 
paragraph (d)(7)--
    (A) The term ``net negative section 481 adjustment'' means the 
decrease (if any) in taxable income taken into account under section 
481(a) to prevent amounts from being duplicated or omitted by reason of 
a change in accounting method; and
    (B) The term ``negative section 481 adjustment with respect to an 
activity'' means the decrease (if any) in taxable income that would be 
taken into account under section 481(a) to prevent only the duplication 
or omission of amounts from such activity by reason of the change in 
accounting method.

[[Page 441]]

    (iii) Ratable portion. The ratable portion of the amount taken into 
account as a net negative section 481 adjustments for a taxable year by 
reason of a change in accounting method is determined with respect to an 
activity by multiplying such amount by the fraction obtained by 
dividing--
    (A) The negative section 481 adjustment with respect to the 
activity; by
    (B) The sum of the negative section 481 adjustments with respect to 
all of the activities of the taxpayer.
    (8) Taxable year in which item arises. [Reserved]. See Sec. 1.469-
2(d)(8) for rules relating to this paragraph.
    (e) Special rules for partners and S corporation shareholders--(1) 
In general. For purposes of section 469 and the regulations thereunder, 
the character (as an item of passive activity gross income or passive 
activity deduction) of each item of gross income and deduction allocated 
to a taxpayer from a partnership or S corporation (a ``passthrough 
entity'') shall be determined, in any case in which participation is 
relevant, by reference to the participation of the taxpayer in the 
activity (or activities) that generated such item. Such participation is 
determined for the taxable year of the passthrough entity (and not the 
taxable year of the taxpayer). The following example illustrates the 
application of this paragraph (e)(1):

    Example. A, a calendar year individual, is a partner in a 
partnership that has a taxable year ending January 31. During its 
taxable year ending on January 31, 1988, the partnership engages in a 
single trade or business activity. For the period from February 1, 1987, 
through January 31, 1988, A does not materially participate in this 
activity. In A's calendar year 1988 return, A's distributive share of 
the partnership's gross income and deductions from the activity must be 
treated as passive activity gross income and passive activity 
deductions, without regard to A's participation in the activity from 
February 1, 1988, through December 31, 1988. See also Sec. 1.469-
11T(a)(4) (relating to the effective date of, and transition rules 
under, section 469 and the regulations thereunder).

    (2) Payments under sections 707(a), 707(c), and 736(b). Items of 
gross income and deduction attributable to a transaction described in 
section 707(a), 707(c), or 736(b) shall be characterized for purposes of 
section 469 and the regulations thereunder in accordance with the 
following rules:
    (i) Section 707(a). Any item of gross income or deduction 
attributable to a transaction that is treated under section 707(a) as a 
transaction between a partnership and a partner acting in a capacity 
other than as a member of such partnership shall be characterized for 
purposes of section 469 and the regulations thereunder in a manner that 
is consistent with the treatment of such transaction under section 
707(a).
    (ii) Section 707(c). [Reserved]. See Sec. 1.469-2(e)(ii) for rules 
relating to this paragraph.
    (iii) Payments in liquidation of a partner's interest in partnership 
property. [Reserved]. See Sec. 1.469-2(e)(iii) for rules relating to 
this paragraph.
    (3) Sale or exchange of interest in passthrough entity--(i) 
Application of this paragraph (e)(3). In the case of the sale, exchange, 
or other disposition (a ``disposition'') of an interest in a passthrough 
entity, the amount of the seller's gain or loss from each activity in 
which such entity has an interest is determined, for purposes of section 
469 and the regulations thereunder, under this paragraph (e)(3). In the 
case of any such disposition, except as otherwise provided in paragraph 
(e)(3)(iii) or (iv) of this section, paragraph (e)(3)(ii) of this 
section shall apply. See paragraphs (c)(2) and (d)(5) of this section 
for rules for determining the character of gain or loss, respectively, 
recognized upon a disposition of an interest in an activity held through 
a passthrough entity.
    (ii) General rule--(A) Allocation among activities. Except as 
otherwise provided in this paragraph (e)(3)(ii) or in paragraph (e)(3) 
(iii) or (iv) of this section, if a holder of an interest in a 
passthrough entity disposes of such interest, a ratable portion (within 
the meaning of paragraph (e)(3)(ii)(B) of this section) of any gain or 
loss from such disposition shall be treated as gain or loss from the 
disposition of an interest in each trade or business, rental, or 
investment activity in which such passthrough entity owns an interest on 
the applicable valuation date.
    (B) Ratable portion--(1) Dispositions on which gain is recognized. 
The ratable

[[Page 442]]

portion of any gain from the disposition of an interest in a passthrough 
entity that is allocable to an activity described in paragraph 
(e)(3)(ii)(A) of this section is determined by multiplying the amount of 
such gain by the fraction obtained by dividing--
    (i) The amount of net gain (within the meaning of paragraph 
(e)(3)(ii)(E)(3) of this section) that would have been allocated to the 
holder of such interest with respect thereto if the passthrough entity 
had sold its entire interest in such activity for its fair market value 
on the applicable valuation date; by
    (ii) The sum of the amounts of net gain that would have been 
allocated to the holder of such interest with respect thereto if the 
passthrough entity had sold its entire interest in each appreciated 
activity (within the meaning of paragraph (e)(3)(ii)(E)(1) of this 
section) described in paragraph (e)(3)(ii)(A) of this section for the 
fair market value of each such activity on the applicable valuation 
date.
    (2) Dispositions on which loss is recognized. The ratable portion of 
any loss from the disposition of an interest in a passthrough entity 
that is allocable to an activity described in paragraph (e)(3)(ii)(A) of 
this section is determined by multiplying the amount of such loss by the 
fraction obtained by dividing--
    (i) The amount of net loss (within the meaning of paragraph 
(e)(3)(ii)(E)(4) of this section) that would have been allocated to the 
holder of such interest with respect thereto if the passthrough entity 
had sold its entire interest in such activity for its fair market value 
on the applicable valuation date; by
    (ii) The sum of the amounts of net loss that would have been 
allocated to the holder of such interest with respect thereto if the 
passthrough entity had sold its entire interest in each depreciated 
activity (within the meaning of paragraph (e)(3)(ii)(E)(2) of this 
section) described in paragraph (e)(3)(ii)(A) of this section for the 
fair market value of each such activity on the applicable valuation 
date.
    (C) Default rule. If the gain or loss recognized upon the 
disposition of an interest in a passthrough entity cannot be allocated 
under paragraph (e)(3)(ii)(A) of this section, such gain or loss shall 
be allocated among the activities described in paragraph (e)(3)(ii)(A) 
of this section in proportion to the respective fair market values of 
the passthrough entity's interests in such activities at the applicable 
valuation date, and the gain or loss allocated to each activity of the 
passthrough entity shall be treated as gain or loss from the disposition 
of an interest in such activity.
    (D) Special rules. For purposes of this paragraph (e)(3)(ii), the 
following rules shall apply:
    (1) Applicable valuation date--(i) In general. Except as otherwise 
provided in paragraph (e)(3)(ii)(D)(1)(ii) of this section, the 
applicable valuation date with respect to any disposition of an interest 
in a passthrough entity is whichever one of the following dates is 
selected by the passthrough entity:
    (a) The beginning of the taxable year of the passthrough entity in 
which such disposition occurs; or
    (b) The date on which such disposition occurs.
    (ii) Exception. If, after the beginning of a passthrough entity's 
taxable year in which a holder's disposition of an interest in such 
passthrough entity occurs and before the time of such disposition--
    (a) The passthrough entity disposes of more than 10 percent of its 
interest (by value as of the beginning of such taxable year) in any 
activity;
    (b) More than 10 percent of the property (by value as of the 
beginning of such taxable year) used in any activity of the passthrough 
entity is disposed of; or
    (c) The holder of such interest contributes to the passthrough 
entity substantially appreciated property or substantially depreciated 
property with a total fair market value or adjusted basis, respectively, 
which exceeds 10 percent of the total fair market value of the holder's 
interest in the passthrough entity as of the beginning of such taxable 
year;

then the applicable valuation date shall be the date immediately 
preceding the date on which such disposition occurs.
    (2) Basis adjustments. Any adjustment to the basis of partnership 
property

[[Page 443]]

under section 743(b) made with respect to the holder of an interest in a 
partnership shall be taken into account in computing the net gain or net 
loss that would have been allocated to the holder with respect to such 
interest if the partnership had sold its entire interest in an activity.
    (3) Tiered passthrough entities. In the case of a disposition of an 
interest in a passthrough entity (the ``subsidiary passthrough entity'') 
by a holder that is also a passthrough entity, any gain or loss from 
such disposition that is taken into account by any person that owns 
(directly or indirectly) an interest in such holder shall be allocated 
among the activities of the subsidiary passthrough entity by applying 
the rules of this paragraph (e)(3)(ii) to the person taking such gain or 
loss into account as if such person has been the holder of an interest 
in such subsidiary passthrough entity and had recognized such gain or 
loss as a result of a disposition of such interest.
    (E) Meaning of certain terms. For purposes of this paragraph 
(e)(3)(ii)--
    (1) An activity is an appreciated activity with respect to a holder 
that has disposed of an interest in a passthrough entity if a net gain 
would have been allocated to the holder with respect to such interest if 
the passthrough entity has sold its entire interest in such activity for 
its fair market value on the applicable valuation date;
    (2) An activity is a depreciated activity with respect to a holder 
that has disposed of an interest in a passthrough entity if a net loss 
would have been allocated to the holder with respect to such interest if 
the passthrough entity had sold its entire interest in such activity for 
its fair market value on the applicable valuation date;
    (3) The term ``net gain'' means, with respect to the sale of a 
passthrough entity's entire interest in an activity, the amount by which 
the gains from the sale of all of the property used by (or representing 
the interest of) the passthrough entity in such activity exceed the 
losses (if any) from such sale;
    (4) The term ``net loss'' means, with respect to the sale of a 
passthrough entity's entire interest in an activity, the amount by which 
the losses from the sale of all of the property used by (or representing 
the interest of) the passthrough entity in such activity exceed the 
gains (if any) from such sale.
    (iii) Treatment of gain allocated to certain passive activities as 
not from a passive activity. If, in the case of a disposition of an 
interest in a passthrough entity--
    (A) An amount of gain recognized on account of such disposition by 
the holder of such interest (or any other person that owns (directly or 
indirectly) an interest in such holder if such holder is a passthrough 
entity) is allocated to a passive activity of such holder (or such other 
person) under paragraph (e)(3)(ii) of this section;
    (B) [Reserved]. See Sec. 1.469-2(e)(3)(iii)(B) for rules relating 
to this paragraph.
    (C) The amount of the gain of the holder (or such other person) 
described in paragraph (e)(3)(iii)(B) of this section exceeds 10 percent 
of the amount of the gain of the holder (or such other person) described 
in paragraph (e)(3)(iii)(A) of this section;

then the gain of the holder (or such other person) that is described in 
paragraph (e)(3)(iii)(A) of this section shall be treated as gain that 
is not from a passive activity to the extent that such gain does not 
exceed the amount of the gain of the holder (or such other person) 
described in paragraph (e)(3)(iii)(B) of this section. For purposes of 
applying the preceding sentence to the disposition of an interest in a 
partnership, the amount of gain that would have been allocated to the 
holder (or such other person) if all of the property used in an activity 
had been sold shall be determined by taking into account any adjustment 
to the basis of partnership property made with respect to such holder 
(or such other person) under section 743(b).
    (iv) Dispositions occurring in taxable years beginning before 
February 19, 1988--(A) In general. Except as otherwise provided in this 
paragraph (e)(3)(iv), if the holder of an interest in a passthrough 
entity sells, exchanges, or otherwise disposes of all or part of such 
interest during a taxable year of

[[Page 444]]

such entity beginning prior to February 19, 1988, any gain or loss 
recognized from such disposition shall be allocated among the activities 
of the passthrough entity under any reasonable method selected by the 
passthrough entity, and the gain or loss allocated to each activity of 
the passthrough entity shall be treated as gain or loss from the 
disposition of an interest in such activity. For purposes of the 
preceding sentence, a reasonable method shall include the method 
prescribed by paragraph (e)(3)(ii) of this section. In addition, a 
method that allocates gain or loss among the passthrough entity's 
activities on the basis of the fair market value, cost, or adjusted 
basis of the property used in such activities shall generally be 
considered a reasonable method for purposes of this paragraph 
(e)(3)(iv).
    (B) Exceptions. This paragraph (e)(3)(iv) shall not apply to any 
disposition of an interest in a passthrough entity occurring after 
February 19, 1988, if after such date, but before the holder's 
disposition of such interest, the holder (or any other person that owns 
(directly or indirectly) an interest in such holder if such holder is a 
passthrough entity) contributes to the passthrough entity substantially 
appreciated portfolio assets or any other substantially appreciated 
property that was used in any trade or business activity (within the 
meaning of Sec. 1.469-1T(e)) of the holder (or such other person) 
during--
    (1) The taxable year of such person in which such contribution 
occurs; or
    (2) The immediately preceding taxable year of such person;

but only if such person materially participated (within the meaning of 
Sec. 1.469-5T) in the activity for such year.
    (v) Treatment of portfolio assets. For purposes of the paragraph 
(e)(3), all portfolio assets owned by a passthrough entity shall be 
treated as held in a single investment activity.
    (vi) Definitions. For purposes of this paragraph (e)(3)--
    (A) The term ``portfolio asset'' means any property of a type that 
produces portfolio income (within the meaning of paragraph (c)(3)(i) of 
this section);
    (B) The term ``substantially appreciated property'' means property 
with a fair market value that exceeds 120 percent of its adjusted basis; 
and
    (C) The term ``substantially depreciated property'' means property 
with an adjusted basis that exceeds 120 percent of its fair market 
value.
    (vii) Examples. The following examples illustrate the application of 
this paragraph (e)(3):

    Example (1). (i) A owns a one-half interest in P, a calendar year 
partnership. In 1993, A sells 50 percent of such interest for $50,000. 
A's adjusted basis for the interest sold is $30,000. Thus, A recognizes 
$20,000 of gain from the sale. P is engaged in three trade or business 
activities, X, Y, and Z, and owns marketable securities that are 
portfolio assets. For 1993, A materially participates in activity Z, but 
does not participate in activities X and Y. Paragraph (c)(2)(iii) of 
this section would not have applied to any of the gain that A would have 
been allocated if, immediately before A's sale, P had disposed of all of 
the property used in its trade or business activities. During the 
portion of 1993 preceding A's sale, P did not sell any of the property 
used in its activities, and A did not contribute any property to P.
    (ii) Under paragraph (e)(3)(ii) of this section, a ratable portion 
of A's $20,000 gain is allocated to each appreciated activity in which P 
owned an interest on the applicable valuation date (within the meaning 
of paragraph (e)(3)(ii)(D)(1) of this section). For this purpose, 
paragraph (e)(3)(v) of this section treats the marketable securities 
owned by P as a single investment activity.
    (iii) P selects the beginning of 1993 as the applicable valuation 
date pursuant to paragraph (e)(3)(ii)(D)(1)(i) of this section. P is not 
required to use the date of A's sale as the applicable valuation date 
under paragraph (e)(3)(ii)(D)(1)(ii) of this section because during the 
portion of 1993 preceding A's sale, P did not sell any of its property 
and A did not contribute any property to P. At the beginning of 1993, 
the fair market value and adjusted basis of the property used in P's 
activities are as follows:

------------------------------------------------------------------------
                                                                  Fair
                                                     Adjusted    market
                                                      basis      value
------------------------------------------------------------------------
X.................................................    $68,000    $48,000
Y.................................................     30,000     62,000
Z.................................................     20,000     80,000
Marketable securities.............................      2,000     10,000
                                                   ---------------------
      Total.......................................    120,000    200,000
------------------------------------------------------------------------

    (iv) Under paragraph (e)(3)(ii)(B) of this section, the portion of 
A's $20,000 gain that is allocated to an appreciated activity of P 
(i.e., activities Y and Z and the marketable securities) is the amount 
of such gain multiplied by the fraction obtained by dividing (a)

[[Page 445]]

the net gain that would have been allocated to A with respect to the 
interest sold by A if P had sold its entire interest in such activity at 
the beginning of 1993 by (b) the sum of the amounts of net gain that 
would have been allocated to A with respect to the interest sold by A if 
P had sold its entire interest in each appreciated activity at the 
beginning of 1993.
    (v) If P had sold its entire interest in activities Y and Z and the 
marketable securities at the beginning of 1993, A would have been 
allocated the following amounts of net gain with respect to the interest 
in P that A sold in 1993:

------------------------------------------------------------------------
                           Activity                             Net gain
------------------------------------------------------------------------
Y............................................................     $8,000
Z............................................................     15,000
Marketable securities........................................      2,000
                                                              ----------
      Total..................................................     25,000
------------------------------------------------------------------------

    (vi) Accordingly, under paragraph (e)(3)(ii) of this section, $6,400 
of A's $20,000 gain ($20,000x$8,000/$25,000) is allocated to activity Y, 
$12,000 of A's $20,000 gain ($20,000x$15,000/$25,000) is allocated to 
activity Z, and $1,600 of A's $20,000 gain ($20,000x$2,000/$25,000) is 
allocated to the marketable securities. The gain allocated to activity Y 
is passive activity gross income. None of that gain is treated as gain 
that is not from a passive activity under paragraph (e)(3)(iii) of this 
section because paragraph (c)(2)(iii) of this section would not have 
applied to any of the gain that A would have been allocated if P had 
sold all of the property used in activity Y immediately prior to A's 
sale.
    Example (2). (i) B and C, calendar year individuals, are equal 
partners in calendar year partnership R, which they formed on January 1, 
2005, with contributions of property and money. The only item of 
property (other than money) contributed by B was a building that B had 
used for 12 years preceding the contribution in an activity that was not 
a passive activity during such period. At the time of its contribution, 
the building had an adjusted basis of $40,000 and a fair market value of 
$66,000. R is engaged in a single activity: the sale of equipment to 
customers in the ordinary course of the business of dealing in such 
property. R uses the building contributed by B in the dealership 
activity. B did not materially participate in the dealership activity 
during 2005. On July 1, 2005, D purchases one-half of B's interest in R 
for $37,500 in cash. At the time of the sale, the balance sheet of R, 
which uses the accrual method of accounting, is as follows:

------------------------------------------------------------------------
                                                     Adjusted     Fair
                                                    basis per    market
                                                      books      value
------------------------------------------------------------------------
                                 Assets
------------------------------------------------------------------------
Cash..............................................    $30,000    $30,000
Accounts receivable:
  Dealership......................................     20,000     18,000
Inventory:
  Dealership......................................     52,000     66,000
Building..........................................     40,000     66,000
                                                   ---------------------
      Total.......................................    142,000    180,000
------------------------------------------------------------------------
                         Liabilities and Capital
------------------------------------------------------------------------
Liabilities.......................................    $30,000    $30,000
Capital:
  B...............................................     47,000     75,000
  C...............................................     65,000     75,000
                                                   ---------------------
      Total.......................................    142,000    180,000
------------------------------------------------------------------------


Thus, B's gain from the sale is $14,000 ($45,000 amount realized from 
the sale (consisting of $37,500 of cash and $7,500 of liabilities 
assumed by the purchaser) minus B's $31,000 adjusted basis for the 
interest sold (one-half of B's total adjusted basis of $62,000)).
    (ii) Under paragraph (e)(3)(ii) of this section, all $14,000 of B's 
gain from the sale is allocated to R's dealership activity, which is a 
passive activity of B for 2005. If, however, R had sold its interest in 
the building immediately prior to B's sale for its fair market value on 
the applicable valuation date (the valuation date selected by R is 
irrelevant since the building had a fair market value of $66,000 at the 
beginning of 2005 and at the time of the sale), B would have been 
allocated $13,000 of gain under section 704(c) with respect to the 
interest in R that B sold to D. This gain would have been treated as 
gain that is not from a passive activity under paragraph (c)(2)(iii) of 
this section and would have exceeded 10 percent of the total amount of 
B's gain that is allocated to the dealership activity under paragraph 
(e)(3)(ii) of this section. Accordingly, under paragraph (e)(3)(iii) of 
this section, B's gain from the sale ($14,000) is treated as gain that 
is not from a passive activity to the extent that such gain does not 
exceed the amount of gain subject to paragraph (c)(2)(iii) of this 
section that B would have been allocated with respect to the interest 
sold to D if R had sold all of the property used in the dealership 
activity immediately prior to B's sale ($13,000). Thus, $13,000 of B's 
gain from the sale is treated as gain that is not from a passive 
activity.

    (f) Recharacterization of passive income in certain situations--(1) 
In general. This paragraph (f) sets forth rules that require income from 
certain passive activities to be treated as income that is not from a 
passive activity (regardless of whether such income is treated as 
passive activity gross income under section 469 or any other provision 
of

[[Page 446]]

the regulations thereunder). For definitions of certain terms used in 
this paragraph (f), see paragraph (f)(9) of this section.
    (2) Special rule for significant participation--(i) In general. An 
amount of the taxpayer's gross income from each significant 
participation passive activity for the taxable year equal to a ratable 
portion of the taxpayer's net passive income from such activity for the 
taxable year shall be treated as not from a passive activity if the 
taxpayer's passive activity gross income from all significant 
participation passive activities for the taxable year (determined 
without regard to paragraphs (f) (2) through (4) of this section) 
exceeds the taxpayer's passive activity deductions from all such 
activities for such year. For purposes of this paragraph (f)(2), the 
ratable portion of the net passive income from an activity is determined 
by multiplying the amount of such income by the fraction obtained by 
dividing--
    (A) The amount of the excess described in the preceding sentence; by
    (B) The amount of the excess described in the preceding sentence 
taking into account only significant participation passive activities 
from which the taxpayer has net passive income for the taxable year.
    (ii) Significant participation passive activity. For purposes of 
this paragraph (f)(2), the term ``significant participation passive 
activity'' means any trade or business activity (within the meaning of 
Sec. 1.469-1T(e)(2)) in which the taxpayer significantly participates 
(within the meaning of Sec. 1.469-5T(c)(2)) for the taxable year but in 
which the taxpayer does not materially participate (within the meaning 
of Sec. 1.469-5T) for such year.
    (iii) Example. The following example illustrates the application of 
this paragraph (f)(2):

    Example. (i) A owns interests in three trade or business activities, 
X, Y, and Z. A does not materially participate in any of these 
activities for the taxable year, but participates in activity X for 110 
hours, in activity Y for 160 hours, and in activity Z for 125 hours. A 
owns no interest in any other trade or business activity in which A does 
not materially participate for the taxable year but in which A 
participates for more than 100 hours during the taxable year. A's net 
passive income (or loss) for the taxable year from activities X, Y, and 
Z is as follows:

------------------------------------------------------------------------
                                                   X        Y        Z
------------------------------------------------------------------------
Passive activity gross income.................   $600      $700    $900
Passive activity deductions...................   (200)   (1,000)   (300)
                                               -------------------------
Net passive income............................    400      (300)    600
------------------------------------------------------------------------

    (ii) Under paragraph (f)(2)(ii) of this section, activities X, Y, 
and Z are A's only significant participation passive activities for the 
taxable year. A's passive activity gross income from significant 
participation passive activities ($2,200) exceeds A's passive activity 
deductions from significant participation passive activities ($1,500) by 
$700 for such year. Therefore, under paragraph (f)(2)(i) of this 
section, a ratable portion of A's gross income from activities X and Z 
(A's significant participation passive activities with net passive 
income for the taxable year) is treated as gross income that is not from 
a passive activity. The ratable portion is determined by dividing (a) 
the amount by which A's passive activity gross income from significant 
participation passive activities exceeds A's passive activity deductions 
from significant participation passive activities for the taxable year 
($700) by (b) such excess taking into account only A's significant 
participation passive activities having net passive income for the 
taxable year ($1,000). Accordingly, $280 of gross income from activity X 
($400x700/1000) and $420 of gross income from activity Z ($600x700/1000) 
is treated as gross income that is not from a passive activity.

    (3) Rental of nondepreciable property. If less than 30 percent of 
the unadjusted basis of the property used or held for use by customers 
in a rental activity (within the meaning of Sec. 1.469-1T(e)(3)) during 
the taxable year is subject to the allowance for depreciation under 
section 167, an amount of the taxpayer's gross income from the activity 
equal to the taxpayer's net passive income from the activity shall be 
treated as not from a passive activity. For purposes of this paragraph 
(f)(3), the term ``unadjusted basis'' means adjusted basis determined 
without regard to any adjustment described in section 1016 that 
decreases basis. The following example illustrates the application of 
this paragraph (f)(3):

    Example. C is a limited partner in a partnership. The partnership 
acquires vacant land for $300,000, constructs improvements on the land 
at a cost of $100,000, and leases the land and improvements to a tenant. 
The

[[Page 447]]

partnership then sells the land and improvements for $600,000, thereby 
realizing a gain on the disposition. The unadjusted basis of the 
improvements ($100,000) equals 25 percent of the unadjusted basis of all 
property ($400,000) used in the rental activity. Therefore, under this 
paragraph (f)(3), an amount of C's gross income from the activity equal 
to the net passive income from the activity (which is computed by taking 
into account the gain from the disposition, including gain allocable to 
the improvements) is treated as not from a passive activity.

    (4) Net interest income from passive equity-financed lending 
activity--(i) In general. An amount of the taxpayer's gross income for 
the taxable year from any equity-financed lending activity equal to the 
lesser of--
    (A) The taxpayer's equity-financed interest income from the activity 
for such year; and
    (B) The taxpayer's net passive income from the activity for such 
year

shall be treated as not from a passive activity.
    (ii) Equity-financed lending activity--(A) In general. For purposes 
of this paragraph (f)(4), an activity is an equity-financed lending 
activity for a taxable year if--
    (1) The activity involves a trade or business of lending money; and
    (2) The average outstanding balance of the liabilities incurred in 
the activity for the taxable year does not exceed 80 percent of the 
average outstanding balance of the interest-bearing assets held in the 
activity for such year.
    (B) Certain liabilities not taken into account. For purposes of 
paragraph (f)(4)(ii)(A)(2) of this section, liabilities incurred 
principally for the purpose of increasing the percentage described in 
paragraph (f)(4)(ii)(A)(2) of this section shall not be taken into 
account in computing such percentage.
    (iii) Equity-financed interest income. For purposes of this 
paragraph (f)(4), the taxpayer's equity-financed interest income from an 
activity for a taxable year is the amount of the taxpayer's net interest 
income from the activity for such year multiplied by the fraction 
obtained by dividing--
    (A) The excess of the average outstanding balance for such year of 
the interest-bearing assets held in the activity over the average 
outstanding balance for such year of the liabilities incurred in the 
activity; by
    (B) The average outstanding balance for such year of the interest-
bearing assets held in the activity.
    (iv) Net interest income. For purposes of this paragraph (f)(4), the 
net interest income from an activity for a taxable year is--
    (A) The gross interest income from the activity for such year; 
reduced by
    (B) Expenses from the activity (other than interest on liabilities 
described in paragraph (f)(4)(vi) of this section) for such year that 
are reasonably allocable to such gross interest income.
    (v) Interest-bearing assets. For purposes of this paragraph (f)(4), 
the interest-bearing assets held in an activity include all assets that 
produce interest income, including loans to customers.
    (vi) Liabilities incurred in the activity. For purposes of this 
paragraph (f)(4), liabilities incurred in an activity include all fixed 
and determinable liabilities incurred in the activity that bear interest 
or are issued with original issue discount other than debts secured by 
tangible property used in the activity. In the case of an activity 
conducted by an entity in which the taxpayer owns an interest, 
liabilities incurred in an activity include only liabilities with 
respect to which the entity is the borrower.
    (vii) Average outstanding balance. For purposes of this paragraph 
(f)(4), the average outstanding balance of liabilities incurred in an 
activity or of the interest-bearing assets held in an activity may be 
computed on a daily, monthly, or quarterly basis at the option of the 
taxpayer.
    (viii) Example. The following example illustrates the application of 
this paragraph (f)(4):

    Example: (i) A, a calendar year individual, acquires on January 1, 
1988, a limited partnership interest in P, a calendar year partnership. 
Under the partnership agreement, A has a one percent share of each item 
of income, gain, loss, deduction, and credit of P. A acquires the 
partnership interest for $90,000, using $50,000 of unborrowed funds and 
$40,000 of proceeds of a loan bearing interest at an annual rate of 10 
percent. A pays $4,000 of interest on the loan in 1988.
    (ii) P's sole activity is a trade or business of lending money. A 
does not materially participate in the activity for 1988. During 1988,

[[Page 448]]

the average outstanding balance of P's interest-bearing assets 
(including loans to customers, temporary deposits with other lending 
institutions, and government and corporate securities) is $20 million. P 
incurs numerous interest-bearing liabilities in connection with its 
lending activity, including liabilities for deposits taken from 
customers, unsecured short-term and long-term loans from other lending 
institutions, and a mortgage loan secured by the building, owned by P, 
in which P conducts its business. For 1988, the average outstanding 
balance of all of these liabilities (other than the mortgage loan) is 
$11 million. None of these liabilities was incurred by P principally for 
the purpose of increasing the percentage described in paragraph 
(f)(4)(ii)(A)(2) of this section.
    (iii) The interest income derived by P for 1988 from its interest-
bearing assets is $2.2 million. The interest expense paid by P for 1988 
with respect to the liabilities incurred in connection with its lending 
activity (other than the mortgage loan) is $990,000. P's other expenses 
for 1988 that are reasonably allocable to P's gross interest income 
(including expenses for advertising, loan processing and servicing, and 
insurance, and depreciation on P's building) total $250,000. P's 
interest expense for 1988 on the mortgage loan secured by the building 
used in P's lending activity is $50,000. All of the interest expense 
paid or incurred by P for 1988 is allocated under Sec. 1.63-8T to 
expeditures in connection with P's lending activity.
    (iv) Under paragraph (f)(4)(ii) of this section, P's activity is an 
equity-financed lending activity for 1988, since, for 1988, the activity 
involves a trade or business of lending money and the average 
outstanding balance of the liabilities incurred in the activity ($11 
million) does not exceed 80 percent of the average outstanding balance 
of the interest-bearing assets held in the activity ($20 million). 
Accordingly, under paragraph (f)(4)(i) of this section, an amount of A's 
gross income from the activity equal to the lesser of (a) A's equity-
financed interest income from the activity for 1988, or (b) A's net 
passive income from the activity for 1988, is treated as income that is 
not from a passive activity.
    (v) Under paragraph (f)(4)(iii) of this section, A's equity-financed 
interest income from the activity for 1988 is determined by multiplying 
A's net interest income from the activity for 1988 by the fraction 
obtained by dividing $9 million (the excess of the average interest-
bearing assets for 1988 over the average interest-bearing liabilities 
for 1988) by $20 million (the average interest-bearing assets for 1988). 
Under paragraph (f)(4)(iv) of this section, A's net interest income from 
the activity for 1988 is $19,000 (A's distributive share of $2.2 million 
of gross interest income less A's distributive share of $300,000 of 
expenses described in paragraph (f)(4)(iv)(B) of this section, including 
interest expense on the mortgage loan). A's distributive share of P's 
other interest expense ($990,000) is not taken into account in computing 
A's net interest income for 1988. Accordingly, A's equity-financed 
interest income from the activity for 1988 is $8,550 ($19,000x$9 
million/$20 million).
    (vi) Under paragraph (f)(9)(i) of this section, A's net passive 
income from the activity for 1988 is determined by taking into account 
A's distributive share of P's gross income and deductions from the 
activity for 1988, as well as any interest expense incurred by A 
individually that is taken into account under Sec. 1.163-8T in 
determining A's income or loss from the activity for 1988. Assuming that 
for 1988 all $4,000 of interest expense on the loan that A used to 
finance the acquisition of A's interest in P is allocated under Sec. 
1.163-8T to expenditures of A in connection with the lending activity 
for 1988, A's net passive income from the activity for 1988 is $5,100, 
computed as set forth in the following table:

Gross income:
  Interest income..........................................     $22,000
Deductions:
  Distributive share of P's expenses from the activity.....     (12,900)
  Interest expense on A's acquisition debt.................      (4,000)
                                                            ------------
  Net passive income.......................................       5,100
 

    (vii) A's net passive income from the activity for 1988 ($5,100) is 
less than A's equity-financed income from the activity for 1988 
($8,550). Accordingly, under this paragraph (f)(4), $5,100 of A's gross 
income from the activity for 1988 is treated as not from a passive 
activity.

    (5) Net income from certain property rented incidental to 
development activity--
    (i) In general. [Reserved]. See Sec. 1.469-2(f)(5)(i) for rules 
relating to this paragraph.
    (ii) Commencement. [Reserved]. See Sec. 1.469-2(f)(5)(ii) for rules 
relating to this paragraph (f)(5)(ii).
    (iii) Services performed for the purpose of enhancing the value of 
property. [Reserved]. See Sec. 1.469-2(f)(5)(iii) for rules relating to 
this paragraph (f)(5)(iii).
    (iv) Examples. [Reserved]. See Sec. 1.469-2(f)(5)(iv) for examples 
relating to this paragraph (f)(5)(iv).
    (6) Property rented to a nonpassive activity. [Reserved]. See Sec. 
1.469-2(f)(6) for rules relating to this paragraph.
    (7) Special rules applicable to the acquisition of an interest in a 
passthrough entity engaged in the trade or business of licensing 
intangible property--(i) In general. If a taxpayer acquires an interest 
in an entity described in paragraph

[[Page 449]]

(c)(3)(iii)(B)(3) of this section (the ``development entity'') after the 
development entity has created an item of intangible property or 
performed substantial services or incurred substantial costs with 
respect to the development or marketing of an item of intangible 
property, an amount of the taxpayer's gross royalty income for the 
taxable year from such item of property equal to the taxpayer's net 
royalty income for the year from such item of property shall be treated 
as not from a passive activity.
    (ii) Royalty income from property. For purposes of this paragraph 
(f)(7)--
    (A) A taxpayer's gross royalty income for a taxable year from an 
item of property is the taxpayer's share of passive activity gross 
income for such year (determined without regard to paragraphs (f)(2) 
through (7) of this section) from the licensing or transfer of any right 
in such property; and
    (B) A taxpayer's net royalty income for a taxable year from an item 
of property is the excess, if any, of--
    (1) The taxpayer's gross royalty income for the taxable year from 
such item of property; over
    (2) Any passive activity deductions for such taxable year (including 
any deduction treated as a deduction for such year under Sec. 1.469-1T 
(f)(4)) that are reasonably allocable to such item of property.
    (iii) Exceptions. Paragraph (f)(7)(i) of this section shall not 
apply to a taxpayer's gross royalty income for a taxable year from the 
licensing of an item of intangible property if--
    (A) The expenditures reasonably incurred by the development entity 
for the taxable year of the entity ending with or within the taxpayer's 
taxable year with respect to the development or marketing of such 
property satisfy paragraph (c)(3)(iii)(B)(2)(ii) (a) of this section; or
    (B) The taxpayer's share of the expenditures reasonably incurred by 
the development entity with respect to the development or marketing of 
such property for all taxable years of the entity beginning with the 
taxable year of the entity in which the taxpayer acquired the interest 
in the entity and ending with the taxable year of the entity ending with 
or within the taxpayer's current taxable year exceeds 25 percent of the 
fair market value of the taxpayer's interest in such property at the 
time the taxpayer acquired the interest in the entity.
    (iv) Capital expenditures. For purposes of paragraph (f)(7)(iii)(B) 
of this section, a capital expenditure shall be taken into account for 
the taxable year of the entity in which such expenditure is chargeable 
to capital account, and the taxpayer's share of such expenditure shall 
be determined as though such expenditure were allowed as a deduction for 
such year.
    (v) Example. The following example illustrates the application of 
this paragraph (f)(7):

    Example. (i) The facts are the same as in example (5) in paragraph 
(c)(3)(iv) of this section, except that, in 1988, D's 10 percent 
partnership interest is sold to F for $13,000, all of which is 
attributable to the design licensed by the partnership.
    (ii) For 1988, the expenditures reasonably incurred by the 
partnership with respect to the development or marketing of the design 
satisfy paragraph (c)(3)(iii)(B)(2)(ii)(a) of this section. Accordingly, 
under paragraph (f)(7)(iii)(A) of this section, paragraph (f)(7)(i) of 
this section does not apply to F's distributive share of the 
partnership's gross income from licensing the design.
    (iii) For 1989, the expenditures reasonably incurred by the 
partnership with respect to the development or marketing of the design 
do not satisfy paragraph (c)(3)(iii)(B)(2)(ii)(a) of this section. 
Moreover, F's distributive share of such expenditures reasonably 
incurred by the partnership for 1988 and 1989 ($27,000x.10 = $2,700) 
does not exceed 25 percent of the fair market value of F's interest in 
the design at the time F acquired the partnership interest ($13,000). 
Accordingly, neither of the exceptions provided in paragraph (f)(7)(iii) 
of this section applies for 1989 and, under paragraph (f)(7)(i) of this 
section, an amount of F's gross royalty income from the design equal to 
F's net royalty income from the design is treated as not from a passive 
activity.

    (8) Limitation on recharacterized income. The amount of gross income 
from an activity that is treated as not from a passive activity for the 
taxable year under subparagraphs (f) (2) through (4) of this paragraph 
(f) shall not exceed the greatest amount of gross income treated as not 
from a passive activity under any one of such subparagraphs.
    (9) Meaning of certain terms. For purposes of this paragraph (f), 
the terms

[[Page 450]]

set forth below shall have the following meanings:
    (i) The net passive income from an activity for a taxable year is 
the amount by which the taxpayer's passive activity gross income from 
the activity for the taxable year (determined without regard to 
paragraphs (f) (2) through (4) of this section) exceeds the taxpayer's 
passive activity deductions from the activity for such year;
    (ii) The net passive loss from an activity for a taxable year is the 
amount by which the taxpayer's passive activity deductions from the 
activity for the taxable year exceeds the taxpayer's passive activity 
gross income from the activity for such year (determined without regard 
to paragraphs (f) (2) through (4) of this section).
    (iii) [Reserved]. See Sec. 1.469-2(f)(9)(iii) for rules relating to 
this paragraph.
    (iv) [Reserved]. See Sec. 1.469-2(f)(9)(iv) for rules relating to 
this paragraph.
    (10) Coordination with section 163(d). [Reserved]. See paragraph 
1.469-2(f)(10) for rules relating to this paragraph.
    (11) Effective date. For the effective date of the rules in this 
paragraph (f), see Sec. 1.469-11T (relating to effective date and 
transition rules).

[T.D. 8175, 53 FR 5711, Feb. 25, 1988; 53 FR 15494, Apr. 29, 1988; as 
amended by T.D. 8253, 54 FR 20538, May 12, 1989; T.D. 8290, 55 FR 6981, 
Feb. 28, 1990; T.D. 8318, 55 FR 48108, Nov. 19, 1990; 55 FR 51688, Dec. 
17, 1990; T.D. 8417, 57 FR 20758, May 15, 1992; T.D. 8477, 58 FR 11538, 
Feb. 26, 1993; T.D. 8495, 58 FR 58788, Nov. 4, 1993]



Sec. 1.469-3  Passive activity credit.

    (a)-(d) [Reserved]
    (e) Coordination with section 38(b). Any credit described in section 
38(b) (1) through (5) is taken into account in computing the current 
year business credit for the first taxable year in which the credit is 
subject to section 469 and is not disallowed by section 469 and the 
regulations thereunder.
    (f) Coordination with section 50. In the case of any cessation 
described in section 50(a) (1) or (2), the credits allocable to the 
taxpayer's activities under Sec. 1.469-1(f)(4) shall be adjusted by 
reason of the cessation.
    (g) [Reserved]

[T.D. 8417, 57 FR 20758, May 15, 1992]



Sec. 1.469-3T  Passive activity credit (temporary).

    (a) Computation of passive activity credit. The taxpayer's passive 
activity credit for the taxable year is the amount (if any) by which--
    (1) The sum of all of the taxpayer's credits that are subject to 
section 469 for such year; exceeds
    (2) The taxpayer's regular tax liability allocable to all passive 
activities for such year.
    (b) Credits subject to section 469--(1) In general. Except as 
otherwise provided in this paragraph (b), a credit is subject to section 
469 for a taxable year if and only if--
    (i) Such credit--
    (A) Is attributable to such taxable year and arises in connection 
with the conduct of an activity that is a passive activity for such 
taxable year; and
    (B) Is described in--
    (1) Section 38(b) (1) through (5) (relating to general business 
credits);
    (2) Section 27(b) (relating to corporations described in section 
936);
    (3) Section 28 (relating to clinical testing of certain drugs); or
    (4) Section 29 (relating to fuel from nonconventional sources); or
    (ii) Such credit is allocable to an activity for such taxable year 
under Sec. 1.469-1T(f)(4).
    (2) Treatment of credits attributable to qualified progress 
expenditures. Any credit attributable to an increase in qualified 
investment under section 46(d)(1)(A) (relating to qualified progress 
expenditures) with respect to progress expenditure property (as defined 
in section 46(d)(2)) is subject to section 469 for a taxable year if--
    (i) Such credit is attributable to such taxable year;
    (ii) Such credit is described in paragraph (b)(1)(i)(B) of this 
section; and
    (iii) It is reasonable to believe that such progress expenditure 
property will be used in a passive activity of the taxpayer when it is 
placed in service.
    (3) Special rule for partners and S corporation shareholders. The 
character of a credit of a taxpayer arising in connection with an 
activity conducted by a partnership or S corporation (as a credit 
subject to section 469) shall be determined, in any case in which 
participation is relevant, by reference to

[[Page 451]]

the participation of the taxpayer in such activity. Such participation 
is determined for the taxable year of the partnership or S corporation 
(and not the taxable year of the taxpayer). See Sec. 1.469-2T(e)(1).
    (4) Exception for pre-1987 credits. A credit is not subject to 
section 469 if it is attributable to a taxable year of the taxpayer 
beginning prior to January 1, 1987.
    (c) Taxable year to which credit is attributable. A credit is 
attributable to the taxable year in which such credit would be (or would 
have been) allowed if the credits regard to the limitations contained in 
sections 26(a), 28(d)(2), 29(b)(5), 38(c), and 469.
    (d) Regular tax liability allocable to passive activities--(1) In 
general. For purposes of paragraph (a)(2) of this section, the 
taxpayer's regular tax liability allocable to all passive activities for 
the taxable year is the excess (if any) of--
    (i) The taxpayer's regular tax liability for such taxable year; over
    (ii) The amount of such regular tax liability determined by reducing 
the taxpayer's taxable income for such year by the excess (if any) of 
the taxpayer's passive activity gross income for such year over the 
taxpayer's passive activity deductions for such year.
    (2) Regular tax liability. For purposes of this section, the term 
``regularly tax liability'' has the meaning given such term in section 
26(b).
    (e) Coordination with section 38(b). [Reserved]. See Sec. 1.469-
3(e) for rules relating to this paragraph.
    (f) Coordination with section 50. [Reserved]. See Sec. 1.469-3(f) 
for rules relating to this paragraph.
    (g) Examples. The following examples illustrate the application of 
this section:

    Example (1). (i) A, a calendar year individual, is a general partner 
in calendar year partnership P. P purchases a building in 1987 and, in 
1987, 1988, and 1989, incurs rehabilitation costs with respect to the 
building. The building is placed in service in the rental activity in 
1989. P's rehabilitation costs are qualified rehabilitation expenditures 
(within the meaning of section 48(g)(2)) and are taken into account in 
determining the amount of the investment credit for rehabilitation 
expenditures. P's qualified rehabilitation expenditures are not 
qualified progress expenditures (within the meaning of section 46(d)).
    (ii) Because, under section 46(c)(1), the credit is allowable for 
the taxable year in which the rehabilitated property is placed in 
service, the credit allowable for P's qualified rehabilitation 
expenditures arises in connection with the activity in which the 
property is placed in service. In addition, the credit is attributable 
to 1989, the year in which the property is placed in service, because it 
would be allowed for such year if A's credits allowed for all taxable 
years were determined without regard to the limitations contained in 
sections 26(a), 28(d)(2), 29(b)(5), 38(c), and 469. Accordingly, under 
paragraph (b)(1) of this section, A's distributive share of the credit 
is subject to section 469 for 1989 because the credit arises in 
connection with a rental activity for such year.
    Example (2). The facts are the same as in example (1), except that 
the rehabilitation costs are incurred in anticipation of placing the 
building in service in a rental activity, the qualified rehabilitation 
expenditures in 1987 and 1988 are qualified progress expenditures 
(``QPEs'') (within the meaning of section 46(d)(3)), the improvements 
resulting from the expenditures are progress expenditure property 
(within the meaning of paragraph (d)(2) of this section), and it is 
reasonable to expect that such property will be transition property 
(within the meaning of section 49(e)) when the property is placed in 
service. Therefore, under section 46(d)(1)(A), the qualified investment 
for 1987 and 1988 is increased by an amount equal to the aggregate of 
the applicable percentage of the qualified rehabilitation expenditures 
incurred in such years. The credits that are based on these expenditures 
are attributable (under paragraph (c) of this section) to 1987 and 1988, 
respectively. It is reasonable to believe in 1987 and 1988 that the 
progress expenditure property will be used in a rental activity when it 
is placed in service. Accordingly, under paragraph (b)(2) of this 
section, A's distributive share of the credit for 1987 and 1988 is 
subject to section 469. Under paragraph (b)(1) of this section (as in 
example (1)), A's distributive share of the credit for 1989 is also 
subject to section 469.
    Example (3). (i) B, a single individual, acquires an interest in a 
partnership that, in 1988, rehabilitates a building and places it in 
service in a trade or business activity in which B does not materially 
participate. For 1988, B has the following items of gross income, 
deduction, and credit:

Gross income:
  Income other than passive activity gross income.   $110,000
  Passive activity gross income...................     20,000   $130,000
                                                   -----------
Deductions:
  Deductions other than passive activity               23,950
   deductions.....................................

[[Page 452]]

 
  Passive activity deductions.....................     18,000   (41,950)
                                                   -----------==========
  Taxable income..................................  .........     88,050
                                                              ==========
Credits:
  Rehabilitation credit from the passive activity.  .........      8,000
 

    (ii) For 1988, the amount by which B's passive activity gross income 
exceeds B's passive activity deductions (B's net passive income) is 
$2,000. Under paragraph (d) of this section, B's regular tax liability 
allocable to passive activities for 1988 is determined as follows:

  (A) Taxable income.............................   $88,050
  (B) Regular tax liability......................  ........   $24,578.50
  (C) Taxable income minus net passive income....    86,050
  (D) Regular tax liability for taxable income of  ........    23,918.50
   $86,050.00....................................
                                                            ------------
  (E) Regular tax liability allocable to passive   ........      $660.00
   activities ((B) minus (D))....................
 

    (iii) Under paragraph (a) of this section, B's passive activity 
credit for 1988 is the amount by which B's credits that are subject to 
section 469 for 1988 ($8,000) exceed B's regular tax liability allocable 
to passive activities for 1988 ($660.00). Accordingly, B's passive 
activity credit for 1988 is $7,340.
    Example (4). (i) The facts are the same as in example (3) except 
that, in 1988, B also has additional deductions of $100,000 from a trade 
or business activity in which B materially participates for 1988. Thus, 
B has a taxable loss for 1988 of $11,950, determined as follows:

Gross income:
  Income other than passive activity gross income   $110,000
  Passive activity gross income..................     20,000   $130,000
                                                  -----------
Deductions:
  Deductions other than passive activity             123,950
   deductions....................................
  Passive activity deductions....................     18,000   (141,950)
                                                  ----------------------
  Taxable income.................................  .........    (11,950)
 

    (ii) Under section 26(b) and paragraph (d)(2) of this section, the 
regular tax liability for a taxable year cannot exceed the tax imposed 
by chapter 1 of subtitle A of the Internal Revenue Code for the taxable 
year. Therefore, under paragraph (d)(1) of this section, B's regular tax 
liability allocable to passive activities for 1988 is zero. Although B's 
net operating loss for the taxable year is reduced by B's net passive 
income, and B's regular tax liability for other taxable years may 
increase as a result of the reduction, such an increase does not change 
B's regular tax liability allocable to passive activities for 1988. 
Accordingly, B's passive activity credit for 1988 is $8,000.

[T.D. 8175, 53 FR 5724, Feb. 25, 1988; 53 FR 15494, Apr. 29, 1988; T.D. 
8253, 54 FR 20542, May 12, 1989; T.D. 8417, 57 FR 20758, May 15, 1992]



Sec. 1.469-4  Definition of activity.

    (a) Scope and purpose. This section sets forth the rules for 
grouping a taxpayer's trade or business activities and rental activities 
for purposes of applying the passive activity loss and credit limitation 
rules of section 469. A taxpayer's activities include those conducted 
through C corporations that are subject to section 469, S corporations, 
and partnerships.
    (b) Definitions. The following definitions apply for purposes of 
this section--
    (1) Trade or business activities. Trade or business activities are 
activities, other than rental activities or activities that are treated 
under Sec. 1.469-1T(e)(3)(vi)(B) as incidental to an activity of 
holding property for investment, that--
    (i) Involve the conduct of a trade or business (within the meaning 
of section 162);
    (ii) Are conducted in anticipation of the commencement of a trade or 
business; or
    (iii) Involve research or experimental expenditures that are 
deductible under section 174 (or would be deductible if the taxpayer 
adopted the method described in section 174(a)).
    (2) Rental activities. Rental activities are activities that 
constitute rental activities within the meaning of Sec. 1.469-1T(e)(3).
    (c) General rules for grouping activities--(1) Appropriate economic 
unit. One or more trade or business activities or rental activities may 
be treated as a single activity if the activities constitute an 
appropriate economic unit for the measurement of gain or loss for 
purposes of section 469.
    (2) Facts and circumstances test. Except as otherwise provided in 
this section, whether activities constitute an appropriate economic unit 
and, therefore, may be treated as a single activity depends upon all the 
relevant facts and circumstances. A taxpayer may use any reasonable 
method of applying the relevant facts and circumstances in grouping 
activities. The factors listed below, not all of which are necessary for 
a taxpayer to treat more than one activity as a single activity, are 
given the greatest weight in determining

[[Page 453]]

whether activities constitute an appropriate economic unit for the 
measurement of gain or loss for purposes of section 469--
    (i) Similarities and differences in types of trades or businesses;
    (ii) The extent of common control;
    (iii) The extent of common ownership;
    (iv) Geographical location; and
    (v) Interdependencies between or among the activities (for example, 
the extent to which the activities purchase or sell goods between or 
among themselves, involve products or services that are normally 
provided together, have the same customers, have the same employees, or 
are accounted for with a single set of books and records).
    (3) Examples. The following examples illustrate the application of 
this paragraph (c).

    Example 1. Taxpayer C has a significant ownership interest in a 
bakery and a movie theater at a shopping mall in Baltimore and in a 
bakery and a movie theater in Philadelphia. In this case, after taking 
into account all the relevant facts and circumstances, there may be more 
than one reasonable method for grouping C's activities. For instance, 
depending on the relevant facts and circumstances, the following 
groupings may or may not be permissible: a single activity; a movie 
theater activity and a bakery activity; a Baltimore activity and a 
Philadelphia activity; or four separate activities. Moreover, once C 
groups these activities into appropriate economic units, paragraph (e) 
of this section requires C to continue using that grouping in subsequent 
taxable years unless a material change in the facts and circumstances 
makes it clearly inappropriate.
    Example 2. Taxpayer B, an individual, is a partner in a business 
that sells non-food items to grocery stores (partnership L). B also is a 
partner in a partnership that owns and operates a trucking business 
(partnership Q). The two partnerships are under common control. The 
predominant portion of Q's business is transporting goods for L, and Q 
is the only trucking business in which B is involved. Under this 
section, B appropriately treats L's wholesale activity and Q's trucking 
activity as a single activity.

    (d) Limitation on grouping certain activities. The grouping of 
activities under this section is subject to the following limitations:
    (1) Grouping rental activities with other trade or business 
activities--(i) Rule. A rental activity may not be grouped with a trade 
or business activity unless the activities being grouped together 
constitute an appropriate economic unit under paragraph (c) of this 
section and--
    (A) The rental activity is insubstantial in relation to the trade or 
business activity;
    (B) The trade or business activity is insubstantial in relation to 
the rental activity; or
    (C) Each owner of the trade or business activity has the same 
proportionate ownership interest in the rental activity, in which case 
the portion of the rental activity that involves the rental of items of 
property for use in the trade or business activity may be grouped with 
the trade or business activity.
    (ii) Examples. The following examples illustrate the application of 
paragraph (d)(1)(i) of this section:

    Example 1. (i) H and W are married and file a joint return. H is the 
sole shareholder of an S corporation that conducts a grocery store trade 
or business activity. W is the sole shareholder of an S corporation that 
owns and rents out a building. Part of the building is rented to H's 
grocery store trade or business activity (the grocery store rental). The 
grocery store rental and the grocery store trade or business are not 
insubstantial in relation to each other.
    (ii) Because they file a joint return, H and W are treated as one 
taxpayer for purposes of section 469. See Sec. 1.469-1T(j). Therefore, 
the sole owner of the trade or business activity (taxpayer H-W) is also 
the sole owner of the rental activity. Consequently, each owner of the 
trade or business activity has the same proportionate ownership interest 
in the rental activity. Accordingly, the grocery store rental and the 
grocery store trade or business activity may be grouped together (under 
paragraph (d)(1)(i) of this section) into a single trade or business 
activity, if the grouping is appropriate under paragraph (c) of this 
section.
    Example 2. Attorney D is a sole practitioner in town X. D also 
wholly owns residential real estate in town X that D rents to third 
parties. D's law practice is a trade or business activity within the 
meaning of paragraph (b)(1) of this section. The residential real estate 
is a rental activity within the meaning of Sec. 1.469-1T(e)(3) and is 
insubstantial in relation to D's law practice. Under the facts and 
circumstances, the law practice and the residential real estate do not 
constitute an appropriate economic unit under paragraph (c) of this 
section. Therefore, D may not treat the law practice and the residential 
real estate as a single activity.


[[Page 454]]


    (2) Grouping real property rentals and personal property rentals 
prohibited. An activity involving the rental of real property and an 
activity involving the rental of personal property (other than personal 
property provided in connection with the real property or real property 
provided in connection with the personal property) may not be treated as 
a single activity.
    (3) Certain activities of limited partners and limited 
entrepreneurs--(i) In general. Except as provided in this paragraph, a 
taxpayer that owns an interest, as a limited partner or a limited 
entrepreneur (as defined in section 464(e)(2)), in an activity described 
in section 465(c)(1), may not group that activity with any other 
activity. A taxpayer that owns an interest as a limited partner or a 
limited entrepreneur in an activity described in the preceding sentence 
may group that activity with another activity in the same type of 
business if the grouping is appropriate under the provisions of 
paragraph (c) of this section.
    (ii) Example. The following example illustrates the application of 
this paragraph (d)(3):

    Example. (i) Taxpayer A, an individual, owns and operates a farm. A 
is also a member of M, a limited liability company that conducts a 
cattle-feeding business. A does not actively participate in the 
management of M (within the meaning of section 464(e)(2)(B)). In 
addition, A is a limited partner in N, a limited partnership engaged in 
oil and gas production.
    (ii) Because A does not actively participate in the management of M, 
A is a limited entrepreneur in M's activity. M's cattle-feeding business 
is described in section 465(c)(1)(B) (relating to farming) and may not 
be grouped with any other activity that does not involve farming. 
Moreover, A's farm may not be grouped with the cattle-feeding activity 
unless the grouping constitutes an appropriate economic unit for the 
measurement of gain or loss for purposes of section 469.
    (iii) Because A is a limited partner in N and N's activity is 
described in section 465(c)(1)(D) (relating to exploring for, or 
exploiting, oil and gas resources), A may not group N's oil and gas 
activity with any other activity that does not involve exploring for, or 
exploiting, oil and gas resources. Thus, N's activity may not be grouped 
with A's farm or with M's cattle-feeding business.

    (4) Other activities identified by the Commissioner. A taxpayer that 
owns an interest in an activity identified in guidance issued by the 
Commissioner as an activity covered by this paragraph (d)(4) may not 
group that activity with any other activity, except as provided in the 
guidance issued by the Commissioner.
    (5) Activities conducted through section 469 entities--(i) In 
general. A C corporation subject to section 469, an S corporation, or a 
partnership (a section 469 entity) must group its activities under the 
rules of this section. Once the section 469 entity groups its 
activities, a shareholder or partner may group those activities with 
each other, with activities conducted directly by the shareholder or 
partner, and with activities conducted through other section 469 
entities, in accordance with the rules of this section. A shareholder or 
partner may not treat activities grouped together by a section 469 
entity as separate activities.
    (ii) Cross reference. An activity that a taxpayer conducts through a 
C corporation subject to section 469 may be grouped with another 
activity of the taxpayer, but only for purposes of determining whether 
the taxpayer materially or significantly participates in the other 
activity. See Sec. 1.469-2T(c)(3)(i)(A) and (c)(4)(i) for the rules 
regarding dividends on C corporation stock and compensation paid for 
personal services.
    (e) Disclosure and consistency requirements--(1) Original groupings. 
Except as provided in paragraph (e)(2) of this section and Sec. 1.469-
11, once a taxpayer has grouped activities under this section, the 
taxpayer may not regroup those activities in subsequent taxable years. 
Taxpayers must comply with disclosure requirements that the Commissioner 
may prescribe with respect to both their original groupings and the 
addition and disposition of specific activities within those chosen 
groupings in subsequent taxable years.
    (2) Regroupings. If it is determined that a taxpayer's original 
grouping was clearly inappropriate or a material change in the facts and 
circumstances has occurred that makes the original grouping clearly 
inappropriate, the taxpayer must regroup the activities

[[Page 455]]

and must comply with disclosure requirements that the Commissioner may 
prescribe.
    (f) Grouping by Commissioner to prevent tax avoidance--(1) Rule. The 
Commissioner may regroup a taxpayer's activities if any of the 
activities resulting from the taxpayer's grouping is not an appropriate 
economic unit and a principal purpose of the taxpayer's grouping (or 
failure to regroup under paragraph (e) of this section) is to circumvent 
the underlying purposes of section 469.
    (2) Example. The following example illustrates the application of 
this paragraph (f):

    Example. (i) Taxpayers D, E, F, G, and H are doctors who operate 
separate medical practices. D invested in a tax shelter several years 
ago that generates passive losses and the other doctors intend to invest 
in real estate that will generate passive losses. The taxpayers form a 
partnership to engage in the trade or business of acquiring and 
operating X-ray equipment. In exchange for equipment contributed to the 
partnership, the taxpayers receive limited partnership interests. The 
partnership is managed by a general partner selected by the taxpayers; 
the taxpayers do not materially participate in its operations. 
Substantially all of the partnership's services are provided to the 
taxpayers or their patients, roughly in proportion to the doctors' 
interests in the partnership. Fees for the partnership's services are 
set at a level equal to the amounts that would be charged if the 
partnership were dealing with the taxpayers at arm's length and are 
expected to assure the partnership a profit. The taxpayers treat the 
partnership's services as a separate activity from their medical 
practices and offset the income generated by the partnership against 
their passive losses.
    (ii) For each of the taxpayers, the taxpayer's own medical practice 
and the services provided by the partnership constitute an appropriate 
economic unit, but the services provided by the partnership do not 
separately constitute an appropriate economic unit. Moreover, a 
principal purpose of treating the medical practices and the 
partnership's services as separate activities is to circumvent the 
underlying purposes of section 469. Accordingly, the Commissioner may 
require the taxpayers to treat their medical practices and their 
interests in the partnership as a single activity, regardless of whether 
the separate medical practices are conducted through C corporations 
subject to section 469, S corporations, partnerships, or sole 
proprietorships. The Commissioner may assert penalties under section 
6662 against the taxpayers in appropriate circumstances.

    (g) Treatment of partial dispositions. A taxpayer may, for the 
taxable year in which there is a disposition of substantially all of an 
activity, treat the part disposed of as a separate activity, but only if 
the taxpayer can establish with reasonable certainty--
    (1) The amount of deductions and credits allocable to that part of 
the activity for the taxable year under Sec. 1.469-1(f)(4) (relating to 
carryover of disallowed deductions and credits); and
    (2) The amount of gross income and of any other deductions and 
credits allocable to that part of the activity for the taxable year.
    (h) Rules for grouping rental real estate activities for taxpayers 
qualifying under section 469(c)(7). See Sec. 1.469-9 for rules for 
certain rental real estate activities.

[T.D. 8565, 59 FR 50487, Oct. 4, 1994, as amended by T.D. 8645, 60 FR 
66499, Dec. 22, 1995]



Sec. 1.469-4T  Definition of activity (temporary).

    (a) Overview--(1) Purpose and effect of overview. This paragraph (a) 
contains a general description of the rules contained in this section 
and is intended solely as an aid to readers. The provisions of this 
paragraph (a) are not a substitute for the more detailed rules contained 
in the remainder of this section and cannot be relied upon in cases in 
which those rules qualify the general description contained in this 
paragraph (a).
    (2) Scope and structure of Sec. 1.469-4T. This section provides 
rules under which a taxpayer's business and rental operations are 
treated as one or more activities for purposes of section 469 and the 
regulations thereunder. (See paragraph (b)(2)(ii) of this section for 
the definition of business and rental operations.) In general, these 
rules are divided into three groups:
    (i) Rules that identify the business and rental operations that 
constitute an undertaking (the undertaking rules).
    (ii) Rules that identify the undertaking or undertakings that 
constitute an activity (the activity rules).
    (iii) Rules that apply only under certain special circumstances (the 
special rules).

[[Page 456]]

    (3) Undertaking rules--(i) In general. The undertaking is generally 
the smallest unit that can constitute an activity. (See paragraph (b)(1) 
of this section for the general rule and paragraph (k)(2)(iii) of this 
section for a special rule that permits taxpayers to treat a single 
rental real estate undertaking as multiple activities.) An undertaking 
may include diverse business and rental operations.
    (ii) Basic undertaking rule. The basic undertaking rule identifies 
the business and rental operations that constitute an undertaking by 
reference to their location and ownership. Under this rule, business and 
rental operations that are conducted at the same location and are owned 
by the same person are generally treated as part of the same 
undertaking. Conversely, business and rental operations generally 
constitute separate undertakings to the extent that they are conducted 
at different locations or are not owned by the same person. (See 
paragraph (c)(2)(i) of this section.)
    (iii) Circumstances in which location is disregarded. In some 
circumstances, the undertaking in which business and rental operations 
are included does not depend on the location at which the operations are 
conducted. Operations that are not conducted at any fixed place of 
business or that are conducted at the customer's place of business are 
treated as part of the undertaking with which the operations are most 
closely associated (see paragraph (c)(2)(iii)(C) of this section). In 
addition, operations that are conducted at a location but do not relate 
to the production of property at that location or to the transaction of 
business with customers at that location are treated, in effect, as part 
of the undertaking or undertakings that the operations support (see 
paragraph (c)(2)(ii) of this section).
    (iv) Rental undertakings. The basic undertaking rule is also 
modified if the undertaking determined under that rule includes both 
rental and nonrental operations. In such cases, the rental operations 
and the nonrental operations generally must be treated as separate 
undertakings (see paragraph (d)(1) of this section). This rule does not 
apply if more than 80 percent of the income of the undertaking 
determined under the basic rule is attributable to one class of 
operations (i.e., rental or nonrental) or if the rental operations would 
not be treated as part of a rental activity because of the exceptions 
contained in Sec. 1.469-1T(e)(3)(ii) (see paragraph (d)(2) of this 
section). In applying the rental undertaking rules, short-term rentals 
of real property (e.g., hotel-room rentals) are generally treated as 
nonrental operations (see paragraph (d)(3)(ii) of this section).
    (v) Oil and gas wells. Another exception to the basic undertaking 
rule treats oil and gas wells that are subject to the working-interest 
exception in Sec. 1.469-1T(e)(4) as separate undertakings (see 
paragraph (e) of this section).
    (4) Activity rules--(i) In general. The basic activity rule treats 
each undertaking in which a taxpayer owns an interest as a separate 
activity of the taxpayer (see paragraph (b)(1) of this section). In the 
case of trade or business undertakings, professional service 
undertakings, and rental real estate undertakings, additional rules may 
either require or permit the aggregation of two or more undertakings 
into a single activity.
    (ii) Aggregation of trade or business undertakings--(A) Trade or 
business undertakings. Trade or business undertakings include all 
nonrental undertakings other than oil and gas undertakings described in 
paragraph (a)(3)(v) of this section and professional service 
undertakings described in paragraph (a)(4)(iii) of this section (see 
paragraph (f)(1)(ii) of this section).
    (B) Similar, commonly-controlled undertakings treated as a single 
activity. An aggregation rule treats trade or business undertakings that 
are both similar and controlled by the same interests as part of the 
same activity. This rule is, however, generally inapplicable to small 
interests held by passive investors in such undertakings, except to the 
extent such interests are held through the same passthrough entity. (See 
paragraph (f)(2) of this section.) Undertakings are similar for purposes 
of this rule if more than half (by value) of their operations are in the 
same line of business (as defined in a revenue procedure issued pursuant 
to paragraph (f)(4)(iv) of this section) or if the undertakings are 
vertically integrated (see

[[Page 457]]

paragraph (f)(4)(iii) of this section). All the facts and circumstances 
are taken into account in determining whether undertakings are 
controlled by the same interests for purposes of the aggregation rule 
(see paragraph (j)(1) of this section). If, however, each member of a 
group of five or fewer persons owns a substantial interest in each of 
the undertakings, the undertakings may be rebuttably presumed to be 
controlled by the same interests (see paragraph (j) (2) and (3) of this 
section).
    (C) Integrated businesses treated as a single activity. Trade or 
business undertakings (including undertakings that have been aggregated 
because of their similarity and common control) are subject to a second 
aggregation rule. Under this rule undertakings that constitute an 
integrated business and are controlled by the same interests must be 
treated as part of the same activity. (See paragraph (g) of this 
section.)
    (iii) Aggregation of professional service undertakings. Professional 
service undertakings are nonrental undertakings that predominantly 
involve the provision of services in the fields of health, law, 
engineering, architecture, accounting, actuarial science, performing 
arts, or consulting (see paragraph (h)(1)(ii) of this section). In 
general, professional service undertakings that are either similar, 
related, or controlled by the same interests must be treated as part of 
the same activity (see paragraph (h)(2) of this section). The rules for 
determining whether trade or business undertakings are controlled by the 
same interests also apply with respect to professional service 
undertakings. Professional service undertakings are similar, however, if 
more than 20 percent (by value) of their operations are in the same 
field, and two professional service undertakings are related if one of 
the undertakings derives more than 20 percent of its gross income from 
persons who are customers of the other undertaking (see paragraph (h)(3) 
of this section).
    (iv) Rules for rental real estate--(A) Taxpayers permitted to 
determine rental real estate activities. The rules for aggregating 
rental real estate undertakings are generally elective. They permit 
taxpayers to treat any combination of rental real estate undertakings as 
a single activity. Taxpayers may also divide their rental real estate 
undertakings and then treat portions of the undertakings as separate 
activities or recombine the portions into activities that include parts 
of different undertakings. (See paragraph (k)(2) (i) and (iii) of this 
section.)
    (B) Limitations on fragmentation and aggregation of rental real 
estate. Taxpayers may not fragment their rental real estate in a manner 
that is inconsistent with their treatment of such property in prior 
taxable years or with the treatment of such property by the passthrough 
entity through which it is held (see paragraph (k) (2)(ii) and (3) of 
this section). There are no comparable limitations on the aggregation of 
rental real estate into a single activity. If however, the income or 
gain from a rental real estate undertaking is subject to 
recharacterization under Sec. 1.469-2T(f)(3) (relating to the rental of 
nondepreciable property), a coordination rule provides that the 
undertaking must be treated as a separate activity (see paragraph (k)(6) 
of this section.)
    (v) Election to treat nonrental undertakings as separate activities. 
Another elective rule permits taxpayers to treat a nonrental undertaking 
as a separate activity even if the undertaking would be treated as part 
of a larger activity under the aggregation rules applicable to the 
undertaking (see paragraph (o)(2) of this section). This elective rule 
is limited by consistency requirements similar to those that apply to 
rental real estate operations (see paragraph (o) (3) and (4) of this 
section). Moreover, in cases in which a taxpayer elects to treat a 
nonrental undertaking as a separate activity, the taxpayer's level of 
participation (i.e., material, significant, or otherwise) in the 
separate activity is the same as the taxpayer's level of participation 
in the larger activity in which the undertaking would be included but 
for the election (see paragraph (o)(6) of this section).
    (5) Special rules--(i) Consolidated groups and publicly traded 
partnerships. Special rules apply to the business and rental operations 
of consolidated groups of corporations and publicly traded partnerships. 
Under these rules, a consolidated group is treated as one

[[Page 458]]

taxpayer in determining its activities and those of its members (see 
paragraph (m) of this section), and business and rental operations owned 
through a publicly traded partnership cannot be aggregated with 
operations that are not owned through the partnership (see paragraph (n) 
of this section).
    (ii) Transitional rule. A special rule applies for taxable years 
ending before August 10, 1989. In those years, taxpayers may organize 
business and rental operations into activities under any reasonable 
method (see paragraph (p)(1) of this section). A taxpayer will also be 
permitted to use any reasonable method to allocate disallowed deductions 
and credits among activities for the first taxable year in which the 
taxpayer's activities are determined under the general rules of Sec. 
1.469-4T (see paragraph (p)(3) of this section).
    (b) General rule and definitions of general application--(1) General 
rule. Except as otherwise provided in this section, each undertaking in 
which a taxpayer owns an interest shall be treated as a separate 
activity of the taxpayer. See paragraphs (f), (g), and (h) of this 
section for rules requiring certain nonrental undertakings to be treated 
as part of the same activity and paragraph (k) of this section for rules 
identifying the rental real estate undertakings (or portions thereof) 
that are included in an activity.
    (2) Definitions of general application. The following definitions 
set forth the meaning of certain terms for purposes of this section:
    (i) Passthrough entity. The term ``passthrough entity'' means a 
partnership, S corporation, estate, or trust.
    (ii) Business and rental operations--(A) In general. Except as 
provided in paragraph (b)(2)(ii)(B) of this section, the term ``business 
and rental operations'' means all endeavors that are engaged in for 
profit or the production of income and satisfy one or more of the 
following conditions for the taxable year:
    (1) Such endeavors involve the conduct of a trade or business 
(within the meaning of section 162) or are conducted in anticipation of 
such endeavors becoming a trade or business;
    (2) Such endeavors involve making tangible property available for 
use by customers; or
    (3) Research or experimental expenditures paid or incurred with 
respect to such endeavors are deductible under section 174 (or would be 
deductible if the taxpayer adopted the method described in section 
174(a)).
    (B) Operations conducted through nonpassthrough entities. For 
purposes of applying section 469 and the regulations thereunder, a 
taxpayer's activities do not include operations that a taxpayer conducts 
through one or more entities (other than passthrough entities). The 
following example illustrates the operation of this paragraph 
(b)(2)(ii)(B):

    Example. (i) A, an individual, owns stock of X, a closely held 
corporation (within the meaning of Sec. 1.469-1T(g)(2)(ii) that is 
directly engaged in the conduct of a real estate development business. A 
participates in X's real estate development business, but does not own 
any interest in the business other than through ownership of the stock 
of X.
    (ii) X is subject to section 469 (see Sec. 1.469-1T(b)(5)) and does 
not hold the real estate development business through another entity. 
Accordingly, for purposes of section 469 and the regulations thereunder, 
the operations of X's real estate development business are treated as 
part of X's activities.
    (iii) A is also subject to section 469 (see Sec. 1.469-1T(b)(1)), 
but A's only interest in the real estate development business is held 
through X. X is a C corporation and therefore is not a passthrough 
entity. Thus, for purposes of section 469 and the regulations 
thereunder, A's activities do not include the operations of X's real 
estate development business. Accordingly, A's participation in X's 
busines is not participation in an activity of A, and is not taken into 
account in determining whether A materially participates (within the 
meaning of Sec. 1.469-5T) or significantly participates (within the 
meaning of Sec. 1.469-1T(c)(2)) in any activity. (See, however, Sec. 
1.469-1T(g)(3) for rules under which a shareholder's participation is 
taken into account for purposes of determining whether a corporation 
materially or significantly participates in an activity.

    (c) Undertaking--(1) In general. Except as otherwise provided in 
paragraphs (d), (e), and (k)(2)(iii) of this section, business and 
rental operations that constitute a separate source of income production 
shall be treated as a single undertaking that is separate from other 
undertakings.

[[Page 459]]

    (2) Operations treated as a separate source of income production--
(i) In general. Except as otherwise provided in this paragraph (c)(2), 
business and rental operations shall be treated for purposes of this 
paragraph (c) as a separate source of income production if and only if--
    (A) Such operations are conducted at the same location (within the 
meaning of paragraph (c)(2)(iii) of this section) and are owned by the 
same person (within the meaning of paragraph (c)(2)(v) of this section); 
and
    (B) Income-producing operations (within the meaning of paragraph 
(c)(2)(iv) of this section) owned by such person are conducted at such 
location.
    (ii) Treatment of support operations--(A) In general. For purposes 
of section 469 and the regulations thereunder--
    (1) The support operations conducted at a location shall not be 
treated as part of an undertaking under paragraph (c)(2)(i) of this 
section; and
    (2) The income and expenses that are attributable to such operations 
and are reasonably allocable to an undertaking conducted at a different 
location shall be taken into account in determining the income or loss 
from the activity or activities that include such undertaking.
    (B) Support operations. For purposes of this paragraph (c)(2), the 
business and rental operations conducted at a location are treated as 
support operations to the extent that--
    (1) Such operations and an undertaking that is conducted at a 
different location are owned by the same person (within the meaning of 
paragraph (c)(2)(v) of this section);
    (2) Such operations involve the provision of property or services to 
such undertaking; and
    (3) Such operations are not income-producing operations (within the 
meaning of paragraph (c)(2)(iv) of this section).
    (iii) Location. For purposes of this paragraph (c)(2)--
    (A) The term ``location'' means, with respect to any business and 
rental operations, a fixed place of business at which such operations 
are regularly conducted;
    (B) Business and rental operations are conducted at the same 
location if they are conducted in the same physical structure or within 
close proximity of one another;
    (C) Business and rental operations that are not conducted at a fixed 
place of business or that are conducted on the customer's premises shall 
be treated as operations that are conducted at the location (other than 
the customer's premises) with which they are most closely associated;
    (D) All the facts and circumstances (including, in particular, the 
factors listed in paragraph (c)(3) of this section) are taken into 
account in determining the location with which business and rental 
operations are most closely associated; and
    (E) Oil and gas operations that are conducted for the development of 
a common reservoir are conducted within close proximity of one another.
    (iv) Income-producing operations. For purposes of this paragraph 
(c)(2), the term ``income-producing operations'' means business and 
rental operations that are conducted at a location and relate to (or are 
conducted in reasonable anticipation of)--
    (A) The production of property at such location;
    (B) The sale of property to customers at such location;
    (C) The performance of services for customers at such location;
    (D) Transactions in which customers take physical possession at such 
location of property that is made available for their use; or
    (E) Any other transactions that involve the presence of customers at 
such location.
    (v) Ownership by the same person. For purposes of this paragraph 
(c)(2), business and rental operations are owned by the same person if 
and only if one person (within the meaning of section 7701(a)(1)) is the 
direct owner of such operations.
    (3) Facts and circumstances determinations. In determining whether a 
location is the location with which business and rental operations are 
most closely associated for purposes of paragraph (c)(2)(iii)(D) of this 
section, the following relationships between operations that are 
conducted at such location and other operations are generally the most 
significant:

[[Page 460]]

    (i) The extent to which other persons conduct similar operations at 
one location;
    (ii) Whether such operations are treated as a unit in the primary 
accounting records reflecting the results of such operations;
    (iii) The extent to which other persons treat similar operations as 
a unit in the primary accounting records reflecting the results of such 
similar operations;
    (iv) The extent to which such operations involve products or 
services that are commonly provided together;
    (v) The extent to which such operations serve the same customers;
    (vi) The extent to which the same personnel, facilities, or 
equipment are used to conduct such operations;
    (vii) The extent to which such operations are conducted in 
coordination with or reliance upon each other;
    (viii) The extent to which the conduct of any such operations is 
incidental to the conduct of the remainder of such operations;
    (ix) The extent to which such operations depend on each other for 
their economic success; and
    (x) Whether such operations are conducted under the same trade name.
    (4) Examples. The following examples illustrate the application of 
this paragraph (c). In each example that does not state otherwise, the 
taxpayer is an individual and the facts, analysis, and conclusion relate 
to a single taxable year.

    Example (1). The taxpayer is the sole owner of a department store 
and a restaurant and conducts both businesses in the same building. 
Thus, the department store and restaurant operations are conducted at 
the same location (within the meaning of paragraph (c)(2)(iii) of this 
section) and are owned by the same person (i.e., the taxpayer is the 
direct owner of the operations). In addition, the taxpayer conducts 
income-producing operations (within the meaning of paragraph (c)(2)(iv) 
of this section) at the location (i.e., property is sold to customers 
and services are performed for customers on the premises of the 
department store). Accordingly, the department store and restaurant 
operations are treated as a separate source of income production (see 
paragraph (c)(2) of this section) and as a single undertaking that is 
separate from other undertakings (see paragraph (c)(1) of this section).
    Example (2). (i) The facts are the same as in example (1), except 
that the taxpayer is also the sole owner of an automotive center that 
services automobiles and sells tires, batteries, motor oil, and 
accessories. The taxpayer operates the automotive center in a separate 
structure in the shopping mall in which the department store is located. 
Although the automotive center operations and the department store and 
restaurant operations are not conducted in the same physical structure, 
they are conducted within close proximity (within the meaning of 
paragraph (c)(2)(iii)(B) of this section) of one another. Thus, the 
department store, restaurant, and automotive center operations are 
conducted at the same location (within the meaning of paragraph 
(c)(2)(iii) of this section).
    (ii) As in example (1), the operations conducted at the same 
location are owned by the same person, and the taxpayer conducts income-
producing operations (within the meaning of paragraph (c)(2)(iv) of this 
section) at the location. Accordingly, the department store, restaurant, 
and automotive center operations are treated as a separate source of 
income production (see paragraph (c)(2) of this section) and as a single 
undertaking that is separate from other undertakings (see paragraph 
(c)(1) of this section).
    Example (3). (i) The facts are the same as in example (2), except 
that the automotive center is located several blocks from the shopping 
mall. As in example (1), the department store and restaurant operations 
are treating as a single undertaking that is separate from other 
undertakings. Because, however, the automotive center operations are not 
conducted within close proximity (within the meaning of paragraph 
(c)(2)(iii)(B) of this section) of the department store and restaurant 
operations, all of the taxpayer's operations are not conducted at the 
same location (within the meaning of paragraph (c)(2)(iii) of this 
section).
    (ii) All of the automotive center operations are conducted at the 
same location (within the meaning of paragraph (c)(2)(iii) of this 
section) and are owned by the same person (i.e., the taxpayer is the 
direct owner of the operations). In addition, the taxpayer conducts 
income producing operations (within the meaning of paragraph (c)(2)(iv) 
of this section) at the location (i.e., property is sold to customers 
and services are performed for customers on the premises of the 
automotive center). Accordingly, the automotive center operations are 
also treated as a separate source of income production (see paragraph 
(c)(2) of this section) and as a single undertaking that is separate 
from other undertakings (see paragraph (c)(1) of this section). See, 
however, paragraph (g) of this section for rules under which certain 
trade or business activities are treated as a single activity.

[[Page 461]]

    Example (4). The taxpayer is the sole owner of a building and rents 
residential, office, and retail space in the building to various 
tenants. The taxpayer manages these rental operations from an office 
located in the building. The rental operations are conducted at the same 
location (within the meaning of paragraph (c)(2)(iii) of this section) 
and are owned by the same person (i.e., the taxpayer is the direct owner 
of the operations). In addition, the taxpayer conducts income-producing 
operations (within the meaning of paragraph (c)(2)(iv) of this section) 
at the location (i.e., customers take physical possession in the 
building of property made available for their use). Accordingly, the 
rental operations are treated as a separate source of income production 
(see paragraph (c)(2) of this section) and as a single undertaking that 
is separate from other undertakings (see paragraph (c)(1) of this 
section). See paragraph (d) of this section for rules for determining 
whether this undertaking is a rental undertaking and paragraph (k) of 
this section for rules for identifying rental real estate activities.
    Example (5). (i) The facts are the same as in example (4), except 
that the taxpayer also uses the rental office in the building 
(``Building 1'') to manage rental operations in another 
building (``Building 2'') that the taxpayer owns. The rental 
operations conducted in Building 2 are treated as a separate 
source of income production under paragraph (c)(2) of this section and 
as a single undertaking that is separate from other undertakings (the 
``Building 2 undertaking'') under paragraph (c)(1) of this 
section.
    (ii) The operations conducted at the rental office in Building 
1 and the Building 2 undertaking are owned by the same 
person (i.e., the taxpayer is the direct owner of the operations). In 
addition, the operations conducted at the rental office with respect to 
the Building 2 undertaking relate to transactions in which 
customers take physical possession at another location of property that 
is made available for their use (i.e., the operations are not income-
producing operations (within the meaning of paragraph (c)(2)(iv) of this 
section)). Thus, to the extent the operations conducted at the rental 
office involve the management of the Building 2 undertaking, 
they are support operations (within the meaning of paragraph 
(c)(2)(ii)(B) of this section) with respect to the Building 2 
undertaking.
    (iii) Paragraph (c)(2)(ii)(A)(1) of this section provides that 
support operations are not treated as part of an undertaking under 
paragraph (c)(2)(i) of this section. Therefore, the support operations 
conducted at the rental office are not treated as part of the 
undertaking that consists of the rental operations conducted in Building 
1 (the ``Building 1 undertaking''). Paragraph 
(c)(2)(ii)(A)(2) of this section provides that the income and expenses 
that are attributable to support operations and are reasonably allocable 
to an undertaking conducted at a different location shall be taken into 
account in determining the income or loss from the activity that 
includes such undertaking. Accordingly, the income and expenses of the 
rental office that are reasonably allocable to the Building 2 
undertaking are taken into account in determining the income or loss 
from the activity or activities that include the Building 2 
undertaking. See paragraph (k) of this section for rules for identifying 
rental real estate activities.
    (iv) Rental office operations that involve the management of rental 
operations conducted in Building 1 are not support operations 
(within the meaning of paragraph (c)(2)(ii)(B) of this section) because 
they relate to an undertaking that is conducted at the same location 
(the ``Building 1 undertaking''). Thus, the rules for support 
operations in paragraph (c)(2)(ii)(A) of this section do not apply to 
such operations, and they are treated as part of the Building 1 
undertaking.
    Example (6). (i) The taxpayer conducts business and rental 
operations at eleven different locations (within the meaning of 
paragraph (c)(2)(iii) of this section). At ten of the locations the 
taxpayer owns grocery stores, and at the eleventh location the taxpayer 
owns a warehouse that receives goods and supplies them to the taxpayer's 
stores. The operations of each store are conducted at the same location 
(within the meaning of paragraph (c)(2)(iii) of this section) and are 
owned by the same person (i.e., the taxpayer is the direct owner of the 
operations). In addition, the taxpayer conducts income-producing 
operations (within the meaning of paragraph (c)(2)(iv) of this section) 
at each location (i.e., property is sold to customers on the store 
premises, and customers take physical possession on the store premises 
of property made available for their use). Accordingly, the operations 
of each of the ten grocery stores are treated as a separate source of 
income production (see paragraph (c)(2) of this section), and each store 
is treated as a single undertaking (a ``grocery store undertaking'') 
that is separate from other undertakings (see paragraph (c)(1) of this 
section). The operations conducted at the warehouse, however, do not 
include any income-producing operations (within the meaning of paragraph 
(c)(2)(iv) of this section). Accordingly, the warehouse operations do 
not satisfy the requirements of paragraph (c)(2)(i) of this section and 
are not treated as a separate undertaking under paragraph (c)(1) of this 
section.
    (ii) The warehouse operations and the grocery store undertakings are 
owned by the same person (i.e., the taxpayer is the direct

[[Page 462]]

owner of the operations), the operations conducted at the warehouse 
involve the provision of property to the grocery store undertakings, and 
the warehouse operations are not income-producing operations (within the 
meaning of paragraph (c)(2)(iv) of this section). Thus, the warehouse 
operations are support operations (within the meaning of paragraph 
(c)(2)(ii)(B) of this section) with respect to the grocery store 
undertakings. Paragraph (c)(2)(ii)(A)(2) of this section provides that 
the income and expenses that are attributable to support operations and 
are reasonably allocable to an undertaking conducted at a different 
location shall be taken into account in determining the income or loss 
from the activity or activities that include such undertaking. 
Accordingly, the income and expenses of the warehouse operations that 
are reasonably allocable to a grocery store undertaking are taken into 
account in determining the income or loss from the activity or 
activities that include such undertaking. See paragraph (f) of this 
section for rules under which certain similar, commonly-controlled 
undertakings are treated as a single activity.
    Example (7). (i) The facts are the same as in example (6), except 
that the warehouse operations also include the sale of goods to grocery 
stores that the taxpayer does not own (``other grocery stores''). 
Because of these sales, the taxpayer conducts income-producing 
operations (within the meaning of paragraph (c)(2)(iv) of this section) 
at the warehouse. The warehouse operations are conducted at the same 
location (within the meaning of paragraph (c)(2)(iii) of this section) 
and are owned by the same person (i.e., the taxpayer is the direct owner 
of the operations). Accordingly, prior to the application of the rules 
for support operations in paragraph (c)(2)(ii) of this section, the 
warehouse operations are treated as a separate source of income 
production (see paragraph (c)(2) of this section) and as a single 
undertaking (the ``separate warehouse undertaking'') that is separate 
from other undertakings (see paragraph (c)(1) of this section).
    (ii) As in example (6), the warehouse operations that involve 
supplying goods to the taxpayer's grocery store undertakings are support 
operations with respect to those undertakings. Therefore, those 
operations are not treated as part of the separate warehouse undertaking 
(see paragraph (c)(2)(ii)(A)(1) of this section), and the income and 
expenses of such operations are taken into account, as in example (6), 
in determining the income or loss from the activity or activities that 
include the taxpayer's grocery store undertakings.
    Example (8). (i) A partnership is formed to acquire real property 
and construct a building on the property. The partnership hires brokers 
to locate a suitable parcel of land, lawyers to negotiate zoning 
variances, easements, and building permits, and architects and engineers 
to design the improvements. After the architects and engineers have 
designed the improvements and other preliminaries have been completed, 
the partnership hires a general contractor who hires subcontractors and 
oversees construction. During the construction process and after 
construction has been completed, the partnership leases out space in the 
building. The partnership then operates the building as a rental 
property. The operations of acquiring the real property, negotiating 
contracts, overseeing the designing and construction of the 
improvements, leasing up the building, and operating the building are 
conducted at an office (the ``management office'') that is not at the 
same location (within the meaning of paragraph (c)(2)(iii) of this 
section) as the building.
    (ii) The operations conducted at the building site (e.g., excavating 
the land, pouring the concrete for the foundation, erecting the frame of 
the building, completing the exterior of the building, and building out 
the interior of the building) are conducted at the same location (within 
the meaning of paragraph (c)(2)(iii) of this section) and are owned by 
the same person (i.e., the partnership is the direct owner of the 
operations). In addition, the partnership conducts income-producing 
operations (within the meaning of paragraph (c)(2)(iv) of this section) 
at the location (i.e., during the construction period property (the 
building) is produced at the building site, and during the rental period 
customers take physical possession in the building of property made 
available for their use). Accordingly, the operations conducted at the 
building site are treated as a separate source of income production (see 
paragraph (c)(2) of this section) and as a single undertaking that is 
separate from other undertakings (see paragraph (c)(1) of this section).
    (iii) The operations conducted at the management office and the 
undertaking conducted at the building site are owned by the same person 
(i.e., the partnership is the direct owner of the operations). In 
addition, the operations conducted at the management office relate to 
transactions in which customers take physical possession at another 
location of property that is made available for their use (i.e., the 
operations are not income-producing operations (within the meaning of 
paragraph (c)(2)(iv) of this section)). Thus, to the extent the 
operations conducted at the management office involve the provision of 
services to the undertaking conducted at the building site, they are 
support operations (within the meaning of paragraph (c)(2)(ii)(B) of 
this section) with respect to such undertaking.
    (iv) Paragraph (c)(2)(ii)(A)(2) of this section provides that the 
income and expenses of

[[Page 463]]

support operations that are reasonably allocable to an undertaking 
conducted at a different location shall be taken into account in 
determining the income or loss from the activity that includes such 
undertaking. Accordingly, the income and expenses of the management 
office that are reasonably allocable to the undertaking conducted at the 
building site are taken into account in determining the income or loss 
from the activity or activities that include such undertaking.
    (v) Until the building is first held out for rent and is in a state 
of readiness for rental, the undertaking conducted at the building site 
is a trade or business undertaking (within the meaning of paragraph 
(f)(1)(ii) of this section). See paragraph (d) of this section for rules 
for determining whether the undertaking is a rental undertaking for 
periods after the building is first held out for rent and is in a state 
of readiness for rental and paragraph (k) of this section for rules for 
identifying rental real estate activities.
    Example (9). The taxpayer owns 15 oil wells pursuant to a single 
working interest (within the meaning of Sec. 1.469-1T (e)(4)(iv). All 
of the wells are drilled and operated for the development of a common 
reservoir. Thus, all of the wells are at the same location (see 
paragraph (c)(2)(iii)(E) of this section). All of the wells are owned by 
the same person (i.e., the taxpayer is the direct owner of the 
operations), and the taxpayer conducts income-producing operations 
(within the meaning of paragraph (c)(2)(iv) of this section) at the 
location (i.e., oil wells are drilled in reasonable anticipation of 
producing oil at the location). Accordingly, the operations of the wells 
are treated as a separate source of income production (see paragraph 
(c)(2) of this section) and as a single undertaking that is separate 
from other undertakings (see paragraph (c)(1) of this section). See 
paragraph (e) of this section for rules under which certain oil and gas 
operations are treated as multiple undertakings even if they would be 
part of the same undertaking under the rules of this paragraph (c).
    Example (10). (i) Partnership X owns an automobile dealership and 
partnership Y owns an automobile repair shop. The dealership and repair 
shop operations are conducted in the same physical structure. 
Individuals A, B, and C are the only partners in partnerships X and Y, 
and each of the partners owns a one-third interest in both partnerships.
    (ii) The dealership operations and the repair-shop operations are 
conducted at the same location (within the meaning of paragraph 
(c)(2)(iii) of this section), but are owned by different persons (i.e., 
X is the direct owner of the dealership operations, and Y is the direct 
owner of the repair-shop operations). Moreover, indirect ownership of 
the operations is not taken into account under paragraph (c)(2)(v) of 
this section. Thus, it is irrelevant that the two partnerships are owned 
by the same persons in identical proportions. Accordingly, the 
dealership and repair-shop operations are not treated as part of the 
same source of income production (see paragraph (c)(2) of this section) 
or as a single undertaking that is separate from other undertakings (see 
paragraph (c)(1) of this section). See, however, paragraph (g) of this 
section for rules under which certain trade or business activities are 
treated as a single activity.
    Example (11). (i) The taxpayer owns and operates a delivery service. 
The business consists of a central office, retail establishments, and 
messengers who transport packages from one place to another. Customers 
may bring their packages to a retail establishment for delivery 
elsewhere or, by calling the central office, may have packages picked up 
at their homes or offices. The central office dispatches messengers and 
coordinates all pickups and deliveries. Customers may pay for deliveries 
when they drop off or pick up packages at a retail establishment, or the 
central office will bill the customer for services rendered. In 
addition, many packages are routed through the central office.
    (ii) The operations conducted at the central office are conducted at 
the same location (within the meaning of paragraph (c)(2)(iii) of this 
section) and are owned by the same person (i.e., the taxpayer is the 
direct owner of the operations). The operations actually conducted at 
the central office, however, do not include any income-producting 
operations (within the meaning of paragraph (c)(2)(iv) of this section).
    (iii) Under paragraph (c)(2)(iii) (C) and (D) of this section, 
business and rental operations that are not conducted at a fixed place 
of business or that are conducted on the customer's premises are treated 
as operations that are conducted at the location (other than the 
customer's premises) with which they are most closely associated, and 
all the facts and circumstances are taken into account in determining 
the location with which business and rental operations are most closely 
associated. The facts and circumstances in this case (including the 
facts that the central office dispatches messengers, coordinates all 
pickups and deliveries, and is the transshipment point for many 
packages) establish that the operations of delivering packages from one 
location to another are most closely associated with the central office. 
Thus, the delivery operations are treated as operations that are 
conducted at the central office, and the deliveries are treated as 
income-producing operations (i.e., the performance of services for 
customers) that the taxpayer conducts at the central office. 
Accordingly, the operations conducted at the central office are

[[Page 464]]

treated as a separate source of income production (see paragraph (c)(2) 
of this section) and as a single undertaking that is separate from other 
undertakings (see paragraph (c)(1) of this section).
    (iv) The operations conducted at each retail establishment are 
conducted at the same location (within the meaning of paragraph 
(c)(2)(iii) of this section) and are owned by the same person (i.e., the 
taxpayer is the direct owner of the operations). At each retail 
establishment, the taxpayer's operations include transactions that 
involve the presence of customers at the establishment. Thus, the 
taxpayer conducts income-producing operations (within the meaning of 
paragraph (c)(2)(iv)(E) of this section) at the retail establishments. 
Accordingly, the operations of each retail establishment are treated as 
a separate source of income production (see paragraph (c)(2) of this 
section) and as a single undertaking that is separate from other 
undertakings (see paragraph (c)(1) of this section). See, however, 
paragraph (f) of this section for rules under which certain similar, 
commonly-controlled undertakings are treated as a single activity.
    Example (12). (i) The taxpayer is the sole owner of a saw mill and a 
lumber yard. The taxpayer's business operations consist of converting 
timber into lumber and other wood products and selling the resulting 
products. The timber is processed at the saw mill, and the resulting 
products are transported to the lumber yard where they are sold. The saw 
mill and the lumber yard are at different locations (within the meaning 
of paragraph (c)(2)(iii) of this section). The transportation operations 
are managed at the saw mill.
    (ii) The operations conducted at the saw mill are conducted at the 
same location (within the meaning of paragraph (c)(2)(iii) of this 
section) and are owned by the same person (i.e., the taxpayer is the 
direct owner of the operations). In addition, the taxpayer conducts 
income-producing operations (within the meaning of paragraph (c)(2)(iv) 
of this section) at the location (i.e., lumber is produced at the mill). 
Similarly, the selling operations at the lumber yard are conducted at 
the same location (within the meaning of paragraph (c)(2)(iii) of this 
section) and are owned by the same person (i.e., the taxpayer is the 
direct owner of the operations). In addition, the taxpayer conducts 
income-producing operations (within the meaning of paragraph (c)(2)(iv) 
of this section) at the location (i.e., lumber is sold to customers at 
the lumber yard). Thus, the milling operations and the selling 
operations are treated as separate sources of income production (see 
paragraph (c)(2) of this section) and as separate undertakings (see 
paragraph (c)(1) of this section).
    (iii) The operations conducted at the mill involve the provision of 
property to the lumber-yard undertaking. Nonetheless, the milling 
operations are income-producing operations because they relate to the 
production of property at the mill, and an undertaking's income-
producing operations are not treated as support operations (see 
paragraph (c)(2)(ii)(B)(3) of this section). Accordingly, the milling 
operations are not support operations with respect to the lumber-yard 
undertaking. See, however, paragraph (f) of this section for rules under 
which certain vertically-integrated undertakings are treated as part of 
the same activity.
    (iv) The operations of transporting finished products from the saw 
mill to the lumber yard are not conducted at a fixed location. Under 
paragraphs (c)(2)(iii) (C) and (D) of this section, business and rental 
operations that are not conducted at a fixed place of business or that 
are conducted on the customer's premises are treated as operations that 
are conducted at the location (other than the customer's premises) with 
which they are most closely associated, and all the facts and 
circumstances are taken into account in determining the location with 
which business and rental operations are most closely associated. The 
facts and circumstances in this case (including the fact that the 
transportation operations are managed at the saw mill) establish that 
the transportation operations are most closely associated with the saw 
mill. Thus, the transportation operations are treated as operations that 
are conducted at the mill and as part of the undertaking that consists 
of the milling operations.

    (d) Rental undertaking--(1) In general. This paragraph (d) applies 
to operations that are treated, under paragraph (c) of this section and 
before the application of paragraph (d)(1)(i) of this section, as a 
single undertaking that is separate from other undertakings (a 
``paragraph (c) undertaking''). For purposes of this section--
    (i) A paragraph (c) undertaking's rental operations and its 
operations other than rental operations shall be treated, except as 
otherwise provided in paragraph (d)(2) of this section, as two separate 
undertakings;
    (ii) The income and expenses that are reasonably allocable to an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) shall be taken into account in determining the income or 
loss from the activity or activities that include such undertaking; and
    (iii) An undertaking (determined after the application of paragraph 
(d)(1)(i) of this section) shall be treated

[[Page 465]]

as a rental undertaking if and only if such undertaking, considered as a 
separate activity, would constitute a rental activity (within the 
meaning of Sec. 1.469-1T(e)(3)).
    (2) Exceptions. Paragraph (d)(1)(i) of this section shall not apply 
to a paragraph (c) undertaking for any taxable year in which--
    (i) The rental operations of the paragraph (c) undertaking, 
considered as a separate activity, would not constitute a rental 
activity (within the meaning of Sec. 1.469-1T(e)(3));
    (ii) Less than 20 percent of the gross income of the paragraph (c) 
undertaking is attributable to rental operations; or
    (iii) Less than 20 percent of the gross income of the paragraph (c) 
undertaking is attributable to operations other than rental operations.
    (3) Rental operations. For purposes of this paragraph (d), a 
paragraph (c) undertaking's rental operations are determined under the 
following rules:
    (i) General rule. Except as otherwise provided in paragraph (d)(3) 
(ii) or (iii) of this section, a paragraph (c) undertaking's rental 
operations are all of the undertaking's business and rental operations 
that involve making tangible property available for use by customers and 
the provision of property and services in connection therewith.
    (ii) Real property provided for short-term use. A paragraph (c) 
undertaking's operations that involve making short-term real property 
available for use by customers and the provision of property and 
services in connection therewith shall not be treated as rental 
operations if such operations, considered as a separate activity, would 
not constitute a rental activity. An item of property is treated as 
short-term real property for this purpose if and only if such item is 
real property that the paragraph (c) undertaking makes available for use 
by customers and the average period of customer use (within the meaning 
of Sec. 1.469-1T(e)(3)(iii)) for all of the paragraph (c) undertaking's 
real property of the same type as such item is 30 days or less.
    (iii) Property made available to licensees. A paragraph (c) 
undertaking's operations that involve making tangible property available 
during defined business hours for nonexclusive use by various customers 
shall not be treated as rental operations. (See Sec. 1.469-
1T(e)(3)(ii)(E).)
    (4) Examples. The following examples illustrate the application of 
this paragraph (d). In each example that does not state otherwise, the 
taxpayer is an individual and the facts, analysis, and conclusions 
relate to a single taxable year.

    Example (1). (i) The taxpayer owns a building in which the taxpayer 
rents office space to tenants and operates a parking garage that is used 
by tenants and other persons. (Assume that, under paragraph (c)(1) of 
this section, the operations conducted in the building are treated as a 
single paragraph (c) undertaking.) The taxpayer's tenants typically 
occupy an office for at least one year, and the services provided to 
tenants are those customarily provided in office buildings. Some persons 
(including tenants) rent spaces in the parking garage on a monthly or 
annual basis. In general, however, spaces are rented on an hourly or 
daily basis, and the average period for which all customers (including 
tenants) use the parking garage is less than 24 hours. The paragraph (c) 
undertaking derives 75 percent of its gross income from office-space 
rentals and 25 percent of its gross income from the parking garage. The 
operations conducted in the building are not incidental to any other 
activity of the taxpayer (within the meaning of Sec. 1.469-
1T(e)(3)(vi)).
    (ii) The parking spaces are real property and the average period of 
customer use (within the meaning of Sec. 1.469-1T(e)(3)(iii)) for the 
parking spaces is 30 days or less. Thus, the parking spaces are short-
term real properties (within the meaning of paragraph (d)(3)(ii) of this 
section). (For this purpose, individual parking spaces that are rented 
on a monthly or annual basis are, nevertheless, short-term real 
properties because all the parking spaces are property of the same type, 
and the average rental period taking all parking spaces into account is 
30 days or less.) In addition, the parking-garage operations involve 
making short-term real properties available for use by customers and the 
provision of property and services in connection therewith.
    (iii) Paragraph (d)(3) (i) and (ii) of this section provides, in 
effect, that a paragraph (c) undertaking's operations that involve 
making short-term real properties available for use by customers and the 
provision of property and services in connection therewith are treated 
as rental operations if and only if the operations, considered as a 
separate activity, would constitute a rental activity (within the 
meaning of Sec. 1.469-1T(e)(3)). In this case, the parking-garage 
operations, if

[[Page 466]]

considered as a separate activity, would not constitute a rental 
activity because the average period of customer use for the parking 
spaces is seven days or less (see Sec. 1.469-1T(e)(3)(ii)(A)). 
Accordingly, the parking-garage operations are not treated as rental 
operations.
    (iv) The paragraph (c) undertaking's remaining operations involve 
the provision of tangible property (the office spaces) for use by 
customers and the provision of property and services in connection 
therewith. The average period of customer use for the office spaces 
exceeds 30 days. Thus, the office spaces are not short-term real 
properties, and the undertaking's operations involving the rental of 
office spaces are rental operations.
    (v) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations and its 
operations other than rental operations are treated as two separate 
undertakings. In this case, at least 20 percent of the paragraph (c) 
undertaking's gross income is attributable to rental operations (the 
office-space operations) and at least 20 percent is attributable to 
operations other than rental operations (the parking-garage operations). 
Thus, the exceptions in paragraph (d)(2) (ii) and (iii) of this section 
do not apply. In addition, the average period of customer use for the 
office spaces exceeds 30 days, extraordinary personal services (within 
the meaning of Sec. 1.469-1T(e)(3)(v)) are not provided, and the rental 
of the office spaces is not treated as incidental to a nonrental 
activity under Sec. 1.469-1T(e)(3)(vi) (relating to incidental rentals 
that are not treated as a rental activity). Thus, the rental operations, 
if considered as a separate activity, would constitute a rental 
activity, and the exception in paragraph (d)(2)(i) of this section does 
not apply. Accordingly, the rental operations and the parking-garage 
operations are treated as two separate undertakings (the ``office-space 
undertaking'' and the ``parking-garage undertaking'').
    (vi) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking if and only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the office-space undertaking, if 
considered as a separate activity, would constitute a rental activity 
(see (v) above), and the parking-garage undertaking, if considered as a 
separate activity, would not constitute a rental activity (see (iii) 
above). Accordingly, the office-space undertaking is treated as a rental 
undertaking, and the parking-garage undertaking is not.
    Example (2). (i) The taxpayer owns a building in which the taxpayer 
rents apartments to tenants and operates a restaurant. (Assume that, 
under paragraph (c)(1) of this section, the operations conducted in the 
building are treated as a single paragraph (c) undertaking.) The 
taxpayer's tenants typically occupy an apartment for at least one year, 
and the services provided to tenants are those customarily provided in 
residential apartment buildings. The paragraph (c) undertaking derives 
85 percent of its gross income from apartment rentals and 15 percent of 
its gross income from the restaurant. The operations conducted in the 
building are not incidental to any other activity of the taxpayer 
(within the meaning of Sec. 1.469-1T(e)(3)(vi)).
    (ii) The operations with respect to apartments (the ``apartment 
operations'') involve the provision of tangible property (the 
apartments) for use by customers and the provision of property and 
services in connection therewith. In addition, the apartments are not 
short-term real properties (within the meaning of paragraph (d)(3)(ii) 
of this section) because the average period of customer use (within the 
meaning of Sec. 1.469-1T(e)(3)(iii)) for the apartments exceeds 30 
days. Accordingly, the apartment operations are rental operations 
(within the meaning of paragraph (d)(3) of this section). The restaurant 
operations do not involve the provision of tangible property for use by 
customers or the provision of property or services in connection 
therewith. Thus, the restaurant operations are not rental operations.
    (iii) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations and its 
operations other than rental operations are treated as two separate 
undertakings. In this case, however, the exception in paragraph 
(d)(2)(iii) of this section applies because less than 20 percent of the 
paragraph (c) undertaking's gross income is attributable to operations 
other than rental operations (the restaurant operations). Accordingly, 
the rental operations and the restaurant operations are not treated as 
two separate undertakings under paragraph (d)(1)(i) of this section.
    (iv) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking if and only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the undertaking (determined after the 
application of paragraph (d)(1)(i) of this section) includes both the 
apartment operations and the restaurant operations, and the gross income 
of this undertaking represents amounts paid principally for the use of 
tangible property (the apartments). Moreover, the average period of 
customer use for the apartments exceeds 30 days, extraordinary personal 
services (within the meaning of Sec. 1.469-1T(e)(3)(v)) are not 
provided, and the rental of the apartments is

[[Page 467]]

not treated as incidental to a nonrental activity under Sec. 1.469-
1T(e)(3)(vi) (relating to incidental rentals that are not treated as a 
rental activity). Thus, the undertaking, if considered as a separate 
activity, would constitute a rental activity. Accordingly, the 
undertaking is treated as a rental undertaking.
    Example (3). (i) The taxpayer owns a building in which the taxpayer 
rents hotel rooms, meeting rooms, and parking spaces to customers, rents 
space to various retailers, and operates a restaurant and health club. 
(Assume that, under paragraph (c)(1) of this section, the operations 
conducted in the building are treated as a single paragraph (c) 
undertaking.) Although some customers occupy hotel rooms for extended 
periods (including some customers who reside in the hotel), customers 
use hotel rooms for an average period of two days and meeting rooms for 
an average period of one day. The services provided to persons using the 
hotel rooms and meeting rooms are those customarily provided in hotels 
(including wake-up calls, valet services, and delivery of food and 
beverages to rooms). Some customers rent spaces in the parking garage on 
a monthly or annual basis. In general, however, parking spaces are 
rented on an hourly or daily basis, and the average period for which 
customers use the parking garage is less than 24 hours. Retail tenants 
typically occupy their space for at least one year, and the services 
provided to retail tenants are those customarily provided in commercial 
buildings. The paragraph (c) undertaking derives 45 percent of its gross 
income from renting hotel rooms, meeting rooms, and parking spaces, 35 
percent of its gross income from renting retail space, and 20 percent of 
its gross income from the restaurant and health club. The operations 
conducted in the building are not incidental to any other activity of 
the taxpayer (within the meaning of Sec. 1.469-1T(e)(3)(vi)).
    (ii) The parking spaces, hotel rooms, and meeting rooms are real 
property of three different types, but the average period of customer 
use (within the meaning of Sec. 1.469-1T (e)(3)(iii)) for property of 
each type is 30 days or less. Thus, the parking spaces, hotel rooms, and 
meeting rooms are short-term real properties. (For this purpose, 
individual parking spaces or hotel rooms that are rented for extended 
periods are, nevertheless, short-term real properties if the average 
rental period for all parking spaces is 30 days or less and the average 
rental period for all hotel rooms is 30 days or less.) In addition, the 
parking garage operations, the operations with respect to hotel rooms 
(the ``hotel-room operations''), and the operations with respect to 
meeting rooms (the ``meeting-room operations'') involve making short-
term real properties available for use by customers and the provision of 
property and services in connection therewith.
    (iii) Paragraph (d)(3) (i) and (ii) of this section provides, in 
effect, that a paragraph (c) undertaking's operations that involve 
making short-term real properties available for use by customers and the 
provision of property and services in connection therewith are treated 
as rental operations if and only if the operations, considered as a 
separate activity, would constitute a rental activity (within the 
meaning of Sec. 1.469-1T (e)(3)). In this case the parking-garage, 
hotel-room and meeting-room operations, if considered as separate 
activities, would not constitute rental activities because the average 
period of customer use for parking spaces, hotel rooms, and meeting 
rooms does not exceed seven days (see Sec. 1.469-1T (e)(3)(ii)(A)). 
Accordingly, the parking-garage, hotel-room, and meeting-room operations 
are not treated as rental operations.
    (iv) The operations with respect to retail space in the building 
(the ``retail-space operations'') involve the provision of tangible 
property (the retail spaces) for use by customers and the provision of 
property and services in connection therewith. In addition, the retail 
spaces are not short-term real properties (within the meaning of 
paragraph (d)(3)(ii) of this section) because the average period of 
customer use (within the meaning of Sec. 1.469-1T (e)(3)(iii)) for the 
retail spaces exceeds 30 days. Accordingly, the retail-space operations 
are rental operations.
    (v) The health-club operations involve making tangible property 
available for use by customers, but the property is customarily made 
available during defined business hours for nonexclusive use by various 
customers. Accordingly, the health-club operations are not rental 
operations (see paragraph (d)(3)(iii) of this seciton). The restaurant 
operations do not involve the provision of tangible property for use by 
customers or the provision of property or services in connection 
therewith. Accordingly, the restaurant operations also are not rental 
operations.
    (vi) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations and its 
operations other than rental operations are treated as two separate 
undertakings. In this case, at least 20 percent of the paragraph (c) 
undertaking's gross income is attributable to rental operations (35 
percent of the paragraph (c) undertaking's gross income is from the 
retail-space operations) and at least 20 percent is attributable to 
operations other than rental operations (45 percent from the hotel-room, 
meeting-room and parking-garage operations and 20 percent from the 
restaurant and health-club operations). Thus, the exceptions in 
paragraph (d)(2) (ii) and (iii) of this section do not

[[Page 468]]

apply. In addition, the average period of customer use for the retail 
space exceeds 30 days, extraordinary personal services (within the 
meaning of Sec. 1.469-1T (e)(3)(v)) are not provided, and the rental of 
the retail space is not treated as incidental to a nonrental activity 
under Sec. 1.469-1T (e)(3)(vi) (relating to incidental rentals that are 
not treated as a rental activity). Thus, the retail-space operations, if 
considered as a separate activity, would constitute a rental activity, 
and the exception in paragraph (d)(2)(i) of this section does not apply. 
Accordingly, the retail-space operations are treated as an undertaking 
(the ``retail-space undertaking'') and all the other operations 
conducted in the building (i.e., renting hotel and meeting rooms and 
parking spaces and operating the restaurant and health club) are treated 
as a separate undertaking (the ``hotel undertaking'').
    (vii) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking if and only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the retail-space undertaking, if 
considered as a separate activity, would constitute a rental activity 
(see (iv) above). Accordingly, the retail-space undertaking is treated 
as a rental undertaking. The hotel undertaking, if considered as a 
separate activity, would not constitute a rental activity because all 
tangible property provided for the use of customers in the hotel 
undertaking is either property for which the average period of customer 
use is seven days or less (see Sec. 1.469-1T (e)(3)(ii)(A)) or property 
customarily made available during defined business hours for 
nonexclusive use by various customers (see Sec. 1.469-1T 
(e)(3)(ii)(E)). Accordingly, the hotel undertaking is not treated as a 
rental undertaking.
    Example (4). (i) A law partnership owns a ten-story building. The 
partnership uses eight floors of the building in its law practice and 
leases two floors to one or more tenants. (Assume that, under paragraph 
(c)(1) of this section, the operations conducted in the building are 
treated as a single paragraph (c) undertaking.) Tenants typically occupy 
space on the two rented floors for at least one year, and the services 
provided to tenants are those customarily provided in office buildings. 
The paragraph (c) undertaking derives 90 percent of its gross income 
from rendering legal services and 10 percent of its gross income from 
renting space. The operations conducted in the building are not 
incidental to any other activity of the taxpayer (within the meaning of 
Sec. 1.469-1T (e)(3)(vi)).
    (ii) The operations with respect to the office space leased to 
tenants (the ``office-space operations'') involve the provision of 
tangible property (the office space) for use by customers and the 
provision of property and services in connection therewith. In addition, 
the office spaces are not short-term real properties (within the meaning 
of paragraph (d)(3)(ii) of this section) because the average period of 
customer use (within the meaning of Sec. 1.469-1T(e)(3)(iii)) for the 
office space exceeds 30 days. Accordingly, the office-space operations 
are rental operations (within the meaning of paragraph (d)(3) of this 
section).
    (iii) The operations that involve the performance of legal services 
(the ``law-practice operations'') do not involve the provision of 
tangible property for use by customers or the provision of property or 
services in connection therewith. Accordingly, the law-practice 
operations are not rental operations.
    (iv) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations and its 
operations other than rental operations are treated as two separate 
undertakings. In this case, however, the exception in paragraph 
(d)(2)(ii) of this section applies because less than 20 percent of the 
paragraph (c) undertaking's gross income is attributable to rental 
operations (the office-space operations). Accordingly, the law-practice 
operations and the office-space operations are not treated as two 
separate undertakings under paragraph (d)(1)(i) of this section.
    (v) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the undertaking (determined after the 
application of paragraph (d)(1)(i) of this section) includes both the 
law-practice operations and the office-space operations, and the gross 
income of this undertaking does not represent amounts paid principally 
for the use of tangible property. Thus, the undertaking, if considered 
as a separate activity, would not constitute a rental activity. 
Accordingly, the undertaking is not treated as a rental undertaking.
    Example (5). (i) The facts are the same as in example (4), except 
that the building is owned by a separate partnership (the ``real estate 
partnership''), which leases eight floors of the building to the law 
partnership for use in its law practice and two floors to one or more 
other tenants. The law partnership and real estate partnership are owned 
by the same individuals in identical proportions.
    (ii) The operations conducted in the building are owned by two 
different persons (i.e., the law partnership and the real estate 
partnership). (See paragraph (c)(2)(v) of this section.) Thus, the 
operations conducted in the

[[Page 469]]

building are not treated as a single undertaking under paragraph (c)(1) 
of this section. Instead, each partnership's share of such operations is 
treated as a separate paragraph (c) undertaking (the ``law-practice 
undertaking'' and the ``office-space undertaking'').
    (iii) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking if and only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the office-space undertaking, if 
considered as a separate activity, would constitute a rental activity 
because all of the undertaking's gross income (including rents paid by 
the law partnership) represents amounts paid principally for the use of 
tangible property (the office space), the average period of customer use 
for the office space exceeds 30 days, extraordinary personal services 
(within the meaning of Sec. 1.469-1T(e)(3)(v)) are not provided, and 
the rental of the office space is not treated as incidental to a 
nonrental activity under Sec. 1.469-1T(e)(3)(vi) (relating to 
incidental rentals that are not treated as a rental activity). 
Accordingly, the office-space undertaking is treated as a rental 
undertaking. See, however, Sec. 1.469-2T(f)(6) (relating to certain 
rentals of property to a trade or business activity in which the 
taxpayer materially participates).
    (iv) The law-practice undertaking, if considered as a separate 
activity, would not constitute a rental activity because none of the 
undertaking's gross income represents amounts paid principally for the 
use of tangible property. Accordingly, the law-practice undertaking is 
not treated as a rental undertaking.
    Example (6). (i) The taxpayer owns a building in which the taxpayer 
operates a nursing home and a medical clinic. (Assume that, under 
paragraph (c)(1) of this section, the operations conducted in the 
building are treated as a single paragraph (c) undertaking.) The 
nursing-home operations consist of renting apartments in the nursing 
home to elderly and handicapped persons and providing medical care, 
meals, and social activities. (Assume that these services are 
extraordinary personal services (within the meaning of Sec. 1.469-
1T(e)(3)(v)). The medical clinic provides medical care to nursing-home 
residents and other individuals. Nursing-home residents typically occupy 
an apartment for at least one year. The paragraph (c) undertaking 
derives 55 percent of its gross income from nursing-home operations 
(including the provision of medical services to nursing-home residents) 
and 45 percent of its gross income from medical-clinic operations. The 
operations conducted in the building are not incidental to any other 
activity of the taxpayer (within the meaning of Sec. 1.469-
1T(e)(3)(vi)).
    (ii) The paragraph (c) undertaking's nursing-home operations involve 
the provision of tangible property (the apartments) for use by customers 
and the provision of property and services in connection therewith. In 
addition, the apartments are not short-term real properties (within the 
meaning of paragraph (d)(3)(ii) of this section) because the average 
period of customer use (within the meaning of Sec. 1.469-1T(e)(3)(iii)) 
for the apartments exceeds 30 days. Accordingly, the nursing-home 
operations are rental operations (within the meaning of paragraph (d)(3) 
of this section). The medical-clinic operations do not involve the 
provision of tangible property for use by customers or the provision of 
property or services in connection therewith. Thus, the medical-clinic 
operations are not rental operations.
    (iii) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations and its 
operations other than rental operations are treated as two separate 
undertakings. In this case, however, the nursing-home operations, if 
considered as a separate activity, would not constitute a rental 
activity because extraordinary personal services are provided in 
connection with making nursing-home apartments available for use by 
customers (see Sec. 1.469-T(e)(3)(ii)(C)). Thus, the exception in 
paragraph (d)(2)(i) of this section applies, and the nursing-home 
operations and the medical-clinic operations are not treated as two 
separate undertakings under paragraph (d)(1)(i) of this section.
    (iv) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the nursing-home operations, if 
considered as a separate activity, would not constitute a rental 
activity (see (iii) above). Thus, an undertaking that includes no rental 
operations other than the nursing-home operations would not, if 
considered as a separate activity, constitute a rental activity. 
Accordingly, the undertaking is not treated as a rental undertaking.
    Example (7). (i) The taxpayer rents and sells videocassettes. 
(Assumes that, under paragraph (c)(1) of this section, the videocassette 
operations are treated as a single paragraph (c) undertaking.) Renters 
of videocassettes typically keep the videocassettes for one or two days, 
and do not receive any other property or services in connection with 
videocassette rentals. The paragraph (c) undertaking derives 70 percent 
of its gross income from renting videocassettes and 30 percent of its 
gross income from selling videocassettes. The videocassette operations 
are not incidental to any other activity of the taxpayer (within the 
meaning of Sec. 1.469-1T(e)(3)(vi)).

[[Page 470]]

    (ii) The rental of videocassettes involves the provision of tangible 
property (the videocassettes) for use by customers. In addition, the 
special rules for short-term real properties contained in paragraph 
(d)(3)(ii) of this section do not apply in this case because the 
videocassettes are not real property. Thus, the operations that involve 
videocassette rentals are rental operations (within the meaning of 
paragraph (d)(3) of this section). The sale of videocassettes does not 
involve the provision of tangible property for use by customers or the 
provision of property or services in connection therewith. Thus, the 
operations that involve videocassette sales are not rental operations.
    (iii) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations and its 
operations other than rental operations are treated as two separate 
undertakings. In this case, however, the rental operations, if 
considered as a separate activity, would not constitute a rental 
activity because the average period of customer use for rented 
videocassettes does not exceed seven days (see Sec. 1.469-
1T(e)(3)(ii)(A)). Accordingly, the exception in paragraph (d)(2)(i) of 
this section applies, and the videocassette-rental operations and 
videocassette-sales operations are not treated as two separate 
undertakings under paragraph (d)(1)(i) of this section.
    (iv) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the videocassette-rental operations, if 
considered as a separate activity, would not constitute a rental 
activity (see (iii) above). Thus, an undertaking that includes no rental 
operations other than the videocassette-rental operations would not, if 
considered as a separate activity, constitute a rental activity. 
Accordingly, the undertaking is not treated as a rental undertaking.
    Example (8). (i) The taxpayer owns a building in which the taxpayer 
sells, leases, and services automobiles. (Assume that, under paragraph 
(c)(1) of this section, the operations conducted in the building are 
treated as a single paragraph (c) undertaking.) The minimum lease term 
for any leased automobile is 31 days, and the services provided to 
lessees (including periodic oil changes, lubrication, and routine 
services and repairs) are those customarily provided in long-term 
automobile leases. The paragraph (c) undertaking derives 75 percent of 
its gross income from selling automobiles, 15 percent of its gross 
income from servicing automobiles other than leased automobiles, and 10 
percent of its gross income from leasing automobiles. The taxpayer's 
automobile operations are not incidental to any other activity of the 
taxpayer (within the meaning of Sec. 1.469-1T(e)(3)(vi)).
    (ii) The paragraph (c) undertaking's automobile-leasing operations 
involve the provision of tangible property (the automobiles) for use by 
customers and the provision of services in connection therewith. In 
addition, the special rules for short-term real properties contained in 
paragraph (d)(3)(ii) of this section do not apply in this case because 
the automobiles are not real property. Accordingly, the automobile-
leasing operations are rental operations (within the meaning of 
paragraph (d)(3) of this section). The paragraph (c) undertaking's 
automobile-sales operations and servicing operations for automobiles 
other than leased automobiles (the ``selling-and-servicing operations'') 
do not involve the provision of tangible property for use by customers 
or the provision of property or services in connection therewith. Thus, 
the selling-and-servicing operations are not rental operations.
    (iii) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations and its 
operations other than rental operations are treated as two separate 
undertakings. In this case, however, the exception in paragraph 
(d)(2)(ii) of this section applies because less than 20 percent of the 
paragraph (c) undertaking's gross income is attributable to rental 
operations (the ``automobile-leasing operations''). Accordingly, the 
rental operations and the selling-and-servicing operations are not 
treated as two separate undertakings under paragraph (d)(1)(i) of this 
section.
    (iv) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the undertaking (determined after the 
application of paragraph (d)(1)(i) of this section) includes both the 
selling-and-servicing operations and the automobile-leasing operations, 
and the gross income of the undertaking does not represent amounts paid 
principally for the use of tangible property. Thus, the undertaking, if 
considered as a separate activity, would not constitute a rental 
activity. Accordingly, the undertaking is not treated as a rental 
undertaking.
    Example (9). (i) The facts are the same as in example (8), except 
that the paragraph (c) undertaking derives 60 percent of its gross 
income from selling automobiles, 15 percent of its gross income from 
servicing automobiles other than leased automobiles, and 25 percent of 
its gross income from leasing automobiles.

[[Page 471]]

    (ii) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations and its 
operations other than rental operations are treated as two separate 
undertakings. In this case, more than 20 percent of the paragraph (c) 
undertaking's gross income is attributable to rental operations (the 
automobile-leasing operations), and more than 20 percent is attributable 
to operations other than rental operations (the selling-and-servicing 
operations). Thus, the exceptions in paragraph (d)(2) (ii) and (iii) of 
this section do not apply. In addition, the average period of customer 
use for leased automobiles exceeds 30 days, extraordinary personal 
services (within the meaning of Sec. 1.469-1T(e)(3)(v)) are not 
provided, and the leasing of the automobiles is not treated as 
incidental to a nonrental activity under Sec. 1.469-1T(e)(3)(vi) 
(relating to incidental rentals that are not treated as a rental 
activity). Thus, the leasing operations, if considered as a separate 
activity, would constitute a rental activity, and the exception in 
paragraph (d)(2)(i) of this section does not apply. Accordingly, the 
rental operations and the selling-and-servicing operations are treated 
as two separate undertakings (the ``automobile-leasing undertaking'' and 
the ``automobile selling-and-servicing undertaking'').
    (iii) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking if and only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the automobile-leasing undertaking would, 
if considered as a separate activity, constitute a rental activity, and 
the automobile selling-and-servicing undertaking would not, if 
considered as a separate activity, constitute a rental activity (see 
example (8) and (ii) above). Accordingly, the automobile-leasing 
undertaking is treated as a rental undertaking, and the automobile 
selling-and-servicing undertaking is not.

    (e) Special rules for certain oil and gas operations--(1) Wells 
treated as nonpassive under Sec. 1.469-1T(e)(4)(i). An oil or gas well 
shall be treated as an undertaking that is separate from other 
undertakings in determining the activities of a taxpayer for a taxable 
year if the following conditions are satisfied:
    (i) The well is drilled or operated pursuant to a working interest 
(within the meaning of Sec. 1.469-1T(e)(4)(iv)) and at any time during 
such taxable year the taxpayer holds such working interest either--
    (A) Directly; or
    (B) Through an entity that does not limit the liability of the 
taxpayer with respect to the drilling or operation of such well pursuant 
to such working interest; and
    (ii) The taxpayer would not be treated as materially participating 
(within the meaning of Sec. 1.469-5T) for the taxable year in the 
activity in which such well would be included if the taxpayer's 
activities were determined without regard to this paragraph (e).
    (2) Business and rental operations that constitute an undertaking. 
In any case in which an oil or gas well is treated under this paragraph 
(e) as an undertaking that is separate from other undertakings, the 
business and rental operations that constitute such undertaking are the 
business and rental operations that are attributable to such well.
    (3) Examples. The following examples illustrate the application of 
this paragraph (e). In each example, the taxpayer is an individual whose 
taxable year is the calendar year.

    Example (1). During 1989, A directly owns an undivided interest in a 
working interest (within the meaning of Sec. 1.469-1T(e)(4)(iv)) in two 
oil wells. A does not participate in the activity in which the wells 
would be included if A's activities were determined without regard to 
this paragraph (e). Under paragraph (e)(1) of this section, each well is 
treated as a separate undertaking in determining A's activities for 1989 
because A holds the working interest directly and would not be treated 
as materially participating for 1989 in the activity in which the wells 
would be included if A's activities were determined without regard to 
this paragraph (e). The aggregation rules in paragraph (f) of this 
section do not apply to these undertakings (see paragraph (f)(1)(ii)(B) 
of this section). Thus, each of the undertakings is treated as a 
separate activity under paragraph (b)(1) of this section. The result is 
the same even if A has net income from one or both wells for 1989 and 
even if the wells would otherwise be treated as part of the same 
undertaking under paragraph (c) of this section. The result would also 
be the same if A held the working interest through an entity, such as a 
general partnership, that does not limit A's liability with respect to 
the drilling or operation of the wells pursuant to the working interest.
    Example (2). (i) During 1989, B is a general partner in a 
partnership that owns a working interest (within the meaning of Sec. 
1.469-1T(e)(4)(iv)) in an oil well. B does not own any interest in the 
well other than through the partnership. At the end of 1989, however,

[[Page 472]]

B's partnership interest is converted into a limited partnership 
interest, and during 1990 B holds the working interest only as a limited 
partner. B does not participate in the activity in which the well would 
be included if B's activities were determined without regard to this 
paragraph (e).
    (ii) Under paragraph (e)(1) of this section, the well is treated as 
a separate undertaking in determining B's activities for 1989 because B 
holds the working interest during 1989 through an entity that does not 
limit B's liability with respect to the drilling or operation of the 
well pursuant to the working interest, and B would not be treated as 
materially participating for 1989 in the activity in which the well 
would be included if B's activities were determined without regard to 
this paragraph (e). Throughout 1990, however, B's liability with respect 
to the drilling and operation of the well is limited by the entity 
through which B holds the working interest (i.e., the limited 
partnership). Accordingly, paragraph (e)(1) of this section does not 
apply to the well in 1990, and the well may be included under paragraph 
(c) of this section in an undertaking that includes other operations.
    Example (3). The facts are the same as in example (2), except that 
B's partnership interest is converted into a limited partnership 
interest at the end of November 1989. An oil or gas well may be treated 
as a separate undertaking under paragraph (e)(1) of this section if at 
any time during the taxable year the taxpayer holds a working interest 
in the well directly or through an entity that does not limit the 
taxpayer's liability with respect to the drilling or operation of the 
well pursuant to the working interest (see Sec. 1.469-1T(e)(4)(i)). 
Thus, although B's liability with respect to the drilling and operation 
of the well is limited during December 1989, the result in both 1989 and 
1990 is the same as in example (2). In 1989, however, disqualified 
deductions and a ratable portion of the gross income from the well may 
be treated under Sec. 1.469-1T(e)(4)(ii) as passive activity deductions 
and passive activity gross income, respectively.

    (f) Certain trade or business undertakings treated as part of the 
same activity--(1) Applicability--(i) In general. This paragraph (f) 
applies to a taxpayer's interests in trade or business undertakings 
(within the meaning of paragraph (f)(1)(ii) of this section).
    (ii) Trade or business undertaking. For purposes of this paragraph 
(f), the term ``trade or business undertaking'' means any undertaking in 
which a taxpayer has an interest, other than--
    (A) A rental undertaking (within the meaning of paragraph (d) of 
this section);
    (B) An oil or gas well treated as an undertaking that is separate 
from other undertakings under paragraph (e) of this section; or
    (C) A professional service undertaking (within the meaning of 
paragraph (h) of this section).
    (2) Treatment as part of the same activity. A taxpayer's interests 
in two or more trade or business undertakings that are similar (within 
the meaning of paragraph (f)(4) of this section) and controlled by the 
same interests (within the meaning of paragraph (j) of this section) 
shall be treated as part of the same activity of the taxpayer for any 
taxable year in which the taxpayer--
    (i) Owns interests in each such undertaking through the same 
passthrough entity;
    (ii) Owns a direct or substantial indirect interest (within the 
meaning of paragraph (f)(3) of this section) in each such undertaking; 
or
    (iii) Materially or significantly participates (within the meaning 
of Sec. 1.469-5T) in the activity that would result if such 
undertakings were treated as part of the same activity.
    (3) Substantial indirect interest--(i) In general. For purposes of 
this paragraph (f), a taxpayer owns a substantial indirect interest in 
an undertaking for a taxable year if at any time during such taxable 
year the taxpayer's ownership percentage (determined in accordance with 
paragraph (j)(3) of this section) in a passthrough entity that directly 
owns such undertaking exceeds ten percent.
    (ii) Coordination rule. A taxpayer shall be treated for purposes of 
this paragraph (f) as owning a substantial indirect interest in each of 
two or more undertakings for any taxable year in which--
    (A) Such undertakings are treated as part of the same activity of 
the taxpayer under paragraph (f)(2)(i) of this section; and
    (B) The taxpayer owns a substantial indirect interest (within the 
meaning of paragraph (f)(3)(i) of this section) in any such undertaking.
    (4) Similar undertakings--(i) In general. Except as provided in 
paragraph

[[Page 473]]

(f)(4)(iii) of this section, two undertakings are similar for purposes 
of this paragraph (f) if and only if--
    (A) There are predominant operations in each such undertaking; and
    (B) The predominant operations of both undertakings are in the same 
line of business.
    (ii) Predominant operations. For purposes of paragraph (f)(4)(i)(A) 
of this section, there are predominant operations in an undertaking if 
more than 50 percent of the undertaking's gross income is attributable 
to operations in a single line of business.
    (iii) Vertically-integrated undertakings. If an undertaking (the 
``supplier undertaking'') provides property or services to other 
undertakings (the ``recipient undertakings''), the following rules apply 
for purposes of this paragraph (f):
    (A) Supplier undertaking similar to recipient undertaking. If the 
supplier undertaking predominantly involves the provision of property 
and services to a recipient undertaking that is controlled by the same 
interests (within the meaning of paragraph (j) of this section), the 
supplier undertaking shall be treated as similar to the recipient 
undertaking. For purposes of applying the preceding sentence--
    (1) If a supplier undertaking and two or more recipient undertakings 
that are similar (within the meaning of paragraph (f)(4)(i) of this 
section) are controlled by the same interests, such recipient 
undertakings shall be treated as a single undertaking; and
    (2) A supplier undertaking predominantly involves the provision of 
property and services to a recipient undertaking for any taxable year in 
which such recipient undertaking obtains more than 50 percent (by value) 
of all property and services provided by the supplier undertaking.
    (B) Recipient undertaking similar to supplier undertaking. If the 
supplier undertaking is the predominant provider of property and 
services to a recipient undertaking that is controlled by the same 
interests (within the meaning of paragraph (j) of this section), the 
recipient undertaking shall be treated, except as otherwise provided in 
paragraph (f)(4)(iii)(C) of this section, as similar to the supplier 
undertaking. For purposes of the preceding sentence, a supplier 
undertaking is the predominant provider of property and services to a 
recipient undertaking for any taxable year in which the supplier 
undertaking provides more than 50 percent (by value) of all property and 
services obtained by the recipient undertaking.
    (C) Coordination rules. (1) Paragraph (f)(4)(iii)(B) of this section 
does not apply if, under paragraph (f)(4)(iii)(A) of this section--
    (i) The supplier undertaking is treated as an undertaking that is 
similar to any recipient undertaking;
    (ii) The recipient undertaking is treated as a supplier undertaking 
that is similar to another recipient undertaking; or
    (iii) Another supplier undertaking is treated as an undertaking that 
is similar to the recipient undertaking.
    (2) If paragraph (f)(4)(iii)(A) of this section applies to a 
supplier undertaking, the supplier undertaking shall be treated as 
similar to undertakings that are similar to the recipient undertaking 
and shall not otherwise be treated as similar to undertakings to which 
the supplier undertaking would be similar without regard to paragraph 
(f)(4)(iii) of this section.
    (3) If paragraph (f)(4)(iii)(B) of this section applies to a 
recipient undertaking, the recipient undertaking shall be treated as 
similar to undertakings that are similar to the supplier undertaking and 
shall not otherwise be treated as similar to undertakings to which the 
recipient undertaking would be similar without regard to paragraph 
(f)(4)(iii) of this section.
    (iv) Lines of business. The Commissioner shall establish, by revenue 
procedure, lines of business for purposes of this paragraph (f)(4). 
Business and rental operations that are not included in the lines of 
business established by the Commissioner shall nonetheless be included 
in a line of business for purposes of this paragraph (f)(4). Such 
operations shall be included in a single line of business or in multiple 
lines of business on a basis that reasonably reflects--
    (A) Similarities and differences in the property or services 
provided pursuant to such operations and in the markets to which such 
property or services are offered; and

[[Page 474]]

    (B) The treatment within the lines of business established by the 
Commissioner of operations that are comparable in their similarities and 
differences.
    (5) Examples. The following examples illustrate the application of 
this paragraph (f). In each example that does not state otherwise, the 
taxpayer is an individual and the facts, analysis, and conclusions 
relate to a single taxable year.

    Example (1). (i) The taxpayer is a partner in partnerships A, B, C, 
and D and owns a five-percent interest in each partnership. Each 
partnership owns a single undertaking (undertakings A, B, C, and D), and 
the undertakings are trade or business undertakings (within the meaning 
of paragraph (f)(1)(ii) of this section) that are controlled by the same 
interests (within the meaning of paragraph (j) of this section). In 
addition, undertakings A, B, and D are similar (within the meaning of 
paragraph (f)(4) of this section). The taxpayer is not related to any of 
the other partners, and does not participate in any of the undertakings.
    (ii) In general, each undertaking in which a taxpayer owns an 
interest is treated as a single activity that is separate from other 
activities of the taxpayer (see paragraph (b)(1) of this section). This 
paragraph (f) provides aggregation rules for trade or business 
undertakings that are similar and controlled by the same interests. 
These aggregation rules do not apply, however, unless the taxpayer owns 
interests in the undertakings through the same passthrough entity, owns 
direct or substantial indirect interests in the undertakings, or 
materially or significantly participates in the undertakings. In this 
case, the taxpayer does not satisfy any of these conditions, and the 
aggregation rules in this paragraph (f) do not apply. Accordingly, 
except as otherwise provided in paragraph (g) of this section (relating 
to an aggregation rule for integrated businesses), undertakings A, B, C, 
and D are treated as separate activities of the taxpayer under paragraph 
(b)(1) of this section.
    Example (2). (i) The facts are the same as in example (1), except 
that the taxpayer owns a 25-percent interest in partnership A, a 15-
percent interest in partnership B, and a 40-percent interest in 
partnership C.
    (ii) Paragraph (f)(2)(ii) of this section provides that trade or 
business undertakings that are similar and controlled by the same 
interests are treated as part of the same activity of the taxpayer if 
the taxpayer owns a direct or substantial indirect interest in each such 
undertaking. In this case, the taxpayer owns more than ten percent of 
partnerships A, B, and C, and these partnerships directly own 
undertakings A, B, and C. Thus, the taxpayer owns a substantial indirect 
interest in undertakings A, B, and C (see paragraph (f)(3)(i) of this 
section). Of these undertakings, only undertakings A and B are both 
similar and controlled by the same interests. Accordingly, the 
taxpayer's interests in undertakings A and B are treated as part of the 
same activity. As in example (1), the aggregation rules in this 
paragraph (f) do not apply to undertakings C and D, and except as 
otherwise provided in paragraph (g) of this section, undertakings C and 
D are treated as separate activities.
    Example (3). (i) The facts are the same as in example (1), except 
that the taxpayer participates (within the meaning of Sec. 1.469-5T(f)) 
for 60 hours in undertaking A and for 60 hours in undertaking B.
    (ii) Paragraph (f)(2)(iii) of this section provides that trade or 
business undertakings that are similar and controlled by the same 
interests are treated as part of the same activity of the taxpayer if 
the taxpayer materially or significantly participates (within the 
meaning of Sec. 1.469-5T) in the activity that would result from the 
treatment of similar, commonly-controlled undertakings as part of the 
same activity. In this case, the activity that would result from 
treating the similar, commonly-controlled undertakings as part of the 
same activity consists of undertakings A, B, and D, and the taxpayer 
participates for 120 hours in the activity that results from this 
treatment. Accordingly, undertakings A, B, and D are treated as part of 
the same activity because the taxpayer significantly participates 
(within the meaning of Sec. 1.469-5T(c)(2)) in the activity that 
results from this treatment. The result is the same whether the taxpayer 
participates in one, two, or all three of the similar, commonly-
controlled undertakings, so long as the taxpayer's aggregate 
participation in undertakings A, B, and D exceeds 100 hours. As in 
example (1), the aggregation rules in this paragraph (f) do not apply to 
undertaking C, and except as otherwise provided in paragraph (g) of this 
section, undertaking C is treated as a separate activity.
    Example (4). (i) The taxpayer owns a 5-percent interest in 
partnership A. Partnership A owns interests in partnerships B and C, 
each of which owns a single undertaking (undertakings B and C). In 
addition, the taxpayer is a partner in partnerships C and D and directly 
owns a 15-percent interest in each partnership. Partnership D also owns 
a single undertaking (undertaking D). Undertakings B, C, and D are trade 
or business undertakings (within the meaning of paragraph (f)(1)(ii) of 
this section) that are similar (within the meaning of paragraph (f)(4) 
of this section) and controlled by the same interests (within the 
meaning of paragraph (j) of this section). The taxpayer does not 
participate in undertaking B, C, or D.

[[Page 475]]

    (ii) Paragraph (f)(2)(i) of this section provides that trade or 
business undertakings that are similar and controlled by the same 
interests are treated as part of the same activity of the taxpayer if 
the taxpayer owns interests in the undertakings through the same 
passthrough entity. In this case, the taxpayer owns interests in 
undertakings B and C through partnership A. Thus, the taxpayer's 
interests in undertakings B and C are treated as part of the same 
activity.
    (iii) Paragraph (f)(2)(ii) of this section provides that trade or 
business undertakings that are similar and controlled by the same 
interests are treated as part of the same activity of the taxpayer if 
the taxpayer owns a direct or substantial indirect interest in each such 
undertaking. In this case, the taxpayer owns more than ten percent of 
partnerships C and D, and these partnerships directly own undertakings C 
and D. Thus, the taxpayer owns a substantial indirect interest in 
undertakings C and D (see paragraph (f)(3)(i) of this section).
    (iv) The coordination rule in paragraph (f)(3)(ii) of this section 
applies to undertakings B and C because they are treated as part of the 
same activity under paragraph (f)(2)(i) of this section, and the 
taxpayer owns a substantial indirect interest in undertaking C. Under 
the coordination rule, the taxpayer is treated as owning a substantial 
indirect interest in undertaking B as well as undertaking C. 
Accordingly, the taxpayer's interests in undertakings B, C, and D are 
treated as part of the same activity.
    Example (5). (i) Undertakings A, B, C, and D are trade or business 
undertakings (within the meaning of paragraph (f)(1)(ii) of this 
section), each of which involves the operation of a department store, 
restaurants, and movie theaters. The following table shows, for each 
undertaking, the percentages of gross income attributable to the various 
operations of the undertaking.

------------------------------------------------------------------------
                                       Department                 Movie
                                          store    Restaurants  Theaters
------------------------------------------------------------------------
Undertaking A........................        70%         20%         10%
Undertaking B........................        60%         20%         20%
Undertaking C........................        35%         35%         30%
Undertaking D........................        35%         10%         55%
------------------------------------------------------------------------

    (ii) Paragraph (f)(4)(i) of this section provides that two 
undertakings are similar for purposes of this paragraph (f) if and only 
if there are predominant operations in each undertaking and the 
predominant operations of the two undertakings are in the same line of 
business. (Assume that the applicable revenue procedure provides that 
``general merchandise stores,'' ``eating and drinking places,'' and 
``motion picture services'' are three separate lines of business.)
    (iii) Undertaking A and undertaking B each derives more than 50 
percent of its gross income from department-store operations, which are 
in the general-merchandise-store line of business. Thus, there are 
predominant operations in undertaking A and undertaking B, and the 
predominant operations of the two undertakings are in the same line of 
business. Accordingly, undertakings A and B are similar.
    (iv) Undertaking C does not derive more than 50 percent of its gross 
income from operations in any single line of business. Thus, there are 
no predominant operations in undertaking C, and undertaking C is not 
similar to any of the other undertakings.
    (v) Undertaking D derives more than 50 percent of its gross income 
from movie-theater operations, which are in the motion-picture-services 
line of business. Thus, there are predominant operations in undertaking 
D. The predominant operations of undertaking D, however, are not in the 
same line of business as those of undertakings A and B. Accordingly, 
undertaking D is not similar to undertakings A and B.
    Example (6). (i) Undertakings A and B are trade or business 
undertakings (within the meaning of paragraph (f)(1)(ii) of this 
section) that derive all of their gross income from the sale of 
automobiles. Undertakings C and D derive all of their gross income from 
the rental of automobiles. Undertaking C is not a rental undertaking 
(within the meaning of paragraph (d)(1)(iii) of this section) because 
the average period of customer use (within the meaning of Sec. 1.469-
1T(e)(3)(iii)) for its automobiles does not exceed seven days (see Sec. 
1.469-1T(e)(3)(ii)(A)). Undertaking D, on the other hand, leases 
automobiles for periods of one year or more and is a rental undertaking.
    (ii) Paragraph (f)(4)(i) of this section provides that two 
undertakings are similar for purposes of this paragraph (f) if and only 
if there are predominant operations in each undertaking and the 
predominant operations of the two undertakings are in the same line of 
business. (Assume that the applicable revenue procedure provides that 
(a) ``automotive dealers and service stations'' (automotive retail) and 
(b) ``auto repair, services (including rentals), and parking'' 
(automotive services) are two separate lines of business.)
    (iii) Undertakings A and B both derive more than 50 percent of their 
gross income from operations in the automotive-retail line of business 
(the automobile-sales operations). Similarly, undertakings C and D both 
derive more than 50 percent of their gross income from operations in the 
automotive-services line of business (the automobile-rental operations). 
Thus, there are predominant operations in each undertaking, the 
predominant operations of undertakings A and B are in the same line of 
business, and the predominant operations of undertakings

[[Page 476]]

C and D are in the same line of business. Accordingly, undertakings A 
and B are similar, undertakings C and D are similar, and undertakings A 
and B are not similar to undertakings C and D.
    (iv) Paragraph (f)(1) of this section provides that this paragraph 
(f) applies only to trade or business undertakings and that a rental 
undertaking is not a trade or business undertaking. Accordingly, this 
paragraph (f) does not apply to undertaking D, and undertakings C and D, 
although similar, are not treated, under this paragraph (f), as part of 
the same activity.
    Example (7). (i) Undertakings A, B, and C are trade or business 
undertakings (within the meaning of paragraph (f)(1)(ii) of this 
section) that involve real estate operations. Undertaking A derives all 
of its gross income from the development of real property, undertaking B 
derives all of its gross income from the management of real property and 
the performance of services as a leasing agent with respect to real 
property, and undertaking C derives all of its gross income from buying, 
selling, or arranging purchases and sales of real property. Undertaking 
D derives all of its gross income from the rental of residential 
apartments and is a rental undertaking (within the meaning of paragraph 
(d)(1)(iii) of this section).
    (ii) Paragraph (f)(4)(i) of this section provides that two 
undertakings are similar for purposes of this paragraph (f) if there are 
predominant operations in each undertaking and the predominant 
operations of the two undertakings are in the same line of business. 
(Assume that the applicable revenue procedure provides that real estate 
development and services (including the development and management of 
real property, dealing in real property, and the performance of services 
as a leasing agent with respect to real property) is a single line of 
business (the ``real-estate'' line of business).)
    (iii) Undertakings A, B, and C all derive more than 50 percent of 
their gross income from operations in the real-estate line of business. 
Thus, there are predominant operations in undertakings A, B, and C, and 
the predominant operations of the three undertakings are in the same 
line of business. Accordingly, undertakings A, B, and C are similar.
    (iv) Undertaking D also derives more than 50 percent of its gross 
income from operations in the real-estate line of business. Thus, there 
are predominant operations in undertaking D, and the predominant 
operations of undertaking D are in the same line of business as those of 
undertakings A, B, and C. Paragraph (f)(1) of this section provides, 
however, that this paragraph (f) applies only to trade or business 
undertakings and that a rental undertaking is not a trade or business 
undertaking. Accordingly, this paragraph (f) does not apply to 
undertaking D, and undertaking D, although similar to undertakings A, B, 
and C, is not treated, under this paragraph (f), as part an activity 
that includes undertaking A, B, or C.
    Example (8). (i) Undertakings A and B are trade or business 
undertakings (within the meaning of paragraph (f)(1)(ii) of this 
section), both of which involve the provision of moving services. 
Undertaking A derives its gross income principally from local moves, and 
undertaking B derives its gross income principally from long-distance 
moves.
    (ii) Paragraph (f)(4)(i) of this section provides that two 
undertakings are similar for purposes of this paragraph (f) if there are 
predominant operations in each undertaking and the predominant 
operations of the two undertakings are in the same line of business. 
Under paragraph (f)(4)(iv) of this section, operations that are not in 
the lines of business established by the applicable revenue procedure 
are nonetheless included in a line of business. In addition, such 
operations are included in a single line of business or in multiple 
lines of business on a basis that reasonably reflects (a) similarities 
and differences in the property or services provided pursuant to such 
operations and in the markets to which such property or services are 
offered, and (b) the treatment within the lines of business established 
by the Commissioner of operations that are comparable in their 
similarities and differences. (Assume that the provision of moving 
services is not in any line of business established by the Commissioner 
and that within the lines of business established by the Commissioner 
services that differ only in the distance over which they are performed 
(e.g., local and long-distance telephone services) are generally treated 
as part of the same line of business.)
    (iii) Undertakings A and B provide the same types of services to 
similar customers, and the only significant difference in the services 
provided is the distance over which they are performed. Thus, treating 
local and long-distance moving services as a single line of business 
(the ``moving-services'' line of business) reasonably reflects the 
treatment within the lines of business established by the Commissioner 
of operations that are comparable in their similarities and differences.
    (iv) Each undertaking derives more than 50 percent of its gross 
income from operations in the moving-services line of business. Thus, 
there are predominant operations in each undertaking, and the 
predominant operations of the two undertakings are in the same line of 
business. Accordingly, undertakings A and B are similar.
    Example (9). (i) Undertakings A, B, C, D, and E are trade or 
business undertakings (within the meaning of paragraph (f)(1)(ii) of 
this section) and are controlled by the same interests (within the 
meaning of paragraph

[[Page 477]]

(j) of this section). Undertakings A, B, and C derive all of their gross 
income from retail sales of dairy products, and undertakings D and E 
derive all of their gross income from the processing of dairy products. 
Undertakings D and E sell less than ten percent of their dairy products 
to undertakings A, B, and C, and sell the remainder to unrelated 
undertakings. Undertakings A, B, and C purchase less than ten percent of 
their inventory from undertakings D and E and purchase the remainder 
from unrelated undertakings.
    (ii) Paragraph (f)(4)(i) of this section provides that, except as 
provided in paragraph (f)(4)(iii) of this section, undertakings are 
similar for purposes of this paragraph (f) if and only if there are 
predominant operations in each undertaking and the predominant 
operations of the undertakings are in the same line of business. (Assume 
that the applicable revenue procedure provides that (a) ``food stores'' 
and (b) ``manufacturing--food and kindred products'' are two separate 
lines of business.)
    (iii) Undertakings A, B, and C all derive more than 50 percent of 
their gross income from operations in the food-store line of business 
(the dairy-sales operations). Thus, there are predominant operations in 
undertakings A, B, and C, and the predominant operations of the three 
undertakings are in the same line of business. Accordingly, undertakings 
A, B, and C are similar.
    (iv) Undertakings D and E both derive more than 50 percent of their 
gross income from operations in the food-manufacturing line of business 
(the dairy-processing operations). Thus, there are predominant 
operations in undertakings D and E, and the predominant operations of 
the two undertakings are in the same line of business. Accordingly, 
undertakings D and E are similar. The predominant operations of 
undertakings D and E are not in the same line of business as those of 
undertakings A, B, and C. Accordingly, undertakings D and E are not 
similar to undertakings A, B, and C.
    (v) Paragraph (f)(4)(iii) of this section provides rules under which 
certain undertakings whose operations are not in the same line of 
business nevertheless are similar to one another if one of the 
undertakings (the ``supplier undertaking'') provides property or 
services to the other undertaking (the ``recipient undertaking''), and 
the undertakings are controlled by the same interests. These rules 
apply, however, only if the supplier undertaking predominantly involves 
the provision of property and services to the recipient undertaking (see 
paragraph (f)(4)(iii)(A) of this section), or the supplier undertaking 
is the predominant provider of property and services to the recipient 
undertaking (see paragraph (f)(4)(iii)(B) of this section). In this 
case, undertakings D and E are supplier undertakings, and undertakings 
A, B, and C are recipient undertakings. Undertakings D and E, however, 
sell less than ten percent of their dairy products to undertakings A, B, 
and C and thus do not predominantly involve the provision of property 
and services to recipient undertakings. Similarly, undertakings D and E 
are not the predominant providers of property and services to 
undertakings A, B, and C. Thus, the rules for vertically-integrated 
undertakings in paragraph (f)(4)(iii) of this section do not apply in 
this case.
    Example (10). (i) The facts are the same as in example (9), except 
that undertaking D sells 75 percent of its dairy products to 
undertakings A, B, and C.
    (ii) Paragraph (f)(4)(iii)(A) of this section applies if a supplier 
undertaking predominantly involves the provision of property to a 
recipient undertaking that is controlled by the same interests. 
Paragraph (f)(4)(iii)(A)(2) of this section provides that a supplier 
undertaking predominantly involves the provision of property to a 
recipient undertaking if the supplier undertaking provides more than 50 
percent of its property to such recipient undertaking. In addition, 
paragraph (f)(4)(iii)(A)(1) of this section provides that if a supplier 
undertaking and two or more similar recipient undertakings are 
controlled by the same interests, the recipient undertakings are treated 
as a single undertaking for purposes of applying paragraph 
(f)(4)(iii)(A) of this section. Undertakings D and E both provide dairy 
products to undertakings A, B, and C. Thus, for purposes of paragraph 
(f)(4)(iii) of this section, undertakings D and E are supplier 
undertakings and undertakings A, B, and C are recipient undertakings. 
Undertaking D predominantly involves the provision of property to 
undertakings A, B, and C. Moreover, undertakings A, B, and C are treated 
as a single undertaking under paragraph (f)(4)(iii)(A)(1) of this 
section because undertakings A, B, and C are similar to one another 
under paragraph (f)(4)(i) of this section, and undertakings A, B, C, and 
D are controlled by the same interests. Accordingly, paragraph 
(f)(4)(iii)(A) of this section applies to undertakings A, B, C, and D.
    (iii) If paragraph (f)(4)(iii)(A) of this section applies to 
supplier and recipient undertakings, the supplier undertaking is treated 
under paragraph (f)(4)(iii) (A) and (C)(2) of this section as an 
undertaking that is similar to the recipient undertakings and to 
undertakings to which the recipient undertakings are similar. 
Accordingly, undertaking D is similar, for purposes of this paragraph 
(f), to undertakings A, B, and C.
    (iv) Undertaking E does not predominantly involve the provision of 
property to undertakings A, B, and C, or to any other related 
undertakings. Thus, paragraph (f)(4)(iii)(A) of this section does not 
apply to undertaking

[[Page 478]]

E, and undertaking E is not similar to undertakings A, B, and C. 
Moreover, undertakings D and E are not similar because, under paragraph 
(f)(4)(iii)(C)(2) of this section, undertaking D is not similar to any 
undertaking that is not similar to undertakings A, B, and C.
    Example (11). (i) The facts are the same as in example (10), except 
that 75 percent of undertaking D's dairy products are sold to 
undertakings A and B, and none are sold to undertaking C.
    (ii) In this case, undertaking D is a supplier undertaking only with 
respect to undertakings A and B. Accordingly, paragraph (f)(4)(iii)(A) 
applies only to undertakings A, B, and D. As in example (10), 
undertaking D is similar to undertakings A and B, and is not similar to 
undertaking E. In addition, if paragraph (f)(4)(iii)(A) of this section 
applies to supplier and recipient undertakings, the supplier undertaking 
is treated under paragraph (f)(4)(iii)(C)(2) of this section as an 
undertaking that is similar to the recipient undertakings and 
undertakings to which the recipient undertakings are similar. 
Accordingly, even though undertaking D does not provide any property or 
services to undertaking C, undertaking D is similar to undertaking C 
because undertaking C is similar to undertakings A and B.
    Example (12). (i) The facts are the same as in example (9), except 
that undertakings A and B purchase 80 percent of their inventory from 
undertaking D.
    (ii) Paragraph (f)(4)(iii)(B) of this section applies, except as 
provided in paragraph (f)(4)(iii)(C) of this section, if a supplier 
undertaking is the predominant provider of property to a recipient 
undertaking that is controlled by the same interests. Undertakings D and 
E both provide dairy products to undertakings A, B, and C. Thus, for 
purposes of paragraph (f)(4)(iii) of this section, undertakings D and E 
are supplier undertakings, and undertakings A, B, and C are recipient 
undertakings. In addition, undertaking D is the predominant provider of 
property and services to undertakings A and B, and undertakings A, B and 
D are controlled by the same interests. Thus, except as provided in 
paragraph (f)(4)(iii)(C) of this section, paragraph (f)(4)(iii)(B) of 
this section applies to undertakings A, B, and D.
    (iii) The coordination rules in paragraph (f)(4)(iii)(C)(1) of this 
section provide that paragraph (f)(4)(iii)(B) of this section does not 
apply in certain cases to which paragraph (f)(4)(iii)(A) of this section 
applies. These coordination rules would apply if undertaking D or E (or 
any other undertaking that is controlled by the interests that control 
undertakings A, B, and C) predominantly involved the provision of 
property and services to undertakings A, B, and C. The coordination 
rules in paragraph (f)(4)(iii)(C)(1) of this section would also apply if 
undertaking A, B, or D predominantly involved the provision of property 
or services to a recipient undertaking that is controlled by the same 
interests. Assume that these coordination rules do not apply in this 
case.
    (iv) If paragraph (f)(4)(iii)(B) of this section applies to supplier 
and recipient undertakings, the recipient undertakings are treated under 
paragraph (f)(4)(iii) (B) and (C)(3) of this section as undertakings 
that are similar to the supplier undertaking and to undertakings to 
which the supplier undertaking is similar. Accordingly, undertakings A 
and B are similar, for purposes of this paragraph (f), to undertaking D 
and, because undertakings D and E are similar, to undertaking E.
    (v) The principal providers of property and services to undertaking 
C are unrelated undertakings. Thus, paragraph (f)(4)(iii)(B) of this 
section does not apply to undertaking C, and undertaking C is not 
similar to undertakings D and E. Moreover, undertaking C is not similar 
to undertakings A and B because, under paragraph (f)(4)(iii)(C)(3) of 
this section, undertakings A and B are not similar to any undertaking 
that is not similar to undertaking D.
    Example (13). (i) Undertakings A through Z are trade or business 
undertakings (within the meaning of paragraph (f)(1)(ii) of this 
section) and are controlled by the same interests (within the meaning of 
paragraph (j) of this section). Undertaking A derives all of its gross 
income from the manufacture and sale of men's and women's clothing, 
undertaking B derives all of its gross income from sales of men's and 
women's clothing to retail stores, and undertakings C through Z derive 
all of their gross income from retail sales of men's and women's 
clothing. Undertaking A sells clothing exclusively to undertaking B. 
Undertaking B sells 75 percent of its clothing to undertakings C through 
Z, and sells the remainder to unrelated retail stores. Undertaking B 
purchases 80 percent of its inventory from undertaking A, and 
undertakings C through Z purchase 60 to 90 percent of their inventory 
from undertaking B.
    (ii) Paragraph (f)(4)(iii)(A) of this section applies if a supplier 
undertaking predominantly involves the provision of property to a 
recipient undertaking that is controlled by the same interests. In 
addition, paragraph (f)(4)(iii)(A)(1) of this section provides that if a 
supplier undertaking and two or more similar recipient undertakings are 
controlled by the same interests, the recipient undertaking are treated 
as a single undertaking for this purpose. Undertaking B provides men's 
and women's clothing to undertaking C through Z. Thus, for purposes of

[[Page 479]]

paragraph (f)(4)(iii) of this section, undertaking B is a supplier 
undertaking and undertakings C through Z are recipient undertakings. In 
addition, undertaking B predominantly involves the provision of property 
to undertakings C through Z, and undertakings C through Z are treated as 
a single undertaking for purposes of paragraph (f)(4)(iii)(A) of this 
section. Accordingly, paragraph (f)(4)(iii)(A) of this section applies 
to undertakings B and C through Z.
    (iii) If paragraph (f)(4)(iii)(A) of this section applies to 
supplier and recipient undertakings, the supplier undertaking is treated 
under paragraph (f)(4)(iii)(A) of this section as an undertaking that is 
similar to the recipient undertakings. Accordingly, undertaking B is 
similar, for purposes of this paragraph (f), to undertakings C through 
Z.
    (iv) Undertaking A provides men's and women's clothing to 
undertaking B. Thus, for purposes of paragraph (f)(4)(iii) of this 
section, undertaking A is a supplier undertaking and undertaking B is a 
recipient undertaking. In addition, undertaking A predominantly involves 
the provision of property to undertaking B, and undertakings A and B are 
controlled by the same interests. Accordingly, paragraph (f)(4)(iii)(A) 
of this section applies to undertakings A and B, and undertaking A is 
similar to undertaking B.
    (v) If paragraph (f)(4)(iii)(A) of this section applies to supplier 
and recipient undertakings, the supplier undertaking is treated under 
paragraph (f)(4)(iii)(C)(2) of this section as an undertaking that is 
similar to undertakings to which the recipient undertakings are similar. 
Accordingly, undertaking A is also similar, for purposes of this 
paragraph (f), to undertakings C through Z.
    (vi) The coordination rule in paragraph (f)(4)(iii)(C)(1)(i) of this 
section provides that paragraph (f)(4)(iii)(B) of this section does not 
apply if, as described above, the supplier undertaking predominantly 
involves the provision of property to recipient undertakings and is 
treated under paragraph (f)(4)(iii)(A) of this section as an undertaking 
that is similar to such recipient undertakings. Accordingly, paragraph 
(f)(4)(iii)(B) of this section does not apply to undertakings B through 
Z, even though undertaking B is the predominant provider of property and 
services to undertakings C through Z, and undertakings B through Z are 
controlled by the same interests. For the same reason, paragraph 
(f)(4)(iii)(B) of this section does not apply to undertaking A and B. 
(Paragraph (f)(4)(iii)(B) of this section is also inapplicable to 
undertakings A and B because the coordination rule in paragraph 
(f)(4)(iii)(C)(1)(ii) of this section applies if the recipient 
undertaking (undertaking B) is itself a supplier undertaking that is 
treated under paragraph (f)(4)(iii)(A) of this section as an undertaking 
that is similar to its recipient undertakings (undertakings C through 
Z).)

    (g) Integrated businesses--(1) Applicability--(i) In general. This 
paragraph (g) applies to a taxpayer's interests in trade or business 
activities (within the meaning of paragraph (g)(1)(ii) of this section).
    (ii) Trade or business activity. For purposes of this paragraph (g), 
the term ``trade or business activity'' means any activity (determined 
without regard to this paragraph (g)) that consists of interests in one 
or more trade or business undertakings (within the meaning of paragraph 
(f)(1)(ii) of this section).
    (2) Treatment as a single activity. A taxpayer's interests in two or 
more trade or business activities shall be treated as a single activity 
if and only if--
    (i) The operations of such trade or business activities constitute a 
single integrated business, activities constitute a single integrated 
business; and
    (ii) Such activities are controlled by the same interests (within 
the meaning of paragraph (j) of this section).
    (3) Facts and circumstances test. In determining whether the 
operations of two or more trade or business activities constitute a 
single integrated business for purposes of this paragraph (g), all the 
facts and circumstances are taken into account, and the following 
factors are generally the most significant:
    (i) Whether such operations are conducted at the same location;
    (ii) The extent to which other persons conduct similar operations at 
one location;
    (iii) Whether such operations are treated as a unit in the primary 
accounting records reflecting the results of such operations;
    (iv) The extent to which other persons treat similar operations as a 
unit in the primary accounting records reflecting the results of such 
similar operations;
    (v) Whether such operations are owned by the same person (within the 
meaning of paragraph (c)(2)(v) of this section);
    (vi) The extent to which such operations involve products or 
services that are commonly provided together;

[[Page 480]]

    (vii) The extent to which such operations serve the same customers;
    (viii) The extent to which the same personnel, facilities, or 
equipment are used to conduct such operations;
    (ix) The extent to which such operations are conducted in 
coordination with or reliance upon each other;
    (x) The extent to which the conduct of any such operations is 
incidental to the conduct of the remainder of such operations;
    (xi) The extent to which such operations depend on each other for 
their economic success; and
    (xii) Whether such operations are conducted under the same trade 
name.
    (4) Examples. The following examples illustrate the application of 
this paragraph (g). The facts, analysis, and conclusion in each example 
relate to a single taxable year, and the trade or business activities 
described in each example are controlled by the same interests (within 
the meaning of paragraph (j) of this section).

    Example (1). (i) The taxpayer owns a number of department stores and 
auto-supply stores. Some of the taxpayer's department stores include 
auto-supply departments. In other cases, the taxpayer operates a 
department store and an auto-supply store at the same location (within 
the meaning of paragraph (c)(2)(iii) of this section), or at different 
locations from which the same group of customers can be served. In cases 
in which a department store and an auto-supply store are operated at the 
same location, the department-store operations are the predominant 
operations (within the meaning of paragraph (f)(4)(ii) of this section), 
and the undertaking that includes the stores is treated as a department-
store undertaking for purposes of paragraph (f) of this section. Under 
paragraph (f) of this section, the department-store undertakings are all 
treated as part of the same activity of the taxpayer (the ``department-
store activity''). Similarly, the auto-supply undertakings (i.e., the 
auto-supply stores that are not operated at a department-store location) 
are all treated as part of the same activity (the ``auto-supply 
activity''). (Assume that department-store undertakings and auto-supply 
undertakings are not similar and are not treated as part of the same 
activity under paragraph (f) of this section.)
    (ii) The department stores and auto-supply stores use a common trade 
name and coordinate their marketing activities (e.g., the stores 
advertise in the same catalog and the same newspaper supplements, honor 
the same credit cards (including credit cards issued by the department 
stores), and jointly conduct sales and other promotional activities). 
Although sales personnel generally work only in a particular store or in 
a particular department within a store, other employees (e.g., cashiers, 
janitorial and maintenance workers, and clerical staff) may work in or 
perform services for various stores, including both department and auto-
supply stores. In addition, the management of store operations is 
organized on a geographical basis, and managers above the level of the 
individual store generally supervise operations in both types of store. 
A central office provides payroll, financial, and other support services 
to all stores and establishes pricing and other business policies. Most 
inventory for both types of stores is acquired through a central 
purchasing department and inventory for all stores in an area is stored 
in a common warehouse.
    (iii) Based on the foregoing facts and circumstances, the operations 
of the department-store activity and the auto-supply activity constitute 
an integrated business. Paragraph (g)(3) of this section provides that 
the factors relevant to this determination include the conduct of 
department-store and auto-supply operations at the same location, the 
location of department and auto-supply stores at sites where the same 
group of customers can be served, the treatment of all such operations 
as a unit in the taxpayer's financial statements, the taxpayer's 
ownership and the common management of all such operations, the use of 
the same personnel, facilities, and equipment to conduct and support the 
operations, the use of a common trade name, and the coordination (as 
evidenced by the coordinated marketing activities) of department-store 
and auto-supply operations.
    (iv) Paragraph (g)(2) of this section provides that a taxpayer's 
interests in two or more trade or business activities (within the 
meaning of paragraph (g)(1)(ii) of this section) are treated as a single 
activity of the taxpayer if the operations of such activities constitute 
an integrated business and the activities are controlled by the same 
interests. The department-store activity and the auto-supply activity 
consist of trade or business undertakings and, thus, are trade or 
business activities. In addition, the activities are controlled by the 
same interests (the taxpayer), and the operations of the activities 
constitute an integrated business. Accordingly, the department-store 
activity and the auto-supply activity are treated as a single activity 
of the taxpayer.
    Example (2). (i) The taxpayer owns a number of stores that sell 
stereo equipment and a repair shop that services stereo equipment. Under 
paragraph (f) of this section, the stores are all treated as part of the 
same activity of the taxpayer (the ``store activity'').

[[Page 481]]

The repair shop does not sell stereo equipment, does not predominantly 
involve the provision of services to the taxpayer's stores, and is 
treated as a separate activity (the ``repair-shop activity''). (Assume 
that stereo-sales undertakings and stereo-repair undertakings are not 
similar and are not treated as part of the same activity under paragraph 
(f) of this section.)
    (ii) The stores sell stereo equipment produced by manufacturers for 
which the stores are an authorized distributor. The repair shop's 
operations principally involve the servicing of stereo equipment 
produced by the same manufacturers. These operations include repairs on 
equipment under warranty for which reimbursement is received from the 
manufacturer and reconditioning of equipment taken as trade-ins by the 
taxpayer's stores. The majority of the operations, however, involve 
repairs that are performed for customers and are not covered by a 
warranty. The taxpayer's distribution agreements with manufacturers 
generally require the taxpayer to repair and service equipment produced 
by the manufacturer both during and after the warranty period. In some 
cases, the distribution agreements require that the taxpayer's repair 
facility meet the manufacturer's standards and provide for periodic 
inspections to ensure that these standards are met.
    (iii) The stores and the repair shop use a common trade name. Sales 
personnel generally work only in a particular store and stereo 
technicians work only in the repair shop. The stores and the repair shop 
are, however, managed from a central office, which supervises both store 
and repair-shop operations, provides payroll, financial, and other 
support services to the stores and the repair shop, and establishes 
pricing and other business policies. In addition, inventory for the 
stores and supplies for the repair shop are acquired through a central 
purchasing department and are stored in a single warehouse.
    (iv) Based on the foregoing facts and circumstances, the operations 
of the store activity and the repair-shop activity constitute an 
integrated business. Paragraph (g)(3) of this section provides that the 
factors relevant to this determination include the treatment of all such 
operations as a unit in the taxpayer's financial statements, the 
taxpayer's ownership and the common management of all such operations, 
the use of the same personnel and facilities to support the operations, 
the use of a common trade name, the extent to which the same customers 
patronize both the stores and the repair shop, the similarity of the 
products (i.e., stereo equipment) involved in both store and repair-shop 
operations, and the extent to which the provision of repair services 
contributes to the taxpayer's ability to obtain the stereo equipment 
sold in store operations.
    (v) Paragraph (g)(2) of this section provides that a taxpayer's 
interests in two or more trade or business activities (within the 
meaning of paragraph (g)(1)(ii) of this section) are treated as a single 
activity of the taxpayer if the operations of such activities constitute 
an integrated business and the activities are controlled by the same 
interests. The store activity and repair-shop activity consist of trade 
or business undertakings and thus are trade or business activities. In 
addition, the activities are controlled by the same interests (the 
taxpayer), and the operations of the activities constitute an integrated 
business. Accordingly, the store activity and the repair-shop activity 
are treated as a single activity of the taxpayer.
    Example (3). (i) The taxpayer owns interests in three partnerships. 
One partnership owns a television station, the second owns a 
professional sports franchise, and the third owns a motion-picture 
production company. The operations of the partnerships are treated as 
three separate undertakings. Although other persons own interests in the 
partnerships, all three undertakings are controlled (within the meaning 
of paragraph (j) of this section) by the taxpayer. The operations of the 
partnerships are treated as three separate activities (the ``television 
activity,'' the ``sports activity,'' and the ``motion-picture 
activity''). (Assume that the undertakings are not similar and are not 
treated as part of the same activity under paragraph (f) of this 
section.)
    (ii) Each partnership prepares financial statements that reflect 
only the results of that partnership's operations, and each of the 
activities is conducted under its own trade name. The taxpayer 
participates extensively in the management of each partnership and makes 
the major business decisions for all three partnerships. Each 
partnership, however, employs separate management and other personnel 
who conduct its operations on a day-to-day basis. The taxpayer generally 
arranges the partnerships' financing and often obtains loans for two, or 
all three, partnerships from the same source. Although the assets of one 
partnership are not used as security for loans to another partnership, 
the taxpayer's interest in a partnership may secure loans to the other 
partnerships. The television station broadcasts the sports franchise's 
games, and the motion-picture production company occasionally prepares 
programming for the television station. In addition, support staff of 
one partnership may, during periods of peak activity or in the case of 
emergency, be made available to another partnership on a temporary 
basis. There are no other significant transactions between the 
partnerships. Moreover, all transactions between the partnerships 
involve essentially

[[Page 482]]

the same terms as would be provided in transactions between unrelated 
persons.
    (iii) Based on the foregoing facts and circumstances, the television 
activity, the sports activity, and the motion-picture activity 
constitute three separate businesses. Paragraph (g)(3) of this section 
provides that the factors relevant to this determination include the 
treatment of the activities as separate units in the partnerships' 
financial statements, the use of a different trade name for each 
activity, the separate day-to-day management of the activities, and the 
limited extent to which the activities contribute to or depend on each 
other (as evidenced by the small number of significant transactions 
between the partnerships and the arm's length nature of those 
transactions). The taxpayer's participation in management and financing 
are taken into account in this determination, as are the transactions 
between the partnerships, but these factors do not of themselves support 
a determination that the activities constitute an integrated business.
    (iv) Paragraph (g)(2) of this section provides that a taxpayer's 
interests in two or more trade or business activities (within the 
meaning of paragraph (g)(1)(ii) of this section) are treated as a single 
activity of the taxpayer only if the operations of such activities 
constitute an integrated business and the activities are controlled by 
the same interests. In this case, the taxpayer's activities do not 
constitute an integrated business, and the aggregation rule in paragraph 
(g)(2) of this section does not apply. Accordingly, the television 
activity, the sports activity, and the motion-picture activity are 
treated as three separate activities of the taxpayer.

    (h) Certain professional service undertakings treated as a single 
activity--(1) Applicability--(i) In general. This paragraph (h) applies 
to a taxpayer's interests in professional service undertakings (within 
the meaning of paragraph (h)(1)(ii) of this section).
    (ii) Professional service undertaking. For purposes of this 
paragraph (h), an undertaking is treated as a professional service 
undertaking for any taxable year in which the undertaking derives more 
than 50 percent of its gross income from the provision of services that 
are treated, for purposes of section 448 (d)(2)(A) and the regulations 
thereunder, as services performed in the fields of health, law, 
engineering, architecture, accounting, actuarial science, performing 
arts, or consulting.
    (2) Treatment as a single activity--(i) Undertakings controlled by 
the same interest. A taxpayer's interests in two or more professional 
service undertakings that are controlled by the same interests (within 
the meaning of paragraph (j) of this section) shall be treated as part 
of the same activity of the taxpayer.
    (ii) Undertakings involving significant similar or significant 
related services. A taxpayer's interests in two or more professional 
service undertakings that involve the provision of significant similar 
services or significant related services shall be treated as part of the 
same activity of the taxpayer.
    (iii) Coordination rule. (A) Except as provided in paragraph 
(h)(2)(iii)(B) of this section, a taxpayer's interests in two or more 
undertakings (the ``original undertakings'') that are treated as part of 
the same activity of the taxpayer under the provisions of paragraph 
(h)(2) (i) or (ii) of this section shall be treated as interests in a 
single professional service undertaking (the ``aggregated undertaking'') 
for purposes of reapplying such provisions.
    (B) If any original undertaking included in an aggregated 
undertaking and any other undertaking that is not included in such 
aggregated undertaking involve the provision of significant similar or 
related services, the aggregated undertaking and such other undertaking 
shall be treated as undertakings that involve the provision of 
significant similar or related services for purposes of reapplying the 
provisions of paragraph (h)(2)(ii) of this section.
    (3) Significant similar or significant related services. For 
purposes of this paragraph (h)--
    (i) Services (other than consulting services) in any field described 
in paragraph (h)(1)(ii) of this section are similar to all other 
services in the same field;
    (ii) All the facts and circumstances are taken into account in 
determining whether consulting services are similar;
    (iii) Two professional service undertakings involve the provision of 
significant similar services if and only if--
    (A) Each such undertaking provides significant professional 
services; and
    (B) Significant professional services provided by one such 
undertaking are

[[Page 483]]

similar to significant professional services provided by the other such 
undertaking;
    (iv) Services are significant professional services if and only if 
such services are in a field described in paragraph (h)(1)(ii) of this 
section and more than 20 percent of the undertaking's gross income is 
attributable to services in such field (or, in the case of consulting 
services, to similar services in such field); and
    (v) Two professional service undertakings involve the provision of 
significant related services if and only if more than 20 percent of the 
gross income of one such undertaking is derived from customers that are 
also customers of the other such undertaking.
    (4) Examples. The following examples illustrate the application of 
this paragraph (h). In each example that does not state otherwise, the 
taxpayer is an individual, and the facts, analysis, and conclusions 
relate to a single taxable year.

    Example (1). (i) The taxpayer is a partner in a law partnership that 
has offices in various cities. Some of the partnership's offices provide 
a full range of legal services. Other offices, however, specialize in a 
particular area or areas of the law (e.g., litigation, tax law, 
corporate law, etc.). In either case, substantially all of the office's 
gross income is derived from the provision of legal services. Under 
paragraph (c)(1) of this section, each of the law partnership's offices 
is treated as a single undertaking that is separate from other 
undertakings (a ``law-office undertaking'').
    (ii) Each law-office undertaking derives more than 50 percent of its 
gross income from the provision of services in the field law. Thus, each 
such undertaking is treated as a professional service undertaking 
(within the meaning of paragraph (h)(1)(ii) of this section).
    (iii) Each law-office undertaking derives more than 20 percent of 
its gross income from services in the field of law. Thus, each such 
undertaking involves significant professional services (within the 
meaning of paragraph (h)(3)(iv) of this section) in the field of law. In 
addition, all services in the field of law are treated as similar 
services under paragraph (h)(3)(i) of this section. Thus, the law-office 
undertakings involve the provision of significant similar services 
(within the meaning of paragraph (h)(3)(iii) of this section).
    (iv) Paragraph (h)(2)(ii) of this section provides that a taxpayer's 
interest in professional service undertakings that involve the provision 
of significant similar services are treated as part of the same activity 
of the taxpayer. Accordingly, the taxpayer's interests in the law-office 
undertakings are treated as part of the same activity of the taxpayer 
under paragraph (h)(2)(ii) of this section even if the undertakings are 
not controlled by the same interests (within the meaning of paragraph 
(j) of this section).
    Example (2). (i) The taxpayer is a partner in medical partnerships A 
and B. Both partnerships derive all of their gross income from the 
provision of medical services, but partnership A specializes in internal 
medicine and partnership B operates a radiology laboratory. Under 
paragraph (c)(1) of this section, the medical-service business of each 
partnership is treated as a single undertaking that is separate from 
other undertakings (a ``medical-service undertaking''). Partnerships A 
and B are not controlled by the same interests (within the meaning of 
paragraph (j) of this section).
    (ii) Each partnership's medical-service undertaking derives more 
than 50 percent of its gross income from the provision of services in 
the field of health. Thus, each partnership's medical-service 
undertaking is treated as a professional service undertaking (within the 
meaning of paragraph (h)(1)(ii) of this section).
    (iii) Each partnership's medical-service undertaking derives more 
than 20 percent of its gross income from services in the field of 
health. Thus, each such undertaking involves significant professional 
services (within the meaning of paragraph (h)(3)(iv) of this section) in 
the field of health. In addition, all services in the field of health 
are treated as similar services under paragraph (h)(3)(i) of this 
section. Thus, the medical-services undertakings of partnerships A and B 
involve the provision of significant similar services (within the 
meaning of paragraph (h)(3)(iii) of this section).
    (iv) Paragraph (h)(2)(ii) of this section provides that a taxpayer's 
interests in professional service undertakings that involve the 
provision of significant similar services are treated as part of the 
same activity of the taxpayer. Accordingly, the taxpayer's interests in 
the medical-service undertakings of partnerships A and B are treated as 
part of the same activity of the taxpayer under paragraph (h)(2)(ii) of 
this section even though the undertakings are not controlled by the same 
interests.
    Example (3). (i) The facts are the same as in example (2), except 
that the taxpayer withdraws from partnership A in 1989 and becomes a 
partner in partnership B in 1990. In addition, the taxpayer was a full-
time participant in the operations of partnership A from 1970 through 
1989, but does not participate in the operations of partnership B.

[[Page 484]]

    (ii) Paragraph (h)(2)(ii) of this section provides that a taxpayer's 
interests in professional service undertakings that involve the 
provision of significant similar services are treated as part of the 
same activity of the taxpayer. This rule is not limited to cases in 
which the taxpayer holds such interests simultaneously. Thus, as in 
example (2), the taxpayer's interests in the medical-service 
undertakings of partnerships A and B are treated as part of the same 
activity of the taxpayer.
    (iii) The activity that includes the taxpayer's interests in the 
medical-service undertakings of partnerships A and B is a personal 
service activity (within the meaning of Sec. 1.469-5T(d)) because it 
involves the performance of personal services in the field of health. In 
addition, the taxpayer materially participated in the activity for three 
or more taxable years preceding 1990 (see Sec. 1.469-5T(j)(1)). Thus, 
even if the taxpayer does not work in the activity after 1989, the 
taxpayer is treated, under Sec. 1.469-5T(a)(6), as materially 
participating in the activity for 1990 and subsequent taxable years.
    Example (4). (i) The taxpayer is a partner in an accounting 
partnership that has offices in various cities (partnership A) and in a 
management-consulting partnership that has a single office (partnership 
B). Each of partnership A's offices derives substantially all of its 
gross income from services in the field of accounting, and partnership B 
derives substantially all of its gross income from services in the field 
of consulting. Under paragraph (c)(1) of this section, partnership B's 
consulting business is treated as a single undertaking that is separate 
from other undertakings (the ``consulting undertaking'') and each of 
partnership A's offices is similarly treated (the ``accounting 
undertakings''). The accounting undertakings are controlled by the same 
interests, but partnerships A and B are not controlled by the same 
interests (within the meaning of paragraph (j) of this section). 
Partnership B's consulting business derives 50 percent of its gross 
income from customers of partnership A's accounting undertakings, but 
does not derive more than 20 percent of its gross income from the 
customers of any single accounting undertaking.
    (ii) Each accounting undertaking derives more than 50 percent of its 
gross income from the provision of services in the field of accounting, 
and the consulting undertaking derives more than 50 percent of its gross 
income from the provision of services in the field of consulting. Thus, 
each accounting undertaking is treated as a professional service 
undertaking (within the meaning of paragraph (h)(1)(ii) of this 
section), and the consulting undertaking is also treated as a 
professional service undertaking.
    (iii) Each accounting undertaking derives more than 20 percent of 
its gross income from services in the field of accounting. Thus, each 
such undertaking involves significant professional services (within the 
meaning of paragraph (h)(3)(iv) of this section) in the field of 
accounting. In addition, all services in the field of accounting are 
treated as similar services under paragraph (h)(3)(i) of this section. 
Thus, the accounting undertakings involve the provision of significant 
similar services (within the meaning of paragraph (h)(3)(iii) of this 
section).
    (iv) Paragraph (h)(2) (i) and (ii) of this section provides that a 
taxpayer's interests in professional service undertakings that are 
controlled by the same interests or that involve the provision of 
significant similar services are treated as part of the same activity of 
the taxpayer. The accounting undertakings are controlled by the same 
interests (see (i) above) and involve the provision of significant 
similar services (see (iii) above). Accordingly, the taxpayer's 
interests in the accounting undertakings are treated as part of the same 
activity under paragraph (h)(2) (i) and (ii) of this section.
    (v) The consulting undertaking derives more than 20 percent of its 
gross income from services in the field of consulting. If, based on all 
the facts and circumstances, these services are determined to be similar 
consulting services under paragraph (h)(3)(ii) of this section, the 
consulting undertaking involves significant professional services 
(within the meaning of paragraph (h)(3)(iv) of this section). In this 
case, however, the consulting undertaking and the accounting 
undertakings do not involve the provision of significant similar 
services (within the meaning of paragraph (h)(3)(iii) of this section) 
because consulting services and accounting services are not treated as 
similar services under paragraph (h)(3)(i) of this section.
    (vi) The consulting undertaking does not derive more than 20 percent 
of its gross income from the customers of any single accounting 
undertaking of partnership A. If, however, partnership A's accounting 
undertakings are aggregated, the consulting undertaking derives more 
than 20 percent of its gross income from customers of the aggregated 
undertakings. Paragraph (h)(3)(v) of this section provides that two 
professional service undertakings involve the provision of significant 
related services if more than 20 percent of the gross income of one 
undertaking is derived from customers of the other undertaking. For 
purposes of applying this rule, partnership A's accounting undertakings 
are treated as a single undertaking under paragraph (h)(2)(iii) of this 
section because the accounting undertakings are treated as part of the 
same activity under paragraph (h)(2)(i) and (ii) of this section. Thus, 
the consulting undertaking and the accounting undertakings involve the 
provision of significant related services.

[[Page 485]]

    (vii) Paragraph (h)(2)(ii) of this section provides that a 
taxpayer's interests in professional service undertakings that involve 
the provision of significant related services are treated as part of the 
same activity of the taxpayer. Accordingly, the taxpayer's interests in 
the consulting undertaking and the accounting undertakings are treated 
as part of the same activity of the taxpayer under paragraph (h)(2)(ii) 
of this section.
    Example (5). (i) The facts are the same as in example (4), except 
that partnership B's consulting business derives only 15 percent of its 
gross income from customers of partnership A's accounting undertakings.
    (ii) As in example (4), the taxpayer's interests in the accounting 
undertakings are treated as part of the same activity under paragraph 
(h)(2)(i) and (ii) of this section and are treated under paragraph 
(h)(2)(iii) of this section as a single undertaking for purposes of 
reapplying those provisions. In this case, however, the consulting 
undertaking does not derive more than 20 percent of its gross income 
from the customers of partnership A's accounting undertakings. Thus, the 
consulting undertaking and the accounting undertakings do not involve 
the provision of significant related services. Accordingly, the 
accounting undertakings and the consulting undertaking are not treated 
as part of the same activity under paragraph (h)(2)(i) or (ii) of this 
section because they are not controlled by the same interests and do not 
involve the provision of significant similar or related services.
    Example (6). (i) The taxpayer is a partner in partnerships A, B, and 
C. Partnership A derives substantially all of its gross income from the 
provision of engineering services, partnership B derives substantially 
all of its gross income from the provision of architectural services, 
and partnership C derives 40 percent of its gross income from the 
provision of engineering services and the remainder from the provision 
of architectural services. Under paragraph (c)(1) of this section, each 
partnership's service business is treated as a single undertaking that 
is separate from other undertakings. Partnerships A, B, and C are not 
controlled by the same interests (within the meaning of paragraph (j) of 
this section).
    (ii) Each partnership's undertaking derives more than 50 percent of 
its gross income from the provision of services in the fields of 
architecture and engineering. Thus, each such undertaking is treated as 
a professional service undertaking (within the meaning of paragraph 
(h)(1)(ii) of this section).
    (iii) Partnership A's undertaking (``undertaking A'') derives more 
than 20 percent of its gross income from services in the field of 
engineering, partnership B's undertaking (``undertaking B'') derives 
more than 20 percent of its gross income from services in the field of 
architecture, and partnership C's undertaking (``undertaking C'') 
derives more than 20 percent of its gross income from services in the 
field of engineering and more than 20 percent of its gross income from 
services in the field of architecture. Thus, undertaking A involves 
significant services in the field of engineering, undertaking B involves 
significant services in the field of architecture, and undertaking C 
involves significant services in both fields. Under paragraph (h)(3)(i) 
of this section, all services within each field are treated as similar 
services, but engineering services and architectural services are not 
treated as similar services. Thus, undertakings A and C, and 
undertakings B and C, involve the provision of significant similar 
services (within the meaning of paragraph (h)(3)(iii) of this section).
    (iv) Paragraph (h)(2)(ii) of this section provides that a taxpayer's 
interests in professional service undertakings that involve the 
provision of significant similar services are treated as part of the 
same activity of the taxpayer. Accordingly, the taxpayer's interests in 
undertakings A and C are treated as part of the same activity of the 
taxpayer.
    (v) Under paragraph (h)(2)(iii)(A) of this section, undertakings A 
and C are also treated as a single undertaking for purposes of 
determining whether undertaking B involves the provision of significant 
similar services. Paragraph (h)(2)(iii)(B) of this section in effect 
provides that treating undertakings A and C as a single undertaking does 
not affect the conclusion that the architectural services provided by 
undertakings B and C are significant similar services. Thus, undertaking 
B and the single undertaking in which undertakings A and C are included 
under paragraph (h)(3)(iii) of this section involve the provision of 
significant similar services, and the taxpayer's interests in 
undertakings A, B, and C are treated as part of the same activity of the 
taxpayer under paragraph (h)(2)(ii) of this section.

    (i) [Reserved]
    (j) Control by the same interests and ownership percentage--(1) In 
general. Except as otherwise provided in paragraph (j)(2) of this 
section, all the facts and circumstances are taken into account in 
determining, for purposes of this section, whether undertakings are 
controlled by the same interests. For this purpose, control includes any 
kind of control, direct or indirect, whether legally enforceable, and 
however exercisable or exercised. It is the reality of control that is 
determinative, and not its form or mode of exercise.
    (2) Presumption--(i) In general. Undertakings are rebuttably 
presumed to be controlled by the same interests if such

[[Page 486]]

undertakings are part of the same common-ownership group.
    (ii) Common-ownership group. Except as provided in paragraph 
(j)(2)(iii) of this section, two or more undertakings of a taxpayer are 
part of the same common-ownership group for purposes of this paragraph 
(j)(2) if and only if the sum of the common-ownership percentages of any 
five or fewer persons (within the meaning of section 7701(a)(1), but not 
including passthrough entities) with respect to such undertakings 
exceeds 50 percent. For this purpose, the common-ownership percentage of 
a person with respect to such undertakings is the person's smallest 
ownership percentage (determined in accordance with paragraph (j)(3) of 
this section) in any such undertaking.
    (iii) Special aggregation rule. If, without regard to this paragraph 
(j)(2)(iii), an undertaking of a taxpayer is part of two or more common-
ownership groups, any undertakings of the taxpayer that are part of any 
such common-ownership group shall be treated for purposes of this 
paragraph (j)(2) as part of a single common-ownership group in 
determining the activities of such taxpayer.
    (3) Ownership percentage--(i) In general. For purposes of this 
section, a person's ownership percentage in an undertaking or in a 
passthrough entity shall include any interest in such undertaking or 
passthrough entity that the person holds directly and the person's share 
of any interest in such undertaking or passthrough entity that is held 
through one or more passthrough entities.
    (ii) Passthrough entities. The following rules apply for purposes of 
applying paragraph (j)(3)(i) of this section:
    (A) A partner's interest in a partnership and share of any interest 
in a passthrough entity or undertaking held through a partnership shall 
be determined on the basis of the greater of such partner's percentage 
interest in the capital (by value) of such partnership or such partner's 
largest distributive share of any item of income or gain (disregarding 
guaranteed payments under section 707(c)) of such partnership.
    (B) A shareholder's interest in an S corporation and share of any 
interest in a passthrough entity or undertaking held through an S 
corporation shall be determined on the basis of such shareholder's stock 
ownership.
    (C) A beneficiary's interest in a trust or estate and share of any 
interest in a passthrough entity or undertaking held through a trust or 
estate shall not be taken into account.
    (iii) Attribution rules--(A) In general. Except as otherwise 
provided in paragraph (j)(3)(iii)(B) of this section, a person's 
ownership percentage in a passthrough entity or in an undertaking shall 
be determined by treating such person as the owner of any interest that 
a person related to such person owns (determined without regard to this 
paragraph (j)(3)(iii)) in such passthrough entity or in such 
undertaking.
    (B) Determination of common-ownership percentage. The common-
ownership percentage of five or fewer persons with respect to two or 
more undertakings shall be determined, in any case in which, after the 
application of paragraph (j)(3)(iii)(A) of this section, two or more 
such persons own the same interest in any such undertaking (the 
``related-party owners'') by treating as the only owner of such interest 
(or portion thereof) the related-party owner whose ownership of such 
interest (or a portion thereof) would result in the highest common-
ownership percentage.
    (C) Related person. A person is related to another person for 
purposes of this paragraph (j)(3)(iii) if the relationship of such 
persons is described in section 267(b) or 707(b)(1).
    (4) Special rule for trade or business activities. In determining 
whether two or more trade or business activities are controlled by the 
same interests for purposes of paragraph (g) of this section, each such 
activity shall be treated as a separate undertaking in applying this 
paragraph (j).
    (5) Examples. The following examples illustrate the application of 
this paragraph (j):

    Example (1). (i) Partnership X is the sole owner of an undertaking 
(undertaking X), and partnership Y is the sole owner of another 
undertaking (undertaking Y). Individuals A, B, C, D, and E are the only 
partners in partnerships X and Y, and the partnership agreements of both 
X and Y provide that no

[[Page 487]]

action may be taken or decision made on behalf of the partnership 
without the unanimous consent of the partners. Moreover, each partner 
actually participates in, and agrees to, all major decisions that affect 
the operations of either partnership. The ownership percentages (within 
the meaning of paragraph (j)(3) of this section) of A, B, C, D, and E in 
each partnership (and in the undertaking owned by the partnership) are 
as follows:

------------------------------------------------------------------------
                                                 Partnership/Undertaking
                    Partner                    -------------------------
                                                X (percent)  Y (percent)
------------------------------------------------------------------------
A.............................................           15            5
B.............................................           10           60
C.............................................           10           20
D.............................................           77           12
E.............................................            8           20
                                               -------------------------
                                                        120          117
------------------------------------------------------------------------

    The sum of the ownership percentages exceeds 100 percent for both X 
and Y because, under paragraph (j)(3)(ii)(A) of this section, each 
partner's ownership percentage is determined on the basis of the greater 
of the partner's percentage interest in the capital of the partnership 
or the partner's largest distributive share of any item of income or 
gain of the partnership.
    (ii) Paragraph (j)(2)(ii) of this section provides that a person's 
common-ownership percentage with respect to any two or more undertakings 
is the person's smallest ownership percentage in any such undertaking. 
Thus, the common-ownership percentages of A, B, C, D, and E with respect 
to undertakings X and Y are as follows:

------------------------------------------------------------------------
                                                       Common-ownership
                      Partner                             percentage
------------------------------------------------------------------------
A..................................................                    5
B..................................................                   10
C..................................................                   10
D..................................................                   12
E..................................................                    8
                                                    --------------------
                                                                      45
------------------------------------------------------------------------

    (iii) Paragraph (j)(2)(i) of this section provides that undertakings 
are rebuttably presumed to be controlled by the same interests if the 
undertakings are part of the same common-ownership group. In general, 
undertakings are part of a common-ownership group only if the sum of the 
common-ownership percentages of any five or fewer persons with respect 
to such undertakings exceeds 50 percent. In this case, the sum of the 
partners' common-ownership percentages with respect to undertakings X 
and Y is only 45 percent. Thus, undertakings X and Y are not part of the 
same common-ownership group.
    (iv) If the presumption in paragraph (j)(2)(i) of this section does 
not apply, all the facts and circumstances are taken into account in 
determining whether undertakings are controlled by the same interests 
(see paragraph (j)(1) of this section). In this case, all actions and 
decisions in both undertakings require the unanimous consent of the same 
persons and each of those persons actually participates in, and agrees 
to, all major decisions. Accordingly, undertakings X and Y are 
controlled by the same interests (i.e., A, B, C, D, and E).
    Example (2). (i) Partnerships W, X, Y, and Z are each the sole owner 
of an undertaking (undertakings W, X, Y, and Z). Individuals A, B, and C 
are partners in each of the four partnerships, and the remaining 
interests in each partnership are owned by a number of unrelated 
individuals, none of whom owns more than a one-percent interest in any 
of the partnerships. The ownership percentages (within the meaning of 
paragraph (j)(3) of this section) of A, B, and C in each partnership 
(and in the undertaking owned by the partnership) are as follows:

------------------------------------------------------------------------
                                                        Partner
           Partnership/Undertaking            --------------------------
                                                 A      B         C
------------------------------------------------------------------------
W............................................    23%    21%          40%
X............................................    19%    30%          22%
Y............................................    25%    25%          20%
Z............................................     8%     4%           2%
------------------------------------------------------------------------

    (ii) Paragraph (j)(2)(ii) of this section provides that a person's 
common-ownership percentage with respect to any two or more undertakings 
is the person's smallest ownership percentage in any such undertaking. 
Thus, the common-ownership percentages of A, B, and C in undertakings W, 
X, Y, and Z are as follows:

------------------------------------------------------------------------
                                                       Common-ownership
                      Partner                             percentage
------------------------------------------------------------------------
A..................................................                    8
B..................................................                    4
C..................................................                    2
                                                    --------------------
                                                                      14
------------------------------------------------------------------------

    (iii) The sum of the common-ownership percentages of A, B, and C 
with respect to undertakings W, X, Y, and Z is 14 percent, and no other 
person owns more than a one-percent interest in any of the undertakings. 
Thus, the sum of the common-ownership percentages of any five or fewer 
persons with respect to all four undertakings cannot exceed 50 percent. 
Accordingly, undertakings W, X, Y, and Z are not part of the same 
common-ownership group (see paragraph (j)(2)(ii) of this section) and 
are not rebuttably presumed to be controlled by the same interests (see 
paragraph (j)(2)(i) of this section).
    (iv) The common-ownership percentages of A, B, and C in undertakings 
W, X, and Y are as follows:

[[Page 488]]



------------------------------------------------------------------------
                                                       Common ownership
                      Partner                             percentage
------------------------------------------------------------------------
A..................................................                   19
B..................................................                   21
C..................................................                   20
                                                    --------------------
                                                                      60
------------------------------------------------------------------------

    (v) The sum of the common-ownership percentages of A, B, and C, 
taking into account only undertakings W, X, and Y, is 60 percent. 
Because the sum of the common-ownership percentages exceeds 50 percent, 
undertakings W, X, and Y are part of the same common-ownership group 
(see paragraph (j)(2)(ii) of this section and are rebuttably presumed to 
be controlled by the same interests (see paragraph (j)(2)(i) of this 
section).
    Example (3). (i) Corporation X, an S corporation, is the sole owner 
of an undertaking (undertaking X), and corporation Y, another S 
corporation, is the sole owner of another undertaking (undertaking Y). 
Individuals A, B, and C are shareholders in corporations X and Y. Both A 
and B are related (within the meaning of paragraph (j)(3)(iii)(C) of 
this section) to C, but not to each other. A, B, and C are not related 
to any other person that owns an interest in either corporation X or 
corporation Y. The ownership percentages (determined without regard to 
the attribution rules of paragraph (j)(3)(iii) of this section) of A, B, 
and C in each corporation (and in the undertaking owned by the 
corporation) are as follows:

                         Corporation/Undertaking
------------------------------------------------------------------------
                  Shareholder                   X (percent)  Y (percent)
------------------------------------------------------------------------
A.............................................           20  ...........
B.............................................  ...........           20
C.............................................            5            5
------------------------------------------------------------------------

    (ii) In general, a person's ownership percentage is determined by 
treating the person as the owner of interests that are actually owned by 
related persons (see paragraph (j)(3)(iii)(A) of this section). If A, B, 
and C are treated as owning interests that are actually owned by related 
persons, their ownership percentages are as follows:

                         Corporation/Undertaking
------------------------------------------------------------------------
                  Shareholder                   X (percent)  Y (percent)
------------------------------------------------------------------------
A.............................................           25            5
B.............................................            5           25
C.............................................           25           25
------------------------------------------------------------------------

    (iii) Paragraph (j)(3)(iii)(B) of this section provides that, in 
determining the sum of the common-ownership percentages of any five or 
fewer persons with respect to any undertakings, each interest in such 
undertakings is counted only once. If two or more persons are treated as 
owners of the same interest under paragraph (j)(3)(iii)(A) of this 
section, the person whose ownership would result in the highest sum is 
treated as the only owner of the interest. In this case, C's common-
ownership percentage with respect to undertakings X and Y, determined by 
treating C as the owner of the interests actually owned by A and B, is 
25 percent. If, however, A and B are treated as the owners of the 
interests actually owned by C, each has a common-ownership percentage of 
only five percent. Thus, in determining the sum of common-ownership 
percentages with respect to undertakings X and Y, C is treated as the 
owner of the interests actually owned by A and B because this treatment 
results in the highest sum of common-ownership percentages with respect 
to such undertakings.
    Example (4). (i) The ownership percentages of individuals A, B, and 
C in undertakings X, Y, and Z are as follows:

                               Undertaking
------------------------------------------------------------------------
            Individual                  X            Y            Z
------------------------------------------------------------------------
A................................          30%          30%          30%
B................................          30%          30%          30%
C................................  ...........          30%          30%
------------------------------------------------------------------------


No other person owns an interest in more than one of the undertakings.
    (ii) Paragraph (j)(2)(ii) of this section provides that a person's 
common ownership percentage with respect to any two or more undertakings 
is the person's smallest ownership percentage in any such undertaking. 
Thus, A's common-ownership percentage with respect to undertakings X, Y, 
and Z is 30 percent, and the common-ownership percentages of B and C 
(and all other persons owning interests in such undertakings) with 
respect to such undertakings is zero. Accordingly, the sum of the common 
ownership percentages with respect to undertakings X, Y, and Z is only 
30 percent, and undertakings X, Y, and Z are not treated as part of the 
same common-ownership group under paragraph (j)(2)(ii) of this section.
    (iii) B's common-ownership percentage with respect to undertakings X 
and Y is 30 percent, and the sum of A's and B's common-ownership 
percentages with respect to such undertakings is 60 percent. Thus, 
undertakings X and Y are treated as part of the same common-ownership 
group under paragraph (j)(2)(ii) of this section. Similarly, C's common-
ownership percentage with respect to undertakings Y and Z is 30 percent, 
and the sum of A's and C's common-ownership percentages with respect to 
such undertakings is 60 percent. Thus, undertakings Y and Z are also 
treated as part of the same common-ownership group under paragraph 
(j)(2)(ii) of this section.
    (iv) Paragraph (j)(2)(iii) of this section requires the aggregation 
of common-ownership

[[Page 489]]

groups that include the same undertaking. In this case, undertaking Y is 
treated as part of the common-ownership group XY and as part of the 
common-ownership group YZ. Accordingly, undertakings X, Y, and Z are 
treated as part of a single common-ownership group and are rebuttably 
presumed to be controlled by the same interests (see paragraph (j)(2)(i) 
of this section) even though B does not own an interest in undertaking Z 
and C does not own an interest in undertaking X. The fact that B and C 
are not common owners with respect to undertakings X and Z is taken into 
account, however, in determining whether this presumption is rebutted.

    (k) Identification of rental real estate activities--(1) 
Applicability--(i) In general. Except as otherwise provided in paragraph 
(k)(6) of this section, this paragraph (k) applies to a taxpayer's 
interests in rental real estate undertakings (within the meaning of 
paragraph (k)(1)(ii) of this section).
    (ii) Rental real estate undertaking. For purposes of this paragraph 
(k), a rental real estate undertaking is a rental undertaking (within 
the meaning of paragraph (d) of this section) in which at least 85 
percent of the unadjusted basis (within the meaning of Sec. 1.469-
2T(f)(3)) of the property made available for use by customers is real 
property. For this purpose the term ``real property'' means any tangible 
property other than tangible personal property (within the meaning of 
Sec. 1.48-1(c)).
    (2) Identification of activities--(i) Multiple undertakings treated 
as a single activity or multiple activities by taxpayer. Except as 
otherwise provided in this paragraph (k), a taxpayer may treat two or 
more rental real estate undertakings (determined after the application 
of paragraph (k)(2) (ii) and (iii) of this section) as a single activity 
or may treat such undertakings as separate activities.
    (ii) Multiple undertakings treated as a single activity by 
passthrough entity. A taxpayer must treat two or more rental real estate 
undertakings as a single rental real estate undertaking for a taxable 
year if any passthrough entity through which the taxpayer holds such 
undertakings treats such undertakings as a single activity on the 
applicable return of the passthrough entity for the taxable year of the 
taxpayer.
    (iii) Single undertaking treated as multiple undertakings. 
Notwithstanding that a taxpayer's interest in leased property would, but 
for the application of this paragraph (k)(2)(iii), be treated as used in 
a single rental real estate undertaking, the taxpayer may, except as 
otherwise provided in paragraph (k)(3) of this section, treat a portion 
of the leased property (including a ratable portion of any common areas 
or facilities) as a rental real estate undertaking that is separate from 
the undertaking or undertakings in which the remaining portion of the 
property is treated as used. This paragraph (k)(2)(iii) shall apply for 
a taxable year if and only if--
    (A) Such portion of the leased property can be separately conveyed 
under applicable State and local law (taking into account the 
limitations, if any, imposed by any special rules or procedures, such as 
condominium conversion laws, restricting the separate conveyance of 
parts of the same structure); and
    (B) The taxpayer holds such leased property directly or through one 
or more passthrough entities, each of which treats such portion of the 
leased property as a separate activity on the applicable return of the 
passthrough entity for the taxable year of the taxpayer.
    (3) Treatment in succeeding taxable years. All rental real estate 
undertakings or portions of such undertakings that are treated, under 
this paragraph (k), as part of the same activity for a taxable year 
ending after August 9, 1989 must be treated as part of the same activity 
in each succeeding taxable year.
    (4) Applicable return of passthrough entity. For purposes of this 
paragraph (k), the applicable return of a passthrough entity for a 
taxable year of a taxpayer is the return reporting the passthrough 
entity's income, gain, loss, deductions, and credits taken into account 
by the taxpayer for such taxable year.
    (5) Evidence of treatment required. For purposes of this paragraph 
(k), a person (including a passthrough entity) does not treat a rental 
real estate undertaking as multiple undertakings for a taxable year or, 
except as otherwise provided in paragraph (k) (2)(ii) or (3) of this 
section, treat multiple rental

[[Page 490]]

real estate undertakings as a single undertaking for a taxable year 
unless such treatment is reflected on a schedule attached to the 
person's return for the taxable year.
    (6) Coordination rule for rental of nondepreciable property. This 
paragraph (k) shall not apply to a rental real estate undertaking if 
less than 30 percent of the unadjusted basis (within the meaning of 
Sec. 1.469-2T(f)(3)) of property used or held for use by customers in 
such undertaking during the taxable year is subject to the allowance for 
depreciation under section 167.
    (7) Coordination rule for rental of dwelling unit. For any taxable 
year in which section 280A(c)(5) applies to a taxpayer's use of a 
dwelling unit--
    (i) Paragraph (k) (2) and (3) of this section shall not apply to the 
taxpayer's interest in such dwelling unit; and
    (ii) The taxpayer's interest in such dwelling unit shall be treated 
as a separate activity of the taxpayer.
    (8) Examples. The following examples illustrate the application of 
this paragraph (k). In each example, the taxpayer is an individual whose 
taxable year is the calendar year.

    Example (1). (i) In 1989, the taxpayer directly owns five 
condominium units (units A, B, C, D, and E) in three different 
buildings. Units A, B, and C are in one of the buildings and constitute 
a single rental real estate undertaking (within the meaning of paragraph 
(k)(1)(ii) of this section). Units D and E are in the other two 
buildings, and each of these units constitutes a separate rental real 
estate undertaking. Each of the units can be separately conveyed under 
applicable State and local law.
    (ii) Paragraph (k)(2)(iii) of this section permits a taxpayer to 
treat a portion of the property included in a rental real estate 
undertaking as a separate rental real estate undertaking if the property 
can be separately conveyed under applicable State and local law and the 
taxpayer owns the property directly. Thus, the taxpayer can treat units 
A, B, and C as three separate undertakings. Alternatively, the taxpayer 
could treat two of those units (e.g., units A and C) as an undertaking 
and the remaining unit as a separate undertaking, or could treat units 
A, B, and C as a single undertaking.
    (iii) Paragraph (k)(2)(i) of this section permits a taxpayer to 
treat two or more rental real estate undertakings as a single activity, 
or to treat such undertakings as separate activities. Thus, the 
taxpayer, by combining undertakings, can treat all five units as a 
single activity. Alternatively, the taxpayer could treat each 
undertaking as a separate activity, or could combine some, but not all, 
undertakings. Thus, for example, the taxpayer could treat units A, B, C, 
and D as an activity and unit E as a separate activity.
    (iv) For purposes of paragraph (k)(2)(i) of this section, a 
taxpayer's rental real estate undertakings are determined after the 
application of paragraph (k)(2)(iii) of this section. Thus, the 
taxpayer, by treating units as separate undertakings under paragraph 
(k)(2)(iii) of this section and combining them with other units under 
paragraph (k)(2)(i) of this section, can treat any combination of units 
as a single activity. For example, the taxpayer could treat units A and 
B as a separate rental real estate undertaking, and then treat units A, 
B, and D as a single activity. In that case, the taxpayer could treat 
units C and E either as a single activity or as two separate activities.
    Example (2). (i) The facts are the same as in example (1). In 
addition, the taxpayer treats all five units as a single activity for 
1989 and sells unit E in 1990. (See paragraph (k)(5) of this section for 
a rule providing that the units are treated as a single activity only if 
such treatment is reflected on a schedule attached to the taxpayer's 
return.)
    (ii) Under paragraph (k)(3) of this section, rental real estate 
undertakings that are treated as part of the same activity for a taxable 
year must be treated as part of the same activity in each succeeding 
year. In this case, all five units were treated as part of the same 
activity for 1989 and must therefore be treated as part of the same 
activity for 1990. Accordingly, the taxpayer's sale of unit E in 1990 
cannot be treated as a disposition of the taxpayer's entire interest in 
an activity for purposes of section 469(g) and the rules to be contained 
in Sec. 1.469-6T (relating to the treatment of losses upon certain 
dispositions of passive and former passive activities).
    Example (3). (i) The facts are the same as in example (1), except 
that the taxpayer is a partner in a partnership that is the direct owner 
of the five condominium units. In its return for its taxable year ending 
on November 30, 1989, the partnership treats the five units as a single 
activity. (See paragraph (k)(5) of this section for a rule providing 
that the units are treated as a single activity only if such treatment 
is reflected on a schedule attached to the partnership's return.) The 
partnership sells unit E on November 1, 1990.
    (ii) Paragraph (k)(2)(ii) of this section provides that a taxpayer 
who holds rental real estate undertakings through a passthrough entity 
must treat those undertakings as a single rental real estate undertaking 
if they are treated as a single activity on the applicable return of the 
passthrough entity.

[[Page 491]]

Under paragraph (k)(4) of this section, the applicable return of the 
partnership for the taxpayer's 1989 taxable year is the partnership's 
return for its taxable year ending on November 30, 1989. Accordingly, 
the taxpayer must treat the five condominium units as a single rental 
real estate undertaking (and thus as part of the same activity) for 1989 
because they are treated as a single activity on the partnership's 
return for its taxable year ending in 1989.
    (iii) Under paragraph (k)(3) of this section, the taxpayer must 
continue treating the condominium units as part of the same activity for 
taxable years after 1989. Accordingly, as in example (2), the five 
condominium units are treated as part of the same activity for 1990, and 
the sale of unit E in 1990 cannot be treated as a disposition of the 
taxpayer's interest in an activity for purposes of section 469(g) and 
the rules to be contained in Sec. 1.469-6T.
    Example (4). (i) The taxpayer owns a shopping center and a vacant 
lot that are separate rental real estate undertakings (within the 
meaning of paragraph (k)(1)(ii) of this section). The taxpayer rents 
space in the shopping center to various tenants and rents the vacant lot 
to a parking lot operator. Most of the unadjusted basis of the property 
used in the shopping-center undertaking (taking into account the land on 
which the shopping center is built) is subject to the allowance for 
depreciation, but no depreciable property is used in the parking-lot 
undertaking.
    (ii) This paragraph (k) provides rules for identifying rental real 
estate activities (including the rule in paragraph (k)(2)(i) of this 
section that permits a taxpayer to treat two or more rental real estate 
undertakings as a single activity). Paragraph (k)(6) of this section 
provides, however, that these rules do not apply to a rental real estate 
undertaking if less than 30 percent of the unadjusted basis of the 
property used in the undertaking is subject to the allowance for 
depreciation. Thus, the taxpayer may not combine the parking-lot 
undertaking, which includes no depreciable property, with the shopping-
center undertaking or any other rental real estate undertaking under 
paragraph (k)(2)(i) of this section. Accordingly, the parking lot 
undertaking is treated as a separate activity under paragraph (b)(1) of 
this section.
    Example (5). (i) The facts are the same as in example (4), except 
that the shopping center and the vacant lot are at the same location 
(within the meaning of paragraph (c)(2)(iii) of this section) and are 
part of the same rental real estate undertaking (within the meaning of 
paragraph (k)(1)(ii) of this section). Taking into account the property 
used in the shopping center operations (including the land on which the 
shopping center is built) and the vacant lot, 50 percent of the 
unadjusted basis of the property used in the undertaking is subject to 
the allowance for depreciation.
    (ii) In this case, the vacant lot is used in a rental real estate 
undertaking in which depreciable property is also used. Moreover, the 
exception in paragraph (k)(6) of this section does not apply to the 
undertaking consisting of the shopping center and the parking lot 
because at least 30 percent of unadjusted basis of the property used in 
the undertaking is subject to the allowance for depreciation. 
Accordingly, the taxpayer may combine the undertaking with other rental 
real estate undertakings and treat the combined undertakings as a single 
activity under paragraph (k)(2)(i) of this section.

    (l) [Reserved]
    (m) Consolidated groups--(1) In general. The activities of a 
consolidated group (within the meaning of Sec. 1.469-1T(h)(2)(ii)) and 
of each member of such group shall be determined under this section as 
if the consolidated group were one taxpayer.
    (2) Examples. The following examples illustrate the application of 
this paragraph (m). In each example, the facts, analysis, and 
conclusions relate to a single taxable year.

    Example (1). (i) Corporations M, N, and O are the members of a 
consolidated group (within the meaning of Sec. 1.469-1T(h)(2)(ii)). 
Under Sec. 1.469-1T(h)(4)(i)(A) and (ii), the consolidated group and 
its members are treated as closely held corporations (within the meaning 
of Sec. 1.469-1T(g)(2)(ii)). Each member of the consolidated group owns 
a two-percent interest in partnership X and a two-percent interest in 
partnership Y, and owns interests in a number of trade or business 
undertakings (within the meaning of paragraph (f)(1)(ii) of this 
section) through the partnerships. Each of these undertakings is 
directly owned by partnership X or Y, and all the undertakings of 
partnerships X and Y are controlled by the same interests (within the 
meaning of paragraph (j) of this section) and are similar (within the 
meaning of paragraph (f)(4) of this section). The employees of the 
consolidated group and the shareholders of its common parent do not 
participate in the undertakings that the member corporations own through 
the partnerships.
    (ii) Paragraph (f)(2)(i) of this section provides that trade or 
business undertakings that are similar and controlled by the same 
interests are treated as part of the same activity of the taxpayer if 
the taxpayer owns interests in the undertakings through the same 
passthrough entity. In this case, the member corporations own interests 
in similar, commonly-controlled undertakings through both partnerships, 
and such interests are treated under this paragraph (m) as

[[Page 492]]

interests owned by one taxpayer (the consolidated group). Accordingly, 
the member corporations' interests in the undertakings owned through 
partnership X are treated as part of the same activity of the 
consolidated group, and their interests in the undertakings owned 
through partnership Y are treated similarly.
    Example (2) . (i) The facts are the same as in example (1), except 
that each member of the consolidated group owns a five-percent interest 
in partnership X and a five-percent interest in partnership Y.
    (ii) Paragraph (f)(2)(ii) of this section provides that trade or 
business undertakings that are similar and controlled by the same 
interests are treated as part of the same activity of the taxpayer if 
the taxpayer owns a direct or substantial indirect interest in each such 
undertaking. In this case, the member corporations own, in the 
aggregate, a 15-percent interest in partnership X and a 15-percent 
interest in partnership Y, and such interests are treated under this 
paragraph (m) as interests owned by one taxpayer (the consolidated 
group). Thus, the consolidated group owns a substantial indirect 
interest in the similar, commonly-controlled undertakings owned by 
partnerships X and Y (see paragraph (f)(3)(i) of this section). 
Accordingly, the member corporations' interests in the undertakings 
owned through partnerships X and Y are treated as part of the same 
activity of the consolidated group.

    (n) Publicly traded partnerships. The rules of this section shall 
apply to a taxpayer's interest in business and rental operations held 
through a publicly traded partnership (within the meaning of section 
469(k)(2)) as if the taxpayer had no interest in any other business and 
rental operations. The following example illustrates the application of 
this paragraph (n):

    Example. (i) The taxpayer, an individual, owns a 20-percent interest 
in partnership X and a 15-percent interest in partnership Y. Partnership 
X directly owns a hotel (``hotel 1'') and a commercial office building 
(``building 1''). Partnership Y directly owns two hotels (``hotels 2 and 
3'') and two commercial office buildings (``buildings 2 and 3''). Each 
of the three hotels is a separate trade or business undertaking (within 
the meaning of paragraph (f)(1)(ii) of this section), and each of the 
three office buildings is a separate rental real estate undertaking 
(within the meaning of paragraph (k)(1)(ii) of this section). The three 
hotel undertakings are similar (within the meaning of paragraph (f)(4) 
of this section) and are controlled by the same interests (within the 
meaning of paragraph (j) of this section). Partnership X is not a 
publicly traded partnership (within the meaning of section 469(k)(2)). 
Partnership Y, however, is a publicly traded partnership and is not 
treated as a corporation under section 7704.
    (ii) This paragraph (n) provides that the rules of this section 
apply to a taxpayer's interest in business and rental operations held 
through a publicly traded partnership as if the taxpayer had no interest 
in any other business and rental operations. Thus, undertakings owned 
through partnership Y may be treated as part of the same activity under 
the rules of this section, but an undertaking owned through partnership 
Y and an undertaking that is not owned through partnership Y may not be 
treated as part of the same activity.
    (iii) Paragraph (f)(2)(i) of this section provides that a taxpayer's 
interests in two or more trade or business undertakings that are similar 
and controlled by the same interests are treated as part of the same 
activity if the taxpayer owns interests in each undertaking through the 
same passthrough entity. Partnership Y's hotel undertakings (i.e., 
hotels 2 and 3) are similar and are controlled by the same interests. In 
addition, the taxpayer owns interests in both undertakings through the 
same partnership. Accordingly, the taxpayer's interests in partnership 
Y's hotel undertakings are treated as part of the same activity.
    (iv) The hotel undertaking owned through partnership X (i.e., hotel 
1) and the hotel undertakings owned through partnership Y are similar 
and controlled by the same interests, and the taxpayer owns a 
substantial indirect interest in each of the undertakings (see paragraph 
(f)(3)(i) of this section). Thus, the three undertakings would 
ordinarily be treated as part of the same activity under paragraph 
(f)(2)(ii) of this section. Under this paragraph (n), however, 
undertakings that are owned through a publicly traded partnership cannot 
be treated as part of the same activity as any undertaking not owned 
through that partnership. Accordingly, the hotel undertaking that the 
taxpayer owns through partnership X and the hotel undertakings that the 
taxpayer owns through partnership Y are treated as two separate 
activities.
    (v) Paragraph (k)(2)(i) of this section provides that, with certain 
exceptions, a taxpayer may treat two or more rental real estate 
undertakings as a single activity or as separate activities. Thus, the 
taxpayer's interests in the rental real estate undertakings owned 
through partnership Y (i.e., buildings 2 and 3) may be treated as a 
single activity or as separate activities. Under this paragraph (n), 
however, undertakings that are owned through a publicly traded 
partnership cannot be treated as part of the same activity as any 
undertaking not owned through

[[Page 493]]

that partnership. Accordingly, the taxpayer's interest in the rental 
real estate undertaking owned through partnership X (building 1) cannot 
be treated as part of an activity that includes any rental real estate 
undertaking owned through partnership Y.

    (o) Elective treatment of undertakings as separate activities--(1) 
Applicability. This paragraph applies to a taxpayer's interest in any 
undertaking (other than a rental real estate undertaking (within the 
meaning of paragraph (k)(1)(ii) of this section)) that would otherwise 
be treated under this section as part of an activity that includes the 
taxpayer's interest in any other undertaking.
    (2) Undertakings treated as separate activities. Except as otherwise 
provided in this paragraph (o), a person (including a passthrough 
entity) shall treat an undertaking to which this paragraph (o) applies 
as an activity separate from the remainder of the activity in which such 
undertaking would otherwise be included for a taxable year if and only 
if, for such taxable year or any preceding taxable year, such person 
made an election with respect to such undertaking under this paragraph 
(o).
    (3) Multiple undertakings treated as a single activity by 
passthrough entity. A person (including a passthrough entity) must treat 
interests in two or more undertakings as part of the same activity for a 
taxable year if any passthrough entity through which the person holds 
such undertakings treats such undertakings as part of the same activity 
on the applicable return of the passthrough entity for the taxable year 
of such person.
    (4) Multiple undertakings treated as a single activity for a 
preceding taxable year. If a person (including a passthrough entity) 
treats undertakings as part of the same activity on such person's return 
for a taxable year ending after August 9, 1989, such person may not 
treat such undertakings as part of different activities under this 
paragraph (o) for any subsequent taxable year.
    (5) Applicable return of passthrough entity. For purposes of this 
paragraph (o), the applicable return of a passthrough entity for a 
taxable year of a taxpayer is the return reporting the passthrough 
entity's income, gain, loss, deductions, and credits taken into account 
by the taxpayer for such taxable year.
    (6) Participation. The following rules apply to multiple activities 
(the ``separate activities'') that would be treated as a single activity 
(the ``original activity'') if the taxpayer's activities were determined 
without regard to this paragraph (o):
    (i) The taxpayer shall be treated as materially participating 
(within the meaning of Sec. 1.469-5T) for the taxable year in the 
separate activities if and only if the taxpayer would, but for the 
application of this paragraph (o), be treated as materially 
participating for the taxable year in the original activity.
    (ii) The taxpayer shall be treated as significantly participating 
(within the meaning of Sec. 1.469-5T(c)(2)) for the taxable year in the 
separate activities if and only if the taxpayer would, but for the 
application of this paragraph (o), be treated as significantly 
participating for the taxable year in the original activity.
    (7) Election--(i) In general. A person makes an election with 
respect to an undertaking under this paragraph (o) by attaching the 
written statement described in paragraph (o)(7)(ii) of this section to 
such person's return for the taxable year for which the election is made 
(see paragraph (o)(2) of this section).
    (ii) Written statement. The written statement required by paragraph 
(o)(7)(i) of this section must--
    (A) State the name, address, and taxpayer identification number of 
the person making the election;
    (B) Contain a declaration that an election is being made under Sec. 
1.469-4T(o);
    (C) Identify the undertaking with respect to which such election is 
being made; and
    (D) Identify the remainder of the activity in which such undertaking 
would otherwise be included.
    (8) Examples. The following examples illustrate the application of 
this paragraph (o):

    Example (1). (i) During 1989, the taxpayer, an individual whose 
taxable year is the calendar year, acquires and is the direct owner of 
ten grocery stores. The operations of each grocery store are treated 
under paragraph

[[Page 494]]

(c)(1) of this section as a single undertaking that is separate from 
other undertakings (a ``grocery-store undertaking''), and the taxpayer's 
interests in the grocery-store undertakings would be treated as part of 
the same activity of the taxpayer under paragraph (f)(2) of this 
section.
    (ii) Paragraph (o)(2) of this section provides that, with certain 
exceptions, undertakings that would be treated as part of the same 
activity under other rules in this section may, at the election of the 
taxpayer, be treated as separate activities. Thus, the taxpayer may 
elect to treat each grocery-store undertaking as a separate activity for 
1989. Alternatively, the taxpayer may combine grocery-store undertakings 
in any manner and treat each combination of undertakings (and each 
uncombined undertaking) as a separate activity for 1989. In either case, 
the election must be made by attaching the written statement described 
in paragraph (o)(7)(ii) of this section to the taxpayer's 1989 return.
    Example (2). (i) The facts are the same as in example (1). In 
addition, the taxpayer, in 1989, elects to treat each grocery-store 
undertaking as a separate activity and participates for 15 hours in each 
of the grocery-store undertakings.
    (ii) The taxpayer's interest in each grocery-store undertaking is 
treated, under paragraph (o)(2) of this section, as a separate activity 
of the taxpayer for 1989 (a ``grocery-store activity''). In 1989, 
however, the taxpayer participates for more than 100 hours in the 
activity in which the undertakings would be included (but for the 
election to treat the grocery-store undertakings as separate activities) 
and would be treated under Sec. 1.469-5T(c)(2) as significantly 
participating in such activity. Accordingly, the taxpayer is treated 
under paragraph (o)(6)(ii) of this section as significantly 
participating in each of the grocery-store activities for 1989.
    Example (3). (i) The facts are the same as in example (1). In 
addition, the taxpayer, in 1989, elects to treat each grocery-store 
undertaking as a separate activity. The taxpayer does not participate in 
any of the grocery-store undertakings in 1989 or 1990, and sells one of 
the grocery stores in 1990.
    (ii) As in example (2), the taxpayer's interests in each grocery-
store undertaking is treated, under paragraph (o)(2) of this section, as 
a separate activity of the taxpayer for 1989. Because the taxpayer 
elected to treat the undertakings as separate activities for a preceding 
taxable year (1989), each grocery-store undertaking is also treated, 
under paragraph (o)(2) of this section, as a separate activity of the 
taxpayer for 1990. In addition, each of the taxpayer's grocery-store 
activities is a passive activity for 1989 and 1990 because the taxpayer 
does not participate in any of the grocery store undertakings for 1989 
and 1990. Accordingly, the taxpayer's sale of the grocery store will 
generally be treated as a disposition of the taxpayer's entire interest 
in a passive activity for purposes of section 469(g) and the rules to be 
contained in Sec. 1.469-6T (relating to the treatment of losses upon 
certain dispositions of passive and former passive activities).
    Example (4). (i) The facts are the same as in example (3), except 
that the taxpayer elects to treat the grocery-store undertakings as two 
separate activities. One of the activities includes three grocery-store 
undertakings, and the store sold in 1990 is part of this activity. The 
other activity includes the seven remaining grocery-store undertakings.
    (ii) Paragraph (o)(4) of this section provides that a person who 
treats undertakings as part of the same activity for a taxable year 
ending after August 9, 1989, may not elect to treat those undertakings 
as separate activities for a subsequent taxable year. The grocery store 
sold in 1990 was treated for 1989 as part of an activity that includes 
two other grocery stores. Thus, those three stores must be treated as 
part of the same activity for 1990. Accordingly, the taxpayer's sale of 
the grocery store cannot be treated as a disposition of the taxpayer's 
entire interest in a passive activity for purposes of section 469(g) and 
the rules to be contained in Sec. 1.469-6T.
    Example (5). (i) The facts are the same as in example (1), except 
that the taxpayer is a partner in a partnership that acquires and is the 
direct owner of the ten grocery stores. The taxable year of the 
partnership ends on November 30, and the partnership acquires the 
grocery stores in its taxable year ending on November 30, 1989. In its 
return for that taxable year, the partnership treats the grocery-store 
undertakings as a single activity.
    (ii) Paragraph (o)(3) of this section provides that a person who 
holds undertakings through a passthrough entity may not elect to treat 
those undertakings as separate activities if they are treated as part of 
the same activity on the applicable return of the passthrough entity. 
Under paragraph (o)(5) of this section, the applicable return of the 
partnership for the taxpayer's 1989 taxable year is the partnership's 
return for its taxable year ending on November 30, 1989. Accordingly, 
the taxpayer must treat the grocery-store undertakings as a single 
activity for 1989 because those undertakings are treated as a single 
activity on the partnership's return for its taxable year ending in 
1989.
    (iii) Under paragraph (o)(4) of this section, the taxpayer must 
continue treating the grocery-store undertakings as part of the same 
activity for taxable years after 1989. This rule applies even if the 
partnership subsequently distributes its interest in the grocery stores 
to the taxpayer, and the taxpayer becomes the direct owner of the 
grocery-store undertakings.


[[Page 495]]


    (p) Special rule for taxable years ending before August 10, 1989--
(1) In general. For purposes of applying section 469 and the regulations 
thereunder for a taxable year ending before August 10, 1989, a 
taxpayer's business and rental operations may be organized into 
activities under the rules or paragraphs (b) through (n) of this section 
or under any other reasonable method. For example, for such taxable 
years a taxpayer may treat each of the taxpayer's undertakings as a 
separate activity, or a taxpayer may treat undertakings that involve the 
provision of similar goods or services as a single activity.
    (2) Unreasonable methods. A method of organizing business and rental 
operations into activities is not reasonable if such method--
    (i) Treats rental operations (within the meaning of paragraph (d)(3) 
of this section) that are not ancillary to a trade or business activity 
(within the meaning of Sec. 1.469-1T(e)(2)) as part of a trade or 
business activity;
    (ii) Treats operations that are not rental operations and are not 
ancillary to a rental activity (within the meaning of Sec. 1.469-
1T(e)(3)) as part of a rental activity;
    (iii) Includes in a passive activity of a taxpayer any oil or gas 
well that would be treated, under paragraph (e)(1) of this section, as a 
separate undertaking in determining the taxpayer's activities;
    (iv) Includes in a passive activity of a taxpayer any interest in a 
dwelling unit that would be treated, under paragraph (K)(7) of this 
section, as a separate activity of the taxpayer; or
    (v) Is inconsistent with the taxpayer's method of organizing 
business and rental operations into activities for the taxpayer's first 
taxable year beginning after December 31, 1986.
    (3) Allocation of dissallowed deductions in succeeding taxable year. 
If any of the taxpayer's passive activity deductions or the taxpayer's 
credits from passive activities are disallowed under Sec. 1.469-1T for 
the last taxable year of the taxpayer ending before August 10, 1989, 
such disallowed deductions or credits shall be allocated among the 
taxpayer's activities for the first taxable year of the taxpayer ending 
after August 9, 1989, using any reasonable method. See Sec. 1.469-
1T(f)(4).

[T.D. 8253, 54 FR 20542, May 12, 1989]



Sec. 1.469-5  Material participation.

    (a)-(e) [Reserved]
    (f) Participation--(1) In general. Except as otherwise provided in 
this paragraph (f), any work done by an individual (without regard to 
the capacity in which the individual does the work) in connection with 
an activity in which the individual owns an interest at the time the 
work is done shall be treated for purposes of this section as 
participation of the individual in the activity.
    (f)(2)-(h)(2) [Reserved]
    (h)(3) Coordination with rules governing the treatment of 
passthrough entities. If a taxpayer takes into account for a taxable 
year of the taxpayer any item of gross income or deduction from a 
partnership or S corporation that is characterized as an item of gross 
income or deduction from an activity in which the taxpayer materially 
participated under Sec. 1.469-2T(e)(1), the taxpayer is treated as 
materially participating in the activity for the taxable year for 
purposes of applying Sec. 1.469-5T(a)(5) and (6) to any succeeding 
taxable year of the taxpayer.
    (i) [Reserved]
    (j) Material participation for preceding taxable years--(1) In 
general. For purposes of Sec. 1.469-5T(a)(5) and (6), a taxpayer has 
materially participated in an activity for a preceding taxable year if 
the activity includes significant section 469 activities that are 
substantially the same as significant section 469 activities that were 
included in an activity in which the taxpayer materially participated 
(determined without regard to Sec. 1.469-5T(a)(5)) for the preceding 
taxable year.
    (2) Material participation for taxable years beginning before 
January 1, 1987. In any case in which it is necessary to determine 
whether an individual materially participated in any activity for a 
taxable year beginning before January 1, 1987 (other than a taxable year 
of a partnership, S corporation, estate, or trust ending after December 
31, 1986), the determination shall be made without regard to paragraphs 
(a)(2) through (7) of this section.

[[Page 496]]

    (k) Examples. Example (1)--Example (4) [Reserved]

    Example (5). In 1993, D, an individual, acquires stock in an S 
corporation engaged in a trade or business activity (within the meaning 
of Sec. 1.469-1(e)(2)). For every taxable year from 1993 through 1997, 
D is treated as materially participating (without regard to Sec. 1.469-
5T(a)(5)) in the activity. D retires from the activity at the beginning 
of 1998, and would not be treated as materially participating in the 
activity for 1998 and subsequent taxable years if material participation 
of those years were determined without regard to Sec. 1.469-5T(a)(5). 
Under Sec. 1.469-5T(a)(5) of this section, however, D is treated as 
materially participating in the activity for taxable years 1998 through 
2003 because D materially participated in the activity (determined 
without regard to Sec. 1.469-5T(a)(5) for five taxable years during the 
ten taxable years that immediately precede each of those years. D is not 
treated under Sec. 1.469-5T(a)(5) as materially participating in the 
activity for taxable years beginning after 2003 because for those years 
D has not materially participated in the activity (determined without 
regard to Sec. 1.469-5T(a)(5) for five of the last ten immediately 
preceding taxable years.

[T.D. 8417, 57 FR 20758, May 15, 1992]



Sec. 1.469-5T  Material participation (temporary).

    (a) In general. Except as provided in paragraphs (e) and (h)(2) of 
this section, an individual shall be treated, for purposes of section 
469 and the regulations thereunder, as materially participating in an 
activity for the taxable year if and only if--
    (1) The individual participates in the activity for more than 500 
hours during such year;
    (2) The individual's participation in the activity for the taxable 
year constitutes substantially all of the participation in such activity 
of all individuals (including individuals who are not owners of 
interests in the activity) for such year;
    (3) The individual participates in the activity for more than 100 
hours during the taxable year, and such individual's participation in 
the activity for the taxable year is not less than the participation in 
the activity of any other individual (including individuals who are not 
owners of interests in the activity) for such year;
    (4) The activity is a significant participation activity (within the 
meaning of paragraph (c) of this section) for the taxable year, and the 
individual's aggregate participation in all significant participation 
activities during such year exceeds 500 hours;
    (5) The individual materially participated in the activity 
(determined without regard to this paragraph (a)(5)) for any five 
taxable years (whether or not consecutive) during the ten taxable years 
that immediately precede the taxable year;
    (6) The activity is a personal service activity (within the meaning 
of paragraph (d) of this section), and the individual materially 
participated in the activity for any three taxable years (whether or not 
consecutive) preceding the taxable year; or
    (7) Based on all of the facts and circumstances (taking into account 
the rules in paragraph (b) of this section), the individual participates 
in the activity on a regular, continuous, and substantial basis during 
such year.
    (b) Facts and circumstances--(1) In general. [Reserved]
    (2) Certain participation insufficient to constitute material 
participation under this paragraph (b)--(i) Participation satisfying 
standards not contained in section 469. Except as provided in section 
469(h)(3) and paragraph (h)(2) of this section (relating to certain 
retired individuals and surviving spouses in the case of farming 
activities), the fact that an individual satisfies the requirements of 
any participation standard (whether or not referred to as ``material 
participation'') under any provision (including sections 1402 and 2032A 
and the regulations thereunder) other than section 469 and the 
regulations thereunder shall not be taken into account in determining 
whether such individual materially participates in any activity for any 
taxable year for purposes of section 469 and the regulations thereunder.
    (ii) Certain management activities. An individual's services 
performed in the management of an activity shall not be taken into 
account in determining whether such individual is treated as

[[Page 497]]

materially participating in such activity for the taxable year under 
paragraph (a)(7) of this section unless, for such taxable year--
    (A) No person (other than such individual) who performs services in 
connection with the management of the activity receives compensation 
described in section 911(d)(2)(A) in consideration for such services; 
and
    (B) No individual performs services in connection with the 
management of the activity that exceed (by hours) the amount of such 
services performed by such individual.
    (iii) Participation less than 100 hours. If an individual 
participates in an activity for 100 hours or less during the taxable 
year, such individual shall not be treated as materially participating 
in such activity for the taxable year under paragraph (a)(7) of this 
section.
    (c) Significant participation activity--(1) In general. For purposes 
of paragraph (a)(4) of this section, an activity is a significant 
participation activity of an individual if and only if such activity--
    (i) Is a trade or business activity (within the meaning of Sec. 
1.469-1T(e)(2)) in which the individual significantly participates for 
the taxable year; and
    (ii) Would be an activity in which the individual does not 
materially participate for the taxable year if material participation 
for such year were determined without regard to paragraph (a)(4) of this 
section.
    (2) Significant participation. An individual is treated as 
significantly participating in an activity for a taxable year if and 
only if the individual participates in the activity for more than 100 
hours during such year.
    (d) Personal service activity. An activity constitutes a personal 
service activity for purposes of paragraph (a)(6) of this section if 
such activity involves the performance of personal services in--
    (1) The fields of health, law, engineering, architecture, 
accounting, actuarial science, performing arts, or consulting; or
    (2) Any other trade or business in which capital is not a material 
income-producing factor.
    (e) Treatment of limited partners--(1) General rule. Except as 
otherwise provided in this paragraph (e), an individual shall not be 
treated as materially participating in any activity of a limited 
partnership for purposes of applying section 469 and the regulations 
thereunder to--
    (i) The individual's share of any income, gain, loss, deduction, or 
credit from such activity that is attributable to a limited partnership 
interest in the partnership; and
    (ii) Any gain or loss from such activity recognized upon a sale or 
exchange of such an interest.
    (2) Exceptions. Paragraph (e)(1) of this section shall not apply to 
an individual's share of income, gain, loss, deduction, and credit for a 
taxable year from any activity in which the individual would be treated 
as materially participating for the taxable year under paragraph (a)(1), 
(5), or (6) of this section if the individual were not a limited partner 
for such taxable year.
    (3) Limited partnership interest--(i) In general. Except as provided 
in paragraph (e)(3)(ii) of this section, for purposes of section 
469(h)(2) and this paragraph (e), a partnership interest shall be 
treated as a limited partnership interest if--
    (A) Such interest is designated a limited partnership interest in 
the limited partnership agreement or the certificate of limited 
partnership, without regard to whether the liability of the holder of 
such interest for obligations of the partnership is limited under the 
applicable State law; or
    (B) The liability of the holder of such interest for obligations of 
the partnership is limited, under the law of the State in which the 
partnership is organized, to a determinable fixed amount (for example, 
the sum of the holder's capital contributions to the partnership and 
contractural obligations to make additional capital contributions to the 
partnership).
    (ii) Limited partner holding general partner interest. A partnership 
interest of an individual shall not be treated as a limited partnership 
interest for the individual's taxable year if the individual is a 
general partner in the partnership at all times during the partnership's 
taxable year ending with or within the individual's taxable year (or the 
portion of the partnership's taxable

[[Page 498]]

year during which the individual (directly or indirectly) owns such 
limited partnership interest).
    (f) Participation--(1) [Reserved]. See Sec. 1.469-5(f)(1) for rules 
relating to this paragraph.
    (2) Exceptions--(i) Certain work not customarily done by owners. 
Work done in connection with an activity shall not be treated as 
participation in the activity for purposes of this section if--
    (A) Such work is not of a type that is customarily done by an owner 
of such an activity; and
    (B) One of the principal purposes for the performance of such work 
is to avoid the disallowance, under section 469 and the regulations 
thereunder, of any loss or credit from such activity.
    (ii) Participation as an investor--(A) In general. Work done by an 
individual in the individual's capacity as an investor in an activity 
shall not be treated as participation in the activity for purposes of 
this section unless the individual is directly involved in the day-to-
day management or operations of the activity.
    (B) Work done in individual's capacity as an investor. For purposes 
of this paragraph (f)(2)(ii), work done by an individual in the 
individual's capacity as an investor in an activity includes--
    (1) Studying and reviewing financial statements or reports on 
operations of the activity;
    (2) Preparing or compiling summaries or analyses of the finances or 
operations of the activity for the individual's own use; and
    (3) Monitoring the finances or operations of the activity in a non-
managerial capacity.
    (3) Participation of spouse. In the case of any person who is a 
married individual (within the meaning of section 7703) for the taxable 
year, any participation by such person's spouse in the activity during 
the taxable year (without regard to whether the spouse owns an interest 
in the activity and without regard to whether the spouses file a joint 
return for the taxable year) shall be treated, for purposes of applying 
section 469 and the regulations thereunder to such person, as 
participation by such person in the activity during the taxable year.
    (4) Methods of proof. The extent of an individual's participation in 
an activity may be established by any reasonable means. Contemporaneous 
daily time reports, logs, or similar documents are not required if the 
extent of such participation may be established by other reasonable 
means. Reasonable means for purposes of this paragraph may include but 
are not limited to the identification of services performed over a 
period of time and the approximate number of hours spent performing such 
services during such period, based on appointment books, calendars, or 
narrative summaries.
    (g) Material participation of trusts and estates. [Reserved]
    (h) Miscellaneous rules--(1) Participation of corporations. For 
rules relating to the participation in an activity of a personal service 
corporation (within the meaning of Sec. 1.468-1T(g)(2)(i)) or a closely 
held corporation (within the meaning of Sec. 1.469-1T(g)(2)(ii)), see 
Sec. 1.469-1T(g)(3).
    (2) Treatment of certain retired farmers and surviving spouses of 
retired or disabled farmers. An individual shall be treated as 
materially participating for a taxable year in any trade or business 
activity of farming if paragraph (4) or (5) of section 2032A(b) would 
cause the requirements of section 2032A(b)(1)(C)(ii) to be met with 
respect to real property used in such activity had the individual died 
during such taxable year.
    (3) Coordination with rules governing the treatment of passthrough 
entities. [Reserved]. See Sec. 1.469-5(h)(3) for rules relating to this 
paragraph.
    (i) [Reserved]
    (j) Material participation for preceding taxable years. [Reserved]. 
See Sec. 1.469-5(j) for rules relating to this paragraph.
    (k) Examples. The following examples illustrate the application of 
this section:
    Example 1. A, a calendar year individual, owns all of the stock of 
X, a C corporation. X is the general partner, and A is the limited 
partner, in P, a calendar year partnership. P has a single activity, a 
restaurant, which is a trade or business activity (within the meaning of 
Sec. 1.469-1T(e)(2)). During the taxable year, A works for an average 
of 30 hours per week in connection with P's restaurant activity. Under 
paragraphs (a)(1) and (e)(2) of

[[Page 499]]

this section, A is treated as materially participating in the activity 
for the taxable year because A participates in the restaurant activity 
during such year for more than 500 hours. In addition, under Sec. 
1.469-1T(g)(3)(i), A's participation will cause X to be treated as 
materially participating in the restaurant activity.
    Example 2. The facts are the same as in example (1), except that the 
partnership agreement provides that P's restaurant activity is to be 
managed by X, and A's work in the activity is performed pursuant to an 
employment contract between A and X. Under paragraph (f)(1) of this 
section, work done by A in connection with the activity in any capacity 
is treated as participation in the activity by A. Accordingly, the 
conclusion is the same as in example (1). The conclusion would be the 
same if A owned no stock in X at any time, although in that case A's 
participation would not be taken into account in determining whether X 
materially participates in the restaurant activity.
    Example 3. B, an individual, is employed fulltime as a carpenter. B 
also owns an interest in a partnership which is engaged in a van 
conversion activity, which is a trade or business activity (within the 
meaning of Sec. 1.469-1T(e)(2)). B and C, the other partner, are the 
only participants in the activity for the taxable year. The activity is 
conducted entirely on Saturdays. Each Saturday throughout the taxable 
year, B and C work for eight hours in the activity. Although B does not 
participate in the activity for more than 500 hours during the taxable 
year, under paragraph (a)(3) of this section, B is treated for such year 
as materially participating in the activity because B participates in 
the activity for more than 100 hours during the taxable year, and B's 
participation in the activity for such year is not less than the 
participation of any other person in the activity for such year.
    Example 4. C, an individual, is employed full-time as an accountant. 
C also owns interests in a restaurant and a shoe store. The restaurant 
and shoe store are trade or business activities (within the meaning of 
Sec. 1.469-1T(e)(2)) that are treated as separate activities under the 
rules to be contained in Sec. 1.469-4T. Each activity has several full-
time employees. During the taxable year, C works in the restaurant 
activity for 400 hours and in the shoe store activity for 150 hours. 
Under paragraph (c) of this section, both the restaurant and shoe store 
activities are significant participation activities of C for the taxable 
year. Accordingly, since C's aggregate participation in the restaurant 
and shoe store activities during the taxable year exceeds 500 hours, C 
is treated under paragraph (a)(4) of this section as materially 
participating in both activities.
    Example 5. [Reserved]. See Sec. 1.469-5(k) Example 5 for this 
example.
    Example 6. The facts are the same as in example (5), except that D 
does not acquire any stock in the S corporation until 1994. Under 
paragraph (f)(1) of this section, D is not treated as participating in 
the activity for any taxable year prior to 1994 because D does not own 
as interest in the activity for any such taxable year. Accordingly, D 
materially participates in the activity for only one taxable year prior 
to 1995, and D is not treated under paragraph (a)(5) of this section as 
materially participating in the activity for 1995 or subsequent taxable 
years.
    Example 7. (i) E, a married individual filing a separate return for 
the taxable year, is employed full-time as an attorney. E also owns an 
interest in a professional football team that is a trade or business 
activity (within the meaning of Sec. 1.469-1T(e)(2)). E does no work in 
connection with this activity. E anticipates that, for the taxable year, 
E's deductions from the activity will exceed E's gross income from the 
activity and that, if E does not materially participate in the activity 
for the taxable year, part or all of F's passive activity loss for the 
taxable year will be disallowed under Sec. 1.469-1T(a)(1)(i). 
Accordingly, E pays E's spouse to work as an office receptionist in 
connection with the activity for an average of 15 hours per week during 
the taxable year.
    (ii) Under paragraph (f)(3) of this section any participation in the 
activity by E's spouse is treated as participation in the activity by E. 
However, under paragraph (f)(2)(i) of this section, the work done by E's 
spouse is not treated as participation in the activity because work as 
an office receptionist is not work of a type customarily done by an 
owner of a football team, and one of E's principal purposes for paying 
E's spouse to do this work is to avoid the disallowance under Sec. 
1.469-1T(a)(1)(i) of E's passive activity loss. Accordingly, E is not 
treated as participating in the activity for the taxable year.
    Example 8. (i) F, an individual, owns an interest in a partnership 
that feeds and sells cattle. The general partner of the partnership 
periodically mails F a letter setting forth certain proposed actions and 
decisions with respect to the cattle-feeding operation. Such actions and 
decisions include, for example, what kind of feed to purchase, how much 
to purchase, and when to purchase it, how often to feed cattle, and when 
to sell cattle. The letters explain the proposed actions and decisions, 
emphasize that taking or not taking a particular action or decision is 
solely within the discretion of F and other partners, and ask F to 
indicate a decision with respect to each proposed action by answering 
certain questions. The general partner receives a fee that constitutes 
earned income (within the meaning of section 911

[[Page 500]]

(d)(2)(A)) for managing the cattle-feeding operation. F is not treated 
as materially participating in the cattle-feeding operation under 
paragraph (a) (1) through (6) of this section.
    (ii) F's only participation in the cattle-feeding operation is to 
make certain managerial decisions. Under paragraph (b)(2)(ii) of this 
section, such management services are not taken into account in 
determining whether the taxpayer is treated as materially participating 
in the activity for a taxable year under paragraph (a)(7) of this 
section, if any other person performs services in connection with the 
management of the activity and receives compensation described in 
section 911(d)(2)(A) for such services. Therefore, F is not treated as 
materially participating for the taxable year in the cattle-feeding 
operation.

[T.D. 8175, 53 FR 5725, Feb. 25, 1988; 53 FR 15494, Apr. 29, 1988, as 
amended by T.D. 8253, 54 FR 20565, May 12, 1989; T.D. 8417, 57 FR 20759, 
May 15, 1992; 61 FR 14247, Apr. 1, 1996]



Sec. 1.469-6  Treatment of losses upon certain dispositions. [Reserved]



Sec. 1.469-7  Treatment of self-charged items of interest income and 
deduction.

    (a) In general--(1) Applicability and effect of rules. This section 
sets forth rules that apply, for purposes of section 469 and the 
regulations thereunder, in the case of a lending transaction (including 
guaranteed payments for the use of capital under section 707(c)) between 
a taxpayer and a passthrough entity in which the taxpayer owns a direct 
or indirect interest, or between certain passthrough entities. The rules 
apply only to items of interest income and interest expense that are 
recognized in the same taxable year. The rules--
    (i) Treat certain interest income resulting from these lending 
transactions as passive activity gross income;
    (ii) Treat certain deductions for interest expense that is properly 
allocable to the interest income as passive activity deductions; and
    (iii) Allocate the passive activity gross income and passive 
activity deductions resulting from this treatment among the taxpayer's 
activities.
    (2) Priority of rules in this section. The character of amounts 
treated under the rules of this section as passive activity gross income 
and passive activity deductions and the activities to which these 
amounts are allocated are determined under the rules of this section and 
not under the rules of Sec. Sec. 1.163-8T, 1.469-2(c) and (d), and 
1.469-2T(c) and (d).
    (b) Definitions. The following definitions set forth the meaning of 
certain terms for purposes of this section:
    (1) Passthrough entity. The term passthrough entity means a 
partnership or an S corporation.
    (2) Taxpayer's share. A taxpayer's share of an item of income or 
deduction of a passthrough entity is the amount treated as an item of 
income or deduction of the taxpayer for the taxable year under section 
702 (relating to the treatment of distributive shares of partnership 
items as items of partners) or section 1366 (relating to the treatment 
of pro rata shares of S corporation items as items of shareholders).
    (3) Taxpayer's indirect interest. The taxpayer has an indirect 
interest in an entity if the interest is held through one or more 
passthrough entities.
    (4) Entity taxable year. In applying this section for a taxable year 
of a taxpayer, the term entity taxable year means the taxable year of 
the passthrough entity for which the entity reports items that are taken 
into account under section 702 or section 1366 for the taxpayer's 
taxable year.
    (5) Deductions for a taxable year. The term deductions for a taxable 
year means deductions that would be allowable for the taxable year if 
the taxpayer's taxable income for all taxable years were determined 
without regard to sections 163(d), 170(b), 469, 613A(d), and 1211.
    (c) Taxpayer loans to passthrough entity--(1) Applicability. Except 
as provided in paragraph (g) of this section, this paragraph (c) applies 
with respect to a taxpayer's interest in a passthrough entity (borrowing 
entity) for a taxable year if--
    (i) The borrowing entity has deductions for the entity taxable year 
for interest charged to the borrowing entity by persons that own direct 
or indirect interests in the borrowing entity at any time during the 
entity taxable year (the borrowing entity's self-charged interest 
deductions);

[[Page 501]]

    (ii) The taxpayer owns a direct or an indirect interest in the 
borrowing entity at any time during the entity taxable year and has 
gross income for the taxable year from interest charged to the borrowing 
entity by the taxpayer or a passthrough entity through which the 
taxpayer holds an interest in the borrowing entity (the taxpayer's 
income from interest charged to the borrowing entity); and
    (iii) The taxpayer's share of the borrowing entity's self-charged 
interest deductions includes passive activity deductions.
    (2) General rule. If any of the borrowing entity's self-charged 
interest deductions are allocable to an activity for a taxable year in 
which this paragraph (c) applies, the passive activity gross income and 
passive activity deductions from that activity are determined under the 
following rules--
    (i) The applicable percentage of each item of the taxpayer's income 
for the taxable year from interest charged to the borrowing entity is 
treated as passive activity gross income from the activity; and
    (ii) The applicable percentage of each deduction for the taxable 
year for interest expense that is properly allocable (within the meaning 
of paragraph (f) of this section) to the taxpayer's income from the 
interest charged to the borrowing entity is treated as a passive 
activity deduction from the activity.
    (3) Applicable percentage. In applying this paragraph (c) with 
respect to a taxpayer's interest in a borrowing entity, the applicable 
percentage is separately determined for each of the taxpayer's 
activities. The percentage applicable to an activity for a taxable year 
is obtained by dividing--
    (i) The taxpayer's share for the taxable year of the borrowing 
entity's self-charged interest deductions that are treated as passive 
activity deductions from the activity by
    (ii) The greater of--
    (A) The taxpayer's share for the taxable year of the borrowing 
entity's aggregate self-charged interest deductions for all activities 
(regardless of whether these deductions are treated as passive activity 
deductions); or
    (B) The taxpayer's aggregate income for the taxable year from 
interest charged to the borrowing entity for all activities of the 
borrowing entity.
    (d) Passthrough entity loans to taxpayer--(1) Applicability. Except 
as provided in paragraph (g) of this section, this paragraph (d) applies 
with respect to a taxpayer's interest in a passthrough entity (lending 
entity) for a taxable year if--
    (i) The lending entity has gross income for the entity taxable year 
from interest charged by the lending entity to persons that own direct 
or indirect interests in the lending entity at any time during the 
entity taxable year (the lending entity's self-charged interest income);
    (ii) The taxpayer owns a direct or an indirect interest in the 
lending entity at any time during the entity taxable year and has 
deductions for the taxable year for interest charged by the lending 
entity to the taxpayer or a passthrough entity through which the 
taxpayer holds an interest in the lending entity (the taxpayer's 
deductions for interest charged by the lending entity); and
    (iii) The taxpayer's deductions for interest charged by the lending 
entity include passive activity deductions.
    (2) General rule. If any of the taxpayer's deductions for interest 
charged by the lending entity are allocable to an activity for a taxable 
year in which this paragraph (d) applies, the passive activity gross 
income and passive activity deductions from that activity are determined 
under the following rules--
    (i) The applicable percentage of the taxpayer's share for the 
taxable year of each item of the lending entity's self-charged interest 
income is treated as passive activity gross income from the activity.
    (ii) The applicable percentage of the taxpayer's share for the 
taxable year of each deduction for interest expense that is properly 
allocable (within the meaning of paragraph (f) of this section) to the 
lending entity's self-charged interest income is treated as a passive 
activity deduction from the activity.
    (3) Applicable percentage. In applying this paragraph (d) with 
respect to a taxpayer's interest in a lending entity, the applicable 
percentage is separately

[[Page 502]]

determined for each of the taxpayer's activities. The percentage 
applicable to an activity for a taxable year is obtained by dividing--
    (i) The taxpayer's deductions for the taxable year for interest 
charged by the lending entity, to the extent treated as passive activity 
deductions from the activity; by
    (ii) The greater of--
    (A) The taxpayer's aggregate deductions for all activities for the 
taxable year for interest charged by the lending entity (regardless of 
whether these deductions are treated as passive activity deductions); or
    (B) The taxpayer's aggregate share for the taxable year of the 
lending entity's self-charged interest income for all activities of the 
lending entity.
    (e) Identically-owned passthrough entities--(1) Applicability. 
Except as provided in paragraph (g) of this section, this paragraph (e) 
applies with respect to lending transactions between passthrough 
entities if each owner of the borrowing entity has the same 
proportionate ownership interest in the lending entity.
    (2) General rule. To the extent an owner shares in interest income 
from a loan between passthrough entities described in paragraph (e)(1) 
of this section, the owner is treated as having made the loan to the 
borrowing passthrough entity and paragraph (c) of this section applies 
to determine the applicable percentage of portfolio income of properly 
allocable interest expense that is recharacterized as passive.
    (3) Example. The following example illustrates the application of 
this paragraph (e):

    Example. (i) A and B, both calendar year taxpayers, each own a 50-
percent interest in the capital and profits of partnerships RS and XY, 
both calendar year partnerships. Under the partnership agreements of RS 
and XY, A and B are each entitled to a 50-percent distributive share of 
each partnership's income, gain, loss, deduction, or credit. RS makes a 
$20,000 loan to XY and XY pays RS $2,000 of interest for the taxable 
year. A's distributive share of interest income attributable to this 
loan is $1,000 (50 percentx$2,000). XY uses all of the proceeds received 
from RS is a passive activity. A's distributive share of interest 
expense attributable to the loan is $1,000 (50 percentx$2,000).
    (ii) This paragraph (e) applies in determining A's passive activity 
gross income because RS and XY are identically-owned passthrough 
entities as described in paragraph (e)(1) of this section. Under 
paragraph (e)(2) of this section, the RS-to-XY loan is treated as if A 
made the loan to XY. Therefore, A must apply paragraph (c) of this 
section to determine the applicable percentage of portfolio income that 
is recharacterized as passive income.
    (iii) Paragraph (c) of this section applies in determining A's 
passive activity gross income because: XY has deductions for interest 
charged to XY by RS for the taxable year (XY's self-charged interest 
deductions); A owns an interest in XY during XY's taxable year and has 
gross income for the taxable year from interest charged to XY by RS; and 
A's share of XY's self-charged interest deductions includes passive 
activity deductions. See paragraph (c)(1) of this section.
    (iv) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of A's interest income is recharacterized as passive activity 
gross income from the activity. Paragraph (c)(3) of this section 
provides that the applicable percentage is obtained by dividing A's 
share for the taxable year of XY's self-charged interest deductions that 
are treated as passive activity deductions from the activity ($1,000) by 
the greater of A's share for the taxable year of XY's self-charged 
interest deductions ($1,000), or A's income for the year from interest 
charged to XY ($1,000). Thus, A's applicable percentage is 100 percent 
($1,000/$1,000), and $1,000 (100 percentx$1,000) of A's income from 
interest charged to XY is treated as passive activity gross income from 
the passive activity.

    (f) Identification of properly allocable deductions. For purposes of 
this section, interest expense is properly allocable to an item of 
interest income if the interest expense is allocated under Sec. 1.163-
8T to an expenditure that--
    (1) Is properly chargeable to capital account with respect to the 
investment producing the item of interest income; or
    (2) May reasonably be taken into account as a cost of producing the 
item of interest income.
    (g) Election to avoid application of the rules of this section--(1) 
In general. Paragraphs (c), (d) and (e) of this section shall not apply 
with respect to any taxpayer's interest in a passthrough entity for a 
taxable year if the passthrough entity has made, under this paragraph 
(g), an election that applies to the entity's taxable year.

[[Page 503]]

    (2) Form of election. A passthrough entity makes an election under 
this paragraph (g) by attaching to its return (or amended return) a 
written statement that includes the name, address, and taxpayer 
identification number of the passthrough entity and a declaration that 
an election is being made under this paragraph (g).
    (3) Period for which election applies. An election under this 
paragraph (g) made with a return (or amended return) for a taxable year 
applies to that taxable year and all subsequent taxable years that end 
before the date on which the election is revoked.
    (4) Revocation. An election under this paragraph (g) may be revoked 
only with the consent of the Commissioner.
    (h) Examples. The following examples illustrate the principles of 
this section. The examples assume for purposes of simplifying the 
presentation, that the lending transactions described do not result in 
foregone interest (within the meaning of section 7872(e)(2)), original 
issue discount (within the meaning of section 1273), or total unstated 
interest (within the meaning of section 483(b)).

    Example 1. (i) A and B, two calendar year individuals, each own 50-
percent interests in the capital, profits and losses of AB, a calendar 
year partnership. AB is engaged in a single rental activity within the 
meaning of Sec. 1.469-1T(e)(3). AB borrows $50,000 from A and uses the 
loan proceeds in the rental activity. AB pays $5,000 of interest to A 
for the taxable year. A and B each incur $2,500 of interest expense as 
their distributive share of AB's interest expense.
    (ii) AB has self-charged interest deductions for the taxable year 
(i.e., the deductions for interest charged to AB by A); A owns a direct 
interest in AB during AB's taxable year and has income for A's taxable 
year from interest charged to AB; and A's share of AB's self-charged 
interest deductions includes passive activity deductions. Accordingly, 
paragraph (c) of this section applies in determining A's passive 
activity gross income. See paragraph (c)(1) of this section.
    (iii) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of A's interest income is recharacterized as passive activity 
gross income from AB's rental activity. Paragraph (c)(3) of this section 
provides that the applicable percentage is obtained by dividing A's 
share for the taxable year of AB's self-charged interest deductions that 
are treated as passive activity deductions from the activity ($2,500) by 
the greater of A's share for the taxable year of AB's self-charged 
interest deductions ($2,500), or A's income for the taxable year from 
interest charged to AB ($5,000). Thus, A's applicable percentage is 50 
percent ($2,500/$5,000), and $2,500 (50 percentx$5,000) of A's income 
from interest charged to AB is treated as passive activity gross income 
from the passive activity A conducts through AB.
    (iv) Because B does not have any gross income for the year from 
interest charged to AB, this section does not apply to B. See paragraph 
(c)(1)(ii) of this section.
    Example 2. (i) C and D, two calendar year taxpayers, each own 50-
percent interests in the capital and profits of CD, a calendar year 
partnership. CD is engaged in a single rental activity, within the 
meaning of Sec. 1.469-1T(e)(3). C obtains a $10,000 loan from a third-
party lender, and pays the lender $900 in interest for the taxable year. 
C lends the $10,000 to CD, and receives $1,000 of interest income from 
CD for the taxable year. D lends $20,000 to CD and receives $2,000 of 
interest income from CD for the taxable year. CD uses all of the 
proceeds in the rental activity. C and D are each allocated $1,500 (50 
percentx$3,000) of interest expense as their distributive share of CD's 
interest expense for the taxable year.
    (ii) CD has self-charged interest deductions for the taxable year 
(i.e., deductions for interest charged to CD by C and D); C and D each 
own direct interests in CD during CD's taxable year and have gross 
income for the taxable year from interest charged to CD; and both C's 
and D's shares of CD's self-charged interest deductions include passive 
activity deductions. Accordingly, paragraph (c) of this section applies 
in determining C's and D's passive activity gross income. See paragraph 
(c)(1) of this section.
    (iii) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of each partner's interest income is recharacterized as 
passive activity gross income from CD's rental activity. Paragraph 
(c)(3) of this section provides that C's applicable percentage is 
obtained by dividing C's share for the taxable year of CD's self-charged 
interest deductions that are treated as passive activity deductions from 
the activity ($1,500) by the greater of C's share for the taxable year 
of CD's self-charged interest deductions ($1,500), or C's income for the 
taxable year from interest charged to CD ($1,000). Thus, C's applicable 
percentage is 100 percent ($1,500/$1,500), and all of C's income from 
interest charged to CD ($1,000) is treated as passive activity gross 
income from the passive activity C conducts through CD. Similarly, D's 
applicable percentage is obtained by dividing D's share for the taxable 
year of CD's self-charged interest deductions that are treated as 
passive activity deductions from the activity ($1,500) by the greater of 
D's share for the taxable year of CD's self-charged interest

[[Page 504]]

deductions ($1,500), or D's income for the taxable year from interest 
charged to CD ($2,000). Thus, D's applicable percentage is 75 percent 
($1,500/$2,000), and $1,500 (75 percentx$2,000) of D's income from 
interest charged to CD is treated as passive activity gross income from 
the rental activity.
    (iv) The $900 of interest expense that C pays to the third-party 
lender is allocated under Sec. 1.163-8T(c)(1) to an expenditure that is 
properly chargeable to capital account with respect to the loan to CD. 
Thus, the expense is properly allocable to the interest income C 
receives from CD (see paragraph (f) of this section). Under paragraph 
(c)(2)(ii) of this section, the applicable percentage of C's deductions 
for the taxable year for interest expense that is properly allocable to 
C's income from interest charged to CD is recharacterized as a passive 
activity deduction from CD's rental activity. Accordingly, all of C's 
$900 interest deduction is treated as a passive activity deduction from 
the rental activity.
    Example 3. (i) E and F, calendar year taxpayers, each own 50 percent 
of the stock of X, a calendar year S corporation. E borrows $30,000 from 
X, and pays X $3,000 of interest for the taxable year. E uses $15,000 of 
the loan proceeds to make a personal expenditure (as defined in Sec. 
1.163-8T(b)(5)), and uses $15,000 of loan proceeds to purchase a trade 
or business activity in which E does not materially participate (within 
the meaning of Sec. 1.469-5T) for the taxable year. E and F each 
receive $1,500 as their pro rata share of X's interest income from the 
loan for the taxable year.
    (ii) X has gross income for X's taxable year from interest charged 
to E (X's self-charged interest income); E owns a direct interest in X 
during X's taxable year and has deductions for the taxable year for 
interest charged by X; and E's deductions for interest charged by X 
include passive activity deductions. Accordingly, paragraph (d) of this 
section applies in determining E's passive activity gross income. See 
paragraph (d)(1) of this section.
    (iii) Under the rules in paragraph (d)(2)(i) of this section, the 
applicable percentage of E's share of X's self-charged interest income 
is recharacterized as passive activity gross income from the activity. 
Paragraph (d)(3) of this section provides that the applicable percentage 
is obtained by dividing E's deductions for the taxable year for interest 
charged by X, to the extent treated as passive activity deductions from 
the activity ($1,500), by the greater of E's deductions for the taxable 
year for interest charged by X, regardless of whether those deductions 
are treated as passive activity deductions ($3,000), or E's share for 
the taxable year of X's self-charged interest income ($1,500). Thus, E's 
applicable percentage is 50 percent ($1,500/$3,000), and $750 (50 
percentx$1,500) of E's share of X's self-charged interest income is 
treated as passive activity gross income.
    (iv) Because F does not have any deductions for the taxable year for 
interest charged by X, this section does not apply to F. See paragraph 
(d)(1)(ii) of this section.
    Example 4. (i) This Example 4 illustrates the application of this 
section to a partner that has a different taxable year from the 
partnership. The facts are the same as in Example 1 except as follows: 
Partnership AB has properly adopted a fiscal year ending June 30 for 
federal tax purposes; AB borrows the $50,000 from A on October 1, 1990; 
and under the terms of the loan, AB must pay A $5,000 in interest 
annually, in quarterly installments, for a term of 2 years.
    (ii) For A's taxable years from 1990 through 1993 and AB's 
corresponding entity taxable years (as defined in paragraph (b)(4) of 
this section) A's interest income and AB's interest deductions from the 
loan are as follows:

------------------------------------------------------------------------
                                                    A's          AB's
                                                  interest     interest
                                                   income     deductions
------------------------------------------------------------------------
1990..........................................       $1,250            0
1991..........................................        5,000       $3,750
1992..........................................        3,750        5,000
1993..........................................            0        1,250
------------------------------------------------------------------------

    (iii) For A's taxable year ending December 31, 1990, the 
corresponding entity taxable year is AB's taxable year ending June 30, 
1990. Because AB does not have any deductions for the entity taxable 
year for interest charged to AB by A, paragraph (c) of this section does 
not apply in determining A's passive activity gross income for 1990 (see 
paragraph (c)(1)(i) of this section). Accordingly, A reports $1,250 of 
portfolio income on A's 1990 income tax return.
    (iv) For A's taxable year ending December 31, 1991, the 
corresponding entity taxable year ends on June 30, 1991. AB has $3,750 
of deductions for the entity taxable year for interest charged to AB by 
A (AB's self-charged interest deductions); A owns a direct interest in 
AB during the entity taxable year and has $5,000 of interest income for 
A's taxable year from interest charged to AB; and A's share of AB's 
self-charged interest deductions includes passive activity deductions. 
Accordingly, paragraph (c) of this section applies in determining A's 
passive activity gross income.
    (v) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of A's 1991 interest income is recharacterized as passive 
activity gross income from the activity. Paragraph (c)(3) of this 
section provides that the applicable percentage is obtained by dividing 
A's share for A's 1991 taxable year of AB's self-charged interest 
deductions that are treated as passive activity deductions from the 
activity (50 percentx$3,750 = $1,875) by the greater of A's share for 
A's taxable year of

[[Page 505]]

AB's self-charged interest deductions ($1,875), or A's income for A's 
taxable year from interest charged to AB ($5,000). Thus, A's applicable 
percentage is 37.5 percent ($1,875/$5,000), and $1,875 (37.5 
percentx$5,000) of A's income from interest charged to AB is treated as 
passive activity gross income from the passive activity A conducts 
through AB.
    (vi) For A's taxable year ending December 31, 1992, the 
corresponding entity taxable year ends on June 30, 1992. AB has $5,000 
of deductions for the entity taxable year for interest charged to AB by 
A (AB's self-charged interest deductions); A owns a direct interest in 
AB during the entity taxable year and has $3,750 of gross income for A's 
taxable year from interest charged to AB; and A's share of AB's self-
charged interest deductions includes passive activity deductions. 
Accordingly, paragraph (c) of this section applies in determining A's 
passive activity gross income.
    (vii) The applicable percentage for 1992 is obtained by dividing A's 
share for A's 1992 taxable year of AB's self-charged interest deductions 
that are treated as passive activity deductions from the activity 
($2,500) by the greater of A's share for A's taxable year of AB's self-
charged interest deductions ($2,500), or A's income for A's taxable year 
from interest charged to AB ($3,750). Thus, A's applicable percentage is 
66\2/3\ percent ($2,500/$3,750), and $2,500 (66\2/3\ percentx$3,750) of 
A's income from interest charged to AB is treated as passive activity 
gross income from the passive activity A conducts through AB.
    (viii) Paragraph (c) of this section does not apply in determining 
A's passive activity gross income for the taxable year ending December 
31, 1993, because A has no gross income for the taxable year from 
interest charged to AB (see paragraph (c)(1)(ii) of this section). A's 
share of AB's self-charged interest deductions for the entity taxable 
year ending June 30, 1993 ($625) is taken into account as a passive 
activity deduction on A's 1993 income tax return.
    (ix) Because B does not have any gross income from interest charged 
to AB for any of the taxable years, this section does not apply to B. 
See paragraph (c)(1)(ii) of this section.
    Example 5. (i) This Example 5 illustrates the application of the 
rules of this section in the case of a taxpayer who has an indirect 
interest in a partnership. G, a calendar year taxpayer, is an 80-percent 
partner in partnership UTP. UTP owns a 25-percent interest in the 
capital and profits of partnership LTP. UTP and LTP are both calendar 
year partnerships. The partners of LTP conduct a single passive activity 
through LTP. UTP obtains a $10,000 loan from a bank, and pays the bank 
$1,000 of interest per year. G's distributive share of the interest paid 
to the bank is $800 (80 percentx$1,000). UTP uses the $10,000 debt 
proceeds and another $10,000 of cash to make a loan to LTP, and LTP pays 
UTP $2,000 of interest for the taxable year. G's distributive share of 
interest income attributable to the UTP-to-LTP loan is $1,600 (80 
percentx$2,000). LTP uses all of the proceeds received from UTP in the 
passive activity. UTP's distributive share of interest expense 
attributable to the UTP-to-LTP loan is $500 (25 percentx$2,000). G's 
distributive share of interest expense attributable to the UTP-to-LTP 
loan is $400 (80 percentx$500).
    (ii) LTP has deductions for interest charged to LTP by UTP for the 
taxable year (LTP's self-charged interest deductions); G owns an 
indirect interest in LTP during LTP's taxable year and has gross income 
for the taxable year from interest charged to LTP by a passthrough 
entity (UTP) through which G owns an interest in LTP; and G's share of 
LTP's self-charged interest deductions includes passive activity 
deductions. Accordingly, paragraph (c) of this section applies in 
determining G's passive activity gross income. See paragraph (c)(1) of 
this section.
    (iii) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of G's interest income is recharacterized as passive activity 
gross income from the activity. Paragraph (c)(3) of this section 
provides that the applicable percentage is obtained by dividing G's 
share for the taxable year of LTP's self-charged interest deductions 
that are treated as passive activity deductions from the activity ($400) 
by the greater of G's share for the taxable year of LTP's self-charged 
interest deductions ($400), or G's income for the year from interest 
charged to LTP ($1,600). Thus, G's applicable percentage is 25 percent 
($400/$1,600), and $400 (25 percentx$1,600) of G's income from interest 
charged to LTP is treated as passive activity gross income from the 
passive activity that G conducts through UTP and LTP.
    (iv) G's $800 distributive share of the interest expense that UTP 
pays to the third-party lender is allocated under Sec. 1.163-8T(c)(1) 
to an expenditure that is properly chargeable to capital account with 
respect to the loan to LTP. Thus, the expense is a deduction properly 
allocable to the interest income that G receives as a result of the UTP-
to-LTP loan (see paragraph (f) of this section). Under paragraph 
(c)(2)(ii) of this section, the applicable percentage of G's deductions 
for the taxable year for interest expense that is properly allocable to 
G's income from interest charged by UTP to LTP is recharacterized as a 
passive activity deduction from LTP's passive activity. Accordingly, 
$200 (25 percentx$800) of G's interest deduction is treated as a passive 
activity deduction from LTP's activity.
    Example 6. (i) This Example 6 illustrates the application of the 
rules of this section in the case of a taxpayer who conducts two passive 
activities through a passthrough entity. J, a calendar year taxpayer, is 
the 100-percent

[[Page 506]]

shareholder of Y, a calendar year S corporation. J conducts two passive 
activities through Y: a rental activity and a trade or business activity 
in which J does not materially participate. Y borrows $80,000 from J, 
and uses $60,000 of the loan proceeds in the rental activity and $20,000 
of the loan proceeds in the passive trade or business activity. Y pays 
$8,000 of interest to J for the taxable year, and J incurs $8,000 of 
interest expense as J's distributive share of Y's interest expense.
    (ii) Y has self-charged interest deductions for the taxable year 
(i.e., the deductions for interest charged to Y by J); J owns a direct 
interest in Y during Y's taxable year and has gross income for J's 
taxable year from interest charged to Y; and J's share of Y's self-
charged interest deductions includes passive activity deductions. 
Accordingly, paragraph (c) of this section applies in determining J's 
passive activity gross income. See paragraph (c)(1) of this section.
    (iii) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of J's interest income is recharacterized as passive activity 
gross income attributable to the rental activity. Paragraph (c)(3) of 
this section provides that the applicable percentage is obtained by 
dividing J's share for the taxable year of Y's self-charged interest 
deductions that are treated as passive activity deductions from the 
rental activity ($6,000) by the greater of J's share for the taxable 
year of Y's self-charged interest deductions ($8,000), or J's income for 
the taxable year from interest charged to Y ($8,000). Thus, J's 
applicable percentage is 75 percent ($6,000/$8,000), and $6,000 (75 
percentx$8,000) of J's income from interest charged to Y is treated as 
passive activity gross income from the rental activity J conducts 
through Y.
    (iv) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of J's interest income is recharacterized as passive activity 
gross income attributable to the passive trade or business activity. 
Paragraph (c)(3) of this section provides that the applicable percentage 
is obtained by dividing J's share for the taxable year of Y's self-
charged interest deductions that are treated as passive activity 
deductions from the passive trade or business activity ($2,000) by the 
greater of J's share for the taxable year of Y's self-charged interest 
deductions ($8,000), or J's income for the taxable year from interest 
charged to Y ($8,000). Thus, J's applicable percentage is 25 percent 
($2,000/$8,000), and $2,000 of J's income from interest charged to Y is 
treated as passive activity gross income from the passive trade or 
business activity J conducts through Y.

[T.D. 9013, 67 FR 54089, Aug. 21, 2002]



Sec. 1.469-8  Application of section 469 to trust, estates, and their 
beneficiaries. [Reserved]



Sec. 1.469-9  Rules for certain rental real estate activities.

    (a) Scope and purpose. This section provides guidance to taxpayers 
engaged in certain real property trades or businesses on applying 
section 469(c)(7) to their rental real estate activities.
    (b) Definitions. The following definitions apply for purposes of 
this section:
    (1) Trade or business. A trade or business is any trade or business 
determined by treating the types of activities in Sec. 1.469-4(b)(1) as 
if they involved the conduct of a trade or business, and any interest in 
rental real estate, including any interest in rental real estate that 
gives rise to deductions under section 212.
    (2) Real property trade or business. Real property trade or business 
is defined in section 469(c)(7)(C).
    (3) Rental real estate. Rental real estate is any real property used 
by customers or held for use by customers in a rental activity within 
the meaning of Sec. 1.469-1T(e)(3). However, any rental real estate 
that the taxpayer grouped with a trade or business activity under Sec. 
1.469-4(d)(1)(i)(A) or (C) is not an interest in rental real estate for 
purposes of this section.
    (4) Personal services. Personal services means any work performed by 
an individual in connection with a trade or business. However, personal 
services do not include any work performed by an individual in the 
individual's capacity as an investor as described in Sec. 1.469-
5T(f)(2)(ii).
    (5) Material participation. Material participation has the same 
meaning as under Sec. 1.469-5T. Paragraph (f) of this section contains 
rules applicable to limited partnership interests in rental real estate 
that a qualifying taxpayer elects to aggregate with other interests in 
rental real estate of that taxpayer.
    (6) Qualifying taxpayer. A qualifying taxpayer is a taxpayer that 
owns at least one interest in rental real estate and meets the 
requirements of paragraph (c) of this section.

[[Page 507]]

    (c) Requirements for qualifying taxpayers--(1) In general. A 
qualifying taxpayer must meet the requirements of section 469(c)(7)(B).
    (2) Closely held C corporations. A closely held C corporation meets 
the requirements of paragraph (c)(1) of this section by satisfying the 
requirements of section 469(c)(7)(D)(i). For purposes of section 
469(c)(7)(D)(i), gross receipts do not include items of portfolio income 
within the meaning of Sec. 1.469-2T(c)(3).
    (3) Requirement of material participation in the real property 
trades or businesses. A taxpayer must materially participate in a real 
property trade or business in order for the personal services provided 
by the taxpayer in that real property trade or business to count towards 
meeting the requirements of paragraph (c)(1) of this section.
    (4) Treatment of spouses. Spouses filing a joint return are 
qualifying taxpayers only if one spouse separately satisfies both 
requirements of section 469(c)(7)(B). In determining the real property 
trades or businesses in which a married taxpayer materially participates 
(but not for any other purpose under this paragraph (c)), work performed 
by the taxpayer's spouse in a trade or business is treated as work 
performed by the taxpayer under Sec. 1.469-5T(f)(3), regardless of 
whether the spouses file a joint return for the year.
    (5) Employees in real property trades or businesses. For purposes of 
paragraph (c)(1) of this section, personal services performed during a 
taxable year as an employee generally will be treated as performed in a 
trade or business but will not be treated as performed in a real 
property trade or business, unless the taxpayer is a five-percent owner 
(within the meaning of section 416(i)(1)(B)) in the employer. If an 
employee is not a five-percent owner in the employer at all times during 
the taxable year, only the personal services performed by the employee 
during the period the employee is a five-percent owner in the employer 
will be treated as performed in a real property trade or business.
    (d) General rule for determining real property trades or 
businesses--(1) Facts and circumstances. The determination of a 
taxpayer's real property trades or businesses for purposes of paragraph 
(c) of this section is based on all of the relevant facts and 
circumstances. A taxpayer may use any reasonable method of applying the 
facts and circumstances in determining the real property trades or 
businesses in which the taxpayer provides personal services. Depending 
on the facts and circumstances, a real property trade or business 
consists either of one or more than one trade or business specifically 
described in section 469(c)(7)(C). A taxpayer's grouping of activities 
under Sec. 1.469-4 does not control the determination of the taxpayer's 
real property trades or businesses under this paragraph (d).
    (2) Consistency requirement. Once a taxpayer determines the real 
property trades or businesses in which personal services are provided 
for purposes of paragraph (c) of this section, the taxpayer may not 
redetermine those real property trades or businesses in subsequent 
taxable years unless the original determination was clearly 
inappropriate or there has been a material change in the facts and 
circumstances that makes the original determination clearly 
inappropriate.
    (e) Treatment of rental real estate activities of a qualifying 
taxpayer--(1) In general. Section 469(c)(2) does not apply to any rental 
real estate activity of a taxpayer for a taxable year in which the 
taxpayer is a qualifying taxpayer under paragraph (c) of this section. 
Instead, a rental real estate activity of a qualifying taxpayer is a 
passive activity under section 469 for the taxable year unless the 
taxpayer materially participates in the activity. Each interest in 
rental real estate of a qualifying taxpayer will be treated as a 
separate rental real estate activity, unless the taxpayer makes an 
election under paragraph (g) of this section to treat all interests in 
rental real estate as a single rental real estate activity. Each 
separate rental real estate activity, or the single combined rental real 
estate activity if the taxpayer makes an election under paragraph (g), 
will be an activity of the taxpayer for all purposes of section 469, 
including the former passive activity rules under section

[[Page 508]]

469(f) and the disposition rules under section 469(g). However, section 
469 will continue to be applied separately with respect to each publicly 
traded partnership, as required under section 469(k), notwithstanding 
the rules of this section.
    (2) Treatment as a former passive activity. For any taxable year in 
which a qualifying taxpayer materially participates in a rental real 
estate activity, that rental real estate activity will be treated as a 
former passive activity under section 469(f) if disallowed deductions or 
credits are allocated to the activity under Sec. 1.469-1(f)(4).
    (3) Grouping rental real estate activities with other activities--
(i) In general. For purposes of this section, a qualifying taxpayer may 
not group a rental real estate activity with any other activity of the 
taxpayer. For example, if a qualifying taxpayer develops real property, 
constructs buildings, and owns an interest in rental real estate, the 
taxpayer's interest in rental real estate may not be grouped with the 
taxpayer's development activity or construction activity. Thus, only the 
participation of the taxpayer with respect to the rental real estate may 
be used to determine if the taxpayer materially participates in the 
rental real estate activity under Sec. 1.469-5T.
    (ii) Special rule for certain management activities. A qualifying 
taxpayer may participate in a rental real estate activity through 
participation, within the meaning of Sec. Sec. 1.469-5(f) and 5T(f), in 
an activity involving the management of rental real estate (even if this 
management activity is conducted through a separate entity). In 
determining whether the taxpayer materially participates in the rental 
real estate activity, however, work the taxpayer performs in the 
management activity is taken into account only to the extent it is 
performed in managing the taxpayer's own rental real estate interests.
    (4) Example. The following example illustrates the application of 
this paragraph (e).

    Example. (i) Taxpayer B owns interests in three rental buildings, U, 
V and W. In 1995, B has $30,000 of disallowed passive losses allocable 
to Building U and $10,000 of disallowed passive losses allocable to 
Building V under Sec. 1.469-1(f)(4). In 1996, B has $5,000 of net 
income from Building U, $5,000 of net losses from Building V, and 
$10,000 of net income from Building W. Also in 1996, B is a qualifying 
taxpayer within the meaning of paragraph (c) of this section. Each 
building is treated as a separate activity of B under paragraph (e)(1) 
of this section, unless B makes the election under paragraph (g) to 
treat the three buildings as a single rental real estate activity. If 
the buildings are treated as separate activities, material participation 
is determined separately with respect to each building. If B makes the 
election under paragraph (g) to treat the buildings as a single 
activity, all participation relating to the buildings is aggregated in 
determining whether B materially participates in the combined activity.
    (ii) Effective beginning in 1996, B makes the election under 
paragraph (g) to treat the three buildings as a single rental real 
estate activity. B works full-time managing the three buildings and thus 
materially participates in the combined activity in 1996 (even if B 
conducts this management function through a separate entity, including a 
closely held C corporation). Accordingly, the combined activity is not a 
passive activity of B in 1996. Moreover, as a result of the election 
under paragraph (g), disallowed passive losses of $40,000 
($30,000+$10,000) are allocated to the combined activity. B's net income 
from the activity for 1996 is $10,000 ($5,000-$5,000+$10,000). This net 
income is nonpassive income for purposes of section 469. However, under 
section 469(f), the net income from a former passive activity may be 
offset with the disallowed passive losses from the same activity. 
Because Buildings U, V and W are treated as one activity for all 
purposes of section 469 due to the election under paragraph (g), and 
this activity is a former passive activity under section 469(f), B may 
offset the $10,000 of net income from the buildings with an equal amount 
of disallowed passive losses allocable to the buildings, regardless of 
which buildings produced the income or losses. As a result, B has 
$30,000 ($40,000-$10,000) of disallowed passive losses remaining from 
the buildings after 1996.

    (f) Limited partnership interests in rental real estate activities--
(1) In general. If a taxpayer elects under paragraph (g) of this section 
to treat all interests in rental real estate as a single rental real 
estate activity, and at least one interest in rental real estate is held 
by the taxpayer as a limited partnership interest (within the meaning of 
Sec. 1.469-

[[Page 509]]

5T(e)(3)), the combined rental real estate activity will be treated as a 
limited partnership interest of the taxpayer for purposes of determining 
material participation. Accordingly, the taxpayer will not be treated 
under this section as materially participating in the combined rental 
real estate activity unless the taxpayer materially participates in the 
activity under the tests listed in Sec. 1.469-5T(e)(2) (dealing with 
the tests for determining the material participation of a limited 
partner).
    (2) De minimis exception. If a qualifying taxpayer elects under 
paragraph (g) of this section to treat all interests in rental real 
estate as a single rental real estate activity, and the taxpayer's share 
of gross rental income from all of the taxpayer's limited partnership 
interests in rental real estate is less than ten percent of the 
taxpayer's share of gross rental income from all of the taxpayer's 
interests in rental real estate for the taxable year, paragraph (f)(1) 
of this section does not apply. Thus the taxpayer may determine material 
participation under any of the tests listed in Sec. 1.469-5T(a) that 
apply to rental real estate activities.
    (g) Election to treat all interests in rental real estate as a 
single rental real estate activity--(1) In general. A qualifying 
taxpayer may make an election to treat all of the taxpayer's interests 
in rental real estate as a single rental real estate activity. This 
election is binding for the taxable year in which it is made and for all 
future years in which the taxpayer is a qualifying taxpayer under 
paragraph (c) of this section, even if there are intervening years in 
which the taxpayer is not a qualifying taxpayer. The election may be 
made in any year in which the taxpayer is a qualifying taxpayer, and the 
failure to make the election in one year does not preclude the taxpayer 
from making the election in a subsequent year. In years in which the 
taxpayer is not a qualifying taxpayer, the election will not have effect 
and the taxpayer's activities will be those determined under Sec. 
1.469-4. If there is a material change in the taxpayer's facts and 
circumstances, the taxpayer may revoke the election using the procedure 
described in paragraph (g)(3) of this section.
    (2) Certain changes not material. The fact that an election is less 
advantageous to the taxpayer in a particular taxable year is not, of 
itself, a material change in the taxpayer's facts and circumstances. 
Similarly, a break in the taxpayer's status as a qualifying taxpayer is 
not, of itself, a material change in the taxpayer's facts and 
circumstances.
    (3) Filing a statement to make or revoke the election. A qualifying 
taxpayer makes the election to treat all interests in rental real estate 
as a single rental real estate activity by filing a statement with the 
taxpayer's original income tax return for the taxable year. This 
statement must contain a declaration that the taxpayer is a qualifying 
taxpayer for the taxable year and is making the election pursuant to 
section 469(c)(7)(A). The taxpayer may make this election for any 
taxable year in which section 469(c)(7) is applicable. A taxpayer may 
revoke the election only in the taxable year in which a material change 
in the taxpayer's facts and circumstances occurs or in a subsequent year 
in which the facts and circumstances remain materially changed from 
those in the taxable year for which the election was made. To revoke the 
election, the taxpayer must file a statement with the taxpayer's 
original income tax return for the year of revocation. This statement 
must contain a declaration that the taxpayer is revoking the election 
under section 469(c)(7)(A) and an explanation of the nature of the 
material change.
    (h) Interests in rental real estate held by certain passthrough 
entities--(1) General rule. Except as provided in paragraph (h)(2) of 
this section, a qualifying taxpayer's interest in rental real estate 
held by a partnership or an S corporation (passthrough entity) is 
treated as a single interest in rental real estate if the passthrough 
entity grouped its rental real estate as one rental activity under Sec. 
1.469-4(d)(5). If the passthrough entity grouped its rental real estate 
into separate rental activities under Sec. 1.469-4(d)(5), each rental 
real estate activity of the passthrough entity will be treated as a 
separate interest in rental real estate of the qualifying taxpayer. 
However, the qualifying taxpayer may elect under paragraph (g) of

[[Page 510]]

this section to treat all interests in rental real estate, including the 
rental real estate interests held through passthrough entities, as a 
single rental real estate activity.
    (2) Special rule if a qualifying taxpayer holds a fifty-percent or 
greater interest in a passthrough entity. If a qualifying taxpayer owns, 
directly or indirectly, a fifty-percent or greater interest in the 
capital, profits, or losses of a passthrough entity for a taxable year, 
each interest in rental real estate held by the passthrough entity will 
be treated as a separate interest in rental real estate of the 
qualifying taxpayer, regardless of the passthrough entity's grouping of 
activities under Sec. 1.469-4(d)(5). However, the qualifying taxpayer 
may elect under paragraph (g) of this section to treat all interests in 
rental real estate, including the rental real estate interests held 
through passthrough entities, as a single rental real estate activity.
    (3) Special rule for interests held in tiered passthrough entities. 
If a passthrough entity owns a fifty-percent or greater interest in the 
capital, profits, or losses of another passthrough entity for a taxable 
year, each interest in rental real estate held by the lower-tier entity 
will be treated as a separate interest in rental real estate of the 
upper-tier entity, regardless of the lower-tier entity's grouping of 
activities under Sec. 1.469-4(d)(5).
    (i) [Reserved]
    (j) $25,000 offset for rental real estate activities of qualifying 
taxpayers--(1) In general. A qualifying taxpayer's passive losses and 
credits from rental real estate activities (including prior-year 
disallowed passive activity losses and credits from rental real estate 
activities in which the taxpayer materially participates) are allowed to 
the extent permitted under section 469(i). The amount of losses or 
credits allowable under section 469(i) is determined after the rules of 
this section are applied. However, losses allowable by reason of this 
section are not taken into account in determining adjusted gross income 
for purposes of section 469(i)(3).
    (2) Example. The following example illustrates the application of 
this paragraph (j).
    Example (i) Taxpayer A owns building X and building Y, both 
interests in rental real estate. In 1995, A is a qualifying taxpayer 
within the meaning of paragraph (c) of this section. A does not elect to 
treat X and Y as one activity under section 469(c)(7)(A) and paragraph 
(g) of this section. As a result, X and Y are treated as separate 
activities pursuant to section 469(c)(7)(A)(ii). A materially 
participates in X which has $100,000 of passive losses disallowed from 
prior years and produces $20,000 of losses in 1995. A does not 
materially participate in Y which produces $40,000 of income in 1995. A 
also has $50,000 of income from other nonpassive sources in 1995. A 
otherwise meets the requirements of section 469(i).
    (ii) Because X is not a passive activity in 1995, the $20,000 of 
losses produced by X in 1995 are nonpassive losses that may be used by A 
to offset part of the $50,000 of nonpassive income. Accordingly, A is 
left with $30,000 ($50,000-$20,000) of nonpassive income. In addition, A 
may use the prior year disallowed passive losses of X to offset any 
income from X and passive income from other sources. Therefore, A may 
offset the $40,000 of passive income from Y with $40,000 of passive 
losses from X.
    (iii) Because A has $60,000 ($100,000-$40,000) of passive losses 
remaining from X and meets all of the requirements of section 469(i), A 
may offset up to $25,000 of nonpassive income with passive losses from X 
pursuant to section 469(i). As a result, A has $5,000 ($30,000-$25,000) 
of nonpassive income remaining and disallowed passive losses from X of 
$35,000 ($60,000-$25,000) in 1995.

[T.D. 8645, 60 FR 66499, Dec. 22, 1995]



Sec. 1.469-10  Application of section 469 to publicly traded 
partnerships.

    (a) [Reserved]
    (b) Publicly traded partnership--(1) In general. For purposes of 
section 469(k), a partnership is a publicly traded partnership only if 
the partnership is a publicly traded partnership as defined in Sec. 
1.7704-1.
    (2) Effective date. This section applies for taxable years of a 
partnership beginning on or after December 17, 1998.

[T.D. 8799, 63 FR 69553, Dec. 17, 1998]



Sec. 1.469-11  Effective date and transition rules.

    (a) Generally applicable effective dates. Except as otherwise 
provided in this section--
    (1) The rules contained in Sec. Sec. 1.469-1, 1.469-1T, 1.469-2, 
1.469-2T, 1.469-3, 1.469-3T, 1.469-4, 1.469-5, and 1.469-5T apply

[[Page 511]]

for taxable years ending after May 10, 1992.
    (2) The rules contained in 26 CFR 1.469-1T, 1.469-2T, 1.469-3T, 
1.469-4T, 1.469-5T, 1.469-11T (b) and (c) (as contained in the CFR 
edition revised as of April 1, 1992) apply for taxable years beginning 
after December 31, 1986, and ending on or before May 10, 1992;
    (3) The rules contained in Sec. 1.469-9 apply for taxable years 
beginning on or after January 1, 1995, and to elections made under Sec. 
1.469-9(g) with returns filed on or after January 1, 1995;
    (4) The rules contained in Sec. 1.469-7 apply for taxable years 
ending after December 31, 1986; and
    (5) This section applies for taxable years beginning after December 
31, 1986.
    (b) Additional effective dates--(1) Application of 1992 amendments 
for taxable years beginning before October 4, 1994. Except as provided 
in paragraph (b)(2) of this section, for taxable years that end after 
May 10, 1992, and begin before October 4, 1994, a taxpayer may determine 
tax liability in accordance with Project PS-1-89 published at 1992-1 
C.B. 1219 (see Sec. 601.601(d)(2)(ii)(b) of this chapter).
    (2) Additional transition rule for 1992 amendments. If a taxpayer's 
first taxable year ending after May 10, 1992, begins on or before that 
date, the taxpayer may treat the taxable year, for purposes of paragraph 
(a) of this section, as a taxable year ending on or before May 10, 1992.
    (3) Fresh starts under consistency rules--(i) Regrouping when tax 
liability is first determined under Project PS-1-89. For the first 
taxable year in which a taxpayer determines its tax liability under 
Project PS-1-89, the taxpayer may regroup its activities without regard 
to the manner in which the activities were grouped in the preceding 
taxable year and must regroup its activities if the grouping in the 
preceding taxable year is inconsistent with the rules of Project PS-1-
89.
    (ii) Regrouping when tax liability is first determined under Sec. 
1.469-4. For the first taxable year in which a taxpayer determines its 
tax liability under Sec. 1.469-4, rather than under the rules of 
Project PS-1-89, the taxpayer may regroup its activities without regard 
to the manner in which the activities were grouped in the preceding 
taxable year and must regroup its activities if the grouping in the 
preceding taxable year is inconsistent with the rules of Sec. 1.469-4.
    (iii) Regrouping when taxpayer is first subject to section 
469(c)(7). For the first taxable year beginning after December 31, 1993, 
a taxpayer may regroup its activities to the extent necessary or 
appropriate to avail itself of the provisions of section 469(c)(7) and 
without regard to the manner in which the activities were grouped in the 
preceding taxable year.
    (4) Certain investment credit property. (i) The rules contained in 
Sec. 1.469-3(f) apply with respect to property placed in service after 
December 31, 1990 (other than property described in section 11813 (c)(2) 
of the Omnibus Reconciliation Act of 1990 (P.L. 101-508)).
    (ii) The rules contained in 26 CFR 1.469-3T(f) (as contained in the 
CFR edition revised as of April 1, 1992) apply with respect to property 
placed in service on or before December 31, 1990, and property described 
in section 11813(c)(2) of the Omnibus Reconcilation Act of 1990.
    (c) Special rules--(1) Application of certain income 
recharacterization rules and self-charged rules--(i) Certain 
recharacterization rules inapplicable in 1987. No amount of gross income 
shall be treated under Sec. 1.469-2T(f)(3) through (7) as income that 
is not from a passive activity for any taxable year of the taxpayer 
beginning before January 1, 1988.
    (ii) Property rented to a nonpassive activity. In applying Sec. 
1.469-2(f)(6) or Sec. 1.469-2T(f)(6) to a taxpayer's rental of an item 
of property, the taxpayer's net rental activity income (within the 
meaning of Sec. 1.469-2(f)(9)(iv) or Sec. 1.469-2T(f)(9)(iv)) from the 
property for any taxable year beginning after December 31, 1987, does 
not include the portion of the income (if any) that is attributable to 
the rental of that item of property pursuant to a written binding 
contract entered into before February 19, 1988.
    (iii) Self-charged rules. For taxable years beginning before June 4, 
1991--
    (1) A taxpayer is not required to apply the rules in Sec. 1.469-7 
in computing

[[Page 512]]

the taxpayer's passive activity loss and passive activity credit; and
    (2) A taxpayer that owns an interest in a passthrough entity may use 
any reasonable method of offsetting items of interest income and 
interest expense from lending transactions between the passthrough 
entity and its owners or between identically-owned passthrough entities 
(as defined in Sec. 1.469-7(e)) to compute the taxpayer's passive 
activity loss and passive activity credit. Items from nonlending 
transactions cannot be offset under the self-charged rules.
    (2) Qualified low-income housing projects. For a transitional rule 
concerning the application of section 469 to losses from qualified low-
income housing projects, see section 502 of the Tax Reform Act of 1986.
    (3) Effect of events occurring in years prior to 1987. The treatment 
for a taxable year beginning after December 31, 1986, of any item of 
income, gain, loss, deduction, or credit as an item of passive activity 
gross income, passive activity deduction, or credit from a passive 
activity, is determined as if section 469 and the regulations thereunder 
had been in effect for taxable years beginning before January 1, 1987, 
but without regard to any passive activity loss or passive activity 
credit that would have been disallowed for any taxable year beginning 
before January 1, 1987, if section 469 and the regulations thereunder 
had been in effect for that year. For example, in determining whether a 
taxpayer materially participates in an activity under Sec. 1.469-
5T(a)(5) (relating to taxpayers who have materially participated in an 
activity for five of the ten immediately preceding taxable years) for 
any taxable year beginning after December 31, 1986, the taxpayer's 
participation in the activity for all prior taxable years (including 
taxable years beginning before 1987) is taken into account. See Sec. 
1.469-5(j) (relating to the determination of material participation for 
taxable years beginning before January 1, 1987).
    (d) Examples. The following examples illustrate the application of 
paragraph (c) of this section:

    Example 1. A, a calendar year individual, is a partner in a 
partnership with a taxable year ending on January 31. During its taxable 
year ending January 31, 1987, the partnership was engaged in a single 
activity involving the conduct of a trade or business. In applying 
section 469 and the regulations thereunder to A for calendar year 1987, 
A's distributive share of partnership items for the partnership's 
taxable year ending January 31, 1987, is taken into account. Therefore, 
under Sec. 1.469-2T(e)(1) and paragraph (c)(3) of this section, A's 
participation in the activity throughout the partnership's taxable year 
beginning February 1, 1986, and ending January 31, 1987, is taken into 
account for purposes of determining the character under section 469 of 
the items of gross income, deduction, and credit allocated to A for the 
partnership's taxable year ending January 31, 1987.
    Example 2. B, a calendar year individual, is a beneficiary of a 
trust described in section 651 that has a taxable year ending January 
31. The trust conducts a rental activity (within the meaning of Sec. 
1.469-1T(e)(3)). Because the trust's taxable year ending January 31, 
1987, began before January 1, 1987, section 469 and the regulations 
thereunder do not applying to the trust for that year. Section 469 and 
the regulations thereunder do apply, however, to B for B's calender year 
1987. Therefore, income of the trust from the rental activity for the 
trust's taxable year ending January 31, 1987, that is included in B's 
gross income for 1987 is taken into account in apply section 469 to B 
for 1987.

[T.D. 8417, 57 FR 20759, May 15, 1992, as amended by T.D. 8417, 59 FR 
45623, Sept. 2, 1994; T.D. 8565, 59 FR 50489, Oct. 4, 1994; T.D. 8645, 
60 FR 66501, Dec. 22, 1995; T.D. 9013, 67 FR 54093, Aug. 21, 2002]

                               inventories



Sec. 1.471-1  Need for inventories.

    In order to reflect taxable income correctly, inventories at the 
beginning and end of each taxable year are necessary in every case in 
which the production, purchase, or sale of merchandise is an income-
producing factor. The inventory should include all finished or partly 
finished goods and, in the case of raw materials and supplies, only 
those which have been acquired for sale or which will physically become 
a part of merchandise intended for sale, in which class fall containers, 
such as kegs, bottles, and cases, whether returnable or not, if title 
thereto will pass to the purchaser of the product to be sold therein. 
Merchandise should be included in the inventory only if title

[[Page 513]]

thereto is vested in the taxpayer. Accordingly, the seller should 
include in his inventory goods under contract for sale but not yet 
segregated and applied to the contract and goods out upon consignment, 
but should exclude from inventory goods sold (including containers), 
title to which has passed to the purchaser. A purchaser should include 
in inventory merchandise purchased (including containers), title to 
which has passed to him, although such merchandise is in transit or for 
other reasons has not been reduced to physical possession, but should 
not include goods ordered for future delivery, transfer of title to 
which has not yet been effected. (But see Sec. 1.472-1.)

[T.D. 6500, 25 FR 11724, Nov. 26, 1960]



Sec. 1.471-2  Valuation of inventories.

    (a) Section 471 provides two tests to which each inventory must 
conform:
    (1) It must conform as nearly as may be to the best accounting 
practice in the trade or business, and
    (2) It must clearly reflect the income.
    (b) It follows, therefore, that inventory rules cannot be uniform 
but must give effect to trade customs which come within the scope of the 
best accounting practice in the particular trade or business. In order 
to clearly reflect income, the inventory practice of a taxpayer should 
be consistent from year to year, and greater weight is to be given to 
consistency than to any particular method of inventorying or basis of 
valuation so long as the method or basis used is in accord with 
Sec. Sec. 1.471-1 through 1.471-11.
    (c) The bases of valuation most commonly used by business concerns 
and which meet the requirements of section 471 are (1) cost and (2) cost 
or market, whichever is lower. (For inventories by dealers in 
securities, see Sec. 1.471-5.) Any goods in an inventory which are 
unsalable at normal prices or unusable in the normal way because of 
damage, imperfections, shop wear, changes of style, odd or broken lots, 
or other similar causes, including second-hand goods taken in exchange, 
should be valued at bona fide selling prices less direct cost of 
disposition, whether subparagraph (1) or (2) of this paragraph is used, 
or if such goods consist of raw materials or partly finished goods held 
for use or consumption, they shall be valued upon a reasonable basis, 
taking into consideration the usability and the condition of the goods, 
but in no case shall such value be less than the scrap value. Bona fide 
selling price means actual offering of goods during a period ending not 
later than 30 days after inventory date. The burden of proof will rest 
upon the taxpayer to show that such exceptional goods as are valued upon 
such selling basis come within the classifications indicated above, and 
he shall maintain such records of the disposition of the goods as will 
enable a verification of the inventory to be made.
    (d) In respect of normal goods, whichever method is adopted must be 
applied with reasonable consistency to the entire inventory of the 
taxpayer's trade or business except as to those goods inventoried under 
the last-in, first-out method authorized by section 472 or to animals 
inventoried under the elective unit, livestock-price-method authorized 
by Sec. 1.471-6. See paragraph (d) of Sec. 1.446-1 for rules 
permitting the use of different methods of accounting if the taxpayer 
has more than one trade or business. Where the taxpayer is engaged in 
more than one trade or business the Commissioner may require that the 
method of valuing inventories with respect to goods in one trade or 
business also be used with respect to similar goods in other trades or 
businesses if, in the opinion of the Commissioner, the use of such 
method with respect to such other goods is essential to a clear 
reflection of income. Taxpayers were given an option to adopt the basis 
of either (1) cost or (2) cost or market, whichever is lower, for their 
1920 inventories. The basis properly adopted for that year or any 
subsequent year is controlling, and a change can now be made only after 
permission is secured from the Commissioner. Application for permission 
to change the basis of valuing inventories shall be made in writing and 
filed with the Commissioner as provided in paragraph (e) of Sec. 1.446-
1. Goods taken in the inventory which have been so intermingled that 
they cannot be identified with specific invoices will be deemed to be 
the goods most recently purchased or produced, and the cost thereof will

[[Page 514]]

be the actual cost of the goods purchased or produced during the period 
in which the quantity of goods in the inventory has been acquired. But 
see section 472 as to last-in, first-out inventories. Where the taxpayer 
maintains book inventories in accordance with a sound accounting system 
in which the respective inventory accounts are charged with the actual 
cost of the goods purchased or produced and credited with the value of 
goods used, transferred, or sold, calculated upon the basis of the 
actual cost of the goods acquired during the taxable year (including the 
inventory at the beginning of the year), the net value as shown by such 
inventory accounts will be deemed to be the cost of the goods on hand. 
The balances shown by such book inventories should be verified by 
physical inventories at reasonable intervals and adjusted to conform 
therewith.
    (e) Inventories should be recorded in a legible manner, properly 
computed and summarized, and should be preserved as a part of the 
accounting records of the taxpayer. The inventories of taxpayers on 
whatever basis taken will be subject to investigation by the district 
director, and the taxpayer must satisfy the district director of the 
correctness of the prices adopted.
    (f) The following methods, among others, are sometimes used in 
taking or valuing inventories, but are not in accord with the 
regulations in this part:
    (1) Deducting from the inventory a reserve for price changes, or an 
estimated depreciation in the value thereof.
    (2) Taking work in process, or other parts of the inventory, at a 
nominal price or at less than its proper value.
    (3) Omitting portions of the stock on hand.
    (4) Using a constant price or nominal value for so-called normal 
quantity of materials or goods in stock.
    (5) Including stock in transit, shipped either to or from the 
taxpayer, the title to which is not vested in the taxpayer.
    (6) Segregating indirect production costs into fixed and variable 
production cost classifications (as defined in Sec. 1.471-11(b)(3)(ii)) 
and allocating only the variable costs to the cost of goods produced 
while treating fixed costs as period costs which are currently 
deductible. This method is commonly referred to as the ``direct cost'' 
method.
    (7) Treating all or substantially all indirect production costs 
(whether classified as fixed or variable) as period costs which are 
currently deductible. This method is generally referred to as the 
``prime cost'' method.

[T.D. 6500, 25 FR 11724, Nov. 26, 1960, as amended by T.D. 7285, 38 FR 
26185, Sept. 19, 1973]



Sec. 1.471-3  Inventories at cost.

    Cost means:
    (a) In the case of merchandise on hand at the beginning of the 
taxable year, the inventory price of such goods.
    (b) In the case of merchandise purchased since the beginning of the 
taxable year, the invoice price less trade or other discounts, except 
strictly cash discounts approximating a fair interest rate, which may be 
deducted or not at the option of the taxpayer, provided a consistent 
course is followed. To this net invoice price should be added 
transportation or other necessary charges incurred in acquiring 
possession of the goods. For taxpayers acquiring merchandise for resale 
that are subject to the provisions of section 263A, see Sec. Sec. 
1.263A-1 and 1.263A-3 for additional amounts that must be included in 
inventory costs.
    (c) In the case of merchandise produced by the taxpayer since the 
beginning of the taxable year, (1) the cost of raw materials and 
supplies entering into or consumed in connection with the product, (2) 
expenditures for direct labor, and (3) indirect production costs 
incident to and necessary for the production of the particular article, 
including in such indirect production costs an appropriate portion of 
management expenses, but not including any cost of selling or return on 
capital, whether by way of interest or profit. See Sec. Sec. 1.263A-1 
and 1.263A-2 for more specific rules regarding the treatment of 
production costs.
    (d) In any industry in which the usual rules for computation of cost 
of production are inapplicable, costs may be approximated upon such 
basis as may be reasonable and in conformity

[[Page 515]]

with established trade practice in the particular industry. Among such 
cases are:
    (1) Farmers and raisers of livestock (see Sec. 1.471-6);
    (2) Miners and manufacturers who by a single process or uniform 
series of processes derive a product of two or more kinds, sizes, or 
grades, the unit cost of which is substantially alike (see Sec. 1.471-
7); and
    (3) Retail merchants who use what is known as the ``retail method'' 
in ascertaining approximate cost (see Sec. 1.471-8).

    Notwithstanding the other rules of this section, cost shall not 
include an amount which is of a type for which a deduction would be 
disallowed under section 162 (c), (f), or (g) and the regulations 
thereunder in the case of a business expense.

[T.D. 6500, 25 FR 11725, Nov. 26, 1960, as amended by T.D. 7285, 38 FR 
26185, Sept. 19, 1973; T.D. 7345, 40 FR 7439, Feb. 20, 1975; T.D. 8131, 
52 FR 10084, Mar. 30, 1987; T.D. 8482, 58 FR 42233, Aug. 9, 1993]



Sec. 1.471-4  Inventories at cost or market, whichever is lower.

    (a) In general--(1) Market definition. Under ordinary circumstances 
and for normal goods in an inventory, market means the aggregate of the 
current bid prices prevailing at the date of the inventory of the basic 
elements of cost reflected in inventories of goods purchased and on 
hand, goods in process of manufacture, and finished manufactured goods 
on hand. The basic elements of cost include direct materials, direct 
labor, and indirect costs required to be included in inventories by the 
taxpayer (e.g., under section 263A and its underlying regulations for 
taxpayers subject to that section). For taxpayers to which section 263A 
applies, for example, the basic elements of cost must reflect all direct 
costs and all indirect costs properly allocable to goods on hand at the 
inventory date at the current bid price of those costs, including but 
not limited to the cost of purchasing, handling, and storage activities 
conducted by the taxpayer, both prior to and subsequent to acquisition 
or production of the goods. The determination of the current bid price 
of the basic elements of costs reflected in goods on hand at the 
inventory date must be based on the usual volume of particular cost 
elements purchased (or incurred) by the taxpayer.
    (2) Fixed price contracts. Paragraph (a)(1) of this section does not 
apply to any goods on hand or in process of manufacture for delivery 
upon firm sales contracts (i.e., those not legally subject to 
cancellation by either party) at fixed prices entered into before the 
date of the inventory, under which the taxpayer is protected against 
actual loss. Any such goods must be inventoried at cost.
    (3) Examples. The valuation principles in paragraph (a)(1) of this 
section are illustrated by the following examples:

    Example 1. (i) Taxpayer A manufactures tractors. A values its 
inventory using cost or market, whichever is lower, under paragraph 
(a)(1) of this section. At the end of 1994, the cost of one of A's 
tractors on hand is determined as follows:

Direct materials..............................................    $3,000
Direct labor..................................................     4,000
Indirect costs under section 263A.............................     3,000
                                                               ---------
      Total section 263A costs (cost).........................   $10,000
 

    (ii) A determines that the aggregate of the current bid prices of 
the materials, labor, and overhead required to reproduce the tractor at 
the end of 1994 are as follows:

Direct materials..............................................    $3,100
Direct labor..................................................     4,100
Indirect costs under section 263A.............................     3,100
                                                               ---------
      Total section 263A costs (market).......................   $10,300
 

    (iii) In determining the lower of cost or market value of the 
tractor, A compares the cost of the tractor, $10,000, with the market 
value of the tractor, $10,300, in accordance with paragraph (c) of this 
section. Thus, under this section, A values the tractor at $10,000.
    Example 2. (i) Taxpayer B purchases and resells several lines of 
shoes and is subject to section 263A. B values its inventory using cost 
or market, whichever is lower, under paragraph (a)(1) of this section. 
At the end of 1994, the cost of one pair of shoes on hand is determined 
as follows:

Acquisition cost..............................................      $200
Indirect costs under section 263A.............................        10
                                                               ---------
      Total section 263A costs (cost).........................      $210
 

    (ii) B determines the aggregate current bid prices prevailing at the 
end of 1994 for the elements of cost (both direct costs and indirect 
costs incurred prior and subsequent to acquisition of the shoes) based 
on the volume of the elements usually purchased (or incurred) by B as 
follows:

Acquisition cost..............................................      $178

[[Page 516]]

 
Indirect costs under section 263A.............................        12
                                                               ---------
      Total Sec.  263A costs (market)........................      $190
 

    (iii) In determining the lower of cost or market value of the shoes, 
B compares the cost of the pair of shoes, $210, with the market value of 
the shoes, $190, in accordance with paragraph (c) of this section. Thus, 
under this section, B values the shoes at $190.

    (b) Inactive markets. Where no open market exists or where 
quotations are nominal, due to inactive market conditions, the taxpayer 
must use such evidence of a fair market price at the date or dates 
nearest the inventory as may be available, such as specific purchases or 
sales by the taxpayer or others in reasonable volume and made in good 
faith, or compensation paid for cancellation of contracts for purchase 
commitments. Where the taxpayer in the regular course of business has 
offered for sale such merchandise at prices lower than the current price 
as above defined, the inventory may be valued at such prices less direct 
cost of disposition, and the correctness of such prices will be 
determined by reference to the actual sales of the taxpayer for a 
reasonable period before and after the date of the inventory. Prices 
which vary materially from the actual prices so ascertained will not be 
accepted as reflecting the market.
    (c) Comparison of cost and market. Where the inventory is valued 
upon the basis of cost or market, whichever is lower, the market value 
of each article on hand at the inventory date shall be compared with the 
cost of the article, and the lower of such values shall be taken as the 
inventory value of the article.
    (d) Effective date. This section applies to inventory valuations for 
taxable years beginning after December 31, 1993. For taxable years 
beginning before January 1, 1994, taxpayers must take reasonable 
positions on their federal income tax returns with respect to the 
application of section 263A, and must have otherwise complied with Sec. 
1.471-4 (as contained in the 26 CFR part 1 edition revised April 1, 
1993). For purposes of this paragraph (d), a reasonable position as to 
the application of section 263A is a position consistent with the 
temporary regulations, revenue rulings, revenue procedures, notices, and 
announcements concerning section 263A applicable in taxable years 
beginning before January 1, 1994. (See Sec. 601.601(d)(2)(ii)(b) of 
this chapter.)

[T.D. 6500, 25 FR 11725, Nov. 26, 1960, as amended by T.D. 8482, 58 FR 
42233, Aug. 9, 1993]



Sec. 1.471-5  Inventories by dealers in securities.

    A dealer in securities who in his books of account regularly 
inventories unsold securities on hand either--
    (a) At cost,
    (b) At cost or market, whichever is lower, or
    (c) At market value,

may make his return upon the basis upon which his accounts are kept, 
provided that a description of the method employed is included in or 
attached to the return, that all the securities are inventoried by the 
same method, and that such method is adhered to in subsequent years, 
unless another method is authorized by the Commissioner pursuant to a 
written application therefor filed as provided in paragraph (e) of Sec. 
1.446-1. A dealer in securities in whose books of account separate 
computations of the gain or loss from the sale of the various lots of 
securities sold are made on the basis of the cost of each lot shall be 
regarded, for the purposes of this section, as regularly inventorying 
his securities at cost. For the purposes of this section, a dealer in 
securities is a merchant of securities, whether an individual, 
partnership, or corporation, with an established place of business, 
regularly engaged in the purchase of securities and their resale to 
customers; that is, one who as a merchant buys securities and sells them 
to customers with a view to the gains and profits that may be derived 
therefrom. If such business is simply a branch of the activities carried 
on by such person, the securities inventoried as provided in this 
section may include only those held for purposes of resale and not for 
investment. Taxpayers who buy and sell or hold securities for investment 
or speculation, irrespective of whether such buying or selling 
constitutes the carrying on of a trade or business, and officers of 
corporations and members of partnerships who in their individual 
capacities buy and sell securities, are not dealers in securities

[[Page 517]]

within the meaning of this section. See Sec. Sec. 1.263A-1 and 1.263A-3 
for rules regarding the treatment of costs with respect to property 
acquired for resale.

[T.D. 6500, 25 FR 11725, Nov. 26, 1960, as amended by T.D. 8131, 52 FR 
10084, Mar 30, 1987; T.D. 8482, 58 FR 42234, Aug. 9, 1993]



Sec. 1.471-6  Inventories of livestock raisers and other farmers.

    (a) A farmer may make his return upon an inventory method instead of 
the cash receipts and disbursements method. It is optional with the 
taxpayer which of these methods of accounting is used but, having 
elected one method, the option so exercised will be binding upon the 
taxpayer for the year for which the option is exercised and for 
subsequent years unless another method is authorized by the Commissioner 
as provided in paragraph (e) of Sec. 1.446-1.
    (b) In any change of accounting method from the cash receipts and 
disbursements method to an inventory method, adjustments shall be made 
as provided in section 481 (relating to adjustments required by change 
in method of accounting) and the regulations thereunder.
    (c) Because of the difficulty of ascertaining actual cost of 
livestock and other farm products, farmers who render their returns upon 
an inventory method may value their inventories according to the ``farm-
price method'', and farmers raising livestock may value their 
inventories of animals according to either the ``farm-price method'' or 
the ``unit-livestock-price method''. In addition, these inventory 
methods may be used to account for the costs of property produced in a 
farming business that are required to be capitalized under section 263A 
regardless of whether the property being produced is otherwise treated 
as inventory by the taxpayer, and regardless of whether the taxpayer is 
otherwise using the cash or an accrual method of accounting.
    (d) The ``farm-price method'' provides for the valuation of 
inventories at market price less direct cost of disposition. If this 
method of valuation is used, it generally must be applied to all 
property produced by the taxpayer in the trade or business of farming, 
except as to livestock accounted for, at the taxpayer's election, under 
the unit livestock method of accounting. However, see Sec. 1.263A-
4(c)(3) for an exception to this rule. If the use of the ``farm-price 
method'' of valuing inventories for any taxable year involves a change 
in method of valuing inventories from that employed in prior years, 
permission for such change shall first be secured from the Commissioner 
as provided in paragraph (e) of Sec. 1.446-1.
    (e) The ``unit-livestock-price method'' provides for the valuation 
of the different classes of animals in the inventory at a standard unit 
price for each animal within a class. A livestock raiser electing this 
method of valuing his animals must adopt a reasonable classification of 
the animals in his inventory with respect to the age and kind included 
so that the unit prices assigned to the several classes will reasonably 
account for the normal costs incurred in producing the animals within 
such classes. Thus, if a cattle raiser determines that it costs 
approximately $15 to produce a calf, and $7.50 each year to raise the 
calf to maturity, his classifications and unit prices would be as 
follows: Calves, $15; yearlings, $22.50; 2-year olds, $30; mature 
animals, $37.50. The classification selected by the livestock raiser, 
and the unit prices assigned to the several classes, are subject to 
approval by the district director upon examination of the taxpayer's 
return.
    (f) A taxpayer that elects to use the ``unit-livestock-price 
method'' must apply it to all livestock raised, whether for sale or for 
draft, breeding, or dairy purposes. The inventoriable costs of animals 
raised for draft, breeding, or dairy purposes can, at the election of 
the livestock raiser, be included in inventory or treated as property 
used in a trade or business subject to depreciation after maturity. See 
Sec. 1.263A-4 for rules regarding the computation of inventoriable 
costs for purposes of the unit-livestock-price method. Once established, 
the methods of accounting used by the taxpayer to determine unit prices 
and to classify animals must be consistently applied in all subsequent 
taxable years. A taxpayer that uses the unit-livestock-price method must 
annually reevaluate its unit prices and

[[Page 518]]

adjust the prices either upward to reflect increases, or downward to 
reflect decreases, in the costs of raising livestock. The consent of the 
Commissioner is not required to make such upward or downward 
adjustments. No other changes in the classification of animals or unit 
prices may be made without the consent of the Commissioner. See Sec. 
1.446-1(e) for procedures for obtaining the consent of the Commissioner. 
The provisions of this paragraph (f) apply to taxable years ending after 
October 28, 2002.
    (g) A livestock raiser who uses the ``unit-livestock-price method'' 
must include in his inventory at cost any livestock purchased, except 
that animals purchased for draft, breeding, or dairy purposes can, at 
the election of the livestock raiser, be included in inventory or be 
treated as property used in a trade or business subject to depreciation 
after maturity. If the animals purchased are not mature at the time of 
purchase, the cost should be increased at the end of each taxable year 
in accordance with the established unit prices, except that no increase 
is to be made in the taxable year of purchase if the animal is acquired 
during the last six months of that year. If the records maintained 
permit identification of a purchased animal, the cost of such animal 
will be eliminated from the closing inventory in the event of its sale 
or loss. Otherwise, the first-in, first-out method of valuing 
inventories must be applied.
    (h) If a taxpayer using the ``farm-price method'' desires to adopt 
the ``unit-livestock-price method'' in valuing his inventories of 
livestock, permission for the change shall first be secured from the 
Commissioner as provided in paragraph (e) of Sec. 1.446-1. However, a 
taxpayer who has filed returns on the basis of inventories at cost, or 
cost or market whichever is lower, may adopt the ``unit-livestock-price 
method'' for valuing his inventories of livestock without formal 
application for permission, but the classifications and unit prices 
selected are subject to approval by the district director upon 
examination of the taxpayer's return. A livestock raiser who has adopted 
a constant unit-price method of valuing livestock inventories and filed 
returns on that basis will be considered as having elected the ``unit-
livestock-price method''.
    (i) If returns have been made in which the taxable income has been 
computed upon incomplete inventories, the abnormality should be 
corrected by submitting with the return for the current taxable year a 
statement for the preceding taxable year. In this statement such 
adjustments shall be made as are necessary to bring the closing 
inventory for the preceding taxable year into agreement with the opening 
complete inventory for the current taxable year. If necessary clearly to 
reflect income, similar adjustments may be made as at the beginning of 
the preceding year or years, and the tax, if any be due, shall be 
assessed and paid at the rate of tax in effect for such year or years.

[T.D. 6500, 25 FR 11726, Nov. 26, 1960, as amended by T.D. 8131, 52 FR 
10084, Mar. 30, 1987; T.D. 8729, 62 FR 44551, Aug. 22, 1997; T.D. 8897, 
65 FR 50650, Aug. 21, 2000; T.D. 9019, 67 FR 65698, Oct. 28, 2002]



Sec. 1.471-7  Inventories of miners and manufacturers.

    A taxpayer engaged in mining or manufacturing who by a single 
process or uniform series of processes derives a product of two or more 
kinds, sizes, or grades, the unit cost of which is substantially alike, 
and who in conformity to a recognized trade practice allocates an amount 
of cost to each kind, size, or grade of product, which in the aggregate 
will absorb the total cost of production, may, with the consent of the 
Commissioner, use such allocated cost as a basis for pricing 
inventories, provided such allocation bears a reasonable relation to the 
respective selling values of the different kinds, sizes, or grades of 
product. See section 472 as to last-in, first-out inventories.

[T.D. 6500, 25 FR 11726, Nov. 26, 1960]



Sec. 1.471-8  Inventories of retail merchants.

    (a) Retail merchants who employ what is known as the ``retail 
method'' of pricing inventories may make their returns upon that method, 
provided that the use of such method is designated upon the return, that 
accurate

[[Page 519]]

accounts are kept, and that such method is consistently adhered to 
unless a change is authorized by the Commissioner as provided in 
paragraph (e) of Sec. 1.446-1. Under the retail method the total of the 
retail selling prices of the goods on hand at the end of the year in 
each department or of each class of goods is reduced to approximate cost 
by deducting therefrom an amount which bears the same ratio to such 
total as--
    (1) The total of the retail selling prices of the goods included in 
the opening inventory plus the retail selling prices of the goods 
purchased during the year, with proper adjustment to such selling prices 
for all mark-ups and mark-downs, less
    (2) The cost of the goods included in the opening inventory plus the 
cost of the goods purchased during the year, bears to (1).

The result should represent as accurately as may be the amounts added to 
the cost price of the goods to cover selling and other expenses of doing 
business and for the margin of profit. See Sec. Sec. 1.263A-1 and 
1.263A-3 for rules regarding the computation of costs with respect to 
property acquired for resale.
    (b) For further adjustments to be made in the case of a retail 
merchant using the last-in, first-out inventory method authorized by 
section 472, see paragraph (k) of Sec. 1.472-1.
    (c) A taxpayer maintaining more than one department in his store or 
dealing in classes of goods carrying different percentages of gross 
profit should not use a percentage of profit based upon an average of 
his entire business, but should compute and use in valuing his inventory 
the proper percentages for the respective departments or classes of 
goods.
    (d) A taxpayer (other than one using the last-in, first-out 
inventory method) who previously has determined inventories in 
accordance with the retail method, except that, to obtain a basis of 
approximate cost or market, whichever is lower, has consistently and 
uniformly followed the practice of adjusting the retail selling prices 
of the goods included in the opening inventory and purchased during the 
taxable year for mark-ups but not for mark-downs, may continue such 
practice subject to the conditions prescribed in this section. The 
adjustments must be bona fide and consistent and uniform. Where mark-
downs are not included in the adjustments, mark-ups made to cancel or 
correct mark-downs shall not be included; and the mark-ups included must 
be reduced by the mark-downs made to cancel or correct such mark-ups.
    (e) In no event shall mark-downs not based on actual reduction of 
retail sale prices, such as mark-downs based on depreciation and 
obsolescence, be recognized in determining the retail selling prices of 
the goods on hand at the end of the taxable year.
    (f) A taxpayer (other than one using the last-in, first-out 
inventory method) who previously has determined inventories without 
following the practice of eliminating mark-downs in making adjustments 
to retail selling prices may adopt such practice, provided permission to 
do so is obtained in accordance with, and subject to the terms provided 
by, paragraph (e) of Sec. 1.446-1. A taxpayer filing a first return of 
income may adopt such practice subject to approval by the district 
director upon examination of the return.
    (g) A taxpayer using the last-in, first-out inventory method in 
conjunction with retail computations must adjust retail selling prices 
for mark-downs as well as mark-ups, in order that there may be reflected 
the approximate cost of the goods on hand at the end of the taxable year 
regardless of market values.

[T.D. 6500, 25 FR 11726, Nov. 26, 1960, as amended by T.D. 8131, 52 FR 
10084, Mar. 30, 1987; T.D. 8482, 58 FR 42234, Aug. 9, 1993]



Sec. 1.471-9  Inventories of acquiring corporations.

    For additional rules in the case of certain corporate acquisitions 
specified in section 381(a), see section 381(c)(5) and the regulations 
thereunder.

[T.D. 6500, 25 FR 11727, Nov. 26, 1960]

[[Page 520]]



Sec. 1.471-10  Applicability of long-term contract methods.

    See Sec. 1.460-2 for rules providing for the application of the 
long-term contract methods to certain manufacturing contracts.

[T.D. 8067, 51 FR 393, Jan. 6, 1986, as amended by T.D. 8929, 66 FR 
2240, Jan. 11, 2001]



Sec. 1.471-11  Inventories of manufacturers.

    (a) Use of full absorption method of inventory costing. In order to 
conform as nearly as may be possible to the best accounting practices 
and to clearly reflect income (as required by section 471 of the Code), 
both direct and indirect production costs must be taken into account in 
the computation of inventoriable costs in accordance with the ``full 
absorption'' method of inventory costing. Under the full absorption 
method of inventory costing production costs must be allocated to goods 
produced during the taxable year, whether sold during the taxable year 
or in inventory at the close of the taxable year determined in 
accordance with the taxpayer's method of identifying goods in inventory. 
Thus, the taxpayer must include as inventoriable costs all direct 
production costs and, to the extent provided by paragraphs (c) and (d) 
of this section, all indirect production costs. For purposes of this 
section, the term ``financial reports'' means financial reports 
(including consolidated financial statements) to shareholders, partners, 
beneficiaries or other proprietors and for credit purposes. See also 
Sec. 1.263A-1T with respect to the treatment of production costs 
incurred in taxable years beginning after December 31, 1986, and before 
January 1, 1994. See also Sec. Sec. 1.263A-1 and 1.263A-2 with respect 
to the treatment of production costs incurred in taxable years beginning 
after December 31, 1993.
    (b) Production costs--(1) In general. Costs are considered to be 
production costs to the extent that they are incident to and necessary 
for production or manufacturing operations or processes. Production 
costs include direct production costs and fixed and variable indirect 
production costs.
    (2) Direct production costs. (i) Costs classified as ``direct 
production costs'' are generally those costs which are incident to and 
necessary for production or manufacturing operations or processes and 
are components of the cost of either direct material or direct labor. 
Direct material costs include the cost of those materials which become 
an integral part of the specific product and those materials which are 
consumed in the ordinary course of manufacturing and can be identified 
or associated with particular units or groups of units of that product. 
See Sec. 1.471-3 for the elements of direct material costs. Direct 
labor costs include the cost of labor which can be identified or 
associated with particular units or groups of units of a specific 
product. The elements of direct labor costs include such items as basic 
compensation, overtime pay, vacation and holiday pay, sick leave pay 
(other than payments pursuant to a wage continuation plan under section 
105(d)), shift differential, payroll taxes and payments to a 
supplemental unemployment benefit plan paid or incurred on behalf of 
employees engaged in direct labor. For the treatment of rework labor, 
scrap, spoilage costs, and any other costs not specifically described as 
direct production costs see Sec. 1.471-11(c)(2).
    (ii) Under the full absorption method, a taxpayer must take into 
account all items of direct production cost in his inventoriable costs. 
Nevertheless, a taxpayer will not be treated as using an incorrect 
method of inventory costing if he treats any direct production costs as 
indirect production costs, provided such costs are allocated to the 
taxpayer's ending inventory to the extent provided by paragraph (d) of 
this section. Thus, for example, a taxpayer may treat direct labor costs 
as part of indirect production costs (for example, by use of the 
conversion cost method), provided all such costs are allocated to ending 
inventory to the extent provided by paragraph (d) of this section.
    (3) Indirect production costs--(i) In general. The term ``indirect 
production costs'' includes all costs which are incident to and 
necessary for production or manufacturing operations or processes other 
than direct production costs (as defined in subparagraph (2) of this 
paragraph). Indirect production costs may be classified as to kind or 
type in accordance with acceptable accounting

[[Page 521]]

principles so as to enable convenient identification with various 
production or manufacturing activities or functions and to facilitate 
reasonable groupings of such costs for purposes of determining unit 
product costs.
    (ii) Fixed and variable classifications. For purposes of this 
section, fixed indirect production costs are generally those costs which 
do not vary significantly with changes in the amount of goods produced 
at any given level of production capacity. These fixed costs may 
include, among other costs, rent and property taxes on buildings and 
machinery incident to and necessary for manufacturing operations or 
processes. On the other hand, variable indirect production costs are 
generally those costs which do vary significantly with changes in the 
amount of goods produced at any given level of production capacity. 
These variable costs may include, among other costs, indirect materials, 
factory janitorial supplies, and utilities. Where a particular cost 
contains both fixed and variable elements, these elements should be 
segregated into fixed and variable classifications to the extent 
necessary under the taxpayer's method of allocation, such as for the 
application of the practical capacity concept (as described in paragraph 
(d) (4) of this section).
    (c) Certain indirect and production costs--(1) General rule. Except 
as provided in paragraph (c)(3) of this section and in paragraph 
(d)(6)(v) of Sec. 1.451-3, in order to determine whether indirect 
production costs referred to in paragraph (b) of this section must be 
included in a taxpayer's computation of the amount of inventoriable 
costs, three categories of costs have been provided in subparagraph (2) 
of this paragraph. Costs described in subparagraph (2)(i) of this 
paragraph must be included in the taxpayer's computation of the amount 
of inventoriable costs, regardless of their treatment by the taxpayer in 
his financial reports. Costs described in subparagraph (2)(ii) of this 
paragraph need not enter into the taxpayer's computation of the amount 
of inventoriable costs, regardless of their treatment by the taxpayer in 
his financial reports. Costs described in subparagraph (2)(iii) of this 
paragraph must be included in or excluded from the taxpayer's 
computation of the amount inventoriable costs in accordance with the 
treatment of such costs by the taxpayer in his financial reports and 
generally accepted accounting principles. For the treatment of indirect 
production costs described in subparagraph (2) of this paragraph in the 
case of a taxpayer who is not using comparable methods of accounting for 
such costs for tax and financial reporting see paragraph (c)(3) of this 
section. For contracts entered into after December 31, 1982, 
notwithstanding this section, taxpayers who use an inventory method of 
accounting for extended period long-term contracts (as defined in 
paragraph (b)(3) of Sec. 1.451-3) for tax purposes may be required to 
use the cost allocation rules provided in paragraph (d)(6) of Sec. 
1.451-3 rather than the cost allocation rules provided in this section. 
See paragraph (d)(6)(v) of Sec. 1.451-3. After a taxpayer has 
determined which costs must be treated as indirect production costs 
includible in the computation of the amount of inventoriable costs, such 
costs must be allocated to a taxpayer's ending inventory in a manner 
prescribed by paragraph (d) of this section.
    (2) Includibility of certain indirect production costs--(i) Indirect 
production costs included in inventoriable costs. Indirect production 
costs which must enter into the computation of the amount of 
inventoriable costs (regardless of their treatment by a taxpayer in his 
financial reports) include:
    (a) Repair expenses,
    (b) Maintenance,
    (c) Utilities, such as heat, power and light,
    (d) Rent,
    (e) Indirect labor and production supervisory wages, including basic 
compensation, overtime pay, vacation and holiday pay, sick leave pay 
(other than payments pursuant to a wage continuation plan under section 
105(d), shift differential, payroll taxes and contributions to a 
supplemental unemployment benefit plan,
    (f) Indirect materials and supplies,
    (g) Tools and equipment not capitalized, and
    (h) Costs of quality control and inspection,


[[Page 522]]



to the extent, and only to the extent, such costs are incident to and 
necessary for production or manufacturing operations or processes.
    (ii) Costs not included in inventoriable costs. Costs which are not 
required to be included for tax purposes in the computation of the 
amount of inventoriable costs (regardless of their treatment by a 
taxpayer in his financial reports) include:
    (a) Marketing expenses,
    (b) Advertising expenses,
    (c) Selling expenses,
    (d) Other distribution expenses,
    (e) Interest,
    (f) Research and experimental expenses including engineering and 
product development expenses,
    (g) Losses under section 165 and the regulations thereunder,
    (h) Percentage depletion in excess of cost depletion,
    (i) Depreciation and amortization reported for Federal income tax 
purposes in excess of depreciation reported by the taxpayer in his 
financial reports,
    (j) Income taxes attributable to income received on the sale of 
inventory,
    (k) Pension contributions to the extent that they represent past 
services cost,
    (l) General and administrative expenses incident to and necessary 
for the taxpayer's activities as a whole rather than to production or 
manufacturing operations or processes, and
    (m) Salaries paid to officers attributable to the performance of 
services which are incident to and necessary for the taxpayer's 
activities taken as a whole rather than to production or manufacturing 
operations or processes.


Notwithstanding the preceding sentence, if a taxpayer consistently 
includes in his computation of the amount of inventoriable costs any of 
the costs described in the preceding sentence, a change in such method 
of inclusion shall be considered a change in method of accounting within 
the meaning of sections 446, 481, and paragraph (e)(4) of this section.
    (iii) Indirect production costs includible in inventoriable costs 
depending upon treatment in taxpayer's financial reports. In the case of 
costs listed in this subdivision, the inclusion or exclusion of such 
costs from the amount of inventoriable costs for purposes of a 
taxpayer's financial reports shall determine whether such costs must be 
included in or excluded from the computation of inventoriable costs for 
tax purposes, but only if such treatment is not inconsistent with 
generally accepted accounting principles. In the case of costs which are 
not included in subdivision (i) or (ii) of this subparagraph, nor listed 
in this subdivision, whether such costs must be included in or excluded 
from the computation of inventoriable costs for tax purposes depends 
upon the extent to which such costs are similar to costs included in 
subdivision (i) or (ii), and if such costs are dissimilar to costs in 
subdivision (i) or (ii), such costs shall be treated as included in or 
excludable from the amount of inventoriable costs in accordance with 
this subdivision. The costs listed in this subdivision are:
    (a) Taxes. Taxes otherwise allowable as a deduction under section 
164 (other than State and local and foreign income taxes) attributable 
to assets incident to and necessary for production or manufacturing 
operations or processes. Thus, for example, the cost of State and local 
property taxes imposed on a factory or other production facility and any 
State and local taxes imposed on inventory must be included in or 
excluded from the computation of the amount of inventoriable costs for 
tax purposes depending upon their treatment by a taxpayer in his 
financial reports.
    (b) Depreciation and depletion. Depreciation reported in financial 
reports and cost depletion on assets incident to and necessary for 
production or manufacturing operations or processes. In computing cost 
depletion under this section, the adjusted basis of such assets shall be 
reduced by cost depletion and not by percentage depletion taken thereon.
    (c) Employee benefits. Pension and profit-sharing contributions 
representing current service costs otherwise allowable as a deduction 
under section 404, and other employee benefits incurred on behalf of 
labor incident to and necessary for production or manufacturing 
operations or processes.

[[Page 523]]

These other benefits include workmen's compensation expenses, payments 
under a wage continuation plan described in section 105(d), amounts of a 
type which would be includible in the gross income of employees under 
non-qualified pension, profit-sharing and stock bonus plans, premiums on 
life and health insurance and miscellaneous benefits provided for 
employees such as safety, medical treatment, cafeteria, recreational 
facilities, membership dues, etc., which are otherwise allowable as 
deductions under chapter 1 of the Code.
    (d) Costs attributable to strikes, rework labor, scrap and spoilage. 
Costs attributable to rework labor, scrap and spoilage which are 
incident to and necessary for production or manufacturing operations or 
processes and costs attributable to strikes incident to production or 
manufacturing operation or processes.
    (e) Factory administrative expenses. Administrative costs of 
production (but not including any cost of selling or any return on 
capital) incident to and necessary for production or manufacturing 
operations or processes.
    (f) Officers' salaries. Salaries paid to officers attributable to 
services performed incident to and necessary for production or 
manufacturing operations or processes.
    (g) Insurance costs. Insurance costs incident to and necessary for 
production or manufacturing operations or processes such as insurance on 
production machinery and equipment. A change in the taxpayer's treatment 
in his financial reports of costs described in this subdivision which 
results in a change in treatment of such costs for tax purposes shall 
constitute a change in method of accounting within the meaning of 
sections 446 and 481 to which paragraph (e) applies.
    (3) Exception. Except as provided in paragraph (d)(6) of Sec. 
1.451-3, in the case of a taxpayer whose method of accounting for 
production costs in his financial reports is not comparable to his 
method of accounting for such costs for tax purposes (such as a taxpayer 
using the prime cost method for purposes of financial reports), the 
following rules apply:
    (i) Indirect production costs included in inventoriable costs. 
Indirect production costs which must enter into the computation of the 
amount of inventoriable costs (to the extent, and only to the extent, 
such costs are incident to and necessary for production or manufacturing 
operations or processes) include:
    (a) Repair expenses,
    (b) Maintenance,
    (c) Utilities, such as heat, power and light,
    (d) Rent,
    (e) Indirect labor and production supervisory wages, including basic 
compensation, overtime pay, vacation and holiday pay, sick leave pay 
(other than payments pursuant to a wage continuation plan under section 
105(d)), shift differential, payroll taxes and contributions to a 
supplemental unemployment benefit plan,
    (f) Indirect materials and supplies,
    (g) Tools and equipment not capitalized,
    (h) Costs of quality control and inspection,
    (i) Taxes otherwise allowable as a deduction under section 164 
(other than State and local and foreign income taxes),
    (j) Depreciation and amortization reported for financial purposes 
and cost depletion,
    (k) Administrative costs of production (but not including any cost 
of selling or any return on capital) incident to and necessary for 
production or manufacturing operations or processes,
    (l) Salaries paid to officers attributable to services performed 
incident to and necessary for production or manufacturing operations or 
processes, and
    (m) Insurance costs incident to and necessary for production or 
manufacturing operations or processes such as insurance on production 
machinery and equipment.
    (ii) Costs not included in inventoriable costs. Costs which are not 
required to be included in the computation of the amount of 
inventoriable costs include:
    (a) Marketing expenses,
    (b) Advertising expenses,
    (c) Selling expenses,
    (d) Other distribution expenses,
    (e) Interest,

[[Page 524]]

    (f) Research and experimental expenses including engineering and 
product development expenses,
    (g) Losses under section 165 and the regulations thereunder,
    (h) Percentage depletion in excess of cost depletion,
    (i) Depreciation reported for Federal income tax purposes in excess 
of depreciation reported by the taxpayer in his financial reports,
    (j) Income taxes attributable to income received on the sale of 
inventory,
    (k) Pension and profit-sharing contributions representing either 
past service costs or representing current service costs otherwise 
allowable as a deduction under section 404, and other employee benefits 
incurred on behalf of labor. These other benefits include workmen's 
compensation expenses, payments under a wage continuation plan described 
in section 105(d), amounts of a type which would be includible in the 
gross income of employees under nonqualified pension, profit-sharing and 
stock bonus plans, premiums on life and health insurance and 
miscellaneous benefits provided for employees such as safety, medical 
treatment, cafeteria, recreational facilities, membership dues, etc., 
which are otherwise allowable as deductions under chapter 1 of the Code,
    (l) Cost attributable to strikes, rework labor, scrap and spoilage,
    (m) General and administrative expenses incident to and necessary 
for the taxpayer's activities as a whole rather than to production or 
manufacturing operations or processes, and
    (n) Salaries paid to officers attributable to the performance of 
services which are incident to and necessary for the taxpayer's 
activities as a whole rather than to production or manufacturing 
operations or processes.
    (d) Allocation methods--(1) In general. Indirect production costs 
required to be included in the computation of the amount of 
inventoriable costs pursuant to paragraphs (b) and (c) of this paragraph 
must be allocated to goods in a taxpayer's ending inventory (determined 
in accordance with the taxpayer's method of identification) by the use 
of a method of allocation which fairly apportions such costs among the 
various items produced. Acceptable methods for allocating indirect 
production costs to the cost of goods in the ending inventory include 
the manufacturing burden rate method and the standard cost method. In 
addition, the practical capacity concept can be used in conjunction with 
either the manufacturing burden rate or standard cost method.
    (2) Manufacturing burden rate method--(i) In general. Manufacturing 
burden rates may be developed in accordance with acceptable accounting 
principles and applied in a reasonable manner. In developing a 
manufacturing burden rate, the factors described in paragraph (d)(2)(ii) 
of this section may be taken into account. Furthermore, if the taxpayer 
chooses, he may allocate different indirect production costs on the 
basis of different manufacturing burden rates. Thus, for example, the 
taxpayer may use one burden rate for allocating rent and another burden 
rate for allocating utilities. The method used by the taxpayer in 
allocating such costs in his financial reports shall be given great 
weight in determining whether the taxpayer's method employed for tax 
purposes fairly allocates indirect production costs to the ending 
inventory. Any change in a manufacturing burden rate which is merely a 
periodic adjustment to reflect current operating conditions, such as 
increases in automation or changes in operation, does not constitute a 
change in method of accounting under section 446. However, a change in 
the concept upon which such rates are developed does constitute a change 
in method of accounting requiring the consent of the Commissioner. The 
taxpayer shall maintain adequate records and working papers to support 
all manufacturing burden rate calculations.
    (ii) Development of manufacturing burden rate. The following 
factors, among others, may be taken into account in developing 
manufacturing burden rates:
    (a) The selection of an appropriate level of activity and period of 
time upon which to base the calculation of rates which will reflect 
operating conditions for purposes of the unit costs being determined;
    (b) The selection of an appropriate statistical base such as direct 
labor

[[Page 525]]

hours, direct labor dollars, or machine hours, or a combination thereof, 
upon which to apply the overhead rate to determine production costs; and
    (c) The appropriate budgeting, classification and analysis of 
expenses (for example, the analysis of fixed and variable costs).
    (iii) Operation of the manufacturing burden rate method. (a) The 
purpose of the manufacturing burden rate method used in conjunction with 
the full absorption method of inventory costing is to allocate an 
appropriate amount of indirect production costs to a taxpayer's goods in 
ending inventory by the use of predetermined rates intended to 
approximate the actual amount of indirect production costs incurred. 
Accordingly, the proper use of the manufacturing burden rate method 
under this section requires that any net negative or net positive 
difference between the total predetermined amount of indirect production 
costs allocated to the goods in ending inventory and the total amount of 
indirect production costs actually incurred and required to be allocated 
to such goods (i.e., the under or over-applied burden) must be treated 
as an adjustment to the taxpayer's ending inventory in the taxable year 
in which such difference arises. However, if such adjustment is not 
significant in amount in relation to the taxpayer's total actual 
indirect production costs for the year then such adjustment need not be 
allocated to the taxpayer's goods in ending inventory unless such 
allocation is made in the taxpayer's financial reports. The taxpayer 
must treat both positive and negative adjustments consistently.
    (b) Notwithstanding subdivision (a), the practical capacity concept 
may be used to determine the total amount of fixed indirect production 
costs which must be allocated to goods in ending inventory. See 
subparagraph (4) of this paragraph.
    (3) Standard cost method--(i) In general. A taxpayer may use the so-
called ``standard cost'' method of allocating inventoriable costs to the 
goods in ending inventory, provided he treats variances in accordance 
with the procedures prescribed in paragraph (d)(3)(ii) of this section. 
The method used by the taxpayer in allocating such costs in his 
financial reports shall be given great weight in determining whether the 
taxpayer's method employed for tax purposes fairly allocates indirect 
production costs to the ending inventory. For purposes of this 
subparagraph, a ``net positive overhead variance'' shall mean the excess 
of total standard (or estimated) indirect production costs over total 
actual indirect production costs and a ``net negative overhead 
variance'' shall mean the excess of total actual indirect production 
costs over total standard (or estimated) indirect production costs.
    (ii) Treatment of variances. (a) The proper use of the standard cost 
method pursuant to this subparagraph requires that a taxpayer must 
reallocate to the goods in ending inventory a pro rata portion of any 
net negative or net positive overhead variances and any net negative or 
net positive direct production cost variances. The taxpayer must 
apportion such variances among his various items in ending inventory. 
However, if such variances are not significant in amount in relation to 
the taxpayer's total actual indirect production costs for the year then 
such variances need not be allocated to the taxpayer's goods in ending 
inventory unless such allocation is made in the taxpayer's financial 
reports. The taxpayer must treat both positive and negative variances 
consistently.
    (b) Notwithstanding subdivision (a), the practical capacity concept 
may be used to determine the total amount of fixed indirect production 
costs which must be allocated to goods in ending inventory. See 
subparagraph (4) of this paragraph.
    (4) Practical capacity concept--(i) In general. Under the practical 
capacity concept, the percentage of practical capacity represented by 
actual production (not greater than 100 percent), as calculated under 
subdivision (ii) of this subparagraph, is used to determine the total 
amount of fixed indirect production costs which must be included in the 
taxpayer's computation of the amount of inventoriable costs. The portion 
of such costs to be included in the taxpayer's computation of the amount 
of inventoriable costs is then combined with variable indirect 
production costs and both are allocated to the goods in

[[Page 526]]

ending inventory in accordance with this paragraph. See the example in 
subdivision (ii)(d) of this subparagraph. The difference (if any) 
between the amount of all fixed indirect production costs and the fixed 
indirect production costs which are included in the computation of the 
amount of inventoriable costs under the practical capacity concept is 
allowable as a deduction for the taxable year in which such difference 
occurs.
    (ii) Calculation of practical capacity--(a) In general. Practical 
capacity and theoretical capacity (as described in (c) of this 
subdivision) may be computed in terms of tons, pounds, yards, labor 
hours, machine hours, or any other unit of production appropriate to the 
cost accounting system used by a particular taxpayer. The determination 
of practical capacity and theoretical capacity should be modified from 
time to time to reflect a change in underlying facts and conditions such 
as increased output due to automation or other changes in plant 
operation. Such a change does not constitute a change in method of 
accounting under sections 446 and 481.
    (b) Based upon taxpayer's experience. In selecting an appropriate 
level of production activity upon which to base the calculation of 
practical capacity, the taxpayer shall establish the production 
operating conditions expected during the period for which the costs are 
being determined, assuming that the utilization of production facilities 
during operations will be approximately at capacity. This level of 
production activity is frequently described as practical capacity for 
the period and is ordinarily based upon the historical experience of the 
taxpayer. For example, a taxpayer operating on a 5-day, 8-hour basis may 
have a ``normal'' production of 100,000 units a year based upon three 
years of experience.
    (c) Based upon theoretical capacity. Practical capacity may also be 
established by the use of ``theoretical'' capacity, adjusted for 
allowances for estimated inability to achieve maximum production, such 
as machine breakdown, idle time, and other normal work stoppages. 
Theoretical capacity is the level of production the manufacturer could 
reach if all machines and departments were operated continously at peak 
efficiency.
    (d) Example. The provisions of (c) of this subdivision may be 
illustrated by the following example:

    Corporation X operates a stamping plant with a theoretical capacity 
of 50 units per hour. The plant actually operates 1960 hours per year 
based on an 8-hour day, 5 day week basis and 15 shutdown days for 
vacations and holidays. A reasonable allowance for down time (the time 
allowed for ordinary and necessary repairs and maintenance) is 5 percent 
of practical capacity before reduction for down time. Assuming no loss 
of production during starting up, closing down, or employee work breaks, 
under these facts and circumstances X may properly make a practical 
capacity computation as follows:

Practical capacity without allowance for down time based on       98,000
 theoretical capacity per hour is (1960x50)....................
Reduction for down time (98,000x5 percent).....................    4,900
Practical capacity.............................................   93,100
 


The 93,100 unit level of activity (i.e., practical capacity) would, 
therefore, constitute an appropriate base for calculating the amount of 
fixed indirect production costs to be included in the computation of the 
amount of inventoriable costs for the period under review. On this basis 
if only 76,000 units were produced for the period, the effect would be 
that approximately 81.6 percent (76,000, the actual number of units 
produced, divided by 93,100, the maximum number of units producible at 
practical capacity) of the fixed indirect production costs would be 
included in the computation of the amount of inventoriable costs during 
the year. The portion of the fixed indirect production costs not so 
included in the computation of the amount of inventoriable costs would 
be deductible in the year in which paid or incurred. Assume further that 
7,600 units were on hand at the end of the taxable year and the 7,600 
units were in the same proportion to the total units produced. Thus, 10 
percent (7,600 units in inventory at the end of the taxable year, 
divided by 76,000, the actual number of units produced) of the fixed 
indirect production costs included in the computation of the amount of 
inventoriable costs (the above-mentioned 81.6 percent) and 10 percent of 
the variable indirect production costs would be included in the cost of 
the goods in the ending inventory, in accordance with a method of 
allocation provided by this paragraph.

    (e) Transition to full absorption method of inventory costing--(1) 
In general--(i) Mandatory requirement. A taxpayer not using the full 
absorption method of inventory costing, as prescribed by paragraph (a) 
of this section, must change

[[Page 527]]

to that method. Any change to the full absorption method must be made by 
the taxpayer with respect to all trades or businesses of the taxpayer to 
which this section applies. A taxpayer not using the full absorption 
method of inventory costing, as prescribed by paragraph (a) of this 
section, who makes the special election provided in subdivision (ii) of 
this subparagraph during the transition period described in subdivision 
(ii) of this subparagraph need not change to the full absorption method 
of inventory costing for taxable years prior to the year for which such 
election is made. In determining whether the taxpayer is changing to a 
more or less inclusive method of inventory costing, all positive and 
negative adjustments for all items and all trades or businesses of the 
taxpayer shall be aggregated. If the net adjustment is positive, 
paragraph (e)(3) shall apply, and if the net adjustment is negative, 
paragraph (e)(4) shall apply to the change. The rules otherwise 
prescribed in sections 446 and 481 and the regulations thereunder shall 
apply to any taxpayer who fails to make the special election in 
subdivision (ii) of this subparagraph. The transition rules of this 
paragraph are available only to those taxpayers who change their method 
of inventory costing.
    (ii) Special election during two-year-transition period. If a 
taxpayer elects to change to the full absorption method of inventory 
costing during the transition period provided herein, he may elect on 
Form 3115 to change to such full absorption method of inventory costing 
and, in so doing, employ the transition procedures and adopt any of the 
transition methods prescribed in subparagraph (3) of this paragraph. 
Such election shall be made during the first 180 days of any taxable 
year beginning on or after September 19, 1973 and before September 19, 
1975 (i.e., the ``transition period'') and the change in inventory 
costing method shall be made for the taxable year in which the election 
is made. Notwithstanding the preceding sentence if the taxpayer's prior 
returns have been examined by the Service prior to Sept. 19, 1973, and 
there is a pending issue involving the taxpayer's method of inventory 
costing, the taxpayer may request the application of this regulation by 
agreeing and filing a letter to that effect with the district director, 
within 90 days after September 19, 1973 to change to the full absorption 
method for the first taxable year of the taxpayer beginning after Sept. 
19, 1973 and subsequently filing Form 3115 within the first 180 days of 
such taxable year of change.
    (iii) Change initiated by the Commissioner. A taxpayer who properly 
makes an election under subdivision (ii) of this subparagraph shall be 
considered to have made a change in method of accounting not initiated 
by the taxpayer, notwithstanding the provisions of Sec. 1.481-1(c)(5). 
Thus, any of the taxpayer's ``pre-1954 inventory balances'' with respect 
to such inventory shall not be taken into account as an adjustment under 
section 481. For purposes of this paragraph, a ``pre-1954 inventory 
balance'' is the net amount of the adjustments which would have been 
required if the taxpayer had made such change in his method of 
accounting with respect to his inventory in his first taxable year which 
began after December 31, 1953, and ended after August 16, 1954. See 
section 481(a)(2) and Sec. 1.481-3.
    (2) Procedural rules for change. If a taxpayer makes an election 
pursuant to subparagraph (1)(ii) of this paragraph, the Commissioner's 
consent will be evidenced by a letter of consent to the taxpayer, 
setting forth the values of inventory, as provided by the taxpayer, 
determined under the full absorption method of inventory costing, except 
to the extent that no determination of such values is necessary under 
subparagraph (3)(ii)(B) of this paragraph (the cut off method), the 
amount of the adjustments (if any) required to be taken into account by 
section 481, and the treatment to be accorded to any such adjustments. 
Such full absorption values shall be subject to verification on 
examination by the district director. The taxpayer shall preserve at his 
principal place of business all records, data, and other evidence 
relating to the full absorption values of inventory.
    (3) Transition methods. In the case of a taxpayer who properly makes 
an election under subparagraph (1)(ii) of this

[[Page 528]]

paragraph during the transition period--
    (i) 10-year adjustment period. Such taxpayer may elect to take any 
adjustment required by section 481 with respect to any inventory being 
revalued under the full absorption method into account ratably over a 
period designated by the taxpayer at the time of such election, not to 
exceed the lesser of 10 taxable years commencing with the year of 
transition or the number of years the taxpayer has been on the inventory 
method from which he is changing. If the taxpayer dies or ceases to 
exist in a transaction other than one to which section 381(a) of the 
Code applies or if the taxpayer's inventory (determined under the full 
absorption method) on the last day of any taxable year is reduced (by 
other than a strike or involuntary conversion) by more than an amount 
equal to 33\1/3\ percent of the taxpayer's inventory (determined under 
the full absorption method) as of the beginning of the year of change, 
the entire amount of the section 481 adjustment not previously taken 
into account in computing income shall be taken into account in 
computing income for the taxable year in which such taxpayer so ceases 
to exist or such taxpayer's inventory is so reduced.
    (ii) Additional rules for LIFO taxpayers. A taxpayer who uses the 
LIFO method of inventory identification may either--
    (a) Employ the special transition rules described in subdivision (i) 
of this subparagraph. Accordingly, all LIFO layers must be revalued 
under the full absorption method and the section 481 adjustment must be 
computed for all items in all layers in inventory, but no pre-1954 
inventory balances shall be taken into account as adjustments under 
section 481; or
    (b)(1) Employ a cut-off method whereby the full absorption method is 
only applied in costing layers of inventory acquired during all taxable 
years beginning with the year for which an election is made under 
subparagraph (e)(1)(ii).
    (2) In the case of a taxpayer using dollar value LIFO, employ a cut-
off method whereby the taxpayer must use, for the year of change, the 
full absorption method in computing the base year cost and current cost 
of a dollar value inventory pool for the beginning of such year. The 
taxpayer shall not be required to recompute his LIFO inventories based 
on the full absorption method for a taxable year beginning prior to the 
year of change to the full absorption method. The base cost and layers 
of increment previously computed shall be retained and treated as if 
such base cost and layers of increment had been computed under the 
method authorized by this section. The taxpayer shall use the year of 
change as the base year in applying the double extension method or other 
method approved by the Commissioner, instead of the earliest year for 
which he adopted the LIFO method for any items in the pool.
    (4) Transition to full absorption method of inventory costing from a 
method more inclusive of indirect production costs--(i) Taxpayer has not 
previously changed to his present method pursuant to subparagraphs (1), 
(2), and (3) of this paragraph. If a taxpayer wishes to change to the 
full absorption method of inventory costing (as prescribed by paragraph 
(a) of this section) from a method of inventory costing which is more 
inclusive of indirect production costs and he has not previously changed 
to his present method by use of the special transition rules provided by 
subparagraphs (1), (2) and (3) of this paragraph, he may elect on Form 
3115 to change to the full absorption method of inventory costing and, 
in so doing, take into account any resulting section 481 adjustment 
generally over 10 taxable years commencing with the year of transition. 
The Commissioner's consent to such election will be evidenced by a 
letter of consent to the taxpayer setting forth the values of inventory, 
as provided by the taxpayer determined under the full absorption method 
of inventory costing, except to the extent that no determination of such 
values is necessary under subparagraph (3)(ii)(b) of this paragraph, the 
amount of the adjustments (if any) required to be taken into account by 
section 481, and the treatment to be accorded such adjustments, subject 
to terms and conditions specified by the Commissioner to prevent 
distortions of income. Such

[[Page 529]]

election must be made within the transition period described in 
subparagraph (1)(ii) of this paragraph. A change pursuant to this 
subparagraph shall be a change initiated by the taxpayer as provided by 
Sec. 1.481-1(c)(5). Thus, any of the taxpayers ``pre-1954 inventory 
balances'' will be taken into account as an adjustment under section 
481.
    (ii) Taxpayer has previously changed to his present method pursuant 
to subparagraph (1), (2), and (3) of this paragraph or would satisfy all 
the requirements of subdivision (i) of this subparagraph but fails to 
elect within the transition period. If a taxpayer wishes to change to 
the full absorption method of inventory costing (as prescribed by 
paragraph (a) of this section) from a method of inventory costing which 
is more inclusive of indirect production costs and he has previously 
changed to his present method pursuant to subparagraphs (1), (2), and 
(3) of this paragraph or he would satisfy the requirements of 
subdivision (i) of this subparagraph but he fails to elect within the 
transition period, he must secure the consent of the Commissioner prior 
to making such change.

[T.D. 7285, 38 FR 26185, Sept. 19, 1973, as amended by T.D. 8067, 51 FR 
393, Jan. 6, 1986; T.D. 8131, 52 FR 10084, Mar. 30, 1987; T.D. 8482, 58 
FR 42234, Aug. 9, 1993]



Sec. 1.472-1  Last-in, first-out inventories.

    (a) Any taxpayer permitted or required to take inventories pursuant 
to the provisions of section 471, and pursuant to the provisions of 
Sec. Sec. 1.471-1 to 1.471-9, inclusive, may elect with respect to 
those goods specified in his application and properly subject to 
inventory to compute his opening and closing inventories in accordance 
with the method provided by section 472, this section, and Sec. 1.472-
2. Under this last-in, first-out (LIFO) inventory method, the taxpayer 
is permitted to treat those goods remaining on hand at the close of the 
taxable year as being:
    (1) Those included in the opening inventory of the taxable year, in 
the order of acquisition and to the extent thereof, and
    (2) Those acquired during the taxable year.


The LIFO inventory method is not dependent upon the character of the 
business in which the taxpayer is engaged, or upon the identity or want 
of identity through commingling of any of the goods on hand, and may be 
adopted by the taxpayer as of the close of any taxable year.
    (b) If the LIFO inventory method is used by a taxpayer who regularly 
and consistently, in a manner similar to hedging on a futures market, 
matches purchases with sales, then firm purchases and sales contracts 
(i.e., those not legally subject to cancellation by either party) 
entered into at fixed prices on or before the date of the inventory may 
be included in purchases or sales, as the case may be, for the purpose 
of determining the cost of goods sold and the resulting profit or loss, 
provided that this practice is regularly and consistently adhered to by 
the taxpayer and provided that, in the opinion of the Commissioner, 
income is clearly reflected thereby.
    (c) A manufacturer or processor who has adopted the LIFO inventory 
method as to a class of goods may elect to have such method apply to the 
raw materials only (including those included in goods in process and in 
finished goods) expressed in terms of appropriate units. If such method 
is adopted, the adjustments are confined to costs of the raw material in 
the inventory and the cost of the raw material in goods in process and 
in finished goods produced by such manufacturer or processor and 
reflected in the inventory. The provisions of this paragraph may be 
illustrated by the following examples:

    Example (1). Assume that the opening inventory had 10 units of raw 
material, 10 units of goods in process, and 10 units of finished goods, 
and that the raw material cost was 6 cents a unit, the processing cost 2 
cents a unit, and overhead cost 1 cent a unit. For the purposes of this 
example, it is assumed that the entire amount of goods in process was 50 
percent processed.

                            Opening Inventory
------------------------------------------------------------------------
                                                        Goods
                                                Raw       in    Finished
                                             material  process    goods
------------------------------------------------------------------------
Raw material                                    $0.60    $0.60     $0.60
Processing cost                              ........      .10       .20
Overhead                                     ........      .05       .10
------------------------------------------------------------------------


In the closing inventory there are 20 units of raw material, 6 units of 
goods in process, and 8 units of finished goods and the costs were:

[[Page 530]]

Raw material 10 cents, processing cost 4 cents, and overhead 1 cent.

                            Closing Inventory
                 [Based on cost and prior to adjustment]
------------------------------------------------------------------------
                                                        Goods
                                                Raw       in    Finished
                                             material  process    goods
------------------------------------------------------------------------
Raw material                                    $2.00    $0.60     $0.80
Processing costs                             ........      .12       .32
Overhead                                     ........      .03       .08
                                            ----------------------------
   Total                                         2.00      .75      1.20
------------------------------------------------------------------------

There were 30 units of raw material in the opening inventory and 34 
units in the closing inventory. The adjustment to the closing inventory 
would be as follows:

                      Closing Inventory as Adjusted
------------------------------------------------------------------------
                                                        Goods
                                                Raw       in    Finished
                                             material  process    goods
------------------------------------------------------------------------
Raw material:
  20 at 6 cents                                 $1.20  .......  ........
  6 at 6 cents                               ........    $0.36  ........
  4 at 6 cents                               ........  .......     $0.24
  4 at 10 cents \1\                          ........  .......       .40
Processing costs                             ........      .12       .32
Overhead                                     ........      .03       .08
                                            ----------------------------
      Total                                      1.20      .51     1.04
------------------------------------------------------------------------
\1\ This excess is subject to determination of price under section
  472(b)(1) and Sec.  1.472-2. If the excess falls in goods in process,
  the same adjustment is applicable.

The only adjustment to the closing inventory is the cost of the raw 
material; the processing costs and overhead cost are not changed.
    Example (2). Assume that the opening inventory had 5 units of raw 
material, 10 units of goods in process, and 20 units of finished goods, 
with the same prices as in example (1), and that the closing inventory 
had 20 units of raw material, 20 units of goods in process, and 10 units 
of finished goods, with raw material costs as in the closing inventory 
in example (1). The adjusted closing inventory would be as follows in so 
far as the raw material is concerned:

Raw material, 20 at 6 cents....................................    $1.20
Goods in process:
  15 at 6 cents................................................      .90
  5 at 10 cents \1\............................................      .50
Finished goods:
  None at 6 cents..............................................     0.00
  10 at 10 cents \1\...........................................     1.00
 
\1\ This excess is subject to determination of price under section
  472(b)(1) and Sec.  1.472-2.

The 20 units of raw material in the raw state plus 15 units of raw 
material in goods in process make up the 35 units of raw material that 
were contained in the opening inventory.

    (d) For the purposes of this section, raw material in the opening 
inventory must be compared with similar raw material in the closing 
inventory. There may be several types of raw materials, depending upon 
the character, quality, or price, and each type of raw material in the 
opening inventory must be compared with a similar type in the closing 
inventory.
    (e) In the cotton textile industry there may be different raw 
materials depending upon marked differences in length of staple, in 
color or grade of the cotton. But where different staple lengths or 
grades of cotton are being used at different times in the same mill to 
produce the same class of goods, such differences would not necessarily 
require the classification into different raw materials.
    (f) As to the pork packing industry a live hog is considered as 
being composed of various raw materials, different cuts of a hog varying 
markedly in price and use. Generally a hog is processed into 
approximately 10 primal cuts and several miscellaneous articles. 
However, due to similarity in price and use, these may be grouped into 
fewer classifications, each group being classed as one raw material.
    (g) When the finished product contains two or more different raw 
materials as in the case of cotton and rayon mixtures, each raw material 
is treated separately and adjustments made accordingly.
    (h) Upon written notice addressed to the Commissioner of Internal 
Revenue, Attention T:R, Washington, D.C. 20224 by the taxpayer, a 
taxpayer who has heretofore adopted the LIFO inventory method in respect 
of any goods may adopt the method authorized in this section and limit 
the election to the raw material including raw materials entering into 
goods in process and in finished goods. If this method is adopted as to 
any specific goods, it must be used exclusively for such goods for any 
prior taxable year (not closed by agreement) to which the prior election 
applies and for all subsequent taxable years, unless permission to 
change is granted by the Commissioner.
    (i) The election may also be limited to that phase in the 
manufacturing process where a product is produced that is recognized 
generally as a salable product as, for example, in the textile industry 
where one phase of the

[[Page 531]]

process is the production of yarn. Since yarn is generally recognized as 
a salable product, the election may be limited to that portion of the 
process when yarn is produced. In the case of copper and brass 
processors, the election may be limited to the production of bars, 
plates, sheets, etc., although these may be further processed into other 
products.
    (j) The election may also apply to any one raw material, when two or 
more raw materials enter into the composition of the finished product; 
for example, in the case of cotton and rayon yarn, the taxpayer may 
elect to inventory the cotton only. However, a taxpayer who has 
previously made an election to use the LIFO inventory method may not 
later elect to exclude any raw materials that were covered by such 
previous election.
    (k) If a taxpayer using the retail method of pricing inventories, 
authorized by Sec. 1.471-8, elects to use in connection therewith the 
LIFO inventory method authorized by section 472 and this section, the 
apparent cost of the goods on hand at the end of the year, determined 
pursuant to Sec. 1.471-8, shall be adjusted to the extent of price 
changes therein taking place after the close of the preceding taxable 
year. The amount of any apparent inventory increase or decrease to be 
eliminated in this adjustment shall be determined by reference to 
acceptable price indexes established to the satisfaction of the 
Commissioner. Price indexes prepared by the United States Bureau of 
Labor Statistics which are applicable to the goods in question will be 
considered acceptable to the Commissioner. Price indexes which are based 
upon inadequate records, or which are not subject to complete and 
detailed audit within the Internal Revenue Service, will not be 
approved.
    (l) If a taxpayer uses consistently the so-called ``dollar-value'' 
method of pricing inventories, or any other method of computation 
established to the satisfaction of the Commissioner as reasonably 
adaptable to the purpose and intent of section 472 and this section, and 
if such taxpayer elects under section 472 to use the LIFO inventory 
method authorized by such section, the taxpayer's opening and closing 
inventories shall be determined under section 472 by the use of the 
appropriate adaptation. See Sec. 1.472-8 for rules relating to the use 
of the dollar-value method.

[T.D. 6500, 25 FR 11727, Nov. 26, 1960, as amended by T.D. 6539, 26 FR 
518, Jan. 20, 1961]



Sec. 1.472-2  Requirements incident to adoption and use of LIFO 
inventory method.

    Except as otherwise provided in Sec. 1.472-1 with respect to raw 
material computations, with respect to retail inventory computations, 
and with respect to other methods of computation established to the 
satisfaction of the Commissioner as reasonably adapted to the purpose 
and intent of section 472, and in Sec. 1.472-8 with respect to the 
``dollar-value'' method, the adoption and use of the LIFO inventory 
method is subject to the following requirements:
    (a) The taxpayer shall file an application to use such method 
specifying with particularity the goods to which it is to be applied.
    (b) The inventory shall be taken at cost regardless of market value.
    (c) Goods of the specified type included in the opening inventory of 
the taxable year for which the method is first used shall be considered 
as having been acquired at the same time and at a unit cost equal to the 
actual cost of the aggregate divided by the number of units on hand. The 
actual cost of the aggregate shall be determined pursuant to the 
inventory method employed by the taxpayer under the regulations 
applicable to the prior taxable year with the exception that restoration 
shall be made with respect to any writedown to market values resulting 
from the pricing of former inventories.
    (d) Goods of the specified type on hand as of the close of the 
taxable year in excess of what were on hand as of the beginning of the 
taxable year shall be included in the closing inventory, regardless of 
identification with specific invoices and regardless of specific cost 
accounting records, at costs determined pursuant to the provisions of 
subparagraph (1) or (2) of this paragraph, dependent upon the character 
of the transactions in which the taxpayer is engaged:

[[Page 532]]

    (1)(i) In the case of a taxpayer engaged in the purchase and sale of 
merchandise, such as a retail grocer or druggist, or engaged in the 
initial production of merchandise and its sale without processing, such 
as a miner selling his ore output without smelting or refining, such 
costs shall be determined--
    (a) By reference to the actual cost of the goods most recently 
purchased or produced;
    (b) By reference to the actual cost of the goods purchased or 
produced during the taxable year in the order of acquisition;
    (c) By application of an average unit cost equal to the aggregate 
cost of all of the goods purchased or produced throughout the taxable 
year divided by the total number of units so purchased or produced, the 
goods reflected in such inventory increase being considered for the 
purposes of section 472 as having been acquired all at the same time; or
    (d) Pursuant to any other proper method which, in the opinion of the 
Commissioner, clearly reflects income.
    (ii) Whichever of the several methods of valuing the inventory 
increase is adopted by the taxpayer and approved by the Commissioner 
shall be consistently adhered to in all subsequent taxable years so long 
as the LIFO inventory method is used by the taxpayer.
    (iii) The application of subdivisions (i) and (ii) of this 
subparagraph may be illustrated by the following examples:

    Example (1). Suppose that the taxpayer adopts the LIFO inventory 
method for the taxable year 1957 with an opening inventory of 10 units 
at 10 cents per unit, that it makes 1957 purchases of 10 units as 
follows:

January...................................      1 at    $0.11=     $0.11
April.....................................      2 at      .12=       .24
July......................................      3 at      .13=       .39
October...................................      4 at      .14=       .56
                                           ----------          ---------
   Totals.................................        10  ........      1.30
 


and that it has a 1957 closing inventory of 15 units. This closing 
inventory, depending upon the taxpayer's method of valuing inventory 
increases, will be computed as follows:
    (a) Most recent purchases--

                                                 10 at    $0.10    $1.00
October......................................     4 at      .14      .56
July.........................................     1 at      .13      .13
                                              ---------         --------
  Totals.....................................       15  .......     1.69
 

    (b) In order of acquisitions--

                                                 10 at    $0.10    $1.00
January......................................     1 at      .11      .11
April........................................     2 at      .12      .24
July.........................................     2 at      .13      .26
                                              ---------         --------
   Totals....................................       15  .......     1.61
 

or
    (c) At an annual average--

                                                 10 at    $0.10    $1.00
(130/10).....................................     5 at      .13      .65
                                              ---------         --------
   Totals....................................       15  .......     1.65
 

    Example (2). Suppose that the taxpayer's closing inventory for 1958, 
the year following that involved in example (1) of this subdivision, 
reflects an inventory decrease for the year, and not an increase; 
suppose that there is, accordingly, a 1958 closing inventory of 13 
units. Inasmuch as the decreased closing inventory will be determined 
wholly by reference to the 15 units reflected in the opening inventory 
for the year, and will be taken ``in the order of acquisition'' pursuant 
to section 472 (b) (1), and inasmuch as the character of the taxpayer's 
opening inventory for 1958 will be dependent upon its method of valuing 
its 5-unit inventory increase for 1957, the closing inventory for 1958 
will be computed as follows:
    (a) In case the increase for 1957 was taken by reference to the most 
recent purchases--

From 1956....................................    10 at    $0.10    $1.00
July 1957....................................     1 at      .13      .13
October 1957.................................     2 at      .14      .28
                                              ---------         --------
    Totals...................................       13  .......     1.41
 


or
    (b) In case the increase for 1957 was taken in the order of 
acquisition--

From 1956....................................    10 at    $0.10    $1.00
January 1957.................................    51 at      .11      .11
April 1957...................................     2 at      .12      .24
                                              ---------         --------
    Totals...................................       13  .......     1.35
 

or
    (c) In case the increase for 1957 was taken on the basis of an 
average--

From 1956....................................    10 at    $0.10    $1.00
From 1957....................................     3 at      .13      .39
                                              ---------         --------
    Totals...................................       13  .......     1.39
 

    (2) In the case of a taxpayer engaged in manufacturing, fabricating, 
processing, or otherwise producing merchandise, such costs shall be 
determined:
    (i) In the case of raw materials purchased or initially produced by 
the taxpayer, in the manner elected by the taxpayer under subparagraph 
(1) of this paragraph to the same extent as if the taxpayer were engaged 
in purchase and sale transactions; and

[[Page 533]]

    (ii) In the case of goods in process, regardless of the stage to 
which the manufacture, fabricating, or processing may have advanced, and 
in the case of finished goods, pursuant to any proper method which, in 
the opinion of the Commissioner, clearly reflects income.
    (e) LIFO conformity requirement--(1) In general. The taxpayer must 
establish to the satisfaction of the Commissioner that the taxpayer, in 
ascertaining the income, profit, or loss for the taxable year for which 
the LIFO inventory method is first used, or for any subsequent taxable 
year, for credit purposes or for purposes of reports to shareholders, 
partners, or other proprietors, or to beneficiaries, has not used any 
inventory method other than that referred to in Sec. 1.472-1 or at 
variance with the requirement referred to in Sec. 1.472-2(c). See 
paragraph (e)(2) of this section for rules relating to the meaning of 
the term ``taxable year'' as used in this paragraph. The following are 
not considered at variance with the requirement of this paragraph:
    (i) The taxpayer's use of an inventory method other than LIFO for 
purposes of ascertaining information reported as a supplement to or 
explanation of the taxpayer's primary presentation of the taxpayer's 
income, profit, or loss for a taxable year in credit statements or 
financial reports (including preliminary and unaudited financial 
reports). See paragraph (e)(3) of this section for rules relating to the 
reporting of supplemental and explanatory information ascertained by the 
use of an inventory method other than LIFO.
    (ii) The taxpayer's use of an inventory method other than LIFO to 
ascertain the value of the taxpayer's inventory of goods on hand for 
purposes of reporting the value of such inventories as assets. See 
paragraph (e)(4) of this section for rules relating to such disclosures.
    (iii) The taxpayer's use of an inventory method other than LIFO for 
purposes of ascertaining information reported in internal management 
reports. See paragraph (e)(5) of this section for rules relating to such 
reports.
    (iv) The taxpayer's use of an inventory method other than LIFO for 
purposes of issuing reports or credit statements covering a period of 
operations that is less than the whole of a taxable year for which the 
LIFO method is used for Federal income tax purposes. See paragraph 
(e)(6) of this section for rules relating to series of interim reports.
    (v) The taxpayer's use of the lower of LIFO cost or market method to 
value LIFO inventories for purposes of financial reports and credit 
statements. However, except as provided in paragraph (e)(7) of this 
section, a taxpayer may not use market value in lieu of cost to value 
inventories for purposes of financial reports or credit statements.
    (vi) The taxpayer's use of a costing method or accounting method to 
ascertain income, profit, or loss for credit purposes or for purposes of 
financial reports if such costing method or accounting method is neither 
inconsistent with the inventory method referred to in Sec. 1.472-1 nor 
at variance with the requirement referred to in Sec. 1.472-2(c), 
regardless of whether such costing method or accounting method is used 
by the taxpayer for Federal income tax purposes. See paragraph (e)(8) of 
this section for examples of such costing methods and accounting 
methods.
    (vii) For credit purposes or for purposes of financial reports, the 
taxpayer's treatment of inventories, after such inventories have been 
acquired in a transaction to which section 351 applies from a transferor 
that used the LIFO method with respect to such inventories, as if such 
inventories had the same acquisition dates and costs as in the hands of 
the transferor.
    (viii) For credit purposes or for purposes of financial reports 
relating to a taxable year, the taxpayer's determination of income, 
profit, or loss for the taxable year by valuing inventories in 
accordance with the procedures described in section 472(b) (1) and (3), 
notwithstanding that such valuation differs from the valuation of 
inventories for Federal income tax purposes because the taxpayer 
either--
    (A) Adopted such procedures for credit or financial reporting 
purposes beginning with an accounting period other than the taxable year 
for which the LIFO method was first used by the

[[Page 534]]

taxpayer for Federal income tax purposes, or
    (B) With respect to such inventories treated a business combination 
for credit or financial reporting purposes in a manner different from 
the treatment of the business combination for Federal income tax 
purposes.
    (2) One-year periods other than a taxable year. The rules of this 
paragraph relating to the determination of income, profit, or loss for a 
taxable year and credit statements or financial reports that cover a 
taxable year also apply to the determination of income, profit, or loss 
for a one-year period other than a taxable year and credit statements or 
financial reports that cover a one-year period other than a taxable 
year, but only if the one-year period both begins and ends in a taxable 
year or years for which the taxpayer uses the LIFO method for Federal 
income tax purposes. For example, the requirements of paragraph (e)(1) 
of this section apply to a taxpayer's determination of income for 
purposes of a credit statement that covers a 52-week fiscal year 
beginning and ending in a taxable year for which the taxpayer uses the 
LIFO method for Federal income tax purposes. Similarly, in the case of a 
calendar year taxpayer, the requirements of paragraph (e)(1) of this 
section apply to the taxpayer's determination of income for purposes of 
a credit statement that covers the period October 1, 1981, through 
September 30, 1982, if the taxpayer uses the LIFO method for Federal 
income tax purposes in taxable years 1981 and 1982. However, the 
Commissioner will waive any violation of the requirements of this 
paragraph in the case of a credit statement or financial report that 
covers a one-year period other than a taxable year if the report was 
issued before January 22, 1981.
    (3) Supplemental and explanatory information--(i) Face of the income 
statement. Information reported on the face of a taxpayer's financial 
income statement for a taxable year is not considered a supplement to or 
explanation of the taxpayer's primary presentation of the taxpayer's 
income, profit, or loss for the taxable year in credit statements or 
financial reports. For purposes of paragraph (e)(3) of this section, the 
face of an income statement does not include notes to the income 
statement presented on the same page as the income statement, but only 
if all notes to the financial income statement are presented together.
    (ii) Notes to the income statement. Information reported in notes to 
a taxpayer's financial income statement is considered a supplement to or 
explanation of the taxpayer's primary presentation of income, profit, or 
loss for the period covered by the income statement if all notes to the 
financial income statement are presented together and if they accompany 
the income statement in a single report. If notes to an income statement 
are issued in a report that does not include the income statement, the 
question of whether the information reported therein is supplemental or 
explanatory is determined under the rules in paragraph (e)(3)(iv) of 
this section.
    (iii) Appendices and supplements to the income statement. 
Information reported in an appendix or supplement to a taxpayer's 
financial income statement is considered a supplement to or explanation 
of the taxpayer's primary presentation of income, profit, or loss for 
the period covered by the income statement if the appendix or supplement 
accompanies the income statement in a single report and the information 
reported in the appendix or supplement is clearly identified as a 
supplement to or explanation of the taxpayer's primary presentation of 
income, profit, or loss as reported on the face of the taxpayer's income 
statement. If an appendix or supplement to an income statement is issued 
in a report that does not include the income statement, the question of 
whether the information reported therein is supplemental or explanatory 
is determined under the rules in paragraph (e)(3)(iv) of this section. 
For purposes of paragraph (e)(3)(iii) of this section, an appendix or 
supplement to an income statement includes written statements, 
schedules, and reports that are labelled supplements or appendices to 
the income statement. However, sections of an annual report such as 
those labelled ``President's Letter'', ``Management's Analysis'', 
``Statement of Changes in Financial Position'', ``Summary of Key

[[Page 535]]

Figures'', and similar sections are reports described in paragraph 
(e)(3)(iv) of this section and are not considered ``supplements or 
appendices to an income statement'' within the meaning of paragraph 
(e)(3)(iii) of this section, regardless of whether such sections are 
also labelled as supplements or appendices. For purposes of paragraph 
(e)(3)(iii) of this section, information is considered to be clearly 
identified as a supplement to or explanation of the taxpayer's primary 
presentation of income, profit, or loss as reported on the face of the 
taxpayer's income statement if the information either--
    (A) Is reported in an appendix or supplement that contains a general 
statement identifying all such supplemental or explanatory information;
    (B) Is identified specifically as supplemental or explanatory by a 
statement immediately preceding or following the disclosure of the 
information;
    (C) Is disclosed in the context of making a comparison to 
corresponding information disclosed both on the face of the taxpayer's 
income statement and in the supplement or appendix; or
    (D) Is a disclosure of the effect on an item reported on the face of 
the taxpayer's income statement of having used the LIFO method.

For example, a restatement of cost of goods sold based on an inventory 
method other than LIFO is considered to be clearly identified as 
supplemental or explanatory information if the supplement or appendix 
containing the restatement contains a general statement that all 
information based on such inventory method is reported in the appendix 
or supplement as a supplement to or explanation of the taxpayer's 
primary presentation of income, profit, or loss as reported on the face 
of the taxpayer's income statement.
    (iv) Other reports; in general. The rules of paragraph (e)(3) (iv), 
(v), and (vi) of this section apply to the following types of reports: 
news releases; letters to shareholders, partners, or other proprietors 
or beneficiaries; oral statements at press conferences, shareholders' 
meetings or securities analysts' meetings; sections of an annual report 
such as those labelled ``President's Letter'', ``Management's 
Analysis'', ``Statement of Changes in Financial Position'', ``Summary of 
Key Figures'', and similar sections; and reports other than a taxpayer's 
income statement or accompanying notes, appendices, or supplements. 
Information disclosed in such a report is considered a supplement to or 
explanation of the taxpayer's primary presentation of income, profit, or 
loss for the period covered by an income statement if the supplemental 
or explanatory information is clearly identified as a supplement to or 
explanation of the taxpayer's primary presentation of income, profit, or 
loss as reported on the face of the taxpayer's income statement and the 
specific item of information being explained or supplemented, such as 
the cost of goods sold, net income, or earnings per share ascertained 
using the LIFO method, is also reported in the other report.
    (v) Other reports; disclosure of non-LIFO income. For purposes of 
paragraph (e)(3)(iv) of this section, supplemental or explanatory 
information is considered to have been clearly identified as such if it 
would be considered to have been clearly identified as such under the 
rules of paragraph (e)(3)(iii) of this section, relating to information 
reported in supplements or appendices to an income statement. For 
example, if at a securities analysts' meeting the following question is 
asked, ``What would the reported earnings per share for the year have 
been if the FIFO method had been used to value inventories?'', it would 
be permissible to respond ``Reported earnings per share for the year 
were $6.00. If the company had used the FIFO method to value inventories 
this year and had computed earnings based upon the following 
assumptions, earnings per share would have been $8.20. FIFO earnings are 
based on the following assumptions:
    ``(A) The use of the same effective tax rate as used in computing 
LIFO earnings, and
    ``(B) All other conditions and assumptions remain the same, 
including--
    ``(1) The use of the LIFO method for Federal income tax purposes and
    ``(2) The investment of the tax savings resulting from such use of 
the

[[Page 536]]

LIFO method, the income from which is included in both LIFO and FIFO 
``earnings.'' ''
    (vi) Other reports; disclosure of effect on income. For purposes of 
paragraph (e)(3)(iv) of this section, if the only supplement to or 
explanation of a specific item is the effect on the item of having used 
LIFO instead of a method other than LIFO to value inventories, it is not 
necessary to also report the specific item. For example, if at a 
shareholders' meeting the question is asked, ``What was the effect on 
reported earnings per share of not having used FIFO to value 
inventories?'', it would be permissible to respond ``If earnings would 
have been computed on the basis of the following assumptions, the use of 
LIFO instead of FIFO to value inventories would have decreased reported 
earnings per share by $2.20. FIFO earnings are based on the following 
assumptions:
    ``(A) The use of the same effective tax rate as used in computing 
LIFO earnings, and
    ``(B) All other conditions and assumptions remain the same, 
including--
    ``(1) The use of the LIFO method for Federal income tax purposes and
    ``(2) The investment of the tax savings resulting from such use of 
the LIFO method, the income from which is included in both LIFO and FIFO 
earnings.''
    (4) Inventory asset value disclosures. Under paragraph (e)(1)(ii) of 
this section, the use of an inventory method other than LIFO to 
ascertain the value of the taxpayer's inventories for purposes of 
reporting the value of the inventories as assets is not considered the 
ascertainment of income, profit, or loss and therefore is not considered 
at variance with the requirement of paragraph (e)(1) of this section. 
Therefore, a taxpayer may disclose the value of inventories on a balance 
sheet using a method other than LIFO to identify the inventories, and 
such a disclosure will not be considered at variance with the 
requirement of paragraph (e)(1) of this section. However, the disclosure 
of income, profit, or loss for a taxable year on a balance sheet issued 
to creditors, shareholders, partners, other proprietors, or 
beneficiaries is considered at variance with the requirement of 
paragraph (e)(1) of this section if such income information is 
ascertained using an inventory method other than LIFO and such income 
information is for a taxable year for which the LIFO method is used for 
Federal income tax purposes. Therefore, a balance sheet that discloses 
the net worth of a taxpayer, determined as if income had been 
ascertained using an inventory method other than LIFO, may be at 
variance with the requirement of paragraph (e)(1) of this section if the 
disclosure of net worth is made in a manner that also discloses income, 
profit, or loss for a taxable year.

However, a disclosure of income, profit, or loss using an inventory 
method other than LIFO is not considered at variance with the 
requirement of paragraph (e)(1) of this section if the disclosure is 
made in the form of either a footnote to the balance sheet or a 
parenthetical disclosure on the face of the balance sheet. In addition, 
an income disclosure is not considered at variance with the requirement 
of paragraph (e)(1) of this section if the disclosure is made on the 
face of a supplemental balance sheet labelled as a supplement to the 
taxpayer's primary presentation of financial position, but only if, 
consistent with the rules of paragraph (e)(3) of this section, such a 
disclosure is clearly identified as a supplement to or explanation of 
the taxpayer's primary presentation of financial income as reported on 
the face of the taxpayer's income statement.
    (5) Internal management reports. [Reserved]
    (6) Series of interim reports. For purposes of paragraph (e)(1)(iv) 
of this section, a series of credit statements or financial reports is 
considered a single statement or report covering a period of operations 
if the statements or reports in the series are prepared using a single 
inventory method and can be combined to disclose the income, profit, or 
loss for the period. However, the Commissioner will waive any violation 
of the requirement of this paragraph in the case of a series of interim 
reports issued before February 6, 1978, that cover a taxable year, or a 
series of interim reports issued before January 22,

[[Page 537]]

1981 that cover a one-year period other than a taxable year.
    (7) Market value. The Commissioner will waive any violation of the 
requirement of this paragraph in the case of a taxpayer's use of market 
value in lieu of cost for a credit statement or financial report issued 
before January 22, 1981. However, the special rule of this (7) applies 
only to a taxpayer's use of market value in lieu of cost and does not 
apply to the use of a method of valuation such as market value in lieu 
of cost but not more than FIFO cost.
    (8) Use of different methods. The following are examples of costing 
methods and accounting methods that are neither inconsistent with the 
inventory method referred to in Sec. 1.472-1 nor at variance with the 
requirement of Sec. 1.472-2(c) and which, under paragraph (e)(1)(vi) of 
this section, may be used to ascertain income, profit, or loss for 
credit purposes or for purposes of financial reports regardless of 
whether such method is also used by the taxpayer for Federal income tax 
purposes:
    (i) Any method relating to the determination of which costs are 
includible in the computation of the cost of inventory under the full 
absorption inventory method.
    (ii) Any method of establishing pools for inventory under the 
dollar-value LIFO inventory method.
    (iii) Any method of determining the LIFO value of a dollar-value 
inventory pool, such as the double-extension method, the index method, 
and the link chain method.
    (iv) Any method of determining or selecting a price index to be used 
with the index or link chain method of valuing inventory pools under the 
dollar-value LIFO inventory method.
    (v) Any method permitted under Sec. 1.472-8 for determining the 
current-year cost of closing inventory for purposes of using the dollar-
value LIFO inventory method.
    (vi) Any method permitted under Sec. 1.472-2(d) for determining the 
cost of goods in excess of goods on hand at the beginning of the year 
for purposes of using a LIFO method other than the dollar-value LIFO 
method.
    (vii) Any method relating to the classification of an item as 
inventory or a capital asset.
    (viii) The use of an accounting period other than the period used 
for Federal income tax purposes.
    (ix) The use of cost estimates.
    (x) The use of actual cost of cut timber or the cost determined 
under section 631(a).
    (xi) The use of inventory costs unreduced by any adjustment required 
by the application of section 108 and section 1017, relating to 
discharge of indebtedness.
    (xii) The determination of the time when sales or purchases are 
accrued.
    (xiii) The use of a method to allocate basis in the case of a 
business combination other than the method used for Federal income tax 
purposes.
    (xiv) The treatment of transfers of inventory between affiliated 
corporations in a manner different from that required by Sec. 1.1502-
13.
    (9) Reconciliation of LIFO inventory values. A taxpayer may be 
required to reconcile differences between the value of inventories 
maintained for credit or financial reporting purposes and for Federal 
income tax purposes in order to show that the taxpayer has satisfied the 
requirements of this paragraph.
    (f) Goods of the specified type on hand as of the close of the 
taxable year preceding the taxable year for which this inventory method 
is first used shall be included in the taxpayer's closing inventory for 
such preceding taxable year at cost determined in the manner prescribed 
in paragraph (c) of this section.
    (g) The LIFO inventory method, once adopted by the taxpayer with the 
approval of the Commissioner, shall be adhered to in all subsequent 
taxable years unless--
    (1) A change to a different method is approved by the Commissioner; 
or
    (2) The Commissioner determines that the taxpayer, in ascertaining 
income, profit, or loss for the whole of any taxable year subsequent to 
his adoption of the LIFO inventory method, for credit purposes or for 
the purpose of reports to shareholders, partners, or other proprietors, 
or to beneficiaries, has used any inventory method at variance with that 
referred to in Sec. 1.472-1 and requires of the taxpayer a change to a 
different method for such

[[Page 538]]

subsequent taxable year or any taxable year thereafter.
    (h) The records and accounts employed by the taxpayer in keeping his 
books shall be maintained in conformity with the inventory method 
referred to in Sec. 1.472-1; and such supplemental and detailed 
inventory records shall be maintained as will enable the district 
director readily to verify the taxpayer's inventory computations as well 
as his compliance with the requirements of section 472 and Sec. Sec. 
1.472-1 through 1.472-7.
    (i) Where the taxpayer is engaged in more than one trade or 
business, the Commissioner may require that if the LIFO method of 
valuing inventories is used with respect to goods in one trade or 
business the same method shall also be used with respect to similar 
goods in the other trades or businesses if, in the opinion of the 
Commissioner, the use of such method with respect to such other goods is 
essential to a clear reflection of income.

[T.D. 6500, 25 FR 11728, Nov. 26, 1960, as amended by T.D. 6539, 26 FR 
518, Jan. 20, 1961; T.D. 7756, 46 FR 6920, Jan. 22, 1981; T.D 7756, 46 
FR 15685, Mar. 9, 1981]



Sec. 1.472-3  Time and manner of making election.

    (a) The LIFO inventory method may be adopted and used only if the 
taxpayer files with his income tax return for the taxable year as of the 
close of which the method is first to be used a statement of his 
election to use such inventory method. The statement shall be made on 
Form 970 pursuant to the instructions printed with respect thereto and 
to the requirements of this section, or in such other manner as may be 
acceptable to the Commissioner. Such statement shall be accompanied by 
an analysis of all inventories of the taxpayer as of the beginning and 
as of the end of the taxable year for which the LIFO inventory method is 
proposed first to be used, and also as of the beginning of the prior 
taxable year. In the case of a manufacturer, this analysis shall show in 
detail the manner in which costs are computed with respect to raw 
materials, goods in process, and finished goods, segregating the 
products (whether in process or finished goods) into natural groups on 
the basis of either (1) similarity in factory processes through which 
they pass, or (2) similarity of raw materials used, or (3) similarity in 
style, shape, or use of finished products. Each group of products shall 
be clearly described.
    (b) The taxpayer shall submit for the consideration of the 
Commissioner in connection with the taxpayer's adoption or use of the 
LIFO inventory method such other detailed information with respect to 
his business or accounting system as may be at any time requested by the 
Commissioner.
    (c) As a condition to the taxpayer's use of the LIFO inventory 
method, the Commissioner may require that the method be used with 
respect to goods other than those specified in the taxpayer's statement 
of election if, in the opinion of the Commissioner, the use of such 
method with respect to such other goods is essential to a clear 
reflection of income.
    (d) Whether or not the taxpayer's application for the adoption and 
use of the LIFO inventory method should be approved, and whether or not 
such method, once adopted, may be continued, and the propriety of all 
computations incidental to the use of such method, will be determined by 
the Commissioner in connection with the examination of the taxpayer's 
income tax returns.

[T.D. 6500, 25 FR 11729, Nov. 26, 1960, as amended by T.D. 7295, 38 FR 
34203, Dec. 12, 1973]



Sec. 1.472-4  Adjustments to be made by taxpayer.

    A taxpayer may not change to the LIFO method of taking inventories 
unless, at the time he files his application for the adoption of such 
method, he agrees to such adjustments incident to the change to or from 
such method, or incident to the use of such method, in the inventories 
of prior taxable years or otherwise, as the district director upon the 
examination of the taxpayer's returns may deem necessary in order that 
the true income of the taxpayer will be clearly reflected for the years 
involved.

[T.D. 6500, 25 FR 11730, Nov. 26, 1960]

[[Page 539]]



Sec. 1.472-5  Revocation of election.

    An election made to adopt and use the LIFO inventory method is 
irrevocable, and the method once adopted shall be used in all subsequent 
taxable years, unless the use of another method is required by the 
Commissioner, or authorized by him pursuant to a written application 
therefor filed as provided in paragraph (e) of Sec. 1.446-1.

[T.D. 6500, 25 FR 11730, Nov. 26, 1960]



Sec. 1.472-6  Change from LIFO inventory method.

    If the taxpayer is granted permission by the Commissioner to 
discontinue the use of LIFO method of taking inventories, and thereafter 
to use some other method, or if the taxpayer is required by the 
Commissioner to discontinue the use of the LIFO method by reason of the 
taxpayer's failure to conform to the requirements detailed in Sec. 
1.472-2, the inventory of the specified goods for the first taxable year 
affected by the change and for each taxable year thereafter shall be 
taken--
    (a) In conformity with the method used by the taxpayer under section 
471 in inventorying goods not included in his LIFO inventory 
computations; or
    (b) If the LIFO inventory method was used by the taxpayer with 
respect to all of his goods subject to inventory, then in conformity 
with the inventory method used by the taxpayer prior to his adoption of 
the LIFO inventory method; or
    (c) If the taxpayer had not used inventories prior to his adoption 
of the LIFO inventory method and had no goods currently subject to 
inventory by a method other than the LIFO inventory method, then in 
conformity with such inventory method as may be selected by the taxpayer 
and approved by the Commissioner as resulting in a clear reflection of 
income; or
    (d) In any event, in conformity with any inventory method to which 
the taxpayer may change pursuant to application approved by the 
Commissioner.

[T.D. 6500, 25 FR 11730, Nov. 26, 1960]



Sec. 1.472-7  Inventories of acquiring corporations.

    For additional rules in the case of certain corporate acquisitions 
specified in section 381(a), see section 381(c)(5) and the regulations 
thereunder.

[T.D. 6500, 25 FR 11730, Nov. 26, 1960]



Sec. 1.472-8  Dollar-value method of pricing LIFO inventories.

    (a) Election to use dollar-value method. Any taxpayer may elect to 
determine the cost of his LIFO inventories under the so-called ``dollar-
value'' LIFO method, provided such method is used consistently and 
clearly reflects the income of the taxpayer in accordance with the rules 
of this section. The dollar-value method of valuing LIFO inventories is 
a method of determining cost by using ``base-year'' cost expressed in 
terms of total dollars rather than the quantity and price of specific 
goods as the unit of measurement. Under such method the goods contained 
in the inventory are grouped into a pool or pools as described in 
paragraphs (b) and (c) of this section. The term ``base-year cost'' is 
the aggregate of the cost (determined as of the beginning of the taxable 
year for which the LIFO method is first adopted, i.e., the base date) of 
all items in a pool. The taxable year for which the LIFO method is first 
adopted with respect to any item in the pool is the ``base year'' for 
that pool, except as provided in paragraph (g)(3) of this section. 
Liquidations and increments of items contained in the pool shall be 
reflected only in terms of a net liquidation or increment for the pool 
as a whole. Fluctuations may occur in quantities of various items within 
the pool, new items which properly fall within the pool may be added, 
and old items may disappear from the pool, all without necessarily 
effecting a change in the dollar value of the pool as a whole. An 
increment in the LIFO inventory occurs when the end of the year 
inventory for any pool expressed in terms of base-year cost is in excess 
of the beginning of the year inventory for that pool expressed in terms 
of base-year cost. In determining the inventory value for a pool, the 
increment, if any, is adjusted for changing

[[Page 540]]

unit costs or values by reference to a percentage, relative to base-
year-cost, determined for the pool as a whole. See paragraph (e) of this 
section. See also paragraph (f) of this section for rules relating to 
the change to the dollar-value LIFO method from another LIFO method.
    (b) Principles for establishing pools of manufacturers and 
processors--(1) Natural business unit pools. A pool shall consist of all 
items entering into the entire inventory investment for a natural 
business unit of a business enterprise, unless the taxpayer elects to 
use the multiple pooling method provided in subparagraph (3) of this 
paragraph. Thus, if a business enterprise is composed of only one 
natural business unit, one pool shall be used for all of its 
inventories, including raw materials, goods in process, and finished 
goods. If, however, a business enterprise is actually composed of more 
than one natural business unit, more than one pool is required. Where 
similar types of goods are inventoried in two or more natural business 
units of the taxpayer, the Commissioner may apportion or allocate such 
goods among the various natural business units, if he determines that 
such apportionment or allocation is necessary in order to clearly 
reflect the income of such taxpayer. Where a manufacturer or processor 
is also engaged in the wholesaling or retailing of goods purchased from 
others, any pooling of the LIFO inventory of such purchased goods for 
the wholesaling or retailing operations shall be determined in 
accordance with the rules of paragraph (c) of this section.
    (2) Definition of natural business unit. (i) Whether an enterprise 
is composed of more than one natural business unit is a matter of fact 
to be determined from all the circumstances. The natural business 
divisions adopted by the taxpayer for internal management purposes, the 
existence of separate and distinct production facilities and processes, 
and the maintenance of separate profit and loss records with respect to 
separate operations are important considerations in determining what is 
a business unit, unless such divisions, facilities, or accounting 
records are set up merely because of differences in geographical 
location. In the case of a manufacturer or processor, a natural business 
unit ordinarily consists of the entire productive activity of the 
enterprise within one product line or within two or more related product 
lines including (to the extent engaged in by the enterprise) the 
obtaining of materials, the processing of materials, and the selling of 
manufactured or processed goods. Thus, in the case of a manufacturer or 
processor, the maintenance and operation of a raw material warehouse 
does not generally constitute, of itself, a natural business unit. If 
the taxpayer maintains and operates a supplier unit the production of 
which is both sold to others and transferred to a different unit of the 
taxpayer to be used as a component part of another product, the supplier 
unit will ordinarily constitute a separate and distinct natural business 
unit. Ordinarily, a processing plant would not in itself be considered a 
natural business unit if the production of the plant, although saleable 
at this stage, is not sold to others, but is transferred to another 
plant of the enterprise, not operated as a separate division, for 
further processing or incorporation into another product. On the other 
hand, if the production of a manufacturing or processing plant is 
transferred to a separate and distinct division of the taxpayer, which 
constitutes a natural business unit, the supplier unit itself will 
ordinarily be considered a natural business unit. However, the mere fact 
that a portion of the production of a manufacturing or processing plant 
may be sold to others at a certain stage of processing with the 
remainder of the production being further processed or incorporated into 
another product will not of itself be determinative that the activities 
devoted to the production of the portion sold constitute a separate 
business unit. Where a manufacturer or processor is also engaged in the 
wholesaling or retailing of goods purchased from others, the wholesaling 
or retailing operations with respect to such purchased goods shall not 
be considered a part of any manufacturing or processing unit.
    (ii) The rules of this subparagraph may be illustrated by the 
following examples:


[[Page 541]]


    Example (1). A corporation manufactures, in one division, automatic 
clothes washers and driers of both commercial and domestic grade as well 
as electric ranges, mangles, and dishwashers. The corporation 
manufactures, in another division, radios and television sets. The 
manufacturing facilities and processes used in manufacturing the radios 
and television sets are distinct from those used in manufacturing the 
automatic clothes washers, etc. Under these circumstances, the 
enterprise would consist of two business units and two pools would be 
appropriate, one consisting of all of the LIFO inventories entering into 
the manufacture of clothes washers and driers, electric ranges, mangles, 
and dishwashers and the other consisting of all of the LIFO inventories 
entering into the production of radio and television sets.
    Example (2). A taxpayer produces plastics in one of its plants. 
Substantial amounts of the production are sold as plastics. The 
remainder of the production is shipped to a second plant of the taxpayer 
for the production of plastic toys which are sold to customers. The 
taxpayer operates his plastics plant and toy plant as separate 
divisions. Because of the different product lines and the separate 
divisions the taxpayer has two natural business units.
    Example (3). A taxpayer is engaged in the manufacture of paper. At 
one stage of processing, uncoated paper is produced. Substantial amounts 
of uncoated paper are sold at this stage of processing. The remainder of 
the uncoated paper is transferred to the taxpayer's finishing mill where 
coated paper is produced and sold. This taxpayer has only one natural 
business unit since coated and uncoated paper are within the same 
product line.

    (3) Multiple pools--(i) Principles for establishing multiple pools. 
(a) A taxpayer may elect to establish multiple pools for inventory items 
which are not within a natural business unit as to which the taxpayer 
has adopted the natural business unit method of pooling as provided in 
subparagraph (1) of this paragraph. Each such pool shall ordinarily 
consist of a group of inventory items which are substantially similar. 
In determining whether such similarity exists, consideration shall be 
given to all the facts and circumstances. The formulation of detailed 
rules for selection of pools applicable to all taxpayers is not 
feasible. Important considerations to be taken into account include, for 
example, whether there is substantial similarity in the types of raw 
materials used or in the processing operations applied; whether the raw 
materials used are readily interchangeable; whether there is similarity 
in the use of the products; whether the groupings are consistently 
followed for purposes of internal accounting and management; and whether 
the groupings follow customary business practice in the taxpayer's 
industry. The selection of pools in each case must also take into 
consideration such factors as the nature of the inventory items subject 
to the dollar-value LIFO method and the significance of such items to 
the taxpayer's business operations. Where similar types of goods are 
inventoried in natural business units and multiple pools of the 
taxpayer, the Commissioner may apportion or allocate such goods among 
the natural business units and the multiple pools, if he determines that 
such apportionment or allocation is necessary in order to clearly 
reflect the income of the taxpayer.
    (b) Raw materials which are substantially similar shall be pooled 
together in accordance with the principles of this subparagraph. 
However, inventories of raw or unprocessed materials of an unlike nature 
may not be placed into one pool, even though such materials become part 
of otherwise identical finished products.
    (c) Finished goods and goods-in-process in the inventory shall be 
placed into pools classified by major classes or types of goods. The 
same class or type of finished goods and goods-in-process shall 
ordinarily be included in the same pool. Where the material content of a 
class of finished goods and goods-in-process included in a pool has been 
changed, for example, to conform with current trends in an industry, a 
separate pool of finished goods and goods-in-process will not ordinarily 
be required unless the change in material content results in a 
substantial change in the finished goods.
    (d) The requirement that pools be established by major types of 
materials or major classes of goods is not to be construed so as to 
preclude the establishment of a miscellaneous pool. Since a taxpayer may 
elect the dollar-value LIFO method with respect to all or any designated 
goods in his inventory, there may be a number of such inventory items 
covered in the election. A

[[Page 542]]

miscellaneous pool shall consist only of items which are relatively 
insignificant in dollar value by comparison with other inventory items 
in the particular trade or business and which are not properly 
includible as part of another pool.
    (ii) Raw materials content pools. The dollar-value method of pricing 
LIFO inventories may be used in conjunction with the raw materials 
content method authorized in Sec. 1.472-1. Raw materials (including the 
raw material content of finished goods and goods-in-process) which are 
substantially similar shall be pooled together in accordance with the 
principles of subdivision (i) of this subparagraph. However, inventories 
of materials of an unlike nature may not be placed into one pool, even 
though such materials become part of otherwise identical finished 
products.
    (4) IPIC method pools. A manufacturer or processor that elects to 
use the inventory price index computation method described in paragraph 
(e)(3) of this section (IPIC method) for a trade or business may elect 
to establish dollar-value pools for those items accounted for using the 
IPIC method based on the 2-digit commodity codes (i.e., major commodity 
groups) in Table 6 (Producer price indexes and percent changes for 
commodity groupings and individual items, not seasonally adjusted) of 
the ``PPI Detailed Report'' published monthly by the United States 
Bureau of Labor Statistics (available from New Orders, Superintendent of 
Documents, PO Box 371954, Pittsburgh, PA 15250-7954). A taxpayer 
electing to establish dollar-value pools under this paragraph (b)(4) may 
combine IPIC pools that comprise less than 5 percent of the total 
current-year cost of all dollar-value pools to form a single 
miscellaneous IPIC pool. A taxpayer electing to establish dollar-value 
pools under this paragraph (b)(4) may combine a miscellaneous IPIC pool 
that comprises less than 5 percent of the total current-year cost of all 
dollar-value pools with the largest IPIC pool. Each of these 5 percent 
rules is a method of accounting. A taxpayer may not change to, or cease 
using, either 5 percent rule without obtaining the Commissioner's prior 
consent. Whether a specific IPIC pool or the miscellaneous IPIC pool 
satisfies the applicable 5 percent rule must be determined in the year 
of adoption or year of change (whichever is applicable) and redetermined 
every third taxable year. Any change in pooling required or permitted as 
a result of a 5 percent rule is a change in method of accounting. A 
taxpayer must secure the consent of the Commissioner pursuant to Sec. 
1.446-1(e) before combining or separating pools and must combine or 
separate its IPIC pools in accordance with paragraph (g)(2) of this 
section.
    (c) Principles for establishing pools for wholesalers, retailers, 
etc--(1) In general. Items of inventory in the hands of wholesalers, 
retailers, jobbers, and distributors shall be placed into pools by major 
lines, types, or classes of goods. In determining such groupings, 
customary business classifications of the particular trade in which the 
taxpayer is engaged is an important consideration. An example of such 
customary business classification is the department in the department 
store. In such case, practices are relatively uniform throughout the 
trade, and departmental grouping is peculiarly adapted to the customs 
and needs of the business. However, in appropriate cases, the principles 
set forth in paragraphs (b) (1) and (2) of this section, relating to 
pooling by natural business units, may be used, with permission of the 
Commissioner, by wholesalers, retailers, jobbers, or distributors. Where 
a wholesaler or retailer is also engaged in the manufacturing or 
processing of goods, the pooling of the LIFO inventory for the 
manufacturing or processing operations shall be determined in accordance 
with the rules of paragraph (b) of this section.
    (2) IPIC method pools. A retailer that elects to use the inventory 
price index computation method described in paragraph (e)(3) of this 
section (IPIC method) for a trade or business may elect to establish 
dollar-value pools for those items accounted for using the IPIC method 
based on either the general expenditure categories (i.e., major groups) 
in Table 3 (Consumer Price Index for all Urban Consumers (CPI-U): U.S. 
city average, detailed expenditure categories) of the ``CPI Detailed 
Report'' or the 2-digit commodity codes

[[Page 543]]

(i.e., major commodity groups) in Table 6 (Producer price indexes and 
percent changes for commodity groupings and individual items, not 
seasonally adjusted) of the ``PPI Detailed Report.'' A wholesaler, 
jobber, or distributor that elects to use the IPIC method for a trade or 
business may elect to establish dollar-value pools for any group of 
goods accounted for using the IPIC method and included within one of the 
2-digit commodity codes (i.e., major commodity groups) in Table 6 
(Producer price indexes and percent changes for commodity groupings and 
individual items, not seasonally adjusted) of the ``PPI Detailed 
Report.'' The ``CPI Detailed Report'' and the ``PPI Detailed Report'' 
are published monthly by the United States Bureau of Labor Statistics 
(BLS) (available from New Orders, Superintendent of Documents, P.O. Box 
371954, Pittsburgh, PA 15250-7954). A taxpayer electing to establish 
dollar-value pools under this paragraph (c)(2) may combine IPIC pools 
that comprise less than 5 percent of the total current-year cost of all 
dollar-value pools to form a single miscellaneous IPIC pool. A taxpayer 
electing to establish pools under this paragraph (c)(2) may combine a 
miscellaneous IPIC pool that comprises less than 5 percent of the total 
current-year cost of all dollar-value pools with the largest IPIC pool. 
Each of these 5 percent rules is a method of accounting. Thus, a 
taxpayer may not change to, or cease using, either 5 percent rule 
without obtaining the Commissioner's prior consent. Whether a specific 
IPIC pool or the miscellaneous IPIC pool satisfies the applicable 5 
percent rule must be determined in the year of adoption or year of 
change (whichever is applicable) and redetermined every third taxable 
year. Any change in pooling required or permitted under a 5 percent rule 
is a change in method of accounting. A taxpayer must secure the consent 
of the Commissioner pursuant to section 1.446-1(e) before combining or 
separating pools and must combine or separate its IPIC pools in 
accordance with paragraph (g)(2) of this section.
    (d) Determination of appropriateness of pools. Whether the number 
and the composition of the pools used by the taxpayer is appropriate, as 
well as the propriety of all computations incidental to the use of such 
pools, will be determined in connection with the examination of the 
taxpayer's income tax returns. Adequate records must be maintained to 
support the base-year unit cost as well as the current-year unit cost 
for all items priced on the dollar-value LIFO inventory method, 
regardless of the method authorized by paragraph (e) of this section 
which is used in computing the LIFO value of the dollar-value pool. The 
pool or pools selected must be used for the year of adoption and for all 
subsequent taxable years unless a change is required by the Commissioner 
in order to clearly reflect income, or unless permission to change is 
granted by the Commissioner as provided in paragraph (e) of Sec. 1.446-
1. However, see paragraph (h) of this section for authorization to 
change the method of pooling in certain specified cases.
    (e) Methods of computation of the LIFO value of a dollar-value 
pool--(1) Methods authorized. A taxpayer may ordinarily use only the so-
called ``double-extension'' method for computing the base-year and 
current-year cost of a dollar-value inventory pool. Where the use of the 
double-extension method is impractical, because of technological 
changes, the extensive variety of items, or extreme fluctuations in the 
variety of the items, in a dollar-value pool, the taxpayer may use an 
index method for computing all or part of the LIFO value of the pool. An 
index may be computed by double-extending a representative portion of 
the inventory in a pool or by the use of other sound and consistent 
statistical methods. The index used must be appropriate to the inventory 
pool to which it is to be applied. The appropriateness of the method of 
computing the index and the accuracy, reliability, and suitability of 
the use of such index must be demonstrated to the satisfaction of the 
district director in connection with the examination of the taxpayer's 
income tax returns. The use of any so-called ``link-chain'' method will 
be approved for taxable years beginning after December 31, 1960, only in 
those cases where the taxpayer can demonstrate to the satisfaction of 
the district director

[[Page 544]]

that the use of either an index method or the double-extension method 
would be impractical or unsuitable in view of the nature of the pool. A 
taxpayer using either an index or link-chain method shall attach to his 
income tax return for the first taxable year beginning after December 
31, 1960, for which the index or link-chain method is used, a statement 
describing the particular link-chain method or the method used in 
computing the index. The statement shall be in sufficient detail to 
facilitate the determination as to whether the method used meets the 
standards set forth in this subparagraph. In addition, a copy of the 
statement shall be filed with the Commissioner of Internal Revenue, 
Attention: T:R, Washington, D.C. 20224. The taxpayer shall submit such 
other information as may be requested with respect to such index or 
link-chain method. Adequate records must be maintained by the taxpayer 
to support the appropriateness, accuracy, and reliability of an index or 
link-chain method. A taxpayer may request the Commissioner to approve 
the appropriateness of an index or link-chain method for the first 
taxable year beginning after December 31, 1960, for which it is used. 
Such request must be submitted within 90 days after the beginning of the 
first taxable year beginning after December 31, 1960, in which the 
taxpayer desires to use the index or link-chain method, or on or before 
May 1, 1961, whichever is later. A taxpayer entitled to use the retail 
method of pricing LIFO inventories authorized by paragraph (k) of Sec. 
1.472-1 may use retail price indexes prepared by the United States 
Bureau of Labor Statistics. Any method of computing the LIFO value of a 
dollar-value pool must be used for the year of adoption and all 
subsequent taxable years, unless the taxpayer obtains the consent of the 
Commissioner in accordance with paragraph (e) of Sec. 1.446-1 to use a 
different method.
    (2) Double-extension method. (i) Under the double-extension method 
the quantity of each item in the inventory pool at the close of the 
taxable year is extended at both base-year unit cost and current-year 
unit cost. The respective extensions at the two costs are then each 
totaled. The first total gives the amount of the current inventory in 
terms of base-year cost and the second total gives the amount of such 
inventory in terms of current-year cost.
    (ii) The total current-year cost of items making up a pool may be 
determined--
    (a) By reference to the actual cost of the goods most recently 
purchased or produced;
    (b) By reference to the actual cost of the goods purchased or 
produced during the taxable year in the order of acquisition;
    (c) By application of an average unit cost equal to the aggregate 
cost of all of the goods purchased or produced throughout the taxable 
year divided by the total number of units so purchased or produced; or
    (d) Pursuant to any other proper method which, in the opinion of the 
Commissioner, clearly reflects income.
    (iii) Under the double-extension method a base-year unit cost must 
be ascertained for each item entering a pool for the first time 
subsequent to the beginning of the base year. In such a case, the base-
year unit cost of the entering item shall be the current-year cost of 
that item unless the taxpayer is able to reconstruct or otherwise 
establish a different cost. If the entering item is a product or raw 
material not in existence on the base date, its cost may be 
reconstructed, that is, the taxpayer using reasonable means may 
determine what the cost of the item would have been had it been in 
existence in the base year. If the item was in existence on the base 
date but not stocked by the taxpayer, he may establish, by using 
available data or records, what the cost of the item would have been to 
the taxpayer had he stocked the item. If the base-year unit cost of the 
entering item is either reconstructed or otherwise established to the 
satisfaction of the Commissioner, such cost may be used as the base-year 
unit cost in applying the double-extension method. If the taxpayer does 
not reconstruct or establish to the satisfaction of the Commissioner a 
base-year unit cost, but does reconstruct or establish to the 
satisfaction of the Commissioner the cost of the item at some year 
subsequent to the base year, he may use the earliest cost which he does

[[Page 545]]

reconstruct or establish as the base-year unit cost.
    (iv) To determine whether there is an increment or liquidation in a 
pool for a particular taxable year, the end of the year inventory of the 
pool expressed in terms of base-year cost is compared with the beginning 
of the year inventory of the pool expressed in terms of base-year cost. 
When the end of the year inventory of the pool is in excess of the 
beginning of the year inventory of the pool an increment occurs in the 
pool for that year. If there is an increment for the taxable year, the 
ratio of the total current-year cost of the pool to the total base-year 
cost of the pool must be computed. This ratio when multiplied by the 
amount of the increment measured in terms of base-year cost gives the 
LIFO value of such increment. The LIFO value of each such increment is 
hereinafter referred to in this section as the ``layer of increment'' 
and must be separately accounted for and a record thereof maintained as 
a separate layer of the pool, and may not be combined with a layer of 
increment occurring in a different year. On the other hand, when the end 
of the year inventory of the pool is less than the beginning of the year 
inventory of the pool, a liquidation occurs in the pool for that year. 
Such liquidation is to be reflected by reducing the most recent layer of 
increment by the excess of the beginning of the year inventory over the 
end of the year inventory of the pool. However, if the amount of the 
liquidation exceeds the amount of the most recent layer of increment, 
the preceding layers of increment in reverse chronological order are to 
be successively reduced by the amount of such excess until all the 
excess is absorbed. The base-year inventory is to be reduced by 
liquidation only to the extent that the aggregate of all liquidation 
exceeds the aggregate of all layers of increment.
    (v) The following examples illustrate inventories under the double-
extension the computation of the LIFO value of method.

    Example (1). (a) A taxpayer elects, beginning with the calendar year 
1961, to compute his inventories by use of the LIFO inventory method 
under section 472 and further elects to use the dollar-value method in 
pricing such inventories as provided in paragraph (a) of this section. 
He creates Pool No. 1 for items A, B, and C. The composition of the 
inventory for Pool No. 1 at the base date, January 1, 1961, is as 
follows:

------------------------------------------------------------------------
                                                          Unit    Total
                     Items                        Units   cost     cost
------------------------------------------------------------------------
A..............................................   1,000      $5   $5,000
B..............................................   2,000       4    8,000
C..............................................     500       2    1,000
                                                                --------
  Total base-year cost at Jan. 1, 1961.........  ......  ......   14,000
------------------------------------------------------------------------

    (b) The closing inventory of Pool No. 1 at December 31, 1961, 
contains 3,000 units of A, 1,000 units of B, and 500 units of C. The 
taxpayer computes the current-year cost of the items making up the pool 
by reference to the actual cost of goods most recently purchased. The 
most recent purchases of items A, B, and C are as follows:

------------------------------------------------------------------------
                                                       Quantity    Unit
              Item                   Purchase date    purchased    cost
------------------------------------------------------------------------
A...............................  Dec. 15, 1961.....      3,500    $6.00
B...............................  Dec. 10, 1961.....      2,000     5.00
C...............................  Nov. 1, 1961......        500     2.50
------------------------------------------------------------------------

    (c) The inventory of Pool No. 1 at December 31, 1961, shown at base-
year and current-year cost is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                               Dec. 31, 1961,    Dec. 31, 1961,
                                                                                inventory at      inventory at
                                                                                Jan. 1, 1961,     current-year
                               Item                                 Quantity   base-year cost         cost
                                                                             -----------------------------------
                                                                               Unit              Unit
                                                                               cost    Amount    cost    Amount
----------------------------------------------------------------------------------------------------------------
A.................................................................    3,000    $5.00   $15,000   $6.00   $18,000
B.................................................................    1,000     4.00     4,000    5.00     5,000
C.................................................................      500     2.00     1,000    2.50     1,250
                                                                                     ----------        ---------
  Total...........................................................  ........  ......    20,000  ......    24,250
----------------------------------------------------------------------------------------------------------------

    (d) If the amount of the December 31, 1961, inventory at base-year 
cost were equal to, or less than, the base-year cost of $14,000 at 
January 1, 1961, such amount would be the closing LIFO inventory at 
December 31, 1961. However, since the base-year cost of the closing LIFO 
inventory at December 31, 1961, amounts to $20,000, and is in excess of 
the $14,000 base-year cost of the opening inventory for that year, there 
is a $6,000 increment in Pool No. 1 during the year. This increment must 
be valued at current-year cost, i.e., the ratio of 24,250/20,000, or 
121.25 percent. The LIFO value of the inventory at December 31, 1961, is 
$21,275, computed as follows:

[[Page 546]]



                               Pool No. 1
------------------------------------------------------------------------
                                                     Ratio of
                                          Dec. 31,    total
                                           1961,     current-   Dec. 31,
                                         inventory  year cost    1961,
                                          at Jan.    to total  inventory
                                          1, 1961,  base-year   at LIFO
                                         base-year     cost      value
                                            cost    (percent)
------------------------------------------------------------------------
Jan. 1, 1961, base cost................     14,000     100.00    $14,000
Dec. 31, 1961, increment...............      6,000     121.25      7,275
                                        -----------           ----------
    Total..............................     20,000  .........     21,275
------------------------------------------------------------------------

    Example (2). (a) Assume the taxpayer in example (1) during the year 
1962 completely disposes of item C and purchases item D. Assume further 
that item D is properly includible in Pool No. 1 under the provisions of 
this section. The closing inventory on December 31, 1962, consists of 
quantities at current-year unit cost, as follows:

------------------------------------------------------------------------
                                                               Current-
                                                               year unit
                       Items                          Units    cost Dec.
                                                               31, 1962
------------------------------------------------------------------------
A..................................................    2,000       $6.50
B..................................................    1,500        6.00
D..................................................    1,000        5.00
------------------------------------------------------------------------

    (b) The taxpayer establishes that the cost of item D, had he 
acquired it on January 1, 1961, would have been $2.00 per unit. Such 
cost shall be used as the base-year unit cost for item D, and the LIFO 
computations at December 31, 1962, are made as follows:

----------------------------------------------------------------------------------------------------------------
                                                                               Dec. 31, 1962,    Dec. 31, 1962,
                                                                                inventory at      inventory at
                                                                                Jan. 1, 1961,     current-year
                               Item                                 Quantity   base-year cost         cost
                                                                             -----------------------------------
                                                                               Unit              Unit
                                                                               cost    Amount    cost    Amount
----------------------------------------------------------------------------------------------------------------
A.................................................................    2,000    $5.00   $10,000   $6.50   $13,000
B.................................................................    1,500     4.00     6,000    6.00     9,000
D.................................................................    1,000     2.00     2,000    5.00     5,000
                                                                                     ----------        ---------
   Total..........................................................  ........  ......    18,000  ......    27,000
----------------------------------------------------------------------------------------------------------------

    (c) Since the closing inventory at base-year cost, $18,000, is less 
than the 1962 opening inventory at base-year cost, $20,000, a 
liquidation of $2,000 has occurred during 1962. This liquidation is to 
be reflected by reducing the most recent layer of increment. The LIFO 
value of the inventory at December 31, 1962, is $18,850, and is 
summarized as follows:

                               Pool No. 1
------------------------------------------------------------------------
                                                     Ratio of
                                          Dec. 31,    total
                                           1962,     current-   Dec. 31,
                                         inventory  year cost    1962,
                                          at Jan.    to total  inventory
                                          1, 1961,  base-year   at LIFO
                                         base-year     cost      value
                                            cost    (percent)
------------------------------------------------------------------------
Jan. 1, 1961, base cost................     14,000     100.00    $14,000
Dec. 31, 1961, increment...............      4,000     121.25      4,850
                                        -----------           ----------
   Total...............................     18,000  .........     18,850
------------------------------------------------------------------------

    (3) Inventory price index computation (IPIC) method--(i) In general. 
The inventory price index computation method provided by this paragraph 
(e)(3) (IPIC method) is an elective method of determining the LIFO value 
of a dollar-value pool using consumer or producer price indexes 
published by the United States Bureau of Labor Statistics (BLS). A 
taxpayer using the IPIC method must compute a separate inventory price 
index (IPI) for each dollar-value pool. This IPI is used to convert the 
total current-year cost of the items in a dollar-value pool to base-year 
cost in order to determine whether there is an increment or liquidation 
in terms of base-year cost and, if there is an increment, to determine 
the LIFO inventory value of the current year's layer of increment 
(layer). Using one IPI to compute the base-year cost of a dollar-value 
pool for the current taxable year and using a different IPI to compute 
the LIFO inventory value of the current taxable year's layer is not 
permitted under the IPIC method. The IPIC method will be accepted by the 
Commissioner as an appropriate method of computing an index, and the use 
of that index to compute the LIFO value of a dollar-value pool will be 
accepted as accurate, reliable, and suitable. The appropriateness of a 
taxpayer's computation of an IPI, which includes all the steps described 
in paragraph (e)(3)(iii) of this section, will be determined in 
connection with an examination of the taxpayer's federal income tax 
return. A taxpayer using the IPIC method may elect to establish dollar-
value pools according to the special rules in paragraphs (b)(4) and 
(c)(2) of this section or the general rules in paragraphs (b) and (c) of 
this section. Taxpayers eligible to use the IPIC

[[Page 547]]

method are described in paragraph (e)(3)(ii) of this section. The manner 
in which an IPI is computed is described in paragraph (e)(3)(iii) of 
this section. Rules relating to the adoption of, or change to, the IPIC 
method are in paragraph (e)(3)(iv) of this section.
    (ii) Eligibility. Any taxpayer electing to use the dollar-value LIFO 
method may elect to use the IPIC method. Except as provided in this 
paragraph (e)(3)(ii) or in other published guidance, a taxpayer that 
elects to use the IPIC method for a specific trade or business must use 
that method to account for all items of dollar-value LIFO inventory. A 
taxpayer that uses the retail price indexes computed by the BLS and 
published in ``Department Store Inventory Price Indexes'' (available 
from the BLS by calling (202) 606-6325 and entering document code 2415) 
may elect to use the IPIC method for items that do not fall within any 
of the major groups listed in ``Department Store Inventory Price 
Indexes.''
    (iii) Computation of an inventory price index--(A) In general. The 
computation of an IPI for a dollar-value pool requires the following 
four steps, which are described in more detail in this paragraph 
(e)(3)(iii): First, selection of a BLS table and an appropriate month; 
second, assignment of items in a dollar-value pool to BLS categories 
(selected BLS categories); third, computation of category inflation 
indexes for selected BLS categories; and fourth, computation of the IPI. 
A taxpayer may compute the IPI for each dollar-value pool using either 
the double-extension method (double-extension IPIC method) or the link-
chain method (link-chain IPIC method), without regard to whether the use 
of a double-extension method is impractical or unsuitable. The use of 
either the double-extension IPIC method or the link-chain IPIC method is 
a method of accounting, and the adopted method must be applied 
consistently to all dollar-value pools within a trade or business 
accounted for under the IPIC method. A taxpayer that wants to change 
from the double-extension IPIC method to the link-chain IPIC method, or 
vice versa, must secure the consent of the Commissioner under Sec. 
1.446-1(e). This change must be made with a new base year as described 
in paragraph (e)(3)(iv)(B)(1).
    (B) Selection of BLS table and appropriate month--(1) In general. 
Under the IPIC method, an IPI is computed using the consumer or producer 
price indexes for certain categories (BLS price indexes and BLS 
categories, respectively) listed in the selected BLS table of the ``CPI 
Detailed Report'' or the ``PPI Detailed Report'' for the appropriate 
month.
    (2) BLS table selection. Manufacturers, processors, wholesalers, 
jobbers, and distributors must select BLS price indexes from Table 6 
(Producer price indexes and percent changes for commodity groupings and 
individual items, not seasonally adjusted) of the ``PPI Detailed 
Report'', unless the taxpayer can demonstrate that selecting BLS price 
indexes from another table of the ``PPI Detailed Report'' is more 
appropriate. Retailers may select BLS price indexes from either Table 3 
(Consumer Price Index for all Urban Consumers (CPI-U): U.S. city 
average, detailed expenditure categories) of the ``CPI Detailed Report'' 
or from Table 6 (or another more appropriate table) of the ``PPI 
Detailed Report.'' The selection of a BLS table is a method of 
accounting and must be used for the taxable year of adoption and all 
subsequent years, unless the taxpayer obtains the Commissioner's consent 
under Sec. 1.446-1(e) to change its table selection. A taxpayer that 
changes its BLS table must establish a new base year in the year of 
change as described in paragraph (e)(3)(iv)(B) of this section.
    (3) Appropriate month. In the case of a retailer using the retail 
method, the appropriate month is the last month of the retailer's 
taxable year. In the case of all other taxpayers, the appropriate month 
is the month most consistent with the method used to determine the 
current-year cost of the dollar-value pool under paragraph (e)(2)(ii) of 
this section and the taxpayer's history of inventory production or 
purchases during the taxable year. A taxpayer not using the retail 
method may annually select an appropriate month for each dollar-value 
pool or make an election on Form 970, ``Application to Use LIFO

[[Page 548]]

Inventory Method,'' to use a representative appropriate month 
(representative month). An election to use a representative month is a 
method of accounting and the month elected must be used for the taxable 
year of the election and all subsequent taxable years, unless the 
taxpayer obtains the Commissioner's consent under Sec. 1.446-1(e) to 
change or revoke its election.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (e)(3)(iii)(B)(3):

    Example 1. Determining an appropriate month. A wholesaler of 
seasonal goods timely files a Form 970, ``Application to Use LIFO 
Inventory Method,'' for the taxable year ending December 31, 2001. The 
taxpayer indicates elections to use the dollar-value LIFO method, to 
determine the current-year cost using the earliest acquisitions method 
in accordance with paragraph (e)(2)(ii)(b) of this section, and to use 
the IPIC method under paragraph (e)(3) of this section. Although the 
taxpayer purchases inventory items regularly throughout the year, the 
items purchased vary according to the seasons. The seasonal items on 
hand at December 31, 2001, are purchased between October and December. 
Thus, based on the taxpayer's use of the earliest acquisitions method of 
determining current-year cost and its experience with inventory 
purchases, the appropriate month for the items represented in the ending 
inventory at December 31, 2001, is October.
    Example 2. Electing a representative month. A retailer not using the 
retail method timely files a Form 970, ``Application to Use LIFO 
Inventory Method,'' for the taxable year ending December 31, 2001. The 
taxpayer indicates elections to use the dollar-value LIFO method, the 
most recent purchases method of determining current-year cost under 
paragraph (e)(2)(ii)(a) of this section, the IPIC method under paragraph 
(e)(3) of this section, and December as its representative month under 
paragraph (e)(3)(iii)(B)(3) of this section. The items in the taxpayer's 
ending inventory are purchased fairly uniformly throughout the year, 
with the first purchases normally occurring in January and the last 
purchases normally occurring in December. The taxpayer's election to use 
December as its representative month is permissible because the taxpayer 
elected to use the most recent purchases method and the taxpayer's last 
purchases of the taxable year normally occur during December, the last 
month of the taxpayer's taxable year.
    Example 3. Changing representative month. The facts are the same as 
in Example 2, except the taxpayer files a Form 3115, ``Application for 
Change in Accounting Method,'' requesting permission to change to the 
earliest acquisitions method of determining current-year cost in 
accordance with paragraph (e)(2)(ii)(b) of this section and to change 
its representative month from December to January beginning with the 
taxable year ending December 31, 2003. If the Commissioner consents to 
the taxpayer's request to change to the earliest acquisitions method, 
December will no longer be a permissible representative month for this 
taxpayer because of the absence of a nexus between the earliest 
acquisitions method, the month of December (the last month of the 
taxpayer's taxable year), and the taxpayer's experience with inventory 
purchases during the year. Thus, the Commissioner will permit the 
taxpayer to change its representative month to January, the first month 
of the taxpayer's taxable year.
    Example 4. Changing representative month. The facts are the same as 
in Example 2. In 2002, the taxpayer changes its annual accounting period 
to a taxable year ending June 30, which requires the taxpayer to file a 
return for the short taxable year beginning January 1, 2002, and ending 
June 30, 2002. As a result, December is no longer a permissible 
representative month because of the absence of a nexus between the most 
recent purchases method, the month of December, and the taxpayer's 
experience with inventory purchases during the year. The taxpayer should 
file a Form 3115 requesting permission to change its representative 
month from December to June beginning with the short taxable year ending 
June 30, 2002. Because the taxpayer's last purchases of the taxable year 
now will occur in June, the Commissioner will consent to the taxpayer's 
request to change its representative month to June.
    Example 5. Changing representative month. The facts are the same as 
in Example 2, except that the taxpayer elects to use January as its 
representative month. The taxpayer timely files a Form 3115 requesting 
permission to change its representative month from January to December 
beginning with the taxable year ending December 31, 2003. January is not 
a permissible representative month because of the absence of a nexus 
between the most recent purchases method, the taxpayer's history of 
inventory purchases, and the month of January, the first month in the 
taxpayer's taxable year. Because December is a permissible 
representative month, the Commissioner will permit the taxpayer to 
change its representative month to December.

    (C) Assignment of inventory items to BLS categories--(1) In general. 
Except as provided in paragraph (e)(3)(iii)(C)(2) of this section, a 
taxpayer must assign each item in a dollar-value pool to the most-
detailed BLS category of the selected BLS table that contains that

[[Page 549]]

item. For example, in Table 6 of the ``PPI Detailed Report'' for a given 
month, the commodity codes for the various BLS categories run from 2 to 
8 digits, with the least-detailed BLS categories having a 2-digit code 
and the most-detailed BLS categories usually (but not always) having an 
8-digit code. For purposes of assigning items to the most-detailed BLS 
category, manufacturers and processors must assign each raw material 
item to the most-detailed PPI category that includes that raw material 
and must assign each finished good item to the most-detailed PPI 
category that includes that finished good. In addition, manufacturers 
and processors must assign each work-in-process (WIP) item to the most-
detailed PPI category that includes the finished good into which the 
item will be manufactured or processed. For this purpose, finished good 
means a salable item that the taxpayer regularly sells. For example, a 
gasoline-engine manufacturer that also manufactures the pistons used in 
those engines and regularly sells some of the pistons (e.g., to 
retailers of replacement parts) must assign both finished pistons that 
have not been affixed to an engine block and piston WIP items to the 
most-detailed PPI category that includes pistons. Finished pistons that 
have been affixed to an engine block must be assigned to the most-
detailed PPI category that includes gasoline engines. In contrast, if 
sales of these pistons occur infrequently, the taxpayer must assign both 
finished pistons and piston WIP items to the most-detailed PPI category 
that includes gasoline engines.
    (2) 10 percent method. Instead of assigning each item in a dollar-
value pool to the most-detailed BLS categories, as described in 
paragraph (e)(3)(iii)(C)(1) of this section, a taxpayer may elect to use 
the 10 percent method described in this paragraph (e)(3)(iii)(C)(2). 
Under the 10 percent method, items are assigned to BLS categories using 
a three-step procedure. First, when the current-year cost of a specific 
item is 10 percent or more of the total current-year cost of the dollar-
value pool, the taxpayer must assign that item to the most-detailed BLS 
category that includes that item (10 percent BLS category). Any other 
item that is includible in that 10 percent BLS category (other than an 
item that qualifies for its own 10 percent BLS category under the 
preceding sentence) must be assigned to that 10 percent BLS category. 
Second, if one or more items have not been assigned to BLS categories in 
the first step, the taxpayer must investigate successively less-detailed 
BLS categories and assign the unassigned item(s) to the first BLS 
category that contains unassigned items whose current-year cost, in the 
aggregate, is 10 percent or more of the total current-year cost of the 
dollar-value pool (also, 10 percent BLS categories). This step must be 
repeated until all the items in the dollar-value pool have been included 
in an appropriate 10 percent BLS category, the current-year cost of the 
unassigned items, in the aggregate, is less than 10 percent of the total 
current-year cost of the dollar-value pool, or the taxpayer determines 
that a single BLS category is not appropriate for the aggregate of the 
unassigned items. Third, if items in a dollar-value pool have not been 
assigned to a 10 percent BLS category because the current-year cost of 
those items, in the aggregate, is less than 10 percent of the total 
current-year cost of the dollar-value pool, the taxpayer must assign 
those items to the most-detailed BLS category that includes all those 
items (also, a 10 percent category). On the other hand, if items in a 
dollar-value pool have not been assigned to a 10 percent BLS category 
because the taxpayer determines that a single BLS category is not 
appropriate for the aggregate of those items, the taxpayer must assign 
each of those items to a single miscellaneous BLS category created by 
the taxpayer (also, a 10 percent category). In no event may a taxpayer 
assign items in a dollar-value pool to a BLS category that is less 
detailed than either the major groups of consumer goods described in 
Table 3 of the monthly ``CPI Detailed Report'' or the major commodity 
groups of producer goods described in Table 6 of the monthly ``PPI 
Detailed Report.'' Principles similar to those described in paragraph 
(e)(3)(iii)(C)(1) apply for purposes of assigning raw material, work-in-
process,

[[Page 550]]

and finished good items to the most-detailed BLS category under the 10 
percent method.
    (3) Change in method of accounting. The 10 percent method of 
assigning items in a dollar-value pool to BLS categories is a method of 
accounting. In addition, a taxpayer's selection of a BLS category for a 
specific item is a method of accounting. However, the assignment of 
items to different BLS categories solely as a result of the application 
of the 10 percent method is a change in underlying facts and not a 
change in method of accounting. Likewise, the selection of a new BLS 
category for a specific item as a result of a revision to a BLS table is 
a change in underlying facts and not a change in method of accounting. A 
taxpayer that wants to change its method of selecting BLS categories 
(i.e., to or from the 10-percent method) or of selecting a BLS category 
for a specific item must secure the Commissioner's consent in accordance 
with Sec. 1.446-1(e). A taxpayer that voluntarily changes its method of 
selecting BLS categories or of selecting a BLS category for a specific 
item must establish a new base year in the year of change as described 
in paragraph (e)(3)(iv)(B) of this section.
    (D) Computation of a category inflation index--(1) In general. As 
described in more detail in this paragraph (e)(3)(iii)(D), a category 
inflation index reflects the inflation that occurs in the BLS price 
indexes for a selected BLS category (or, if applicable, 10 percent BLS 
category) during the relevant measurement period.
    (2) BLS price indexes. The BLS price indexes are the cumulative 
indexes published in the selected BLS table for the appropriate month. A 
taxpayer may elect to use either preliminary or final BLS price indexes 
for the appropriate month, provided that the selected BLS price indexes 
are used consistently. However, a taxpayer that elects to use final BLS 
price indexes for the appropriate month must use preliminary BLS price 
indexes for any taxable year for which the taxpayer files its original 
federal income tax return before the BLS publishes final BLS price 
indexes for the appropriate month. If a BLS price index for a most-
detailed or 10 percent BLS category is not otherwise available for the 
appropriate or representative month (but not because the BLS categories 
in the BLS table have been revised), the taxpayer must use the BLS price 
index for the next most-detailed BLS category that includes the specific 
item(s) in the most-detailed or 10 percent BLS category. If a BLS price 
index is not otherwise available for the appropriate or representative 
month because the BLS categories in the BLS table have been revised, the 
rules of paragraph (e)(3)(iii)(D)(4) of this section apply.
    (3) Category inflation index--(i) In general. Except as provided in 
paragraph (e)(3)(iii)(D)(4) of this section (concerning compound 
category inflation indexes) or (e)(3)(iii)(D)(5) of this section 
(concerning category inflation indexes for certain 10 percent BLS 
categories), a category inflation index for a selected BLS category (or, 
if applicable, 10 percent BLS category) is computed under the rules of 
this paragraph (e)(3)(iii)(D)(3).
    (ii) Double-extension IPIC method. In the case of a taxpayer using 
the double-extension IPIC method, the category inflation index for a BLS 
category is the quotient of the BLS price index for the appropriate or 
representative month of the current year divided by the BLS price index 
for the appropriate month of the taxable year preceding the base year 
(base month). However, if the taxpayer did not have an opening inventory 
in the year that its election to use the dollar-value LIFO method and 
double-extension IPIC method became effective, the category inflation 
index for a BLS category is the quotient of the BLS price index for the 
appropriate or representative month of the current year divided by the 
BLS price index for the month immediately preceding the month of the 
taxpayer's first inventory production or purchase.
    (iii) Link-chain IPIC method. In the case of a taxpayer using the 
link-chain IPIC method, the category inflation index for a BLS category 
is the quotient of the BLS price index for the appropriate or 
representative month of the current year divided by the BLS price index 
for the appropriate month used for the immediately preceding taxable 
year. However, if the taxpayer

[[Page 551]]

did not have an opening inventory in the year that its election to use 
the dollar-value LIFO method and link-chain IPIC method became 
effective, the category inflation index for a BLS category for the year 
of election is the quotient of the BLS price index for the appropriate 
or representative month of the current year divided by the BLS price 
index for the month immediately preceding the month of the taxpayer's 
first inventory production or purchase.
    (iv) Special rules concerning representative months. A taxpayer 
electing to use a representative month under paragraph (e)(3)(iii)(B)(3) 
of this section must use an appropriate month, rather than the 
representative month, to determine category inflation indexes in the 
circumstances described in this paragraph (e)(3)(iii)(D)(3)(iv) and in 
other similar circumstances. For example, in the case of a short taxable 
year, the category inflation index should reflect the inflation that 
occurs from the base month (in the case of the double-extension IPIC 
method), or the appropriate or representative month used for the 
preceding taxable year (in the case of the link-chain IPIC method), and 
the appropriate month for the short taxable year. Similarly, if a 
taxpayer using the link-chain IPIC method is granted consent to change 
both its method of determining the current-year cost of a dollar-value 
pool and its representative month, the category inflation index for the 
year of change should reflect the inflation that occurs between the old 
representative month used for the preceding taxable year and the new 
representative month used for the year of change.
    (4) Compound category inflation index for revised BLS categories or 
price indexes--(i) In general. Periodically, the BLS revises a BLS table 
to add one or more new BLS categories, eliminate one or more previously 
reported BLS categories, or reset the base-year BLS price index of one 
or more BLS categories. If the BLS has revised the applicable BLS table 
for a taxable year, a taxpayer must compute the category inflation index 
for each BLS category for which the taxpayer cannot compute a category 
inflation index in accordance with paragraph (e)(3)(iii)(D)(3) of this 
section (affected BLS category) using a reasonable method, provided the 
method is used consistently for all affected BLS categories within a 
particular taxable year. For example, if the BLS revised the CPI by 
adding new BLS categories as of January 2001 and eliminating some 
previously reported BLS categories as of December 2000, January 2002 
would be the first month for which it would be possible to compute a 
category inflation index for a 12-month period using the BLS price 
indexes for any affected category. The compound category inflation index 
described in paragraph (e)(3)(iii)(D)(4)(ii) of this section is a 
reasonable method of computing the category inflation index for an 
affected BLS category.
    (ii) Computation of compound category inflation index. When the 
applicable BLS table is revised as described in paragraph 
(e)(3)(iii)(D)(4)(i) of this section, a taxpayer may use the procedure 
described in this paragraph (e)(3)(iii)(D)(4)(ii) to compute a compound 
category inflation index for each affected BLS category represented in 
the taxpayer's ending inventory. For this purpose, a compound category 
inflation index is the product of the category inflation index for the 
``first portion'' multiplied by the corresponding category inflation 
index for the ``second portion.'' The category inflation index for the 
first portion must reflect the inflation that occurs between the end of 
the base month (in the case of the double-extension IPIC method), or the 
preceding year's appropriate or representative month (in the case of the 
link-chain IPIC method), and the end of the last month covered by the 
unrevised BLS table based on the old BLS category. The corresponding 
category inflation index for the second portion must reflect the 
inflation that occurs between the beginning of the first month covered 
by the revised BLS table based on the new BLS category and the end of 
the current year's appropriate or representative month. First, using the 
revised BLS table for the current-year's appropriate or representative 
month, the taxpayer assigns items in the dollar-value pool using its 
method of assigning items to BLS categories as described in paragraph 
(e)(3)(iii)(C) of this section. Second, for each affected BLS category

[[Page 552]]

represented in the ending inventory, the taxpayer computes the category 
inflation index for the second portion using this formula: [A/B], where 
A equals the BLS price index for the current year's appropriate or 
representative month and B equals the BLS price index for the last month 
covered by the unrevised BLS table (as published for the first month of 
the revised BLS table). Third, using the unrevised BLS table for the 
base month (in the case of the double extension IPIC method) or the 
preceding year's appropriate or representative month (in the case of the 
link-chain IPIC method), the taxpayer assigns each of the items in the 
dollar-value pool using its method of assigning items to BLS categories. 
Fourth, for each affected BLS category represented in the ending 
inventory, the taxpayer computes the category inflation index for the 
first portion using this formula: [C/D], where C equals the BLS price 
index for the last month covered by the unrevised BLS table (as 
published for the last month of the unrevised BLS table) and D equals 
the BLS price index for the base month (in the case of the double-
extension IPIC method) or the preceding year's appropriate or 
representative month (in the case of the link-chain IPIC method). Fifth, 
for each affected BLS category represented in the ending inventory, the 
taxpayer computes the compound category inflation index using this 
formula: [X*Y], where X equals the category inflation index for the 
second portion, and Y equals the corresponding category inflation index 
for the first portion. For the purpose of computing the compound 
category inflation index for each affected BLS category, the 
corresponding category inflation index for the first portion is the 
category inflation index for the unrevised BLS category that includes 
the specific inventory item(s) included in the revised BLS category. If 
items included in a single revised BLS category had been included in 
separate BLS categories before the revision of the BLS table, the 
corresponding category inflation index for the first portion is the 
weighted harmonic mean of the category inflation indexes for these 
unrevised BLS categories. See paragraph (e)(3)(iii)(E)(1) of this 
section for a formula of the weighted harmonic mean. When computing this 
weighted-average category inflation index, a taxpayer must use the 
current-year costs (or in the case of a retailer using the retail 
method, the retail selling prices) in ending inventory as the weights.
    (iii) New base year. A taxpayer may establish a new base year in the 
year following the taxable year for which the taxpayer computed a 
compound category inflation index under this paragraph (e)(3)(iii)(D)(4) 
for one or more affected BLS categories in a dollar-value pool. See 
paragraph (e)(3)(iv)(B) of this section for the procedures and 
computations incident to establishing a new base year.
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (e)(3)(iii)(D)(4):

    Example 1. BLS categories eliminated. (i) A retailer, whose taxable 
year ends January 31, elected to account for its inventories using the 
dollar-value LIFO method and double-extension IPIC method (based on the 
CPI), beginning with the taxable year ending January 31, 1997. The 
taxpayer does not use the retail method, but elected to use January as 
its representative month. On January 31, 1999, the taxpayer's only 
dollar-value pool contains only two items--lemons and peaches. The total 
current-year cost of these items is as follows: lemons, $40, and 
peaches, $30. (ii) The CPI was revised in October of 1998 to eliminate 
the ``Citrus fruits'' subcategory of ``Other fresh fruits.'' In 
addition, the base-year BLS price index for ``Other fresh fruits'' was 
reset to 100.00 as of October 1, 1998. In relevant part, the January 
1999 CPI permits the assignment of both lemons and peaches to ``Other 
fresh fruits.'' The January 1999 BLS price indexes for ``Citrus fruits'' 
and ``Other fresh fruits'' are 96.6 and 105.6, respectively. In relevant 
part, the September 1998 CPI permits the assignment of lemons to 
``Citrus fruits'' and peaches to ``Other fresh fruits.'' The September 
1998 BLS price indexes for ``Citrus fruits'' and ``Other fresh fruits'' 
are 194.9 and 294.9, respectively, and the January 1997 BLS price 
indexes for ``Citrus fruits'' and ``Other fresh fruits'' are 190.2 and 
290.2, respectively.
    (iii) Because the BLS eliminated the category, ``Citrus fruits,'' as 
of October 1998, it did not publish a BLS price index for that category 
in the January 1999 CPI. Thus, the taxpayer cannot compute a category 
inflation index for ``Citrus fruits'' under the normal procedures, but 
may compute a compound category inflation index for that affected BLS 
category using the procedures described in paragraph 
(e)(3)(iii)(D)(4)(ii) of this section.

[[Page 553]]

    (iv) The taxpayer computes a compound category inflation index for 
the two BLS categories that formerly included lemons and peaches. The 
taxpayer first assigns lemons and peaches to ``Other fresh fruits,'' the 
most-detailed index in the January 1999 CPI, and then computes the 
category inflation index for the second portion as follows:

----------------------------------------------------------------------------------------------------------------
                                                                       Jan. 1999 index/Sept.
              Item                          1999 category                  1998 index (as           Category
                                                                      published in Oct. 1998)   inflation index
----------------------------------------------------------------------------------------------------------------
Lemons and Peaches.............  Other fresh fruits.................              105.6/100.0             1.0560
----------------------------------------------------------------------------------------------------------------

    (v) The taxpayer assigns the lemons and peaches to the most-detailed 
BLS categories in the January 1998 CPI as follows: lemons to ``Citrus 
fruits'' and peaches to ``Other fresh fruits.'' Then, the taxpayer 
computes the category inflation index for the first portion as follows:

----------------------------------------------------------------------------------------------------------------
                                                                       Sept. 1998 index (as
             Item                          1998 category                published in Sept.    Category inflation
                                                                         1998)/Jan. 1997             index
----------------------------------------------------------------------------------------------------------------
Lemons........................  Citrus fruits......................              194.9/190.2             1.0247
Peaches.......................  Other fresh Fruits.................              294.9/290.2             1.0162
----------------------------------------------------------------------------------------------------------------

    (vi) Because lemons and peaches, which are included together in the 
revised ``Other fresh fruits'' category, had been included in separate 
BLS categories before the BLS table was revised, the taxpayer must 
compute a single corresponding category inflation index for the affected 
BLS categories for the first portion. This corresponding category 
inflation index is the weighted harmonic mean of the separate 
corresponding category inflation indexes for the first portion using the 
cost of the items in ending inventory as the weights. The taxpayer 
computes the corresponding category inflation index for ``Other fresh 
fruits'' for the first portion as follows:

----------------------------------------------------------------------------------------------------------------
                                                               (I)  Weight     (II)  Category   (III)  Quotient:
                           Item                              (cost of item)    inflation index      (I)/(II)
----------------------------------------------------------------------------------------------------------------
Lemons....................................................            $40.00            1.0247            $39.04
Peaches...................................................             30.00            1.0162             29.52
                                                           -----------------------------------------------------
    Total.................................................             70.00  ................             68.56
----------------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------------
                                                                (V)  Sum of (weight/     (VI)  Weighted harmonic
                    (IV)  Sum of weights                         category inflation        mean of other fresh
                                                                       index)               fruits: (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$70.00......................................................                   $68.56                    1.0210
----------------------------------------------------------------------------------------------------------------

    (vii) Finally, the taxpayer computes the compound category inflation 
index for Other fresh fruits as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                (III)  Compound
                                                           (I)  Category      (II)  Category        category
                          Item                            inflation index    inflation index    inflation index:
                                                          (second portion)   (first portion)        (I)*(II)
----------------------------------------------------------------------------------------------------------------
Other fresh fruits.....................................            1.0560             1.0210             1.0782
----------------------------------------------------------------------------------------------------------------

    (viii) The taxpayer may establish a new base year for the taxable 
year ending January 31, 2000.
    Example 2. BLS categories separated. (i) The facts are the same as 
in Example 1, except prior to October 1998, both lemons and peaches were 
assigned to ``Other fresh fruits'' and in the October 1998 CPI, the BLS 
created a new category, ``Citrus fruits,'' for citrus fruits, such as 
lemons. Moreover, the BLS reset the base-year BLS price index for 
``Other fresh fruits'' to 100.0 as of October 1, 1998. As a result of 
these changes, the

[[Page 554]]

taxpayer may no longer assign lemons to ``Other fresh fruits.'' (ii) 
Because ``Citrus fruits'' is new as of October 1998, the BLS did not 
publish a BLS price index for this BLS category in the January 1999 CPI. 
Thus, because the taxpayer cannot compute a category inflation index for 
``Citrus fruits'' under the normal procedures, the taxpayer may compute 
a compound category inflation index for the affected BLS category using 
the procedures described in paragraph (e)(3)(iii)(D)(4)(ii) of this 
section.
    (iii) Based on the January 1999 CPI, the taxpayer assigns lemons to 
``Citrus fruits'' and peaches to ``Other fresh fruits.'' Then, the 
taxpayer computes a compound category inflation index for each of the 
two BLS categories. The computation of the category inflation index for 
the second portion is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                       Jan. 1999 index/Sept.
              Item                          1999 category                  1998 index (as           Category
                                                                      published in Oct. 1998)   inflation index
----------------------------------------------------------------------------------------------------------------
Lemons.........................  Citrus fruits......................                 96.6/100             0.9660
Peaches........................  Other fresh fruits.................                105.6/100             1.0560
----------------------------------------------------------------------------------------------------------------

    (iv) Then, the taxpayer computes the category inflation index for 
the first portion as follows:

----------------------------------------------------------------------------------------------------------------
                                                                      Sept. 1998 index (as
             Item                          1998 category            published in Sept. 1998)/ Category inflation
                                                                            Jan. 1997                index
----------------------------------------------------------------------------------------------------------------
Lemons & Peaches..............  Other fresh fruits................              294.9/290.2              1.0162
----------------------------------------------------------------------------------------------------------------

    (v) Finally, the taxpayer computes the compound category inflation 
index for ``Citrus fruits'' and ``Other fresh fruits'':

----------------------------------------------------------------------------------------------------------------
                                                                                                 (III)  Compound
                                                              (I)  Category    (II)  Category       category
                           Item                              inflation index   inflation index  inflation index:
                                                            (second portion)   (first portion)      (I)*(II)
----------------------------------------------------------------------------------------------------------------
Citrus fruits.............................................            0.9660            1.0162            0.9816
Other fresh fruits........................................            1.0560            1.0162            1.0731
----------------------------------------------------------------------------------------------------------------

    (vi) The taxpayer may establish a new base year for the taxable year 
ending January 31, 2000.

    (5) 10 percent method. (i) Applicability. A taxpayer that elects to 
use the 10 percent method described in paragraph (e)(3)(iii)(C)(2) of 
this section must compute a category inflation index for a less-detailed 
10 percent BLS category as provided in this paragraph (e)(3)(iii)(D)(5). 
A less-detailed 10 percent category is a BLS category that--
    (A) subsumes two or more BLS categories;
    (B) Does not have a single assigned item whose current-year cost is 
10 percent or more of the current-year cost of all the items in the 
dollar-value pool;
    (C) Has at least one item in at least one of the subsumed BLS 
categories; and
    (D) Has at least one subsumed BLS category that either does not have 
any assigned items or is a separate 10 percent BLS category.
    (ii) Determination of category inflation index. If the rules of this 
paragraph (e)(3)(iii)(D)(5) apply, the category inflation index for the 
less-detailed 10 percent BLS category is equal to the weighted 
arithmetic mean of the category inflation index (or, compound category 
inflation index, if applicable) for each of the subsumed BLS categories 
that have been assigned at least one item from the taxpayer's dollar-
value pool (excluding any item that is properly assigned to a separate 
10 percent BLS category). [Weighted Arithmetic Mean = Sum of (Weight x 
Category Inflation Index)]/Sum of Weights]. The appropriate weight for

[[Page 555]]

each of the most-detailed BLS categories referenced in the preceding 
sentence is the corresponding BLS weight. Currently, in January of each 
year, the BLS publishes the BLS weights determined for December of the 
preceding year. In the case of a taxpayer using the double-extension 
IPIC method, the BLS weights for December of the taxable year preceding 
the base year are to be used for all taxable years. In the case of a 
taxpayer using the link-chain IPIC method, the BLS weights for December 
of a given calendar year are to be used for taxable years that end 
during the 12-month period that begins on July 1 of the following 
calendar year. However, if the BLS weights are not published for all of 
the most-detailed BLS categories referenced above, the taxpayer may use 
the current-year cost (or in the case of a retailer using the retail 
method, the retail selling prices) of all items assigned to a specific 
most-detailed BLS category as the appropriate weight for that category, 
but must compute a weighted harmonic mean. See paragraph 
(e)(3)(iii)(E)(1) of this section for a formula of the weighted harmonic 
mean.
    (E) Computation of Inventory Price Index (IPI)--(1) Double-extension 
IPIC method. Under the double-extension IPIC method, the IPI for a 
dollar-value pool is the weighted harmonic mean of the category 
inflation indexes (or, if applicable, compound category inflation 
indexes) determined under paragraph (e)(3)(iii)(D) of this section for 
each selected BLS category (or, if applicable 10 percent BLS category) 
represented in the taxpayer's dollar-value pool at the end of the 
taxable year. The formula for computing the weighted harmonic mean of 
the category inflation indexes is: [Sum of Weights/Sum of (Weight/
Category Inflation Index)]. The weights to be used when computing this 
weighted harmonic mean are the current-year costs (or, in the case of a 
retailer using the retail method, the retail selling prices) in each 
selected BLS category represented in the dollar-value pool at the end of 
the taxable year.
    (2) Link-chain IPIC method. Under the link-chain IPIC method, the 
IPI for a dollar-value pool is the product of the weighted harmonic mean 
of the category inflation indexes (or, if applicable, the compound 
category inflation indexes) determined under paragraph (e)(3)(iii)(D) of 
this section for each selected BLS category (or, if applicable, 10 
percent BLS category) represented in the taxpayer's dollar-value pool at 
the end of the taxable year multiplied by the IPI for the immediately 
preceding taxable year. The formula for computing the weighted harmonic 
mean of the category inflation indexes is: [Sum of Weights/Sum of 
(Weight/Category Inflation Index)]. The weights to be used when 
computing this weighted harmonic mean are the current-year costs (or, in 
the case of a retailer using the retail method, the retail selling 
prices) in each selected BLS category represented in the dollar-value 
pool at the end of the taxable year.
    (3) Examples. The following examples illustrate the rules of this 
paragraph (e)(3)(iii)(E):

    Example 1. Double-extension method. (i) Introduction. R is a retail 
furniture merchant that does not use the retail method. For the taxable 
year ending December 31, 2000, R used the first-in, first-out method of 
identifying inventory and valued its inventory at cost. The total cost 
of R's inventory on December 31, 2000, was $850,000. R elected to use 
the dollar-value LIFO and double-extension IPIC methods for its taxable 
year ending December 31, 2001. R does not elect to use the 10 percent 
method described in paragraph (e)(3)(iii)(C)(2) of this section. R 
determines the current-year cost of the items using the actual cost of 
the most recently purchased goods. R elected to pool its inventory based 
on the major groups in Table 6 of the monthly ``PPI Detailed Report'' in 
accordance with the special IPIC pooling rules of paragraph (b)(4) of 
this section. All items in R's inventory fall within the 2-digit 
commodity code in Table 6 of the monthly ``PPI Detailed Report'' for 
``furniture and household durables.'' Therefore, R will maintain a 
single dollar-value pool. (ii) Select a BLS table and appropriate month 
for 2001. R determines that the appropriate month for 2001 is October. R 
also determines that the appropriate month for 2000 would have been 
December if R had used the IPIC method for that year.
    (iii) Assign inventory items to BLS categories for 2001. For 2001, R 
assigns all items in the dollar-value pool to the most-detailed BLS 
categories listed in Table 6 of the October 2001 ``PPI Detailed Report'' 
that contain those items. The BLS categories and the current-year cost 
of the items assigned to them are summarized as follows:

[[Page 556]]



----------------------------------------------------------------------------------------------------------------
                                                                                                  Current-year
                 Commodity code                                     Category                          cost
----------------------------------------------------------------------------------------------------------------
12120101........................................  Living Room Table...........................       $111,924.00
12120211........................................  Dining Room Table...........................        159,578.00
12120216........................................  Dining Room Chairs..........................         98,639.00
12130101........................................  Upholstered Sofas...........................        332,488.00
12130111........................................  Upholstered Chairs..........................        218,751.00
                                                                                               -----------------
    Total.......................................  ............................................        921,380.00
----------------------------------------------------------------------------------------------------------------

    (iv) Compute category inflation indexes for 2001. Because R elected 
to use the double-extension IPIC method and did not elect the 10 percent 
method, the category inflation indexes are computed in accordance with 
paragraph (e)(3)(iii)(D)(3)(ii) of this section (BLS price indexes for 
October 2001 divided by BLS price indexes for December 2000). R computes 
the category inflation indexes for 2001 as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                 (III)  Category
                         Category                            (I)  Oct. 2001    (II)  Dec. 2000  inflation index:
                                                                  index             index           (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Table.........................................             172.4             169.2          1.018913
Dining Room Table.........................................             171.9             168.1          1.022606
Dining Room Chairs........................................             172.8             169.7          1.018268
Upholstered Sofas.........................................             142.2             140.9          1.009226
Upholstered Chairs........................................             134.1             132.5          1.012075
----------------------------------------------------------------------------------------------------------------

    (v) Compute IPI for 2001. R must compute the IPI for 2001, which is 
the weighted harmonic mean of the category inflation indexes for 2001. 
The formula for the weighted harmonic mean provided in paragraph 
(e)(3)(iii)(E)(1) of this section is [Sum of Weights/Sum of (Weight/
Category Inflation Index)]. The IPI for 2001 is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                               (II)  Category   (III)  Quotient:
                         Category                              (I)  Weight     inflation index      (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Table.........................................       $111,924.00          1.018913       $109,846.47
Dining Room Table.........................................        159,578.00          1.022606        156,050.33
Dining Room Chairs........................................         98,639.00          1.018268         96,869.39
Upholstered Sofas.........................................        332,488.00          1.009226        329,448.51
Upholstered Chairs........................................        218,751.00          1.012075        216,141.10
                                                           -----------------------------------------------------
    Total.................................................       $921,380.00  ................       $908,355.80
----------------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------------
                                                                     (V)  Sum of (weight/
                       (IV)  Sum of weights                           category inflation   (VI)  Inventory price
                                                                            index)            index: (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$921,380.00.......................................................           $908,355.80             1.01433821
----------------------------------------------------------------------------------------------------------------

    (vi) Determine the LIFO value of the dollar-value pool for 2001. For 
2001, R determines the total base-year cost of its ending inventory by 
dividing the total current-year cost of the items in the dollar-value 
pool by the IPI for 2001. The total base-year cost of R's ending 
inventory is $908,355.80 ($921,380/1.01433821). Comparing the base-year 
cost of the ending inventory to the base-year cost of the beginning 
inventory, R determines that the base-year cost of the 2001 increment is 
$58,355.80 ($908,355.80 - $850,000.00). R multiplies the base-year cost 
of the 2001 increment by the IPI for 2001 and determines that the LIFO 
value of the 2001 layer is $59,192.52 ($58,355.80 * 1.01433821). Thus, 
the LIFO value of R's total inventory at the end of 2001 is $909,192.52 
($850,000.00 (opening inventory) + $59,192.52 (2001 layer)).
    (vii) Select a BLS table and appropriate month for 2002. For 2002, R 
must compute a new IPI under the double-extension IPIC method to 
determine the LIFO value of its dollar-value pool. R determines that the 
appropriate month for 2002 is November.
    (viii) Assign inventory items to BLS categories for 2002. For 2002, 
R assigns all items in the dollar-value pool to the most-detailed BLS 
categories listed in Table 6 of the November 2002 ``PPI Detailed 
Report'' that contain those items. The BLS categories and the

[[Page 557]]

current-year cost of the items assigned to them are summarized as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                  Current-year
                 Commodity code                                     Category                          cost
----------------------------------------------------------------------------------------------------------------
12120103........................................  Living Room Desks...........................       $125,008.00
12120211........................................  Dining Room Table...........................        136,216.00
12120216........................................  Dining Room Chairs..........................        113,569.00
12130101........................................  Upholstered Sofas...........................        343,900.00
12130111........................................  Upholstered Chairs..........................        233,050.00
                                                                                               -----------------
    Total.......................................  ............................................       $951,743.00
----------------------------------------------------------------------------------------------------------------

    (ix) Compute category inflation indexes for 2002. Because R uses the 
double-extension IPIC method and did not elect the 10 percent method, 
the category inflation indexes are computed in accordance with paragraph 
(e)(3)(iii)(D)(3)(ii) of this section (BLS price indexes for November 
2002 divided by BLS price indexes for December 2000). R computes the 
category inflation indexes for 2002 as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                 (III)  Category
                         Category                            (I)  Nov. 2002    (II)  Dec. 2000   inflation index
                                                                  index             index           (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Desks.........................................             172.6             160.3          1.076731
Dining Room Table.........................................             174.8             168.1          1.039857
Dining Room Chairs........................................             177.0             169.7          1.043017
Upholstered Sofas.........................................             144.9             140.9          1.028389
Upholstered Chairs........................................             136.6             132.5          1.030943
----------------------------------------------------------------------------------------------------------------

    (x) Compute IPI for 2002. R must compute the IPI for 2002, which is 
the weighted harmonic mean [Sum of Weights/Sum of (Weight/Category 
Inflation Index)] of the category inflation indexes for 2002. The IPI 
for 2002 is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                               (II)  Category   (III)  Quotient:
                         Category                              (I)  Weight     inflation index      (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Desks.........................................       $125,008.00          1.076731       $116,099.56
Dining Room Table.........................................        136,216.00          1.039857        130,994.93
Dining Room Chairs........................................        113,569.00          1.043017        108,885.09
Upholstered Sofas.........................................        343,900.00          1.028389        334,406.53
Upholstered Chairs........................................        233,050.00          1.030943        226,055.17
                                                           -----------------------------------------------------
    Total.................................................        951,743.00  ................        916,441.28
----------------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------------
                                                                        (V)  Category      (VI)  Inventory price
                       (IV)  Sum of weights                            inflation index        index: (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$951,743.00.......................................................           $916,441.28             1.03852044
----------------------------------------------------------------------------------------------------------------

    (xi) Determine the LIFO value of the pool for 2002. For 2002, R 
determines the total base-year cost of its ending inventory by dividing 
the total current-year cost of the items in the dollar-value pool by the 
IPI for 2002. The total base-year cost of the ending inventory is 
$916,441.28 ($951,743.00/1.03852044). Comparing the base-year cost of 
the ending inventory to the base-year cost of the beginning inventory, R 
determines that the base-year cost of the 2002 increment is $8,085.48 
($916,441.28-$908,355.80). R multiplies the base-year cost of the 2002 
increment by the IPI for 2002 and determines that the LIFO value of the 
2002 layer is $8,396.94 ($8,085.48 * 1.03852044). Thus, the LIFO value 
of R's total inventory at the end of 2002 is $917,589.46 ($850,000.00 
(opening inventory) + $59,192.52 (2001 layer) + $8,396.94 (2002 layer)).
    Example 2. Link-chain method. (i) Introduction. The facts are the 
same as Example 1, except that R uses the link-chain IPIC method. The 
double-extension IPIC method and the link-chain IPIC method yield the 
same results for the first taxable year in which the dollar-value LIFO 
and IPIC methods are used. Therefore, this example illustrates only how 
R will compute the IPI for, and determine the LIFO value of, its dollar-
value pool for 2002. (ii) Select a BLS

[[Page 558]]

table and appropriate month for 2002. R determines that the appropriate 
month for 2002 is November.
    (iii) Assign inventory items to BLS categories for 2002. For 2002, R 
assigns all items in the dollar-value pool to the most-detailed BLS 
categories listed in Table 6 of the November 2002 ``PPI Detailed 
Report'' that contain those items. The BLS categories and the current-
year cost of the items assigned to them are summarized as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                  Current-year
                 Commodity code                                     Category                          cost
----------------------------------------------------------------------------------------------------------------
12120103........................................  Living Room Desks...........................       $125,008.00
12120211........................................  Dining Room Table...........................        136,216.00
12120216........................................  Dining Room Chairs..........................        113,569.00
12130101........................................  Upholstered Sofas...........................        343,900.00
12130111........................................  Upholstered Chairs..........................        233,050.00
                                                                                               -----------------
    Total.......................................  ............................................        951,743.00
----------------------------------------------------------------------------------------------------------------

    (iv) Compute category inflation indexes for 2002. Because R uses the 
link-chain IPIC method and did not elect the 10 percent method, the 
category inflation indexes are computed in accordance with paragraph 
(e)(3)(iii)(D)(3)(iii) of this section (BLS price indexes for November 
2002 divided by BLS price indexes for October 2001). R computes the 
category inflation indexes for 2002 as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                 (III)  Category
                         Category                            (I)  Nov. 2002    (II)  Oct. 2001  inflation index:
                                                                  index             index           (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Desks.........................................             172.6             162.0          1.065432
Dining Room Table.........................................             174.8             171.9          1.016870
Dining Room Chairs........................................             177.0             172.8          1.024306
Upholstered Sofas.........................................             144.9             142.2          1.018987
Upholstered Chairs........................................             136.6             134.1          1.018643
----------------------------------------------------------------------------------------------------------------

    (v) Compute IPI for 2002. As provided in paragraph (e)(3)(iii)(E)(2) 
of this section, R must compute the IPI for 2002 by multiplying the 
weighted harmonic mean of the category inflation indexes for 2002 by the 
IPI for 2001. The IPI for 2002 is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                               (II)  Category   (III)  Quotient:
                         Category                              (I)  Weight     inflation index      (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Desks.........................................       $125,008.00          1.065432       $117,330.81
Dining Room Table.........................................        136,216.00          1.016870        133,956.16
Dining Room Chairs........................................        113,569.00          1.024306        110,874.09
Upholstered Sofas.........................................        343,900.00          1.018987        337,492.04
                                                           ------------------                  -----------------
Upholstered Chairs........................................        233,050.00          1.018643        228,784.77
    Total.................................................        951,743.00  ................        928,437.87
----------------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------------
                                                      (VI)  Weighted
                              (V)  Sum of (weight/   harmonic mean of     (VII)  Inventory    (VIII)  Inventory
    (IV)  Sum of weights       category inflation   category inflation    price index for      price index for
                                     index)         indexes for 2002:           2001           2002: (VI)*(VII)
                                                         (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$951,743.00.................         $928,437.87           1.02510144           1.01433821           1.03979956
----------------------------------------------------------------------------------------------------------------

    (vi) Determine the LIFO value of the pool for 2002. R determines the 
total base-year cost of its ending inventory by dividing the total 
current-year cost of the items in the dollar-value pool by the IPI for 
2002. The total base-year cost of the ending inventory is $915,313.91 
($951,743.00 / 1.03979956). Comparing the base-year cost of the ending 
inventory to the base-year cost of the beginning inventory, R determines 
that the base-year cost of the 2002 layer is $6,958.11 ($915,313.91-
$908,355.80). R multiplies the base-year cost of the 2002 layer by the 
IPI for 2002 and determines that the LIFO value of the 2002 layer is 
$7,235.04 ($6,958.11 * 1.03979956). Thus, the LIFO value of R's total 
inventory at the end

[[Page 559]]

of 2002 is $916,427.56 ($850,000.00 (opening inventory) + $59,192.52 
(2001 layer) + $7,235.04 (2002 layer)).

    (iv) Adoption or change of method--(A) Adoption or change to IPIC 
method. The use of an inventory price index computed under the IPIC 
method is a method of accounting. A taxpayer permitted to adopt the 
dollar-value LIFO method without first securing the Commissioner's 
consent also may adopt the IPIC method without first securing the 
Commissioner's consent. The IPIC method may be adopted and used, 
however, only if the taxpayer provides the following information on a 
Form 970, ``Application to Use LIFO Inventory Method,'' or in another 
manner as may be acceptable to the Commissioner: A complete list of 
dollar-value pools (including a description of the items in each dollar-
value pool); the BLS table (i.e., CPI or PPI) selected for each dollar-
value pool; the representative month, if applicable, elected for each 
dollar-value pool; the BLS categories to which the items in each dollar-
value pool will be assigned; the method of assigning items to BLS 
categories (e.g., the 10 percent method) for each dollar-value pool; and 
the method of computing the IPI (i.e., double-extension IPIC method or 
link-chain IPIC method) for each dollar-value pool. In the case of a 
taxpayer permitted to adopt the IPIC method without requesting the 
Commissioner's consent, the Form 970 must be attached to the taxpayer's 
income tax return for the taxable year of adoption. In all other cases, 
a taxpayer may change to the IPIC method only after securing the 
Commissioner's consent as provided in Sec. 1.446-1(e). In these latter 
cases, the Form 970 containing the information described in this 
paragraph (e)(3)(iv)(A) must be attached to a Form 3115, ``Application 
for Change in Accounting Method,'' filed as required by Sec. 1.446-
1(e). A taxpayer that simultaneously changes to the dollar-value LIFO 
and IPIC methods from another LIFO method must apply the rules of 
paragraph (f)(2) of this section before applying the rules of paragraph 
(e)(3)(iv)(B)(1) of this section. To satisfy the requirements of Sec. 
1.472-2(h), taxpayers must maintain adequate books and records, 
including those concerning the use of the IPIC method and necessary 
computations. Notwithstanding the rules in paragraph (e)(1) of this 
section, a taxpayer that adopts, or changes to, the link-chain IPIC 
method is not required to demonstrate that the use of any other method 
of determining the LIFO value of a dollar-value pool is impractical.
    (B) New base year--(1) Voluntary change--(i) In general. In the case 
of a taxpayer using a non-IPIC method to determine the LIFO value of 
inventory, the layers previously determined under that method, if any, 
and the LIFO values of those layers are retained if the taxpayer 
voluntarily changes to the IPIC method. Instead of using the earliest 
taxable year for which the taxpayer adopted the LIFO method for any 
items in the dollar-value pool, the year of change is used as the new 
base year for the purpose of determining the amount of increments and 
liquidations, if any, for the year of change and subsequent taxable 
years. The base-year cost of the layers in a dollar-value pool at the 
beginning of the year of change must be restated in terms of new base-
year cost using the year of change as the new base year and, if 
applicable, the indexes for the previously determined layers must be 
recomputed accordingly. The recomputed indexes will be used to determine 
the LIFO value of subsequent liquidations. For purposes of computing an 
IPI under paragraph (e)(3)(iii)(E) of this section, the IPI for the 
immediately preceding year is 1.00. The new total base-year cost of the 
items in a dollar-value pool for the purpose of determining future 
increments and liquidations is equal to the total current-year cost of 
the items in the dollar-value pool (determined using the taxpayer's 
method of determining the total current-year cost of the items in the 
dollar-value pool under paragraph (e)(2)(ii) of this section). A 
taxpayer must allocate this new total base-year cost to each layer based 
on the ratio of the old base-year cost of the layer to the old total 
base-year cost of the dollar-value pool.
    (ii) Example. The following example illustrates the rules of this 
paragraph (e)(3)(iv)(B)(1):

    Example. (i) In 1990, X elected to use a dollar-value LIFO method 
(other than the IPIC

[[Page 560]]

method) for its single dollar-value pool. X is granted permission to 
change to the link-chain IPIC method, beginning with the taxable year 
ending December 31, 2001. X will continue using a single dollar-value 
pool. X's beginning inventory as of January 1, 2001, computed using its 
former inventory method, is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                   (III)  LIFO
                           Layer                             (I)  Base-year    (II)  Inflation    value: (I) *
                                                                  cost              index             (II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................          $135,000              1.00          $135,000
1991 layer................................................            20,000              1.43            28,600
1994 layer................................................            60,000              1.55            93,000
1995 layer................................................            13,000              1.59            20,670
1997 layer................................................             2,000              1.61             3,220
                                                           ------------------                  -----------------
    Total.................................................           230,000  ................           280,490
----------------------------------------------------------------------------------------------------------------

    (ii) Under X's method of determining the current-year cost of items 
in a dollar-value pool, the current-year cost of the beginning inventory 
is $391,000. Thus, X's new base-year cost as of January 1, 2001, is 
$391,000. X allocates this new base-year cost to each layer based on the 
ratio of old base-year cost of the layer to the total old base-year cost 
of the dollar-value pool. To recompute the inflation indexes for each of 
its layers, X divides the LIFO value of each layer by the new base-year 
cost attributable to the layer. The new base-year cost, recomputed 
inflation indexes, and LIFO value of X's layers as of January 1, 2001, 
are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                   (III)  LIFO
                           Layer                             (I)  Base-year    (II)  Inflation    value: (I) *
                                                                  cost              index             (II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................          $229,500          0.588235          $135,000
1991 layer................................................            34,000          0.841176            28,600
1994 layer................................................           102,000          0.911765            93,000
1995 layer................................................            22,100          0.935294            20,670
1997 layer................................................             3,400          0.947059             3,220
                                                           ------------------                  -----------------
    Total.................................................           391,000  ................           280,490
----------------------------------------------------------------------------------------------------------------

    (iii) In 2001, the current-year cost of X's ending inventory is 
$430,139. The weighted harmonic mean of the category inflation indexes 
applicable to X's ending inventory is 1.075347, and in accordance with 
paragraph (e)(3)(iv)(B)(1)(i) of this section, the inflation index for 
the immediately preceding taxable year is 1.00. Thus, X's IPI for 2001 
is 1.075347 (1.00 * 1.075347). The total base-year cost of X's ending 
inventory is $400,000 ($430,139/1.075347). The base-year cost, IPI, and 
LIFO value of X's layers as of December 31, 2001, are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                   (III)  LIFO
                           Layer                             (I)  Base-year    (II)  Inventory    value: (I) *
                                                                  cost           price index          (II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................          $229,500          0.588235          $135,000
1991 layer................................................            34,000          0.841176            28,600
1994 layer................................................           102,000          0.911765            93,000
1995 layer................................................            22,100          0.935294            20,670
1997 layer................................................             3,400          0.947059             3,220
2001 layer................................................             9,000          1.075347             9,678
                                                           ------------------                  -----------------
    Total.................................................           400,000  ................           290,168
----------------------------------------------------------------------------------------------------------------

    (iv) In 2002, the current-year cost of X's ending inventory is 
$418,000. The weighted harmonic mean of the category inflation indexes 
applicable to X's ending inventory is 1.02292562, and the IPI for the 
immediately preceding year is 1.075347. Thus, X's IPI for 2001 is 1.10 
(1.075347 * 1.02292562). The total base-year cost of X's ending 
inventory is $380,000 ($418,000/1.10), which results in a liquidation of 
$20,000 ($400,000-$380,000) in terms of base-year cost. This liquidation 
eliminates the 2001 layer ($9,000 base-year cost), the 1997 layer 
($3,400 base-year cost), and part of the 1995 layer ($7,600 base-year 
cost). The base-year cost, indexes, and LIFO

[[Page 561]]

value of X's layers as of December 31, 2002, are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                   (III)  LIFO
                           Layer                             (I)  Base-year    (II)  Inventory    value: (I) *
                                                                  cost           price index          (II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................          $229,500          0.588235          $135,000
1991 layer................................................            34,000          0.841176            28,600
1994 layer................................................           102,000          0.911765            93,000
1995 layer................................................            14,500          0.935294            13,562
                                                           ------------------                  -----------------
    Total.................................................           380,000  ................           270,162
----------------------------------------------------------------------------------------------------------------

    (2) Involuntary change--(i) In general. If a taxpayer uses a non-
IPIC method to compute the LIFO value of a dollar-value pool, and if the 
Commissioner determines that the taxpayer's method does not clearly 
reflect income, the Commissioner may require the taxpayer to change to 
the IPIC method. If the Commissioner requires a taxpayer to change to 
the IPIC method, and the taxpayer does not provide sufficient 
information from its books and records to compute an adjustment under 
section 481, the Commissioner may implement the change using the 
simplified transition method described in paragraph (e)(3)(iv)(B)(2)(ii) 
of this section.
    (ii) Simplified Transition Method. Under the simplified transition 
method, the Commissioner will recompute the LIFO value of each dollar-
value pool as of the beginning of the year of change using the double-
extension IPIC method or the link-chain IPIC method. The adjustment 
under section 481 is equal to the difference between the recomputed LIFO 
value and the LIFO value of the pool determined under the taxpayer's 
former method. The Commissioner will compute an IPI using the double-
extension IPIC method or link-chain IPIC method for each taxable year in 
which the LIFO method was used by the taxpayer based on the assumptions 
that the ending inventory of the pool in each taxable year was comprised 
of items that fall into the same BLS categories as the items in the 
ending inventory of the year of change and that the relative weights of 
those BLS categories in all prior years were the same as the relative 
weights of those BLS categories in the ending inventory of the year of 
change. The base-year cost of the items in a dollar-value pool at the 
end of a taxable year will be determined by dividing the IPI computed 
for the taxable year into the current-year cost of the items in that 
pool determined in accordance with paragraph (e)(2)(ii) of this section. 
If the comparison of the base-year cost of the beginning and ending 
inventory produces a current-year increment, the base-year cost of that 
increment will be multiplied by the IPI computed for that taxable year 
to determine the LIFO value of that layer.
    (iii) Example. The following example illustrates the rules of this 
paragraph (e)(3)(iv)(B)(2)(ii).

    Example. (i) Z began using a dollar-value LIFO method other than the 
IPIC method in the taxable year ending December 31, 1998, and maintains 
a single dollar-value pool. Z's beginning inventory as of January 1, 
2000, computed using its method of accounting, was as follows:

----------------------------------------------------------------------------------------------------------------
                                                             (I)  Base-year    (II)  Inflation     (III)  LIFO
                           Layer                                  cost              index       value:  (I)*(II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................          $105,000              1.00          $105,000
1998 layer................................................             3,000              1.40             4,200
                                                           ------------------                  -----------------
    Total.................................................           108,000  ................           109,200
----------------------------------------------------------------------------------------------------------------

    (ii) Upon examining Z's federal income tax return for the taxable 
year ending December 31, 2000, the examining agent determines that Z's 
dollar-value LIFO method does not clearly reflect income. The examining 
agent chooses to change Z to the double-extension IPIC method for 2000 
and implements the

[[Page 562]]

change using the simplified transition method as follows. First, the 
inventory in Z's dollar-value pool at the end of 2000 is assigned to the 
most-detailed categories in the CPI or PPI, whichever is appropriate. 
Assume that 80 percent of the current-year cost of Z's inventory as of 
December 31, 2000, is assigned to Category 1, 10 percent is assigned to 
Category 2, and 10 percent is assigned to Category 3. Assume further 
that the current-year cost of the inventory in Z's dollar-value pool at 
the end of 1998 and 1999 was $133,000 and $145,000, respectively.
    (iii) The category inflation indexes for 1998 computed under the 
double-extension IPIC method are 1.17 for Category 1, 1.26 for Category 
2, and 1.19 for Category 3. The weights to be used in computing the IPI 
for 1998 are $106,400 ($133,000 * 80 percent) for Category 1, $13,300 
($133,000 * 10 percent) for Category 2, and $13,300 ($133,000 * 10 
percent) for Category 3. The IPI for 1998 is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                               (II)  Category   (III)  Quotient:
                         Category                              (I)  Weight     inflation index      (I)/(II)
----------------------------------------------------------------------------------------------------------------
1.........................................................          $106,400              1.17            90,940
2.........................................................            13,300              1.26            10,556
3.........................................................            13,300              1.19            11,176
                                                           ------------------                  -----------------
    Total.................................................           133,000  ................           112,672
----------------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------------
                                                                     (V)  Sum of (weight/
                       (IV)  Sum of weights                           category inflation    (VI) Inventory price
                                                                            index)            index: (IV)/(V)
----------------------------------------------------------------------------------------------------------------
 $133,000.........................................................              $112,672               1.180417
----------------------------------------------------------------------------------------------------------------

    (iv) The base-year cost of the inventory in Z's pool at the end of 
1998 is $112,672 ($133,000/1.180417), and the base-year cost of the 1998 
increment is $7,672 ($112,672-$105,000). The LIFO value of the 1998 
layer is $9,056 ($7,672x1.180417).
    (v) The category inflation indexes for 1999 computed under the 
double-extension IPIC method were 1.21 for Category 1, 1.29 for Category 
2 and 1.23 for Category 3. The weights to be used in computing the IPI 
for 1999 are $116,000 ($145,000x80 percent) for Category 1, $14,500 
($145,000x10 percent) for Category 2, and $14,500 ($145,000x10 percent) 
for Category 3. The IPI for 1999 is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                               (II)  Category   (III)  Quotient:
                         Category                              (I)  Weight     inflation index      (I)/(II)
----------------------------------------------------------------------------------------------------------------
1.........................................................          $116,000              1.21           $95,868
2.........................................................            14,500              1.29            11,240
3.........................................................            14,500              1.23            11,789
                                                           ------------------                  -----------------
    Total.................................................           145,000  ................           118,897
----------------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------------
                                                                     (V)  Sum of (weight/
                       (IV)  Sum of weights                           category inflation    (VI) Inventory price
                                                                            index)            index: (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$145,000..........................................................              $118,897               1.219543
----------------------------------------------------------------------------------------------------------------

    (vi) The base-year cost of the inventory in Z's pool at the end of 
1999 is $118,897 ($145,000/1.219543), and the base-year cost of the 1999 
layer is $6,225 ($118,897-$112,672). The LIFO value of the 1999 layer is 
$7,592 ($6,225x1.219543).
    (vii) The LIFO value of Z's dollar-value pool at the end of 1999 
computed under the double-extension IPIC method is as follows:

----------------------------------------------------------------------------------------------------------------
                                                             (I)  Base-year    (II)  Inventory     (III)  LIFO
                           Layer                                  cost           price index     value: (I)*(II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................          $105,000          1.000000          $105,000
1998 layer................................................             7,672          1.180417             9,056
1999 layer................................................             6,225          1.219542             7,592
ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½
    Total.................................................           118,897  ................           121,648
----------------------------------------------------------------------------------------------------------------


[[Page 563]]

    (viii) The section 481(a) adjustment is equal to the difference 
between the LIFO value of the inventory at the beginning of 2000 
computed under Z's former method of accounting and recomputed by the 
examining agent under the double-extension IPIC method, or $12,448 
($121,648--$109,200).
    (ix) Finally, the examining agent will recompute Z's taxable income 
for 2000 and succeeding taxable years using the double-extension IPIC 
method.

    (v) Effective date--(A) In general. The rules of this paragraph 
(e)(3) and paragraphs (b)(4) and (c)(2) of this section are applicable 
for taxable years ending on or after December 31, 2001.
    (B) Change in method of accounting. Any change in a taxpayer's 
method of accounting necessary to comply with this paragraph (e)(3) or 
with paragraphs (b)(4) or (c)(2) of this section is a change in method 
of accounting to which the provisions of section 446 and the regulations 
thereunder apply. For the first or second taxable year ending on or 
after December 31, 2001, a taxpayer is granted the consent of the 
Commissioner to change its method of accounting to a method required or 
permitted by this paragraph (e)(3) and paragraphs (b)(4) and (c)(2) of 
this section. A taxpayer that wants to change its method of accounting 
under this paragraph (e)(3)(v) must follow the automatic consent 
procedures in Rev. Proc. 2002-9 (2002-3 I.R.B. xxx) (see Sec. 
601.601(d)(2) of this chapter). However, the scope limitations in 
section 4.02 of Rev. Proc. 2002-9 do not apply, and the five-year 
limitation on the readoption of the LIFO method under section 10.01(2) 
of the Appendix is waived. In addition, if the taxpayer's method of 
accounting for its LIFO inventories is an issue under consideration at 
the time the application is filed with the national office, the audit 
protection of section 7 of Rev. Proc. 2002-9 does not apply. If a 
taxpayer changing its method of accounting under this paragraph 
(e)(3)(v)(B) is under examination, before an appeals office, or before a 
federal court with respect to any income tax issue, the taxpayer must 
provide a copy of the application to the examining agent(s), appeals 
officer or counsel for the government, as appropriate, at the same time 
it files the application with the national office. Any change under this 
paragraph (e)(3)(v)(B) must be made using a cut-off method and new base 
year. See paragraph (e)(3)(iv)(B)(1) of this section for an example of 
this computation. Because a change under this paragraph (e)(3)(v)(B) is 
made using a cut-off method, a section 481(a) adjustment is not 
permitted. However, a taxpayer changing its method of accounting under 
this paragraph (e)(3)(v)(B) must comply with the requirements of section 
10.06(3) of the APPENDIX of Rev. Proc. 2002-9 (concerning bargain 
purchases).
    (f) Change to dollar-value method from another method of pricing 
LIFO inventories--(1) Consent required. Except as provided in Sec. 
1.472-3 in the case of a taxpayer electing to use a LIFO inventory 
method for the first time, or in the case of a taxpayer changing to the 
dollar-value method and continuing to use the same pools as were used 
under another LIFO method, a taxpayer using another LIFO method of 
pricing inventories may not change to the dollar-value method of pricing 
such inventories unless he first secures the consent of the Commissioner 
in accordance with paragraph (e) of Sec. 1.446-1.
    (2) Method of converting inventory. Where the taxpayer changes from 
one method of pricing LIFO inventories to the dollar-value method, the 
ending LIFO inventory for the taxable year immediately preceding the 
year of change shall be converted to the dollar-value LIFO method. This 
is done to establish the base-year cost for subsequent calculations. 
Thus, if the taxpayer was previously valuing LIFO inventories on the 
specific goods method, these separate values shall be combined into 
appropriate pools. For this purpose, the base year for the pool shall be 
the earliest taxable year for which the LIFO inventory method had been 
adopted for any item in that pool. No change will be made in the overall 
LIFO value of the opening inventory for the year of change as a result 
of the conversion, and that inventory will merely be restated in the 
manner used under the dollar-value method. All layers of increment for 
such inventory must be retained, except that all layers of increment 
which occurred in the same taxable year must be combined.

[[Page 564]]

The following examples illustrate the provisions of this subparagraph:

    Example (1). (i) Assume that the taxpayer has used another LIFO 
method for finished goods since 1954 and has complied with all the 
requirements prerequisite for a change to the dollar-value method. Items 
A, B, and C, which have previously been inventoried under the specific 
goods LIFO method, may properly be included in a single dollar-value 
LIFO pool. The LIFO inventory value of items A, B, and C at December 31, 
1960, is $12,200, computed as follows:

------------------------------------------------------------------------
                                                                Dec. 31,
                                             Base                1960,
                  Year                     quantity     Unit   inventory
                                          and yearly    cost    at LIFO
                                          increments             value
------------------------------------------------------------------------
                 Item A
1954 (base year)........................         100       $1       $100
1955....................................         200        2        400
1956....................................         100        4        400
1960....................................         100        6        600
                                         ------------         ----------
   Total................................         500  .......      1,500
 
                 Item B
 
1954 (base year)........................         300        6      1,800
1955....................................         100        8        800
1960....................................          50       10        500
                                         ------------         ----------
   Total................................         450  .......      3,100
 
                 Item C
 
1954 (base year)........................       1,000        4      4,000
1955....................................         200        6      1,200
1956....................................         300        8      2,400
                                         ------------         ----------
  Total.................................       1,500  .......      7,600
                                         ============
  LIFO value of items A, B, and C at      ..........  .......     12,200
   Dec. 31, 1960........................
------------------------------------------------------------------------


There were no increments in the years 1957, 1958, or 1959.
    (ii) The computation of the ratio of the total current-year cost to 
the total base-year cost for the base year and each layer of increment 
in Pool No. 1 is shown as follows:

----------------------------------------------------------------------------------------------------------------
                                                       1954                              Increments
                                                      base-               --------------------------------------
                        Item                           year    Year 1954
                                                       unit                    1955         1956         1960
                                                       cost
----------------------------------------------------------------------------------------------------------------
                         A
 
Base-year cost.....................................    $1.00         $100         $200         $100         $100
LIFO value.........................................  .......          100          400          400          600
                         B
 
Base-year cost.....................................     6.00        1,800          600  ...........          300
LIFO value.........................................  .......        1,800          800  ...........          500
 
                         C
 
Base-year cost.....................................     4.00        4,000          800        1,200  ...........
LIFO value.........................................  .......        4,000        1,200        2,400  ...........
                                                             ---------------------------------------------------
Total--Base-year cost..............................    5,900        1,600        1,300          400
Total--LIFO value..................................    5,900        2,400        2,800        1,100
                                                             ===================================================
Ratio of total current-year cost to total base-year  .......       100.00       150.00       215.38       275.00
 cost (percent)....................................
----------------------------------------------------------------------------------------------------------------

    (iii) On the basis of the foregoing computations, the LIFO inventory 
of Pool No. 1, at December 31, 1960, is restated as follows:

------------------------------------------------------------------------
                                                    Ratio of
                                                      total
                                        Dec. 31,    current-    Dec. 31,
                                          1960,     year cost    1960,
                                        inventory   to total   inventory
                                        at base-    base-year   at LIFO
                                        year cost     cost       value
                                                    (percent)
------------------------------------------------------------------------
1954 base cost.......................      $5,900      100.00     $5,900
1955 increment.......................       1,600      150.00      2,400
1956 increment.......................       1,300      215.38      2,800
1960 increment.......................         400      275.00      1,100
                                      ------------            ----------
    Total............................       9,200  ..........     12,200
------------------------------------------------------------------------

    Example (2). Assume the same facts as in example (1) and assume 
further that the base-year cost of Pool No. 1 at December 31, 1961, is 
$8,350. Since the closing inventory for the taxable year 1961 at base-
year cost is less than the opening inventory for that year at base-year 
cost, a liquidation has occurred during 1961. This liquidation absorbs 
all of the 1960 layer of increment and part of the 1956 layer of 
increment. The December 31, 1961, inventory is $10,131, computed as 
follows:

[[Page 565]]



------------------------------------------------------------------------
                                                    Ratio of
                                                      total
                                        Dec. 31,    current-    Dec. 31,
                                          1961,     year cost    1961,
                                        inventory   to total   inventory
                                        at base-    base-year   at LIFO
                                        year cost     cost       value
                                                    (percent)
------------------------------------------------------------------------
1954 base cost.......................      $5,900      100.00     $5,900
1955 increment.......................       1,600      150.00      2,400
1956 increment.......................         850      215.38      1,831
                                      ------------            ----------
    Total............................       8,350  ..........     10,131
------------------------------------------------------------------------

    (g) Transitional rules--(1) Change in method of pooling. Any method 
of pooling authorized by this section and used by the taxpayer in 
computing his LIFO inventories under the dollar-value method shall be 
treated as a method of accounting. Any method of pooling which is 
authorized by this section shall be used for the year of adoption and 
for all subsequent taxable years unless a change is required by the 
Commissioner in order to clearly reflect income, or unless permission to 
change is granted by the Commissioner as provided in paragraph (e) of 
Sec. 1.446-1. Where the taxpayer changes from one method of pooling to 
another method of pooling permitted by this section, the ending LIFO 
inventory for the taxable year preceding the year of change shall be 
restated under the new method of pooling.
    (2) Manner of combining or separating dollar-value pools. (i) A 
taxpayer who has been using the dollar-value LIFO method and who is 
permitted or required to change his method of pooling, shall combine or 
separate the LIFO value of his inventory for the base year and each 
yearly layer of increment in order to conform to the new pool or pools. 
Each yearly layer of increment in the new pool or pools must be 
separately accounted for and a record thereof maintained, and any 
liquidation occurring in the new pool or pools subsequent to the 
formation thereof shall be treated in the same manner as if the new pool 
or pools had existed from the date the taxpayer first adopted the LIFO 
inventory method. The combination or separation of the LIFO value of his 
inventory for the base year and each yearly layer of increment shall be 
made in accordance with the appropriate method set forth in this 
subparagraph, unless the use of a different method is approved by the 
Commissioner.
    (ii) Where the taxpayer is permitted or required to separate a pool 
into more than one pool, the separation shall be made in the following 
manner: First, each item in the former pool shall be placed in an 
appropriate new pool. Every item in each new pool is then extended at 
its base-year unit cost and the extensions are totaled. Each total is 
the amount of inventory for each new pool expressed in terms of base-
year cost. Then a ratio of the total base-year cost of each new pool to 
the base-year cost of the former pool is computed. The resulting ratio 
is applied to the amount of inventory for the base year and each yearly 
layer of increment of the former pool to obtain an allocation to each 
new pool of the base-year inventory of the former pool and subsequent 
layers of increment thereof. The foregoing may be illustrated by the 
following example of a change for the taxable year 1961:

    Example. (a) Assume that items A, B, C, and D are all grouped 
together in one pool prior to December 31, 1960. The LIFO inventory 
value at December 31, 1960, is computed as follows:

------------------------------------------------------------------------
                                                   Pool ABCD
                                      ----------------------------------
                                                    Ratio of
                                        Dec. 31,      total
                                          1960,     current-    Dec. 31,
                                        inventory   year cost    1960,
                                       at Jan. 1,   to total   inventory
                                       1956, base-  base-year   at LIFO
                                        year cost     cost       value
                                                    (percent)
------------------------------------------------------------------------
Jan. 1, 1956, base cost..............     $10,000         100    $10,000
Dec. 31, 1956, increment.............       1,000         110      1,100
Dec. 31, 1958, increment.............       5,000         120      6,000
Dec. 31, 1960, increment.............       4,000         125      5,000
                                      ------------            ----------
  Total..............................      20,000  ..........     22,100
------------------------------------------------------------------------

    (b) The extension of the quantity of items A, B, C, and D at 
respective base-year unit costs is as follows:

------------------------------------------------------------------------
                                                         Base-
                                                         year
                    Item                     Quantity    unit     Amount
                                                         cost
------------------------------------------------------------------------
A..........................................    2,000         $2   $4,000
B..........................................    1,000          3    3,000
C..........................................    1,000          5    5,000
D..........................................    4,000          2    8,000
                                                                --------
    Total..................................  ........  ........   20,000
------------------------------------------------------------------------

    (c) Under the provisions of this section the taxpayer separates 
former Pool ABCD into

[[Page 566]]

two pools, Pool AB and Pool CD. The computation of the ratio of total 
base-year cost for each of the new pools to the base-year cost of the 
former pool is as follows:

------------------------------------------------------------------------
                                                 Total
                     Item                      base-year       Ratio
                                                  cost
------------------------------------------------------------------------
Pool AB:
  A..........................................     $4,000  ..............
  B..........................................      3,000  ..............
                                              -----------
                                                   7,000    7,000/20,000
                                              ===========
Pool CD:
  C..........................................      5,000  ..............
  D..........................................      8,000  ..............
                                                  13,000   13,000/20,000
                                              -----------
  Total for pool ABCD........................     20,000  ..............
------------------------------------------------------------------------

    (d) The ratio of the base-year cost of new Pools AB and CD to the 
base-year cost of former Pool ABCD is 7,000/20,000 and 13,000/20,000, 
respectively. The allocation of the January 1, 1956 base cost and 
subsequent yearly layers of increment of former Pool ABCD to new Pools 
AB and CD is as follows:

------------------------------------------------------------------------
                                             Base-year        Pool
                                              cost to  -----------------
                                                 be
                                             allocated     AB       CD
------------------------------------------------------------------------
Jan. 1, 1956, base cost....................    $10,000   $3,500   $6,500
Dec. 31, 1956, increment...................      1,000      350      650
Dec. 31, 1958, increment...................      5,000    1,750    3,250
  Dec. 31, 1960, increment.................      4,000    1,400    2,600
                                            ----------------------------
      Total................................     20,000    7,000   13,000
------------------------------------------------------------------------

    (e) The LIFO value of new Pools AB and CD at December 31, 1960, as 
allocated, is as follows:

------------------------------------------------------------------------
                                                    Ratio of
                                        Dec. 31,      total
                                          1960,     current-    Dec. 31,
                                        inventory   year cost    1960,
                                       at Jan. 1,   to total   inventory
                                       1956, base-  base-year   at LIFO
                                        year cost     cost       value
                                                    (percent)
------------------------------------------------------------------------
               Pool AB
Jan. 1, 1956, base cost..............      $3,500         100     $3,500
Dec. 31, 1956, increment.............         350         110        385
Dec. 31, 1958, increment.............       1,750          20      2,100
Dec. 31, 1960, increment.............       1,400         125      1,750
                                      ------------            ----------
      Total..........................       7,000  ..........      7,735
                                      =============
               Pool CD
 
Jan. 1, 1956, base cost..............       6,500         100      6,500
Dec. 31, 1956, increment.............         650         110        715
Dec. 31, 1958, increment.............       3,250         120      3,900
Dec. 31, 1960, increment.............       2,600         125      3,250
                                      ------------            ----------
      Total..........................      13,000  ..........     14,365
------------------------------------------------------------------------

    (iii) Where the taxpayer is permitted or required to combine two or 
more pools having the same base year, they shall be combined into one 
pool in the following manner: The LIFO value of the base-year inventory 
of each of the former pools is combined to obtain a LIFO value of the 
base-year inventory for the new pool. Then, any layers of increment in 
the various pools which occurred in the same taxable year are combined 
into one total layer of increment for that taxable year. However, layers 
of increment which occurred in different taxable years may not be 
combined. In combining the layers of increment a new ratio of current-
year cost to base-year cost is computed for each of the combined layers 
of increment. The foregoing may be illustrated by the following example:

    Example. (a) Assume the taxpayer has two pools at December 31, 1960. 
Under the provisions of this section the taxpayer combines these pools 
into a single pool as of January 1, 1961. The LIFO inventory value of 
each pool at December 31, 1960, is shown as follows:

------------------------------------------------------------------------
                                                    Ratio of
                                        Dec. 31,      total
                                          1960,     current-    Dec. 31,
                                        inventory   year cost    1960,
                                       at Jan. 1,   to total   inventory
                                       1957, base-  base-year   at LIFO
                                        year cost     cost       value
                                                    (percent)
------------------------------------------------------------------------
              Pool No. 1
Jan. 1, 1956, base cost..............     $10,000         100    $10,000
Dec. 31, 1957, increment.............       2,000         110      2,200
Dec. 31, 1960, increment.............       1,000         120      1,200
                                      ------------            ----------
      Total..........................      13,000  ..........     13,400
                                      ==================================
              Pool No. 2
 
Jan. 1, 1957, base cost..............       5,000         100      5,000
Dec. 31, 1960, increment.............       3,000         140      4,200
                                      ------------            ----------
      Total..........................       8,000  ..........      9,200
------------------------------------------------------------------------

    (b) The computation of the ratio of the total current-year cost to 
the total base-year cost for the base year and each yearly layer of 
increment in the new pool is as follows:

[[Page 567]]



------------------------------------------------------------------------
                                                          Increments
                                              Base   -------------------
                   Pool                       year    Dec. 31,  Dec. 31,
                                              1957      1957      1960
------------------------------------------------------------------------
No. 1:
  Base-year cost..........................   $10,000    $2,000    $1,000
  LIFO value..............................    10,000     2,200     1,200
No. 2:
  Base-year cost..........................     5,000  ........     3,000
  LIFO value..............................     5,000  ........     4,200
                                           -----------------------------
  Total, base-year cost...................    15,000     2,000     4,000
  Total, LIFO value.......................    15,000     2,200     5,400
                                           =============================
Ratio of total current-year cost to total        100       110       135
 base-year cost (percent).................
------------------------------------------------------------------------

    (c) On the basis of the foregoing computations, the LIFO inventory 
of the new pool at December 31, 1960, is restated as follows:

------------------------------------------------------------------------
                                                    Ratio of
                                        Dec. 31,      total
                                          1960,     current-    Dec. 31,
                                        inventory   year cost    1960,
                                       at Jan. 1,   to total   inventory
                                       1957, base-  base-year   at LIFO
                                        year cost     cost       value
                                                    (percent)
------------------------------------------------------------------------
Jan. 1, 1957, base cost..............     $15,000         100    $15,000
Dec. 31, 1957, increment.............       2,000         110      2,200
Dec. 31, 1960, increment.............       4,000         135      5,400
                                      ------------            ----------
      Total..........................      21,000  ..........     22,600
------------------------------------------------------------------------

    (iv) In combining pools having different base years, the principles 
set forth in subdivision (iii) of this subparagraph are to be applied, 
except that all base years subsequent to the earliest base year shall be 
treated as increments, and the base-year costs for all pools having a 
base year subsequent to the earliest base year of any pool shall be 
redetermined in terms of the base cost for the earliest base year. The 
foregoing may be illustrated by the following example:

    Example. (a) Assume that the taxpayer has two pools at December 31, 
1960. Under the provisions of this section the taxpayer combines these 
pools into a single pool as of January 1, 1961. The LIFO inventory value 
of each pool at December 31, 1960, is shown as follows:

------------------------------------------------------------------------
                                                    Ratio of
                                        Dec. 31,      total
                                          1960,      current    Dec. 31,
                                        inventory   rent-year    1960,
                                       at Jan. 1,    cost to   inventory
                                       1956, base- total base-  at LIFO
                                        year cost   year cost    value
                                                    (percent)
------------------------------------------------------------------------
              Pool No. 1
Jan. 1, 1956, base cost..............      $7,000         100     $7,000
Dec. 31, 1956, increment.............       1,000         105      1,050
Dec. 31, 1957, increment.............         500         110        550
Dec. 31, 1958, increment.............         500         110        550
Dec. 31, 1960, increment.............       1,000         120      1,200
                                      ------------            ----------
      Total..........................      10,000  ..........     10,350
                                      ==================================
              Pool No. 2
 
Jan. 1, 1958, base cost..............       3,500         100      3,500
Dec. 31, 1958, increment.............       1,000         110      1,100
Dec. 31, 1959, increment.............         500         115        575
      Total..........................       5,000  ..........      5,175
------------------------------------------------------------------------

    (b) The next step is to redetermine the 1958 base-year cost for Pool 
No. 2 in terms of 1956 base-year cost. January 1, 1956 base-year unit 
cost must be reconstructed or established in accordance with paragraph 
(e)(2) of this section for each item in Pool No. 2. Such costs are 
assumed to be $9.00 for item A, $20.00 for item B, and $1.80 for item C. 
A ratio of the 1958 total base-year cost to the 1956 total base-year 
cost for Pool No. 2 is computed as follows:

------------------------------------------------------------------------
                                                       Jan. 1,
                                                        1956,    Jan. 1,
                                                        base-     1956,
                   Item                     Quantity    year      base-
                                                        unit      year
                                                        cost      cost
------------------------------------------------------------------------
A.........................................      250      $9.00    $2,250
B.........................................       75      20.00     1,500
C.........................................      500       1.80       900
                                                               ---------
      Total...............................  ........  ........     4,650
                                           -----------------------------
A.........................................      250      10.00     2,500
B.........................................       75      20.00     1,500
C.........................................      500       2.00     1,000
                                                               ---------
      Total...............................  ........  ........     5,000
------------------------------------------------------------------------

    (c) The ratio of the 1956 total base-year cost to the 1958 total 
base-year cost for Pool No. 2 is 4,650/5,000 or 93 percent. The January 
1, 1958 base cost and each yearly layer of increment at 1958 base-year 
cost is multiplied by this ratio. Such computation is as follows:

[[Page 568]]



------------------------------------------------------------------------
                                                               Dec. 31,
                                        Dec. 31,                 1960,
                                          1960,                inventory
                                        inventory    Ratio     restated
                                       at Jan. 1,  (percent)  at Jan. 1,
                                       1958, base-            1956, base-
                                        year cost              year cost
------------------------------------------------------------------------
Jan. 1, 1958, base cost..............      $3,500         93      $3,255
Dec. 31, 1958, increment.............       1,000         93         930
Dec. 31, 1959, increment.............         500         93         465
                                                             -----------
      Total..........................  ..........  .........       4,650
------------------------------------------------------------------------

    (d) The computation of the ratio of the total current-year cost to 
the total base-year cost for the base year (1956) and each yearly layer 
of increment in the new pool is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                 Increments
                                                Base year ------------------------------------------------------
                     Pool                         1956      Dec. 31,   Dec. 31,   Dec. 31,   Dec. 31,   Dec. 31,
                                                              1956       1957       1958       1959       1960
----------------------------------------------------------------------------------------------------------------
No. 1:
  Base-year cost.............................      $7,000     $1,000       $500       $500  .........     $1,000
  LIFO value.................................       7,000      1,050        550        550  .........      1,200
No. 2:
  Base-year cost as restated.................  ..........  .........      3,255        930       $465  .........
  LIFO value.................................  ..........  .........      3,500      1,100        575  .........
                                              ------------------------------------------------------------------
      Total, base-year cost..................       7,000      1,000      3,755      1,430        465      1,000
      Total, LIFO value......................       7,000      1,050      4,050      1,650        575      1,200
                                              ==================================================================
  Ratio of total current-year cost to total        100.00     105.00     107.86     115.38     133.66     120.00
   base-year cost (percent)..................
----------------------------------------------------------------------------------------------------------------

    (e) On the basis of the foregoing computation, the LIFO inventory of 
the new pool at December 31, 1960, is restated as follows:

------------------------------------------------------------------------
                                                    Ratio of
                                        Dec. 31,      total
                                          1960,     current-    Dec. 31,
                                        inventory   year cost    1960,
                                       at Jan. 1,   to total   inventory
                                       1956, base-  base-year   at LIFO
                                        year cost     cost       value
                                                    (percent)
------------------------------------------------------------------------
Jan. 1, 1956, base cost..............      $7,000      100.00     $7,000
Dec. 31, 1956, increment.............       1,000      105.00      1,050
Dec. 31, 1957, increment.............       3,755      107.86      4,050
Dec. 31, 1958, increment.............       1,430      115.38      1,650
Dec. 31, 1959, increment.............         465      123.66        575
Dec. 31, 1960, increment.............       1,000      120.00      1,200
                                      ------------            ----------
      Total..........................      14,650  ..........     15,525
------------------------------------------------------------------------

    (3) Change in methods of computation at the LIFO value of a dollar-
value pool. For the first taxable year beginning after December 31, 
1960, the taxpayer must use a method authorized by paragraph (e)(1) of 
this section in computing the base-year cost and current-year cost of a 
dollar-value inventory pool for the end of such year. If the taxpayer 
had previously used any methods other than one authorized by paragraph 
(e)(1) of this section, he shall not be required to recompute his LIFO 
inventories for taxable years beginning on or before December 31, 1960, 
under a method authorized by such paragraph. The base cost and layers of 
increment previously computed by such other method shall be retained and 
treated as if such base cost and layers of increment had been computed 
under a method authorized by paragraph (e)(1) of this section. The 
taxpayer shall use the year of change as the base year in applying the 
double-extension method or other method approved by the Commissioner, 
instead of the earliest year for which he adopted the LIFO method for 
any items in the pool.
    (h) LIFO inventories received in certain nonrecognition 
transactions--(1) In general. Except as provided in paragraph (h)(3) of 
this section, if inventory items accounted for under the LIFO method are 
received in a transaction described in paragraph (h)(2) of this section, 
then, for the purpose of determining future increments and liquidations, 
the transferee must use the year of transfer as the base year and must 
use its current-year cost (computed under the

[[Page 569]]

transferee's method of accounting) of those items as their new base-year 
cost. If the transferee had opening inventories in the year of transfer, 
then, for the purpose of determining future increments and liquidations, 
the transferee must use its current-year cost (computed under the 
transferee's method of accounting) of those inventories as their new 
base-year cost. For this purpose, ``opening inventory'' refers to all 
items owned by the transferee before the transfer for which the 
transferee uses, or elects to use, the LIFO method. The total new base-
year cost of the transferee's inventory as of the beginning of the year 
of transfer is equal to the new base-year cost of the inventory received 
from the transferor and the new base-year cost of the transferee's 
opening inventory. The index (or, the cumulative index in the case of 
the link-chain method) for the year immediately preceding the year of 
transfer is 1.00. The base-year cost of any layers in the dollar-value 
pool, as determined after the transfer, must be recomputed accordingly. 
See paragraph (e)(3)(iv)(B)(1) of this section for an example of this 
computation.
    (2) Transactions to which this paragraph (h) applies. The rules in 
this paragraph (h) apply to a transaction in which--
    (i) The transferee determines its basis in the inventories, in whole 
or in part, by reference to the basis of the inventories in the hands of 
the transferor;
    (ii) The transferor used the dollar-value LIFO method to account for 
the transferred inventories;
    (iii) The transferee uses the dollar-value LIFO method to account 
for the inventories in the year of the transfer; and
    (iv) The transaction is not described in section 381(a).
    (3) Anti-avoidance rule. The rules in this paragraph (h) do not 
apply to a transaction entered into with the principal purpose to avail 
the transferee of a method of accounting that would be unavailable to 
the transferor (or would be unavailable to the transferor without 
securing consent from the Commissioner). In determining the principal 
purpose of a transfer, consideration will be given to all of the facts 
and circumstances. However, a transfer is deemed made with the principal 
purpose to avail the transferee of a method of accounting that would be 
unavailable to the transferor without securing consent from the 
Commissioner if the transferor acquired inventory in a bargain purchase 
within the five taxable years preceding the year of the transfer and 
used a dollar-value LIFO method to account for that inventory that did 
not treat the bargain purchase inventory and physically identical 
inventory acquired at market prices as separate items. Inventory is 
deemed acquired in a bargain purchase if the actual cost of the 
inventory (or, if appropriate, the allocated cost of the inventory) was 
less than or equal to 50 percent of the replacement cost of physically 
identical inventory. Inventory is not considered acquired in a bargain 
purchase if the actual cost of the inventory (or, if appropriate, the 
allocated cost of the inventory) was greater than or equal to 75 percent 
of the replacement cost of physically identical inventory.
    (4) Effective date. The rules of this paragraph (h) are applicable 
for transfers that occur during a taxable year ending on or after 
December 31, 2001.

[T.D. 6539, 26 FR 518, Jan. 20, 1961, as amended by T.D. 7814, 47 FR 
11272, Mar. 16, 1982; T.D. 8976, 67 FR 1082, Jan. 9, 2002; 67 FR 5062, 
5148, Feb. 4, 2002]



Sec. 1.475-0  Table of contents.

    This section lists the major captions in Sec. Sec. 1.475(a)-3, 
1.475(b)-1, 1.475(b)-2, 1.475(b)-4, 1.475(c)-1, 1.475(c)-2, 1.475(d)-1, 
and 1.475(e)-1.

              Sec. Sec. 1.475(a)-1--1.475(a)-2 [Reserved]

     Sec. 1.475(a)-3 Acquisition by a dealer of a security with a 
                           substituted basis.

    (a) Scope.
    (b) Rules.

  Sec. 1.475(b)-1 Scope of exemptions from mark-to-market requirement.

    (a) Securities held for investment or not held for sale.
    (b) Securities deemed identified as held for investment.
    (1) In general.
    (2) Relationships.
    (i) General rule.
    (ii) Attribution.
    (iii) Trusts treated as partnerships.

[[Page 570]]

    (3) Securities traded on certain established financial markets.
    (4) Changes in status.
    (i) Onset of prohibition against marking.
    (ii) Termination of prohibition against marking.
    (iii) Examples.
    (c) Securities deemed not held for investment; dealers in notional 
principal contracts and derivatives.
    (d) Special rule for hedges of another member's risk.
    (e) Transitional rules.
    (1) Stock, partnership, and beneficial ownership interests in 
certain controlled corporations, partnerships, and trusts before January 
23, 1997.
    (i) In general.
    (ii) Control defined.
    (iii) Applicability.
    (2) Dealers in notional principal contracts and derivatives acquired 
before January 23, 1997.
    (i) General rule.
    (ii) Exception for securities not acquired in dealer capacity.
    (iii) Applicability.

        Sec. 1.475(b)-2 Exemptions--identification requirements.

    (a) Identification of the basis for exemption.
    (b) Time for identifying a security with a substituted basis.
    (c) Integrated transactions under Sec. 1.1275-6.
    (1) Definitions.
    (2) Synthetic debt held by a taxpayer as a result of legging in.
    (3) Securities held after legging out.

                       Sec. 1.475(b)-3 [Reserved]

            Sec. 1.475(b)-4 Exemptions--transitional issues.

    (a) Transitional identification.
    (1) Certain securities previously identified under section 1236.
    (2) Consistency requirement for other securities.
    (b) Corrections on or before January 31, 1994.
    (1) Purpose.
    (2) To conform to Sec. 1.475(b)-1(a).
    (i) Added identifications.
    (ii) Limitations.
    (3) To conform to Sec. 1.475(b)-1(c).
    (c) Effect of corrections.

           Sec. 1.475(c)-1 Definitions--dealer in securities.

    (a) Dealer-customer relationship.
    (1) [Reserved]
    (2) Transactions described in section 475(c)(1)(B).
    (i) In general.
    (ii) Examples.
    (3) Related parties.
    (i) General rule.
    (ii) Special rule for members of a consolidated group.
    (iii) The intragroup-customer election.
    (A) Effect of election.
    (B) Making and revoking the election.
    (iv) Examples.
    (b) Sellers of nonfinancial goods and services.
    (1) Purchases and sales of customer paper.
    (2) Definition of customer paper.
    (3) Exceptions.
    (4) Election not to be governed by the exception for sellers of 
nonfinancial goods or services.
    (i) Method of making the election.
    (A) Taxable years ending after December 24, 1996.
    (B) Taxable years ending on or before December 24, 1996.
    (ii) Continued applicability of an election.
    (c) Taxpayers that purchase securities from customers but engage in 
no more than negligible sales of the securities.
    (1) Exemption from dealer status.
    (i) General rule.
    (ii) Election to be treated as a dealer.
    (2) Negligible sales.
    (3) Special rules for members of a consolidated group.
    (i) Intragroup-customer election in effect.
    (ii) Intragroup-customer election not in effect.
    (4) Special rules.
    (5) Example.
    (d) Issuance of life insurance products.

                 Sec. 1.475(c)-2 Definitions--security.

    (a) Items that are not securities.
    (b) Synthetic debt that Sec. 1.1275-6(b) treats the taxpayer as 
holding.
    (c) Negative value REMIC residuals acquired before January 4, 1995.
    (1) Description.
    (2) Special rules applicable to negative value REMIC residuals 
acquired before January 4, 1995.

               Sec. 1.475(d)-1 Character of gain or loss.

    (a) Securities never held in connection with the taxpayer's 
activities as a dealer in securities.
    (b) Ordinary treatment for notional principal contracts and 
derivatives held by dealers in notional principal contracts and 
derivatives.

                    Sec. 1.475(e)-1 Effective dates.

[T.D. 8700, 61 FR 67719, Dec. 24, 1996]



Sec. Sec. 1.475(a)-1--1.475(a)-2  [Reserved]



Sec. 1.475(a)-3  Acquisition by a dealer of a security with a 
substituted basis.

    (a) Scope. This section applies if--

[[Page 571]]

    (1) A dealer in securities acquires a security that is subject to 
section 475(a) and the dealer's basis in the security is determined, in 
whole or in part, by reference to the basis of that security in the 
hands of the person from whom the security was acquired; or
    (2) A dealer in securities acquires a security that is subject to 
section 475(a) and the dealer's basis in the security is determined, in 
whole or in part, by reference to other property held at any time by the 
dealer.
    (b) Rules. If this section applies to a security--
    (1) Section 475(a) applies only to changes in value of the security 
occurring after the acquisition; and
    (2) Any built-in gain or loss with respect to the security (based on 
the difference between the fair market value of the security on the date 
the dealer acquired it and its basis to the dealer on that date) is 
taken into account at the time, and has the character, provided by the 
sections of the Internal Revenue Code that would apply to the built-in 
gain or loss if section 475(a) did not apply to the security.

[T.D. 8700, 61 FR 67720, Dec. 24, 1996]



Sec. 1.475(b)-1  Scope of exemptions from mark-to-market requirement.

    (a) Securities held for investment or not held for sale. Except as 
otherwise provided by this section and subject to the identification 
requirements of section 475(b)(2), a security is held for investment 
(within the meaning of section 475(b)(1)(A)) or not held for sale 
(within the meaning of section 475(b)(1)(B)) if it is not held by the 
taxpayer primarily for sale to customers in the ordinary course of the 
taxpayer's trade or business.
    (b) Securities deemed identified as held for investment--(1) In 
general. The following items held by a dealer in securities are per se 
held for investment within the meaning of section 475(b)(1)(A) and are 
deemed to be properly identified as such for purposes of section 
475(b)(2)--
    (i) Except as provided in paragraph (b)(3) of this section, stock in 
a corporation, or a partnership or beneficial ownership interest in a 
widely held or publicly traded partnership or trust, to which the 
taxpayer has a relationship specified in paragraph (b)(2) of this 
section; or
    (ii) A contract that is treated for federal income tax purposes as 
an annuity, endowment, or life insurance contract (see sections 72, 817, 
and 7702).
    (2) Relationships--(i) General rule. The relationships specified in 
this paragraph (b)(2) are--
    (A) Those described in section 267(b) (2), (3), (10), (11), or (12); 
or
    (B) Those described in section 707(b)(1)(A) or (B).
    (ii) Attribution. The relationships described in paragraph (b)(2)(i) 
of this section are determined taking into account sections 267(c) and 
707(b)(3), as appropriate.
    (iii) Trusts treated as partnerships. For purposes of this paragraph 
(b)(2), the phrase partnership or trust is substituted for the word 
partnership in sections 707(b) (1) and (3), and a reference to 
beneficial ownership interest is added to each reference to capital 
interest or profits interest in those sections.
    (3) Securities traded on certain established financial markets. 
Paragraph (b)(1)(i) of this section does not apply to a security if--
    (i) The security is actively traded within the meaning of Sec. 
1.1092(d)-1(a) taking into account only established financial markets 
identified in Sec. 1.1092(d)-1(b)(1) (i) or (ii) (describing national 
securities exchanges and interdealer quotation systems);
    (ii) Less than 15 percent of all of the outstanding shares or 
interests in the same class are held by the taxpayer and all persons 
having a relationship to the taxpayer that is specified in paragraph 
(b)(2) of this section; and
    (iii) If the security was acquired (e.g., on original issue) from a 
person having a relationship to the taxpayer that is specified in 
paragraph (b)(2) of this section, then, after the time the security was 
acquired--
    (A) At least one full business day has passed; and
    (B) There has been significant trading involving persons not having 
a relationship to the taxpayer that is specified in paragraph (b)(2) of 
this section.

[[Page 572]]

    (4) Changes in status--(i) Onset of prohibition against marking. (A) 
Once paragraph (b)(1) of this section begins to apply to the security 
and for so long as it continues to apply, section 475(a) does not apply 
to the security in the hands of the taxpayer.
    (B) If a security has not been timely identified under section 
475(b)(2) and, after the last day on which such an identification would 
have been timely, paragraph (b)(1) of this section begins to apply to 
the security, then the dealer must recognize gain or loss on the 
security as if it were sold for its fair market value as of the close of 
business of the last day before paragraph (b)(1) of this section begins 
to apply to the security, and gain or loss is taken into account at that 
time.
    (ii) Termination of prohibition against marking. If a taxpayer did 
not timely identify a security under section 475(b)(2), and paragraph 
(b)(1) of this section applies to the security on the last day on which 
such an identification would have been timely but thereafter ceases to 
apply--
    (A) An identification of the security under section 475(b)(2) is 
timely if made on or before the close of the day paragraph (b)(1) of 
this section ceases to apply; and
    (B) Unless the taxpayer timely identifies the security under section 
475(b)(2) (taking into account the additional time for identification 
that is provided by paragraph (b)(4)(ii)(A) of this section), section 
475(a) applies to changes in value of the security after the cessation 
in the same manner as under section 475(b)(3).
    (iii) Examples. These examples illustrate this paragraph (b)(4):

    Example 1. Onset of prohibition against marking--(A) Facts. 
Corporation H owns 75 percent of the stock of corporation D, a dealer in 
securities within the meaning of section 475(c)(1). On December 1, 1995, 
D acquired less than half of the stock in corporation X. D did not 
identify the stock for purposes of section 475(b)(2). On July 17, 1996, 
H acquired from other persons 70 percent of the stock of X. As a result, 
D and X became related within the meaning of paragraph (b)(2)(i) of this 
section. The stock of X is not described in paragraph (b)(3) of this 
section (concerning some securities traded on certain established 
financial markets).
    (B) Holding. Under paragraph (b)(4)(i) of this section, D recognizes 
gain or loss on its X stock as if the stock were sold for its fair 
market value at the close of business on July 16, 1996, and the gain or 
loss is taken into account at that time. As with any application of 
section 475(a), proper adjustment is made in the amount of any gain or 
loss subsequently realized. After July 16, 1996, section 475(a) does not 
apply to D's X stock while paragraph (b)(1)(i) of this section 
(concerning the relationship between X and D) continues to apply.
    Example 2. Termination of prohibition against marking; retained 
securities identified as held for investment--(A) Facts. On July 1, 
1996, corporation H owned 60 percent of the stock of corporation Y and 
all of the stock of corporation D, a dealer in securities within the 
meaning of section 475(c)(1). Thus, D and Y are related within the 
meaning of paragraph (b)(2)(i) of this section. Also on July 1, 1996, D 
acquired, as an investment, 10 percent of the stock of Y. The stock of Y 
is not described in paragraph (b)(3) of this section (concerning some 
securities traded on certain established financial markets). When D 
acquired its shares of Y stock, it did not identify them for purposes of 
section 475(b)(2). On December 24, 1996, D identified its shares of Y 
stock as held for investment under section 475(b)(2). On December 30, 
1996, H sold all of its shares of stock in Y to an unrelated party. As a 
result, D and Y ceased to be related within the meaning of paragraph 
(b)(2)(i) of this section.
    (B) Holding. Under paragraph (b)(4)(ii)(A) of this section, 
identification of the Y shares is timely if done on or before the close 
of December 30, 1996. Because D timely identified its Y shares under 
section 475(b)(2), it continues after December 30, 1996, to refrain from 
marking to market its Y stock.
    Example 3. Termination of prohibition against marking; retained 
securities not identified as held for investment--(A) Facts. The facts 
are the same as in Example 2 above, except that D did not identify its 
stock in Y for purposes of section 475(b)(2) on or before December 30, 
1996. Thus, D did not timely identify these securities under section 
475(b)(2) (taking into account the additional time for identification 
provided in paragraph (b)(4)(ii)(A) of this section).
    (B) Holding. Under paragraph (b)(4)(ii)(B) of this section, section 
475(a) applies to changes in value of D's Y stock after December 30, 
1996, in the same manner as under section 475(b)(3).
    Thus, any appreciation or depreciation that occurred while the 
securities were prohibited from being marked to market is suspended. 
Further, section 475(a) applies only to those changes occurring after 
December 30, 1996.
    Example 4. Acquisition of actively traded stock from related party--
(A) Facts. Corporation P is the parent of a consolidated group whose 
taxable year is the calendar year, and

[[Page 573]]

corporation M, a member of that group, is a dealer in securities within 
the meaning of section 475(c)(1). Corporation M regularly acts as a 
market maker with respect to common and preferred stock of corporation 
P. Corporation P has outstanding 2,000,000 shares of series X preferred 
stock, which are traded on a national securities exchange. During the 
business day on December 29, 1997, corporation P sold 100,000 shares of 
series X preferred stock to corporation M for $100 per share. 
Subsequently, also on December 29, 1997, persons not related to 
corporation M engaged in significant trading of the series X preferred 
stock. At the close of business on December 30, 1997, the fair market 
value of series X stock was $99 per share. At the close of business on 
December 31, 1997, the fair market value of series X stock was $98.50 
per share. Corporation M sold the series X stock on the exchange on 
January 2, 1998. At all relevant times, corporation M and all persons 
related to M owned less than 15% of the outstanding series X preferred 
stock.
    (B) Holding. The 100,000 shares of series X preferred stock held by 
corporation M are not subject to mark-to-market treatment under section 
475(a) on December 29, 1997, because at that time the stock was held for 
less than one full business day and is therefore treated as properly 
identified as held for investment. At the close of business on December 
30, 1997, that prohibition on marking ceases to apply, and section 
475(b)(3) begins to apply. The built-in loss is suspended, and 
subsequent appreciation and depreciation are subject to section 475(a). 
Accordingly, when corporation M marks the series X stock to market at 
the close of business on December 31, 1997, under section 475(a) it 
recognizes and takes into account a loss of $.50 per share. Under 
section 475(b)(3), when corporation M sells the series X stock on 
January 2, 1998, it takes into account the suspended loss, that is, the 
difference between the $100 per share it paid corporation P for that 
stock and the $99-per-share fair market value when section 475(b)(1) 
ceased to be applied to the stock. No deduction, however, is allowed for 
that loss. (See Sec. 1.1502-13(f)(6), under which no deduction is 
allowed to a member of a consolidated group for a loss with respect to a 
share of stock of the parent of that consolidated group, if the member 
does not take the gain or loss into account pursuant to section 475(a).)

    (c) Securities deemed not held for investment; dealers in notional 
principal contracts and derivatives. (1) Except as otherwise determined 
by the Commissioner in a revenue ruling, revenue procedure, or letter 
ruling, section 475(b)(1)(A) (exempting from mark-to-market accounting 
certain securities that are held for investment) does not apply to a 
security if--
    (i) The security is described in section 475(c)(2) (D) or (E) 
(describing certain notional principal contracts and derivative 
securities); and
    (ii) The taxpayer is a dealer in such securities.
    (2) See Sec. 1.475(d)-1(b) for a rule concerning the character of 
gain or loss on securities described in this paragraph (c).
    (d) Special rule for hedges of another member's risk. A taxpayer may 
identify under section 475(b)(1)(C) (exempting certain hedges from mark-
to-market accounting) a security that hedges a position of another 
member of the taxpayer's consolidated group if the security meets the 
following requirements--
    (1) The security is a hedging transaction within the meaning of 
Sec. 1.1221-2(b);
    (2) The security is timely identified as a hedging transaction under 
Sec. 1.1221-2(f) (including identification of the hedged item); and
    (3) The security hedges a position that is not marked to market 
under section 475(a).
    (e) Transitional rules--(1) Stock, partnership, and beneficial 
ownership interests in certain controlled corporations, partnerships, 
and trusts before January 23, 1997--(i) In general. The following items 
held by a dealer in securities are per se held for investment within the 
meaning of section 475(b)(1)(A) and are deemed to be properly identified 
as such for purposes of section 475(b)(2)--
    (A) Stock in a corporation that the taxpayer controls (within the 
meaning of paragraph (e)(1)(ii) of this section); or
    (B) A partnership or beneficial ownership interest in a widely held 
or publicly traded partnership or trust that the taxpayer controls 
(within the meaning of paragraph (e)(1)(ii) of this section).
    (ii) Control defined. Control means the ownership, directly or 
indirectly through persons described in section 267(b) (taking into 
account section 267(c)), of--
    (A) 50 percent or more of the total combined voting power of all 
classes of stock entitled to vote; or

[[Page 574]]

    (B) 50 percent or more of the capital interest, the profits 
interest, or the beneficial ownership interest in the widely held or 
publicly traded partnership or trust.
    (iii) Applicability. The rules of this paragraph (e)(1) apply only 
before January 23, 1997.
    (2) Dealers in notional principal contracts and derivatives acquired 
before January 23, 1997--(i) General rule. Section 475(b)(1)(A) 
(exempting certain securities from mark-to-market accounting) does not 
apply to a security if--
    (A) The security is described in section 475(c)(2) (D) or (E) 
(describing certain notional principal contracts and derivative 
securities); and
    (B) The taxpayer is a dealer in such securities.
    (ii) Exception for securities not acquired in dealer capacity. This 
paragraph (e)(2) does not apply if the taxpayer establishes 
unambiguously that the security was not acquired in the taxpayer's 
capacity as a dealer in such securities.
    (iii) Applicability. The rules of paragraph (e)(2) apply only to 
securities acquired before January 23, 1997.

[T.D. 8700, 61 FR 67720, Dec. 24, 1996, as amended by T.D. 8985, 67 FR 
12865, Mar. 20, 2002]



Sec. 1.475(b)-2  Exemptions--identification requirements.

    (a) Identification of the basis for exemption. An identification of 
a security as exempt from mark to market does not satisfy section 
475(b)(2) if it fails to state whether the security is described in--
    (1) Either of the first two subparagraphs of section 475(b)(1) 
(identifying a security as held for investment or not held for sale); or
    (2) The third subparagraph thereof (identifying a security as a 
hedge).
    (b) Time for identifying a security with a substituted basis. For 
purposes of determining the timeliness of an identification under 
section 475(b)(2), the date that a dealer acquires a security is not 
affected by whether the dealer's basis in the security is determined, in 
whole or in part, either by reference to the basis of the security in 
the hands of the person from whom the security was acquired or by 
reference to other property held at any time by the dealer. See Sec. 
1.475(a)-3 for rules governing how the dealer accounts for such a 
security if this identification is not made.
    (c) Integrated transactions under Sec. 1.1275-6--(1) Definitions. 
The following terms are used in this paragraph (c) with the meanings 
that are given to them by Sec. 1.1275-6: integrated transaction, 
legging into, legging out, qualifying debt instrument, Sec. 1.1275-6 
hedge, and synthetic debt instrument.
    (2) Synthetic debt held by a taxpayer as a result of legging in. If 
a taxpayer is treated as the holder of a synthetic debt instrument as 
the result of legging into an integrated transaction, then, for purposes 
of the timeliness of an identification under section 475(b)(2), the 
synthetic debt instrument is treated as having the same acquisition date 
as the qualifying debt instrument. A pre-leg-in identification of the 
qualifying debt instrument under section 475(b)(2) applies to the 
integrated transaction as well.
    (3) Securities held after legging out. If a taxpayer legs out of an 
integrated transaction, then, for purposes of the timeliness of an 
identification under section 475(b)(2), the qualifying debt instrument, 
or the Sec. 1.1275-6 hedge, that remains in the taxpayer's hands is 
generally treated as having been acquired, originated, or entered into, 
as the case may be, immediately after the leg-out. If any loss or 
deduction determined under Sec. 1.1275-6(d)(2)(ii)(B) is disallowed by 
Sec. 1.1275-6(d)(2)(ii)(D) (which disallows deductions when a taxpayer 
legs out of an integrated transaction within 30 days of legging in), 
then, for purposes of this section and section 475(b)(2), the qualifying 
debt instrument that remains in the taxpayer's hands is treated as 
having been acquired on the same date that the synthetic debt instrument 
was treated as having been acquired.

[T.D. 8700, 61 FR 67722, Dec. 24, 1996]



Sec. 1.475(b)-3  [Reserved]



Sec. 1.475(b)-4  Exemptions--transitional issues.

    (a) Transitional identification--(1) Certain securities previously 
identified under section 1236. If, as of the close of the last taxable 
year ending before December 31, 1993, a security was identified

[[Page 575]]

under section 1236 as a security held for investment, the security is 
treated as being identified as held for investment for purposes of 
section 475(b).
    (2) Consistency requirement for other securities. In the case of a 
security (including a security described in section 475(c)(2)(F)) that 
is not described in paragraph (a)(1) of this section and that was held 
by the taxpayer as of the close of the last taxable year ending before 
December 31, 1993, the security is treated as having been properly 
identified under section 475(b)(2) or 475(c)(2)(F)(iii) if the 
information contained in the dealer's books and records as of the close 
of that year supports the identification. If there is any ambiguity in 
those records, the taxpayer must, no later than January 31, 1994, place 
in its records a statement resolving this ambiguity and indicating 
unambiguously which securities are to be treated as properly identified. 
Any information that supports treating a security as having been 
properly identified under section 475(b)(2) or (c)(2)(F)(iii) must be 
applied consistently from one security to another.
    (b) Corrections on or before January 31, 1994--(1) Purpose. This 
paragraph (b) allows a taxpayer to add or remove certain identifications 
covered by Sec. 1.475(b)-1.
    (2) To conform to Sec. 1.475(b)-1(a)--(i) Added identifications. To 
the extent permitted by paragraph (b)(2)(ii) of this section, a taxpayer 
may identify as being described in section 475(b)(1) (A) or (B)--
    (A) A security that was held for immediate sale but was not held 
primarily for sale to customers in the ordinary course of the taxpayer's 
trade or business (for example, a trading security); or
    (B) An evidence of indebtedness that was not held for sale to 
customers in the ordinary course of the taxpayer's trade or business and 
that the taxpayer intended to hold for less than one year.
    (ii) Limitations. An identification described in paragraph (b)(2)(i) 
of this section is permitted only if--
    (A) Prior to December 28, 1993, the taxpayer did not identify as 
being described in section 475(b)(1) (A) or (B) any of the securities 
described in paragraph (b)(2)(i) of this section;
    (B) The taxpayer identifies every security described in paragraph 
(b)(2)(i) of this section for which a timely identification of the 
security under section 475(b)(2) cannot be made after the date on which 
the taxpayer makes these added identifications; and
    (C) The identification is made on or before January 31, 1994.
    (3) To conform to Sec. 1.475(b)-1(c). On or before January 31, 
1994, a taxpayer described in Sec. 1.475(b)-1(e)(2)(i)(B) may remove an 
identification under section 475(b)(1)(A) of a security described in 
Sec. 1.475(b)-1(e)(2)(i)(A).
    (c) Effect of corrections. An identification added under paragraph 
(a)(2) or (b)(2) of this section is timely for purposes of section 
475(b)(2) or (c)(2)(F)(iii). An identification removed under paragraph 
(a)(2) or (b)(3) of this section does not subject the taxpayer to the 
provisions of section 475(d)(2).

[T.D. 8700, 61 FR 67722, Dec. 24, 1996]



Sec. 1.475(c)-1  Definitions--dealer in securities.

    (a) Dealer-customer relationship. Whether a taxpayer is transacting 
business with customers is determined on the basis of all of the facts 
and circumstances.
    (1) [Reserved]
    (2) Transactions described in section 475(c)(1)(B)--(i) In general. 
For purposes of section 475(c)(1)(B), the term dealer in securities 
includes, but is not limited to, a taxpayer that, in the ordinary course 
of the taxpayer's trade or business, regularly holds itself out as being 
willing and able to enter into either side of a transaction enumerated 
in section 475(c)(1)(B).
    (ii) Examples. The following examples illustrate the rules of this 
paragraph (a)(2). In the following examples, B is a bank and is not a 
member of a consolidated group:

    Example 1. B regularly offers to enter into interest rate swaps with 
other persons in the ordinary course of its trade or business. B is 
willing to enter into interest rate swaps under which it either pays a 
fixed interest rate and receives a floating rate or pays a floating rate 
and receives a fixed rate. B is a dealer in securities under section 
475(c)(1)(B), and the counterparties are its customers.
    Example 2. B, in the ordinary course of its trade or business, 
regularly holds itself out as being willing and able to enter into 
either

[[Page 576]]

side of positions in a foreign currency with other banks in the 
interbank market. B's activities in the foreign currency make it a 
dealer in securities under section 475(c)(1)(B), and the other banks in 
the interbank market are its customers.
    Example 3. B engages in frequent transactions in a foreign currency 
in the interbank market. Unlike the facts in Example 2, however, B does 
not regularly hold itself out as being willing and able to enter into 
either side of positions in the foreign currency, and all of B's 
transactions are driven by its internal need to adjust its position in 
the currency. No other circumstances are present to suggest that B is a 
dealer in securities for purposes of section 475(c)(1)(B). B's activity 
in the foreign currency does not qualify it as a dealer in securities 
for purposes of section 475(c)(1)(B), and its transactions in the 
interbank market are not transactions with customers.

    (3) Related parties--(i) General rule. Except as provided in 
paragraph (a)(3)(ii) of this section (concerning transactions between 
members of a consolidated group, as defined in Sec. 1.1502-1(h)), a 
taxpayer's transactions with related persons may be transactions with 
customers for purposes of section 475. For example, if a taxpayer, in 
the ordinary course of the taxpayer's trade or business, regularly holds 
itself out to its foreign subsidiaries or other related persons as being 
willing and able to enter into either side of transactions enumerated in 
section 475(c)(1)(B), the taxpayer is a dealer in securities within the 
meaning of section 475(c)(1), even if it engages in no other 
transactions with customers.
    (ii) Special rule for members of a consolidated group. Solely for 
purposes of paragraph (c)(1) of section 475 (concerning the definition 
of dealer in securities) and except as provided in paragraph (a)(3)(iii) 
of this section, a taxpayer's transactions with other members of its 
consolidated group are not with customers. Accordingly, notwithstanding 
paragraph (a)(2) of this section, the fact that a taxpayer regularly 
holds itself out to other members of its consolidated group as being 
willing and able to enter into either side of a transaction enumerated 
in section 475(c)(1)(B) does not cause the taxpayer to be a dealer in 
securities within the meaning of section 475(c)(1)(B).
    (iii) The intragroup-customer election--(A) Effect of election. If a 
consolidated group makes the intragroup-customer election, paragraph 
(a)(3)(ii) of this section (special rule for members of a consolidated 
group) does not apply to the members of the group. Thus, a member of a 
group that has made this election may be a dealer in securities within 
the meaning of section 475(c)(1) even if its only customer transactions 
are with other members of its consolidated group.
    (B) Making and revoking the election. Unless the Commissioner 
otherwise prescribes, the intragroup-customer election is made by filing 
a statement that says, ``[Insert name and employer identification number 
of common parent] hereby makes the Intragroup-Customer Election (as 
described in Sec. 1.475(c)-1(a)(3)(iii) of the income tax regulations) 
for the taxable year ending [describe the last day of the year] and for 
subsequent taxable years.'' The statement must be signed by the common 
parent and attached to the timely filed federal income tax return for 
the consolidated group for that taxable year. The election applies for 
that year and continues in effect for subsequent years until revoked. 
The election may be revoked only with the consent of the Commissioner.
    (iv) Examples. The following examples illustrate this paragraph 
(a)(3):

    General Facts. HC, a hedging center, provides interest rate hedges 
to all of the members of its affiliated group (as defined in section 
1504(a)(1)). Because of the efficiencies created by having a centralized 
risk manager, group policy prohibits members other than HC from entering 
into derivative interest rate positions with outside parties. HC 
regularly holds itself out as being willing and able to, and in fact 
does, enter into either side of interest rate swaps with its fellow 
members. HC periodically computes its aggregate position and hedges the 
net risk with an unrelated party. HC does not otherwise enter into 
interest rate positions with persons that are not members of the 
affiliated group. HC attempts to operate at cost, and the terms of its 
swaps do not factor in any risk of default by the affiliate. Thus, HC's 
affiliates receive somewhat more favorable terms then they would receive 
from an unrelated swaps dealer (a fact that may subject HC and its 
fellow members to reallocation of income under section 482). No other 
circumstances are present to suggest that HC is a dealer in securities 
for purposes of section 475(c)(1)(B).

[[Page 577]]

    Example 1. General rule for related persons. In addition to the 
General Facts stated above, assume that HC's affiliated group has not 
elected under section 1501 to file a consolidated return. Under 
paragraph (a)(3)(i) of this section, HC's transactions with its 
affiliates can be transactions with customers for purposes of section 
475(c)(1). Thus, under paragraph (a)(2)(i) of this section, HC is a 
dealer in securities within the meaning of section 475(c)(1)(B), and the 
members of the group with which it does business are its customers.

    Example 2. Special rule for members of a consolidated group. In 
addition to the General Facts stated above, assume that HC's affiliated 
group has elected to file consolidated returns and has not made the 
intragroup-customer election. Under paragraph (a)(3)(ii) of this 
section, HC's interest rate swap transactions with the members of its 
consolidated group are not transactions with customers for purposes of 
determining whether HC is a dealer in securities within the meaning of 
section 475(c)(1). Further, the fact that HC regularly holds itself out 
to members of its consolidated group as being willing and able to enter 
into either side of a transaction enumerated in section 475(c)(1)(B) 
does not cause HC to be a dealer in securities within the meaning of 
section 475(c)(1)(B). Because no other circumstances are present to 
suggest that HC is a dealer in securities for purposes of section 
475(c)(1)(B), HC is not a dealer in securities.
    Example 3. Intragroup-customer election. In addition to the General 
Facts stated above, assume that HC's affiliated group has elected to 
file a consolidated return but has also made the intragroup-customer 
election under paragraph (a)(3)(iii) of this section. Thus, the analysis 
and result are the same as in Example 1.

    (b) Sellers of nonfinancial goods and services--(1) Purchases and 
sales of customer paper. Except as provided in paragraph (b)(3) of this 
section, if a taxpayer would not be a dealer in securities within the 
meaning of section 475(c)(1) but for its purchases and sales of debt 
instruments that, at the time of purchase or sale, are customer paper 
with respect to either the taxpayer or a corporation that is a member of 
the same consolidated group (as defined in Sec. 1.1502-1(h)) as the 
taxpayer, then for purposes of section 475 the taxpayer is not a dealer 
in securities.
    (2) Definition of customer paper. A debt instrument is customer 
paper with respect to a person at a point in time if--
    (i) The person's principal activity is selling nonfinancial goods or 
providing nonfinancial services;
    (ii) The debt instrument was issued by a purchaser of the goods or 
services at the time of the purchase of those goods or services in order 
to finance the purchase; and
    (iii) At all times since the debt instrument was issued, it has been 
held either by the person selling those goods or services or by a 
corporation that is a member of the same consolidated group as that 
person.
    (3) Exceptions. Paragraph (b)(1) of this section does not apply if--
    (i) For purposes of section 471, the taxpayer accounts for any 
security (as defined in section 475(c)(2)) as inventory;
    (ii) The taxpayer is subject to an election under paragraph (b)(4) 
of this section; or
    (iii) The taxpayer is not described in paragraph (b)(2)(i) of this 
section and one or more debt instruments that are customer paper with 
respect to a corporation that is a member of the same consolidated group 
as the taxpayer are accounted for by the taxpayer, or by a corporation 
that is a member of the same consolidated group as the taxpayer, in a 
manner that allows recognition of unrealized gains or losses or 
deductions for additions to a reserve for bad debts.
    (4) Election not to be governed by the exception for sellers of 
nonfinancial goods or services--(i) Method of making the election. 
Unless the Commissioner otherwise prescribes, an election under this 
paragraph (b)(4) must be made in the manner, and at the time, prescribed 
in this paragraph (b)(4)(i). The taxpayer must file with the Internal 
Revenue Service a statement that says, ``[Insert name and taxpayer 
identification number of the taxpayer] hereby elects not to be governed 
by Sec. 1.475(c)-1(b)(1) of the income tax regulations for the taxable 
year ending [describe the last day of the year] and for subsequent 
taxable years.''
    (A) Taxable years ending after December 24, 1996. If the first 
taxable year subject to an election under this paragraph (b)(4) ends 
after December 24, 1996, the statement must be attached

[[Page 578]]

to a timely filed federal income tax return for that taxable year.
    (B) Taxable years ending on or before December 24, 1996. If the 
first taxable year subject to an election under this paragraph (b)(4) 
ends on or before December 24, 1996 and the election changes the 
taxpayer's taxable income for any taxable year the federal income tax 
return for which was filed before February 24, 1997, the statement must 
be attached to an amended return for the earliest such year that is so 
affected, and that amended return (and an amended return for any other 
such year that is so affected) must be filed not later than June 23, 
1997. If the first taxable year subject to an election under this 
paragraph (b)(4) ends on or before December 24, 1996 but the taxpayer is 
not described in the preceding sentence, the statement must be attached 
to the first federal income tax return that is for a taxable year 
subject to the election and that is filed on or after February 24, 1997.
    (ii) Continued applicability of an election. An election under this 
paragraph (b)(4) continues in effect for subsequent taxable years until 
revoked. The election may be revoked only with the consent of the 
Commissioner.
    (c) Taxpayers that purchase securities from customers but engage in 
no more than negligible sales of the securities--(1) Exemption from 
dealer status--(i) General rule. A taxpayer that regularly purchases 
securities from customers in the ordinary course of a trade or business 
(including regularly making loans to customers in the ordinary course of 
a trade or business of making loans) but engages in no more than 
negligible sales of the securities so acquired is not a dealer in 
securities within the meaning of section 475(c)(1) unless the taxpayer 
elects to be so treated or, for purposes of section 471, the taxpayer 
accounts for any security (as defined in section 475(c)(2)) as 
inventory.
    (ii) Election to be treated as a dealer. A taxpayer described in 
paragraph (c)(1)(i) of this section elects to be treated as a dealer in 
securities by filing a federal income tax return reflecting the 
application of section 475(a) in computing its taxable income.
    (2) Negligible sales. Solely for purposes of paragraph (c)(1) of 
this section, a taxpayer engages in negligible sales of debt instruments 
that it regularly purchases from customers in the ordinary course of its 
business if, and only if, during the taxable year, either--
    (i) The taxpayer sells all or part of fewer than 60 debt 
instruments, regardless how acquired; or
    (ii) The total adjusted basis of the debt instruments (or parts of 
debt instruments), regardless how acquired, that the taxpayer sells is 
less than 5 percent of the total basis, immediately after acquisition, 
of the debt instruments that it acquires in that year.
    (3) Special rules for members of a consolidated group--(i) 
Intragroup-customer election in effect. If a taxpayer is a member of a 
consolidated group that has made the intragroup-customer election 
(described in paragraph (a)(3)(iii) of this section), the negligible 
sales test in paragraph (c)(2) of this section takes into account all of 
the taxpayer's sales of debt instruments to other group members.
    (ii) Intragroup-customer election not in effect. If a taxpayer is a 
member of a consolidated group that has not made the intragroup-customer 
election (described in paragraph (a)(3)(iii) of this section), the 
taxpayer satisfies the negligible sales test in paragraph (c)(2) of this 
section if either--
    (A) The test is satisfied by the taxpayer, taking into account sales 
of debt instruments to other group members (as in paragraph (c)(3)(i) of 
this section); or
    (B) The test is satisfied by the group, treating the members of the 
group as if they were divisions of a single corporation.
    (4) Special rules. Whether sales of securities are negligible is 
determined without regard to--
    (i) Sales of securities that are necessitated by exceptional 
circumstances and that are not undertaken as recurring business 
activities;
    (ii) Sales of debt instruments that decline in quality while in the 
taxpayer's hands and that are sold pursuant to an established policy of 
the taxpayer to dispose of debt instruments below a certain quality; or
    (iii) Acquisitions and sales of debt instruments that are 
qualitatively different from all debt instruments that

[[Page 579]]

the taxpayer purchases from customers in the ordinary course of its 
business.
    (5) Example. The following example illustrates paragraph (c)(4)(iii) 
of this section:

    Example. I, an insurance company, regularly makes policy loans to 
its customers but does not sell them. I, however, actively trades 
Treasury securities. No other circumstances are present to suggest that 
I is a dealer in securities for purposes of section 475(c)(1). Since the 
Treasuries are qualitatively different from the policy loans that I 
originates, under paragraph (c)(4)(iii) of this section, I disregards 
the purchases and sales of Treasuries in applying the negligible sales 
test in paragraph (c)(2) of this section.

    (d) Issuance of life insurance products. A life insurance company 
that is not otherwise a dealer in securities within the meaning of 
section 475(c)(1) does not become a dealer in securities solely because 
it regularly issues life insurance products to its customers in the 
ordinary course of a trade or business. For purposes of the preceding 
sentence, the term life insurance product means a contract that is 
treated for federal income tax purposes as an annuity, endowment, or 
life insurance contract. See sections 72, 817, and 7702.

[T.D. 8700, 61 FR 67723, Dec. 24, 1996]



Sec. 1.475(c)-2  Definitions--security.

    (a) Items that are not securities. The following items are not 
securities within the meaning of section 475(c)(2) with respect to a 
taxpayer and, therefore, are not subject to section 475--
    (1) A security (determined without regard to this paragraph (a)) if 
section 1032 prevents the taxpayer from recognizing gain or loss with 
respect to that security;
    (2) A debt instrument issued by the taxpayer (including a synthetic 
debt instrument, within the meaning of Sec. 1.1275-6(b)(4), that Sec. 
1.1275-6(b) treats the taxpayer as having issued); or
    (3) A REMIC residual interest, or an interest or arrangement that is 
determined by the Commissioner to have substantially the same economic 
effect, if the residual interest or the interest or arrangement is 
acquired on or after January 4, 1995.
    (b) Synthetic debt that Sec. 1.1275-6(b) treats the taxpayer as 
holding. If Sec. 1.1275-6 treats a taxpayer as the holder of a 
synthetic debt instrument (within the meaning of Sec. 1.1275-6(b)(4)), 
the synthetic debt instrument is a security held by the taxpayer within 
the meaning of section 475(c)(2)(C).
    (c) Negative value REMIC residuals acquired before January 4, 1995. 
A REMIC residual interest that is described in paragraph (c)(1) of this 
section or an interest or arrangement that is determined by the 
Commissioner to have substantially the same economic effect is not a 
security within the meaning of section 475(c)(2).
    (1) Description. A residual interest in a REMIC is described in this 
paragraph (c)(1) if, on the date the taxpayer acquires the residual 
interest, the present value of the anticipated tax liabilities 
associated with holding the interest exceeds the sum of--
    (i) The present value of the expected future distributions on the 
interest; and
    (ii) The present value of the anticipated tax savings associated 
with holding the interest as the REMIC generates losses.
    (2) Special rules applicable to negative value REMIC residuals 
acquired before January 4, 1995. Solely for purposes of this paragraph 
(c)--
    (i) If a transferee taxpayer acquires a residual interest with a 
basis determined by reference to the transferor's basis, then the 
transferee is deemed to acquire the interest on the date the transferor 
acquired it (or is deemed to acquire it under this paragraph (c)(2)(i)).
    (ii) Anticipated tax liabilities, expected future distributions, and 
anticipated tax savings are determined under the rules in Sec. 1.860E-
2(a)(3) and without regard to the operation of section 475.
    (iii) Present values are determined under the rules in Sec. 1.860E-
2(a)(4).

[T.D. 8700, 61 FR 67725, Dec. 24, 1996]



Sec. 1.475(d)-1  Character of gain or loss.

    (a) Securities never held in connection with the taxpayer's 
activities as a dealer in securities. If a security is never held in 
connection with the taxpayer's activities as a dealer in securities, 
section 475(d)(3)(A) does not affect the

[[Page 580]]

character of gain or loss from the security, even if the taxpayer fails 
to identify the security under section 475(b)(2).
    (b) Ordinary treatment for notional principal contracts and 
derivatives held by dealers in notional principal contracts and 
derivatives. Section 475(d)(3)(B)(ii) (concerning the character of gain 
or loss with respect to a security held by a person other than in 
connection with its activities as a dealer in securities) does not apply 
to a security if Sec. 1.475(b)-1(c) and the absence of a determination 
by the Commissioner prevent section 475(b)(1)(A) from applying to the 
security.

[T.D. 8700, 61 FR 67725, Dec. 24, 1996]



Sec. 1.475(e)-1  Effective dates.

    (a)-(b) [Reserved]
    (c) Section 1.475(a)-3 (concerning acquisition by a dealer of a 
security with a substituted basis) applies to securities acquired, 
originated, or entered into on or after January 4, 1995.
    (d) Except as provided elsewhere in this paragraph (d), Sec. 
1.475(b)-1 (concerning the scope of exemptions from the mark-to-market 
requirement) applies to taxable years ending on or after December 31, 
1993.
    (1) Section 1.475(b)-1(b) applies as follows:
    (i) Section 1.475(b)-1(b)(1)(i) (concerning equity interests issued 
by a related person) applies beginning June 19, 1996. If, on June 18, 
1996, a security is subject to mark-to-market accounting and, on June 
19, 1996, Sec. 1.475(b)-1(b)(1) begins to apply to the security solely 
because of the effective dates in this paragraph (d) (rather than 
because of a change in facts), then the rules of Sec. 1.475(b)-
1(b)(4)(i)(A) (concerning the prohibition against marking) apply, but 
Sec. 1.475(b)-1(b)(4)(i)(B) (imposing a mark-to-market on the day 
before the onset of the prohibition) does not apply.
    (ii) Section 1.475(b)-1(b)(2) (concerning relevant relationships for 
purposes of determining whether equity interests in related persons are 
prohibited from being marked to market) applies beginning June 19, 1996.
    (iii) Section 1.475(b)-1(b)(3) (concerning certain actively traded 
securities) applies beginning June 19, 1996, to securities held on or 
after that date, except for securities described in Sec. 1.475(b)-
1(e)(1)(i) (concerning equity interests issued by controlled entities). 
If a security is described in Sec. 1.475(b)-1(e)(1)(i), Sec. 1.475(b)-
1(b)(3) applies only on or after January 23, 1997 if the security is 
held on or after that date. If Sec. 1.475(b)-1(b)(1) ceases to apply to 
a security by virtue of the operation of this paragraph (d)(1)(iii), the 
rules of Sec. 1.475(b)-1(b)(4)(ii) apply to the cessation.
    (iv) Except to the extent provided in paragraph (d)(1) of this 
section, Sec. 1.475(b)-1(b)(4) (concerning changes in status) applies 
beginning June 19, 1996.
    (2) Section 1.475(b)-1(c) (concerning securities deemed not held for 
investment by dealers in notional principal contracts and derivatives) 
applies to securities acquired on or after January 23, 1997.
    (3) Section 1.475(b)-1(d) (concerning the special rule for hedges of 
another member's risk) is effective for securities acquired, originated, 
or entered into on or after January 23, 1997.
    (e) Section 1.475(b)-2 (concerning identification of securities that 
are exempt from mark-to-market treatment) applies as follows:
    (1) Section 1.475(b)-2(a) (concerning the general rules for 
identification of basis for exemption from mark to market treatment) 
applies to identifications made on or after July 1, 1997.
    (2) Section 1.475(b)-2(b) (concerning time for identifying a 
security with a substituted basis) applies to securities acquired, 
originated, or entered into on or after January 4, 1995.
    (3) Section 1.475(b)-2(c) (concerning identification in the context 
of integrated transactions under Sec. 1.1275-6) applies on and after 
August 13, 1996 (the effective date of Sec. 1.1275-6).
    (f) [Reserved]
    (g) Section 1.475(b)-4 (concerning transitional issues relating to 
exemptions) applies to taxable years ending on or after December 31, 
1993.
    (h) Section 1.475(c)-1 applies as follows:
    (1) Except as otherwise provided in this paragraph (h)(1), Sec. 
1.475(c)-1(a) (concerning the dealer-customer relationship) applies to 
taxable years beginning on or after January 1, 1995.

[[Page 581]]

    (i) [Reserved]
    (ii) Section 1.475(c)-1(a)(2)(ii) (illustrating rules concerning the 
dealer-customer relationship) applies to taxable years beginning on or 
after June 20, 1996.
    (iii)(A) Section 1.475(c)-1(a)(3) applies to taxable years beginning 
on or after June 20, 1996, except for transactions between members of 
the same consolidated group.
    (B) For transactions between members of the same consolidated group, 
paragraph Sec. 1.475(c)-1(a)(3) applies to taxable years beginning on 
or after December 24, 1996.
    (2) Section 1.475(c)-1(b) (concerning sellers of nonfinancial goods 
and services) applies to taxable years ending on or after December 31, 
1993.
    (3) Except as otherwise provided in this paragraph (h)(3), section 
1.475(c)-1(c) (concerning taxpayers that purchase securities but engage 
in no more than negligible sales of the securities) applies to taxable 
years ending on or after December 31, 1993.
    (i) Section 1.475(c)-1(c)(3) (special rules for members of a 
consolidated group) is effective for taxable years beginning on or after 
December 24, 1996.
    (ii) A taxpayer may rely on the rules set out in Sec. 1.475(c)-
1T(b) (as contained in 26 CFR part 1 revised April 1, 1996) for taxable 
years beginning before January 23, 1997, provided the taxpayer applies 
that paragraph reasonably and consistently.
    (4) Section 1.475(c)-1(d) (concerning the issuance of life insurance 
products) applies to taxable years beginning on or after January 1, 
1995.
    (i) Section 1.475(c)-2 (concerning the definition of security) 
applies to taxable years ending on or after December 31, 1993. By its 
terms, however, Sec. 1.475(c)-2(a)(3) applies only to residual 
interests or to interests or arrangements that are acquired on or after 
January 4, 1995; and the integrated transactions that are referred to in 
Sec. Sec. 1.475(c)-2(a)(2) and 1.475(c)-2(b) exist only after August 
13, 1996 (the effective date of Sec. 1.1275-6).
    (j) Section 1.475(d)-1 (concerning the character of gain or loss) 
applies to taxable years ending on or after December 31, 1993.

[T.D. 8700, 61 FR 67725, Dec. 24, 1996]

                               Adjustments



Sec. 1.481-1  Adjustments in general.

    (a)(1) Section 481 prescribes the rules to be followed in computing 
taxable income in cases where the taxable income of the taxpayer is 
computed under a method of accounting different from that under which 
the taxable income was previously computed. A change in method of 
accounting to which section 481 applies includes a change in the over-
all method of accounting for gross income or deductions, or a change in 
the treatment of a material item. For rules relating to changes in 
methods of accounting, see section 446(e) and paragraph (e) of Sec. 
1.446-1. In computing taxable income for the taxable year of the change, 
there shall be taken into account those adjustments which are determined 
to be necessary solely by reason of such change in order to prevent 
amounts from being duplicated or omitted. The ``year of the change'' is 
the taxable year for which the taxable income of the taxpayer is 
computed under a method of accounting different from that used for the 
preceding taxable year.
    (2) Unless the adjustments are attributable to a change in method of 
accounting initiated by the taxpayer, no part of the adjustments 
required by subparagraph (1) of this paragraph shall be based on amounts 
which were taken into account in computing income (or which should have 
been taken into account had the new method of accounting been used) for 
taxable years beginning before January 1, 1954, or ending before August 
17, 1954 (hereinafter referred to as pre-1954 years).
    (b) The adjustments specified in section 481(a) and this section 
shall take into account inventories, accounts receivable, accounts 
payable, and any other item determined to be necessary in order to 
prevent amounts from being duplicated or omitted.
    (c)(1) The term ``adjustments'', as used in section 481, has 
reference to the net amount of the adjustments required by section 
481(a) and paragraph (b) of this section. In the case of a change in the 
over-all method of accounting, such as from the cash receipts and 
disbursements method to an

[[Page 582]]

accrual method, the term ``net amount of the adjustments'' means the 
consolidation of adjustments (whether the amounts thereof represent 
increases or decreases in items of income or deductions) arising with 
respect to balances in various accounts, such as inventory, accounts 
receivable, and accounts payable, at the beginning of the taxable year 
of the change in method of accounting. With respect to the portion of 
the adjustments attributable to pre-1954 years, it is immaterial that 
the same items or class of items with respect to which adjustments would 
have to be made (for the first taxable year to which section 481 
applies) do not exist at the time the actual change in method of 
accounting occurs. For purposes of section 481, only the net dollar 
balance is to be taken into account. In the case of a change in the 
treatment of a single material item, the amount of the adjustment shall 
be determined with reference only to the net dollar balances in that 
particular account.
    (2) If a change in method of accounting is voluntary (i.e., 
initiated by the taxpayer), the entire amount of the adjustments 
required by section 481(a) is generally taken into account in computing 
taxable income in the taxable year of the change, regardless of whether 
the adjustments increase or decrease taxable income. See, however, 
Sec. Sec. 1.446-1(e)(3) and 1.481-4 which provide that the Commissioner 
may prescribe the taxable year or years in which the adjustments are 
taken into account.
    (3) If the change in method of accounting is involuntary (i.e., not 
initiated by the taxpayer), then only the amount of the adjustments 
required by section 481(a) that is attributable to taxable years 
beginning after December 31, 1953, and ending after August 16, 1954, 
(hereinafter referred to as post-1953 years) is taken into account. This 
amount is generally taken into account in computing taxable income in 
the taxable year of the change, regardless of whether the adjustments 
increase or decrease taxable income. See, however, Sec. Sec. 1.446-
1(e)(3) and 1.481-4 which provide that the Commissioner may prescribe 
the taxable year or years in which the adjustments are taken into 
account. See also Sec. 1.481-3 for rules relating to adjustments 
attributable to pre-1954 years.
    (4) For any adjustments attributable to post-1953 years that are 
taken into account entirely in the year of change and that increase 
taxable income by more than $3,000, the limitations on tax provided in 
section 481(b) (1) or (2) apply. See Sec. 1.481-2 for rules relating to 
the limitations on tax provided by sections 481(b) (1) and (2).
    (5) A change in the method of accounting initiated by the taxpayer 
includes not only a change which he originates by securing the consent 
of the Commissioner, but also a change from one method of accounting to 
another made without the advance approval of the Commissioner. A change 
in the taxpayer's method of accounting required as a result of an 
examination of the taxpayer's income tax return will not be considered 
as initiated by the taxpayer. On the other hand, a taxpayer who, on his 
own initiative, changes his method of accounting in order to conform to 
the requirements of any Federal income tax regulation or ruling shall 
not, merely because of such fact, be considered to have made an 
involuntary change.
    (d) Any adjustments required under section 481(a) that are taken 
into account during a taxable year must be properly taken into account 
for purposes of computing gross income, adjusted gross income, or 
taxable income in determining the amount of any item of gain, loss, 
deduction, or credit that depends on gross income, adjusted gross 
income, or taxable income.

[T.D. 6500, 25 FR 11731, Nov. 26, 1960, as amended by T.D. 8608, 60 FR 
40078, Aug. 7, 1995]



Sec. 1.481-2  Limitation on tax.

    (a) Three-year allocation. Section 481(b)(1) provides a limitation 
on the tax under chapter 1 of the Internal Revenue Code for the taxable 
year of change that is attributable to the adjustments required under 
section 481(a) and Sec. 1.481-1 if the entire amount of the adjustments 
is taken into account in the year of change. If such adjustments 
increase the taxpayer's taxable income for the taxable year of the 
change by more than $3,000, then the tax for such taxable year that is 
attributable to the

[[Page 583]]

adjustments shall not exceed the lesser of the tax attributable to 
taking such adjustments into account in computing taxable income for the 
taxable year of the change under section 481(a) and Sec. 1.481-1, or 
the aggregate of the increases in tax that would result if the 
adjustments were included ratably in the taxable year of the change and 
the two preceding taxable years. For the purpose of computing the 
limitation on tax under section 481(b)(1), the adjustments shall be 
allocated ratably to the taxable year of the change and the two 
preceding taxable years, whether or not the adjustments are in fact 
attributable in whole or in part to such years. The limitation on the 
tax provided in this paragraph shall be applicable only if the taxpayer 
used the method of accounting from which the change was made in 
computing taxable income for the two taxable years preceding the taxable 
year of the change.
    (b) Allocation under new method of accounting. Section 481(b)(2) 
provides a second alternative limitation on the tax for the taxable year 
of change under chapter 1 of the Internal Revenue Code that is 
attributable to the adjustments required under section 481(a) and Sec. 
1.481-1 where such adjustments increase taxable income for the taxable 
year of change by more than $3,000. If the taxpayer establishes from his 
books of account and other records what his taxable income would have 
been under the new method of accounting for one or more consecutive 
taxable years immediately preceding the taxable year of the change, and 
if the taxpayer in computing taxable income for such years used the 
method of accounting from which the change was made, then the tax 
attributable to the adjustments shall not exceed the smallest of the 
following amounts:
    (1) The tax attributable to taking the adjustments into account in 
computing taxable income for the taxable year of the change under 
section 481(a) and Sec. 1.481-1;
    (2) The tax attributable to such adjustments computed under the 3-
year allocation provided in section 481(b)(1), if applicable; or
    (3) The net increase in the taxes under chapter 1 (or under 
corresponding provisions of prior revenue laws) which would result from 
allocating that portion of the adjustments to the one or more 
consecutive preceding taxable years to which properly allocable under 
the new method of accounting and from allocating the balance thereof to 
the taxable year of the change.
    (c) Rules for computation of tax. (1) The first step in determining 
whether either of the limitations described in section 481(b) (1) or (2) 
applies is to compute the increase in tax for the taxable year of the 
change that is attributable to the increase in taxable income for such 
year resulting solely from the adjustments required under section 481(a) 
and Sec. 1.481-1. This increase in tax is the excess of the tax for the 
taxable year computed by taking into account such adjustments under 
section 481(a) over the tax computed for such year without taking the 
adjustments into account.
    (2) The next step is to compute under section 481(b)(1) the tax 
attributable to the adjustments referred to in paragraph (c)(1) of this 
section for the taxable year of the change and the two preceding taxable 
years as if an amount equal to one-third of the net amount of such 
adjustments had been received or accrued in each of such taxable years. 
The increase in tax attributable to the adjustments for each such 
taxable year is the excess of the tax for such year computed with the 
allocation of one-third of the net adjustments to such taxable year over 
the tax computed without the allocation of any part of the adjustments 
to such year. For the purpose of computing the aggregate increase in 
taxes for such taxable years, there shall be taken into account the 
increase or decrease in tax for any taxable year preceding the taxable 
year of the change to which no adjustment is allocated under section 
481(b)(1) but which is affected by a net operating loss under section 
172 or by a capital loss carryback or carryover under section 1212, 
determined with reference to taxable years with respect to which 
adjustments under section 481(b)(1) are allocated.
    (3) In the event that the taxpayer satisfies the conditions set 
forth in section 481(b)(2), the next step is to determine the amount of 
the net increase in

[[Page 584]]

tax attributable to the adjustments referred to in paragraph (c)(1) of 
this section for:
    (i) The taxable year of the change,
    (ii) The consecutive taxable year or years immediately preceding the 
taxable year of the change for which the taxpayer can establish his 
taxable income under the new method of accounting, and
    (iii) Any taxable year preceding the taxable year of the change to 
which no adjustment is allocated under section 481(b)(2), but which is 
affected by a net operating loss or by a capital loss carryback or 
carryover determined with reference to taxable years with respect to 
which such adjustments are allocated.

The net increase in tax for the taxable years specified in subdivisions 
(i), (ii), and (iii) of this subparagraph shall be computed as if the 
amount of the adjustments for the prior taxable years to which properly 
allocable in accordance with section 481(b)(2) had been received or 
accrued, or paid or incurred, as the case may be, in such prior years 
and the balance of the adjustments in the taxable year of the change. 
The amount of tax attributable to such adjustments for the taxable years 
specified in subdivisions (i), (ii), and (iii) of this subparagraph is 
the aggregate of the differences (increases and decreases) between the 
tax for each such year computed by taking into account the allocable 
portion of the adjustments in computing taxable income and the tax 
computed without taking into account any portion of the adjustments in 
computing taxable income. Generally, where there is an increase in 
taxable income for a preceding consecutive taxable year established 
under the new method of accounting, computed without regard to 
adjustments attributable to any preceding taxable year, the amount of 
the adjustments to be allocated to each such year shall be an amount 
equal to such increase. However, where the amount of the adjustments to 
be allocated to a prior taxable year is less than the increase in 
taxable income for such year established under the new method of 
accounting, the amount of the increase in such taxable income for 
purposes of determining the increase in tax under section 481(b)(2) for 
such year shall be considered to be the amount so allocated. For 
example, if the amount of the adjustments required by section 481(a) for 
1958 (the taxable year of the change) is $60,000, and the increase in 
taxable income is determined by the taxpayer to be $40,000, $5,000, and 
$35,000, computed under the new method of accounting, for the taxable 
years 1957, 1956, and 1955, respectively, then the amount of the 
adjustments to be allocated to 1955 will be the balance of the 
adjustments, or $15,000.
    (4) The tax for the taxable year of the change shall be the tax for 
such year, computed without taking any of the adjustments referred to in 
paragraph (c)(1) of this section into account, increased by the smallest 
of the following amounts--
    (i) The amount of tax for the taxable year of the change 
attributable solely to taking into account the entire amount of the 
adjustments required by section 481(a) and Sec. 1.481-1;
    (ii) The sum of the increases in tax liability for the taxable year 
of the change and the two immediately preceding taxable years that would 
have resulted solely from taking into account one-third of the amount of 
such adjustments required for each of such years as though such amounts 
had been properly attributable to such years (computed in accordance 
with paragraph (c)(2) of this section); or
    (iii) The net increase in tax attributable to allocating such 
adjustments under the new method of accounting (computed in accordance 
with paragraph (c)(3) of this section).
    (5)(i) In the case of a change in method of accounting by a 
partnership, the adjustments required by section 481 shall be made with 
respect to the taxable income of the partnership but the limitations on 
tax under section 481(b) shall apply to the individual partners. Each 
partner shall take into account his distributive share of the 
partnership items, as so adjusted, for the taxable year of the change. 
Section 481(b) applies to a partner whose taxable income is so increased 
by more than $3,000 as a result of such adjustments to the partnership 
taxable income. It is not necessary for the partner to have been a 
member of the partnership for

[[Page 585]]

the two taxable years immediately preceding the taxable year of the 
change of the partnership's accounting method in order to have the 
limitation provided by section 481(b)(1) apply. Further, a partner may 
apply section 481(b)(2) even though he was not a member of the 
partnership for all the taxable years affected by the computation 
thereunder.
    (ii) In the case of a change in method of accounting by an electing 
small business corporation under subchapter S, chapter 1 of the Code, 
the adjustments required by section 481 shall be made with respect to 
the taxable income of such electing corporation in the year of the 
change, but the limitations on tax under section 481(b) shall apply to 
the individual shareholders. Section 481(b) applies to a shareholder of 
an electing small business corporation whose taxable income is so 
increased by more than $3,000 as a result of such adjustments to such 
corporation's taxable income. It is not necessary for the shareholder to 
have been a member of the electing small business corporation, or for 
such corporation to have been an electing small business corporation, 
for the two taxable years immediately preceding the taxable year of the 
change of the corporation's accounting method in order to have the 
limitation provided by section 481(b)(1) apply. Further, a shareholder 
may apply section 481(b)(2), even though he was not a shareholder, or 
the corporation was not an electing small business corporation, for all 
the taxable years affected by the computation thereunder.
    (6) For the purpose of the successive computations of the 
limitations on tax under section 481(b) (1) or (2), if the treatment of 
any item under the provisions of the Internal Revenue Code of 1986 (or 
corresponding provisions of prior internal revenue laws) depends upon 
the amount of gross income, adjusted gross income, or taxable income 
(for example, medical expenses, charitable contributions, or credits 
against the tax), such item shall be determined for the purpose of each 
such computation by taking into account the proper portion of the amount 
of any adjustments required to be taken into account under section 481 
in each such computation.
    (7) The increase or decrease in the tax for any taxable year for 
which an assessment of any deficiency, or a credit or refund of any 
overpayment, is prevented by any law or rule of law, shall be determined 
by reference to the tax previously determined (within the meaning 
section 1314(a) for such year.
    (8) In applying section 7807(b)(1), the provisions of chapter 1 
(other than subchapter E, relating to tax on self-employment income) and 
chapter 2 of the Internal Revenue Code of 1939 shall be treated as the 
corresponding provisions of the Internal Revenue Code of 1939.
    (d) Examples. The application of section 481(b) (1) and (2) may be 
illustrated by the following examples. Although the examples in this 
paragraph are based upon adjustments required in the case of a change in 
the over-all method of accounting, the principles illustrated would be 
equally applicable to adjustments required in the case of a change in 
method of accounting for a particular material item, provided the 
treatment of such adjustments is not specifically subject to some other 
provision of the Internal Revenue Code of 1986.

    Example (1). An unmarried individual taxpayer using the cash 
receipts and disbursements method of accounting for the calendar year is 
required by the Commissioner to change to an accrual method effective 
with the year 1958. As of January 1, 1958, he had an opening inventory 
of $11,000. On December 31, 1958, he had a closing inventory of $12,500. 
Merchandise purchases during the year amounted to $22,500, and net sales 
were $32,000. Total deductible business expenses were $5,000. There were 
no receivables or payables at January 1, 1958. The computation of 
taxable income for 1958, assuming no other adjustments, using the new 
method of accounting follows:

Net sales...........................................  ........   $32,000
Opening inventory...................................   $11,000
Purchases...........................................    22,500
                                                     -----------
   Total............................................    33,500
Less closing inventory..............................    12,500
                                                     -----------
Cost of goods sold..................................  ........    21,000
                                                               ---------
   Gross profit.....................................  ........    11,000
Business expenses...................................  ........     5,000
                                                               ---------
  Business income...................................  ........     6,000
Personal exemption and itemized deductions..........  ........     1,600
                                                               ---------

[[Page 586]]

 
   Taxable income...................................  ........     4,400
 


Under the cash receipts and disbursements method of accounting, only 
$9,000 of the $11,000 opening inventory had been included in the cost of 
goods sold and claimed as a deduction for the taxable years 1954 through 
1957; the remaining $2,000 had been so accounted for in pre-1954 years. 
In order to prevent the same item from reducing taxable income twice, an 
adjustment of $9,000 must be made to the taxable income of 1958 under 
the provisions of section 481(a) and Sec. 1.481-1. Since the change in 
method of accounting was not initiated by the taxpayer, the $2,000 of 
opening inventory which had been included in cost of goods sold in pre-
1954 years is not taken into account. Taxable income for 1958 is 
accordingly increased by $9,000 under section 481(a) to $13,400. 
Assuming that the tax on $13,400 is $4,002 and that the tax on $4,400 
(income without the adjustment) is $944, the increase in tax 
attributable to the adjustment, if taken into account for the taxable 
year of the change, would be the difference between the two, or $3,058. 
Since the adjustment required by section 481(a) and Sec. 1.481-1 
($9,000) increases taxable income by more than $3,000, the increase in 
tax for the taxable year 1958 attributable to the adjustment of $9,000 
(i.e., $3,058) may be limited under the provisions of section 481(b) (1) 
or (2). See examples (2) and (3).
    Example (2). Assume that the taxpayer in example (1) used the cash 
receipts and disbursements method of accounting in computing taxable 
income for the years 1956 and 1957 and that the taxable income for these 
years determined under such method was $4,000 and $6,000, respectively. 
The section 481(b)(1) limitation on tax with a pro rata three-year 
allocation of the $9,000 adjustment is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                     Increase in
                                                   Taxable      Taxable                Assumed tax       tax
                  Taxable year                      income    income with    Assume       before    attributable
                                                    before     adjustment   total tax   adjustment       to
                                                  adjustment                                         adjustment
----------------------------------------------------------------------------------------------------------------
1956...........................................       $4,000       $7,000      $1,660         $840          $820
1957...........................................        6,000        9,000       2,300        1,360           940
1958...........................................        4,400        7,400       1,780          944           836
                                                ----------------------------------------------------------------
   Total.......................................  ...........  ...........  ..........  ...........         2,596
----------------------------------------------------------------------------------------------------------------


Since this increase in tax of $2,596 is less than the increase in tax 
attributable to the inclusion of the entire adjustment in the income for 
the taxable year of the change ($3,058), the limitation provided by 
section 481(b)(1) applies, and the total tax for 1958, the taxable year 
of the change, if section 481(b)(2) does not apply, is determined as 
follows:

Tax without any portion of adjustment..........................     $944
Increase in tax attributable to adjustment computed under          2,596
 section 481(b)(1).............................................
                                                                --------
   Total tax for taxable year of the change....................    3,540
 

    Example (3). (i) Assume the same facts as in example (1) and, in 
addition, assume that the taxpayer used the cash receipts and 
disbursements method of accounting in computing taxable income for the 
years 1953 through 1957; that he established his taxable income under 
the new method for the taxable years 1953, 1954, and 1957, but did not 
have sufficient records to establish his taxable income under such 
method for the taxable years 1955 and 1956. The original taxable income 
and taxable income as redetermined are as follows:

------------------------------------------------------------------------
                                        Taxable income
                                 ----------------------------  Increase
                                    Determined                    or
          Taxable year              under cash   Established  (decrease)
                                   receipts and   under new   in taxable
                                  disbursements     method      income
                                      method
------------------------------------------------------------------------
1953............................        $5,000       $7,000       $2,000
1954............................         6,000        7,000        1,000
1955............................         5,500        (\1\)   ..........
1956............................         4,000        (\1\)   ..........
1957............................         6,000       10,000        4,000
------------------------------------------------------------------------
\1\ Undetermined.


As in examples (1) and (2), the total adjustment under section 481(a) is 
$9,000. Of the $9,000 adjustment, $4,000 may be allocated to 1957, which 
is the only year consecutively preceding the taxable year of the change 
for which the taxpayer was able to establish his income under the new 
method. Since the income cannot be established under the new method for 
1956 and 1955, no allocation may be made to 1954 or 1953, even though 
the taxpayer has established his income for those years under the new 
method of accounting. The balance of $5,000 ($9,000 minus $4,000) must 
be allocated to 1958.
    (ii) The limitation provided by section 481(b)(2) is computed as 
follows: The tax for 1957, based on taxable income of $6,000, is assumed 
to be $1,360. Under the new method,

[[Page 587]]

based on taxable income of $10,000, the tax for 1957 is assumed to be 
$2,640, the increase attributable to $4,000 of the $9,000 section 481(a) 
adjustment being $1,280, ($2,640 minus $1,360). The tax for 1958, 
computed on the basis of taxable income of $4,400 (determined under the 
new method), is assumed to be $944. The tax computed for 1958 on taxable 
income of $9,400 ($4,400 plus the $5,000 adjustment allocated to 1958) 
is assumed to be $2,436, leaving a difference of $1,492 ($2,436 minus 
$944) attributable to the inclusion in 1958 of the portion of the total 
adjustment to be taken into account which could not be properly 
allocated to the taxable year or years consecutively preceding 1958.
    (iii) The tax attributable to the adjustment is determined by 
selecting the smallest of the three following amounts:

Increase in tax attributable to adjustment computed under         $2,772
 section 481(b)(2) ($1,280+$1,492).............................
Increase in tax attributable to adjustment computed under          2,596
 section 481(b)(1) (example (2))...............................
Increase in tax if the entire adjustment is taken into account     3,058
 in the taxable year of the change (example (1))...............
 

    The final tax for 1958 is then $3,540 computed as follows:

Tax before inclusion of any adjustment.........................     $944
Increase in tax attributable to adjustments (smallest of           2,596
 $2,772, $2,596 or $3,058).....................................
                                                                --------
   Total tax for 1958 (limited in accordance with section          3,540
   481(b)(1))..................................................
 

    Example (4). Assume that X Corporation has maintained its books of 
account and filed its income tax returns using the cash receipts and 
disbursements method of accounting for the years 1953 through 1957. The 
corporation secures permission to change to an accrual method of 
accounting for the calendar year 1958. The following tabulation presents 
the data with respect to the taxpayer's income for the years involved:

----------------------------------------------------------------------------------------------------------------
                                                 Taxable income under the
                                                     cash receipts and
                                                   disbursements method      Taxable                  Changes in
                                                --------------------------    income     Increase or    taxable
                                                    Before       After     established   (decrease)   income due
                      Year                       application  application     under     attributable  to changes
                                                    of net       of net      accrual      to change     in net
                                                  operating    operating      method                     loss
                                                     loss         loss                                 carryback
                                                  carryback    carryback
----------------------------------------------------------------------------------------------------------------
1953...........................................       $2,000            0        (\1\)  ............      $2,000
1954...........................................        4,000       $1,000        (\1\)  ............       3,000
1955...........................................      (5,000)  ...........       $1,000       $6,000   ..........
1956...........................................       80,000       80,000       77,000      (3,000)   ..........
1957...........................................       90,000       90,000       96,000        6,000   ..........
1958...........................................  ...........  ...........      100,000  ............  ..........
----------------------------------------------------------------------------------------------------------------
\1\ Not established.


As indicated above, taxable income for 1953 and 1954, as determined 
under the cash receipts and disbursements method of accounting, was 
$2,000 and $4,000, respectively, and after application of the net 
operating loss carryback from 1955, the taxable income was reduced to 
zero in 1953 and to $1,000 in 1954. The taxpayer was unable to establish 
taxable income for these years under an accrual method of accounting; 
however, under section 481(b)(3)(A), increases or decreases in the tax 
for taxable years to which no adjustment is allocated must, 
nevertheless, be taken into account to the extent the tax for such years 
would be affected by a net operating loss determined with reference to 
taxable years to which adjustments are allocated. The total amount of 
the adjustments required under section 481(a) and attributable to the 
taxable years 1953 through 1957 in this example is assumed to be 
$10,000. The redetermination of taxable income established by the 
taxpayer for the taxable years 1955, 1956, and 1957 appears under the 
heading ``Taxable income established under accrual method'' in the above 
tabulation. The tabulation assumes that the taxpayer has been able to 
recompute the income for those years so as to establish a net adjustment 
of $9,000, which leaves a balance of $1,000 unaccounted for. In 
accordance with the requirements of section 481(b)(2), the $1,000 amount 
is allocated to 1958, the taxable year of the change. The following 
computations are necessary in order to determine the tax attributable to 
the adjustments under section 481(a):

 Increase in tax attributable to inclusion in 1958 of the entire $10,000
                               adjustment
Tax on income of 1958 increased by entire amount of adjustment   $51,700
 ($100,000+$10,000)...........................................
Tax on income of 1958 without adjustment ($100,000)...........    46,500
                                                               ---------
Increase in tax attributable to inclusion of entire adjustment     5,200
 in year of the change........................................
 


[[Page 588]]


                    Increase in tax attributed to adjustment computed under section 481(b)(1)
----------------------------------------------------------------------------------------------------------------
                                                                                                     Increase in
                                                                                                         tax
                                                                 Amount of  Tax before   Tax after    liability
                             Year                               adjustment  adjustment  adjustment  attributable
                                                                                                         to
                                                                                                     adjustment
----------------------------------------------------------------------------------------------------------------
1958..........................................................      $3,334     $46,500     $48,234       $1,734
1957..........................................................       3,333      41,300      43,033        1,733
1956..........................................................       3,333      36,100      37,833        1,733
                                                                                                   -------------
  Increase in tax attributable to adjustment computed under     ..........  ..........  ..........        5,200
   section 481(b)(1)..........................................
----------------------------------------------------------------------------------------------------------------
                    Increase in tax attributed to adjustment computed under section 481(b)(2)
----------------------------------------------------------------------------------------------------------------
1953..........................................................  \1\ $2,000           0    \1\ $600         $600
1954..........................................................   \1\ 3,000        $300    \1\1,200          900
1955..........................................................       6,000           0         300          300
1956..........................................................     (3,000)      36,100      34,540      (1,560)
1957..........................................................      96,000      41,300      44,420        3,120
1958..........................................................   \2\ 1,000      46,500  \2\ 47,020          520
                                                                                                   -------------
  Increase in tax attributable to the adjustment computed       ..........  ..........  ..........        3,880
   under section 481(b)(2)....................................
----------------------------------------------------------------------------------------------------------------
\1\ Attributable to recomputations of net operating loss carrybacks determined with reference to net operating
  loss in 1955.
\2\ Attributable to the inclusion of $1,000 in the year of the change which represents the portion of the
  $10,000 adjustment not allocated to taxable years prior to the year of the change for which taxable income is
  established under the new method.

Since the limitation under section 481(b)(2) ($3,880) on the amount of 
tax attributable to the adjustments is applicable, the final tax for the 
taxable year of the change is computed by adding such amount to the tax 
for that year computed without the inclusion of any amount attributable 
to the adjustments, that is, $46,500 plus $3,880, or $50,380.

[T.D. 6500, 25 FR 11732, Nov. 26, 1960, as amended by T.D. 6490, 25 FR 
8374, Sept. 1, 1960; T.D. 7301, 39 FR 963, Jan. 4, 1974; T.D. 8608, 60 
FR 40078, Aug. 7, 1995]



Sec. 1.481-3  Adjustments attributable to pre-1954 years where change 
was not initiated by taxpayer.

    If the adjustments required by section 481(a) and Sec. 1.481-1 are 
attributable to a change in method of accounting which was not initiated 
by the taxpayer, no portion of any adjustments which is attributable to 
pre-1954 years shall be taken into account in computing taxable income. 
For example, if the total adjustments in the case of a change in method 
of accounting which is not initiated by the taxpayer amount to $10,000, 
of which $4,000 is attributable to pre-1954 years, only $6,000 of the 
$10,000 total adjustments is required to be taken into account under 
section 481 in computing taxable income. The portion of the adjustments 
which is attributable to pre-1954 years is the net amount of the 
adjustments which would have been required if the taxpayer had changed 
his method of accounting in his first taxable year which began after 
December 31, 1953, and ended after August 16, 1954.

[T.D. 6500, 25 FR 11735, Nov. 26, 1960, as amended by T.D. 8608, 60 FR 
40079, Aug. 7, 1995]



Sec. 1.481-4  Adjustments taken into account with consent.

    (a) In addition to the terms and conditions prescribed by the 
Commissioner under Sec. 1.446-1(e)(3) for effecting a change in method 
of accounting, including the taxable year or years in which the amount 
of the adjustments required by section 481(a) is to be taken into 
account, or the methods of allocation described in section 481(b), a 
taxpayer may request approval of an alternative method of allocating the 
amount of the adjustments under section 481. See section 481(c). 
Requests for approval of an alternative method of allocation shall set 
forth in detail the facts and circumstances upon which the taxpayer 
bases its request. Permission will be granted only if the taxpayer and 
the Commissioner agree to the terms and conditions under which the 
allocation is to be effected. See Sec. 1.446-1(e) for the rules 
regarding how to secure the Commissioner's consent to a change in method 
of accounting.

[[Page 589]]

    (b) An agreement to the terms and conditions of a change in method 
of accounting under Sec. 1.446-1(e)(3), including the taxable year or 
years prescribed by the Commissioner under that section (or an 
alternative method described in paragraph (a) of this section) for 
taking the amount of the adjustments under section 481(a) into account, 
shall be in writing and shall be signed by the Commissioner and the 
taxpayer. It shall set forth the items to be adjusted, the amount of the 
adjustments, the taxable year or years for which the adjustments are to 
be taken into account, and the amount of the adjustments allocable to 
each year. The agreement shall be binding on the parties except upon a 
showing of fraud, malfeasance, or misrepresentation of material fact.

[T.D. 8608, 60 FR 40079, Aug. 7, 1995]



Sec. 1.481-5  Effective dates.

    Sections 1.481-1, 1.481-2, 1.481-3, and 1.481-4 are effective for 
Consent Agreements signed on or after December 27, 1994. For Consent 
Agreements signed before December 27, 1994, see Sec. Sec. 1.481-1, 
1.481-2, 1.481-3, 1.481-4, and 1.481-5 (as contained in the 26 CFR part 
1 edition revised as of April 1, 1995).

[T.D. 8608, 60 FR 40079, Aug. 7, 1995]



Sec. 1.482-0  Outline of regulations under 482.

    This section contains major captions for Sec. Sec. 1.482-1 through 
1.482-8.

   Sec. 1.482-1 Allocation of income and deductions among taxpayers.

    (a) In general.
    (1) Purpose and scope.
    (2) Authority to make allocations.
    (3) Taxpayer's use of section 482.
    (b) Arm's length standard.
    (1) In general.
    (2) Arm's length methods.
    (i) Methods.
    (ii) Selection of category of method applicable to transaction.
    (c) Best method rule.
    (1) In general.
    (2) Determining the best method.
    (i) Comparability.
    (ii) Data and assumptions.
    (A) Completeness and accuracy of data.
    (B) Reliability of assumptions.
    (C) Sensitivity of results to deficiencies in data and assumptions.
    (iii) Confirmation of results by another method.
    (d) Comparability.
    (1) In general.
    (2) Standard of comparability.
    (3) Factors for determining comparability.
    (i) Functional analysis.
    (ii) Contractual terms.
    (A) In general.
    (B) Identifying contractual terms.
    (1) Written agreement.
    (2) No written agreement.
    (C) Examples.
    (iii) Risk.
    (A) In general.
    (B) Identification of party that bears risk.
    (C) Examples.
    (iv) Economic conditions.
    (v) Property or services.
    (4) Special circumstances.
    (i) Market share strategy.
    (ii) Different geographic markets.
    (A) In general.
    (B) Example.
    (C) Location savings.
    (D) Example.
    (iii) Transactions ordinarily not accepted as comparables.
    (A) In general.
    (B) Examples.
    (e) Arm's length range.
    (1) In general.
    (2) Determination of arm's length range.
    (i) Single method.
    (ii) Selection of comparables.
    (iii) Comparables included in arm's length range.
    (A) In general.
    (B) Adjustment of range to increase reliability.
    (C) Interquartile range.
    (3) Adjustment if taxpayer's results are outside arm's length range.
    (4) Arm's length range not prerequisite to allocation.
    (5) Examples.
    (f) Scope of review.
    (1) In general.
    (i) Intent to evade or avoid tax not a prerequisite.
    (ii) Realization of income not a prerequisite.
    (A) In general.
    (B) Example.
    (iii) Nonrecognition provisions may not bar allocation.
    (A) In general.
    (B) Example.
    (iv) Consolidated returns.
    (2) Rules relating to determination of true taxable income.
    (i) Aggregation of transactions.
    (A) In general.
    (B) Examples.
    (ii) Allocation based on taxpayer's actual transactions.
    (A) In general.

[[Page 590]]

    (B) Example.
    (iii) Multiple year data.
    (A) In general.
    (B) Circumstances warranting consideration of multiple year data.
    (C) Comparable effect over comparable period.
    (D) Applications of methods using multiple year averages.
    (E) Examples.
    (iv) Product lines and statistical techniques.
    (v) Allocations apply to results, not methods.
    (A) In general.
    (B) Example.
    (g) Collateral adjustments with respect to allocations under section 
482.
    (1) In general.
    (2) Correlative allocations.
    (i) In general.
    (ii) Manner of carrying out correlative allocation.
    (iii) Events triggering correlative allocation.
    (iv) Examples.
    (3) Adjustments to conform accounts to reflect section 482 
allocations.
    (i) In general.
    (ii) Example.
    (4) Setoffs.
    (i) In general.
    (ii) Requirements.
    (iii) Examples.
    (h) Special rules.
    (1) Small taxpayer safe harbor. [Reserved]
    (2) Effect of foreign legal restrictions.
    (i) In general.
    (ii) Applicable legal restrictions.
    (iii) Requirement for electing the deferred income method of 
accounting.
    (iv) Deferred income method of accounting.
    (v) Examples.
    (3) Coordination with section 936.
    (i) Cost sharing under section 936.
    (ii) Use of terms.
    (i) Definitions.
    (j) Effective dates.

  Sec. 1.482-2 Determination of taxable income in specific situations.

    (a) Loans or advances.
    (1) Interest on bona fide indebtedness.
    (i) In general.
    (ii) Application of paragraph (a) of this section.
    (A) Interest on bona fide indebtedness.
    (B) Alleged indebtedness.
    (iii) Period for which interest shall be charged.
    (A) General rule.
    (B) Exception for certain intercompany transactions in the ordinary 
course of business.
    (C) Exception for trade or business of debtor member located outside 
the United States.
    (D) Exception for regular trade practice of creditor member or 
others in creditor's industry.
    (E) Exception for property purchased for resale in a foreign 
country.
    (1) General rule.
    (2) Interest-free period.
    (3) Average collection period.
    (4) Illustration.
    (iv) Payment; book entries.
    (2) Arm's length interest rate.
    (i) In general.
    (ii) Funds obtained at situs of borrower.
    (iii) Safe haven interest rates for certain loans and advances made 
after May 8, 1986.
    (A) Applicability.
    (1) General rule.
    (2) Grandfather rule for existing loans.
    (B) Safe haven interest rate based on applicable Federal rate.
    (C) Applicable Federal rate.
    (D) Lender in business of making loans.
    (E) Foreign currency loans.
    (3) Coordination with interest adjustments required under certain 
other Internal Revenue Code sections.
    (4) Examples.
    (b) Performance of services for another.
    (1) General rule.
    (2) Benefit test.
    (3) Arm's length charge.
    (4) Costs or deductions to be taken into account.
    (5) Costs and deductions not to be taken into account.
    (6) Methods.
    (7) Certain services.
    (8) Services rendered in connection with the transfer of property.
    (c) Use of tangible property.
    (1) General rule.
    (2) Arm's length charge.
    (i) In general.
    (ii) Safe haven rental charge.
    (iii) Subleases.
    (d) Transfer of property.

 Sec. 1.482-3 Methods to determine taxable income in connection with a 
                     transfer of tangible property.

    (a) In general.
    (b) Comparable uncontrolled price method.
    (1) In general.
    (2) Comparability and reliability considerations.
    (i) In general.
    (ii) Comparability.
    (A) In general.
    (B) Adjustments for differences between controlled and uncontrolled 
transactions.
    (iii) Data and assumptions.
    (3) Arm's length range.
    (4) Examples.
    (5) Indirect evidence of comparable uncontrolled transactions.
    (i) In general.
    (ii) Limitations.

[[Page 591]]

    (iii) Examples.
    (c) Resale price method.
    (1) In general.
    (2) Determination of arm's length price.
    (i) In general.
    (ii) Applicable resale price.
    (iii) Appropriate gross profit.
    (iv) Arm's length range.
    (3) Comparability and reliability considerations.
    (i) In general.
    (ii) Comparability.
    (A) Functional comparability.
    (B) Other comparability factors.
    (C) Adjustments for differences between controlled and uncontrolled 
transactions.
    (D) Sales agent.
    (iii) Data and assumptions.
    (A) In general.
    (B) Consistency in accounting.
    (4) Examples.
    (d) Cost plus method.
    (1) In general.
    (2) Determination of arm's length price.
    (i) In general.
    (ii) Appropriate gross profit.
    (iii) Arm's length range.
    (3) Comparability and reliability considerations.
    (i) In general.
    (ii) Comparability.
    (A) Functional comparability.
    (B) Other comparability factors.
    (C) Adjustments for differences between controlled and uncontrolled 
transactions.
    (D) Purchasing agent.
    (iii) Data and assumptions.
    (A) In general.
    (B) Consistency in accounting.
    (4) Examples.
    (e) Unspecified methods.
    (1) In general.
    (2) Example.
    (f) Coordination with intangible property rules.

 Sec. 1.482-4 Methods to determine taxable income in connection with a 
                    transfer of intangible property.

    (a) In general.
    (b) Definition of intangible.
    (c) Comparable uncontrolled transaction method.
    (1) In general.
    (2) Comparability and reliability considerations.
    (i) In general.
    (ii) Reliability.
    (iii) Comparability.
    (A) In general.
    (B) Factors to be considered in determining comparability.
    (1) Comparable intangible property.
    (2) Comparable circumstances.
    (iv) Data and assumptions.
    (3) Arm's length range.
    (4) Examples.
    (d) Unspecified methods.
    (1) In general.
    (2) Example.
    (e) Coordination with tangible property rules.
    (f) Special rules for transfers of intangible property.
    (1) Form of consideration.
    (2) Periodic adjustments.
    (i) General rule.
    (ii) Exceptions.
    (A) Transactions involving the same intangible.
    (B) Transactions involving comparable intangible.
    (C) Methods other than comparable uncontrolled transaction.
    (D) Extraordinary events.
    (E) Five-year period.
    (iii) Examples.
    (3) Ownership of intangible property.
    (i) In general.
    (ii) Identification of the owner.
    (A) Legally protected intangible property.
    (B) Intangible property that is not legally protected.
    (iii) Allocations with respect to assistance provided to the owner.
    (iv) Examples.
    (4) Consideration not artificially limited.
    (5) Lump sum payments.
    (i) In general.
    (ii) Exceptions.
    (iii) Example.

                Sec. 1.482-5 Comparable profits method.

    (a) In general.
    (b) Determination of arm's length result.
    (1) In general.
    (2) Tested party.
    (i) In general.
    (ii) Adjustments for tested party.
    (3) Arm's length range.
    (4) Profit level indicators.
    (i) Rate of return on capital employed.
    (ii) Financial ratios.
    (iii) Other profit level indicators.
    (c) Comparability and reliability considerations.
    (1) In general.
    (2) Comparability.
    (i) In general.
    (ii) Functional, risk and resource comparability.
    (iii) Other comparability factors.
    (iv) Adjustments for differences between tested party and the 
uncontrolled taxpayers.
    (3) Data and assumptions.
    (i) In general.
    (ii) Consistency in accounting.
    (iii) Allocations between the relevant business activity and other 
activities.
    (d) Definitions.
    (e) Examples.

                   Sec. 1.482-6 Profit split method.

    (a) In general.

[[Page 592]]

    (b) Appropriate share of profits and losses.
    (c) Application.
    (1) In general.
    (2) Comparable profit split.
    (i) In general.
    (ii) Comparability and reliability considerations.
    (A) In general.
    (B) Comparability.
    (1) In general.
    (2) Adjustments for differences between the controlled and 
uncontrolled taxpayers.
    (C) Data and assumptions.
    (D) Other factors affecting reliability.
    (3) Residual profit split.
    (i) In general.
    (A) Allocate income to routine contributions.
    (B) Allocate residual profit.
    (ii) Comparability and reliability considerations.
    (A) In general.
    (B) Comparability.
    (C) Data and assumptions.
    (D) Other factors affecting reliability.
    (iii) Example.

                     Sec. 1.482-7 Sharing of costs.

    (a) In general.
    (1) Scope and application of the rules in this section.
    (2) Limitation on allocations.
    (3) Coordination with Sec. 1.482-1.
    (4) Cross references.
    (b) Qualified cost sharing arrangement.
    (c) Participant.
    (1) In general.
    (2) Treatment of a controlled taxpayer that is not a controlled 
participant.
    (i) In general.
    (ii) Example.
    (3) Treatment of consolidated group.
    (d) Costs.
    (1) Intangible development costs.
    (2) Stock-based compensation.
    (i) In general.
    (ii) Identification of stock-based compensation related to 
intangible development.
    (iii) Measurement and timing of stock-based compensation expense.
    (A) In general.
    (1) Transfers to which section 421 applies.
    (2) Deductions of foreign controlled participants.
    (3) Modification of stock option.
    (4) Expiration or termination of qualified cost sharing arrangement.
    (B) Election with respect to options on publicly traded stock.
    (1) In general.
    (2) Publicly traded stock.
    (3) Generally accepted accounting principles.
    (4) Time and manner of making the election.
    (C) Consistency.
    (3) Examples.
    (e) Anticipated benefits.
    (1) Benefits.
    (2) Reasonably anticipated benefits.
    (f) Cost allocations.
    (1) In general.
    (2) Share of intangible development costs.
    (i) In general.
    (ii) Example.
    (3) Share of reasonably anticipated benefits.
    (i) In general.
    (ii) Measure of benefits.
    (iii) Indirect bases for measuring anticipated benefits.
    (A) Units used, produced or sold.
    (B) Sales.
    (C) Operating profit.
    (D) Other bases for measuring anticipated benefits.
    (E) Examples.
    (iv) Projections used to estimate anticipated benefits.
    (A) In general.
    (B) Unreliable projections.
    (C) Foreign-to-foreign adjustments.
    (D) Examples.
    (4) Timing of allocations.
    (g) Allocations of income, deductions or other tax items to reflect 
transfers of intangibles (buy-in).
    (1) In general.
    (2) Pre-existing intangibles.
    (3) New controlled participant.
    (4) Controlled participant relinquishes interests.
    (5) Conduct inconsistent with the terms of a cost sharing 
arrangement.
    (6)Failure to assign interests under a qualified cost sharing 
arrangement.
    (7) Form of consideration.
    (i) Lump sum payments.
    (ii) Installment payments.
    (iii) Royalties.
    (8) Examples.
    (h) Character of payments made pursuant to a qualified cost sharing 
arrangement.
    (1) In general.
    (2) Examples.
    (i) Accounting requirements.
    (j) Administrative requirements.
    (1) In general.
    (2) Documentation.
    (i) Requirements.
    (ii) Coordination with penalty regulation.
    (3) Reporting requirements.
    (k) Effective date.
    (l) Transition rule.

             Sec. 1.482-8 Examples of the best method rule.

    (a) In general.
    (b) Examples.

[T.D. 8552, 59 FR 34988, July 8, 1994, as amended by T.D. 8632, 60 FR 
65557, Dec. 20, 1995; 61 FR 7157, Feb. 26, 1996; T.D. 8670, 61 FR 21956, 
May 13, 1996; T.D. 9088, 68 FR 51177, Aug. 26, 2003]

[[Page 593]]



Sec. 1.482-1  Allocation of income and deductions among taxpayers.

    (a) In general--(1) Purpose and scope. The purpose of section 482 is 
to ensure that taxpayers clearly reflect income attributable to 
controlled transactions, and to prevent the avoidance of taxes with 
respect to such transactions. Section 482 places a controlled taxpayer 
on a tax parity with an uncontrolled taxpayer by determining the true 
taxable income of the controlled taxpayer. This Sec. 1.482-1 sets forth 
general principles and guidelines to be followed under section 482. 
Section 1.482-2 provides rules for the determination of the true taxable 
income of controlled taxpayers in specific situations, including 
controlled transactions involving loans or advances, services, and 
property. Sections 1.482-3 through 1.482-6 elaborate on the rules that 
apply to controlled transactions involving property. Section 1.482-7T 
sets forth the cost sharing provisions applicable to taxable years 
beginning on or after October 6, 1994, and before January 1, 1996. 
Section 1.482-7 sets forth the cost sharing provisions applicable to 
taxable years beginning on or after January 1, 1996. Finally, Sec. 
1.482-8 provides examples illustrating the application of the best 
method rule.
    (2) Authority to make allocations. The district director may make 
allocations between or among the members of a controlled group if a 
controlled taxpayer has not reported its true taxable income. In such 
case, the district director may allocate income, deductions, credits, 
allowances, basis, or any other item or element affecting taxable income 
(referred to as allocations). The appropriate allocation may take the 
form of an increase or decrease in any relevant amount.
    (3) Taxpayer's use of section 482. If necessary to reflect an arm's 
length result, a controlled taxpayer may report on a timely filed U.S. 
income tax return (including extensions) the results of its controlled 
transactions based upon prices different from those actually charged. 
Except as provided in this paragraph, section 482 grants no other right 
to a controlled taxpayer to apply the provisions of section 482 at will 
or to compel the district director to apply such provisions. Therefore, 
no untimely or amended returns will be permitted to decrease taxable 
income based on allocations or other adjustments with respect to 
controlled transactions. See Sec. 1.6662-6T(a)(2) or successor 
regulations.
    (b) Arm's length standard--(1) In general. In determining the true 
taxable income of a controlled taxpayer, the standard to be applied in 
every case is that of a taxpayer dealing at arm's length with an 
uncontrolled taxpayer. A controlled transaction meets the arm's length 
standard if the results of the transaction are consistent with the 
results that would have been realized if uncontrolled taxpayers had 
engaged in the same transaction under the same circumstances (arm's 
length result). However, because identical transactions can rarely be 
located, whether a transaction produces an arm's length result generally 
will be determined by reference to the results of comparable 
transactions under comparable circumstances. See Sec. 1.482-1(d)(2) 
(Standard of comparability). Evaluation of whether a controlled 
transaction produces an arm's length result is made pursuant to a method 
selected under the best method rule described in Sec. 1.482-1(c).
    (2) Arm's length methods--(i) Methods. Sections 1.482-2 through 
1.482-6 provide specific methods to be used to evaluate whether 
transactions between or among members of the controlled group satisfy 
the arm's length standard, and if they do not, to determine the arm's 
length result. Section 1.482-7 provides the specific method to be used 
to evaluate whether a qualified cost sharing arrangement produces 
results consistent with an arm's length result.
    (ii) Selection of category of method applicable to transaction. The 
methods listed in Sec. 1.482-2 apply to different types of 
transactions, such as transfers of property, services, loans or 
advances, and rentals. Accordingly, the method or methods most 
appropriate to the calculation of arm's length results for controlled 
transactions must be selected, and different methods may be applied to 
interrelated transactions if such transactions are most reliably 
evaluated on a separate basis. For example, if services are provided in 
connection with the transfer of property,

[[Page 594]]

it may be appropriate to separately apply the methods applicable to 
services and property in order to determine an arm's length result. But 
see Sec. 1.482-1(f)(2)(i) (Aggregation of transactions). In addition, 
other applicable provisions of the Code may affect the characterization 
of a transaction, and therefore affect the methods applicable under 
section 482. See for example section 467.
    (c) Best method rule--(1) In general. The arm's length result of a 
controlled transaction must be determined under the method that, under 
the facts and circumstances, provides the most reliable measure of an 
arm's length result. Thus, there is no strict priority of methods, and 
no method will invariably be considered to be more reliable than others. 
An arm's length result may be determined under any method without 
establishing the inapplicability of another method, but if another 
method subsequently is shown to produce a more reliable measure of an 
arm's length result, such other method must be used. Similarly, if two 
or more applications of a single method provide inconsistent results, 
the arm's length result must be determined under the application that, 
under the facts and circumstances, provides the most reliable measure of 
an arm's length result. See Sec. 1.482-8 for examples of the 
application of the best method rule. See Sec. 1.482-7 for the 
applicable method in the case of a qualified cost sharing arrangement.
    (2) Determining the best method. Data based on the results of 
transactions between unrelated parties provides the most objective basis 
for determining whether the results of a controlled transaction are 
arm's length. Thus, in determining which of two or more available 
methods (or applications of a single method) provides the most reliable 
measure of an arm's length result, the two primary factors to take into 
account are the degree of comparability between the controlled 
transaction (or taxpayer) and any uncontrolled comparables, and the 
quality of the data and assumptions used in the analysis. In addition, 
in certain circumstances, it also may be relevant to consider whether 
the results of an analysis are consistent with the results of an 
analysis under another method. These factors are explained in paragraphs 
(c)(2)(i), (ii), and (iii) of this section.
    (i) Comparability. The relative reliability of a method based on the 
results of transactions between unrelated parties depends on the degree 
of comparability between the controlled transaction or taxpayers and the 
uncontrolled comparables, taking into account the factors described in 
Sec. 1.482-1(d)(3) (Factors for determining comparability), and after 
making adjustments for differences, as described in Sec. 1.482-1(d)(2) 
(Standard of comparability). As the degree of comparability increases, 
the number and extent of potential differences that could render the 
analysis inaccurate is reduced. In addition, if adjustments are made to 
increase the degree of comparability, the number, magnitude, and 
reliability of those adjustments will affect the reliability of the 
results of the analysis. Thus, an analysis under the comparable 
uncontrolled price method will generally be more reliable than analyses 
obtained under other methods if the analysis is based on closely 
comparable uncontrolled transactions, because such an analysis can be 
expected to achieve a higher degree of comparability and be susceptible 
to fewer differences than analyses under other methods. See Sec. 1.482-
3(b)(2)(ii)(A). An analysis will be relatively less reliable, however, 
as the uncontrolled transactions become less comparable to the 
controlled transaction.
    (ii) Data and assumptions. Whether a method provides the most 
reliable measure of an arm's length result also depends upon the 
completeness and accuracy of the underlying data, the reliability of the 
assumptions, and the sensitivity of the results to possible deficiencies 
in the data and assumptions. Such factors are particularly relevant in 
evaluating the degree of comparability between the controlled and 
uncontrolled transactions. These factors are discussed in paragraphs 
(c)(2)(ii) (A), (B), and (C) of this section.
    (A) Completeness and accuracy of data. The completeness and accuracy 
of the data affects the ability to identify and quantify those factors 
that would affect the result under any particular

[[Page 595]]

method. For example, the completeness and accuracy of data will 
determine the extent to which it is possible to identify differences 
between the controlled and uncontrolled transactions, and the 
reliability of adjustments that are made to account for such 
differences. An analysis will be relatively more reliable as the 
completeness and accuracy of the data increases.
    (B) Reliability of assumptions. All methods rely on certain 
assumptions. The reliability of the results derived from a method 
depends on the soundness of such assumptions. Some assumptions are 
relatively reliable. For example, adjustments for differences in payment 
terms between controlled and uncontrolled transactions may be based on 
the assumption that at arm's length such differences would lead to price 
differences that reflect the time value of money. Although selection of 
the appropriate interest rate to use in making such adjustments involves 
some judgement, the economic analysis on which the assumption is based 
is relatively sound. Other assumptions may be less reliable. For 
example, the residual profit split method may be based on the assumption 
that capitalized intangible development expenses reflect the relative 
value of the intangible property contributed by each party. Because the 
costs of developing an intangible may not be related to its market 
value, the soundness of this assumption will affect the reliability of 
the results derived from this method.
    (C) Sensitivity of results to deficiencies in data and assumptions. 
Deficiencies in the data used or assumptions made may have a greater 
effect on some methods than others. In particular, the reliability of 
some methods is heavily dependent on the similarity of property or 
services involved in the controlled and uncontrolled transaction. For 
certain other methods, such as the resale price method, the analysis of 
the extent to which controlled and uncontrolled taxpayers undertake the 
same or similar functions, employ similar resources, and bear similar 
risks is particularly important. Finally, under other methods, such as 
the profit split method, defining the relevant business activity and 
appropriate allocation of costs, income, and assets may be of particular 
importance. Therefore, a difference between the controlled and 
uncontrolled transactions for which an accurate adjustment cannot be 
made may have a greater effect on the reliability of the results derived 
under one method than the results derived under another method. For 
example, differences in management efficiency may have a greater effect 
on a comparable profits method analysis than on a comparable 
uncontrolled price method analysis, while differences in product 
characteristics will ordinarily have a greater effect on a comparable 
uncontrolled price method analysis than on a comparable profits method 
analysis.
    (iii) Confirmation of results by another method. If two or more 
methods produce inconsistent results, the best method rule will be 
applied to select the method that provides the most reliable measure of 
an arm's length result. If the best method rule does not clearly 
indicate which method should be selected, an additional factor that may 
be taken into account in selecting a method is whether any of the 
competing methods produce results that are consistent with the results 
obtained from the appropriate application of another method. Further, in 
evaluating different applications of the same method, the fact that a 
second method (or another application of the first method) produces 
results that are consistent with one of the competing applications may 
be taken into account.
    (d) Comparability--(1) In general. Whether a controlled transaction 
produces an arm's length result is generally evaluated by comparing the 
results of that transaction to results realized by uncontrolled 
taxpayers engaged in comparable transactions under comparable 
circumstances. For this purpose, the comparability of transactions and 
circumstances must be evaluated considering all factors that could 
affect prices or profits in arm's length dealings (comparability 
factors). While a specific comparability factor may be of particular 
importance in applying a method, each method requires analysis of all of 
the factors that affect comparability under that method. Such factors 
include the following--

[[Page 596]]

    (i) Functions;
    (ii) Contractual terms;
    (iii) Risks;
    (iv) Economic conditions; and
    (v) Property or services.
    (2) Standard of comparability. In order to be considered comparable 
to a controlled transaction, an uncontrolled transaction need not be 
identical to the controlled transaction, but must be sufficiently 
similar that it provides a reliable measure of an arm's length result. 
If there are material differences between the controlled and 
uncontrolled transactions, adjustments must be made if the effect of 
such differences on prices or profits can be ascertained with sufficient 
accuracy to improve the reliability of the results. For purposes of this 
section, a material difference is one that would materially affect the 
measure of an arm's length result under the method being applied. If 
adjustments for material differences cannot be made, the uncontrolled 
transaction may be used as a measure of an arm's length result, but the 
reliability of the analysis will be reduced. Generally, such adjustments 
must be made to the results of the uncontrolled comparable and must be 
based on commercial practices, economic principles, or statistical 
analyses. The extent and reliability of any adjustments will affect the 
relative reliability of the analysis. See Sec. 1.482-1(c)(1) (Best 
method rule). In any event, unadjusted industry average returns 
themselves cannot establish arm's length results.
    (3) Factors for determining comparability. The comparability factors 
listed in Sec. 1.482-1(d)(1) are discussed in this section. Each of 
these factors must be considered in determining the degree of 
comparability between transactions or taxpayers and the extent to which 
comparability adjustments may be necessary. In addition, in certain 
cases involving special circumstances, the rules under paragraph (d)(4) 
of this section must be considered.
    (i) Functional analysis. Determining the degree of comparability 
between controlled and uncontrolled transactions requires a comparison 
of the functions performed, and associated resources employed, by the 
taxpayers in each transaction. This comparison is based on a functional 
analysis that identifies and compares the economically significant 
activities undertaken, or to be undertaken, by the taxpayers in both 
controlled and uncontrolled transactions. A functional analysis should 
also include consideration of the resources that are employed, or to be 
employed, in conjunction with the activities undertaken, including 
consideration of the type of assets used, such as plant and equipment, 
or the use of valuable intangibles. A functional analysis is not a 
pricing method and does not itself determine the arm's length result for 
the controlled transaction under review. Functions that may need to be 
accounted for in determining the comparability of two transactions 
include--
    (A) Research and development;
    (B) Product design and engineering;
    (C) Manufacturing, production and process engineering;
    (D) Product fabrication, extraction, and assembly;
    (E) Purchasing and materials management;
    (F) Marketing and distribution functions, including inventory 
management, warranty administration, and advertising activities;
    (G) Transportation and warehousing; and
    (H) Managerial, legal, accounting and finance, credit and 
collection, training, and personnel management services.
    (ii) Contractual terms--(A) In general. Determining the degree of 
comparability between the controlled and uncontrolled transactions 
requires a comparison of the significant contractual terms that could 
affect the results of the two transactions. These terms include--
    (1) The form of consideration charged or paid;
    (2) Sales or purchase volume;
    (3) The scope and terms of warranties provided;
    (4) Rights to updates, revisions or modifications;
    (5) The duration of relevant license, contract or other agreements, 
and termination or renegotiation rights;
    (6) Collateral transactions or ongoing business relationships 
between the buyer and the seller, including arrangements for the 
provision of ancillary or subsidiary services; and

[[Page 597]]

    (7) Extension of credit and payment terms. Thus, for example, if the 
time for payment of the amount charged in a controlled transaction 
differs from the time for payment of the amount charged in an 
uncontrolled transaction, an adjustment to reflect the difference in 
payment terms should be made if such difference would have a material 
effect on price. Such comparability adjustment is required even if no 
interest would be allocated or imputed under Sec. 1.482-2(a) or other 
applicable provisions of the Internal Revenue Code or regulations.
    (B) Identifying contractual terms--(1) Written agreement. The 
contractual terms, including the consequent allocation of risks, that 
are agreed to in writing before the transactions are entered into will 
be respected if such terms are consistent with the economic substance of 
the underlying transactions. In evaluating economic substance, greatest 
weight will be given to the actual conduct of the parties, and the 
respective legal rights of the parties (see, for example, Sec. 1.482-
4(f)(3) (Ownership of intangible property)). If the contractual terms 
are inconsistent with the economic substance of the underlying 
transaction, the district director may disregard such terms and impute 
terms that are consistent with the economic substance of the 
transaction.
    (2) No written agreement. In the absence of a written agreement, the 
district director may impute a contractual agreement between the 
controlled taxpayers consistent with the economic substance of the 
transaction. In determining the economic substance of the transaction, 
greatest weight will be given to the actual conduct of the parties and 
their respective legal rights (see, for example, Sec. 1.482-4(f)(3) 
(Ownership of intangible property)). For example, if, without a written 
agreement, a controlled taxpayer operates at full capacity and regularly 
sells all of its output to another member of its controlled group, the 
district director may impute a purchasing contract from the course of 
conduct of the controlled taxpayers, and determine that the producer 
bears little risk that the buyer will fail to purchase its full output. 
Further, if an established industry convention or usage of trade assigns 
a risk or resolves an issue, that convention or usage will be followed 
if the conduct of the taxpayers is consistent with it. See UCC 1-205. 
For example, unless otherwise agreed, payment generally is due at the 
time and place at which the buyer is to receive goods. See UCC 2-310.
    (C) Examples. The following examples illustrate this paragraph 
(d)(3)(ii).

    Example 1--Differences in volume. USP, a United States agricultural 
exporter, regularly buys transportation services from FSub, its foreign 
subsidiary, to ship its products from the United States to overseas 
markets. Although FSub occasionally provides transportation services to 
URA, an unrelated domestic corporation, URA accounts for only 10% of the 
gross revenues of FSub, and the remaining 90% of FSub's gross revenues 
are attributable to FSub's transactions with USP. In determining the 
degree of comparability between FSub's uncontrolled transaction with URA 
and its controlled transaction with USP, the difference in volumes 
involved in the two transactions and the regularity with which these 
services are provided must be taken into account if such difference 
would have a material effect on the price charged. Inability to make 
reliable adjustments for these differences would affect the reliability 
of the results derived from the uncontrolled transaction as a measure of 
the arm's length result.
    Example 2-- Reliability of adjustment for differences in volume. (i) 
FS manufactures product XX and sells that product to its parent 
corporation, P. FS also sells product XX to uncontrolled taxpayers at a 
price of $100 per unit. Except for the volume of each transaction, the 
sales to P and to uncontrolled taxpayers take place under substantially 
the same economic conditions and contractual terms. In uncontrolled 
transactions, FS offers a 2% discount for quantities of 20 per order, 
and a 5% discount for quantities of 100 per order. If P purchases 
product XX in quantities of 60 per order, in the absence of other 
reliable information, it may reasonably be concluded that the arm's 
length price to P would be $100, less a discount of 3.5%.
    (ii) If P purchases product XX in quantities of 1,000 per order, a 
reliable estimate of the appropriate volume discount must be based on 
proper economic or statistical analysis, not necessarily a linear 
extrapolation from the 2% and 5% catalog discounts applicable to sales 
of 20 and 100 units, respectively.
    Example 3-- Contractual term imputed from economic substance. (i) 
USD, a United States corporation, is the exclusive distributor of 
products manufactured by FP, its foreign parent. The FP products are 
sold under a tradename that is not known in the United

[[Page 598]]

States. USD does not have an agreement with FP for the use of FP's 
tradename. For Years 1 through 6, USD bears marketing expenses promoting 
FP's tradename in the United States that are substantially above the 
level of such expenses incurred by comparable distributors in 
uncontrolled transactions. FP does not directly or indirectly reimburse 
USD for its marketing expenses. By Year 7, the FP tradename has become 
very well known in the market and commands a price premium. At this 
time, USD becomes a commission agent for FP.
    (ii) In determining USD's arm's length result for Year 7, the 
district director considers the economic substance of the arrangements 
between USD and FP throughout the course of their relationship. It is 
unlikely that at arm's length, USD would incur these above-normal 
expenses without some assurance it could derive a benefit from these 
expenses. In this case, these expenditures indicate a course of conduct 
that is consistent with an agreement under which USD received a long-
term right to use the FP tradename in the United States. Such conduct is 
inconsistent with the contractual arrangements between FP and USD under 
which USD was merely a distributor, and later a commission agent, for 
FP. Therefore, the district director may impute an agreement between USD 
and FP under which USD will retain an appropriate portion of the price 
premium attributable to the FP tradename.

    (iii) Risk--(A) Comparability. Determining the degree of 
comparability between controlled and uncontrolled transactions requires 
a comparison of the significant risks that could affect the prices that 
would be charged or paid, or the profit that would be earned, in the two 
transactions. Relevant risks to consider include--
    (1) Market risks, including fluctuations in cost, demand, pricing, 
and inventory levels;
    (2) Risks associated with the success or failure of research and 
development activities;
    (3) Financial risks, including fluctuations in foreign currency 
rates of exchange and interest rates;
    (4) Credit and collection risks;
    (5) Product liability risks; and
    (6) General business risks related to the ownership of property, 
plant, and equipment.
    (B) Identification of taxpayer that bears risk. In general, the 
determination of which controlled taxpayer bears a particular risk will 
be made in accordance with the provisions of Sec. 1.482-1(d)(3)(ii)(B) 
(Identifying contractual terms). Thus, the allocation of risks specified 
or implied by the taxpayer's contractual terms will generally be 
respected if it is consistent with the economic substance of the 
transaction. An allocation of risk between controlled taxpayers after 
the outcome of such risk is known or reasonably knowable lacks economic 
substance. In considering the economic substance of the transaction, the 
following facts are relevant--
    (1) Whether the pattern of the controlled taxpayer's conduct over 
time is consistent with the purported allocation of risk between the 
controlled taxpayers; or where the pattern is changed, whether the 
relevant contractual arrangements have been modified accordingly;
    (2) Whether a controlled taxpayer has the financial capacity to fund 
losses that might be expected to occur as the result of the assumption 
of a risk, or whether, at arm's length, another party to the controlled 
transaction would ultimately suffer the consequences of such losses; and
    (3) The extent to which each controlled taxpayer exercises 
managerial or operational control over the business activities that 
directly influence the amount of income or loss realized. In arm's 
length dealings, parties ordinarily bear a greater share of those risks 
over which they have relatively more control.
    (C) Examples. The following examples illustrate this paragraph 
(d)(3)(iii).

    Example 1. FD, the wholly-owned foreign distributor of USM, a U.S. 
manufacturer, buys widgets from USM under a written contract. Widgets 
are a generic electronic appliance. Under the terms of the contract, FD 
must buy and take title to 20,000 widgets for each of the five years of 
the contract at a price of $10 per widget. The widgets will be sold 
under FD's label, and FD must finance any marketing strategies to 
promote sales in the foreign market. There are no rebate or buy back 
provisions. FD has adequate financial capacity to fund its obligations 
under the contract under any circumstances that could reasonably be 
expected to arise. In Years 1, 2 and 3, FD sold only 10,000 widgets at a 
price of $11 per unit. In Year 4, FD sold its entire inventory of 
widgets at a price of $25 per unit. Since the contractual terms 
allocating market risk were agreed to before

[[Page 599]]

the outcome of such risk was known or reasonably knowable, FD had the 
financial capacity to bear the market risk that it would be unable to 
sell all of the widgets it purchased currently, and its conduct was 
consistent over time, FD will be deemed to bear the risk.
    Example 2. The facts are the same as in Example 1, except that in 
Year 1 FD had only $100,000 in total capital, including loans. In 
subsequent years USM makes no additional contributions to the capital of 
FD, and FD is unable to obtain any capital through loans from an 
unrelated party. Nonetheless, USM continues to sell 20,000 widgets 
annually to FD under the terms of the contract, and USM extends credit 
to FD to enable it to finance the purchase. FD does not have the 
financial capacity in Years 1, 2 and 3 to finance the purchase of the 
widgets given that it could not sell most of the widgets it purchased 
during those years. Thus, notwithstanding the terms of the contract, USM 
and not FD assumed the market risk that a substantial portion of the 
widgets could not be sold, since in that event FD would not be able to 
pay USM for all of the widgets it purchased.
    Example 3. S, a Country X corporation, manufactures small motors 
that it sells to P, its U.S. parent. P incorporates the motors into 
various products and sells those products to uncontrolled customers in 
the United States. The contract price for the motors is expressed in 
U.S. dollars, effectively allocating the currency risk for these 
transactions to S for any currency fluctuations between the time the 
contract is signed and payment is made. As long as S has adequate 
financial capacity to bear this currency risk (including by hedging all 
or part of the risk) and the conduct of S and P is consistent with the 
terms of the contract (i.e., the contract price is not adjusted to 
reflect exchange rate movements), the agreement of the parties to 
allocate the exchange risk to S will be respected.
    Example 4. USSub is the wholly-owned U.S. subsidiary of FP, a 
foreign manufacturer. USSub acts as a distributor of goods manufactured 
by FP. FP and USSub execute an agreement providing that FP will bear any 
ordinary product liability costs arising from defects in the goods 
manufactured by FP. In practice, however, when ordinary product 
liability claims are sustained against USSub and FP, USSub pays the 
resulting damages. Therefore, the district director disregards the 
contractual arrangement regarding product liability costs between FP and 
USSub, and treats the risk as having been assumed by USSub.

    (iv) Economic conditions. Determining the degree of comparability 
between controlled and uncontrolled transactions requires a comparison 
of the significant economic conditions that could affect the prices that 
would be charged or paid, or the profit that would be earned in each of 
the transactions. These factors include--
    (A) The similarity of geographic markets;
    (B) The relative size of each market, and the extent of the overall 
economic development in each market;
    (C) The level of the market (e.g., wholesale, retail, etc.);
    (D) The relevant market shares for the products, properties, or 
services transferred or provided;
    (E) The location-specific costs of the factors of production and 
distribution;
    (F) The extent of competition in each market with regard to the 
property or services under review;
    (G) The economic condition of the particular industry, including 
whether the market is in contraction or expansion; and
    (H) The alternatives realistically available to the buyer and 
seller.
    (v) Property or services. Evaluating the degree of comparability 
between controlled and uncontrolled transactions requires a comparison 
of the property or services transferred in the transactions. This 
comparison may include any intangibles that are embedded in tangible 
property or services being transferred. The comparability of the 
embedded intangibles will be analyzed using the factors listed in Sec. 
1.482-4(c)(2)(iii)(B)(1) (Comparable intangible property). The relevance 
of product comparability in evaluating the relative reliability of the 
results will depend on the method applied. For guidance concerning the 
specific comparability considerations applicable to transfers of 
tangible and intangible property, see Sec. Sec. 1.482-3 through 1.482-
6; see also Sec. 1.482-3(f), dealing with the coordination of the 
intangible and tangible property rules.
    (4) Special circumstances--(i) Market share strategy. In certain 
circumstances, taxpayers may adopt strategies to enter new markets or to 
increase a product's share of an existing market (market share 
strategy). Such a strategy would be reflected by temporarily increased 
market development expenses or resale prices that are temporarily lower 
than the prices

[[Page 600]]

charged for comparable products in the same market. Whether or not the 
strategy is reflected in the transfer price depends on which party to 
the controlled transaction bears the costs of the pricing strategy. In 
any case, the effect of a market share strategy on a controlled 
transaction will be taken into account only if it can be shown that an 
uncontrolled taxpayer engaged in a comparable strategy under comparable 
circumstances for a comparable period of time, and the taxpayer provides 
documentation that substantiates the following--
    (A) The costs incurred to implement the market share strategy are 
borne by the controlled taxpayer that would obtain the future profits 
that result from the strategy, and there is a reasonable likelihood that 
the strategy will result in future profits that reflect an appropriate 
return in relation to the costs incurred to implement it;
    (B) The market share strategy is pursued only for a period of time 
that is reasonable, taking into consideration the industry and product 
in question; and
    (C) The market share strategy, the related costs and expected 
returns, and any agreement between the controlled taxpayers to share the 
related costs, were established before the strategy was implemented.
    (ii) Different geographic markets--(A) In general. Uncontrolled 
comparables ordinarily should be derived from the geographic market in 
which the controlled taxpayer operates, because there may be significant 
differences in economic conditions in different markets. If information 
from the same market is not available, an uncontrolled comparable 
derived from a different geographic market may be considered if 
adjustments are made to account for differences between the two markets. 
If information permitting adjustments for such differences is not 
available, then information derived from uncontrolled comparables in the 
most similar market for which reliable data is available may be used, 
but the extent of such differences may affect the reliability of the 
method for purposes of the best method rule. For this purpose, a 
geographic market is any geographic area in which the economic 
conditions for the relevant product or service are substantially the 
same, and may include multiple countries, depending on the economic 
conditions.
    (B) Example. The following example illustrates this paragraph 
(d)(4)(ii).

    Example. Manuco, a wholly-owned foreign subsidiary of P, a U.S. 
corporation, manufactures products in Country Z for sale to P. No 
uncontrolled transactions are located that would provide a reliable 
measure of the arm's length result under the comparable uncontrolled 
price method. The district director considers applying the cost plus 
method or the comparable profits method. Information on uncontrolled 
taxpayers performing comparable functions under comparable circumstances 
in the same geographic market is not available. Therefore, adjusted data 
from uncontrolled manufacturers in other markets may be considered in 
order to apply the cost plus method. In this case, comparable 
uncontrolled manufacturers are found in the United States. Accordingly, 
data from the comparable U.S. uncontrolled manufacturers, as adjusted to 
account for differences between the United States and Country Z's 
geographic market, is used to test the arm's length price paid by P to 
Manuco. However, the use of such data may affect the reliability of the 
results for purposes of the best method rule. See Sec. 1.482-1(c).

    (C) Location savings. If an uncontrolled taxpayer operates in a 
different geographic market than the controlled taxpayer, adjustments 
may be necessary to account for significant differences in costs 
attributable to the geographic markets. These adjustments must be based 
on the effect such differences would have on the consideration charged 
or paid in the controlled transaction given the relative competitive 
positions of buyers and sellers in each market. Thus, for example, the 
fact that the total costs of operating in a controlled manufacturer's 
geographic market are less than the total costs of operating in other 
markets ordinarily justifies higher profits to the manufacturer only if 
the cost differences would increase the profits of comparable 
uncontrolled manufacturers operating at arm's length, given the 
competitive positions of buyers and sellers in that market.
    (D) Example. The following example illustrates the principles of 
this paragraph (d)(4)(ii)(C).


[[Page 601]]


    Example. Couture, a U.S. apparel design corporation, contracts with 
Sewco, its wholly owned Country Y subsidiary, to manufacture its 
clothes. Costs of operating in Country Y are significantly lower than 
the operating costs in the United States. Although clothes with the 
Couture label sell for a premium price, the actual production of the 
clothes does not require significant specialized knowledge that could 
not be acquired by actual or potential competitors to Sewco at 
reasonable cost. Thus, Sewco's functions could be performed by several 
actual or potential competitors to Sewco in geographic markets that are 
similar to Country Y. Thus, the fact that production is less costly in 
Country Y will not, in and of itself, justify additional profits derived 
from lower operating costs in Country Y inuring to Sewco, because the 
competitive positions of the other actual or potential producers in 
similar geographic markets capable of performing the same functions at 
the same low costs indicate that at arm's length such profits would not 
be retained by Sewco.

    (iii) Transactions ordinarily not accepted as comparables--(A) In 
general. Transactions ordinarily will not constitute reliable measures 
of an arm's length result for purposes of this section if--
    (1) They are not made in the ordinary course of business; or
    (2) One of the principal purposes of the uncontrolled transaction 
was to establish an arm's length result with respect to the controlled 
transaction.
    (B) Examples. The following examples illustrate the principle of 
this paragraph (d)(4)(iii).

    Example 1 Not in the ordinary course of business. USP, a United 
States manufacturer of computer software, sells its products to FSub, 
its foreign distributor in country X. Compco, a United States competitor 
of USP, also sells its products in X through unrelated distributors. 
However, in the year under review, Compco is forced into bankruptcy, and 
Compco liquidates its inventory by selling all of its products to 
unrelated distributors in X for a liquidation price. Because the sale of 
its entire inventory was not a sale in the ordinary course of business, 
Compco's sale cannot be used as an uncontrolled comparable to determine 
USP's arm's length result from its controlled transaction.
    Example 2 Principal purpose of establishing an arm's length result. 
USP, a United States manufacturer of farm machinery, sells its products 
to FSub, its wholly-owned distributor in Country Y. USP, operating at 
nearly full capacity, sells 95% of its inventory to FSub. To make use of 
its excess capacity, and also to establish a comparable uncontrolled 
price for its transfer price to FSub, USP increases its production to 
full capacity. USP sells its excess inventory to Compco, an unrelated 
foreign distributor in Country X. Country X has approximately the same 
economic conditions as that of Country Y. Because one of the principal 
purposes of selling to Compco was to establish an arm's length price for 
its controlled transactions with FSub, USP's sale to Compco cannot be 
used as an uncontrolled comparable to determine USP's arm's length 
result from its controlled transaction.

    (e) Arm's length range--(1) In general. In some cases, application 
of a pricing method will produce a single result that is the most 
reliable measure of an arm's length result. In other cases, application 
of a method may produce a number of results from which a range of 
reliable results may be derived. A taxpayer will not be subject to 
adjustment if its results fall within such range (arm's length range).
    (2) Determination of arm's length range--(i) Single method. The 
arm's length range is ordinarily determined by applying a single pricing 
method selected under the best method rule to two or more uncontrolled 
transactions of similar comparability and reliability. Use of more than 
one method may be appropriate for the purposes described in paragraph 
(c)(2)(iii) of this section (Best method rule).
    (ii) Selection of comparables. Uncontrolled comparables must be 
selected based upon the comparability criteria relevant to the method 
applied and must be sufficiently similar to the controlled transaction 
that they provide a reliable measure of an arm's length result. If 
material differences exist between the controlled and uncontrolled 
transactions, adjustments must be made to the results of the 
uncontrolled transaction if the effect of such differences on price or 
profits can be ascertained with sufficient accuracy to improve the 
reliability of the results. See Sec. 1.482-1(d)(2) (Standard of 
comparability). The arm's length range will be derived only from those 
uncontrolled comparables that have, or through adjustments can be 
brought to, a similar level of comparability and reliability, and 
uncontrolled comparables that have a significantly

[[Page 602]]

lower level of comparability and reliability will not be used in 
establishing the arm's length range.
    (iii) Comparables included in arm's length range--(A) In general. 
The arm's length range will consist of the results of all of the 
uncontrolled comparables that meet the following conditions: the 
information on the controlled transaction and the uncontrolled 
comparables is sufficiently complete that it is likely that all material 
differences have been identified, each such difference has a definite 
and reasonably ascertainable effect on price or profit, and an 
adjustment is made to eliminate the effect of each such difference.
    (B) Adjustment of range to increase reliability. If there are no 
uncontrolled comparables described in paragraph (e)(2)(iii)(A) of this 
section, the arm's length range is derived from the results of all the 
uncontrolled comparables, selected pursuant to paragraph (e)(2)(ii) of 
this section, that achieve a similar level of comparability and 
reliability. In such cases the reliability of the analysis must be 
increased, where it is possible to do so, by adjusting the range through 
application of a valid statistical method to the results of all of the 
uncontrolled comparables so selected. The reliability of the analysis is 
increased when statistical methods are used to establish a range of 
results in which the limits of the range will be determined such that 
there is a 75 percent probability of a result falling above the lower 
end of the range and a 75 percent probability of a result falling below 
the upper end of the range. The interquartile range ordinarily provides 
an acceptable measure of this range; however a different statistical 
method may be applied if it provides a more reliable measure.
    (C) Interquartile range. For purposes of this section, the 
interquartile range is the range from the 25th to the 75th percentile of 
the results derived from the uncontrolled comparables. For this purpose, 
the 25th percentile is the lowest result derived from an uncontrolled 
comparable such that at least 25 percent of the results are at or below 
the value of that result. However, if exactly 25 percent of the results 
are at or below a result, then the 25th percentile is equal to the 
average of that result and the next higher result derived from the 
uncontrolled comparables. The 75th percentile is determined analogously.
    (3) Adjustment if taxpayer's results are outside arm's length range. 
If the results of a controlled transaction fall outside the arm's length 
range, the district director may make allocations that adjust the 
controlled taxpayer's result to any point within the arm's length range. 
If the interquartile range is used to determine the arm's length range, 
such adjustment will ordinarily be to the median of all the results. The 
median is the 50th percentile of the results, which is determined in a 
manner analogous to that described in paragraph (e)(2)(iii)(C) of this 
section (Interquartile range). In other cases, an adjustment normally 
will be made to the arithmetic mean of all the results. See Sec. 1.482-
1(f)(2)(iii)(D) for determination of an adjustment when a controlled 
taxpayer's result for a multiple year period falls outside an arm's 
length range consisting of the average results of uncontrolled 
comparables over the same period.
    (4) Arm's length range not prerequisite to allocation. The rules of 
this paragraph (e) do not require that the district director establish 
an arm's length range prior to making an allocation under section 482. 
Thus, for example, the district director may properly propose an 
allocation on the basis of a single comparable uncontrolled price if the 
comparable uncontrolled price method, as described in Sec. 1.482-3(b), 
has been properly applied. However, if the taxpayer subsequently 
demonstrates that the results claimed on its income tax return are 
within the range established by additional equally reliable comparable 
uncontrolled prices in a manner consistent with the requirements set 
forth in Sec. 1.482-1(e)(2)(iii), then no allocation will be made.
    (5) Examples. The following examples illustrate the principles of 
this paragraph (e).

    Example 1 Selection of comparables. (i) To evaluate the arm's length 
result of a controlled transaction between USSub, the United States 
taxpayer under review, and FP, its foreign parent, the district director 
considers applying the resale price method. The district director 
identifies ten potential uncontrolled transactions. The distributors

[[Page 603]]

in all ten uncontrolled transactions purchase and resell similar 
products and perform similar functions to those of USSub.
    (ii) Data with respect to three of the uncontrolled transactions is 
very limited, and although some material differences can be identified 
and adjusted for, the level of comparability of these three uncontrolled 
comparables is significantly lower than that of the other seven. 
Further, of those seven, adjustments for the identified material 
differences can be reliably made for only four of the uncontrolled 
transactions. Therefore, pursuant to Sec. 1.482-1(e)(2)(ii) only these 
four uncontrolled comparables may be used to establish an arm's length 
range.
    Example 2 Arm's length range consists of all the results. (i) The 
facts are the same as in Example 1. Applying the resale price method to 
the four uncontrolled comparables, and making adjustments to the 
uncontrolled comparables pursuant to Sec. 1.482-1(d)(2), the district 
director derives the following results:

------------------------------------------------------------------------
                                                                 Result
                          Comparable                            (price)
------------------------------------------------------------------------
1............................................................     $44.00
2............................................................      45.00
3............................................................      45.00
4............................................................      45.50
------------------------------------------------------------------------

    (ii) The district director determines that data regarding the four 
uncontrolled transactions is sufficiently complete and accurate so that 
it is likely that all material differences between the controlled and 
uncontrolled transactions have been identified, such differences have a 
definite and reasonably ascertainable effect, and appropriate 
adjustments were made for such differences. Accordingly, if the resale 
price method is determined to be the best method pursuant to Sec. 
1.482-1(c), the arm's length range for the controlled transaction will 
consist of the results of all of the uncontrolled comparables, pursuant 
to paragraph (e)(2)(iii)(A) of this section. Thus, the arm's length 
range in this case would be the range from $44 to $45.50.
    Example 3 Arm's length range limited to interquartile range. (i) The 
facts are the same as in Example 2, except in this case there are some 
product and functional differences between the four uncontrolled 
comparables and USSub. However, the data is insufficiently complete to 
determine the effect of the differences. Applying the resale price 
method to the four uncontrolled comparables, and making adjustments to 
the uncontrolled comparables pursuant to Sec. 1.482-1(d)(2), the 
district director derives the following results:

------------------------------------------------------------------------
                                                                 Result
                   Uncontrolled comparable                      (price)
------------------------------------------------------------------------
1............................................................     $42.00
2............................................................      44.00
3............................................................      45.00
4............................................................      47.50
------------------------------------------------------------------------

    (ii) It cannot be established in this case that all material 
differences are likely to have been identified and reliable adjustments 
made for those differences. Accordingly, if the resale price method is 
determined to be the best method pursuant to Sec. 1.482-1(c), the arm's 
length range for the controlled transaction must be established pursuant 
to paragraph (e)(2)(iii)(B) of this section. In this case, the district 
director uses the interquartile range to determine the arm's length 
range, which is the range from $43 to $46.25. If USSub's price falls 
outside this range, the district director may make an allocation. In 
this case that allocation would be to the median of the results, or 
$44.50.
    Example 4 Arm's length range limited to interquartile range. (i) To 
evaluate the arm's length result of controlled transactions between USP, 
a United States manufacturing company, and FSub, its foreign subsidiary, 
the district director considers applying the comparable profits method. 
The district director identifies 50 uncontrolled taxpayers within the 
same industry that potentially could be used to apply the method.
    (ii) Further review indicates that only 20 of the uncontrolled 
manufacturers engage in activities requiring similar capital investments 
and technical know-how. Data with respect to five of the uncontrolled 
manufacturers is very limited, and although some material differences 
can be identified and adjusted for, the level of comparability of these 
five uncontrolled comparables is significantly lower than that of the 
other 15. In addition, for those five uncontrolled comparables it is not 
possible to accurately allocate costs between the business activity 
associated with the relevant transactions and other business activities. 
Therefore, pursuant to Sec. 1.482-1(e)(2)(ii) only the other fifteen 
uncontrolled comparables may be used to establish an arm's length range.
    (iii) Although the data for the fifteen remaining uncontrolled 
comparables is relatively complete and accurate, there is a significant 
possibility that some material differences may remain. The district 
director has determined, for example, that it is likely that there are 
material differences in the level of technical expertise or in 
management efficiency. Accordingly, if the comparable profits method is 
determined to be the best method pursuant to Sec. 1.482-1(c), the arm's 
length range for the controlled transaction may be established only 
pursuant to paragraph (e)(2)(iii)(B) of this section.


[[Page 604]]


    (f) Scope of review--(1) In general. The authority to determine true 
taxable income extends to any case in which either by inadvertence or 
design the taxable income, in whole or in part, of a controlled taxpayer 
is other than it would have been had the taxpayer, in the conduct of its 
affairs, been dealing at arm's length with an uncontrolled taxpayer.
    (i) Intent to evade or avoid tax not a prerequisite. In making 
allocations under section 482, the district director is not restricted 
to the case of improper accounting, to the case of a fraudulent, 
colorable, or sham transaction, or to the case of a device designed to 
reduce or avoid tax by shifting or distorting income, deductions, 
credits, or allowances.
    (ii) Realization of income not a prerequisite--(A) In general. The 
district director may make an allocation under section 482 even if the 
income ultimately anticipated from a series of transactions has not been 
or is never realized. For example, if a controlled taxpayer sells a 
product at less than an arm's length price to a related taxpayer in one 
taxable year and the second controlled taxpayer resells the product to 
an unrelated party in the next taxable year, the district director may 
make an appropriate allocation to reflect an arm's length price for the 
sale of the product in the first taxable year, even though the second 
controlled taxpayer had not realized any gross income from the resale of 
the product in the first year. Similarly, if a controlled taxpayer lends 
money to a related taxpayer in a taxable year, the district director may 
make an appropriate allocation to reflect an arm's length charge for 
interest during such taxable year even if the second controlled taxpayer 
does not realize income during such year. Finally, even if two 
controlled taxpayers realize an overall loss that is attributable to a 
particular controlled transaction, an allocation under section 482 is 
not precluded.
    (B) Example. The following example illustrates this paragraph 
(f)(1)(ii).

    Example. USSub is a U.S. subsidiary of FP, a foreign corporation. 
Parent manufactures product X and sells it to USSub. USSub functions as 
a distributor of product X to unrelated customers in the United States. 
The fact that FP may incur a loss on the manufacture and sale of product 
X does not by itself establish that USSub, dealing with FP at arm's 
length, also would incur a loss. An independent distributor acting at 
arm's length with its supplier would in many circumstances be expected 
to earn a profit without regard to the level of profit earned by the 
supplier.

    (iii) Nonrecognition provisions may not bar allocation--(A) In 
general. If necessary to prevent the avoidance of taxes or to clearly 
reflect income, the district director may make an allocation under 
section 482 with respect to transactions that otherwise qualify for 
nonrecognition of gain or loss under applicable provisions of the 
Internal Revenue Code (such as section 351 or 1031).
    (B) Example. The following example illustrates this paragraph 
(f)(1)(iii).

    Example. (i) In Year 1 USP, a United States corporation, bought 100 
shares of UR, an unrelated corporation, for $100,000. In Year 2, when 
the value of the UR stock had decreased to $40,000, USP contributed all 
100 shares of UR stock to its wholly-owned subsidiary in exchange for 
subsidiary's capital stock. In Year 3, the subsidiary sold all of the UR 
stock for $40,000 to an unrelated buyer, and on its U.S. income tax 
return, claimed a loss of $60,000 attributable to the sale of the UR 
stock. USP and its subsidiary do not file a consolidated return.
    (ii) In determining the true taxable income of the subsidiary, the 
district director may disallow the loss of $60,000 on the ground that 
the loss was incurred by USP. National Securities Corp. v Commissioner, 
137 F.2d 600 (3rd Cir. 1943), cert. denied, 320 U.S. 794 (1943).

    (iv) Consolidated returns. Section 482 and the regulations 
thereunder apply to all controlled taxpayers, whether the controlled 
taxpayer files a separate or consolidated U.S. income tax return. If a 
controlled taxpayer files a separate return, its true separate taxable 
income will be determined. If a controlled taxpayer is a party to a 
consolidated return, the true consolidated taxable income of the 
affiliated group and the true separate taxable income of the controlled 
taxpayer must be determined consistently with the principles of a 
consolidated return.
    (2) Rules relating to determination of true taxable income. The 
following rules

[[Page 605]]

must be taken into account in determining the true taxable income of a 
controlled taxpayer.
    (i) Aggregation of transactions--(A) In general. The combined effect 
of two or more separate transactions (whether before, during, or after 
the taxable year under review) may be considered, if such transactions, 
taken as a whole, are so interrelated that consideration of multiple 
transactions is the most reliable means of determining the arm's length 
consideration for the controlled transactions. Generally, transactions 
will be aggregated only when they involve related products or services, 
as defined in Sec. 1.6038A-3(c)(7)(vii).
    (B) Examples. The following examples illustrate this paragraph 
(f)(2)(i).

    Example 1. P enters into a license agreement with S1, its 
subsidiary, that permits S1 to use a proprietary manufacturing process 
and to sell the output from this process throughout a specified region. 
S1 uses the manufacturing process and sells its output to S2, another 
subsidiary of P, which in turn resells the output to uncontrolled 
parties in the specified region. In evaluating the arm's length 
character of the royalty paid by S1 to P, it may be appropriate to 
consider the arm's length character of the transfer prices charged by S1 
to S2 and the aggregate profits earned by S1 and S2 from the use of the 
manufacturing process and the sale to uncontrolled parties of the 
products produced by S1.
    Example 2. S1, S2, and S3 are Country Z subsidiaries of U.S. 
manufacturer P. S1 is the exclusive Country Z distributor of computers 
manufactured by P. S2 provides marketing services in connection with 
sales of P computers in Country Z, and in this regard uses significant 
marketing intangibles provided by P. S3 administers the warranty program 
with respect to P computers in Country Z, including maintenance and 
repair services. In evaluating the arm's length character of the 
transfer price paid by S1 to P, of the fees paid by S2 to P for the use 
of P marketing intangibles, and of the service fees earned by S2 and S3, 
it may be appropriate to consider the combined effects of these separate 
transactions because they are so interrelated that they are most 
reliably analyzed on an aggregated basis.
    Example 3. The facts are the same as in Example 2. In addition, U1, 
U2, and U3 are uncontrolled taxpayers that carry out functions 
comparable to those of S1, S2, and S3, respectively, with respect to 
computers produced by unrelated manufacturers. R1, R2, and R3 are a 
controlled group of taxpayers (unrelated to the P controlled group) that 
also carry out functions comparable to those of S1, S2, and S3 with 
respect to computers produced by their common parent. Prices charged to 
uncontrolled customers of the R group differ from the prices charged to 
customers of U1, U2, and U3. In determining whether the transactions of 
U1, U2, and U3, or the transactions of R1, R2, and R3 would provide a 
more reliable measure of the arm's length result, it is determined that 
the interrelated R group transactions are more reliable than the wholly 
independent transactions of U1, U2, and U3, given the interrelationship 
of the P group transactions.
    Example 4. P enters into a license agreement with S1 that permits S1 
to use a propriety process for manufacturing product X and to sell 
product X to uncontrolled parties throughout a specified region. P also 
sells to S1 product Y which is manufactured by P in the United States, 
and which is unrelated to product X. Product Y is resold by S1 to 
uncontrolled parties in the specified region. In evaluating the arm's 
length character of the royalty paid by S1 to P for the use of the 
manufacturing process for product X, and the transfer prices charged for 
unrelated product Y, it would not be appropriate to consider the 
combined effects of these separate and unrelated transactions.

    (ii) Allocation based on taxpayer's actual transactions--(A) In 
general. The district director will evaluate the results of a 
transaction as actually structured by the taxpayer unless its structure 
lacks economic substance. However, the district director may consider 
the alternatives available to the taxpayer in determining whether the 
terms of the controlled transaction would be acceptable to an 
uncontrolled taxpayer faced with the same alternatives and operating 
under comparable circumstances. In such cases the district director may 
adjust the consideration charged in the controlled transaction based on 
the cost or profit of an alternative as adjusted to account for material 
differences between the alternative and the controlled transaction, but 
will not restructure the transaction as if the alternative had been 
adopted by the taxpayer. See Sec. 1.482-1(d)(3) (Factors for 
determining comparability, Contractual terms and Risk); Sec. Sec. 
1.482-3(e) and 1.482-4(d) (Unspecified methods).
    (B) Example. The following example illustrates this paragraph 
(f)(2)(ii).

    Example. P and S are controlled taxpayers. P enters into a license 
agreement with S that permits S to use a proprietary process for 
manufacturing product X. Using its sales

[[Page 606]]

and marketing employees, S sells product X to related and unrelated 
customers outside the United States. If the license agreement between P 
and S has economic substance, the district director ordinarily will not 
restructure the taxpayer's transaction to treat P as if it had elected 
to exploit directly the manufacturing process. However, the fact that P 
could have manufactured product X may be taken into account under Sec. 
1.482-4(d) in determining the arm's length consideration for the 
controlled transaction. For an example of such an analysis, see Example 
in Sec. 1.482-4(d)(2).

    (iii) Multiple year data--(A) In general. The results of a 
controlled transaction ordinarily will be compared with the results of 
uncontrolled comparables occurring in the taxable year under review. It 
may be appropriate, however, to consider data relating to the 
uncontrolled comparables or the controlled taxpayer for one or more 
years before or after the year under review. If data relating to 
uncontrolled comparables from multiple years is used, data relating to 
the controlled taxpayer for the same years ordinarily must be 
considered. However, if such data is not available, reliable data from 
other years, as adjusted under paragraph (d)(2) (Standard of 
comparability) of this section may be used.
    (B) Circumstances warranting consideration of multiple year data. 
The extent to which it is appropriate to consider multiple-year data 
depends on the method being applied and the issue being addressed. 
Circumstances that may warrant consideration of data from multiple years 
include the extent to which complete and accurate data is available for 
the taxable year under review, the effect of business cycles in the 
controlled taxpayer's industry, or the effects of life cycles of the 
product or intangible being examined. Data from one or more years before 
or after the taxable year under review must ordinarily be considered for 
purposes of applying the provisions of Sec. 1.482-1(d)(3)(iii) (Risk), 
Sec. 1.482-1(d)(4)(i) (Market share strategy), Sec. 1.482-4(f)(2) 
(Periodic adjustments), and Sec. 1.482-5 (Comparable profits method). 
On the other hand, multiple-year data ordinarily will not be considered 
for purposes of applying the comparable uncontrolled price method 
(except to the extent that risk or market share strategy issues are 
present).
    (C) Comparable effect over comparable period. Data from multiple 
years may be considered to determine whether the same economic 
conditions that caused the controlled taxpayer's results had a 
comparable effect over a comparable period of time on the uncontrolled 
comparables that establish the arm's length range. For example, given 
that uncontrolled taxpayers enter into transactions with the ultimate 
expectation of earning a profit, persistent losses among controlled 
taxpayers may be an indication of non-arm's length dealings. Thus, if a 
controlled taxpayer that realizes a loss with respect to a controlled 
transaction seeks to demonstrate that the loss is within the arm's 
length range, the district director may take into account data from 
taxable years other than the taxable year of the transaction to 
determine whether the loss was attributable to arm's length dealings. 
The rule of this paragraph (f)(2)(iii)(C) is illustrated by Example 3 of 
paragraph (f)(2)(iii)(E) of this section.
    (D) Applications of methods using multiple year averages. If a 
comparison of a controlled taxpayer's average result over a multiple 
year period with the average results of uncontrolled comparables over 
the same period would reduce the effect of short-term variations that 
may be unrelated to transfer pricing, it may be appropriate to establish 
a range derived from the average results of uncontrolled comparables 
over a multiple year period to determine if an adjustment should be 
made. In such a case the district director may make an adjustment if the 
controlled taxpayer's average result for the multiple year period is not 
within such range. Such a range must be determined in accordance with 
Sec. 1.482-1(e) (Arm's length range). An adjustment in such a case 
ordinarily will be equal to the difference, if any, between the 
controlled taxpayer's result for the taxable year and the mid-point of 
the uncontrolled comparables' results for that year. If the 
interquartile range is used to determine the range of average results 
for the multiple year period, such adjustment will ordinarily

[[Page 607]]

be made to the median of all the results of the uncontrolled comparables 
for the taxable year. See Example 2 of Sec. 1.482-5(e). In other cases, 
the adjustment normally will be made to the arithmetic mean of all the 
results of the uncontrolled comparables for the taxable year. However, 
an adjustment will be made only to the extent that it would move the 
controlled taxpayer's multiple year average closer to the arm's length 
range for the multiple year period or to any point within such range. In 
determining a controlled taxpayer's average result for a multiple year 
period, adjustments made under this section for prior years will be 
taken into account only if such adjustments have been finally 
determined, as described in Sec. 1.482-1(g)(2)(iii). See Example 3 of 
Sec. 1.482-5(e).
    (E) Examples. The following examples, in which S and P are 
controlled taxpayers, illustrate this paragraph (f)(2)(iii). Examples 1 
and 4 also illustrate the principle of the arm's length range of 
paragraph (e) of this section.

    Example 1. P sold product Z to S for $60 per unit in 1995. Applying 
the resale price method to data from uncontrolled comparables for the 
same year establishes an arm's length range of prices for the controlled 
transaction from $52 to $59 per unit. Since the price charged in the 
controlled transaction falls outside the range, the district director 
would ordinarily make an allocation under section 482. However, in this 
case there are cyclical factors that affect the results of the 
uncontrolled comparables (and that of the controlled transaction) that 
cannot be adequately accounted for by specific adjustments to the data 
for 1995. Therefore, the district director considers results over 
multiple years to account for these factors. Under these circumstances, 
it is appropriate to average the results of the uncontrolled comparables 
over the years 1993, 1994, and 1995 to determine an arm's length range. 
The averaged results establish an arm's length range of $56 to $58 per 
unit. For consistency, the results of the controlled taxpayers must also 
be averaged over the same years. The average price in the controlled 
transaction over the three years is $57. Because the controlled transfer 
price of product Z falls within the arm's length range, the district 
director makes no allocation.
    Example 2. (i) FP, a Country X corporation, designs and manufactures 
machinery in Country X. FP's costs are incurred in Country X currency. 
USSub is the exclusive distributor of FP's machinery in the United 
States. The price of the machinery sold by FP to USSub is expressed in 
Country X currency. Thus, USSub bears all of the currency risk 
associated with fluctuations in the exchange rate between the time the 
contract is signed and the payment is made. The prices charged by FP to 
USSub for 1995 are under examination. In that year, the value of the 
dollar depreciated against the currency of Country X, and as a result, 
USSub's gross margin was only 8%.
    (ii) UD is an uncontrolled distributor of similar machinery that 
performs distribution functions substantially the same as those 
performed by USSub, except that UD purchases and resells machinery in 
transactions where both the purchase and resale prices are denominated 
in U.S. dollars. Thus, UD had no currency exchange risk. UD's gross 
margin in 1995 was 10%. UD's average gross margin for the period 1990 to 
1998 has been 12%.
    (iii) In determining whether the price charged by FP to USSub in 
1995 was arm's length, the district director may consider USSub's 
average gross margin for an appropriate period before and after 1995 to 
determine whether USSub's average gross margin during the period was 
sufficiently greater than UD's average gross margin during the same 
period such that USSub was sufficiently compensated for the currency 
risk it bore throughout the period. See Sec. 1.482- 1(d)(3)(iii) 
(Risk).
    Example 3. FP manufactures product X in Country M and sells it to 
USSub, which distributes X in the United States. USSub realizes losses 
with respect to the controlled transactions in each of five consecutive 
taxable years. In each of the five consecutive years a different 
uncontrolled comparable realized a loss with respect to comparable 
transactions equal to or greater than USSub's loss. Pursuant to 
paragraph (f)(3)(iii)(C) of this section, the district director examines 
whether the uncontrolled comparables realized similar losses over a 
comparable period of time, and finds that each of the five comparables 
realized losses in only one of the five years, and their average result 
over the five-year period was a profit. Based on this data, the district 
director may conclude that the controlled taxpayer's results are not 
within the arm's length range over the five year period, since the 
economic conditions that resulted in the controlled taxpayer's loss did 
not have a comparable effect over a comparable period of time on the 
uncontrolled comparables.
    Example 4. (i) USP, a U.S. corporation, manufactures product Y in 
the United States and sells it to FSub, which acts as USP's exclusive 
distributor of product Y in Country N. The resale price method described 
in Sec. 1.482-3(c) is used to evaluate whether the transfer price 
charged by USP to FSub for the 1994 taxable year for product Y was arm's 
length. For the period 1992 through 1994,

[[Page 608]]

FSub had a gross profit margin for each year of 13%. A, B, C and D are 
uncontrolled distributors of products that compete directly with product 
Y in country N. After making appropriate adjustments in accordance with 
Sec. Sec. 1.482-1(d)(2) and 1.482-3(c), the gross profit margins for A, 
B, C, and D are as follows:

------------------------------------------------------------------------
                                        1992     1993     1994   Average
------------------------------------------------------------------------
A...................................       13        3        8     8.00
B...................................       11       13        2     8.67
7C..................................        4        7       13     8.00
7D..................................        7        9        6     7.33
------------------------------------------------------------------------

    (ii) Applying the provisions of Sec. 1.482-1(e), the district 
director determines that the arm's length range of the average gross 
profit margins is between 7.33 and 8.67. The district director concludes 
that FSub's average gross margin of 13% is not within the arm's length 
range, despite the fact that C's gross profit margin for 1994 was also 
13%, since the economic conditions that caused S's result did not have a 
comparable effect over a comparable period of time on the results of C 
or the other uncontrolled comparables. In this case, the district 
director makes an allocation equivalent to adjusting FSub's gross profit 
margin for 1994 from 13% to the mean of the uncontrolled comparables' 
results for 1994 (7.25%).

    (iv) Product lines and statistical techniques. The methods described 
in Sec. Sec. 1.482-2 through 1.482-6 are generally stated in terms of 
individual transactions. However, because a taxpayer may have controlled 
transactions involving many different products, or many separate 
transactions involving the same product, it may be impractical to 
analyze every individual transaction to determine its arm's length 
price. In such cases, it is permissible to evaluate the arm's length 
results by applying the appropriate methods to the overall results for 
product lines or other groupings. In addition, the arm's length results 
of all related party transactions entered into by a controlled taxpayer 
may be evaluated by employing sampling and other valid statistical 
techniques.
    (v) Allocations apply to results, not methods--(A) In general. In 
evaluating whether the result of a controlled transaction is arm's 
length, it is not necessary for the district director to determine 
whether the method or procedure that a controlled taxpayer employs to 
set the terms for its controlled transactions corresponds to the method 
or procedure that might have been used by a taxpayer dealing at arm's 
length with an uncontrolled taxpayer. Rather, the district director will 
evaluate the result achieved rather than the method the taxpayer used to 
determine its prices.
    (B) Example. The following example illustrates this paragraph 
(f)(2)(v).

    Example. (i) FS is a foreign subsidiary of P, a U.S. corporation. P 
manufactures and sells household appliances. FS operates as P's 
exclusive distributor in Europe. P annually establishes the price for 
each of its appliances sold to FS as part of its annual budgeting, 
production allocation and scheduling, and performance evaluation 
processes. FS's aggregate gross margin earned in its distribution 
business is 18%.
    (ii) ED is an uncontrolled European distributor of competing 
household appliances. After adjusting for minor differences in the level 
of inventory, volume of sales, and warranty programs conducted by FS and 
ED, ED's aggregate gross margin is also 18%. Thus, the district director 
may conclude that the aggregate prices charged by P for its appliances 
sold to FS are arm's length, without determining whether the budgeting, 
production, and performance evaluation processes of P are similar to 
such processes used by ED.

    (g) Collateral adjustments with respect to allocations under section 
482--(1) In general. The district director will take into account 
appropriate collateral adjustments with respect to allocations under 
section 482. Appropriate collateral adjustments may include correlative 
allocations, conforming adjustments, and setoffs, as described in this 
paragraph (g).
    (2) Correlative allocations--(i) In general. When the district 
director makes an allocation under section 482 (referred to in this 
paragraph (g)(2) as the primary allocation), appropriate correlative 
allocations will also be made with respect to any other member of the 
group affected by the allocation. Thus, if the district director makes 
an allocation of income, the district director will not only increase 
the income of one member of the group, but correspondingly decrease the 
income of the other member. In addition, where appropriate, the district 
director may make such further correlative allocations as may be 
required by the initial correlative allocation.

[[Page 609]]

    (ii) Manner of carrying out correlative allocation. The district 
director will furnish to the taxpayer with respect to which the primary 
allocation is made a written statement of the amount and nature of the 
correlative allocation. The correlative allocation must be reflected in 
the documentation of the other member of the group that is maintained 
for U.S. tax purposes, without regard to whether it affects the U.S. 
income tax liability of the other member for any open year. In some 
circumstances the allocation will have an immediate U.S. tax effect, by 
changing the taxable income computation of the other member (or the 
taxable income computation of a shareholder of the other member, for 
example, under the provisions of subpart F of the Internal Revenue 
Code). Alternatively, the correlative allocation may not be reflected on 
any U.S. tax return until a later year, for example when a dividend is 
paid.
    (iii) Events triggering correlative allocation. For purposes of this 
paragraph (g)(2), a primary allocation will not be considered to have 
been made (and therefore, correlative allocations are not required to be 
made) until the date of a final determination with respect to the 
allocation under section 482. For this purpose, a final determination 
includes--
    (A) Assessment of tax following execution by the taxpayer of a Form 
870 (Waiver of Restrictions on Assessment and Collection of Deficiency 
in Tax and Acceptance of Overassessment) with respect to such 
allocation;
    (B) Acceptance of a Form 870-AD (Offer of Waiver of Restriction on 
Assessment and Collection of Deficiency in Tax and Acceptance of 
Overassessment);
    (C) Payment of the deficiency;
    (D) Stipulation in the Tax Court of the United States; or
    (E) Final determination of tax liability by offer-in-compromise, 
closing agreement, or final resolution (determined under the principles 
of section 7481) of a judicial proceeding.
    (iv) Examples. The following examples illustrate this paragraph 
(g)(2). In each example, X and Y are members of the same group of 
controlled taxpayers and each regularly computes its income on a 
calendar year basis.

    Example 1. (i) In 1996, Y, a U.S. corporation, rents a building 
owned by X, also a U.S. corporation. In 1998 the district director 
determines that Y did not pay an arm's length rental charge. The 
district director proposes to increase X's income to reflect an arm's 
length rental charge. X consents to the assessment reflecting such 
adjustment by executing Form 870, a Waiver of Restrictions on Assessment 
and Collection of Deficiency in Tax and Acceptance of Overassessment. 
The assessment of the tax with respect to the adjustment is made in 
1998. Thus, the primary allocation, as defined in paragraph (g)(2)(i) of 
this section, is considered to have been made in 1998.
    (ii) The adjustment made to X's income under section 482 requires a 
correlative allocation with respect to Y's income. The district director 
notifies X in writing of the amount and nature of the adjustment made 
with respect to Y. Y had net operating losses in 1993, 1994, 1995, 1996, 
and 1997. Although a correlative adjustment will not have an effect on 
Y's U.S. income tax liability for 1996, an adjustment increasing Y's net 
operating loss for 1996 will be made for purposes of determining Y's 
U.S. income tax liability for 1998 or a later taxable year to which the 
increased net operating loss may be carried.
    Example 2. (i) In 1995, X, a U.S. construction company, provided 
engineering services to Y, a U.S. corporation, in the construction of 
Y's factory. In 1997, the district director determines that the fees 
paid by Y to X for its services were not arm's length and proposes to 
make an adjustment to the income of X. X consents to an assessment 
reflecting such adjustment by executing Form 870. An assessment of the 
tax with respect to such adjustment is made in 1997. The district 
director notifies X in writing of the amount and nature of the 
adjustment to be made with respect to Y.
    (ii) The fees paid by Y for X's engineering services properly 
constitute a capital expenditure. Y does not place the factory into 
service until 1998. Therefore, a correlative adjustment increasing Y's 
basis in the factory does not affect Y's U.S. income tax liability for 
1997. However, the correlative adjustment must be made in the books and 
records maintained by Y for its U.S. income tax purposes and such 
adjustment will be taken into account in computing Y's allowable 
depreciation or gain or loss on a subsequent disposition of the factory.
    Example 3. In 1995, X, a U.S. corporation, makes a loan to Y, its 
foreign subsidiary not engaged in a U.S. trade or business. In 1997, the 
district director, upon determining that the interest charged on the 
loan was not arm's length, proposes to adjust X's income to reflect an 
arm's length interest rate. X

[[Page 610]]

consents to an assessment reflecting such allocation by executing Form 
870, and an assessment of the tax with respect to the section 482 
allocation is made in 1997. The district director notifies X in writing 
of the amount and nature of the correlative allocation to be made with 
respect to Y. Although the correlative adjustment does not have an 
effect on Y's U.S. income tax liability, the adjustment must be 
reflected in the documentation of Y that is maintained for U.S. tax 
purposes. Thus, the adjustment must be reflected in the determination of 
the amount of Y's earnings and profits for 1995 and subsequent years, 
and the adjustment must be made to the extent it has an effect on any 
person's U.S. income tax liability for any taxable year.

    (3) Adjustments to conform accounts to reflect section 482 
allocations--(i) In general. Appropriate adjustments must be made to 
conform a taxpayer's accounts to reflect allocations made under section 
482. Such adjustments may include the treatment of an allocated amount 
as a dividend or a capital contribution (as appropriate), or, in 
appropriate cases, pursuant to such applicable revenue procedures as may 
be provided by the Commissioner (see Sec. 601.601(d)(2) of this 
chapter), repayment of the allocated amount without further income tax 
consequences.
    (ii) Example. The following example illustrates the principles of 
this paragraph (g)(3).

    Example Conforming cash accounts. (i) USD, a United States 
corporation, buys Product from its foreign parent, FP. In reviewing 
USD's income tax return, the district director determines that the arm's 
length price would have increased USD's taxable income by $5 million. 
The district director accordingly adjusts USD's income to reflect its 
true taxable income.
    (ii) To conform its cash accounts to reflect the section 482 
allocation made by the district director, USD applies for relief under 
Rev. Proc. 65-17, 1965-1 C.B. 833 (see Sec. 601.601(d)(2)(ii)(b) of 
this chapter), to treat the $5 million adjustment as an account 
receivable from FP, due as of the last day of the year of the 
transaction, with interest accruing therefrom.

    (4) Setoffs--(i) In general. If an allocation is made under section 
482 with respect to a transaction between controlled taxpayers, the 
district director will also take into account the effect of any other 
non-arm's length transaction between the same controlled taxpayers in 
the same taxable year which will result in a setoff against the original 
section 482 allocation. Such setoff, however, will be taken into account 
only if the requirements of Sec. 1.482-1(g)(4)(ii) are satisfied. If 
the effect of the setoff is to change the characterization or source of 
the income or deductions, or otherwise distort taxable income, in such a 
manner as to affect the U.S. tax liability of any member, adjustments 
will be made to reflect the correct amount of each category of income or 
deductions. For purposes of this setoff provision, the term arm's length 
refers to the amount defined in paragraph (b) (Arm's length standard) of 
this section, without regard to the rules in Sec. 1.482-2 under which 
certain charges are deemed to be equal to arm's length.
    (ii) Requirements. The district director will take a setoff into 
account only if the taxpayer--
    (A) Establishes that the transaction that is the basis of the setoff 
was not at arm's length and the amount of the appropriate arm's length 
charge;
    (B) Documents, pursuant to paragraph (g)(2) of this section, all 
correlative adjustments resulting from the proposed setoff; and
    (C) Notifies the district director of the basis of any claimed 
setoff within 30 days after the earlier of the date of a letter by which 
the district director transmits an examination report notifying the 
taxpayer of proposed adjustments or the date of the issuance of the 
notice of deficiency.
    (iii) Examples. The following examples illustrate this paragraph 
(g)(4).

    Example 1. P, a U.S. corporation, renders services to S, its foreign 
subsidiary in Country Y, in connection with the construction of S's 
factory. An arm's length charge for such services determined under Sec. 
1.482-2(b) would be $100,000. During the same taxable year P makes 
available to S the use of a machine to be used in the construction of 
the factory, and the arm's length rental value of the machine is 
$25,000. P bills S $125,000 for the services, but does not charge S for 
the use of the machine. No allocation will be made with respect to the 
undercharge for the machine if P notifies the district director of the 
basis of the claimed setoff within 30 days after the date of the letter 
from the district director transmitting the examination report notifying 
P of the proposed adjustment, establishes that the excess amount charged 
for services was equal to an arm's length charge

[[Page 611]]

for the use of the machine and that the taxable income and income tax 
liabilities of P are not distorted, and documents the correlative 
allocations resulting from the proposed setoff.
    Example 2. The facts are the same as in Example 1, except that, if P 
had reported $25,000 as rental income and $25,000 less as service 
income, it would have been subject to the tax on personal holding 
companies. Allocations will be made to reflect the correct amounts of 
rental income and service income.

    (h) Special rules--(1) Small taxpayer safe harbor. [Reserved]
    (2) Effect of foreign legal restrictions--(i) In general. The 
district director will take into account the effect of a foreign legal 
restriction to the extent that such restriction affects the results of 
transactions at arm's length. Thus, a foreign legal restriction will be 
taken into account only to the extent that it is shown that the 
restriction affected an uncontrolled taxpayer under comparable 
circumstances for a comparable period of time. In the absence of 
evidence indicating the effect of the foreign legal restriction on 
uncontrolled taxpayers, the restriction will be taken into account only 
to the extent provided in paragraphs (h)(2) (iii) and (iv) of this 
section (Deferred income method of accounting).
    (ii) Applicable legal restrictions. Foreign legal restrictions 
(whether temporary or permanent) will be taken into account for purposes 
of this paragraph (h)(2) only if, and so long as, the conditions set 
forth in paragraphs (h)(2)(ii) (A) through (D) of this section are met.
    (A) The restrictions are publicly promulgated, generally applicable 
to all similarly situated persons (both controlled and uncontrolled), 
and not imposed as part of a commercial transaction between the taxpayer 
and the foreign sovereign;
    (B) The taxpayer (or other member of the controlled group with 
respect to which the restrictions apply) has exhausted all remedies 
prescribed by foreign law or practice for obtaining a waiver of such 
restrictions (other than remedies that would have a negligible prospect 
of success if pursued);
    (C) The restrictions expressly prevented the payment or receipt, in 
any form, of part or all of the arm's length amount that would otherwise 
be required under section 482 (for example, a restriction that applies 
only to the deductibility of an expense for tax purposes is not a 
restriction on payment or receipt for this purpose); and
    (D) The related parties subject to the restriction did not engage in 
any arrangement with controlled or uncontrolled parties that had the 
effect of circumventing the restriction, and have not otherwise violated 
the restriction in any material respect.
    (iii) Requirement for electing the deferred income method of 
accounting. If a foreign legal restriction prevents the payment or 
receipt of part or all of the arm's length amount that is due with 
respect to a controlled transaction, the restricted amount may be 
treated as deferrable if the following requirements are met--
    (A) The controlled taxpayer establishes to the satisfaction of the 
district director that the payment or receipt of the arm's length amount 
was prevented because of a foreign legal restriction and circumstances 
described in paragraph (h)(2)(ii) of this section; and
    (B) The controlled taxpayer whose U.S. tax liability may be affected 
by the foreign legal restriction elects the deferred income method of 
accounting, as described in paragraph (h)(2)(iv) of this section, on a 
written statement attached to a timely U.S. income tax return (or an 
amended return) filed before the IRS first contacts any member of the 
controlled group concerning an examination of the return for the taxable 
year to which the foreign legal restriction applies. A written statement 
furnished by a taxpayer subject to the Coordinated Examination Program 
will be considered an amended return for purposes of this paragraph 
(h)(2)(iii)(B) if it satisfies the requirements of a qualified amended 
return for purposes of Sec. 1.6664-2(c)(3) as set forth in those 
regulations or as the Commissioner may prescribe by applicable revenue 
procedures. The election statement must identify the affected 
transactions, the parties to the transactions, and the applicable 
foreign legal restrictions.
    (iv) Deferred income method of accounting. If the requirements of 
paragraph (h)(2)(ii) of this section are satisfied,

[[Page 612]]

any portion of the arm's length amount, the payment or receipt of which 
is prevented because of applicable foreign legal restrictions, will be 
treated as deferrable until payment or receipt of the relevant item 
ceases to be prevented by the foreign legal restriction. For purposes of 
the deferred income method of accounting under this paragraph 
(h)(2)(iv), deductions (including the cost or other basis of inventory 
and other assets sold or exchanged) and credits properly chargeable 
against any amount so deferred, are subject to deferral under the 
provisions of Sec. 1.461- 1(a)(4). In addition, income is deferrable 
under this deferred income method of accounting only to the extent that 
it exceeds the related deductions already claimed in open taxable years 
to which the foreign legal restriction applied.
    (v) Examples. The following examples, in which Sub is a Country FC 
subsidiary of U.S. corporation, Parent, illustrate this paragraph 
(h)(2).

    Example 1. Parent licenses an intangible to Sub. FC law generally 
prohibits payments by any person within FC to recipients outside the 
country. The FC law meets the requirements of paragraph (h)(2)(ii) of 
this section. There is no evidence of unrelated parties entering into 
transactions under comparable circumstances for a comparable period of 
time, and the foreign legal restrictions will not be taken into account 
in determining the arm's length amount. The arm's length royalty rate 
for the use of the intangible property in the absence of the foreign 
restriction is 10% of Sub's sales in country FC. However, because the 
requirements of paragraph (h)(2)(ii) of this section are satisfied, 
Parent can elect the deferred income method of accounting by attaching 
to its timely filed U.S. income tax return a written statement that 
satisfies the requirements of paragraph (h)(2)(iii)(B) of this section.
    Example 2. (i) The facts are the same as in Example 1, except that 
Sub, although it makes no royalty payment to Parent, arranges with an 
unrelated intermediary to make payments equal to an arm's length amount 
on its behalf to Parent.
    (ii) The district director makes an allocation of royalty income to 
Parent, based on the arm's length royalty rate of 10%. Further, the 
district director determines that because the arrangement with the third 
party had the effect of circumventing the FC law, the requirements of 
paragraph (h)(2)(ii)(D) of this section are not satisfied. Thus, Parent 
could not validly elect the deferred income method of accounting, and 
the allocation of royalty income cannot be treated as deferrable. In 
appropriate circumstances, the district director may permit the amount 
of the distribution to be treated as payment by Sub of the royalty 
allocated to Parent, under the provisions of Sec. 1.482-1(g) 
(Collateral adjustments).
    Example 3. The facts are the same as in Example 1, except that the 
laws of FC do not prevent distributions from corporations to their 
shareholders. Sub distributes an amount equal to 8% of its sales in 
country FC. Because the laws of FC did not expressly prevent all forms 
of payment from Sub to Parent, Parent cannot validly elect the deferred 
income method of accounting with respect to any of the arm's length 
royalty amount. In appropriate circumstances, the district director may 
permit the 8% that was distributed to be treated as payment by Sub of 
the royalty allocated to Parent, under the provisions of Sec. 1.482-
1(g) (Collateral adjustments).
    Example 4. The facts are the same as in Example 1, except that 
Country FC law permits the payment of a royalty, but limits the amount 
to 5% of sales, and Sub pays the 5% royalty to Parent. Parent 
demonstrates the existence of a comparable uncontrolled transaction for 
purposes of the comparable uncontrolled transaction method in which an 
uncontrolled party accepted a royalty rate of 5%. Given the evidence of 
the comparable uncontrolled transaction, the 5% royalty rate is 
determined to be the arm's length royalty rate.

    (3) Coordination with section 936--(i) Cost sharing under section 
936. If a possessions corporation makes an election under section 
936(h)(5)(C)(i)(I), the corporation must make a section 936 cost sharing 
payment that is at least equal to the payment that would be required 
under section 482 if the electing corporation were a foreign 
corporation. In determining the payment that would be required under 
section 482 for this purpose, the provisions of Sec. Sec. 1.482-1 and 
1.482-4 will be applied, and to the extent relevant to the valuation of 
intangibles, Sec. Sec. 1.482-5 and 1.482-6 will be applied. The 
provisions of section 936(h)(5)(C)(i)(II) (Effect of Election--electing 
corporation treated as owner of intangible property) do not apply until 
the payment that would be required under section 482 has been 
determined.
    (ii) Use of terms. A cost sharing payment, for the purposes of 
section 936(h)(5)(C)(i)(I), is calculated using the provisions of 
section 936 and the regulations thereunder and the provisions

[[Page 613]]

of this paragraph (h)(3). The provisions relating to cost sharing under 
section 482 do not apply to payments made pursuant to an election under 
section 936(h)(5)(C)(i)(I). Similarly, a profit split payment, for the 
purposes of section 936(h)(5)(C)(ii)(I), is calculated using the 
provisions of section 936 and the regulations thereunder, not section 
482 and the regulations thereunder.
    (i) Definitions. The definitions set forth in paragraphs (i) (1) 
through (10) of this section apply to Sec. Sec. 1.482-1 through 1.482-
8.
    (1) Organization includes an organization of any kind, whether a 
sole proprietorship, a partnership, a trust, an estate, an association, 
or a corporation (as each is defined or understood in the Internal 
Revenue Code or the regulations thereunder), irrespective of the place 
of organization, operation, or conduct of the trade or business, and 
regardless of whether it is a domestic or foreign organization, whether 
it is an exempt organization, or whether it is a member of an affiliated 
group that files a consolidated U.S. income tax return, or a member of 
an affiliated group that does not file a consolidated U.S. income tax 
return.
    (2) Trade or business includes a trade or business activity of any 
kind, regardless of whether or where organized, whether owned 
individually or otherwise, and regardless of the place of operation. 
Employment for compensation will constitute a separate trade or business 
from the employing trade or business.
    (3) Taxpayer means any person, organization, trade or business, 
whether or not subject to any internal revenue tax.
    (4) Controlled includes any kind of control, direct or indirect, 
whether legally enforceable or not, and however exercisable or 
exercised, including control resulting from the actions of two or more 
taxpayers acting in concert or with a common goal or purpose. It is the 
reality of the control that is decisive, not its form or the mode of its 
exercise. A presumption of control arises if income or deductions have 
been arbitrarily shifted.
    (5) Controlled taxpayer means any one of two or more taxpayers owned 
or controlled directly or indirectly by the same interests, and includes 
the taxpayer that owns or controls the other taxpayers. Uncontrolled 
taxpayer means any one of two or more taxpayers not owned or controlled 
directly or indirectly by the same interests.
    (6) Group, controlled group, and group of controlled taxpayers mean 
the taxpayers owned or controlled directly or indirectly by the same 
interests.
    (7) Transaction means any sale, assignment, lease, license, loan, 
advance, contribution, or any other transfer of any interest in or a 
right to use any property (whether tangible or intangible, real or 
personal) or money, however such transaction is effected, and whether or 
not the terms of such transaction are formally documented. A transaction 
also includes the performance of any services for the benefit of, or on 
behalf of, another taxpayer.
    (8) Controlled transaction or controlled transfer means any 
transaction or transfer between two or more members of the same group of 
controlled taxpayers. The term uncontrolled transaction means any 
transaction between two or more taxpayers that are not members of the 
same group of controlled taxpayers.
    (9) True taxable income means, in the case of a controlled taxpayer, 
the taxable income that would have resulted had it dealt with the other 
member or members of the group at arm's length. It does not mean the 
taxable income resulting to the controlled taxpayer by reason of the 
particular contract, transaction, or arrangement the controlled taxpayer 
chose to make (even though such contract, transaction, or arrangement is 
legally binding upon the parties thereto).
    (10) Uncontrolled comparable means the uncontrolled transaction or 
uncontrolled taxpayer that is compared with a controlled transaction or 
taxpayer under any applicable pricing methodology. Thus, for example, 
under the comparable profits method, an uncontrolled comparable is any 
uncontrolled taxpayer from which data is used to establish a comparable 
operating profit.
    (j) Effective dates--(1) The regulations in this are generally 
effective for taxable years beginning after October 6, 1994.

[[Page 614]]

    (2) Taxpayers may elect to apply retroactively all of the provisions 
of these regulations for any open taxable year. Such election will be 
effective for the year of the election and all subsequent taxable years.
    (3) Although these regulations are generally effective for taxable 
years as stated, the final sentence of section 482 (requiring that the 
income with respect to transfers or licenses of intangible property be 
commensurate with the income attributable to the intangible) is 
generally effective for taxable years beginning after December 31, 1986. 
For the period prior to the effective date of these regulations, the 
final sentence of section 482 must be applied using any reasonable 
method not inconsistent with the statute. The IRS considers a method 
that applies these regulations or their general principles to be a 
reasonable method.
    (4) These regulations will not apply with respect to transfers made 
or licenses granted to foreign persons before November 17, 1985, or 
before August 17, 1986, for transfers or licenses to others. 
Nevertheless, they will apply with respect to transfers or licenses 
before such dates if, with respect to property transferred pursuant to 
an earlier and continuing transfer agreement, such property was not in 
existence or owned by the taxpayer on such date.
    (5) The last sentences of paragraphs (b)(2)(i) and (c)(1) of this 
section and of paragraph (c)(2)(iv) of Sec. 1.482-5 apply for taxable 
years beginning on or after August 26, 2003.

[T.D. 8552, 59 FR 34990, July 8, 1994, as amended by T.D. 9088, 68 FR 
51177, Aug. 26, 2003]



Sec. 1.482-2  Determination of taxable income in specific situations.

    (a) Loans or advances--(1) Interest on bona fide indebtedness--(i) 
In general. Where one member of a group of controlled entities makes a 
loan or advance directly or indirectly to, or otherwise becomes a 
creditor of, another member of such group and either charges no 
interest, or charges interest at a rate which is not equal to an arm's 
length rate of interest (as defined in paragraph (a)(2) of this section) 
with respect to such loan or advance, the district director may make 
appropriate allocations to reflect an arm's length rate of interest for 
the use of such loan or advance.
    (ii) Application of paragraph (a) of this section--(A) Interest on 
bona fide indebtedness. Paragraph (a) of this section applies only to 
determine the appropriateness of the rate of interest charged on the 
principal amount of a bona fide indebtedness between members of a group 
of controlled entities, including--
    (1) Loans or advances of money or other consideration (whether or 
not evidenced by a written instrument); and
    (2) Indebtedness arising in the ordinary course of business from 
sales, leases, or the rendition of services by or between members of the 
group, or any other similar extension of credit.
    (B) Alleged indebtedness. This paragraph (a) does not apply to so 
much of an alleged indebtedness which is not in fact a bona fide 
indebtedness, even if the stated rate of interest thereon would be 
within the safe haven rates prescribed in paragraph (a)(2)(iii) of this 
section. For example, paragraph (a) of this section does not apply to 
payments with respect to all or a portion of such alleged indebtedness 
where in fact all or a portion of an alleged indebtedness is a 
contribution to the capital of a corporation or a distribution by a 
corporation with respect to its shares. Similarly, this paragraph (a) 
does not apply to payments with respect to an alleged purchase-money 
debt instrument given in consideration for an alleged sale of property 
between two controlled entities where in fact the transaction 
constitutes a lease of the property. Payments made with respect to 
alleged indebtedness (including alleged stated interest thereon) shall 
be treated according to their substance. See Sec. 1.482-2(a)(3)(i).
    (iii) Period for which interest shall be charged--(A) General rule. 
This paragraph (a)(1)(iii) is effective for indebtedness arising after 
June 30, 1988. See Sec. 1.482-2(a)(3) (26 CFR Part 1 edition revised as 
of April 1, 1988) for indebtedness arising before July 1, 1988. Except 
as otherwise provided in paragraphs (a)(1)(iii)(B) through (E) of this 
section, the period for which interest shall be charged with respect to 
a bona fide indebtedness between controlled entities

[[Page 615]]

begins on the day after the day the indebtedness arises and ends on the 
day the indebtedness is satisfied (whether by payment, offset, 
cancellation, or otherwise). Paragraphs (a)(1)(iii)(B) through (E) of 
this section provide certain alternative periods during which interest 
is not required to be charged on certain indebtedness. These exceptions 
apply only to indebtedness described in paragraph (a)(1)(ii)(A)(2) of 
this section (relating to indebtedness incurred in the ordinary course 
of business from sales, services, etc., between members of the group) 
and not evidenced by a written instrument requiring the payment of 
interest. Such amounts are hereinafter referred to as intercompany trade 
receivables. The period for which interest is not required to be charged 
on intercompany trade receivables under this paragraph (a)(1)(iii) is 
called the interest-free period. In general, an intercompany trade 
receivable arises at the time economic performance occurs (within the 
meaning of section 461(h) and the regulations thereunder) with respect 
to the underlying transaction between controlled entities. For purposes 
of this paragraph (a)(1)(iii), the term United States includes any 
possession of the United States, and the term foreign country excludes 
any possession of the United States.
    (B) Exception for certain intercompany transactions in the ordinary 
course of business. Interest is not required to be charged on an 
intercompany trade receivable until the first day of the third calendar 
month following the month in which the intercompany trade receivable 
arises.
    (C) Exception for trade or business of debtor member located outside 
the United States. In the case of an intercompany trade receivable 
arising from a transaction in the ordinary course of a trade or business 
which is actively conducted outside the United States by the debtor 
member, interest is not required to be charged until the first day of 
the fourth calendar month following the month in which such intercompany 
trade receivable arises.
    (D) Exception for regular trade practice of creditor member or 
others in creditor's industry. If the creditor member or unrelated 
persons in the creditor member's industry, as a regular trade practice, 
allow unrelated parties a longer period without charging interest than 
that described in paragraph (a)(1)(iii)(B) or (C) of this section 
(whichever is applicable) with respect to transactions which are similar 
to transactions that give rise to intercompany trade receivables, such 
longer interest-free period shall be allowed with respect to a 
comparable amount of intercompany trade receivables.
    (E) Exception for property purchased for resale in a foreign 
country--(1) General rule. If in the ordinary course of business one 
member of the group (related purchaser) purchases property from another 
member of the group (related seller) for resale to unrelated persons 
located in a particular foreign country, the related purchaser and the 
related seller may use as the interest-free period for the intercompany 
trade receivables arising during the related seller's taxable year from 
the purchase of such property within the same product group an interest-
free period equal the sum of--
    (i) The number of days in the related purchaser's average collection 
period (as determined under paragraph (a)(1)(iii)(E)(2) of this section) 
for sales of property within the same product group sold in the ordinary 
course of business to unrelated persons located in the same foreign 
country; plus
    (ii) Ten (10) calendar days.
    (2) Interest-free period. The interest-free period under this 
paragraph (a)(1)(iii)(E), however, shall in no event exceed 183 days. 
The related purchaser does not have to conduct business outside the 
United States in order to be eligible to use the interest-free period of 
this paragraph (a)(1)(iii)(E). The interest-free period under this 
paragraph (a)(1)(iii)(E) shall not apply to intercompany trade 
receivables attributable to property which is manufactured, produced, or 
constructed (within the meaning of Sec. 1.954-3(a)(4)) by the related 
purchaser. For purposes of this paragraph (a)(1)(iii)(E) a product group 
includes all products within the same three-digit Standard Industrial 
Classification (SIC) Code (as prepared by the Statistical Policy 
Division of the Office of Management and Budget, Executive Office of the 
President.)

[[Page 616]]

    (3) Average collection period. An average collection period for 
purposes of this paragraph (a)(1)(iii)(E) is determined as follows--
    (i) Step 1. Determine total sales (less returns and allowances) by 
the related purchaser in the product group to unrelated persons located 
in the same foreign country during the related purchaser's last taxable 
year ending on or before the first day of the related seller's taxable 
year in which the intercompany trade receivable arises.
    (ii) Step 2. Determine the related purchaser's average month-end 
accounts receivable balance with respect to sales described in paragraph 
(a)(1)(iii)(E)(2)(i) of this section for the related purchaser's last 
taxable year ending on or before the first day of the related seller's 
taxable year in which the intercompany trade receivable arises.
    (iii) Step 3. Compute a receivables turnover rate by dividing the 
total sales amount described in paragraph (a)(1)(iii)(E)(2)(i) of this 
section by the average receivables balance described in paragraph 
(a)(1)(iii)(E)(2)(ii) of this section.
    (iv) Step 4. Divide the receivables turnover rate determined under 
paragraph (a)(1)(iii)(E)(2)(iii) of this section into 365, and round the 
result to the nearest whole number to determine the number of days in 
the average collection period.
    (v) Other considerations. If the related purchaser makes sales in 
more than one foreign country, or sells property in more than one 
product group in any foreign country, separate computations of an 
average collection period, by product group within each country, are 
required. If the related purchaser resells fungible property in more 
than one foreign country and the intercompany trade receivables arising 
from the related party purchase of such fungible property cannot 
reasonably be identified with resales in particular foreign countries, 
then solely for the purpose of assigning an interest-free period to such 
intercompany trade receivables under this paragraph (a)(1)(iii)(E), an 
amount of each such intercompany trade receivable shall be treated as 
allocable to a particular foreign country in the same proportion that 
the related purchaser's sales of such fungible property in such foreign 
country during the period described in paragraph (a)(1)(iii)(E)(2)(i) of 
this section bears to the related purchaser's sales of all such fungible 
property in all such foreign countries during such period. An interest-
free period under this paragraph (a)(1)(iii)(E) shall not apply to any 
intercompany trade receivables arising in a taxable year of the related 
seller if the related purchaser made no sales described in paragraph 
(a)(1)(iii)(E)(2)(i) of this section from which the appropriate 
interest-free period may be determined.
    (4) Illustration. The interest-free period provided under paragraph 
(a)(1)(iii)(E) of this section may be illustrated by the following 
example:

    Example--(i) Facts. X and Y use the calendar year as the taxable 
year and are members of the same group of controlled entities within the 
meaning of section 482. For Y's 1988 calendar taxable year X and Y 
intend to use the interest-free period determined under this paragraph 
(a)(1)(iii)(E) for intercompany trade receivables attributable to X's 
purchases of certain products from Y for resale by X in the ordinary 
course of business to unrelated persons in country Z. For its 1987 
calendar taxable year all of X's sales in country Z were of products 
within a single product group based upon a three-digit SIC code, were 
not manufactured, produced, or constructed (within the meaning of Sec. 
1.954-3(a)(4)) by X, and were sold in the ordinary course of X's trade 
or business to unrelated persons located only in country Z. These sales 
and the month-end accounts receivable balances (for such sales and for 
such sales uncollected from prior months) are as follows:

------------------------------------------------------------------------
                                                             Accounts
                   Month                        Sales       receivable
------------------------------------------------------------------------
Jan. 1987..................................     $500,000      $2,835,850
Feb........................................      600,000       2,840,300
Mar........................................      450,000       2,850,670
Apr........................................      550,000       2,825,700
May........................................      650,000       2,809,360
June.......................................      525,000       2,803,200
July.......................................      400,000       2,825,850
Aug........................................      425,000       2,796,240
Sept.......................................      475,000       2,839,390
Oct........................................      525,000       2,650,550
Nov........................................      450,000       2,775,450
Dec. 1987..................................      650,000       2,812,600
                                            ----------------------------
      Totals...............................    6,200,000      33,665,160
------------------------------------------------------------------------

    (ii) Average collection period. X's total sales within the same 
product group to unrelated persons within country Z for the period are 
$6,200,000. The average receivables balance

[[Page 617]]

for the period is $2,805,430 ($33,665,160/12). The average collection 
period in whole days is determined as follows:
[GRAPHIC] [TIFF OMITTED] TR08JY94.000

[GRAPHIC] [TIFF OMITTED] TR08JY94.001

    (iii) Interest-free period. Accordingly, for intercompany trade 
receivables incurred by X during Y's 1988 calendar taxable year 
attributable to the purchase of property from Y for resale to unrelated 
persons located in country Z and included in the product group, X may 
use an interest-free period of 175 days (165 days in the average 
collection period plus 10 days, but not in excess of a maximum of 183 
days). All other intercompany trade receivables incurred by X are 
subject to the interest-free periods described in paragraphs (a)(1)(iii) 
(B), (C), or (D), whichever are applicable. If X makes sales in other 
foreign countries in addition to country Z or makes sales of property in 
more than one product group in any foreign country, separate 
computations of X's average collection period, by product group within 
each country, are required in order for X and Y to determine an 
interest-free period for such product groups in such foreign countries 
under this paragraph (a)(1)(iii)(E).
    (iv) Payment; book entries--(A) Except as otherwise provided in this 
paragraph (a)(1)(iv), in determining the period of time for which an 
amount owed by one member of the group to another member is outstanding, 
payments or other credits to an account are considered to be applied 
against the earliest amount outstanding, that is, payments or credits 
are applied against amounts in a first-in, first-out (FIFO) order. Thus, 
tracing payments to individual intercompany trade receivables is 
generally not required in order to determine whether a particular 
intercompany trade receivable has been paid within the applicable 
interest-free period determined under paragraph (a)(1)(iii) of this 
section. The application of this paragraph (a)(1)(iv)(A) may be 
illustrated by the following example:

    Example (i) Facts. X and Y are members of a group of controlled 
entities within the meaning of section 482. Assume that the balance of 
intercompany trade receivables owed by X to Y on June 1 is $100, and 
that all of the $100 balance represents amounts incurred by X to Y 
during the month of May. During the month of June X incurs an additional 
$200 of intercompany trade receivables to Y. Assume that on July 15, $60 
is properly credited against X's intercompany account to Y, and that 
$240 is properly credited against the intercompany account on August 31. 
Assume that under paragraph (a)(1)(iii)(B) of this section interest must 
be charged on X's intercompany trade receivables to Y beginning with the 
first day of the third calendar month following the month the 
intercompany trade receivables arise, and that no alternative interest-
free period applies. Thus, the interest-free period for intercompany 
trade receivables incurred during the month of May ends on July 31, and 
the interest-free period for intercompany trade receivables incurred 
during the month of June ends on August 31.
    (ii) Application of payments. Using a FIFO payment order, the 
aggregate payments of $300 are applied first to the opening June 
balance, and then to the additional amounts incurred during the month of 
June. With respect to X's June opening balance of $100, no interest is 
required to be accrued on $60 of such balance paid by X on July 15, 
because such portion was paid within its interest-free period. Interest 
for 31 days, from August 1 to August 31 inclusive, is required to be 
accrued on the $40 portion of the opening balance not paid until August 
31. No interest is required to be accrued on the $200 of intercompany 
trade receivables X incurred to Y during June because the $240 credited 
on August 31, after eliminating the $40 of indebtedness remaining from 
periods before June, also eliminated the $200 incurred by X during June 
prior to the end of the interest-free period for that amount. The amount 
of interest incurred by X to Y on the $40 amount during

[[Page 618]]

August creates bona fide indebtedness between controlled entities and is 
subject to the provisions of paragraph (a)(1)(iii)(A) of this section 
without regard to any of the exceptions contained in paragraphs 
(a)(1)(iii)(B) through (E).

    (B) Notwithstanding the first-in, first-out payment application rule 
described in paragraph (a)(1)(iv)(A) of this section, the taxpayer may 
apply payments or credits against amounts owed in some other order on 
its books in accordance with an agreement or understanding of the 
related parties if the taxpayer can demonstrate that either it or others 
in its industry, as a regular trade practice, enter into such agreements 
or understandings in the case of similar balances with unrelated 
parties.
    (2) Arm's length interest rate--(i) In general. For purposes of 
section 482 and paragraph (a) of this section, an arm's length rate of 
interest shall be a rate of interest which was charged, or would have 
been charged, at the time the indebtedness arose, in independent 
transactions with or between unrelated parties under similar 
circumstances. All relevant factors shall be considered, including the 
principal amount and duration of the loan, the security involved, the 
credit standing of the borrower, and the interest rate prevailing at the 
situs of the lender or creditor for comparable loans between unrelated 
parties.
    (ii) Funds obtained at situs of borrower. Notwithstanding the other 
provisions of paragraph (a)(2) of this section, if the loan or advance 
represents the proceeds of a loan obtained by the lender at the situs of 
the borrower, the arm's length rate for any taxable year shall be equal 
to the rate actually paid by the lender increased by an amount which 
reflects the costs or deductions incurred by the lender in borrowing 
such amounts and making such loans, unless the taxpayer establishes a 
more appropriate rate under the standards set forth in paragraph 
(a)(2)(i) of this section.
    (iii) Safe haven interest rates for certain loans and advances made 
after May 8, 1986--(A) Applicability--(1) General rule. Except as 
otherwise provided in paragraph (a)(2) of this section, paragraph 
(a)(2)(iii)(B) applies with respect to the rate of interest charged and 
to the amount of interest paid or accrued in any taxable year--
    (i) Under a term loan or advance between members of a group of 
controlled entities where (except as provided in paragraph 
(a)(2)(iii)(A)(2)(ii) of this section) the loan or advance is entered 
into after May 8, 1986; and
    (ii) After May 8, 1986 under a demand loan or advance between such 
controlled entities.
    (2) Grandfather rule for existing loans. The safe haven rates 
prescribed in paragraph (a)(2)(iii)(B) of this section shall not apply, 
and the safe haven rates prescribed in Sec. 1.482-2(a)(2)(iii) (26 CFR 
part 1 edition revised as of April 1, 1985), shall apply to--
    (i) Term loans or advances made before May 9, 1986; and
    (ii) Term loans or advances made before August 7, 1986, pursuant to 
a binding written contract entered into before May 9, 1986.
    (B) Safe haven interest rate based on applicable Federal rate. 
Except as otherwise provided in this paragraph (a)(2), in the case of a 
loan or advance between members of a group of controlled entities, an 
arm's length rate of interest referred to in paragraph (a)(2)(i) of this 
section shall be for purposes of chapter 1 of the Internal Revenue 
Code--
    (1) The rate of interest actually charged if that rate is--
    (i) Not less than 100 percent of the applicable Federal rate (lower 
limit); and
    (ii) Not greater than 130 percent of the applicable Federal rate 
(upper limit); or
    (2) If either no interest is charged or if the rate of interest 
charged is less than the lower limit, then an arm's length rate of 
interest shall be equal to the lower limit, compounded semiannually; or
    (3) If the rate of interest charged is greater than the upper limit, 
then an arm's length rate of interest shall be equal to the upper limit, 
compounded semiannually, unless the taxpayer establishes a more 
appropriate compound rate of interest under paragraph (a)(2)(i) of this 
section. However, if the compound rate of interest actually charged is 
greater than the upper limit and less than the rate determined

[[Page 619]]

under paragraph (a)(2)(i) of this section, or if the compound rate 
actually charged is less than the lower limit and greater than the rate 
determined under paragraph (a)(2)(i) of this section, then the compound 
rate actually charged shall be deemed to be an arm's length rate under 
paragraph (a)(2)(i). In the case of any sale-leaseback described in 
section 1274(e), the lower limit shall be 110 percent of the applicable 
Federal rate, compounded semiannually.
    (C) Applicable Federal rate. For purposes of paragraph 
(a)(2)(iii)(B) of this section, the term applicable Federal rate means, 
in the case of a loan or advance to which this section applies and 
having a term of--
    (1) Not over 3 years, the Federal short-term rate;
    (2) Over 3 years but not over 9 years, the Federal mid-term rate; or
    (3) Over 9 years, the Federal long-term rate, as determined under 
section 1274(d) in effect on the date such loan or advance is made. In 
the case of any sale or exchange between controlled entities, the lower 
limit shall be the lowest of the applicable Federal rates in effect for 
any month in the 3-calendar- month period ending with the first calendar 
month in which there is a binding written contract in effect for such 
sale or exchange (lowest 3-month rate, as defined in section 
1274(d)(2)). In the case of a demand loan or advance to which this 
section applies, the applicable Federal rate means the Federal short-
term rate determined under section 1274(d) (determined without regard to 
the lowest 3-month short term rate determined under section 1274(d)(2)) 
in effect for each day on which any amount of such loan or advance 
(including unpaid accrued interest determined under paragraph (a)(2) of 
this section) is outstanding.
    (D) Lender in business of making loans. If the lender in a loan or 
advance transaction to which paragraph (a)(2) of this section applies is 
regularly engaged in the trade or business of making loans or advances 
to unrelated parties, the safe haven rates prescribed in paragraph 
(a)(2)(iii)(B) of this section shall not apply, and the arm's length 
interest rate to be used shall be determined under the standards 
described in paragraph (a)(2)(i) of this section, including reference to 
the interest rates charged in such trade or business by the lender on 
loans or advances of a similar type made to unrelated parties at and 
about the time the loan or advance to which paragraph (a)(2) of this 
section applies was made.
    (E) Foreign currency loans. The safe haven interest rates prescribed 
in paragraph (a)(2)(iii)(B) of this section do not apply to any loan or 
advance the principal or interest of which is expressed in a currency 
other than U.S. dollars.
    (3) Coordination with interest adjustments required under certain 
other Code sections. If the stated rate of interest on the stated 
principal amount of a loan or advance between controlled entities is 
subject to adjustment under section 482 and is also subject to 
adjustment under any other section of the Internal Revenue Code (for 
example, section 467, 483, 1274 or 7872), section 482 and paragraph (a) 
of this section may be applied to such loan or advance in addition to 
such other Internal Revenue Code section. After the enactment of the Tax 
Reform Act of 1964, Pub. L. 98-369, and the enactment of Pub. L. 99-121, 
such other Internal Revenue Code sections include sections 467, 483, 
1274 and 7872. The order in which the different provisions shall be 
applied is as follows--
    (i) First, the substance of the transaction shall be determined; for 
this purpose, all the relevant facts and circumstances shall be 
considered and any law or rule of law (assignment of income, step 
transaction, etc.) may apply. Only the rate of interest with respect to 
the stated principal amount of the bona fide indebtedness (within the 
meaning of paragraph (a)(1) of this section), if any, shall be subject 
to adjustment under section 482, paragraph (a) of this section, and any 
other Internal Revenue Code section.
    (ii) Second, the other Internal Revenue Code section shall be 
applied to the loan or advance to determine whether any amount other 
than stated interest is to be treated as interest, and if so, to 
determine such amount according to the provisions of such other Internal 
Revenue Code section.
    (iii) Third, whether or not the other Internal Revenue Code section 
applies

[[Page 620]]

to adjust the amounts treated as interest under such loan or advance, 
section 482 and paragraph (a) of this section may then be applied by the 
district director to determine whether the rate of interest charged on 
the loan or advance, as adjusted by any other Code section, is greater 
or less than an arm's length rate of interest, and if so, to make 
appropriate allocations to reflect an arm's length rate of interest.
    (iv) Fourth, section 482 and paragraphs (b) through (d) of this 
section and Sec. Sec. 1.482-3 through 1.482-7, if applicable, may be 
applied by the district director to make any appropriate allocations, 
other than an interest rate adjustment, to reflect an arm's length 
transaction based upon the principal amount of the loan or advance and 
the interest rate as adjusted under paragraph (a)(3) (i), (ii) or (iii) 
of this section. For example, assume that two commonly controlled 
taxpayers enter into a deferred payment sale of tangible property and no 
interest is provided, and assume also that section 483 is applied to 
treat a portion of the stated sales price as interest, thereby reducing 
the stated sales price. If after this recharacterization of a portion of 
the stated sales price as interest, the recomputed sales price does not 
reflect an arm's length sales price under the principles of Sec. 1.482-
3, the district director may make other appropriate allocations (other 
than an interest rate adjustment) to reflect an arm's length sales 
price.
    (4) Examples. The principles of paragraph (a)(3) of this section may 
be illustrated by the following examples:

    Example 1. An individual, A, transfers $20,000 to a corporation 
controlled by A in exchange for the corporation's note which bears 
adequate stated interest. The district director recharacterizes the 
transaction as a contribution to the capital of the corporation in 
exchange for preferred stock. Under paragraph (a)(3)(i) of this section, 
section 1.482-2(a) does not apply to the transaction because there is no 
bona fide indebtedness.
    Example 2. B, an individual, is an employee of Z corporation, and is 
also the controlling shareholder of Z. Z makes a term loan of $15,000 to 
B at a rate of interest that is less than the applicable Federal rate. 
In this instance the other operative Code section is section 7872. Under 
section 7872(b), the difference between the amount loaned and the 
present value of all payments due under the loan using a discount rate 
equal to 100 percent of the applicable Federal rate is treated as an 
amount of cash transferred from the corporation to B and the loan is 
treated as having original issue discount equal to such amount. Under 
paragraph (a)(3)(iii) of this section, section 482 and paragraph (a) of 
this section may also be applied by the district director to determine 
if the rate of interest charged on this $15,000 loan (100 percent of the 
AFR, compounded semiannually, as adjusted by section 7872) is an arm's 
length rate of interest. Because the rate of interest on the loan, as 
adjusted by section 7872, is within the safe haven range of 100-130 
percent of the AFR, compounded semiannually, no further interest rate 
adjustments under section 482 and paragraph (a) of this section will be 
made to this loan.
    Example 3. The facts are the same as in Example 2 except that the 
amount lent by Z to B is $9,000, and that amount is the aggregate 
outstanding amount of loans between Z and B. Under the $10,000 de 
minimis exception of section 7872(c)(3), no adjustment for interest will 
be made to this $9,000 loan under section 7872. Under paragraph 
(a)(3)(iii) of this section, the district director may apply section 482 
and paragraph (a) of this section to this $9,000 loan to determine 
whether the rate of interest charged is less than an arm's length rate 
of interest, and if so, to make appropriate allocations to reflect an 
arm's length rate of interest.
    Example 4. X and Y are commonly controlled taxpayers. At a time when 
the applicable Federal rate is 12 percent, compounded semiannually, X 
sells property to Y in exchange for a note with a stated rate of 
interest of 18 percent, compounded semiannually. Assume that the other 
applicable Code section to the transaction is section 483. Section 483 
does not apply to this transaction because, under section 483(d), there 
is no total unstated interest under the contract using the test rate of 
interest equal to 100 percent of the applicable Federal rate. Under 
paragraph (a)(3)(iii) of this section, section 482 and paragraph (a) of 
this section may be applied by the district director to determine 
whether the rate of interest under the note is excessive, that is, to 
determine whether the 18 percent stated interest rate under the note 
exceeds an arm's length rate of interest.
    Example 5. Assume that A and B are commonly controlled taxpayers and 
that the applicable Federal rate is 10 percent, compounded semiannually. 
On June 30, 1986, A sells property to B and receives in exchange B's 
purchase-money note in the amount of $2,000,000. The stated interest 
rate on the note is 9%, compounded semiannually, and the stated 
redemption price at maturity on the note is $2,000,000. Assume that the 
other applicable Code section to this transaction is section 1274. As 
provided in section 1274A(a)

[[Page 621]]

and (b), the discount rate for purposes of section 1274 will be nine 
percent, compounded semiannually, because the stated principal amount of 
B's note does not exceed $2,800,000. Section 1274 does not apply to this 
transaction because there is adequate stated interest on the debt 
instrument using a discount rate equal to 9%, compounded semiannually, 
and the stated redemption price at maturity does not exceed the stated 
principal amount. Under paragraph (a)(3)(iii) of this section, the 
district director may apply section 482 and paragraph (a) of this 
section to this $2,000,000 note to determine whether the 9% rate of 
interest charged is less than an arm's length rate of interest, and if 
so, to make appropriate allocations to reflect an arm's length rate of 
interest.

    (b) Performance of services for another--(1) General rule. Where one 
member of a group of controlled entities performs marketing, managerial, 
administrative, technical, or other services for the benefit of, or on 
behalf of another member of the group without charge, or at a charge 
which is not equal to an arm's length charge as defined in paragraph 
(b)(3) of this section, the district director may make appropriate 
allocations to reflect an arm's length charge for such services.
    (2) Benefit test--(i) Allocations may be made to reflect arm's 
length charges with respect to services undertaken for the joint benefit 
of the members of a group of controlled entities, as well as with 
respect to services performed by one member of the group exclusively for 
the benefit of another member of the group. Any allocations made shall 
be consistent with the relative benefits intended from the services, 
based upon the facts known at the time the services were rendered, and 
shall be made even if the potential benefits anticipated are not 
realized. No allocations shall be made if the probable benefits to the 
other members were so indirect or remote that unrelated parties would 
not have charged for such services. In general, allocations may be made 
if the service, at the time it was performed, related to the carrying on 
of an activity by another member or was intended to benefit another 
member, either in the member's overall operations or in its day-to-day 
activities. The principles of this paragraph (b)(2)(i) may be 
illustrated by the following examples in each of which it is assumed 
that X and Y are corporate members of the same group of controlled 
entities:

    Example 1. X's International Division engages in a wide range of 
sales promotion activities. Although most of these activities are 
undertaken exclusively for the benefit of X's international operations, 
some are intended to jointly benefit both X and Y and others are 
undertaken exclusively for the benefit of Y. The district director may 
make an allocation to reflect an arm's length charge with respect to the 
activities undertaken for the joint benefit of X and Y consistent with 
the relative benefits intended as well as with respect to the services 
performed exclusively for the benefit of Y.
    Example 2. X operates an international airline, and Y owns and 
operates hotels in several cities which are serviced by X. X, in 
conjunction with its advertising of the airline, often pictures Y's 
hotels and mentions Y's name. Although such advertising was primarily 
intended to benefit X's airline operations, it was reasonable to 
anticipate that there would be substantial benefits to Y resulting from 
patronage by travelers who responded to X's advertising. Since an 
unrelated hotel operator would have been charged for such advertising, 
the district director may make an appropriate allocation to reflect an 
arm's length charge consistent with the relative benefits intended.
    Example 3. Assume the same facts as in Example 2 except that X's 
advertising neither mentions nor pictures Y's hotels. Although it is 
reasonable to anticipate that increased air travel attributable to X's 
advertising will result in some benefit to Y due to increased patronage 
by air travelers, the district director will not make an allocation with 
respect to such advertising since the probable benefit to Y was so 
indirect and remote that an unrelated hotel operator would not have been 
charged for such advertising.

    (ii) Allocations will generally not be made if the service is merely 
a duplication of a service which the related party has independently 
performed or is performing for itself. In this connection, the ability 
to independently perform the service (in terms of qualification and 
availability of personnel) shall be taken into account. The principles 
of this paragraph (b)(2)(ii) may be illustrated by the following 
examples, in each of which it is assumed that X and Y are corporate 
members of the same group of controlled entities:

    Example 1. At the request of Y, the financial staff of X makes an 
analysis to determine the amount and source of the borrowing needs of Y. 
Y does not have personnel qualified to make the analysis, and it does

[[Page 622]]

not undertake the same analysis. The district director may make an 
appropriate allocation to reflect an arm's length charge for such 
analysis.
    Example 2. Y, which has a qualified financial staff, makes an 
analysis to determine the amount and source of its borrowing needs. Its 
report, recommending a loan from a bank, is submitted to X. X's 
financial staff reviews the analysis to determine whether X should 
advise Y to reconsider its plan. No allocation should be made with 
respect to X's review.

    (3) Arm's length charge. For the purpose of this paragraph an arm's 
length charge for services rendered shall be the amount which was 
charged or would have been charged for the same or similar services in 
independent transactions with or between unrelated parties under similar 
circumstances considering all relevant facts. However, except in the 
case of services which are an integral part of the business activity of 
either the member rendering the services or the member receiving the 
benefit of the services (as described in paragraph (b)(7) of this 
section) the arm's length charge shall be deemed equal to the costs or 
deductions incurred with respect to such services by the member or 
members rendering such services unless the taxpayer establishes a more 
appropriate charge under the standards set forth in the first sentence 
of this subparagraph. Where costs or deductions are a factor in applying 
the provisions of this paragraph adequate books and records must be 
maintained by taxpayers to permit verification of such costs or 
deductions by the Internal Revenue Service.
    (4) Costs or deductions to be taken into account--(i) Where the 
amount of an arm's length charge for services is determined with 
reference to the costs or deductions incurred with respect to such 
services, it is necessary to take into account on some reasonable basis 
all the costs or deductions which are directly or indirectly related to 
the service performed.
    (ii) Direct costs or deductions are those identified specifically 
with a particular service. These include, but are not limited to, costs 
or deductions for compensation, bonuses, and travel expenses 
attributable to employees directly engaged in performing such services, 
for material and supplies directly consumed in rendering such services, 
and for other costs such as the cost of overseas cables in connection 
with such services.
    (iii) Indirect costs or deductions are those which are not 
specifically identified with a particular activity or service but which 
relate to the direct costs referred to in paragraph (b)(4)(ii) of this 
section. Indirect costs or deductions generally include costs or 
deductions with respect to utilities, occupancy, supervisory and 
clerical compensation, and other overhead burden of the department 
incurring the direct costs or deductions referred to in paragraph 
(b)(4)(ii) of this section. Indirect costs or deductions also generally 
include an appropriate share of the costs or deductions relating to 
supporting departments and other applicable general and administrative 
expenses to the extent reasonably allocable to a particular service or 
activity. Thus, for example, if a domestic corporation's advertising 
department performs services for the direct benefit of a foreign 
subsidiary, in addition to direct costs of such department, such as 
salaries of employees and fees paid to advertising agencies or 
consultants, which are attributable to such foreign advertising, 
indirect costs must be taken into account on some reasonable basis in 
determining the amount of costs or deductions with respect to which the 
arm's length charge to the foreign subsidiary is to be determined. These 
generally include depreciation, rent, property taxes, other costs of 
occupancy, and other overhead costs of the advertising department 
itself, and allocations of costs from other departments which service 
the advertising department, such as the personnel, accounting, payroll, 
and maintenance departments, and other applicable general and 
administrative expenses including compensation of top management.
    (5) Costs and deductions not to be taken into account. Costs or 
deductions of the member rendering the services which are not to be 
taken into account in determining the amount of an arm's length charge 
for services include--
    (i) Interest expense on indebtedness not incurred specifically for 
the benefit of another member of the group;

[[Page 623]]

    (ii) Expenses associated with the issuance of stock and maintenance 
of shareholder relations; and
    (iii) Expenses of compliance with regulations or policies imposed 
upon the member rendering the services by its government which are not 
directly related to the service in question.
    (6) Methods--(i) Where an arm's length charge for services rendered 
is determined with reference to costs or deductions, and a member has 
allocated and apportioned costs or deductions to reflect arm's length 
charges by employing in a consistent manner a method of allocation and 
apportionment which is reasonable and in keeping with sound accounting 
practice, such method will not be disturbed. If the member has not 
employed a method of allocation and apportionment which is reasonable 
and in keeping with sound accounting practice, the method of allocating 
and apportioning costs or deductions for the purpose of determining the 
amount of arm's length charges shall be based on the particular 
circumstances involved.
    (ii) The methods of allocation and apportionment referred to in this 
paragraph (b)(6) are applicable both in allocating and apportioning 
indirect costs to a particular activity or service (see paragraph 
(b)(4)(iii) of this section) and in allocating and apportioning the 
total costs (direct and indirect) of a particular activity or service 
where such activity or service is undertaken for the joint benefit of 
two or more members of a group (see paragraph (b)(2)(i) of this 
section). While the use of one or more bases may be appropriate under 
the circumstances, in establishing the method of allocation and 
apportionment, appropriate consideration should be given to all bases 
and factors, including, for example, total expenses, asset size, sales, 
manufacturing expenses, payroll, space utilized, and time spent. The 
costs incurred by supporting departments may be apportioned to other 
departments on the basis of reasonable overall estimates, or such costs 
may be reflected in the other departments' costs by means of application 
of reasonable departmental overhead rates Allocations and apportionments 
of costs or deductions must be made on the basis of the full cost as 
opposed to the incremental cost. Thus, if an electronic data processing 
machine, which is rented by the taxpayer, is used for the joint benefit 
of itself and other members of a controlled group, the determination of 
the arm's length charge to each member must be made with reference to 
the full rent and cost of operating the machine by each member, even if 
the additional use of the machine for the benefit of the other members 
did not increase the cost to the taxpayer.
    (iii) Practices actually employed to apportion costs or expenses in 
connection with the preparation of statements and analyses for the use 
of management, creditors, minority shareholders, joint venturers, 
clients, customers, potential investors, or other parties or agencies in 
interest shall be considered by the district director. Similarly, in 
determining the extent to which allocations are to be made to or from 
foreign members of a controlled group, practices employed by the 
domestic members of a controlled group in apportioning costs between 
themselves shall also be considered if the relationships with the 
foreign members of the group are comparable to the relationships between 
the domestic members of the group. For example, if, for purposes of 
reporting to public stockholders or to a governmental agency, a 
corporation apportions the costs attributable to its executive officers 
among the domestic members of a controlled group on a reasonable and 
consistent basis, and such officers exercise comparable control over 
foreign members of such group, such domestic apportionment practice will 
be taken into consideration in determining the amount of allocations to 
be made to the foreign members.
    (7) Certain services. An arm's length charge shall not be deemed 
equal to costs or deductions with respect to services which are an 
integral part of the business activity of either the member rendering 
the services (referred to in this paragraph (b) as the renderer) or the 
member receiving the benefit of the services (referred to in this 
paragraph (b) as the recipient). Paragraphs (b)(7)(i) through (b)(7)(iv) 
of this section describe those situations in which services shall be 
considered an

[[Page 624]]

integral part of the business activity of a member of a group of 
controlled entities.
    (i) Services are an integral part of the business activity of a 
member of a controlled group where either the renderer or the recipient 
is engaged in the trade or business of rendering similar services to one 
or more unrelated parties.
    (ii) (A) Services are an integral part of the business activity of a 
member of a controlled group where the renderer renders services to one 
or more related parties as one of its principal activities. Except in 
the case of services which constitute a manufacturing, production, 
extraction, or construction activity, it will be presumed that the 
renderer does not render services to related parties as one of its 
principal activities if the cost of services of the renderer 
attributable to the rendition of services for the taxable year to 
related parties does not exceed 25 percent of the total costs or 
deductions of the renderer for the taxable year. Where the cost of 
services rendered to related parties is in excess of 25 percent of the 
total costs or deductions of the renderer for the taxable year or where 
the 25-percent test does not apply, the determination of whether the 
rendition of such services is one of the principal activities of the 
renderer will be based on the facts and circumstances of each particular 
case. Such facts and circumstances may include the time devoted to the 
rendition of the services, the relative cost of the services, the 
regularity with which the services are rendered, the amount of capital 
investment, the risk of loss involved, and whether the services are in 
the nature of supporting services or independent of the other activities 
of the renderer.
    (B) For purposes of the 25-percent test provided in this paragraph 
(b)(7)(ii), the cost of services rendered to related parties shall 
include all costs or deductions directly or indirectly related to the 
rendition of such services including the cost of services which 
constitute a manufacturing, production, extraction, or construction 
activity; and the total costs or deductions of the renderer for the 
taxable year shall exclude amounts properly reflected in the cost of 
goods sold of the renderer. Where any of the costs or deductions of the 
renderer do not reflect arm's length consideration and no adjustment is 
made under any provision of the Internal Revenue Code to reflect arm's 
length consideration, the 25-percent test will not apply if, had an 
arm's length charge been made, the costs or deductions attributable to 
the renderer's rendition of services to related entities would exceed 25 
percent of the total costs or deductions of the renderer for the taxable 
year.
    (C) For purposes of the 25-percent test in this paragraph 
(b)(7)(ii), a consolidated group (as defined in this paragraph 
(b)(7)(ii)(C)) may, at the option of the taxpayer, be considered as the 
renderer where one or more members of the consolidated group render 
services for the benefit of or on behalf of a related party which is not 
a member of the consolidated group. In such case, the cost of services 
rendered by members of the consolidated group to any related parties not 
members of the consolidated group, as well as the total costs or 
deductions of the members of the consolidated group, shall be considered 
in the aggregate to determine if such services constitute a principal 
activity of the renderer. Where a consolidated group is considered the 
renderer in accordance with this paragraph (b)(7)(ii)(C), the costs or 
deductions referred to in this paragraph (b)(7)(ii) shall not include 
costs or deductions paid or accrued to any member of the consolidated 
group. In addition to the preceding provisions of this paragraph 
(b)(7)(ii)(C), if part or all of the services rendered by a member of a 
consolidated group to any related party not a member of the consolidated 
group are similar to services rendered by any other member of the 
consolidated group to unrelated parties as part of a trade or business, 
the 25-percent test in this paragraph (b)(7)(ii) shall be applied with 
respect to such similar services without regard to this paragraph 
(b)(7)(ii)(C). For purposes of this paragraph (b)(7)(ii)(C), the term 
consolidated group means all members of a group of controlled entities 
created or organized within a single country and subjected to an income 
tax by such country on the basis of their combined income.

[[Page 625]]

    (iii) Services are an integral part of the business activity of a 
member of a controlled group where the renderer is peculiarly capable of 
rendering the services and such services are a principal element in the 
operations of the recipient. The renderer is peculiarly capable of 
rendering the services where the renderer, in connection with the 
rendition of such services, makes use of a particularly advantageous 
situation or circumstance such as by utilization of special skills and 
reputation, utilization of an influential relationship with customers, 
or utilization of its intangible property (as defined in Sec. 1.482-
4(b)). However, the renderer will not be considered peculiarly capable 
of rendering services unless the value of the services is substantially 
in excess of the costs or deductions of the renderer attributable to 
such services.
    (iv) Services are an integral part of the business activity of a 
member of a controlled group where the recipient has received the 
benefit of a substantial amount of services from one or more related 
parties during its taxable year. For purposes of this paragraph 
(b)(7)(iv), services rendered by one or more related parties shall be 
considered substantial in amount if the total costs or deductions of the 
related party or parties rendering services to the recipient during its 
taxable year which are directly or indirectly related to such services 
exceed an amount equal to 25 percent of the total costs or deductions of 
the recipient during its taxable year. For purposes of the preceding 
sentence, the total costs or deductions of the recipient shall include 
the renderers' costs or deductions directly or indirectly related to the 
rendition of such services and shall exclude any amounts paid or accrued 
to the renderers by the recipient for such services and shall also 
exclude any amounts paid or accrued for materials the cost of which is 
properly reflected in the cost of goods sold of the recipient. At the 
option of the taxpayer, where the taxpayer establishes that the amount 
of the total costs or deductions of a recipient for the recipient's 
taxable year are abnormally low due to the commencement or cessation of 
an operation by the recipient, or other unusual circumstances of a 
nonrecurring nature, the costs or deductions referred to in the 
preceding two sentences shall be the total of such amount for the 3-year 
period immediately preceding the close of the taxable year of the 
recipient (or for the first 3 years of operation of the recipient if the 
recipient had been in operation for less than 3 years as of the close of 
the taxable year in which the services in issue were rendered).
    (v) The principles of paragraphs (b)(7) (i) through (iv) of this 
section may be illustrated by the following examples:

    Example 1. Y is engaged in the business of selling merchandise and 
X, an entity related to Y, is a printing company regularly engaged in 
printing and mailing advertising literature for unrelated parties. X 
also prints circulars advertising Y's products, mails the circulars to 
potential customers of Y, and in addition, performs the art work 
involved in the preparation of the circulars. Since the printing, 
mailing, and art work services rendered by X to Y are similar to the 
printing and mailing services rendered by X as X's trade or business, 
the services rendered to Y are an integral part of the business activity 
of X as described in paragraph (b)(7)(i) of this section.
    Example 2. V, W, X, and Y are members of the same group of 
controlled entities. Each member of the group files a separate income 
tax return. X renders wrecking services to V, W, and Y, and, in 
addition, sells building materials to unrelated parties. The total costs 
or deductions incurred by X for the taxable year (exclusive of amounts 
properly reflected in the cost of goods sold of X) are $4 million. The 
total costs or deductions of X for the taxable year which are directly 
or indirectly related to the services rendered to V, W, and Y are 
$650,000. Since $650,000 is less than 25 percent of the total costs or 
deductions of X (exclusive of amounts properly reflected in the cost of 
goods sold of X) for the taxable year ($4,000,000 * 25% = $1,000,000), 
the services rendered by X to V, W, and Y will not be considered one of 
X's principal activities within the meaning of paragraph (b)(7)(ii) of 
this section.
    Example 3. Assume the same facts as in Example 2, except that the 
total costs or deductions of X for the taxable year which are directly 
or indirectly related to the services rendered to V, W, and Y are 
$1,800,000. Assume in addition, that there is a high risk of loss 
involved in the rendition of the wrecking services by X, that X has a 
large investment in the wrecking equipment, and that a substantial 
amount of X's time is devoted to the rendition of wrecking services to 
V, W, and Y. Since $1,800,000 is greater than 25 percent of the total 
costs or deductions of X for

[[Page 626]]

the taxable year (exclusive of amounts properly reflected in the cost of 
goods sold of X), i.e., $1 million, the services rendered by X to V, W, 
and Y will not be automatically excluded from classification as one of 
the principal activities of X as in Example 2, and consideration must be 
given to the facts and circumstances of the particular case. Based on 
the facts and circumstances in this case, X would be considered to 
render wrecking services to related parties as one of its principal 
activities. Thus, the wrecking services are an integral part of the 
business activity of X as described in paragraph (b)(7)(ii) of this 
section.
    Example 4. Z is a domestic corporation and has several foreign 
subsidiaries. Z and X, a domestic subsidiary of Z, have exercised the 
privilege granted under section 1501 to file a consolidated return and, 
therefore, constitute a consolidated group within the meaning of 
paragraph (b)(7)(ii)(C) of this section. Pursuant to paragraph 
(b)(7)(ii)(C) of this section, the taxpayer treats X and Z as the 
renderer. The sole function of X is to provide accounting, billing, 
communication, and travel services to the foreign subsidiaries of Z. Z 
also provides some other services for the benefit of its foreign 
subsidiaries. The total costs or deductions of X and Z related to the 
services rendered for the benefit of the foreign subsidiaries is 
$750,000. Of that amount, $710,000 represents the costs of X, which are 
X's total operating costs. The total costs or deductions of X and Z for 
the taxable year with respect to their operations (exclusive of amounts 
properly reflected in the cost of goods sold of X and Z) is $6,500,000. 
Since the total costs or deductions related to the services rendered to 
the foreign subsidiaries ($750,000) is less than 25 percent of the total 
costs or deductions of X and Z (exclusive of amounts properly reflected 
in the costs of goods sold of X or Z) in the aggregate ($6,500,000 * 25% 
= $1,625,000), the services rendered by X and Z to the foreign 
subsidiaries will not be considered one of the principal activities of X 
and Z within the meaning of paragraph (b)(7)(ii) of this section.
    Example 5. Assume the same facts as in Example 4, except that all 
the communication services rendered for the benefit of the foreign 
subsidiaries are rendered by X and that Z renders communication services 
to unrelated parties as part of its trade or business. X is regularly 
engaged in rendering communication services to foreign subsidiaries and 
devotes a substantial amount of its time to this activity. The costs or 
deductions of X related to the rendition of the communication services 
to the foreign subsidiaries are $355,000. By application of the 
paragraph (b)(7)(ii)(C) of this section, the services provided by X and 
Z to related entities other than the communication services will not be 
considered one of the principal activities of X and Z. However, since Z 
renders communication services to unrelated parties as a part of its 
trade or business, the communication services rendered by X to the 
foreign subsidiaries will be subject to the provisions of paragraph 
(b)(7)(ii) of this section without regard to paragraph (b)(7)(ii)(C) of 
this section. Since the costs or deductions of X related to the 
rendition of the communication services ($355,000) are in excess of 25 
percent of the total costs or deductions of X (exclusive of amounts 
properly reflected in the cost of goods sold of X) for the taxable year 
($710,000 * 25% = $177,500), the determination of whether X renders the 
communication services as one of its principal activities will depend on 
the particular facts and circumstances. The given facts and 
circumstances indicate that X renders the communication services as one 
of its principal activities.
    Example 6. X and Y are members of the same group of controlled 
entities. Y produces and sells product D. As a part of the production 
process, Y sends materials to X who converts the materials into 
component parts. This conversion activity constitutes only a portion of 
X's operations. X then ships the component parts back to Y who assembles 
them (along with other components) into the finished product for sale to 
unrelated parties. Since the services rendered by X to Y constitute a 
manufacturing activity, the 25-percent test in paragraph (b)(7)(ii) of 
this section does not apply.
    Example 7. X and Y are members of the same group of controlled 
entities. X manufactures product D for distribution and sale in the 
United States, Canada, and Mexico. Y manufactures product D for 
distribution and sale in South and Central America. Due to a breakdown 
of machinery, Y is forced to cease its manufacturing operations for a 1-
month period. In order to meet demand for product D during the shutdown 
period, Y sends partially finished goods to X. X, for that period, 
completes the manufacture of product D for Y and ships the finished 
product back to Y. The costs or deductions of X related to the 
manufacturing services rendered to Y are $750,000. The total costs or 
deductions of X are $24,000,000. Since the services in issue constitute 
a manufacturing activity, the 25-percent test in paragraph (b)(7)(ii) of 
this section does not apply. However, under these facts and 
circumstances, i.e., the insubstantiality of the services rendered to Y 
in relation to X's total operations, the lack of regularity with which 
the services are rendered, and the short duration for which the services 
are rendered, X's rendition of manufacturing services to Y is not 
considered one of X's principal activities within the meaning of 
paragraph (b)(7)(ii) of this section.
    Example 8. Assume the same facts as in Example 7, except that, 
instead of temporarily ceasing operations, Y requests assistance

[[Page 627]]

from X in correcting the defects in the manufacturing equipment. In 
response, X sends a team of engineers to discover and correct the 
defects without the necessity of a shutdown. Although the services 
performed by the engineers were related to a manufacturing activity, the 
services are essentially supporting in nature and, therefore, do not 
constitute a manufacturing, production, extraction, or construction 
activity. Thus, the 25-percent test in paragraph (b)(7)(ii) of this 
section applies.
    Example 9. X is a domestic manufacturing corporation. Y, a foreign 
subsidiary of X, has decided to construct a plant in Country A. In 
connection with the construction of Y's plant, X draws up the 
architectural plans for the plant, arranges the financing of the 
construction, negotiates with various Government authorities in Country 
A, invites bids from unrelated parties for several phases of 
construction, and negotiates, on Y's behalf, the contracts with 
unrelated parties who are retained to carry out certain phases of the 
construction. Although the unrelated parties retained by X for Y perform 
the physical construction, the aggregate services performed by X for Y 
are such that they, in themselves, constitute a construction activity. 
Thus, the 25-percent test in paragraph (b)(7)(ii) of this section does 
not apply with respect to such services.
    Example 10. X and Y are members of the same group of controlled 
entities. X is a finance company engaged in financing automobile loans. 
In connection with such loans it requires the borrower to have life 
insurance in the amount of the loan. Although X's borrowers are not 
required to take out life insurance from any particular insurance 
company, at the same time that the loan agreement is being finalized, 
X's employees suggest that the borrower take out life insurance from Y, 
which is an agency for life insurance companies. Since there would be a 
delay in the processing of the loan if some other company were selected 
by the borrower, almost all of X's borrowers take out life insurance 
through Y. Because of this utilization of its influential relationship 
with its borrowers, X is peculiarly capable of rendering selling 
services to Y and, since a substantial amount of Y's business is derived 
from X's borrowers, such selling services are a principal element in the 
operation of Y's insurance business. In addition, the value of the 
services is substantially in excess of the costs incurred by X. Thus, 
the selling services rendered by X to Y are an integral part of the 
business activity of a member of the controlled group as described in 
paragraph (b)(7)(iii) of this section.
    Example 11. X and Y are members of the same group of controlled 
entities. Y is a manufacturer of product E. In past years product E has 
not always operated properly because of imperfections present in the 
finished product. X owns an exclusive patented process by which such 
imperfections can be detected and removed prior to sale of the product, 
thereby greatly increasing the marketability of the product. In 
connection with its manufacturing operations Y sends its products to X 
for inspection which involves utilization of the patented process. The 
inspection of Y's products by X is not one of the principal activities 
of X. However, X is peculiarly capable of rendering the inspection 
services to Y because of its utilization of the patented process. Since 
this inspection greatly increases the marketability of product E it is 
extremely valuable. Such value is substantially in excess of the cost 
incurred by X in rendition of such services. Because of the impact of 
the inspection on sales, such services are a principal element in the 
operations of Y. Thus, the inspection services rendered by X to Y are an 
integral part of the business activity of a member of the controlled 
group as described in paragraph (b)(7)(iii) of this section.
    Example 12. Assume the same facts as in Example 11 except that Y 
owns the patented process for detecting the imperfections. Y, however, 
does not have the facilities to implement the inspection process. 
Therefore, Y sends its products to X for inspection which involves 
utilization of the patented process owned by Y. Since Y owns the patent, 
X is not peculiarly capable of rendering the inspection services to Y 
within the meaning of paragraph (b)(7)(iii) of this section.
    Example 13. Assume the same facts as in Example 12 except that X and 
Y both own interests in the patented process as a result of having 
developed the process pursuant to a bona fide cost sharing plan (within 
the meaning of Sec. 1.482-7T). Since Y owns the requisite interest in 
the patent, X is not peculiarly capable of rendering the inspection 
services to Y within the meaning of paragraph (b)(7)(iii) of this 
section.
    Example 14. X and Y are members of the same group of controlled 
entities. X is a large manufacturing concern. X's accounting department 
has, for many years, maintained the financial records of Y, a 
distributor of X's products. Although X is able to render these 
accounting services more efficiently than others due to its thorough 
familiarity with the operations of Y, X is not peculiarly capable of 
rendering the accounting services to Y because such familiarity does 
not, in and of itself, constitute a particularly advantageous situation 
or circumstance within the meaning of paragraph (b)(7)(iii) of this 
section. Furthermore, under these circumstances, the accounting services 
are supporting in nature and, therefore, do not constitute a principal 
element in the operations of Y. Thus, the accounting services rendered 
by X to Y are not an integral part of the business activity of either X 
or Y within the

[[Page 628]]

meaning of paragraph (b)(7)(iii) of this section.
    Example 15. (i) Corporations X, Y, and Z are members of the same 
group of controlled entities. X is a manufacturer, and Y and Z are 
distributors of X's products. X provides a variety of services to Y 
including billing, shipping, accounting, and other general and 
administrative services. During Y's taxable year, on several occasions, 
Z renders selling and other promotional services to Y. None of the 
services rendered to Y constitute one of the principal activities of any 
of the renderers within the meaning of paragraph (b)(7)(ii) of this 
section. Y's total costs and deductions for Y's taxable year (exclusive 
of amounts paid to X and Z for services rendered and amounts paid for 
goods purchased for resale) are $1,600,000. The total direct and 
indirect costs of X and Z for services rendered to Y during Y's taxable 
year are as follows:

Services provided by X:
  Billing..................................  $50,000
  Shipping.................................  250,000
  Accounting...............................  150,000
  Other....................................  200,000
Services provided by Z:
  Selling..................................  500,000
                                            ----------------------------
Total Costs                                  1,150,000
 

    (ii) Since the total costs or deductions of X and Z related to the 
rendition of services to Y exceed the amount equal to 25 percent of the 
total costs or deductions of Y (exclusive of amounts paid to X and Z for 
the services rendered and amounts paid for goods purchased for resale) 
plus the total costs or deductions of X and Z related to the rendition 
of services to Y ($1,150,000 / [$1,600,000 + $1,150,000] = 41.8%), the 
services rendered by X and Z to Y are substantial within the meaning of 
paragraph (b)(7)(iv) of this section. Thus, the services rendered by X 
and Z to Y are an integral part of the business activity of Y as 
described in paragraph (b)(7)(iv) of this section.
    Example 16. Assume the same facts as in Example 15, except that the 
taxpayer establishes that, due to a major change in the operations of Y, 
Y's total costs or deductions for Y's taxable year were abnormally low. 
Y has always used the calendar year as its taxable year. Y's total costs 
and deductions for the 2 years immediately preceding the taxable year in 
issue (exclusive of amounts paid to X and Z for services rendered and 
amounts paid for goods purchased for resale) were $6 million and 
$6,200,000 respectively. The total direct and indirect costs of X and Z 
for services rendered to Y were $1,150,000 for each of the 3 years. 
Applying the same formula to the costs or deductions for the 3 years 
immediately preceding the close of the taxable year in issue, the costs 
or deductions of X and Z related to the rendition of services to Y (3 * 
$1,150,000=$3,450,000) amount to 20 percent of the sum of the total 
costs or deductions of Y (exclusive of amounts paid to X and Z for the 
services rendered and amounts paid for goods purchased for resale) plus 
the total costs or deductions of X and Z related to the rendition of 
services to Y ($3,450,000 $1,600,000 + $6,000,000 + $6,200,000 + 
$3,450,000=20%). If the taxpayer chooses to use the 3-year period, the 
services rendered by X and Z to Y are not substantial within the meaning 
of paragraph (b)(7)(iv) of this section. Thus, the services will not be 
an integral part of the business activity of a member of the controlled 
group as described in paragraph (b)(7)(iv) of this section.

    (8) Services rendered in connection with the transfer of property. 
Where tangible or intangible property is transferred, sold, assigned, 
loaned, leased, or otherwise made available in any manner by one member 
of a group to another member of the group and services are rendered by 
the transferor to the transferee in connection with the transfer, the 
amount of any allocation that may be appropriate with respect to such 
transfer shall be determined in accordance with the rules of paragraph 
(c) of this section, or Sec. Sec. 1.482-3 or 1.482-4, whichever is 
appropriate and a separate allocation with respect to such services 
under this paragraph shall not be made. Services are rendered in 
connection with the transfer of property where such services are merely 
ancillary and subsidiary to the transfer of the property or to the 
commencement of effective use of the property by the transferee. Whether 
or not services are merely ancillary and subsidiary to a property 
transfer is a question of fact. Ancillary and subsidiary services could 
be performed, for example, in promoting the transaction by demonstrating 
and explaining the use of the property, or by assisting in the effective 
starting-up of the property transferred, or by performing under a 
guarantee relating to such effective starting-up. Thus, where an 
employee of one member of a group, acting under the instructions of his 
employer, reveals a valuable secret process owned by his employer to a 
related entity, and at the same time supervises the integration of such 
process into the manufacturing operation of the related entity, such 
services could be considered to be rendered in connection with the 
transfer, and, if so considered, shall not

[[Page 629]]

be the basis for a separate allocation. However, if the employee 
continues to render services to the related entity by supervising the 
manufacturing operation after the secret process has been effectively 
integrated into such operation, a separate allocation with respect to 
such additional services may be made in accordance with the rules of 
this paragraph.
    (c) Use of tangible property--(1) General rule. Where possession, 
use, or occupancy of tangible property owned or leased by one member of 
a group of controlled entities (referred to in this paragraph as the 
owner) is transferred by lease or other arrangement to another member of 
such group (referred to in this paragraph as the user) without charge or 
at a charge which is not equal to an arm's length rental charge (as 
defined in paragraph (c)(2)(i) of this section) the district director 
may make appropriate allocations to properly reflect such arm's length 
charge. Where possession, use, or occupancy of only a portion of such 
property is transferred, the determination of the arm's length charge 
and the allocation shall be made with reference to the portion 
transferred.
    (2) Arm's length charge--(i) In general. For purposes of paragraph 
(c) of this section, an arm's length rental charge shall be the amount 
of rent which was charged, or would have been charged for the use of the 
same or similar property, during the time it was in use, in independent 
transactions with or between unrelated parties under similar 
circumstances considering the period and location of the use, the 
owner's investment in the property or rent paid for the property, 
expenses of maintaining the property, the type of property involved, its 
condition, and all other relevant facts.
    (ii) Safe haven rental charge. See Sec. 1.482-2(c)(2)(ii) (26 CFR 
Part 1 revised as of April 1, 1985), for the determination of safe haven 
rental charges in the case of certain leases entered into before May 9, 
1986, and for leases entered into before August 7, 1986, pursuant to a 
binding written contract entered into before May 9, 1986.
    (iii) Subleases--(A) Except as provided in paragraph (c)(2)(iii)(B) 
of this section, where possession, use, or occupancy of tangible 
property, which is leased by the owner (lessee) from an unrelated party 
is transferred by sublease or other arrangement to the user, an arm's 
length rental charge shall be considered to be equal to all the 
deductions claimed by the owner (lessee) which are attributable to the 
property for the period such property is used by the user. Where only a 
portion of such property was transferred, any allocations shall be made 
with reference to the portion transferred. The deductions to be 
considered include the rent paid or accrued by the owner (lessee) during 
the period of use and all other deductions directly and indirectly 
connected with the property paid or accrued by the owner (lessee) during 
such period. Such deductions include deductions for maintenance and 
repair, utilities, management and other similar deductions.
    (B) The provisions of paragraph (c)(2)(iii)(A) of this section shall 
not apply if either--
    (1) The taxpayer establishes a more appropriate rental charge under 
the general rule set forth in paragraph (c)(2)(i) of this section; or
    (2) During the taxable year, the owner (lessee) or the user was 
regularly engaged in the trade or business of renting property of the 
same general type as the property in question to unrelated persons.
    (d) Transfer of property. For rules governing allocations under 
section 482 to reflect an arm's length consideration for controlled 
transactions involving the transfer of property, see Sec. Sec. 1.482-3 
through 1.482-6.

[T.D. 8552, 59 FR 35002, July 8, 1994; 60 FR 16381, 16382, Mar. 30, 
1995]



Sec. 1.482-3  Methods to determine taxable income in connection with 
a transfer of tangible property.

    (a) In general. The arm's length amount charged in a controlled 
transfer of tangible property must be determined under one of the six 
methods listed in this paragraph (a). Each of the methods must be 
applied in accordance with all of the provisions of Sec. 1.482-1, 
including the best method rule of Sec. 1.482-1(c), the comparability 
analysis of Sec. 1.482-1(d), and the arm's length range of Sec. 1.482-
1(e). The methods are--

[[Page 630]]

    (1) The comparable uncontrolled price method, described in paragraph 
(b) of this section;
    (2) The resale price method, described in paragraph (c) of this 
section;
    (3) The cost plus method, described in paragraph (d) of this 
section;
    (4) The comparable profits method, described in Sec. 1.482-5;
    (5) The profit split method, described in Sec. 1.482-6; and
    (6) Unspecified methods, described in paragraph (e) of this section.
    (b) Comparable uncontrolled price method--(1) In general. The 
comparable uncontrolled price method evaluates whether the amount 
charged in a controlled transaction is arm's length by reference to the 
amount charged in a comparable uncontrolled transaction.
    (2) Comparability and reliability considerations--(i) In general. 
Whether results derived from applications of this method are the most 
reliable measure of the arm's length result must be determined using the 
factors described under the best method rule in Sec. 1.482-1(c). The 
application of these factors under the comparable uncontrolled price 
method is discussed in paragraph (b)(2)(ii) and (iii) of this section.
    (ii) Comparability--(A) In general. The degree of comparability 
between controlled and uncontrolled transactions is determined by 
applying the provisions of Sec. 1.482-1(d). Although all of the factors 
described in Sec. 1.482-1(d)(3) must be considered, similarity of 
products generally will have the greatest effect on comparability under 
this method. In addition, because even minor differences in contractual 
terms or economic conditions could materially affect the amount charged 
in an uncontrolled transaction, comparability under this method depends 
on close similarity with respect to these factors, or adjustments to 
account for any differences. The results derived from applying the 
comparable uncontrolled price method generally will be the most direct 
and reliable measure of an arm's length price for the controlled 
transaction if an uncontrolled transaction has no differences with the 
controlled transaction that would affect the price, or if there are only 
minor differences that have a definite and reasonably ascertainable 
effect on price and for which appropriate adjustments are made. If such 
adjustments cannot be made, or if there are more than minor differences 
between the controlled and uncontrolled transactions, the comparable 
uncontrolled price method may be used, but the reliability of the 
results as a measure of the arm's length price will be reduced. Further, 
if there are material product differences for which reliable adjustments 
cannot be made, this method ordinarily will not provide a reliable 
measure of an arm's length result.
    (B) Adjustments for differences between controlled and uncontrolled 
transactions. If there are differences between the controlled and 
uncontrolled transactions that would affect price, adjustments should be 
made to the price of the uncontrolled transaction according to the 
comparability provisions of Sec. 1.482-1(d)(2). Specific examples of 
the factors that may be particularly relevant to this method include--
    (1) Quality of the product;
    (2) Contractual terms (e.g., scope and terms of warranties provided, 
sales or purchase volume, credit terms, transport terms);
    (3) Level of the market (i.e., wholesale, retail, etc.);
    (4) Geographic market in which the transaction takes place;
    (5) Date of the transaction;
    (6) Intangible property associated with the sale;
    (7) Foreign currency risks; and
    (8) Alternatives realistically available to the buyer and seller.
    (iii) Data and assumptions. The reliability of the results derived 
from the comparable uncontrolled price method is affected by the 
completeness and accuracy of the data used and the reliability of the 
assumptions made to apply the method. See Sec. 1.482-1(c) (Best method 
rule).
    (3) Arm's length range. See Sec. 1.482-1(e)(2) for the 
determination of an arm's length range.
    (4) Examples. The principles of this paragraph (b) are illustrated 
by the following examples.

    Example 1. Comparable Sales of Same Product. USM, a U.S. 
manufacturer, sells the same product to both controlled and uncontrolled 
distributors. The circumstances surrounding the controlled and 
uncontrolled

[[Page 631]]

transactions are substantially the same, except that the controlled 
sales price is a delivered price and the uncontrolled sales are made 
f.o.b. USM's factory. Differences in the contractual terms of 
transportation and insurance generally have a definite and reasonably 
ascertainable effect on price, and adjustments are made to the results 
of the uncontrolled transaction to account for such differences. No 
other material difference has been identified between the controlled and 
uncontrolled transactions. Because USM sells in both the controlled and 
uncontrolled transactions, it is likely that all material differences 
between the two transactions have been identified. In addition, because 
the comparable uncontrolled price method is applied to an uncontrolled 
comparable with no product differences, and there are only minor 
contractual differences that have a definite and reasonably 
ascertainable effect on price, the results of this application of the 
comparable uncontrolled price method will provide the most direct and 
reliable measure of an arm's length result. See Sec. 1.482-
3(b)(2)(ii)(A).
    Example 2. Effect of Trademark. The facts are the same as in Example 
1, except that USM affixes its valuable trademark to the property sold 
in the controlled transactions, but does not affix its trademark to the 
property sold in the uncontrolled transactions. Under the facts of this 
case, the effect on price of the trademark is material and cannot be 
reliably estimated. Because there are material product differences for 
which reliable adjustments cannot be made, the comparable uncontrolled 
price method is unlikely to provide a reliable measure of the arm's 
length result. See Sec. 1.482-3(b)(2)(ii)(A).
    Example 3. Minor Product Differences. The facts are the same as in 
Example 1, except that USM, which manufactures business machines, makes 
minor modifications to the physical properties of the machines to 
satisfy specific requirements of a customer in controlled sales, but 
does not make these modifications in uncontrolled sales. If the minor 
physical differences in the product have a material effect on prices, 
adjustments to account for these differences must be made to the results 
of the uncontrolled transactions according to the provisions of Sec. 
1.482- 1(d)(2), and such adjusted results may be used as a measure of 
the arm's length result.
    Example 4. Effect of Geographic Differences. FM, a foreign specialty 
radio manufacturer, sells its radios to a controlled U.S. distributor, 
AM, that serves the West Coast of the United States. FM sells its radios 
to uncontrolled distributors to serve other regions in the United 
States. The product in the controlled and uncontrolled transactions is 
the same, and all other circumstances surrounding the controlled and 
uncontrolled transactions are substantially the same, other than the 
geographic differences. If the geographic differences are unlikely to 
have a material effect on price, or they have definite and reasonably 
ascertainable effects for which adjustments are made, then the adjusted 
results of the uncontrolled sales may be used under the comparable 
uncontrolled price method to establish an arm's length range pursuant to 
Sec. 1.482-1(e)(2)(iii)(A). If the effects of the geographic 
differences would be material but cannot be reliably ascertained, then 
the reliability of the results will be diminished. However, the 
comparable uncontrolled price method may still provide the most reliable 
measure of an arm's length result, pursuant to the best method rule of 
Sec. 1.482-1(c), and, if so, an arm's length range may be established 
pursuant to Sec. 1.482-1(e)(2)(iii)(B).

    (5) Indirect evidence of comparable uncontrolled transactions--(i) 
In general. A comparable uncontrolled price may be derived from data 
from public exchanges or quotation media, but only if the following 
requirements are met--
    (A) The data is widely and routinely used in the ordinary course of 
business in the industry to negotiate prices for uncontrolled sales;
    (B) The data derived from public exchanges or quotation media is 
used to set prices in the controlled transaction in the same way it is 
used by uncontrolled taxpayers in the industry; and
    (C) The amount charged in the controlled transaction is adjusted to 
reflect differences in product quality and quantity, contractual terms, 
transportation costs, market conditions, risks borne, and other factors 
that affect the price that would be agreed to by uncontrolled taxpayers.
    (ii) Limitation. Use of data from public exchanges or quotation 
media may not be appropriate under extraordinary market conditions.
    (iii) Examples. The following examples illustrate this paragraph 
(b)(5).

    Example 1. Use of Quotation Medium. (i) On June 1, USOil, a United 
States corporation, enters into a contract to purchase crude oil from 
its foreign subsidiary, FS, in Country Z. USOil and FS agree to base 
their sales price on the average of the prices published for that crude 
in a quotation medium in the five days before August 1, the date set for 
delivery. USOil and FS agree to adjust the price for the particular 
circumstances of their transactions, including the quantity of the crude 
sold, contractual terms, transportation costs, risks borne, and other 
factors that affect the price.

[[Page 632]]

    (ii) The quotation medium used by USOil and FS is widely and 
routinely used in the ordinary course of business in the industry to 
establish prices for uncontrolled sales. Because USOil and FS use the 
data to set their sales price in the same way that unrelated parties use 
the data from the quotation medium to set their sales prices, and 
appropriate adjustments were made to account for differences, the price 
derived from the quotation medium used by USOil and FS to set their 
transfer prices will be considered evidence of a comparable uncontrolled 
price.
    Example 2. Extraordinary Market Conditions. The facts are the same 
as in Example 1, except that before USOil and FS enter into their 
contract, war breaks out in Countries X and Y, major oil producing 
countries, causing significant instability in world petroleum markets. 
As a result, given the significant instability in the price of oil, the 
prices listed on the quotation medium may not reflect a reliable measure 
of an arm's length result. See Sec. 1.482-3(b)(5)(ii).

    (c) Resale price method--(1) In general. The resale price method 
evaluates whether the amount charged in a controlled transaction is 
arm's length by reference to the gross profit margin realized in 
comparable uncontrolled transactions. The resale price method measures 
the value of functions performed, and is ordinarily used in cases 
involving the purchase and resale of tangible property in which the 
reseller has not added substantial value to the tangible goods by 
physically altering the goods before resale. For this purpose, 
packaging, repackaging, labelling, or minor assembly do not ordinarily 
constitute physical alteration. Further the resale price method is not 
ordinarily used in cases where the controlled taxpayer uses its 
intangible property to add substantial value to the tangible goods.
    (2) Determination of arm's length price--(i) In general. The resale 
price method measures an arm's length price by subtracting the 
appropriate gross profit from the applicable resale price for the 
property involved in the controlled transaction under review.
    (ii) Applicable resale price. The applicable resale price is equal 
to either the resale price of the particular item of property involved 
or the price at which contemporaneous resales of the same property are 
made. If the property purchased in the controlled sale is resold to one 
or more related parties in a series of controlled sales before being 
resold in an uncontrolled sale, the applicable resale price is the price 
at which the property is resold to an uncontrolled party, or the price 
at which contemporaneous resales of the same property are made. In such 
case, the determination of the appropriate gross profit will take into 
account the functions of all members of the group participating in the 
series of controlled sales and final uncontrolled resales, as well as 
any other relevant factors described in Sec. 1.482-1(d)(3).
    (iii) Appropriate gross profit. The appropriate gross profit is 
computed by multiplying the applicable resale price by the gross profit 
margin (expressed as a percentage of total revenue derived from sales) 
earned in comparable uncontrolled transactions.
    (iv) Arm's length range. See Sec. 1.482-1(e)(2) for determination 
of the arm's length range.
    (3) Comparability and reliability considerations--(i) In general. 
Whether results derived from applications of this method are the most 
reliable measure of the arm's length result must be determined using the 
factors described under the best method rule in Sec. 1.482-1(c). The 
application of these factors under the resale price method is discussed 
in paragraphs (c)(3) (ii) and (iii) of this section.
    (ii) Comparability--(A) Functional comparability. The degree of 
comparability between an uncontrolled transaction and a controlled 
transaction is determined by applying the comparability provisions of 
Sec. 1.482-1(d). A reseller's gross profit provides compensation for 
the performance of resale functions related to the product or products 
under review, including an operating profit in return for the reseller's 
investment of capital and the assumption of risks. Therefore, although 
all of the factors described in Sec. 1.482-1(d)(3) must be considered, 
comparability under this method is particularly dependent on similarity 
of functions performed, risks borne, and contractual terms, or 
adjustments to account for the effects of any such differences. If 
possible, appropriate gross profit margins should be derived from 
comparable uncontrolled purchases and resales of the reseller involved 
in the controlled sale,

[[Page 633]]

because similar characteristics are more likely to be found among 
different resales of property made by the same reseller than among sales 
made by other resellers. In the absence of comparable uncontrolled 
transactions involving the same reseller, an appropriate gross profit 
margin may be derived from comparable uncontrolled transactions of other 
resellers.
    (B) Other comparability factors. Comparability under this method is 
less dependent on close physical similarity between the products 
transferred than under the comparable uncontrolled price method. For 
example, distributors of a wide variety of consumer durables might 
perform comparable distribution functions without regard to the specific 
durable goods distributed. Substantial differences in the products may, 
however, indicate significant functional differences between the 
controlled and uncontrolled taxpayers. Thus, it ordinarily would be 
expected that the controlled and uncontrolled transactions would involve 
the distribution of products of the same general type (e.g., consumer 
electronics). Furthermore, significant differences in the value of the 
distributed goods due, for example, to the value of a trademark, may 
also affect the reliability of the comparison. Finally, the reliability 
of profit measures based on gross profit may be adversely affected by 
factors that have less effect on prices. For example, gross profit may 
be affected by a variety of other factors, including cost structures (as 
reflected, for example, in the age of plant and equipment), business 
experience (such as whether the business is in a start-up phase or is 
mature), or management efficiency (as indicated, for example, by 
expanding or contracting sales or executive compensation over time). 
Accordingly, if material differences in these factors are identified 
based on objective evidence, the reliability of the analysis may be 
affected.
    (C) Adjustments for differences between controlled and uncontrolled 
transactions. If there are material differences between the controlled 
and uncontrolled transactions that would affect the gross profit margin, 
adjustments should be made to the gross profit margin earned with 
respect to the uncontrolled transaction according to the comparability 
provisions of Sec. 1.482-1(d)(2). For this purpose, consideration of 
operating expenses associated with functions performed and risks assumed 
may be necessary, because differences in functions performed are often 
reflected in operating expenses. If there are differences in functions 
performed, however, the effect on gross profit of such differences is 
not necessarily equal to the differences in the amount of related 
operating expenses. Specific examples of the factors that may be 
particularly relevant to this method include--
    (1) Inventory levels and turnover rates, and corresponding risks, 
including any price protection programs offered by the manufacturer;
    (2) Contractual terms (e.g., scope and terms of warranties provided, 
sales or purchase volume, credit terms, transport terms);
    (3) Sales, marketing, advertising programs and services, (including 
promotional programs, rebates, and co-op advertising);
    (4) The level of the market (e.g., wholesale, retail, etc.); and
    (5) Foreign currency risks.
    (D) Sales agent. If the controlled taxpayer is comparable to a sales 
agent that does not take title to goods or otherwise assume risks with 
respect to ownership of such goods, the commission earned by such sales 
agent, expressed as a percentage of the uncontrolled sales price of the 
goods involved, may be used as the comparable gross profit margin.
    (iii) Data and assumptions--(A) In general. The reliability of the 
results derived from the resale price method is affected by the 
completeness and accuracy of the data used and the reliability of the 
assumptions made to apply this method. See Sec. 1.482-1(c) (Best method 
rule).
    (B) Consistency in accounting. The degree of consistency in 
accounting practices between the controlled transaction and the 
uncontrolled comparables that materially affect the gross profit margin 
affects the reliability of the result. Thus, for example, if differences 
in inventory and other cost accounting practices would materially affect 
the gross profit margin,

[[Page 634]]

the ability to make reliable adjustments for such differences would 
affect the reliability of the results. Further, the controlled 
transaction and the uncontrolled comparable should be consistent in the 
reporting of items (such as discounts, returns and allowances, rebates, 
transportation costs, insurance, and packaging) between cost of goods 
sold and operating expenses.
    (4) Examples. The following examples illustrate the principles of 
this paragraph (c).

    Example 1. A controlled taxpayer sells property to another member of 
its controlled group that resells the property in uncontrolled sales. 
There are no changes in the beginning and ending inventory for the year 
under review. Information regarding an uncontrolled comparable is 
sufficiently complete to conclude that it is likely that all material 
differences between the controlled and uncontrolled transactions have 
been identified and adjusted for. If the applicable resale price of the 
property involved in the controlled sale is $100 and the appropriate 
gross profit margin is 20%, then an arm's length result of the 
controlled sale is a price of $80 ($100 minus (20%x$100)).
    Example 2. (i) S, a U.S. corporation, is the exclusive distributor 
for FP, its foreign parent. There are no changes in the beginning and 
ending inventory for the year under review. S's total reported cost of 
goods sold is $800, consisting of $600 for property purchased from FP 
and $200 of other costs of goods sold incurred to unrelated parties. S's 
applicable resale price and reported gross profit are as follows:

Applicable resale price.........................................   $1000
Cost of goods sold:
    Cost of purchases from FP...................................     600
    Costs incurred to unrelated parties.........................     200
Reported gross profit...........................................     200
 

    (ii) The district director determines that the appropriate gross 
profit margin is 25%. Therefore, S's appropriate gross profit is $250 
(i.e., 25% of the applicable resale price of $1000). Because S is 
incurring costs of sales to unrelated parties, an arm's length price for 
property purchased from FP must be determined under a two-step process. 
First, the appropriate gross profit ($250) is subtracted from the 
applicable resale price ($1000). The resulting amount ($750) is then 
reduced by the costs of sales incurred to unrelated parties ($200). 
Therefore, an arm's length price for S's cost of sales of FP's product 
in this case equals $550 (i.e., $750 minus $200).
    Example 3. FP, a foreign manufacturer, sells Product to USSub, its 
U.S. subsidiary, which in turn sells Product to its domestic affiliate 
Sister. Sister sells Product to unrelated buyers. In this case, the 
applicable resale price is the price at which Sister sells Product in 
uncontrolled transactions. The determination of the appropriate gross 
profit margin for the sale from FP to USSub will take into account the 
functions performed by USSub and Sister, as well as other relevant 
factors described in Sec. 1.482-1(d)(3).
    Example 4. USSub, a U.S. corporation, is the exclusive distributor 
of widgets for its foreign parent. To determine whether the gross profit 
margin of 25% earned by USSub is an arm's length result, the district 
director considers applying the resale price method. There are several 
uncontrolled distributors that perform similar functions under similar 
circumstances in uncontrolled transactions. However, the uncontrolled 
distributors treat certain costs such as discounts and insurance as cost 
of goods sold, while USSub treats such costs as operating expenses. In 
such cases, accounting reclassifications, pursuant to Sec. 1.482-
3(c)(3)(iii)(B), must be made to ensure consistent treatment of such 
material items. Inability to make such accounting reclassifications will 
decrease the reliability of the results of the uncontrolled 
transactions.
    Example 5. (i) USP, a U.S. corporation, manufactures Product X, an 
unbranded widget, and sells it to FSub, its wholly owned foreign 
subsidiary. FSub acts as a distributor of Product X in country M, and 
sells it to uncontrolled parties in that country. Uncontrolled 
distributors A, B, C, D, and E distribute competing products of 
approximately similar value in country M. All such products are 
unbranded.
    (ii) Relatively complete data is available regarding the functions 
performed and risks borne by the uncontrolled distributors and the 
contractual terms under which they operate in the uncontrolled 
transactions. In addition, data is available to ensure accounting 
consistency between all of the uncontrolled distributors and FSub. 
Because the available data is sufficiently complete and accurate to 
conclude that it is likely that all material differences between the 
controlled and uncontrolled transactions have been identified, such 
differences have a definite and reasonably ascertainable effect, and 
reliable adjustments are made to account for such differences, the 
results of each of the uncontrolled distributors may be used to 
establish an arm's length range pursuant to Sec. 1.482-1(e)(2)(iii)(A).
    Example 6. The facts are the same as Example 5, except that 
sufficient data is not available to determine whether any of the 
uncontrolled distributors provide warranties or to determine the payment 
terms of the contracts. Because differences in these contractual terms 
could materially affect price or profits, the inability to determine 
whether

[[Page 635]]

these differences exist between the controlled and uncontrolled 
transactions diminishes the reliability of the results of the 
uncontrolled comparables. However, the reliability of the results may be 
enhanced by the application of a statistical method when establishing an 
arm's length range pursuant to Sec. 1.482-1(e)(2)(iii)(B).
    Example 7. The facts are the same as in Example 5, except that 
Product X is branded with a valuable trademark that is owned by P. A, B, 
and C distribute unbranded competing products, while D and E distribute 
products branded with other trademarks. D and E do not own any rights in 
the trademarks under which their products are sold. The value of the 
products that A, B, and C sold are not similar to the value of the 
products sold by S. The value of products sold by D and E, however, is 
similar to that of Product X. Although close product similarity is not 
as important for a reliable application of the resale price method as 
for the comparable uncontrolled price method, significant differences in 
the value of the products involved in the controlled and uncontrolled 
transactions may affect the reliability of the results. In addition, 
because in this case it is difficult to determine the effect the 
trademark will have on price or profits, reliable adjustments for the 
differences cannot be made. Because D and E have a higher level of 
comparability than A, B, and C with respect to S, pursuant to Sec. 
1.482-1(e)(2)(ii), only D and E may be included in an arm's length 
range.

    (d) Cost plus method--(1) In general. The cost plus method evaluates 
whether the amount charged in a controlled transaction is arm's length 
by reference to the gross profit markup realized in comparable 
uncontrolled transactions. The cost plus method is ordinarily used in 
cases involving the manufacture, assembly, or other production of goods 
that are sold to related parties.
    (2) Determination of arm's length price--(i) In general. The cost 
plus method measures an arm's length price by adding the appropriate 
gross profit to the controlled taxpayer's costs of producing the 
property involved in the controlled transaction.
    (ii) Appropriate gross profit. The appropriate gross profit is 
computed by multiplying the controlled taxpayer's cost of producing the 
transferred property by the gross profit markup, expressed as a 
percentage of cost, earned in comparable uncontrolled transactions.
    (iii) Arm's length range. See Sec. 1.482-1(e)(2) for determination 
of an arm's length range.
    (3) Comparability and reliability considerations--(i) In general. 
Whether results derived from the application of this method are the most 
reliable measure of the arm's length result must be determined using the 
factors described under the best method rule in Sec. 1.482-1(c).
    (ii) Comparability--(A) Functional comparability. The degree of 
comparability between controlled and uncontrolled transactions is 
determined by applying the comparability provisions of Sec. 1.482-1(d). 
A producer's gross profit provides compensation for the performance of 
the production functions related to the product or products under 
review, including an operating profit for the producer's investment of 
capital and assumption of risks. Therefore, although all of the factors 
described in Sec. 1.482-1(d)(3) must be considered, comparability under 
this method is particularly dependent on similarity of functions 
performed, risks borne, and contractual terms, or adjustments to account 
for the effects of any such differences. If possible, the appropriate 
gross profit markup should be derived from comparable uncontrolled 
transactions of the taxpayer involved in the controlled sale, because 
similar characteristics are more likely to be found among sales of 
property by the same producer than among sales by other producers. In 
the absence of such sales, an appropriate gross profit markup may be 
derived from comparable uncontrolled sales of other producers whether or 
not such producers are members of the same controlled group.
    (B) Other comparability factors. Comparability under this method is 
less dependent on close physical similarity between the products 
transferred than under the comparable uncontrolled price method. 
Substantial differences in the products may, however, indicate 
significant functional differences between the controlled and 
uncontrolled taxpayers. Thus, it ordinarily would be expected that the 
controlled and uncontrolled transactions involve the production of goods 
within the same product categories. Furthermore, significant differences 
in the value of the

[[Page 636]]

products due, for example, to the value of a trademark, may also affect 
the reliability of the comparison. Finally, the reliability of profit 
measures based on gross profit may be adversely affected by factors that 
have less effect on prices. For example, gross profit may be affected by 
a variety of other factors, including cost structures (as reflected, for 
example, in the age of plant and equipment), business experience (such 
as whether the business is in a start-up phase or is mature), or 
management efficiency (as indicated, for example, by expanding or 
contracting sales or executive compensation over time). Accordingly, if 
material differences in these factors are identified based on objective 
evidence, the reliability of the analysis may be affected.
    (C) Adjustments for differences between controlled and uncontrolled 
transactions. If there are material differences between the controlled 
and uncontrolled transactions that would affect the gross profit markup, 
adjustments should be made to the gross profit markup earned in the 
comparable uncontrolled transaction according to the provisions of Sec. 
1.482-1(d)(2). For this purpose, consideration of the operating expenses 
associated with the functions performed and risks assumed may be 
necessary, because differences in functions performed are often 
reflected in operating expenses. If there are differences in functions 
performed, however, the effect on gross profit of such differences is 
not necessarily equal to the differences in the amount of related 
operating expenses. Specific examples of the factors that may be 
particularly relevant to this method include--
    (1) The complexity of manufacturing or assembly;
    (2) Manufacturing, production, and process engineering;
    (3) Procurement, purchasing, and inventory control activities;
    (4) Testing functions;
    (5) Selling, general, and administrative expenses;
    (6) Foreign currency risks; and
    (7) Contractual terms (e.g., scope and terms of warranties provided, 
sales or purchase volume, credit terms, transport terms).
    (D) Purchasing agent. If a controlled taxpayer is comparable to a 
purchasing agent that does not take title to property or otherwise 
assume risks with respect to ownership of such goods, the commission 
earned by such purchasing agent, expressed as a percentage of the 
purchase price of the goods, may be used as the appropriate gross profit 
markup.
    (iii) Data and assumptions--(A) In general. The reliability of the 
results derived from the cost plus method is affected by the 
completeness and accuracy of the data used and the reliability of the 
assumptions made to apply this method. See Sec. 1.482-1(c) (Best method 
rule).
    (B) Consistency in accounting. The degree of consistency in 
accounting practices between the controlled transaction and the 
uncontrolled comparables that materially affect the gross profit markup 
affects the reliability of the result. Thus, for example, if differences 
in inventory and other cost accounting practices would materially affect 
the gross profit markup, the ability to make reliable adjustments for 
such differences would affect the reliability of the results. Further, 
the controlled transaction and the comparable uncontrolled transaction 
should be consistent in the reporting of costs between cost of goods 
sold and operating expenses. The term cost of producing includes the 
cost of acquiring property that is held for resale.
    (4) Examples. The following examples illustrate the principles of 
this paragraph (d).

    Example 1. (i) USP, a domestic manufacturer of computer components, 
sells its products to FS, its foreign distributor. UT1, UT2, and UT3 are 
domestic computer component manufacturers that sell to uncontrolled 
foreign purchasers.
    (ii) Relatively complete data is available regarding the functions 
performed and risks borne by UT1, UT2, and UT3, and the contractual 
terms in the uncontrolled transactions. In addition, data is available 
to ensure accounting consistency between all of the uncontrolled 
manufacturers and USP. Because the available data is sufficiently 
complete to conclude that it is likely that all material differences 
between the controlled and uncontrolled transactions have been 
identified, the effect of the differences are definite and reasonably 
ascertainable,

[[Page 637]]

and reliable adjustments are made to account for the differences, an 
arm's length range can be established pursuant to Sec. 1.482-
1(e)(2)(iii)(A).
    Example 2. The facts are the same as in Example 1, except that USP 
accounts for supervisory, general, and administrative costs as operating 
expenses, which are not allocated to its sales to FS. The gross profit 
markups of UT1, UT2, and UT3, however, reflect supervisory, general, and 
administrative expenses because they are accounted for as costs of goods 
sold. Accordingly, the gross profit markups of UT1, UT2, and UT3 must be 
adjusted as provided in paragraph (d)(3)(iii)(B) of this section to 
provide accounting consistency. If data is not sufficient to determine 
whether such accounting differences exist between the controlled and 
uncontrolled transactions, the reliability of the results will be 
decreased.
    Example 3. The facts are the same as in Example 1, except that under 
its contract with FS, USP uses materials consigned by FS. UT1, UT2, and 
UT3, on the other hand, purchase their own materials, and their gross 
profit markups are determined by including the costs of materials. The 
fact that USP does not carry an inventory risk by purchasing its own 
materials while the uncontrolled producers carry inventory is a 
significant difference that may require an adjustment if the difference 
has a material effect on the gross profit markups of the uncontrolled 
producers. Inability to reasonably ascertain the effect of the 
difference on the gross profit markups will affect the reliability of 
the results of UT1, UT2, and UT3.
    Example 4. (i) FS, a foreign corporation, produces apparel for USP, 
its U.S. parent corporation. FS purchases its materials from unrelated 
suppliers and produces the apparel according to designs provided by USP. 
The district director identifies 10 uncontrolled foreign apparel 
producers that operate in the same geographic market and are similar in 
many respect to FS.
    (ii) Relatively complete data is available regarding the functions 
performed and risks borne by the uncontrolled producers. In addition, 
data is sufficiently detailed to permit adjustments for differences in 
accounting practices. However, sufficient data is not available to 
determine whether it is likely that all material differences in 
contractual terms have been identified. For example, it is not possible 
to determine which parties in the uncontrolled transactions bear 
currency risks. Because differences in these contractual terms could 
materially affect price or profits, the inability to determine whether 
differences exist between the controlled and uncontrolled transactions 
will diminish the reliability of these results. Therefore, the 
reliability of the results of the uncontrolled transactions must be 
enhanced by the application of a statistical method in establishing an 
arm's length range pursuant to Sec. 1.482-1(e)(2)(iii)(B).

    (e) Unspecified methods--(1) In general. Methods not specified in 
paragraphs (a)(1), (2), (3), (4), and (5) of this section may be used to 
evaluate whether the amount charged in a controlled transaction is arm's 
length. Any method used under this paragraph (e) must be applied in 
accordance with the provisions of Sec. 1.482-1. Consistent with the 
specified methods, an unspecified method should take into account the 
general principle that uncontrolled taxpayers evaluate the terms of a 
transaction by considering the realistic alternatives to that 
transaction, and only enter into a particular transaction if none of the 
alternatives is preferable to it. For example, the comparable 
uncontrolled price method compares a controlled transaction to similar 
uncontrolled transactions to provide a direct estimate of the price to 
which the parties would have agreed had they resorted directly to a 
market alternative to the controlled transaction. Therefore, in 
establishing whether a controlled transaction achieved an arm's length 
result, an unspecified method should provide information on the prices 
or profits that the controlled taxpayer could have realized by choosing 
a realistic alternative to the controlled transaction. As with any 
method, an unspecified method will not be applied unless it provides the 
most reliable measure of an arm's length result under the principles of 
the best method rule. See Sec. 1.482-1(c). Therefore, in accordance 
with Sec. 1.482-1(d) (Comparability), to the extent that a method 
relies on internal data rather than uncontrolled comparables, its 
reliability will be reduced. Similarly, the reliability of a method will 
be affected by the reliability of the data and assumptions used to apply 
the method, including any projections used.
    (2) Example. The following example illustrates an application of the 
principle of this paragraph (e).

    Example. Amcan, a U.S. company, produces unique vessels for storing 
and transporting toxic waste, toxicans, at its U.S. production facility. 
Amcan agrees by contract to supply its Canadian subsidiary, Cancan, with 
4000 toxicans per year to serve the Canadian market for toxicans. Prior 
to entering into the

[[Page 638]]

contract with Cancan, Amcan had received a bona fide offer from an 
independent Canadian waste disposal company, Cando, to serve as the 
Canadian distributor for toxicans and to purchase a similar number of 
toxicans at a price of $5,000 each. If the circumstances and terms of 
the Cancan supply contract are sufficiently similar to those of the 
Cando offer, or sufficiently reliable adjustments can be made for 
differences between them, then the Cando offer price of $5,000 may 
provide reliable information indicating that an arm's length 
consideration under the Cancan contract will not be less than $5,000 per 
toxican.

    (f) Coordination with intangible property rules. The value of an 
item of tangible property may be affected by the value of intangible 
property, such as a trademark affixed to the tangible property (embedded 
intangible). Ordinarily, the transfer of tangible property with an 
embedded intangible will not be considered a transfer of such intangible 
if the controlled purchaser does not acquire any rights to exploit the 
intangible property other than rights relating to the resale of the 
tangible property under normal commercial practices. Pursuant to Sec. 
1.482-1(d)(3)(v), however, the embedded intangible must be accounted for 
in evaluating the comparability of the controlled transaction and 
uncontrolled comparables. For example, because product comparability has 
the greatest effect on an application of the comparable uncontrolled 
price method, trademarked tangible property may be insufficiently 
comparable to unbranded tangible property to permit a reliable 
application of the comparable uncontrolled price method. The effect of 
embedded intangibles on comparability will be determined under the 
principles of Sec. 1.482-4. If the transfer of tangible property 
conveys to the recipient a right to exploit an embedded intangible 
(other than in connection with the resale of that item of tangible 
property), it may be necessary to determine the arm's length 
consideration for such intangible separately from the tangible property, 
applying methods appropriate to determining the arm's length result for 
a transfer of intangible property under Sec. 1.482-4. For example, if 
the transfer of a machine conveys the right to exploit a manufacturing 
process incorporated in the machine, then the arm's length consideration 
for the transfer of that right must be determined separately under Sec. 
1.482-4.

[T.D. 8552, 59 FR 35011, July 8, 1994; 60 FR 16382, Mar. 30, 1995]



Sec. 1.482-4  Methods to determine taxable income in connection with 
a transfer of intangible property.

    (a) In general. The arm's length amount charged in a controlled 
transfer of intangible property must be determined under one of the four 
methods listed in this paragraph (a). Each of the methods must be 
applied in accordance with all of the provisions of Sec. 1.482-1, 
including the best method rule of Sec. 1.482-1(c), the comparability 
analysis of Sec. 1.482-1(d), and the arm's length range of Sec. 1.482-
1(e). The arm's length consideration for the transfer of an intangible 
determined under this section must be commensurate with the income 
attributable to the intangible. See Sec. 1.482-4(f)(2) (Periodic 
adjustments). The available methods are--
    (1) The comparable uncontrolled transaction method, described in 
paragraph (c) of this section;
    (2) The comparable profits method, described in Sec. 1.482-5;
    (3) The profit split method, described in Sec. 1.482-6; and
    (4) Unspecified methods described in paragraph (d) of this section.
    (b) Definition of intangible. For purposes of section 482, an 
intangible is an asset that comprises any of the following items and has 
substantial value independent of the services of any individual--
    (1) Patents, inventions, formulae, processes, designs, patterns, or 
know-how;
    (2) Copyrights and literary, musical, or artistic compositions;
    (3) Trademarks, trade names, or brand names;
    (4) Franchises, licenses, or contracts;
    (5) Methods, programs, systems, procedures, campaigns, surveys, 
studies, forecasts, estimates, customer lists, or technical data; and
    (6) Other similar items. For purposes of section 482, an item is 
considered similar to those listed in paragraph

[[Page 639]]

(b)(1) through (5) of this section if it derives its value not from its 
physical attributes but from its intellectual content or other 
intangible properties.
    (c) Comparable uncontrolled transaction method--(1) In general. The 
comparable uncontrolled transaction method evaluates whether the amount 
charged for a controlled transfer of intangible property was arm's 
length by reference to the amount charged in a comparable uncontrolled 
transaction. The amount determined under this method may be adjusted as 
required by paragraph (f)(2) of this section (Periodic adjustments).
    (2) Comparability and reliability considerations--(i) In general. 
Whether results derived from applications of this method are the most 
reliable measure of an arm's length result is determined using the 
factors described under the best method rule in Sec. 1.482-1(c). The 
application of these factors under the comparable uncontrolled 
transaction method is discussed in paragraphs (c)(2)(ii), (iii), and 
(iv) of this section.
    (ii) Reliability. If an uncontrolled transaction involves the 
transfer of the same intangible under the same, or substantially the 
same, circumstances as the controlled transaction, the results derived 
from applying the comparable uncontrolled transaction method will 
generally be the most direct and reliable measure of the arm's length 
result for the controlled transfer of an intangible. Circumstances 
between the controlled and uncontrolled transactions will be considered 
substantially the same if there are at most only minor differences that 
have a definite and reasonably ascertainable effect on the amount 
charged and for which appropriate adjustments are made. If such 
uncontrolled transactions cannot be identified, uncontrolled 
transactions that involve the transfer of comparable intangibles under 
comparable circumstances may be used to apply this method, but the 
reliability of the analysis will be reduced.
    (iii) Comparability--(A) In general. The degree of comparability 
between controlled and uncontrolled transactions is determined by 
applying the comparability provisions of Sec. 1.482-1(d). Although all 
of the factors described in Sec. 1.482-1(d)(3) must be considered, 
specific factors may be particularly relevant to this method. In 
particular, the application of this method requires that the controlled 
and uncontrolled transactions involve either the same intangible 
property or comparable intangible property, as defined in paragraph 
(c)(2)(iii)(B)(1) of this section. In addition, because differences in 
contractual terms, or the economic conditions in which transactions take 
place, could materially affect the amount charged, comparability under 
this method also depends on similarity with respect to these factors, or 
adjustments to account for material differences in such circumstances.
    (B) Factors to be considered in determining comparability--(1) 
Comparable intangible property. In order for the intangible property 
involved in an uncontrolled transaction to be considered comparable to 
the intangible property involved in the controlled transaction, both 
intangibles must--
    (i) Be used in connection with similar products or processes within 
the same general industry or market; and
    (ii) Have similar profit potential. The profit potential of an 
intangible is most reliably measured by directly calculating the net 
present value of the benefits to be realized (based on prospective 
profits to be realized or costs to be saved) through the use or 
subsequent transfer of the intangible, considering the capital 
investment and start-up expenses required, the risks to be assumed, and 
other relevant considerations. The need to reliably measure profit 
potential increases in relation to both the total amount of potential 
profits and the potential rate of return on investment necessary to 
exploit the intangible. If the information necessary to directly 
calculate net present value of the benefits to be realized is 
unavailable, and the need to reliably measure profit potential is 
reduced because the potential profits are relatively small in terms of 
total amount and rate of return, comparison of profit potential may be 
based upon the factors referred to in paragraph (c)(2)(iii)(B)(2) of 
this section. See Example 3 of Sec. 1.482-4(c)(4). Finally, the 
reliability of a measure of profit potential is affected by the extent 
to which

[[Page 640]]

the profit attributable to the intangible can be isolated from the 
profit attributable to other factors, such as functions performed and 
other resources employed.
    (2) Comparable circumstances. In evaluating the comparability of the 
circumstances of the controlled and uncontrolled transactions, although 
all of the factors described in Sec. 1.482-1(d)(3) must be considered, 
specific factors that may be particularly relevant to this method 
include the following--
    (i) The terms of the transfer, including the exploitation rights 
granted in the intangible, the exclusive or nonexclusive character of 
any rights granted, any restrictions on use, or any limitations on the 
geographic area in which the rights may be exploited;
    (ii) The stage of development of the intangible (including, where 
appropriate, necessary governmental approvals, authorizations, or 
licenses) in the market in which the intangible is to be used;
    (iii) Rights to receive updates, revisions, or modifications of the 
intangible;
    (iv) The uniqueness of the property and the period for which it 
remains unique, including the degree and duration of protection afforded 
to the property under the laws of the relevant countries;
    (v) The duration of the license, contract, or other agreement, and 
any termination or renegotiation rights;
    (vi) Any economic and product liability risks to be assumed by the 
transferee;
    (vii) The existence and extent of any collateral transactions or 
ongoing business relationships between the transferee and transferor; 
and
    (viii) The functions to be performed by the transferor and 
transferee, including any ancillary or subsidiary services.
    (iv) Data and assumptions. The reliability of the results derived 
from the comparable uncontrolled transaction method is affected by the 
completeness and accuracy of the data used and the reliability of the 
assumptions made to apply this method. See Sec. 1.482-1(c) (Best method 
rule).
    (3) Arm's length range. See Sec. 1.482-1(e)(2) for the 
determination of an arm's length range.
    (4) Examples. The following examples illustrate the principles of 
this paragraph (c).

    Example 1. (i) USpharm, a U.S. pharmaceutical company, develops a 
new drug Z that is a safe and effective treatment for the disease 
zeezee. USpharm has obtained patents covering drug Z in the United 
States and in various foreign countries. USpharm has also obtained the 
regulatory authorizations necessary to market drug Z in the United 
States and in foreign countries.
    (ii) USpharm licenses its subsidiary in country X, Xpharm, to 
produce and sell drug Z in country X. At the same time, it licenses an 
unrelated company, Ydrug, to produce and sell drug Z in country Y, a 
neighboring country. Prior to licensing the drug, USpharm had obtained 
patent protection and regulatory approvals in both countries and both 
countries provide similar protection for intellectual property rights. 
Country X and country Y are similar countries in terms of population, 
per capita income and the incidence of disease zeezee. Consequently, 
drug Z is expected to sell in similar quantities and at similar prices 
in both countries. In addition, costs of producing and marketing drug Z 
in each country are expected to be approximately the same.
    (iii) USpharm and Xpharm establish terms for the license of drug Z 
that are identical in every material respect, including royalty rate, to 
the terms established between USpharm and Ydrug. In this case the 
district director determines that the royalty rate established in the 
Ydrug license agreement is a reliable measure of the arm's length 
royalty rate for the Xpharm license agreement.
    Example 2. The facts are the same as in Example 1, except that the 
incidence of the disease zeezee in Country Y is much higher than in 
Country X. In this case, the profit potential from exploitation of the 
right to make and sell drug Z is likely to be much higher in country Y 
than it is in Country X. Consequently, the Ydrug license agreement is 
unlikely to provide a reliable measure of the arm's length royalty rate 
for the Xpharm license.
    Example 3. (i) FP, is a foreign company that designs, manufactures 
and sells industrial equipment. FP has developed proprietary components 
that are incorporated in its products. These components are important in 
the operation of FP's equipment and some of them have distinctive 
features, but other companies produce similar components and none of 
these components by itself accounts for a substantial part of the value 
of FP's products.

[[Page 641]]

    (ii) FP licenses its U.S. subsidiary, USSub, exclusive North 
American rights to use the patented technology for producing component 
X, a heat exchanger used for cooling operating mechanisms in industrial 
equipment. Component X incorporates proven technology that makes it 
somewhat more efficient than the heat exchangers commonly used in 
industrial equipment. FP also agrees to provide technical support to 
help adapt component X to USSub's products and to assist with initial 
production. Under the terms of the license agreement USSub pays FP a 
royalty equal to 3 percent of sales of USSub equipment incorporating 
component X.
    (iii) FP does not license unrelated parties to use component X, but 
many similar components are transferred between uncontrolled taxpayers. 
Consequently, the district director decides to apply the comparable 
uncontrolled transaction method to evaluate whether the 3 percent 
royalty for component X is an arm's length royalty.
    (iv) The district director uses a database of company documents 
filed with the Securities and Exchange Commission (SEC) to identify 
potentially comparable license agreements between uncontrolled taxpayers 
that are on file with the SEC. The district director identifies 40 
license agreements that were entered into in the same year as the 
controlled transfer or in the prior or following year, and that relate 
to transfers of technology associated with industrial equipment that has 
similar applications to USSub's products. Further review of these 
uncontrolled agreements indicates that 25 of them involved components 
that have a similar level of technical sophistication as component X and 
could be expected to play a similar role in contributing to the total 
value of the final product.
    (v) The district director makes a detailed review of the terms of 
each of the 25 uncontrolled agreements and finds that 15 of them are 
similar to the controlled agreement in that they all involve--
    (A) The transfer of exclusive rights for the North American market;
    (B) Products for which the market could be expected to be of a 
similar size to the market for the products into which USSub 
incorporates component X;
    (C) The transfer of patented technology;
    (D) Continuing technical support;
    (E) Access to technical improvements;
    (F) Technology of a similar age; and
    (G) A similar duration of the agreement.
    (vi) Based on these factors and the fact that none of the components 
to which these license agreements relate accounts for a substantial part 
of the value of the final products, the district director concludes that 
these fifteen intangibles have similar profit potential to the component 
X technology.
    (vii) The 15 uncontrolled comparables produce the following royalty 
rates:

------------------------------------------------------------------------
                                                                Royalty
                           License                               rate
                                                               (percent)
------------------------------------------------------------------------
1...........................................................        1.0
2...........................................................        1.0
3...........................................................        1.25
4...........................................................        1.25
5...........................................................        1.5
6...........................................................        1.5
7...........................................................        1.75
8...........................................................        2.0
9...........................................................        2.0
10..........................................................        2.0
11..........................................................        2.25
12..........................................................        2.5
13..........................................................        2.5
14..........................................................        2.75
15..........................................................        3.0
------------------------------------------------------------------------

    (viii) Although the uncontrolled comparables are clearly similar to 
the controlled transaction, it is likely that unidentified material 
differences exist between the uncontrolled comparables and the 
controlled transaction. Therefore, an appropriate statistical technique 
must be used to establish the arm's length range. In this case the 
district director uses the interquartile range to determine the arm's 
length range. Therefore, the arm's length range covers royalty rates 
from 1.25 to 2.5 percent, and an adjustment is warranted to the 3 
percent royalty charged in the controlled transfer. The district 
director determines that the appropriate adjustment corresponds to a 
reduction in the royalty rate to 2.0 percent, which is the median of the 
uncontrolled comparables.
    Example 4. (i) USdrug, a U.S. pharmaceutical company, has developed 
a new drug, Nosplit, that is useful in treating migraine headaches and 
produces no significant side effects. Nosplit replaces another drug, 
Lessplit, that USdrug had previously produced and marketed as a 
treatment for migraine headaches. A number of other drugs for treating 
migraine headaches are already on the market, but Nosplit can be 
expected rapidly to dominate the worldwide market for such treatments 
and to command a premium price since all other treatments produce side 
effects. Thus, USdrug projects that extraordinary profits will be 
derived from Nosplit in the U.S. market and other markets.
    (ii) USdrug licenses its newly established European subsidiary, 
Eurodrug, the rights to produce and market Nosplit in the European 
market. In setting the royalty rate for this license, USdrug considers 
the royalty that it established previously when it licensed the right to 
produce and market Lessplit in the European market to an unrelated 
European pharmaceutical company. In many respects the two license 
agreements are closely comparable. The drugs were licensed at the same 
stage in their development and the agreements conveyed identical rights 
to the licensees. Moreover, there appear to have been

[[Page 642]]

no significant changes in the European market for migraine headache 
treatments since Lessplit was licensed. However, at the time that 
Lessplit was licensed there were several other similar drugs already on 
the market to which Lessplit was not in all cases superior. 
Consequently, the projected and actual Lessplit profits were 
substantially less than the projected Nosplit profits. Thus, USdrug 
concludes that the profit potential of Lessplit is not similar to the 
profit potential of Nosplit, and the Lessplit license agreement 
consequently is not a comparable uncontrolled transaction for purposes 
of this paragraph (c) in spite of the other indicia of comparability 
between the two intangibles.

    (d) Unspecified methods--(1) In general. Methods not specified in 
paragraphs (a)(1), (2), and (3) of this section may be used to evaluate 
whether the amount charged in a controlled transaction is arm's length. 
Any method used under this paragraph (d) must be applied in accordance 
with the provisions of Sec. 1.482-1. Consistent with the specified 
methods, an unspecified method should take into account the general 
principle that uncontrolled taxpayers evaluate the terms of a 
transaction by considering the realistic alternatives to that 
transaction, and only enter into a particular transaction if none of the 
alternatives is preferable to it. For example, the comparable 
uncontrolled transaction method compares a controlled transaction to 
similar uncontrolled transactions to provide a direct estimate of the 
price the parties would have agreed to had they resorted directly to a 
market alternative to the controlled transaction. Therefore, in 
establishing whether a controlled transaction achieved an arm's length 
result, an unspecified method should provide information on the prices 
or profits that the controlled taxpayer could have realized by choosing 
a realistic alternative to the controlled transaction. As with any 
method, an unspecified method will not be applied unless it provides the 
most reliable measure of an arm's length result under the principles of 
the best method rule. See Sec. 1.482-1(c). Therefore, in accordance 
with Sec. 1.482-1(d) (Comparability), to the extent that a method 
relies on internal data rather than uncontrolled comparables, its 
reliability will be reduced. Similarly, the reliability of a method will 
be affected by the reliability of the data and assumptions used to apply 
the method, including any projections used.
    (2) Example. The following example illustrates an application of the 
principle of this paragraph (d).

    Example. (i) USbond is a U.S. company that licenses to its foreign 
subsidiary, Eurobond, a proprietary process that permits the manufacture 
of Longbond, a long-lasting industrial adhesive, at a substantially 
lower cost than otherwise would be possible. Using the proprietary 
process, Eurobond manufactures Longbond and sells it to related and 
unrelated parties for the market price of $550 per ton. Under the terms 
of the license agreement, Eurobond pays USbond a royalty of $100 per ton 
of Longbond sold. USbond also manufactures and markets Longbond in the 
United States.
    (ii) In evaluating whether the consideration paid for the transfer 
of the proprietary process to Eurobond was arm's length, the district 
director may consider, subject to the best method rule of Sec. 1.482-
1(c), USbond's alternative of producing and selling Longbond itself. 
Reasonably reliable estimates indicate that if USbond directly supplied 
Longbond to the European market, a selling price of $300 per ton would 
cover its costs and provide a reasonable profit for its functions, risks 
and investment of capital associated with the production of Longbond for 
the European market. Given that the market price of Longbond was $550 
per ton, by licensing the proprietary process to Eurobond, USbond 
forgoes $250 per ton of profit over the profit that would be necessary 
to compensate it for the functions, risks and investment involved in 
supplying Longbond to the European market itself. Based on these facts, 
the district director concludes that a royalty of $100 for the 
proprietary process is not arm's length.

    (e) Coordination with tangible property rules. See Sec. 1.482-3(f) 
for the provisions regarding the coordination between the tangible 
property and intangible property rules.
    (f) Special rules for transfers of intangible property--(1) Form of 
consideration. If a transferee of an intangible pays nominal or no 
consideration and the transferor has retained a substantial interest in 
the property, the arm's length consideration shall be in the form of a 
royalty, unless a different form is demonstrably more appropriate.
    (2) Periodic adjustments--(i) General rule. If an intangible is 
transferred under an arrangement that covers more than one year, the 
consideration charged in each taxable year may be

[[Page 643]]

adjusted to ensure that it is commensurate with the income attributable 
to the intangible. Adjustments made pursuant to this paragraph (f)(2) 
shall be consistent with the arm's length standard and the provisions of 
Sec. 1.482-1. In determining whether to make such adjustments in the 
taxable year under examination, the district director may consider all 
relevant facts and circumstances throughout the period the intangible is 
used. The determination in an earlier year that the amount charged for 
an intangible was an arm's length amount will not preclude the district 
director in a subsequent taxable year from making an adjustment to the 
amount charged for the intangible in the subsequent year. A periodic 
adjustment under the commensurate with income requirement of section 482 
may be made in a subsequent taxable year without regard to whether the 
taxable year of the original transfer remains open for statute of 
limitation purposes. For exceptions to this rule see paragraph 
(f)(2)(ii) of this section.
    (ii) Exceptions--(A) Transactions involving the same intangible. If 
the same intangible was transferred to an uncontrolled taxpayer under 
substantially the same circumstances as those of the controlled 
transaction; this transaction serves as the basis for the application of 
the comparable uncontrolled transaction method in the first taxable year 
in which substantial periodic consideration was required to be paid; and 
the amount paid in that year was an arm's length amount, then no 
allocation in a subsequent year will be made under paragraph (f)(2)(i) 
of this paragraph for a controlled transfer of intangible property.
    (B) Transactions involving comparable intangible. If the arm's 
length result is derived from the application of the comparable 
uncontrolled transaction method based on the transfer of a comparable 
intangible under comparable circumstances to those of the controlled 
transaction, no allocation will be made under paragraph (f)(2)(i) of 
this section if each of the following facts is established--
    (1) The controlled taxpayers entered into a written agreement 
(controlled agreement) that provided for an amount of consideration with 
respect to each taxable year subject to such agreement, such 
consideration was an arm's length amount for the first taxable year in 
which substantial periodic consideration was required to be paid under 
the agreement, and such agreement remained in effect for the taxable 
year under review;
    (2) There is a written agreement setting forth the terms of the 
comparable uncontrolled transaction relied upon to establish the arm's 
length consideration (uncontrolled agreement), which contains no 
provisions that would permit any change to the amount of consideration, 
a renegotiation, or a termination of the agreement, in circumstances 
comparable to those of the controlled transaction in the taxable year 
under review (or that contains provisions permitting only specified, 
non-contingent, periodic changes to the amount of consideration);
    (3) The controlled agreement is substantially similar to the 
uncontrolled agreement, with respect to the time period for which it is 
effective and the provisions described in paragraph (f)(2)(ii)(B)(2) of 
this section;
    (4) The controlled agreement limits use of the intangible to a 
specified field or purpose in a manner that is consistent with industry 
practice and any such limitation in the uncontrolled agreement;
    (5) There were no substantial changes in the functions performed by 
the controlled transferee after the controlled agreement was executed, 
except changes required by events that were not foreseeable; and
    (6) The aggregate profits actually earned or the aggregate cost 
savings actually realized by the controlled taxpayer from the 
exploitation of the intangible in the year under examination, and all 
past years, are not less than 80% nor more than 120% of the prospective 
profits or cost savings that were foreseeable when the comparability of 
the uncontrolled agreement was established under paragraph (c)(2) of 
this section.
    (C) Methods other than comparable uncontrolled transaction. If the 
arm's length amount was determined under any method other than the 
comparable uncontrolled transaction method, no

[[Page 644]]

allocation will be made under paragraph (f)(2)(i) of this section if 
each of the following facts is established--
    (1) The controlled taxpayers entered into a written agreement 
(controlled agreement) that provided for an amount of consideration with 
respect to each taxable year subject to such agreement, and such 
agreement remained in effect for the taxable year under review;
    (2) The consideration called for in the controlled agreement was an 
arm's length amount for the first taxable year in which substantial 
periodic consideration was required to be paid, and relevant supporting 
documentation was prepared contemporaneously with the execution of the 
controlled agreement;
    (3) There have been no substantial changes in the functions 
performed by the transferee since the controlled agreement was executed, 
except changes required by events that were not foreseeable; and
    (4) The total profits actually earned or the total cost savings 
realized by the controlled transferee from the exploitation of the 
intangible in the year under examination, and all past years, are not 
less than 80% nor more than 120% of the prospective profits or cost 
savings that were foreseeable when the controlled agreement was entered 
into.
    (D) Extraordinary events. No allocation will be made under paragraph 
(f)(2)(i) of this section if the following requirements are met--
    (1) Due to extraordinary events that were beyond the control of the 
controlled taxpayers and that could not reasonably have been anticipated 
at the time the controlled agreement was entered into, the aggregate 
actual profits or aggregate cost savings realized by the taxpayer are 
less than 80% or more than 120% of the prospective profits or cost 
savings; and
    (2) All of the requirements of paragraph (f)(2)(ii) (B) or (C) of 
this section are otherwise satisfied.
    (E) Five-year period. If the requirements of Sec. 1.482-4 
(f)(2)(ii)(B) or (f)(2)(ii)(C) are met for each year of the five-year 
period beginning with the first year in which substantial periodic 
consideration was required to be paid, then no periodic adjustment will 
be made under paragraph (f)(2)(i) of this section in any subsequent 
year.
    (iii) Examples. The following examples illustrate this paragraph 
(f)(2).

    Example 1. (i) USdrug, a U.S. pharmaceutical company, has developed 
a new drug, Nosplit, that is useful in treating migraine headaches and 
produces no significant side effects. A number of other drugs for 
treating migraine headaches are already on the market, but Nosplit can 
be expected rapidly to dominate the worldwide market for such treatments 
and to command a premium price since all other treatments produce side 
effects. Thus, USdrug projects that extraordinary profits will be 
derived from Nosplit in the U.S. and European markets.
    (ii) USdrug licenses its newly established European subsidiary, 
Eurodrug, the rights to produce and market Nosplit for the European 
market for 5 years. In setting the royalty rate for this license, USdrug 
makes projections of the annual sales revenue and the annual profits to 
be derived from the exploitation of Nosplit by Eurodrug. Based on the 
projections, a royalty rate of 3.9% is established for the term of the 
license.
    (iii) In Year 1, USdrug evaluates the royalty rate it received from 
Eurodrug. Given the high profit potential of Nosplit, USdrug is unable 
to locate any uncontrolled transactions dealing with licenses of 
comparable intangible property. USdrug therefore determines that the 
comparable uncontrolled transaction method will not provide a reliable 
measure of an arm's length royalty. However, applying the comparable 
profits method to Eurodrug, USdrug determines that a royalty rate of 
3.9% will result in Eurodrug earning an arm's length return for its 
manufacturing and marketing functions.
    (iv) In Year 5, the U.S. income tax return for USdrug is examined, 
and the district director must determine whether the royalty rate 
between USdrug and Eurodrug is commensurate with the income attributable 
to Nosplit. In making this determination, the district director 
considers whether any of the exceptions in Sec. 1.482-4(f)(2)(ii) are 
applicable. In particular, the district director compares the profit 
projections attributable to Nosplit made by USdrug against the actual 
profits realized by Eurodrug. The projected and actual profits are as 
follows:

------------------------------------------------------------------------
                                              Profit
                                            projections   Actual profits
------------------------------------------------------------------------
Year 1..................................             200             250
Year 2..................................             250             300
Year 3..................................             500             600
Year 4..................................             350             200
Year 5..................................             100             100
                                         -------------------------------
    Total...............................            1400            1450
------------------------------------------------------------------------


[[Page 645]]

    (v) The total profits earned through Year 5 were not less than 80% 
nor more than 120% of the profits that were projected when the license 
was entered into. If the district director determines that the other 
requirements of Sec. 1.482-4(f)(2)(ii)(C) were met, no adjustment will 
be made to the royalty rate between USdrug and Eurodrug for the license 
of Nosplit.
    Example 2. (i) The facts are the same as in Example 1, except that 
Eurodrug's actual profits earned were much higher than the projected 
profits, as follows:

------------------------------------------------------------------------
                                              Profit
                                            projections   Actual profits
------------------------------------------------------------------------
Year 1..................................             200             250
Year 2..................................             250             500
Year 3..................................             500             800
Year 4..................................             350             700
Year 5..................................             100             600
                                         -------------------------------
    Total...............................            1400            2850
------------------------------------------------------------------------

    (ii) In examining USdrug's tax return for Year 5, the district 
director considers the actual profits realized by Eurodrug in Year 5, 
and all past years. Accordingly, although Years 1 through 4 may be 
closed under the statute of limitations, for purposes of determining 
whether an adjustment should be made with respect to the royalty rate in 
Year 5 with respect to Nosplit, the district director aggregates the 
actual profits from those years with the profits of Year 5. However, the 
district director will make an adjustment, if any, only with respect to 
Year 5.
    Example 3. (i) FP, a foreign corporation, licenses to USS, its U.S. 
subsidiary, a new air-filtering process that permits manufacturing 
plants to meet new environmental standards. The license runs for a 10-
year period, and the profit derived from the new process is projected to 
be $15 million per year, for an aggregate profit of $150 million.
    (ii) The royalty rate for the license is based on a comparable 
uncontrolled transaction involving a comparable intangible under 
comparable circumstances. The requirements of paragraphs 
(f)(2)(ii)(B)(1) through (5) of this section have been met. 
Specifically, FP and USS have entered into a written agreement that 
provides for a royalty in each year of the license, the royalty rate is 
considered arm's length for the first taxable year in which a 
substantial royalty was required to be paid, the license limited the use 
of the process to a specified field, consistent with industry practice, 
and there are no substantial changes in the functions performed by USS 
after the license was entered into.
    (iii) In examining Year 4 of the license, the district director 
determines that the aggregate actual profits earned by USS through Year 
4 are $30 million, less than 80% of the projected profits of $60 
million. However, USS establishes to the satisfaction of the district 
director that the aggregate actual profits from the process are less 
than 80% of the projected profits in Year 3 because an earthquake 
severely damaged USS's manufacturing plant. Because the difference 
between the projected profits and actual profits was due to an 
extraordinary event that was beyond the control of USS, and could not 
reasonably have been anticipated at the time the license was entered 
into, the requirement under Sec. 1.482-4(f)(2)(ii)(D) has been met, and 
no adjustment under this section is made.

    (3) Ownership of intangible property--(i) In general. If the owner 
of the rights to exploit an intangible transfers such rights to a 
controlled taxpayer, the owner must receive an amount of consideration 
with respect to such transfer that is determined in accordance with the 
provisions of this section. If another controlled taxpayer provides 
assistance to the owner in connection with the development or 
enhancement of an intangible, such person may be entitled to receive 
consideration with respect to such assistance. See Sec. 1.482-
4(f)(3)(iii) (Allocations with respect to assistance provided to the 
owner). Because the right to exploit an intangible can be subdivided in 
various ways, a single intangible may have multiple owners for purposes 
of this paragraph (3)(i). Thus, for example, the owner of a trademark 
may license to another person the exclusive right to use that trademark 
in a specified geographic area for a specified period of time (while 
otherwise retaining the right to use the intangible). In such a case, 
both the licensee and the licensor will be considered owners for 
purposes of this paragraph (f)(3)(i), with respect to their respective 
exploitation rights.
    (ii) Identification of owner--(A) Legally protected intangible 
property. The legal owner of a right to exploit an intangible ordinarily 
will be considered the owner for purposes of this section. Legal 
ownership may be acquired by operation of law or by contract under which 
the legal owner transfers all or part of its rights to another. Further, 
the district director may impute an agreement to convey legal ownership 
if the conduct of the controlled taxpayers indicates the existence in 
substance of such an agreement. See Sec. 1.482-

[[Page 646]]

1(d)(3)(ii)(B) (Identifying contractual terms).
    (B) Intangible property that is not legally protected. In the case 
of intangible property that is not legally protected, the developer of 
the intangible will be considered the owner. Except as provided in Sec. 
1.482-7T, if two or more controlled taxpayers jointly develop an 
intangible, for purposes of section 482, only one of the controlled 
taxpayers will be regarded as the developer and owner of the intangible, 
and the other participating members will be regarded as assisters. 
Ordinarily, the developer is the controlled taxpayer that bore the 
largest portion of the direct and indirect costs of developing the 
intangible, including the provision, without adequate compensation, of 
property or services likely to contribute substantially to developing 
the intangible. A controlled taxpayer will be presumed not to have borne 
the costs of development if, pursuant to an agreement entered into 
before the success of the project is known, another person is obligated 
to reimburse the controlled taxpayer for its costs. If it cannot be 
determined which controlled taxpayer bore the largest portion of the 
costs of development, all other facts and circumstances will be taken 
into consideration, including the location of the development 
activities, the capability of each controlled taxpayer to carry on the 
project independently, the extent to which each controlled taxpayer 
controls the project, and the conduct of the controlled taxpayers.
    (iii) Allocations with respect to assistance provided to the owner. 
Allocations may be made to reflect an arm's length consideration for 
assistance provided to the owner of an intangible in connection with the 
development or enhancement of the intangible. Such assistance may 
include loans, services, or the use of tangible or intangible property. 
Assistance does not, however, include expenditures of a routine nature 
that an unrelated party dealing at arm's length would be expected to 
incur under circumstances similar to those of the controlled taxpayer. 
The amount of any allocation required with respect to that assistance 
must be determined in accordance with the applicable rules under section 
482.
    (iv) Examples. The principles of this paragraph are illustrated by 
the following examples.

    Example 1. A, a member of a controlled group, allows B, another 
member of the controlled group and the owner of an intangible, to use 
tangible property, such as laboratory equipment, in connection with the 
development of the intangible. Any allocations with respect to the 
owner's use of the property will be determined under Sec. 1.482-2(c).
    Example 2. FP, a foreign producer of cheese, markets the cheese in 
countries other than the United States under the tradename Fromage 
Frere. FP owns all the worldwide rights to this name. The name is widely 
known and is valuable outside the United States but is not known within 
the United States. In 1995, FP decides to enter the United States market 
and incorporates U.S. subsidiary, USSub, to be its U.S. distributor and 
to supervise the advertising and other marketing efforts that will be 
required to develop the name Fromage Frere in the United States. USSub 
incurs expenses that are not reimbursed by FP for developing the U.S. 
market for Fromage Frere. These expenses are comparable to the levels of 
expense incurred by independent distributors in the U.S. cheese industry 
when introducing a product in the U.S. market under a brand name owned 
by a foreign manufacturer. Since USSub would have been expected to incur 
these expenses if it were unrelated to FP, no allocation to USSub is 
made with respect to the market development activities performed by 
USSub.
    Example 3. The facts are the same as in Example 2, except that the 
expenses incurred by USSub are significantly larger than the expenses 
incurred by independent distributors under similar circumstances. FP 
does not reimburse USSub for its expenses. The district director 
concludes based on this evidence that an unrelated party dealing at 
arm's length under similar circumstances would not have engaged in the 
same level of activity relating to the development of FP's marketing 
intangibles. The expenditures in excess of the level incurred by the 
independent distributors therefore are considered to be a service 
provided to FP that adds to the value of FP's trademark for Fromage 
Frere. Accordingly, the district director makes an allocation under 
section 482 for the fair market value of the services that USSub is 
considered to have performed for FP.
    Example 4. The facts are the same as in Example 3, except that FP 
and USSub conclude a long term agreement under which USSub receives the 
exclusive right to distribute cheese in the United States under FP's 
trademark. USSub purchases cheese from FP at an arm's length price. 
Since USSub is the owner of the trademark under paragraph (f)(3)(ii)(A) 
of this section, and its conduct is

[[Page 647]]

consistent with that status, its activities related to the development 
of the trademark are not considered to be a service performed for the 
benefit of FP, and no allocation is made with respect to such 
activities.

    (4) Consideration not artificially limited. The arm's length 
consideration for the controlled transfer of an intangible is not 
limited by the consideration paid in any uncontrolled transactions that 
do not meet the requirements of the comparable uncontrolled transaction 
method described in paragraph (c) of this section. Similarly, the arm's 
length consideration for an intangible is not limited by the prevailing 
rates of consideration paid for the use or transfer of intangibles 
within the same or similar industry.
    (5) Lump sum payments--(i) In general. If an intangible is 
transferred in a controlled transaction for a lump sum, that amount must 
be commensurate with the income attributable to the intangible. A lump 
sum is commensurate with income in a taxable year if the equivalent 
royalty amount for that taxable year is equal to an arm's length 
royalty. The equivalent royalty amount for a taxable year is the amount 
determined by treating the lump sum as an advance payment of a stream of 
royalties over the useful life of the intangible (or the period covered 
by an agreement, if shorter), taking into account the projected sales of 
the licensee as of the date of the transfer. Thus, determining the 
equivalent royalty amount requires a present value calculation based on 
the lump sum, an appropriate discount rate, and the projected sales over 
the relevant period. The equivalent royalty amount is subject to 
periodic adjustments under Sec. 1.482-4(f)(2)(i) to the same extent as 
an actual royalty payment pursuant to a license agreement.
    (ii) Exceptions. No periodic adjustment will be made under paragraph 
(f)(2)(i) of this section if any of the exceptions to periodic 
adjustments provided in paragraph (f)(2)(ii) of this section apply.
    (iii) Example. The following example illustrates the principle of 
this paragraph (f)(5).

    Example. Calculation of the equivalent royalty amount. (i) FSub is 
the foreign subsidiary of USP, a U.S. company. USP licenses FSub the 
right to produce and sell the whopperchopper, a patented new kitchen 
appliance, for the foreign market. The license is for a period of five 
years, and payment takes the form of a single lump-sum charge of 
$500,000 that is paid at the beginning of the period.
    (ii) The equivalent royalty amount for this license is determined by 
deriving an equivalent royalty rate equal to the lump-sum payment 
divided by the present discounted value of FSub's projected sales of 
whopperchoppers over the life of the license. Based on the riskiness of 
the whopperchopper business, an appropriate discount rate is determined 
to be 10 percent. Projected sales of whopperchoppers for each year of 
the license are as follows:

------------------------------------------------------------------------
                                                             Projected
                          Year                                 sales
------------------------------------------------------------------------
1.......................................................      $2,500,000
2.......................................................       2,600,000
3.......................................................       2,700,000
4.......................................................       2,700,000
5.......................................................       2,750,000
------------------------------------------------------------------------

    (iii) Based on this information, the present discounted value of the 
projected whopperchopper sales is approximately $10 million, yielding an 
equivalent royalty rate of approximately 5%. Thus, the equivalent 
royalty amounts for each year are as follows:

------------------------------------------------------------------------
                                             Projected      Equivalent
                  Year                         sales      royalty amount
------------------------------------------------------------------------
1.......................................      $2,500,000        $125,000
2.......................................       2,600,000         130,000
3.......................................       2,700,000         135,000
4.......................................       2,700,000         135,000
5.......................................       2,750,000         137,500
------------------------------------------------------------------------

    (iv) If in any of the five taxable years the equivalent royalty 
amount is determined not to be an arm's length amount, a periodic 
adjustment may be made pursuant to Sec. 1.482-4(f)(2)(i). The 
adjustment in such case would be equal to the difference between the 
equivalent royalty amount and the arm's length royalty in that taxable 
year.

[T.D. 8552, 59 FR 35016, July 8, 1994]



Sec. 1.482-5  Comparable profits method.

    (a) In general. The comparable profits method evaluates whether the 
amount charged in a controlled transaction is arm's length based on 
objective measures of profitability (profit level indicators) derived 
from uncontrolled taxpayers that engage in similar business activities 
under similar circumstances.
    (b) Determination of arm's length result--(1) In general. Under the 
comparable profits method, the determination of an arm's length result 
is based

[[Page 648]]

on the amount of operating profit that the tested party would have 
earned on related party transactions if its profit level indicator were 
equal to that of an uncontrolled comparable (comparable operating 
profit). Comparable operating profit is calculated by determining a 
profit level indicator for an uncontrolled comparable, and applying the 
profit level indicator to the financial data related to the tested 
party's most narrowly identifiable business activity for which data 
incorporating the controlled transaction is available (relevant business 
activity). To the extent possible, profit level indicators should be 
applied solely to the tested party's financial data that is related to 
controlled transactions. The tested party's reported operating profit is 
compared to the comparable operating profits derived from the profit 
level indicators of uncontrolled comparables to determine whether the 
reported operating profit represents an arm's length result.
    (2) Tested party--(i) In general. For purposes of this section, the 
tested party will be the participant in the controlled transaction whose 
operating profit attributable to the controlled transactions can be 
verified using the most reliable data and requiring the fewest and most 
reliable adjustments, and for which reliable data regarding uncontrolled 
comparables can be located. Consequently, in most cases the tested party 
will be the least complex of the controlled taxpayers and will not own 
valuable intangible property or unique assets that distinguish it from 
potential uncontrolled comparables.
    (ii) Adjustments for tested party. The tested party's operating 
profit must first be adjusted to reflect all other allocations under 
section 482, other than adjustments pursuant to this section.
    (3) Arm's length range. See Sec. 1.482-1(e)(2) for the 
determination of the arm's length range. For purposes of the comparable 
profits method, the arm's length range will be established using 
comparable operating profits derived from a single profit level 
indicator.
    (4) Profit level indicators. Profit level indicators are ratios that 
measure relationships between profits and costs incurred or resources 
employed. A variety of profit level indicators can be calculated in any 
given case. Whether use of a particular profit level indicator is 
appropriate depends upon a number of factors, including the nature of 
the activities of the tested party, the reliability of the available 
data with respect to uncontrolled comparables, and the extent to which 
the profit level indicator is likely to produce a reliable measure of 
the income that the tested party would have earned had it dealt with 
controlled taxpayers at arm's length, taking into account all of the 
facts and circumstances. The profit level indicators should be derived 
from a sufficient number of years of data to reasonably measure returns 
that accrue to uncontrolled comparables. Generally, such a period should 
encompass at least the taxable year under review and the preceding two 
taxable years. This analysis must be applied in accordance with Sec. 
1.482-1(f)(2)(iii)(D). Profit level indicators that may provide a 
reliable basis for comparing operating profits of the tested party and 
uncontrolled comparables include the following--
    (i) Rate of return on capital employed. The rate of return on 
capital employed is the ratio of operating profit to operating assets. 
The reliability of this profit level indicator increases as operating 
assets play a greater role in generating operating profits for both the 
tested party and the uncontrolled comparable. In addition, reliability 
under this profit level indicator depends on the extent to which the 
composition of the tested party's assets is similar to that of the 
uncontrolled comparable. Finally, difficulties in properly valuing 
operating assets will diminish the reliability of this profit level 
indicator.
    (ii) Financial ratios. Financial ratios measure relationships 
between profit and costs or sales revenue. Since functional differences 
generally have a greater effect on the relationship between profit and 
costs or sales revenue than the relationship between profit and 
operating assets, financial ratios are more sensitive to functional 
differences than the rate of return on capital employed. Therefore, 
closer functional comparability normally is required under a financial 
ratio than under the rate of return on capital employed to achieve a 
similarly reliable

[[Page 649]]

measure of an arm's length result. Financial ratios that may be 
appropriate include the following--
    (A) Ratio of operating profit to sales; and
    (B) Ratio of gross profit to operating expenses. Reliability under 
this profit level indicator also depends on the extent to which the 
composition of the tested party's operating expenses is similar to that 
of the uncontrolled comparables.
    (iii) Other profit level indicators. Other profit level indicators 
not described in this paragraph (b)(4) may be used if they provide 
reliable measures of the income that the tested party would have earned 
had it dealt with controlled taxpayers at arm's length. However, profit 
level indicators based solely on internal data may not be used under 
this paragraph (b)(4) because they are not objective measures of 
profitability derived from operations of uncontrolled taxpayers engaged 
in similar business activities under similar circumstances.
    (c) Comparability and reliability considerations--(1) In general. 
Whether results derived from application of this method are the most 
reliable measure of the arm's length result must be determined using the 
factors described under the best method rule in Sec. 1.482-1(c).
    (2) Comparability--(i) In general. The degree of comparability 
between an uncontrolled taxpayer and the tested party is determined by 
applying the provisions of Sec. 1.482-1(d)(2). The comparable profits 
method compares the profitability of the tested party, measured by a 
profit level indicator (generally based on operating profit), to the 
profitability of uncontrolled taxpayers in similar circumstances. As 
with all methods that rely on external market benchmarks, the greater 
the degree of comparability between the tested party and the 
uncontrolled taxpayer, the more reliable will be the results derived 
from the application of this method. The determination of the degree of 
comparability between the tested party and the uncontrolled taxpayer 
depends upon all the relevant facts and circumstances, including the 
relevant lines of business, the product or service markets involved, the 
asset composition employed (including the nature and quantity of 
tangible assets, intangible assets and working capital), the size and 
scope of operations, and the stage in a business or product cycle.
    (ii) Functional, risk and resource comparability. An operating 
profit represents a return for the investment of resources and 
assumption of risks. Therefore, although all of the factors described in 
Sec. 1.482-1(d)(3) must be considered, comparability under this method 
is particularly dependent on resources employed and risks assumed. 
Moreover, because resources and risks usually are directly related to 
functions performed, it is also important to consider functions 
performed in determining the degree of comparability between the tested 
party and an uncontrolled taxpayer. The degree of functional 
comparability required to obtain a reliable result under the comparable 
profits method, however, is generally less than that required under the 
resale price or cost plus methods. For example, because differences in 
functions performed often are reflected in operating expenses, taxpayers 
performing different functions may have very different gross profit 
margins but earn similar levels of operating profit.
    (iii) Other comparability factors. Other factors listed in Sec. 
1.482-1(d)(3) also may be particularly relevant under the comparable 
profits method. Because operating profit usually is less sensitive than 
gross profit to product differences, reliability under the comparable 
profits method is not as dependent on product similarity as the resale 
price or cost plus method. However, the reliability of profitability 
measures based on operating profit may be adversely affected by factors 
that have less effect on results under the comparable uncontrolled 
price, resale price, and cost plus methods. For example, operating 
profit may be affected by varying cost structures (as reflected, for 
example, in the age of plant and equipment), differences in business 
experience (such as whether the business is in a start-up phase or is 
mature), or differences in management efficiency (as indicated, for 
example, by objective evidence such as expanding or contracting sales or 
executive compensation over time). Accordingly, if material differences 
in these factors

[[Page 650]]

are identified based on objective evidence, the reliability of the 
analysis may be affected.
    (iv) Adjustments for the differences between the tested party and 
the uncontrolled taxpayers. If there are differences between the tested 
party and an uncontrolled comparable that would materially affect the 
profits determined under the relevant profit level indicator, 
adjustments should be made according to the comparability provisions of 
Sec. 1.482-1(d)(2). In some cases, the assets of an uncontrolled 
comparable may need to be adjusted to achieve greater comparability 
between the tested party and the uncontrolled comparable. In such cases, 
the uncontrolled comparable's operating income attributable to those 
assets must also be adjusted before computing a profit level indicator 
in order to reflect the income and expense attributable to the adjusted 
assets. In certain cases it may also be appropriate to adjust the 
operating profit of the tested party and comparable parties. For 
example, where there are material differences in accounts payable among 
the comparable parties and the tested party, it will generally be 
appropriate to adjust the operating profit of each party by increasing 
it to reflect an imputed interest charge on each party's accounts 
payable. As another example, it may be appropriate to adjust the 
operating profit of a party to account for material differences in the 
utilization of or accounting for stock-based compensation (as defined by 
Sec. 1.482-7(d)(2)(i)) among the tested party and comparable parties.
    (3) Data and assumptions--(i) In general. The reliability of the 
results derived from the comparable profits method is affected by the 
quality of the data and assumptions used to apply this method.
    (ii) Consistency in accounting. The degree of consistency in 
accounting practices between the controlled transaction and the 
uncontrolled comparables that materially affect operating profit affects 
the reliability of the result. Thus, for example, if differences in 
inventory and other cost accounting practices would materially affect 
operating profit, the ability to make reliable adjustments for such 
differences would affect the reliability of the results.
    (iii) Allocations between the relevant business activity and other 
activities. The reliability of the allocation of costs, income, and 
assets between the relevant business activity and other activities of 
the tested party or an uncontrolled comparable will affect the 
reliability of the determination of operating profit and profit level 
indicators. If it is not possible to allocate costs, income, and assets 
directly based on factual relationships, a reasonable allocation formula 
may be used. To the extent direct allocations are not made, the 
reliability of the results derived from the application of this method 
is reduced relative to the results of a method that requires fewer 
allocations of costs, income, and assets. Similarly, the reliability of 
the results derived from the application of this method is affected by 
the extent to which it is possible to apply the profit level indicator 
to the tested party's financial data that is related solely to the 
controlled transactions. For example, if the relevant business activity 
is the assembly of components purchased from both controlled and 
uncontrolled suppliers, it may not be possible to apply the profit level 
indicator solely to financial data related to the controlled 
transactions. In such a case, the reliability of the results derived 
from the application of this method will be reduced.
    (d) Definitions. The definitions set forth in paragraphs (d)(1) 
through (6) of this section apply for purposes of this section.
    (1) Sales revenue means the amount of the total receipts from sale 
of goods and provision of services, less returns and allowances. 
Accounting principles and conventions that are generally accepted in the 
trade or industry of the controlled taxpayer under review must be used.
    (2) Gross profit means sales revenue less cost of goods sold.
    (3) Operating expenses includes all expenses not included in cost of 
goods sold except for interest expense, foreign income taxes (as defined 
in Sec. 1.901-2(a)), domestic income taxes, and any other expenses not 
related to the operation of the relevant business activity.

[[Page 651]]

Operating expenses ordinarily include expenses associated with 
advertising, promotion, sales, marketing, warehousing and distribution, 
administration, and a reasonable allowance for depreciation and 
amortization.
    (4) Operating profit means gross profit less operating expenses. 
Operating profit includes all income derived from the business activity 
being evaluated by the comparable profits method, but does not include 
interest and dividends, income derived from activities not being tested 
by this method, or extraordinary gains and losses that do not relate to 
the continuing operations of the tested party.
    (5) Reported operating profit means the operating profit of the 
tested party reflected on a timely filed U.S. income tax return. If the 
tested party files a U.S. income tax return, its operating profit is 
considered reflected on a U.S. income tax return if the calculation of 
taxable income on its return for the taxable year takes into account the 
income attributable to the controlled transaction under review. If the 
tested party does not file a U.S. income tax return, its operating 
profit is considered reflected on a U.S. income tax return in any 
taxable year for which income attributable to the controlled transaction 
under review affects the calculation of the U.S. taxable income of any 
other member of the same controlled group. If the comparable operating 
profit of the tested party is determined from profit level indicators 
derived from financial statements or other accounting records and 
reports of comparable parties, adjustments may be made to the reported 
operating profit of the tested party in order to account for material 
differences between the tested party's operating profit reported for U.S 
income tax purposes and the tested party's operating profit for 
financial statement purposes. In addition, in accordance with Sec. 
1.482-1(f)(2)(iii)(D), adjustments under section 482 that are finally 
determined may be taken into account in determining reported operating 
profit.
    (6) Operating assets. The term operating assets means the value of 
all assets used in the relevant business activity of the tested party, 
including fixed assets and current assets (such as cash, cash 
equivalents, accounts receivable, and inventories).
    The term does not include investments in subsidiaries, excess cash, 
and portfolio investments. Operating assets may be measured by their net 
book value or by their fair market value, provided that the same method 
is consistently applied to the tested party and the comparable parties, 
and consistently applied from year to year. In addition, it may be 
necessary to take into account recent acquisitions, leased assets, 
intangibles, currency fluctuations, and other items that may not be 
explicitly recorded in the financial statements of the tested party or 
uncontrolled comparable. Finally, operating assets must be measured by 
the average of the values for the beginning of the year and the end of 
the year, unless substantial fluctuations in the value of operating 
assets during the year make this an inaccurate measure of the average 
value over the year. In such a case, a more accurate measure of the 
average value of operating assets must be applied.
    (e) Examples. The following examples illustrate the application of 
this section.

    Example 1. Transfer of tangible property resulting in no adjustment. 
(i) FP is a publicly traded foreign corporation with a U.S. subsidiary, 
USSub, that is under audit for its 1996 taxable year. FP manufactures a 
consumer product for worldwide distribution. USSub imports the assembled 
product and distributes it within the United States at the wholesale 
level under the FP name.
    (ii) FP does not allow uncontrolled taxpayers to distribute the 
product. Similar products are produced by other companies but none of 
them is sold to uncontrolled taxpayers or to uncontrolled distributors.
    (iii) Based on all the facts and circumstances, the district 
director determines that the comparable profits method will provide the 
most reliable measure of an arm's length result. USSub is selected as 
the tested party because it engages in activities that are less complex 
than those undertaken by FP.
    There is data from a number of independent operators of wholesale 
distribution businesses. These potential comparables are further 
narrowed to select companies in the same industry segment that perform 
similar functions and bear similar risks to USSub. An analysis of the 
information available on these taxpayers shows that the ratio of 
operating profit to sales is the most appropriate

[[Page 652]]

profit level indicator, and this ratio is relatively stable where at 
least three years are included in the average. For the taxable years 
1994 through 1996, USSub shows the following results:

----------------------------------------------------------------------------------------------------------------
                                                                 1994         1995         1996        Average
----------------------------------------------------------------------------------------------------------------
Sales......................................................     $500,000     $560,000     $500,000      $520,000
Cost of Goods Sold.........................................      393,000      412,400      400,000       401,800
Operating Expenses.........................................       80,000      110,000      104,600        98,200
Operating Profit...........................................       27,000       37,600       (4,600)       20,000
----------------------------------------------------------------------------------------------------------------

    (iv) After adjustments have been made to account for identified 
material differences between USSub and the uncontrolled distributors, 
the average ratio of operating profit to sales is calculated for each of 
the uncontrolled distributors. Applying each ratio to USSub would lead 
to the following comparable operating profit (COP) for USSub:

------------------------------------------------------------------------
                                                       OP/S
             Uncontrolled distributor               (percent)  USSub COP
------------------------------------------------------------------------
A.................................................       1.7      $8,840
B.................................................       3.1      16,120
C.................................................       3.8      19,760
D.................................................       4.5      23,400
E.................................................       4.7      24,440
F.................................................       4.8      24,960
G.................................................       4.9      25,480
H.................................................       6.7      34,840
I.................................................       9.9      51,480
J.................................................      10.5      54,600
------------------------------------------------------------------------

    (v) The data is not sufficiently complete to conclude that it is 
likely that all material differences between USSub and the uncontrolled 
distributors have been identified. Therefore, an arm's length range can 
be established only pursuant to Sec. 1.482- 1(e)(2)(iii)(B). The 
district director measures the arm's length range by the interquartile 
range of results, which consists of the results ranging from $19,760 to 
$34,840. Although USSub's operating income for 1996 shows a loss of 
$4,600, the district director determines that no allocation should be 
made, because USSub's average reported operating profit of $20,000 is 
within this range.
    Example 2. Transfer of tangible property resulting in adjustment. 
(i) The facts are the same as in Example 1 except that USSub reported 
the following income and expenses:

----------------------------------------------------------------------------------------------------------------
                                                                1994         1995          1996        Average
----------------------------------------------------------------------------------------------------------------
Sales.....................................................     $500,000     $560,000      $500,000      $520,000
Cost of Good Sold.........................................      370,000      460,000       400,000       410,000
Operating Expenses........................................      110,000      110,000       110,000       110,000
Operating Profit..........................................       20,000      (10,000)      (10,000)            0
----------------------------------------------------------------------------------------------------------------

    (ii) The interquartile range of comparable operating profits remains 
the same as derived in Example 1: $19,760 to $34,840. USSub's average 
operating profit for the years 1994 through 1996 ($0) falls outside this 
range. Therefore, the district director determines that an allocation 
may be appropriate.
    (iii) To determine the amount, if any, of the allocation, the 
district director compares USSub's reported operating profit for 1996 to 
comparable operating profits derived from the uncontrolled distributors' 
results for 1996. The ratio of operating profit to sales in 1996 is 
calculated for each of the uncontrolled comparables and applied to 
USSub's 1996 sales to derive the following results:

------------------------------------------------------------------------
                                                         OP/S     USSub
              Uncontrolled distributor                (percent)    COP
------------------------------------------------------------------------
C...................................................       0.5    $2,500
D...................................................       1.5     7,500
E...................................................       2.0    10,000
A...................................................       1.6    13,000
F...................................................       2.8    14,000
B...................................................       2.9    14,500
J...................................................       3.0    15,000
I...................................................       4.4    22,000
H...................................................       6.9    34,500
G...................................................       7.4    37,000
------------------------------------------------------------------------

    (iv) Based on these results, the median of the comparable operating 
profits for 1996 is $14,250. Therefore, USSub's income for 1996 is 
increased by $24,250, the difference between USSub's reported operating 
profit for 1996 and the median of the comparable operating profits for 
1996.
    Example 3. Multiple year analysis. (i) The facts are the same as in 
Example 2. In addition, the district director examines the taxpayer's 
results for the 1997 taxable year. As in Example 2, the district 
director increases USSub's income for the 1996 taxable year by $24,250. 
The results for the 1997 taxable year,

[[Page 653]]

together with the 1995 and 1996 taxable years, are as follows:

----------------------------------------------------------------------------------------------------------------
                                                              1995          1996          1997         Average
----------------------------------------------------------------------------------------------------------------
Sales...................................................     $560,000      $500,000      $530,000      $530,000
Cost of Good Sold.......................................      460,000       400,000       430,000       430,000
Operating Expenses......................................      110,000       110,000       110,000       110,000
Operating Profit........................................      (10,000)      (10,000)      (10,000)      (10,000)
----------------------------------------------------------------------------------------------------------------

    (ii) The interquartile range of comparable operating profits, based 
on average results from the uncontrolled comparables and average sales 
for USSub for the years 1995 through 1997, ranges from $15,500 to 
$30,000. In determining whether an allocation for the 1997 taxable year 
may be made, the district director compares USSub's average reported 
operating profit for the years 1995 through 1997 to the interquartile 
range of average comparable operating profits over this period. USSub's 
average reported operating profit is determined without regard to the 
adjustment made with respect to the 1996 taxable year. See Sec. 1.482-
1(f)(2)(iii)(D). Therefore, USSub's average reported operating profit 
for the years 1995 through 1997 is ($10,000). Because this amount of 
income falls outside the interquartile range, the district director 
determines that an allocation may be appropriate.
    (iii) To determine the amount, if any, of the allocation for the 
1997 taxable year, the district director compares USSub's reported 
operating profit for 1997 to the median of the comparable operating 
profits derived from the uncontrolled distributors' results for 1997. 
The median of the comparable operating profits derived from the 
uncontrolled comparables results for the 1997 taxable year is $12,000. 
Based on this comparison, the district director increases USSub's 1997 
taxable income by $22,000, the difference between the median of the 
comparable operating profits for the 1997 taxable year and USSub's 
reported operating profit of ($10,000) for the 1997 taxable year.
    Example 4. Transfer of intangible to offshore manufacturer. (i) 
DevCo is a U.S. developer, producer and marketer of widgets. DevCo 
develops a new ``high tech widget'' (htw) that is manufactured by its 
foreign subsidiary ManuCo located in Country H. ManuCo sells the htw to 
MarkCo (a U.S. subsidiary of DevCo) for distribution and marketing in 
the United States. The taxable year 1996 is under audit, and the 
district director examines whether the royalty rate of 5 percent paid by 
ManuCo to DevCo is an arm's length consideration for the htw technology.
    (ii) Based on all the facts and circumstances, the district director 
determines that the comparable profits method will provide the most 
reliable measure of an arm's length result. ManuCo is selected as the 
tested party because it engages in relatively routine manufacturing 
activities, while DevCo engages in a variety of complex activities using 
unique and valuable intangibles. Finally, because ManuCo engages in 
manufacturing activities, it is determined that the ratio of operating 
profit to operating assets is an appropriate profit level indicator.
    (iii) Uncontrolled taxpayers performing similar functions cannot be 
found in country H. It is determined that data available in countries M 
and N provides the best match of companies in a similar market 
performing similar functions and bearing similar risks. Such data is 
sufficiently complete to identify many of the material differences 
between ManuCo and the uncontrolled comparables, and to make adjustments 
to account for such differences. However, data is not sufficiently 
complete so that it is likely that no material differences remain. In 
particular, the differences in geographic markets might have materially 
affected the results of the various companies.
    (iv) In a separate analysis, it is determined that the price that 
ManuCo charged to MarkCo for the htw's is an arm's length price under 
Sec. 1.482-3(b). Therefore, ManuCo's financial data derived from its 
sales to MarkCo are reliable. ManuCo's financial data from 1994-1996 is 
as follows:

----------------------------------------------------------------------------------------------------------------
                                                                 1994         1995         1996        Average
----------------------------------------------------------------------------------------------------------------
Assets.....................................................      $24,000      $25,000      $26,000       $25,000
Sales to MarkCo............................................       25,000       30,000       35,000        30,000
Cost of Goods Sold.........................................        6,250        7,500        8,750         7,500
  Royalty to DevCo (5%)....................................        1,250        1,500        1,750         1,500
  Other....................................................        5,000        6,000        7,000         6,000
Operating Expenses.........................................        1,000        1,000        1,000         1,000
Operating Profit...........................................       17,750       21,500       25,250        21,500
----------------------------------------------------------------------------------------------------------------


[[Page 654]]

    (v) Applying the ratios of average operating profit to operating 
assets for the 1994 through 1996 taxable years derived from a group of 
similar uncontrolled comparables located in country M and N to ManuCo's 
average operating assets for the same period provides a set of 
comparable operating profits. The interquartile range for these average 
comparable operating profits is $3,000 to $4,500. ManuCo's average 
reported operating profit for the years 1994 through 1996 ($21,500) 
falls outside this range. Therefore, the district director determines 
that an allocation may be appropriate for the 1996 taxable year.
    (vi) To determine the amount, if any, of the allocation for the 1996 
taxable year, the district director compares ManuCo's reported operating 
profit for 1996 to the median of the comparable operating profits 
derived from the uncontrolled distributors' results for 1996. The median 
result for the uncontrolled comparables for 1996 is $3,750. Based on 
this comparison, the district director increases royalties that ManuCo 
paid by $21,500 (the difference between $25,250 and the median of the 
comparable operating profits, $3,750).
    Example 5. Adjusting operating assets and operating profit for 
differences in accounts receivable. (i) USM is a U.S. company that 
manufactures parts for industrial equipment and sells them to its 
foreign parent corporation. For purposes of applying the comparable 
profits method, 15 uncontrolled manufacturers that are similar to USM 
have been identified.
    (ii) USM has a significantly lower level of accounts receivable than 
the uncontrolled manufacturers. Since the rate of return on capital 
employed is to be used as the profit level indicator, both operating 
assets and operating profits must be adjusted to account for this 
difference. Each uncontrolled comparable's operating assets is reduced 
by the amount (relative to sales) by which they exceed USM's accounts 
receivable. Each uncontrolled comparable's operating profit is adjusted 
by deducting imputed interest income on the excess accounts receivable. 
This imputed interest income is calculated by multiplying the 
uncontrolled comparable's excess accounts receivable by an interest rate 
appropriate for short-term debt.
    Example 6. Adjusting operating profit for differences in accounts 
payable. (i) USD is the U.S. subsidiary of a foreign corporation. USD 
purchases goods from its foreign parent and sells them in the U.S. 
market. For purposes of applying the comparable profits method, 10 
uncontrolled distributors that are similar to USD have been identified.
    (ii) There are significant differences in the level of accounts 
payable among the uncontrolled distributors and USD. To adjust for these 
differences, the district director increases the operating profit of the 
uncontrolled distributors and USD to reflect interest expense imputed to 
the accounts payable. The imputed interest expense for each company is 
calculated by multiplying the company's accounts payable by an interest 
rate appropriate for its short-term debt.

[T.D. 8552, 59 FR 35021, July 8, 1994; 60 FR 16703, Mar. 31, 1995; T.D. 
9088, 68 FR 51177, Aug. 26, 2003]



Sec. 1.482-6  Profit split method.

    (a) In general. The profit split method evaluates whether the 
allocation of the combined operating profit or loss attributable to one 
or more controlled transactions is arm's length by reference to the 
relative value of each controlled taxpayer's contribution to that 
combined operating profit or loss. The combined operating profit or loss 
must be derived from the most narrowly identifiable business activity of 
the controlled taxpayers for which data is available that includes the 
controlled transactions (relevant business activity).
    (b) Appropriate share of profits and losses. The relative value of 
each controlled taxpayer's contribution to the success of the relevant 
business activity must be determined in a manner that reflects the 
functions performed, risks assumed, and resources employed by each 
participant in the relevant business activity, consistent with the 
comparability provisions of Sec. 1.482-1(d)(3). Such an allocation is 
intended to correspond to the division of profit or loss that would 
result from an arrangement between uncontrolled taxpayers, each 
performing functions similar to those of the various controlled 
taxpayers engaged in the relevant business activity. The profit 
allocated to any particular member of a controlled group is not 
necessarily limited to the total operating profit of the group from the 
relevant business activity. For example, in a given year, one member of 
the group may earn a profit while another member incurs a loss. In 
addition, it may not be assumed that the combined operating profit or 
loss from the relevant business activity should be shared equally, or in 
any other arbitrary proportion. The specific method of allocation must 
be determined under paragraph (c) of this section.
    (c) Application--(1) In general. The allocation of profit or loss 
under the

[[Page 655]]

profit split method must be made in accordance with one of the following 
allocation methods--(i) The comparable profit split, described in 
paragraph (c)(2) of this section; or
    (ii) The residual profit split, described in paragraph (c)(3) of 
this section.
    (2) Comparable profit split--(i) In general. A comparable profit 
split is derived from the combined operating profit of uncontrolled 
taxpayers whose transactions and activities are similar to those of the 
controlled taxpayers in the relevant business activity. Under this 
method, each uncontrolled taxpayer's percentage of the combined 
operating profit or loss is used to allocate the combined operating 
profit or loss of the relevant business activity.
    (ii) Comparability and reliability considerations--(A) In general. 
Whether results derived from application of this method are the most 
reliable measure of the arm's length result is determined using the 
factors described under the best method rule in Sec. 1.482-1(c).
    (B) Comparability--(1) In general. The degree of comparability 
between the controlled and uncontrolled taxpayers is determined by 
applying the comparability provisions of Sec. 1.482-1(d). The 
comparable profit split compares the division of operating profits among 
the controlled taxpayers to the division of operating profits among 
uncontrolled taxpayers engaged in similar activities under similar 
circumstances. Although all of the factors described in Sec. 1.482-
1(d)(3) must be considered, comparability under this method is 
particularly dependent on the considerations described under the 
comparable profits method in Sec. 1.482-5(c)(2), because this method is 
based on a comparison of the operating profit of the controlled and 
uncontrolled taxpayers. In addition, because the contractual terms of 
the relationship among the participants in the relevant business 
activity will be a principal determinant of the allocation of functions 
and risks among them, comparability under this method also depends 
particularly on the degree of similarity of the contractual terms of the 
controlled and uncontrolled taxpayers. Finally, the comparable profit 
split may not be used if the combined operating profit (as a percentage 
of the combined assets) of the uncontrolled comparables varies 
significantly from that earned by the controlled taxpayers.
    (2) Adjustments for differences between the controlled and 
uncontrolled taxpayers. If there are differences between the controlled 
and uncontrolled taxpayers that would materially affect the division of 
operating profit, adjustments must be made according to the provisions 
of Sec. 1.482-1(d)(2).
    (C) Data and assumptions. The reliability of the results derived 
from the comparable profit split is affected by the quality of the data 
and assumptions used to apply this method. In particular, the following 
factors must be considered--
    (1) The reliability of the allocation of costs, income, and assets 
between the relevant business activity and the participants' other 
activities will affect the accuracy of the determination of combined 
operating profit and its allocation among the participants. If it is not 
possible to allocate costs, income, and assets directly based on factual 
relationships, a reasonable allocation formula may be used. To the 
extent direct allocations are not made, the reliability of the results 
derived from the application of this method is reduced relative to the 
results of a method that requires fewer allocations of costs, income, 
and assets. Similarly, the reliability of the results derived from the 
application of this method is affected by the extent to which it is 
possible to apply the method to the parties' financial data that is 
related solely to the controlled transactions. For example, if the 
relevant business activity is the assembly of components purchased from 
both controlled and uncontrolled suppliers, it may not be possible to 
apply the method solely to financial data related to the controlled 
transactions. In such a case, the reliability of the results derived 
from the application of this method will be reduced.
    (2) The degree of consistency between the controlled and 
uncontrolled taxpayers in accounting practices that materially affect 
the items that determine the amount and allocation of operating profit 
affects the reliability of

[[Page 656]]

the result. Thus, for example, if differences in inventory and other 
cost accounting practices would materially affect operating profit, the 
ability to make reliable adjustments for such differences would affect 
the reliability of the results. Further, accounting consistency among 
the participants in the controlled transaction is required to ensure 
that the items determining the amount and allocation of operating profit 
are measured on a consistent basis.
    (D) Other factors affecting reliability. Like the methods described 
in Sec. Sec. 1.482-3, 1.482-4, and 1.482-5, the comparable profit split 
relies exclusively on external market benchmarks. As indicated in Sec. 
1.482-1(c)(2)(i), as the degree of comparability between the controlled 
and uncontrolled transactions increases, the relative weight accorded 
the analysis under this method will increase. In addition, the 
reliability of the analysis under this method may be enhanced by the 
fact that all parties to the controlled transaction are evaluated under 
the comparable profit split. However, the reliability of the results of 
an analysis based on information from all parties to a transaction is 
affected by the reliability of the data and the assumptions pertaining 
to each party to the controlled transaction. Thus, if the data and 
assumptions are significantly more reliable with respect to one of the 
parties than with respect to the others, a different method, focusing 
solely on the results of that party, may yield more reliable results.
    (3) Residual profit split--(i) In general. Under this method, the 
combined operating profit or loss from the relevant business activity is 
allocated between the controlled taxpayers following the two-step 
process set forth in paragraphs (c)(3)(i)(A) and (B) of this section.
    (A) Allocate income to routine contributions. The first step 
allocates operating income to each party to the controlled transactions 
to provide a market return for its routine contributions to the relevant 
business activity. Routine contributions are contributions of the same 
or a similar kind to those made by uncontrolled taxpayers involved in 
similar business activities for which it is possible to identify market 
returns. Routine contributions ordinarily include contributions of 
tangible property, services and intangibles that are generally owned by 
uncontrolled taxpayers engaged in similar activities. A functional 
analysis is required to identify these contributions according to the 
functions performed, risks assumed, and resources employed by each of 
the controlled taxpayers. Market returns for the routine contributions 
should be determined by reference to the returns achieved by 
uncontrolled taxpayers engaged in similar activities, consistent with 
the methods described in Sec. Sec. 1.482-3, 1.482-4 and 1.482-5.
    (B) Allocate residual profit. The allocation of income to the 
controlled taxpayers' routine contributions will not reflect profits 
attributable to the controlled group's valuable intangible property 
where similar property is not owned by the uncontrolled taxpayers from 
which the market returns are derived. Thus, in cases where such 
intangibles are present there normally will be an unallocated residual 
profit after the allocation of income described in paragraph 
(c)(3)(i)(A) of this section. Under this second step, the residual 
profit generally should be divided among the controlled taxpayers based 
upon the relative value of their contributions of intangible property to 
the relevant business activity that was not accounted for as a routine 
contribution. The relative value of the intangible property contributed 
by each taxpayer may be measured by external market benchmarks that 
reflect the fair market value of such intangible property. 
Alternatively, the relative value of intangible contributions may be 
estimated by the capitalized cost of developing the intangibles and all 
related improvements and updates, less an appropriate amount of 
amortization based on the useful life of each intangible. Finally, if 
the intangible development expenditures of the parties are relatively 
constant over time and the useful life of the intangible property of all 
parties is approximately the same, the amount of actual expenditures in 
recent years may be used to estimate the relative value of intangible 
contributions. If the intangible property contributed by one of the 
controlled

[[Page 657]]

taxpayers is also used in other business activities (such as 
transactions with other controlled taxpayers), an appropriate allocation 
of the value of the intangibles must be made among all the business 
activities in which it is used.
    (ii) Comparability and reliability considerations--(A) In general. 
Whether results derived from this method are the most reliable measure 
of the arm's length result is determined using the factors described 
under the best method rule in Sec. 1.482-1(c). Thus, comparability and 
the quality of data and assumptions must be considered in determining 
whether this method provides the most reliable measure of an arm's 
length result. The application of these factors to the residual profit 
split is discussed in paragraph (c)(3)(ii)(B), (C), and (D) of this 
section.
    (B) Comparability. The first step of the residual profit split 
relies on market benchmarks of profitability. Thus, the comparability 
considerations that are relevant for the first step of the residual 
profit split are those that are relevant for the methods that are used 
to determine market returns for the routine contributions. The second 
step of the residual profit split, however, may not rely so directly on 
market benchmarks. Thus, the reliability of the results under this 
method is reduced to the extent that the allocation of profits in the 
second step does not rely on market benchmarks.
    (C) Data and assumptions. The reliability of the results derived 
from the residual profit split is affected by the quality of the data 
and assumptions used to apply this method. In particular, the following 
factors must be considered--
    (1) The reliability of the allocation of costs, income, and assets 
as described in paragraph (c)(2)(ii)(C)(1) of this section;
    (2) Accounting consistency as described in paragraph 
(c)(2)(ii)(C)(2) of this section;
    (3) The reliability of the data used and the assumptions made in 
valuing the intangible property contributed by the participants. In 
particular, if capitalized costs of development are used to estimate the 
value of intangible property, the reliability of the results is reduced 
relative to the reliability of other methods that do not require such an 
estimate, for the following reasons. First, in any given case, the costs 
of developing the intangible may not be related to its market value. 
Second, the calculation of the capitalized costs of development may 
require the allocation of indirect costs between the relevant business 
activity and the controlled taxpayer's other activities, which may 
affect the reliability of the analysis. Finally, the calculation of 
costs may require assumptions regarding the useful life of the 
intangible property.
    (D) Other factors affecting reliability. Like the methods described 
in Sec. Sec. 1.482-3, 1.482-4, and 1.482-5, the first step of the 
residual profit split relies exclusively on external market benchmarks. 
As indicated in Sec. 1.482-1(c)(2)(i), as the degree of comparability 
between the controlled and uncontrolled transactions increases, the 
relative weight accorded the analysis under this method will increase. 
In addition, to the extent the allocation of profits in the second step 
is not based on external market benchmarks, the reliability of the 
analysis will be decreased in relation to an analysis under a method 
that relies on market benchmarks. Finally, the reliability of the 
analysis under this method may be enhanced by the fact that all parties 
to the controlled transaction are evaluated under the residual profit 
split. However, the reliability of the results of an analysis based on 
information from all parties to a transaction is affected by the 
reliability of the data and the assumptions pertaining to each party to 
the controlled transaction. Thus, if the data and assumptions are 
significantly more reliable with respect to one of the parties than with 
respect to the others, a different method, focusing solely on the 
results of that party, may yield more reliable results.
    (iii) Example. The provisions of this paragraph (c)(3) are 
illustrated by the following example.

    Example--Application of Residual Profit Split. (i) XYZ is a U.S. 
corporation that develops, manufactures and markets a line of products 
for police use in the United States. XYZ's research unit developed a 
bulletproof material for use in protective clothing and headgear 
(Nulon). XYZ obtains patent protection for

[[Page 658]]

the chemical formula for Nulon. Since its introduction in the U.S., 
Nulon has captured a substantial share of the U.S. market for 
bulletproof material.
    (ii) XYZ licensed its European subsidiary, XYZ-Europe, to 
manufacture and market Nulon in Europe. XYZ-Europe is a well- 
established company that manufactures and markets XYZ products in 
Europe. XYZ-Europe has a research unit that adapts XYZ products for the 
defense market, as well as a well-developed marketing network that 
employs brand names that it developed.
    (iii) XYZ-Europe's research unit alters Nulon to adapt it to 
military specifications and develops a high-intensity marketing campaign 
directed at the defense industry in several European countries. 
Beginning with the 1995 taxable year, XYZ-Europe manufactures and sells 
Nulon in Europe through its marketing network under one of its brand 
names.
    (iv) For the 1995 taxable year, XYZ has no direct expenses 
associated with the license of Nulon to XYZ-Europe and incurs no 
expenses related to the marketing of Nulon in Europe. For the 1995 
taxable year, XYZ-Europe's Nulon sales and pre-royalty expenses are $500 
million and $300 million, respectively, resulting in net pre-royalty 
profit of $200 million related to the Nulon business. The operating 
assets employed in XYZ-Europe's Nulon business are $200 million. Given 
the facts and circumstances, the district director determines under the 
best method rule that a residual profit split will provide the most 
reliable measure of an arm's length result. Based on an examination of a 
sample of European companies performing functions similar to those of 
XYZ-Europe, the district director determines that an average market 
return on XYZ-Europe's operating assets in the Nulon business is 10 
percent, resulting in a market return of $20 million (10% X $200 
million) for XYZ- Europe's Nulon business, and a residual profit of $180 
million.
    (v) Since the first stage of the residual profit split allocated 
profits to XYZ-Europe's contributions other than those attributable to 
highly valuable intangible property, it is assumed that the residual 
profit of $180 million is attributable to the valuable intangibles 
related to Nulon, i.e., the European brand name for Nulon and the Nulon 
formula (including XYZ-Europe's modifications). To estimate the relative 
values of these intangibles, the district director compares the ratios 
of the capitalized value of expenditures as of 1995 on Nulon-related 
research and development and marketing over the 1995 sales related to 
such expenditures.
    (vi) Because XYZ's protective product research and development 
expenses support the worldwide protective product sales of the XYZ 
group, it is necessary to allocate such expenses among the worldwide 
business activities to which they relate. The district director 
determines that it is reasonable to allocate the value of these expenses 
based on worldwide protective product sales. Using information on the 
average useful life of its investments in protective product research 
and development, the district director capitalizes and amortizes XYZ's 
protective product research and development expenses. This analysis 
indicates that the capitalized research and development expenditures 
have a value of $0.20 per dollar of global protective product sales in 
1995.
    (vii) XYZ-Europe's expenditures on Nulon research and development 
and marketing support only its sales in Europe. Using information on the 
average useful life of XYZ-Europe's investments in marketing and 
research and development, the district director capitalizes and 
amortizes XYZ-Europe's expenditures and determines that they have a 
value in 1995 of $0.40 per dollar of XYZ-Europe's Nulon sales.
    (viii) Thus, XYZ and XYZ-Europe together contributed $0.60 in 
capitalized intangible development expenses for each dollar of XYZ-
Europe's protective product sales for 1995, of which XYZ contributed 
one-third (or $0.20 per dollar of sales). Accordingly, the district 
director determines that an arm's length royalty for the Nulon license 
for the 1995 taxable year is $60 million, i.e., one-third of XYZ-
Europe's $180 million in residual Nulon profit.

[T.D. 8552, 59 FR 35025, July 8, 1994; 60 FR 16382, Mar. 30, 1995]



Sec. 1.482-7  Sharing of costs.

    (a) In general--(1) Scope and application of the rules in this 
section. A cost sharing arrangement is an agreement under which the 
parties agree to share the costs of development of one or more 
intangibles in proportion to their shares of reasonably anticipated 
benefits from their individual exploitation of the interests in the 
intangibles assigned to them under the arrangement. A taxpayer may claim 
that a cost sharing arrangement is a qualified cost sharing arrangement 
only if the agreement meets the requirements of paragraph (b) of this 
section. Consistent with the rules of Sec. 1.482-1(d)(3)(ii)(B) 
(Identifying contractual terms), the district director may apply the 
rules of this section to any arrangement that in substance constitutes a 
cost sharing arrangement, notwithstanding a failure to comply with any 
requirement of this section. A qualified cost sharing arrangement, or an 
arrangement to which the district director applies the rules of this 
section, will not be treated

[[Page 659]]

as a partnership to which the rules of subchapter K apply. See Sec. 
301.7701-3(e) of this chapter. Furthermore, a participant that is a 
foreign corporation or nonresident alien individual will not be treated 
as engaged in trade or business within the United States solely by 
reason of its participation in such an arrangement. See generally Sec. 
1.864-2(a).
    (2) Limitation on allocations. The district director shall not make 
allocations with respect to a qualified cost sharing arrangement except 
to the extent necessary to make each controlled participant's share of 
the costs (as determined under paragraph (d) of this section) of 
intangible development under the qualified cost sharing arrangement 
equal to its share of reasonably anticipated benefits attributable to 
such development, under the rules of this section. If a controlled 
taxpayer acquires an interest in intangible property from another 
controlled taxpayer (other than in consideration for bearing a share of 
the costs of the intangible's development), then the district director 
may make appropriate allocations to reflect an arm's length 
consideration for the acquisition of the interest in such intangible 
under the rules of Sec. Sec. 1.482-1 and 1.482-4 through 1.482-6. See 
paragraph (g) of this section. An interest in an intangible includes any 
commercially transferable interest, the benefits of which are 
susceptible of valuation. See Sec. 1.482-4(b) for the definition of an 
intangible.
    (3) Coordination with Sec. 1.482-1. A qualified cost sharing 
arrangement produces results that are consistent with an arm's length 
result within the meaning of Sec. 1.482-1(b)(1) if, and only if, each 
controlled participant's share of the costs (as determined under 
paragraph (d) of this section) of intangible development under the 
qualified cost sharing arrangement equals its share of reasonably 
anticipated benefits attributable to such development (as required by 
paragraph (a)(2) of this section) and all other requirements of this 
section are satisfied.
    (4) Cross references. Paragraph (c) of this section defines 
participant. Paragraph (d) of this section defines the costs of 
intangible development. Paragraph (e) of this section defines the 
anticipated benefits of intangible development. Paragraph (f) of this 
section provides rules governing cost allocations. Paragraph (g) of this 
section provides rules governing transfers of intangibles other than in 
consideration for bearing a share of the costs of the intangible's 
development. Rules governing the character of payments made pursuant to 
a qualified cost sharing arrangement are provided in paragraph (h) of 
this section. Paragraph (i) of this section provides accounting 
requirements. Paragraph (j) of this section provides administrative 
requirements. Paragraph (k) of this section provides an effective date. 
Paragraph (l) provides a transition rule.
    (b) Qualified cost sharing arrangement. A qualified cost sharing 
arrangement must--
    (1) Include two or more participants;
    (2) Provide a method to calculate each controlled participant's 
share of intangible development costs, based on factors that can 
reasonably be expected to reflect that participant's share of 
anticipated benefits;
    (3) Provide for adjustment to the controlled participants' shares of 
intangible development costs to account for changes in economic 
conditions, the business operations and practices of the participants, 
and the ongoing development of intangibles under the arrangement; and
    (4) Be recorded in a document that is contemporaneous with the 
formation (and any revision) of the cost sharing arrangement and that 
includes--
    (i) A list of the arrangement's participants, and any other member 
of the controlled group that will benefit from the use of intangibles 
developed under the cost sharing arrangement;
    (ii) The information described in paragraphs (b)(2) and (b)(3) of 
this section;
    (iii) A description of the scope of the research and development to 
be undertaken, including the intangible or class of intangibles intended 
to be developed;
    (iv) A description of each participant's interest in any covered 
intangibles. A covered intangible is any intangible property that is 
developed as a result of the research and development undertaken under 
the cost sharing arrangement (intangible development area);

[[Page 660]]

    (v) The duration of the arrangement; and
    (vi) The conditions under which the arrangement may be modified or 
terminated and the consequences of such modification or termination, 
such as the interest that each participant will receive in any covered 
intangibles.
    (c) Participant--(1) In general. For purposes of this section, a 
participant is a controlled taxpayer that meets the requirements of this 
paragraph (c)(1) (controlled participant) or an uncontrolled taxpayer 
that is a party to the cost sharing arrangement (uncontrolled 
participant). See Sec. 1.482-1(i)(5) for the definitions of controlled 
and uncontrolled taxpayers. A controlled taxpayer may be a controlled 
participant only if it--
    (i) Reasonably anticipates that it will derive benefits from the use 
of covered intangibles;
    (ii) Substantially complies with the accounting requirements 
described in paragraph (i) of this section; and
    (iii) Substantially complies with the administrative requirements 
described in paragraph (j) of this section.
    (iv) The following example illustrates paragraph (c)(1)(i) of this 
section:

    Example. Foreign Parent (FP) is a foreign corporation engaged in the 
extraction of a natural resource. FP has a U.S. subsidiary (USS) to 
which FP sells supplies of this resource for sale in the United States. 
FP enters into a cost sharing arrangement with USS to develop a new 
machine to extract the natural resource. The machine uses a new 
extraction process that will be patented in the United States and in 
other countries. The cost sharing arrangement provides that USS will 
receive the rights to use the machine in the extraction of the natural 
resource in the United States, and FP will receive the rights in the 
rest of the world. This resource does not, however, exist in the United 
States. Despite the fact that USS has received the right to use this 
process in the United States, USS is not a qualified participant because 
it will not derive a benefit from the use of the intangible developed 
under the cost sharing arrangement.

    (2) Treatment of a controlled taxpayer that is not a controlled 
participant--(i) In general. If a controlled taxpayer that is not a 
controlled participant (within the meaning of this paragraph (c)) 
provides assistance in relation to the research and development 
undertaken in the intangible development area, it must receive 
consideration from the controlled participants under the rules of Sec. 
1.482-4(f)(3)(iii) (Allocations with respect to assistance provided to 
the owner). For purposes of paragraph (d) of this section, such 
consideration is treated as an operating expense and each controlled 
participant must be treated as incurring a share of such consideration 
equal to its share of reasonably anticipated benefits (as defined in 
paragraph (f)(3) of this section).
    (ii) Example. The following example illustrates this paragraph 
(c)(2):

    Example. (i) U.S. Parent (USP), one foreign subsidiary (FS), and a 
second foreign subsidiary constituting the group's research arm (R+D) 
enter into a cost sharing agreement to develop manufacturing intangibles 
for a new product line A. USP and FS are assigned the exclusive rights 
to exploit the intangibles respectively in the United States and the 
rest of the world, where each presently manufactures and sells various 
existing product lines. R+D is not assigned any rights to exploit the 
intangibles. R+D's activity consists solely in carrying out research for 
the group. It is reliably projected that the shares of reasonably 
anticipated benefits of USP and FS will be 66\2/3\% and 33\1/3\, 
respectively, and the parties' agreement provides that USP and FS will 
reimburse 66\2/3\% and 33\1/3\%, respectively, of the intangible 
development costs incurred by R+D with respect to the new intangible.
    (ii) R+D does not qualify as a controlled participant within the 
meaning of paragraph (c) of this section, because it will not derive any 
benefits from the use of covered intangibles. Therefore, R+D is treated 
as a service provider for purposes of this section and must receive 
arm's length consideration for the assistance it is deemed to provide to 
USP and FS, under the rules of Sec. 1.482-4(f)(3)(iii). Such 
consideration must be treated as intangible development costs incurred 
by USP and FS in proportion to their shares of reasonably anticipated 
benefits (i.e., 66\2/3\% and 33\1/3\%, respectively). R+D will not be 
considered to bear any share of the intangible development costs under 
the arrangement.

    (3) Treatment of consolidated group. For purposes of this section, 
all members of the same affiliated group (within the meaning of section 
1504(a)) that join in the filing of a consolidated return for the 
taxable year under section 1501 shall be treated as one taxpayer.
    (d) Costs--(1) Intangible development costs. For purposes of this 
section, a controlled participant's costs of developing intangibles for 
a taxable year

[[Page 661]]

mean all of the costs incurred by that participant related to the 
intangible development area, plus all of the cost sharing payments it 
makes to other controlled and uncontrolled participants, minus all of 
the cost sharing payments it receives from other controlled and 
uncontrolled participants. Costs incurred related to the intangible 
development area consist of the following items: operating expenses as 
defined in Sec. 1.482-5(d)(3), other than depreciation or amortization 
expense, plus (to the extent not included in such operating expenses, as 
defined in Sec. 1.482-5(d)(3)) the charge for the use of any tangible 
property made available to the qualified cost sharing arrangement. If 
tangible property is made available to the qualified cost sharing 
arrangement by a controlled participant, the determination of the 
appropriate charge will be governed by the rules of Sec. 1.482-2(c) 
(Use of tangible property). Intangible development costs do not include 
the consideration for the use of any intangible property made available 
to the qualified cost sharing arrangement. See paragraph (g)(2) of this 
section. If a particular cost contributes to the intangible development 
area and other areas or other business activities, the cost must be 
allocated between the intangible development area and the other areas or 
business activities on a reasonable basis. In such a case, it is 
necessary to estimate the total benefits attributable to the cost 
incurred. The share of such cost allocated to the intangible development 
area must correspond to covered intangibles' share of the total 
benefits. Costs that do not contribute to the intangible development 
area are not taken into account.
    (2) Stock-based compensation--(i) In general. For purposes of this 
section, a controlled participant's operating expenses include all costs 
attributable to compensation, including stock-based compensation. As 
used in this section, the term stock-based compensation means any 
compensation provided by a controlled participant to an employee or 
independent contractor in the form of equity instruments, options to 
acquire stock (stock options), or rights with respect to (or determined 
by reference to) equity instruments or stock options, including but not 
limited to property to which section 83 applies and stock options to 
which section 421 applies, regardless of whether ultimately settled in 
the form of cash, stock, or other property.
    (ii) Identification of stock-based compensation related to 
intangible development. The determination of whether stock-based 
compensation is related to the intangible development area within the 
meaning of paragraph (d)(1) of this section is made as of the date that 
the stock-based compensation is granted. Accordingly, all stock-based 
compensation that is granted during the term of the qualified cost 
sharing arrangement and is related at date of grant to the development 
of intangibles covered by the arrangement is included as an intangible 
development cost under paragraph (d)(1) of this section. In the case of 
a repricing or other modification of a stock option, the determination 
of whether the repricing or other modification constitutes the grant of 
a new stock option for purposes of this paragraph (d)(2)(ii) will be 
made in accordance with the rules of section 424(h) and related 
regulations.
    (iii) Measurement and timing of stock-based compensation expense--
(A) In general. Except as otherwise provided in this paragraph 
(d)(2)(iii), the operating expense attributable to stock-based 
compensation is equal to the amount allowable to the controlled 
participant as a deduction for Federal income tax purposes with respect 
to that stock-based compensation (for example, under section 83(h)) and 
is taken into account as an operating expense under this section for the 
taxable year for which the deduction is allowable.
    (1) Transfers to which section 421 applies. Solely for purposes of 
this paragraph (d)(2)(iii)(A), section 421 does not apply to the 
transfer of stock pursuant to the exercise of an option that meets the 
requirements of section 422(a) or 423(a).
    (2) Deductions of foreign controlled participants. Solely for 
purposes of this paragraph (d)(2)(iii)(A), an amount is treated as an 
allowable deduction of a controlled participant to the extent that a 
deduction would be allowable to a United States taxpayer.

[[Page 662]]

    (3) Modification of stock option. Solely for purposes of this 
paragraph (d)(2)(iii)(A), if the repricing or other modification of a 
stock option is determined, under paragraph (d)(2)(ii) of this section, 
to constitute the grant of a new stock option not related to the 
development of intangibles, the stock option that is repriced or 
otherwise modified will be treated as being exercised immediately before 
the modification, provided that the stock option is then exercisable and 
the fair market value of the underlying stock then exceeds the price at 
which the stock option is exercisable. Accordingly, the amount of the 
deduction that would be allowable (or treated as allowable under this 
paragraph (d)(2)(iii)(A)) to the controlled participant upon exercise of 
the stock option immediately before the modification must be taken into 
account as an operating expense as of the date of the modification.
    (4) Expiration or termination of qualified cost sharing arrangement. 
Solely for purposes of this paragraph (d)(2)(iii)(A), if an item of 
stock-based compensation related to the development of intangibles is 
not exercised during the term of a qualified cost sharing arrangement, 
that item of stock-based compensation will be treated as being exercised 
immediately before the expiration or termination of the qualified cost 
sharing arrangement, provided that the stock-based compensation is then 
exercisable and the fair market value of the underlying stock then 
exceeds the price at which the stock-based compensation is exercisable. 
Accordingly, the amount of the deduction that would be allowable (or 
treated as allowable under this paragraph (d)(2)(iii)(A)) to the 
controlled participant upon exercise of the stock-based compensation 
must be taken into account as an operating expense as of the date of the 
expiration or termination of the qualified cost sharing arrangement.
    (B) Election with respect to options on publicly traded stock--(1) 
In general. With respect to stock-based compensation in the form of 
options on publicly traded stock, the controlled participants in a 
qualified cost sharing arrangement may elect to take into account all 
operating expenses attributable to those stock options in the same 
amount, and as of the same time, as the fair value of the stock options 
reflected as a charge against income in audited financial statements or 
disclosed in footnotes to such financial statements, provided that such 
statements are prepared in accordance with United States generally 
accepted accounting principles by or on behalf of the company issuing 
the publicly traded stock.
    (2) Publicly traded stock. As used in this paragraph (d)(2)(iii)(B), 
the term publicly traded stock means stock that is regularly traded on 
an established United States securities market and is issued by a 
company whose financial statements are prepared in accordance with 
United States generally accepted accounting principles for the taxable 
year.
    (3) Generally accepted accounting principles. For purposes of this 
paragraph (d)(2)(iii)(B), a financial statement prepared in accordance 
with a comprehensive body of generally accepted accounting principles 
other than United States generally accepted accounting principles is 
considered to be prepared in accordance with United States generally 
accepted accounting principles provided that either--
    (i) The fair value of the stock options under consideration is 
reflected in the reconciliation between such other accounting principles 
and United States generally accepted accounting principles required to 
be incorporated into the financial statement by the securities laws 
governing companies whose stock is regularly traded on United States 
securities markets; or
    (ii) In the absence of a reconciliation between such other 
accounting principles and United States generally accepted accounting 
principles that reflects the fair value of the stock options under 
consideration, such other accounting principles require that the fair 
value of the stock options under consideration be reflected as a charge 
against income in audited financial statements or disclosed in footnotes 
to such statements.
    (4) Time and manner of making the election. The election described 
in this paragraph (d)(2)(iii)(B) is made by an explicit reference to the 
election in the

[[Page 663]]

written cost sharing agreement required by paragraph (b)(4) of this 
section or in a written amendment to the cost sharing agreement entered 
into with the consent of the Commissioner pursuant to paragraph 
(d)(2)(iii)(C) of this section. In the case of a qualified cost sharing 
arrangement in existence on August 26, 2003, the election must be made 
by written amendment to the cost sharing agreement not later than the 
latest due date (with regard to extensions) of a Federal income tax 
return of any controlled participant for the first taxable year 
beginning after August 26, 2003, and the consent of the Commissioner is 
not required.
    (C) Consistency. Generally, all controlled participants in a 
qualified cost sharing arrangement taking options on publicly traded 
stock into account under paragraph (d)(2)(iii)(A) or (B) of this section 
must use that same method of measurement and timing for all options on 
publicly traded stock with respect to that qualified cost sharing 
arrangement. Controlled participants may change their method only with 
the consent of the Commissioner and only with respect to stock options 
granted during taxable years subsequent to the taxable year in which the 
Commissioner's consent is obtained. All controlled participants in the 
qualified cost sharing arrangement must join in requests for the 
Commissioner's consent under this paragraph. Thus, for example, if the 
controlled participants make the election described in paragraph 
(d)(2)(iii)(B) of this section upon the formation of the qualified cost 
sharing arrangement, the election may be revoked only with the consent 
of the Commissioner, and the consent will apply only to stock options 
granted in taxable years subsequent to the taxable year in which consent 
is obtained. Similarly, if controlled participants already have granted 
stock options that have been or will be taken into account under the 
general rule of paragraph (d)(2)(iii)(A) of this section, then except in 
cases specified in the last sentence of paragraph (d)(2)(iii)(B)(4) of 
this section, the controlled participants may make the election 
described in paragraph (d)(2)(iii)(B) of this section only with the 
consent of the Commissioner, and the consent will apply only to stock 
options granted in taxable years subsequent to the taxable year in which 
consent is obtained.
    (3) Examples. The following examples illustrate this paragraph (d):

    Example 1. Foreign Parent (FP) and U.S. Subsidiary (USS) enter into 
a qualified cost sharing arrangement to develop a better mousetrap. USS 
and FP share the costs of FP's research and development facility that 
will be exclusively dedicated to this research, the salaries of the 
researchers, and reasonable overhead costs attributable to the project. 
They also share the cost of a conference facility that is at the 
disposal of the senior executive management of each company but does not 
contribute to the research and development activities in any measurable 
way. In this case, the cost of the conference facility must be excluded 
from the amount of intangible development costs.
    Example 2. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into 
a qualified cost sharing arrangement to develop a new device. USP and FS 
share the costs of a research and development facility, the salaries of 
researchers, and reasonable overhead costs attributable to the project. 
USP also incurs costs related to field testing of the device, but does 
not include them in the amount of intangible development costs of the 
cost sharing arrangement. The district director may determine that the 
field testing costs are intangible development costs that must be 
shared.

    (e) Anticipated benefits--(1) Benefits. Benefits are additional 
income generated or costs saved by the use of covered intangibles.
    (2) Reasonably anticipated benefits. For purposes of this section, a 
controlled participant's reasonably anticipated benefits are the 
aggregate benefits that it reasonably anticipates that it will derive 
from covered intangibles.
    (f) Cost allocations--(1) In general. For purposes of determining 
whether a cost allocation authorized by paragraph (a)(2) of this section 
is appropriate for a taxable year, a controlled participant's share of 
intangible development costs for the taxable year under a qualified cost 
sharing arrangement must be compared to its share of reasonably 
anticipated benefits under the arrangement. A controlled participant's 
share of intangible development costs is determined under paragraph 
(f)(2) of this section. A controlled participant's share of reasonably 
anticipated benefits under the arrangement

[[Page 664]]

is determined under paragraph (f)(3) of this section. In determining 
whether benefits were reasonably anticipated, it may be appropriate to 
compare actual benefits to anticipated benefits, as described in 
paragraph (f)(3)(iv) of this section.
    (2) Share of intangible development costs--(i) In general. A 
controlled participant's share of intangible development costs for a 
taxable year is equal to its intangible development costs for the 
taxable year (as defined in paragraph (d) of this section), divided by 
the sum of the intangible development costs for the taxable year (as 
defined in paragraph (d) of this section) of all the controlled 
participants.
    (ii) Example. The following example illustrates this paragraph 
(f)(2):

    Example (i) U.S. Parent (USP), Foreign Subsidiary (FS), and 
Unrelated Third Party (UTP) enter into a cost sharing arrangement to 
develop new audio technology. In the first year of the arrangement, the 
controlled participants incur $2,250,000 in the intangible development 
area, all of which is incurred directly by USP. In the first year, UTP 
makes a $250,000 cost sharing payment to USP, and FS makes a $800,000 
cost sharing payment to USP, under the terms of the arrangement. For 
that year, the intangible development costs borne by USP are $1,200,000 
(its $2,250,000 intangible development costs directly incurred, minus 
the cost sharing payments it receives of $250,000 from UTP and $800,000 
from FS); the intangible development costs borne by FS are $800,000 (its 
cost sharing payment); and the intangible development costs borne by all 
of the controlled participants are $2,000,000 (the sum of the intangible 
development costs borne by USP and FS of $1,200,000 and $800,000, 
respectively). Thus, for the first year, USP's share of intangible 
development costs is 60% ($1,200,000 divided by $2,000,000), and FS's 
share of intangible development costs is 40% ($800,000 divided by 
$2,000,000).
    (ii) For purposes of determining whether a cost allocation 
authorized by paragraph Sec. 1.482-7(a)(2) is appropriate for the first 
year, the district director must compare USP's and FS's shares of 
intangible development costs for that year to their shares of reasonably 
anticipated benefits. See paragraph (f)(3) of this section.

    (3) Share of reasonably anticipated benefits--(i) In general. A 
controlled participant's share of reasonably anticipated benefits under 
a qualified cost sharing arrangement is equal to its reasonably 
anticipated benefits (as defined in paragraph (e)(2) of this section), 
divided by the sum of the reasonably anticipated benefits (as defined in 
paragraph (e)(2) of this section) of all the controlled participants. 
The anticipated benefits of an uncontrolled participant will not be 
included for purposes of determining each controlled participant's share 
of anticipated benefits. A controlled participant's share of reasonably 
anticipated benefits will be determined using the most reliable estimate 
of reasonably anticipated benefits. In determining which of two or more 
available estimates is most reliable, the quality of the data and 
assumptions used in the analysis must be taken into account, consistent 
with Sec. 1.482-1(c)(2)(ii) (Data and assumptions). Thus, the 
reliability of an estimate will depend largely on the completeness and 
accuracy of the data, the soundness of the assumptions, and the relative 
effects of particular deficiencies in data or assumptions on different 
estimates. If two estimates are equally reliable, no adjustment should 
be made based on differences in the results. The following factors will 
be particularly relevant in determining the reliability of an estimate 
of anticipated benefits--
    (A) The reliability of the basis used for measuring benefits, as 
described in paragraph (f)(3)(ii) of this section; and
    (B) The reliability of the projections used to estimate benefits, as 
described in paragraph (f)(3)(iv) of this section.
    (ii) Measure of benefits. In order to estimate a controlled 
participant's share of anticipated benefits from covered intangibles, 
the amount of benefits that each of the controlled participants is 
reasonably anticipated to derive from covered intangibles must be 
measured on a basis that is consistent for all such participants. See 
paragraph (f)(3)(iii)(E), Example 8, of this section. If a controlled 
participant transfers covered intangibles to another controlled 
taxpayer, such participant's benefits from the transferred intangibles 
must be measured by reference to the transferee's benefits, disregarding 
any consideration paid by the transferee to the controlled participant 
(such as a royalty pursuant to a license agreement). Anticipated 
benefits are measured either on a direct basis, by

[[Page 665]]

reference to estimated additional income to be generated or costs to be 
saved by the use of covered intangibles, or on an indirect basis, by 
reference to certain measurements that reasonably can be assumed to be 
related to income generated or costs saved. Such indirect bases of 
measurement of anticipated benefits are described in paragraph 
(f)(3)(iii) of this section. A controlled participant's anticipated 
benefits must be measured on the most reliable basis, whether direct or 
indirect. In determining which of two bases of measurement of reasonably 
anticipated benefits is most reliable, the factors set forth in Sec. 
1.482-1(c)(2)(ii) (Data and assumptions) must be taken into account. It 
normally will be expected that the basis that provided the most reliable 
estimate for a particular year will continue to provide the most 
reliable estimate in subsequent years, absent a material change in the 
factors that affect the reliability of the estimate. Regardless of 
whether a direct or indirect basis of measurement is used, adjustments 
may be required to account for material differences in the activities 
that controlled participants undertake to exploit their interests in 
covered intangibles. See Example 6 of paragraph (f)(3)(iii)(E) of this 
section.
    (iii) Indirect bases for measuring anticipated benefits. Indirect 
bases for measuring anticipated benefits from participation in a 
qualified cost sharing arrangement include the following:
    (A) Units used, produced or sold. Units of items used, produced or 
sold by each controlled participant in the business activities in which 
covered intangibles are exploited may be used as an indirect basis for 
measuring its anticipated benefits. This basis of measurement will be 
more reliable to the extent that each controlled participant is expected 
to have a similar increase in net profit or decrease in net loss 
attributable to the covered intangibles per unit of the item or items 
used, produced or sold. This circumstance is most likely to arise when 
the covered intangibles are exploited by the controlled participants in 
the use, production or sale of substantially uniform items under similar 
economic conditions.
    (B) Sales. Sales by each controlled participant in the business 
activities in which covered intangibles are exploited may be used as an 
indirect basis for measuring its anticipated benefits. This basis of 
measurement will be more reliable to the extent that each controlled 
participant is expected to have a similar increase in net profit or 
decrease in net loss attributable to covered intangibles per dollar of 
sales. This circumstance is most likely to arise if the costs of 
exploiting covered intangibles are not substantial relative to the 
revenues generated, or if the principal effect of using covered 
intangibles is to increase the controlled participants' revenues (e.g., 
through a price premium on the products they sell) without affecting 
their costs substantially. Sales by each controlled participant are 
unlikely to provide a reliable basis for measuring benefits unless each 
controlled participant operates at the same market level (e.g., 
manufacturing, distribution, etc.).
    (C) Operating profit. Operating profit of each controlled 
participant from the activities in which covered intangibles are 
exploited may be used as an indirect basis for measuring its anticipated 
benefits. This basis of measurement will be more reliable to the extent 
that such profit is largely attributable to the use of covered 
intangibles, or if the share of profits attributable to the use of 
covered intangibles is expected to be similar for each controlled 
participant. This circumstance is most likely to arise when covered 
intangibles are integral to the activity that generates the profit and 
the activity could not be carried on or would generate little profit 
without use of those intangibles.
    (D) Other bases for measuring anticipated benefits. Other bases for 
measuring anticipated benefits may, in some circumstances, be 
appropriate, but only to the extent that there is expected to be a 
reasonably identifiable relationship between the basis of measurement 
used and additional income generated or costs saved by the use of 
covered intangibles. For example, a division of costs based on employee 
compensation would be considered unreliable unless there were a 
relationship between the amount of compensation and the expected income 
of the controlled participants from the use of covered intangibles.

[[Page 666]]

    (E) Examples. The following examples illustrate this paragraph 
(f)(3)(iii):

    Example 1. Foreign Parent (FP) and U.S. Subsidiary (USS) both 
produce a feedstock for the manufacture of various high-performance 
plastic products. Producing the feedstock requires large amounts of 
electricity, which accounts for a significant portion of its production 
cost. FP and USS enter into a cost sharing arrangement to develop a new 
process that will reduce the amount of electricity required to produce a 
unit of the feedstock. FP and USS currently both incur an electricity 
cost of X% of its other production costs and rates for each are expected 
to remain similar in the future. How much the new process, if it is 
successful, will reduce the amount of electricity required to produce a 
unit of the feedstock is uncertain, but it will be about the same amount 
for both companies. Therefore, the cost savings each company is expected 
to achieve after implementing the new process are similar relative to 
the total amount of the feedstock produced. Under the cost sharing 
arrangement FP and USS divide the costs of developing the new process 
based on the units of the feedstock each is anticipated to produce in 
the future. In this case, units produced is the most reliable basis for 
measuring benefits and dividing the intangible development costs because 
each participant is expected to have a similar decrease in costs per 
unit of the feedstock produced.
    Example 2. The facts are the same as in Example 1, except that USS 
pays X% of its other production costs for electricity while FP pays 2X% 
of its other production costs. In this case, units produced is not the 
most reliable basis for measuring benefits and dividing the intangible 
development costs because the participants do not expect to have a 
similar decrease in costs per unit of the feedstock produced. The 
district director determines that the most reliable measure of benefit 
shares may be based on units of the feedstock produced if FP's units are 
weighted relative to USS's units by a factor of 2. This reflects the 
fact that FP pays twice as much as USS as a percentage of its other 
production costs for electricity and, therefore, FP's savings per unit 
of the feedstock would be twice USS's savings from any new process 
eventually developed.
    Example 3. The facts are the same as in Example 2, except that to 
supply the particular needs of the U.S. market USS manufactures the 
feedstock with somewhat different properties than FP's feedstock. This 
requires USS to employ a somewhat different production process than does 
FP. Because of this difference, it will be more costly for USS to adopt 
any new process that may be developed under the cost sharing agreement. 
In this case, units produced is not the most reliable basis for 
measuring benefit shares. In order to reliably determine benefit shares, 
the district director offsets the reasonably anticipated costs of 
adopting the new process against the reasonably anticipated total 
savings in electricity costs.
    Example 4. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into 
a cost sharing arrangement to develop new anesthetic drugs. USP obtains 
the right to use any resulting patent in the U.S. market, and FS obtains 
the right to use the patent in the European market. USP and FS divide 
costs on the basis of anticipated operating profit from each patent 
under development. USP anticipates that it will receive a much higher 
profit than FS per unit sold because drug prices are uncontrolled in the 
U.S., whereas drug prices are regulated in many European countries. In 
this case, the controlled taxpayers' basis for measuring benefits is the 
most reliable.
    Example 5. (i) Foreign Parent (FP) and U.S. Subsidiary (USS) both 
manufacture and sell fertilizers. They enter into a cost sharing 
arrangement to develop a new pellet form of a common agricultural 
fertilizer that is currently available only in powder form. Under the 
cost sharing arrangement, USS obtains the rights to produce and sell the 
new form of fertilizer for the U.S. market while FP obtains the rights 
to produce and sell the fertilizer for the rest of the world. The costs 
of developing the new form of fertilizer are divided on the basis of the 
anticipated sales of fertilizer in the participants' respective markets.
    (ii) If the research and development is successful the pellet form 
will deliver the fertilizer more efficiently to crops and less 
fertilizer will be required to achieve the same effect on crop growth. 
The pellet form of fertilizer can be expected to sell at a price premium 
over the powder form of fertilizer based on the savings in the amount of 
fertilizer that needs to be used. If the research and development is 
successful, the costs of producing pellet fertilizer are expected to be 
approximately the same as the costs of producing powder fertilizer and 
the same for both FP and USS. Both FP and USS operate at approximately 
the same market levels, selling their fertilizers largely to independent 
distributors.
    (iii) In this case, the controlled taxpayers' basis for measuring 
benefits is the most reliable.
    Example 6. The facts are the same as in Example 5, except that FP 
distributes its fertilizers directly while USS sells to independent 
distributors. In this case, sales of USS and FP are not the most 
reliable basis for measuring benefits unless adjustments are made to 
account for the difference in market levels at which the sales occur.
    Example 7. Foreign Parent (FP) and U.S. Subsidiary (USS) enter into 
a cost sharing arrangement to develop materials that will

[[Page 667]]

be used to train all new entry-level employees. FP and USS determine 
that the new materials will save approximately ten hours of training 
time per employee. Because their entry-level employees are paid on 
differing wage scales, FP and USS decide that they should not divide 
costs based on the number of entry-level employees hired by each. 
Rather, they divide costs based on compensation paid to the entry-level 
employees hired by each. In this case, the basis used for measuring 
benefits is the most reliable because there is a direct relationship 
between compensation paid to new entry-level employees and costs saved 
by FP and USS from the use of the new training materials.
    Example 8. U.S. Parent (USP), Foreign Subsidiary 1 (FS1) and Foreign 
Subsidiary 2 (FS2) enter into a cost sharing arrangement to develop 
computer software that each will market and install on customers' 
computer systems. The participants divide costs on the basis of 
projected sales by USP, FS1, and FS2 of the software in their respective 
geographic areas. However, FS1 plans not only to sell but also to 
license the software to unrelated customers, and FS1's licensing income 
(which is a percentage of the licensees' sales) is not counted in the 
projected benefits. In this case, the basis used for measuring the 
benefits of each participant is not the most reliable because all of the 
benefits received by participants are not taken into account. In order 
to reliably determine benefit shares, FS1's projected benefits from 
licensing must be included in the measurement on a basis that is the 
same as that used to measure its own and the other participants' 
projected benefits from sales (e.g., all participants might measure 
their benefits on the basis of operating profit).

    (iv) Projections used to estimate anticipated benefits--(A) In 
general. The reliability of an estimate of anticipated benefits also 
depends upon the reliability of projections used in making the estimate. 
Projections required for this purpose generally include a determination 
of the time period between the inception of the research and development 
and the receipt of benefits, a projection of the time over which 
benefits will be received, and a projection of the benefits anticipated 
for each year in which it is anticipated that the intangible will 
generate benefits. A projection of the relevant basis for measuring 
anticipated benefits may require a projection of the factors that 
underlie it. For example, a projection of operating profits may require 
a projection of sales, cost of sales, operating expenses, and other 
factors that affect operating profits. If it is anticipated that there 
will be significant variation among controlled participants in the 
timing of their receipt of benefits, and consequently benefit shares are 
expected to vary significantly over the years in which benefits will be 
received, it may be necessary to use the present discounted value of the 
projected benefits to reliably determine each controlled participant's 
share of those benefits. If it is not anticipated that benefit shares 
will significantly change over time, current annual benefit shares may 
provide a reliable projection of anticipated benefit shares. This 
circumstance is most likely to occur when the cost sharing arrangement 
is a long-term arrangement, the arrangement covers a wide variety of 
intangibles, the composition of the covered intangibles is unlikely to 
change, the covered intangibles are unlikely to generate unusual 
profits, and each controlled participant's share of the market is 
stable.
    (B) Unreliable projections. A significant divergence between 
projected benefit shares and actual benefit shares may indicate that the 
projections were not reliable. In such a case, the district director may 
use actual benefits as the most reliable measure of anticipated 
benefits. If benefits are projected over a period of years, and the 
projections for initial years of the period prove to be unreliable, this 
may indicate that the projections for the remaining years of the period 
are also unreliable and thus should be adjusted. Projections will not be 
considered unreliable based on a divergence between a controlled 
participant's projected benefit share and actual benefit share if the 
amount of such divergence for every controlled participant is less than 
or equal to 20% of the participant's projected benefit share. Further, 
the district director will not make an allocation based on such 
divergence if the difference is due to an extraordinary event, beyond 
the control of the participants, that could not reasonably have been 
anticipated at the time that costs were shared. For purposes of this 
paragraph, all controlled participants that are not U.S.

[[Page 668]]

persons will be treated as a single controlled participant. Therefore, 
an adjustment based on an unreliable projection will be made to the cost 
shares of foreign controlled participants only if there is a matching 
adjustment to the cost shares of controlled participants that are U.S. 
persons. Nothing in this paragraph (f)(3)(iv)(B) will prevent the 
district director from making an allocation if the taxpayer did not use 
the most reliable basis for measuring anticipated benefits. For example, 
if the taxpayer measures anticipated benefits based on units sold, and 
the district director determines that another basis is more reliable for 
measuring anticipated benefits, then the fact that actual units sold 
were within 20% of the projected unit sales will not preclude an 
allocation under this section.
    (C) Foreign-to-foreign adjustments. Notwithstanding the limitations 
on adjustments provided in paragraph (f)(3)(iv)(B) of this section, 
adjustments to cost shares based on an unreliable projection also may be 
made solely among foreign controlled participants if the variation 
between actual and projected benefits has the effect of substantially 
reducing U.S. tax.
    (D) Examples. The following examples illustrate this paragraph 
(f)(3)(iv):

    Example 1. (i) Foreign Parent (FP) and U.S. Subsidiary (USS) enter 
into a cost sharing arrangement to develop a new car model. The 
participants plan to spend four years developing the new model and four 
years producing and selling the new model. USS and FP project total 
sales of $4 billion and $2 billion, respectively, over the planned four 
years of exploitation of the new model. Cost shares are divided for each 
year based on projected total sales. Therefore, USS bears 66\2/3\% of 
each year's intangible development costs and FP bears 33\1/3\% of such 
costs.
    (ii) USS typically begins producing and selling new car models a 
year after FP begins producing and selling new car models. The district 
director determines that in order to reflect USS's one-year lag in 
introducing new car models, a more reliable projection of each 
participant's share of benefits would be based on a projection of all 
four years of sales for each participant, discounted to present value.
    Example 2. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into 
a cost sharing arrangement to develop new and improved household 
cleaning products. Both participants have sold household cleaning 
products for many years and have stable market shares. The products 
under development are unlikely to produce unusual profits for either 
participant. The participants divide costs on the basis of each 
participant's current sales of household cleaning products. In this 
case, the participants' future benefit shares are reliably projected by 
current sales of cleaning products.
    Example 3. The facts are the same as in Example 2, except that FS's 
market share is rapidly expanding because of the business failure of a 
competitor in its geographic area. The district director determines that 
the participants' future benefit shares are not reliably projected by 
current sales of cleaning products and that FS's benefit projections 
should take into account its growth in sales.
    Example 4. Foreign Parent (FP) and U.S. Subsidiary (USS) enter into 
a cost sharing arrangement to develop synthetic fertilizers and 
insecticides. FP and USS share costs on the basis of each participant's 
current sales of fertilizers and insecticides. The market shares of the 
participants have been stable for fertilizers, but FP's market share for 
insecticides has been expanding. The district director determines that 
the participants' projections of benefit shares are reliable with regard 
to fertilizers, but not reliable with regard to insecticides; a more 
reliable projection of benefit shares would take into account the 
expanding market share for insecticides.
    Example 5. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into 
a cost sharing arrangement to develop new food products, dividing costs 
on the basis of projected sales two years in the future. In year 1, USP 
and FS project that their sales in year 3 will be equal, and they divide 
costs accordingly. In year 3, the district director examines the 
participants' method for dividing costs. USP and FS actually accounted 
for 42% and 58% of total sales, respectively. The district director 
agrees that sales two years in the future provide a reliable basis for 
estimating benefit shares. Because the differences between USP's and 
FS's actual and projected benefit shares are less than 20% of their 
projected benefit shares, the projection of future benefits for year 3 
is reliable.
    Example 6. The facts are the same as in Example 5, except that the 
in year 3 USP and FS actually accounted for 35% and 65% of total sales, 
respectively. The divergence between USP's projected and actual benefit 
shares is greater than 20% of USP's projected benefit share and is not 
due to an extraordinary event beyond the control of the participants. 
The district director concludes that the projection of anticipated 
benefit shares was unreliable, and uses actual benefits as the basis for 
an adjustment to the cost shares borne by USP and FS.
    Example 7. U.S. Parent (USP), a U.S. corporation, and its foreign 
subsidiary (FS)

[[Page 669]]

enter a cost sharing arrangement in year 1. They project that they will 
begin to receive benefits from covered intangibles in years 4 through 6, 
and that USP will receive 60% of total benefits and FS 40% of total 
benefits. In years 4 through 6, USP and FS actually receive 50% each of 
the total benefits. In evaluating the reliability of the participants' 
projections, the district director compares these actual benefit shares 
to the projected benefit shares. Although USP's actual benefit share 
(50%) is within 20% of its projected benefit share (60%), FS's actual 
benefit share (50%) is not within 20% of its projected benefit share 
(40%). Based on this discrepancy, the district director may conclude 
that the participants' projections were not reliable and may use actual 
benefit shares as the basis for an adjustment to the cost shares borne 
by USP and FS.
    Example 8. Three controlled taxpayers, USP, FS1 and FS2 enter into a 
cost sharing arrangement. FS1 and FS2 are foreign. USP is a United 
States corporation that controls all the stock of FS1 and FS2. The 
participants project that they will share the total benefits of the 
covered intangibles in the following percentages: USP 50%; FS1 30%; and 
FS2 20%. Actual benefit shares are as follows: USP 45%; FS1 25%; and FS2 
30%. In evaluating the reliability of the participants' projections, the 
district director compares these actual benefit shares to the projected 
benefit shares. For this purpose, FS1 and FS2 are treated as a single 
participant. The actual benefit share received by USP (45%) is within 
20% of its projected benefit share (50%). In addition, the non-US 
participants' actual benefit share (55%) is also within 20% of their 
projected benefit share (50%). Therefore, the district director 
concludes that the participants' projections of future benefits were 
reliable, despite the fact that FS2's actual benefit share (30%) is not 
within 20% of its projected benefit share (20%).
    Example 9. The facts are the same as in Example 8. In addition, the 
district director determines that FS2 has significant operating losses 
and has no earnings and profits, and that FS1 is profitable and has 
earnings and profits. Based on all the evidence, the district director 
concludes that the participants arranged that FS1 would bear a larger 
cost share than appropriate in order to reduce FS1's earnings and 
profits and thereby reduce inclusions USP otherwise would be deemed to 
have on account of FS1 under subpart F. Pursuant to Sec. 1.482-7 
(f)(3)(iv)(C), the district director may make an adjustment solely to 
the cost shares borne by FS1 and FS2 because FS2's projection of future 
benefits was unreliable and the variation between actual and projected 
benefits had the effect of substantially reducing USP's U.S. income tax 
liability (on account of FS1 subpart F income).
    Example 10. (i)(A) Foreign Parent (FP) and U.S. Subsidiary (USS) 
enter into a cost sharing arrangement in 1996 to develop a new treatment 
for baldness. USS's interest in any treatment developed is the right to 
produce and sell the treatment in the U.S. market while FP retains 
rights to produce and sell the treatment in the rest of the world. USS 
and FP measure their anticipated benefits from the cost sharing 
arrangement based on their respective projected future sales of the 
baldness treatment. The following sales projections are used:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                          Year                              USS     FP
------------------------------------------------------------------------
1997....................................................       5      10
1998....................................................      20      20
1999....................................................      30      30
2000....................................................      40      40
2001....................................................      40      40
2002....................................................      40      40
2003....................................................      40      40
2004....................................................      20      20
2005....................................................      10      10
2006....................................................       5       5
------------------------------------------------------------------------

    (B) In 1997, the first year of sales, USS is projected to have lower 
sales than FP due to lags in U.S. regulatory approval for the baldness 
treatment. In each subsequent year USS and FP are projected to have 
equal sales. Sales are projected to build over the first three years of 
the period, level off for several years, and then decline over the final 
years of the period as new and improved baldness treatments reach the 
market.
    (ii) To account for USS's lag in sales in the first year, the 
present discounted value of sales over the period is used as the basis 
for measuring benefits. Based on the risk associated with this venture, 
a discount rate of 10 percent is selected. The present discounted value 
of projected sales is determined to be approximately $154.4 million for 
USS and $158.9 million for FP. On this basis USS and FP are projected to 
obtain approximately 49.3% and 50.7% of the benefit, respectively, and 
the costs of developing the baldness treatment are shared accordingly.
    (iii) (A) In the year 2002 the district director examines the cost 
sharing arrangement. USS and FP have obtained the following sales 
results through the year 2001:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                          Year                              USS     FP
------------------------------------------------------------------------
1997....................................................       0      17
1998....................................................      17      35
1999....................................................      25      41
2000....................................................      38      41
2001....................................................      39      41
------------------------------------------------------------------------


[[Page 670]]

    (B) USS's sales initially grew more slowly than projected while FP's 
sales grew more quickly. In each of the first three years of the period 
the share of total sales of at least one of the parties diverged by over 
20% from its projected share of sales. However, by the year 2001 both 
parties' sales had leveled off at approximately their projected values. 
Taking into account this leveling off of sales and all the facts and 
circumstances, the district director determines that it is appropriate 
to use the original projections for the remaining years of sales. 
Combining the actual results through the year 2001 with the projections 
for subsequent years, and using a discount rate of 10%, the present 
discounted value of sales is approximately $141.6 million for USS and 
$187.3 million for FP. This result implies that USS and FP obtain 
approximately 43.1% and 56.9%, respectively, of the anticipated benefits 
from the baldness treatment. Because these benefit shares are within 20% 
of the benefit shares calculated based on the original sales 
projections, the district director determines that, based on the 
difference between actual and projected benefit shares, the original 
projections were not unreliable. No adjustment is made based on the 
difference between actual and projected benefit shares.
    Example 11. (i) The facts are the same as in Example 10, except that 
the actual sales results through the year 2001 are as follows:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                          Year                              USS     FP
------------------------------------------------------------------------
1997....................................................       0      17
1998....................................................      17      35
1999....................................................      25      44
2000....................................................      34      54
2001....................................................      36      55
------------------------------------------------------------------------

    (ii) Based on the discrepancy between the projections and the actual 
results and on consideration of all the facts, the district director 
determines that for the remaining years the following sales projections 
are more reliable than the original projections:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                          Year                             USS      FP
------------------------------------------------------------------------
2002...................................................     36        55
2003...................................................     36        55
2004...................................................     18        28
2005...................................................      9        14
2006...................................................      4.5       7
------------------------------------------------------------------------

    (iii) Combining the actual results through the year 2001 with the 
projections for subsequent years, and using a discount rate of 10%, the 
present discounted value of sales is approximately $131.2 million for 
USS and $229.4 million for FP. This result implies that USS and FP 
obtain approximately 35.4% and 63.6%, respectively, of the anticipated 
benefits from the baldness treatment. These benefit shares diverge by 
greater than 20% from the benefit shares calculated based on the 
original sales projections, and the district director determines that, 
based on the difference between actual and projected benefit shares, the 
original projections were unreliable. The district director adjusts 
costs shares for each of the taxable years under examination to conform 
them to the recalculated shares of anticipated benefits.

    (4) Timing of allocations. If the district director reallocates 
costs under the provisions of this paragraph (f), the allocation must be 
reflected for tax purposes in the year in which the costs were incurred. 
When a cost sharing payment is owed by one member of a qualified cost 
sharing arrangement to another member, the district director may make 
appropriate allocations to reflect an arm's length rate of interest for 
the time value of money, consistent with the provisions of Sec. 1.482-
2(a) (Loans or advances).
    (g) Allocations of income, deductions or other tax items to reflect 
transfers of intangibles (buy-in)--(1) In general. A controlled 
participant that makes intangible property available to a qualified cost 
sharing arrangement will be treated as having transferred interests in 
such property to the other controlled participants, and such other 
controlled participants must make buy-in payments to it, as provided in 
paragraph (g)(2) of this section. If the other controlled participants 
fail to make such payments, the district director may make appropriate 
allocations, under the provisions of Sec. Sec. 1.482-1 and 1.482-4 
through 1.482-6, to reflect an arm's length consideration for the 
transferred intangible property. Further, if a group of controlled 
taxpayers participates in a qualified cost sharing arrangement, any 
change in the controlled participants' interests in covered intangibles, 
whether by reason of entry of a new participant or otherwise by reason 
of transfers (including deemed transfers) of interests among existing 
participants, is a transfer of intangible property, and the district 
director may make appropriate allocations, under the provisions of 
Sec. Sec. 1.482-1 and 1.482-4 through 1.482-6, to reflect an arm's 
length consideration for the

[[Page 671]]

transfer. See paragraphs (g) (3), (4), and (5) of this section. 
Paragraph (g)(6) of this section provides rules for assigning unassigned 
interests under a qualified cost sharing arrangement.
    (2) Pre-existing intangibles. If a controlled participant makes pre-
existing intangible property in which it owns an interest available to 
other controlled participants for purposes of research in the intangible 
development area under a qualified cost sharing arrangement, then each 
such other controlled participant must make a buy-in payment to the 
owner. The buy-in payment by each such other controlled participant is 
the arm's length charge for the use of the intangible under the rules of 
Sec. Sec. 1.482-1 and 1.482-4 through 1.482-6, multiplied by the 
controlled participant's share of reasonably anticipated benefits (as 
defined in paragraph (f)(3) of this section). A controlled participant's 
payment required under this paragraph (g)(2) is deemed to be reduced to 
the extent of any payments owed to it under this paragraph (g)(2) from 
other controlled participants. Each payment received by a payee will be 
treated as coming pro rata out of payments made by all payors. See 
paragraph (g)(8), Example 4, of this section. Such payments will be 
treated as consideration for a transfer of an interest in the intangible 
property made available to the qualified cost sharing arrangement by the 
payee. Any payment to or from an uncontrolled participant in 
consideration for intangible property made available to the qualified 
cost sharing arrangement will be shared by the controlled participants 
in accordance with their shares of reasonably anticipated benefits (as 
defined in paragraph (f)(3) of this section). A controlled participant's 
payment required under this paragraph (g)(2) is deemed to be reduced by 
such a share of payments owed from an uncontrolled participant to the 
same extent as by any payments owed from other controlled participants 
under this paragraph (g)(2). See paragraph (g)(8), Example 5, of this 
section.
    (3) New controlled participant. If a new controlled participant 
enters a qualified cost sharing arrangement and acquires any interest in 
the covered intangibles, then the new participant must pay an arm's 
length consideration, under the provisions of Sec. Sec. 1.482-1 and 
1.482-4 through 1.482-6, for such interest to each controlled 
participant from whom such interest was acquired.
    (4) Controlled participant relinquishes interests. A controlled 
participant in a qualified cost sharing arrangement may be deemed to 
have acquired an interest in one or more covered intangibles if another 
controlled participant transfers, abandons, or otherwise relinquishes an 
interest under the arrangement, to the benefit of the first participant. 
If such a relinquishment occurs, the participant relinquishing the 
interest must receive an arm's length consideration, under the 
provisions of Sec. Sec. 1.482-1 and 1.482-4 through 1.482-6, for its 
interest. If the controlled participant that has relinquished its 
interest subsequently uses that interest, then that participant must pay 
an arm's length consideration, under the provisions of Sec. Sec. 1.482-
1 and 1.482-4 through 1.482-6, to the controlled participant that 
acquired the interest.
    (5) Conduct inconsistent with the terms of a cost sharing 
arrangement. If, after any cost allocations authorized by paragraph 
(a)(2) of this section, a controlled participant bears costs of 
intangible development that over a period of years are consistently and 
materially greater or lesser than its share of reasonably anticipated 
benefits, then the district director may conclude that the economic 
substance of the arrangement between the controlled participants is 
inconsistent with the terms of the cost sharing arrangement. In such a 
case, the district director may disregard such terms and impute an 
agreement consistent with the controlled participants' course of 
conduct, under which a controlled participant that bore a 
disproportionately greater share of costs received additional interests 
in covered intangibles. See Sec. 1.482-1(d)(3)(ii)(B) (Identifying 
contractual terms) and Sec. 1.482- 4(f)(3)(ii) (Identification of 
owner). Accordingly, that participant must receive an arm's length 
payment from any controlled participant whose share of the intangible 
development costs is less than its share of reasonably anticipated 
benefits over time, under the provisions of Sec. Sec. 1.482-1 and 
1.482-4 through 1.482-6.

[[Page 672]]

    (6) Failure to assign interests under a qualified cost sharing 
arrangement. If a qualified cost sharing arrangement fails to assign an 
interest in a covered intangible, then each controlled participant will 
be deemed to hold a share in such interest equal to its share of the 
costs of developing such intangible. For this purpose, if cost shares 
have varied materially over the period during which such intangible was 
developed, then the costs of developing the intangible must be measured 
by their present discounted value as of the date when the first such 
costs were incurred.
    (7) Form of consideration. The consideration for an acquisition 
described in this paragraph (g) may take any of the following forms:
    (i) Lump sum payments. For the treatment of lump sum payments, see 
Sec. 1.482-4(f)(5) (Lump sum payments);
    (ii) Installment payments. Installment payments spread over the 
period of use of the intangible by the transferee, with interest 
calculated in accordance with Sec. 1.482-2(a) (Loans or advances); and
    (iii) Royalties. Royalties or other payments contingent on the use 
of the intangible by the transferee.
    (8) Examples. The following examples illustrate allocations 
described in this paragraph (g):

    Example 1. In year one, four members of a controlled group enter 
into a cost sharing arrangement to develop a commercially feasible 
process for capturing energy from nuclear fusion. Based on a reliable 
projection of their future benefits, each cost sharing participant bears 
an equal share of the costs. The cost of developing intangibles for each 
participant with respect to the project is approximately $1 million per 
year. In year ten, a fifth member of the controlled group joins the cost 
sharing group and agrees to bear one-fifth of the future costs in 
exchange for part of the fourth member's territory reasonably 
anticipated to yield benefits amounting to one-fifth of the total 
benefits. The fair market value of intangible property within the 
arrangement at the time the fifth company joins the arrangement is $45 
million. The new member must pay one-fifth of that amount (that is, $9 
million total) to the fourth member from whom it acquired its interest 
in covered intangibles.
    Example 2. U.S. Subsidiary (USS), Foreign Subsidiary (FS) and 
Foreign Parent (FP) enter into a cost sharing arrangement to develop new 
products within the Group X product line. USS manufactures and sells 
Group X products in North America, FS manufactures and sells Group X 
products in South America, and FP manufactures and sells Group X 
products in the rest of the world. USS, FS and FP project that each will 
manufacture and sell a third of the Group X products under development, 
and they share costs on the basis of projected sales of manufactured 
products. When the new Group X products are developed, however, USS 
ceases to manufacture Group X products, and FP sells its Group X 
products to USS for resale in the North American market. USS earns a 
return on its resale activity that is appropriate given its function as 
a distributor, but does not earn a return attributable to exploiting 
covered intangibles. The district director determines that USS's share 
of the costs (one-third) was greater than its share of reasonably 
anticipated benefits (zero) and that it has transferred an interest in 
the intangibles for which it should receive a payment from FP, whose 
share of the intangible development costs (one-third) was less than its 
share of reasonably anticipated benefits over time (two-thirds). An 
allocation is made under Sec. Sec. 1.482-1 and 1.482-4 through 1.482-6 
from FP to USS to recognize USS' one-third interest in the intangibles. 
No allocation is made from FS to USS because FS did not exploit USS's 
interest in covered intangibles.
    Example 3. U.S. Parent (USP), Foreign Subsidiary 1 (FS1), and 
Foreign Subsidiary 2 (FS2) enter into a cost sharing arrangement to 
develop a cure for the common cold. Costs are shared USP-50%, FS1-40% 
and FS2-10% on the basis of projected units of cold medicine to be 
produced by each. After ten years of research and development, FS1 
withdraws from the arrangement, transferring its interests in the 
intangibles under development to USP in exchange for a lump sum payment 
of $10 million. The district director may review this lump sum payment, 
under the provisions of Sec. 1.482-4(f)(5), to ensure that the amount 
is commensurate with the income attributable to the intangibles.
    Example 4. (i) Four members A, B, C, and D of a controlled group 
form a cost sharing arrangement to develop the next generation 
technology for their business. Based on a reliable projection of their 
future benefits, the participants agree to bear shares of the costs 
incurred during the term of the agreement in the following percentages: 
A 40%; B 15%; C 25%; and D 20%. The arm's length charges, under the 
rules of Sec. Sec. 1.482-1 and 1.482-4 through 1.482-6, for the use of 
the existing intangible property they respectively make available to the 
cost sharing arrangement are in the following amounts for the taxable 
year: A 80X; B 40X; C 30X; and D 30X. The provisional (before offsets) 
and final buy-in payments/receipts among A, B, C, and D are shown in the 
table as follows:

[[Page 673]]



                       [All amounts stated in X's]
------------------------------------------------------------------------
                                      A         B         C         D
------------------------------------------------------------------------
Payments........................  <40
Sec. 1.482-8  Examples of the best method rule.

    In accordance with the best method rule of Sec. 1.482-1(c), a 
method may be applied in a particular case only if the comparability, 
quality of data, and reliability of assumptions under that method make 
it more reliable than any other available measure of the arm's length 
result. The following examples illustrate the comparative analysis 
required to apply this rule. As with all of the examples in these 
regulations, these examples are based on simplified facts, are provided 
solely for purposes of illustrating the type of analysis required under 
the relevant rule, and do not provide rules of general application. 
Thus, conclusions reached in these examples as to the relative 
reliability of methods are based on the assumed facts of the examples, 
and are not general conclusions concerning the relative reliability of 
any method.

    Example 1. Preference for comparable uncontrolled price method. 
Company A is the U.S. distribution subsidiary of Company B, a foreign 
manufacturer of consumer electrical appliances. Company A purchases 
toaster ovens from Company B for resale in the U.S. market. To exploit 
other outlets for its toaster ovens, Company B also sells its toaster 
ovens to Company C, an unrelated U.S. distributor of toaster ovens. The 
products sold to Company A and Company C are identical in every respect 
and there are no material differences between the transactions. In this 
case application of the CUP method, using the sales of toaster ovens to 
Company C, generally will provide a more reliable measure of an arm's 
length result for the controlled sale of toaster ovens to Company A than 
the application of any other method. See Sec. Sec. 1.482-1(c)(2)(i) and 
-3(b)(2)(ii)(A).
    Example 2. Resale price method preferred to comparable uncontrolled 
price method. The facts are the same as in Example 1, except that the 
toaster ovens sold to Company A are of substantially higher quality than 
those sold to Company C and the effect on price of such quality 
differences cannot be accurately determined. In addition, in order to 
round out its line of consumer appliances Company A purchases blenders 
from unrelated parties for resale in the United States. The blenders are 
resold to substantially the same customers as the toaster ovens, have a 
similar resale value to the toaster ovens, and are purchased under 
similar terms and in similar volumes. The distribution functions 
performed by Company A appear to be similar for toaster ovens and 
blenders. Given the product differences between the toaster ovens, 
application of the resale price method using the purchases and resales 
of blenders as the uncontrolled comparables is likely to provide a more 
reliable measure of an arm's length result than application of the 
comparable uncontrolled price method using Company B's sales of toaster 
ovens to Company C.
    Example 3. Resale price method preferred to comparable profits 
method. (i) The facts are the same as in Example 2 except that Company A 
purchases all its products from Company B and Company B makes no 
uncontrolled sales into the United States. However, six uncontrolled 
U.S. distributors are identified that purchase a similar line of 
products from unrelated parties. The uncontrolled distributors purchase 
toaster ovens from unrelated parties, but there are significant 
differences in the characteristics of the toaster ovens, including the 
brandnames under which they are sold.
    (ii) Under the facts of this case, reliable adjustments for the 
effect of the different brandnames cannot be made. Except for some 
differences in payment terms and inventory levels, the purchases and 
resales of toaster ovens by the three uncontrolled distributors are 
closely similar to the controlled purchases in terms of the markets in 
which they occur, the volume of the transactions, the marketing 
activities undertaken by the distributor, inventory levels, warranties, 
allocation of currency risk, and other relevant functions and risks. 
Reliable adjustments can be made for the differences in payment terms 
and inventory levels. In addition, sufficiently detailed accounting 
information is available to permit adjustments to be made for 
differences in accounting methods or in reporting of costs between cost 
of goods sold and operating expenses. There are

[[Page 676]]

no other material differences between the controlled and uncontrolled 
transactions.
    (iii) Because reliable adjustments for the differences between the 
toaster ovens, including the trademarks under which they are sold, 
cannot be made, these uncontrolled transactions will not serve as 
reliable measures of an arm's length result under the comparable 
uncontrolled price method. There is, however, close functional 
similarity between the controlled and uncontrolled transactions and 
reliable adjustments have been made for material differences that would 
be likely to affect gross profit. Under these circumstances, the gross 
profit margins derived under the resale price method are less likely to 
be susceptible to any unidentified differences than the operating profit 
measures used under the comparable profits method. Therefore, given the 
close functional comparability between the controlled and uncontrolled 
transactions, and the high quality of the data, the resale price method 
achieves a higher degree of comparability and will provide a more 
reliable measure of an arm's length result. See Sec. 1.482-1(c) (Best 
method rule).
    Example 4. Comparable profits method preferred to resale price 
method. The facts are the same as in Example 3, except that the 
accounting information available for the uncontrolled comparables is not 
sufficiently detailed to ensure consistent reporting between cost of 
goods sold and operating expenses of material items such as discounts, 
insurance, warranty costs, and supervisory, general and administrative 
expenses. These expenses are significant in amount. Therefore, whether 
these expenses are treated as costs of goods sold or operating expenses 
would have a significant effect on gross margins. Because in this case 
reliable adjustments can not be made for such accounting differences, 
the reliability of the resale price method is significantly reduced. 
There is, however, close functional similarity between the controlled 
and uncontrolled transactions and reliable adjustments have been made 
for all material differences other than the potential accounting 
differences. Because the comparable profits method is not adversely 
affected by the potential accounting differences, under these 
circumstances the comparable profits method is likely to produce a more 
reliable measure of an arm's length result than the resale price method. 
See Sec. 1.482-1(c) (Best method rule).
    Example 5. Cost plus method preferred to comparable profits method. 
(i) USS is a U.S. company that manufactures machine tool parts and sells 
them to its foreign parent corporation, FP. Four U.S. companies are 
identified that also manufacture various types of machine tool parts but 
sell them to uncontrolled purchasers.
    (ii) Except for some differences in payment terms, the manufacture 
and sales of machine tool parts by the four uncontrolled companies are 
closely similar to the controlled transactions in terms of the functions 
performed and risks assumed. Reliable adjustments can be made for the 
differences in payment terms. In addition, sufficiently detailed 
accounting information is available to permit adjustments to be made for 
differences between the controlled transaction and the uncontrolled 
comparables in accounting methods and in the reporting of costs between 
cost of goods sold and operating expenses.
    (iii) There is close functional similarity between the controlled 
and uncontrolled transactions and reliable adjustments can be made for 
material differences that would be likely to affect gross profit. Under 
these circumstances, the gross profit markups derived under the cost 
plus method are less likely to be susceptible to any unidentified 
differences than the operating profit measures used under the comparable 
profits method. Therefore, given the close functional comparability 
between the controlled and uncontrolled transactions, and the high 
quality of the data, the cost plus method achieves a higher degree of 
comparability and will provide a more reliable measure of an arm's 
length result. See Sec. 1.482-1(c) (Best method rule).
    Example 6. Comparable profits method preferred to cost plus method. 
The facts are the same as in Example 5, except that there are 
significant differences between the controlled and uncontrolled 
transactions in terms of the types of parts and components manufactured 
and the complexity of the manufacturing process. The resulting 
functional differences are likely to materially affect gross profit 
margins, but it is not possible to identify the specific differences and 
reliably adjust for their effect on gross profit. Because these 
functional differences would be reflected in differences in operating 
expenses, the operating profit measures used under the comparable 
profits method implicitly reflect to some extent these functional 
differences. Therefore, because in this case the comparable profits 
method is less sensitive than the cost plus method to the potentially 
significant functional differences between the controlled and 
uncontrolled transactions, the comparable profits method is likely to 
produce a more reliable measure of an arm's length result than the cost 
plus method. See Sec. 1.482-1(c) (Best method rule).
    Example 7. Preference for comparable uncontrolled transaction 
method. (i) USpharm, a U.S. pharmaceutical company, develops a new drug 
Z that is a safe and effective treatment for the disease zeezee. USpharm 
has obtained patents covering drug Z in the United States and in various 
foreign countries. USpharm has also obtained the regulatory 
authorizations necessary to market drug Z

[[Page 677]]

in the United States and in foreign countries.
    (ii) USpharm licenses its subsidiary in country X, Xpharm, to 
produce and sell drug Z in country X. At the same time, it licenses an 
unrelated company, Ydrug, to produce and sell drug Z in country Y, a 
neighboring country. Prior to licensing the drug, USpharm had obtained 
patent protection and regulatory approvals in both countries and both 
countries provide similar protection for intellectual property rights. 
Country X and country Y are similar countries in terms of population, 
per capita income and the incidence of disease zeezee. Consequently, 
drug Z is expected to sell in similar quantities and at similar prices 
in both countries. In addition, costs of producing drug Z in each 
country are expected to be approximately the same.
    (iii) USpharm and Xpharm establish terms for the license of drug Z 
that are identical in every material respect, including royalty rate, to 
the terms established between USpharm and Ydrug. In this case the 
district director determines that the royalty rate established in the 
Ydrug license agreement is a reliable measure of the arm's length 
royalty rate for the Xpharm license agreement. Given that the same 
property is transferred in the controlled and uncontrolled transactions, 
and that the circumstances under which the transactions occurred are 
substantially the same, in this case the comparable uncontrolled 
transaction method is likely to provide a more reliable measure of an 
arm's length result than any other method. See Sec. 1.482-4(c)(2)(ii).
    Example 8. Residual profit split method preferred to other methods. 
(i) USC is a U.S. company that develops, manufactures and sells 
communications equipment. EC is the European subsidiary of USC. EC is an 
established company that carries out extensive research and development 
activities and develops, manufactures and sells communications equipment 
in Europe. There are extensive transactions between USC and EC. USC 
licenses valuable technology it has developed to EC for use in the 
European market but EC also licenses valuable technology it has 
developed to USC. Each company uses components manufactured by the other 
in some of its products and purchases products from the other for resale 
in its own market.
    (ii) Detailed accounting information is available for both USC and 
EC and adjustments can be made to achieve a high degree of consistency 
in accounting practices between them. Relatively reliable allocations of 
costs, income and assets can be made between the business activities 
that are related to the controlled transactions and those that are not. 
Relevant marketing and research and development expenditures can be 
identified and reasonable estimates of the useful life of the related 
intangibles are available so that the capitalized value of the 
intangible development expenses of USC and EC can be calculated. In this 
case there is no reason to believe that the relative value of these 
capitalized expenses is substantially different from the relative value 
of the intangible property of USC and EC. Furthermore, comparables are 
identified that could be used to estimate a market return for the 
routine contributions of USC and EC. Based on these facts, the residual 
profit split could provide a reliable measure of an arm's length result.
    (iii) There are no uncontrolled transactions involving property that 
is sufficiently comparable to much of the tangible and intangible 
property transferred between USC and EC to permit use of the comparable 
uncontrolled price method or the comparable uncontrolled transaction 
method. Uncontrolled companies are identified in Europe and the United 
States that perform somewhat similar activities to USC and EC; however, 
the activities of none of these companies are as complex as those of USC 
and EC and they do not use similar levels of highly valuable intangible 
property that they have developed themselves. Under these circumstances, 
the uncontrolled companies may be useful in determining a market return 
for the routine contributions of USC and EC, but that return would not 
reflect the value of the intangible property employed by USC and EC. 
Thus, none of the uncontrolled companies is sufficiently similar so that 
reliable results would be obtained using the resale price, cost plus, or 
comparable profits methods. Moreover, no uncontrolled companies can be 
identified that engaged in sufficiently similar activities and 
transactions with each other to employ the comparable profit split 
method.
    (iv) Given the difficulties in applying the other methods, the 
reliability of the internal data on USC and EC, and the fact that 
acceptable comparables are available for deriving a market return for 
the routine contributions of USC and EC, the residual profit split 
method is likely to provide the most reliable measure of an arm's length 
result in this case.
    Example 9. Comparable profits method preferred to profit split. (i) 
Company X is a large, complex U.S. company that carries out extensive 
research and development activities and manufactures and markets a 
variety of products. Company X has developed a new process by which 
compact disks can be fabricated at a fraction of the cost previously 
required. The process is expected to prove highly profitable, since 
there is a large market for compact disks. Company X establishes a new 
foreign subsidiary, Company Y, and licenses it the rights to use the 
process to fabricate compact disks for the foreign

[[Page 678]]

market as well as continuing technical support and improvements to the 
process. Company Y uses the process to fabricate compact disks which it 
supplies to related and unrelated parties.
    (ii) The process licensed to Company Y is unique and highly valuable 
and no uncontrolled transfers of intangible property can be found that 
are sufficiently comparable to permit reliable application of the 
comparable uncontrolled transaction method. Company X is a large, 
complex company engaged in a variety of activities that owns unique and 
highly valuable intangible property. Consequently, no uncontrolled 
companies can be found that are similar to Company X. Furthermore, 
application of the profit split method in this case would involve the 
difficult and problematic tasks of allocating Company X's costs and 
assets between the relevant business activity and other activities and 
assigning a value to Company X's intangible contributions. On the other 
hand, Company Y performs relatively routine manufacturing and marketing 
activities and there are a number of similar uncontrolled companies. 
Thus, application of the comparable profits method using Company Y as 
the tested party is likely to produce a more reliable measure of an 
arm's length result than a profit split in this case.

[T.D. 8552, 59 FR 35028, July 8, 1994]



Sec. 1.483-1  Interest on certain deferred payments.

    (a) Amount constituting interest in certain deferred payment 
transactions--(1) In general. Except as provided in paragraph (c) of 
this section, section 483 applies to a contract for the sale or exchange 
of property if the contract provides for one or more payments due more 
than 1 year after the date of the sale or exchange, and the contract 
does not provide for adequate stated interest. In general, a contract 
has adequate stated interest if the contract provides for a stated rate 
of interest that is at least equal to the test rate (determined under 
Sec. 1.483-3) and the interest is paid or compounded at least annually. 
Section 483 may apply to a contract whether the contract is express 
(written or oral) or implied. For purposes of section 483, a sale or 
exchange is any transaction treated as a sale or exchange for tax 
purposes. In addition, for purposes of section 483, property includes 
debt instruments and investment units, but does not include money, 
services, or the right to use property. For the treatment of certain 
obligations given in exchange for services or the use of property, see 
sections 404 and 467. For purposes of this paragraph (a), money includes 
functional currency and, in certain circumstances, nonfunctional 
currency. See Sec. 1.988-2(b)(2) for circumstances when nonfunctional 
currency is treated as money rather than as property.
    (2) Treatment of contracts to which section 483 applies--(i) 
Treatment of unstated interest. If section 483 applies to a contract, 
unstated interest under the contract is treated as interest for tax 
purposes. Thus, for example, unstated interest is not treated as part of 
the amount realized from the sale or exchange of property (in the case 
of the seller), and is not included in the purchaser's basis in the 
property acquired in the sale or exchange.
    (ii) Method of accounting for interest on contracts subject to 
section 483. Any stated or unstated interest on a contract subject to 
section 483 is taken into account by a taxpayer under the taxpayer's 
regular method of accounting (e.g., an accrual method or the cash 
receipts and disbursements method). See Sec. Sec. 1.446-1, 1.451-1, and 
1.461-1. For purposes of the preceding sentence, the amount of interest 
(including unstated interest) allocable to a payment under a contract to 
which section 483 applies is determined under Sec. 1.446-2(e).
    (b) Definitions--(1) Deferred payments. For purposes of the 
regulations under section 483, a deferred payment means any payment that 
constitutes all or a part of the sales price (as defined in paragraph 
(b)(2) of this section), and that is due more than 6 months after the 
date of the sale or exchange. Except as provided in section 483(c)(2) 
(relating to the treatment of a debt instrument of the purchaser), a 
payment may be made in the form of cash, stock or securities, or other 
property.
    (2) Sales price. For purposes of section 483, the sales price for 
any sale or exchange is the sum of the amount due under the contract 
(other than stated interest) and the amount of any liability included in 
the amount realized from the sale or exchange. See Sec. 1.1001-2. Thus, 
the sales price for any sale or exchange includes any amount of unstated 
interest under the contract.

[[Page 679]]

    (c) Exceptions to and limitations on the application of section 
483--(1) In general. Sections 483(d), 1274(c)(4), and 1275(b) contain 
exceptions to and limitations on the application of section 483.
    (2) Sales price of $3,000 or less. Section 483(d)(2) applies only if 
it can be determined at the time of the sale or exchange that the sales 
price cannot exceed $3,000, regardless of whether the sales price 
eventually paid for the property is less than $3,000.
    (3) Other exceptions and limitations--(i) Certain transfers subject 
to section 1041. Section 483 does not apply to any transfer of property 
subject to section 1041 (relating to transfers of property between 
spouses or incident to divorce).
    (ii) Treatment of certain obligees. Section 483 does not apply to an 
obligee under a contract for the sale or exchange of personal use 
property (within the meaning of section 1275(b)(3)) in the hands of the 
obligor and that evidences a below-market loan described in section 
7872(c)(1).
    (iii) Transactions involving certain demand loans. Section 483 does 
not apply to any payment under a contract that evidences a demand loan 
that is a below-market loan described in section 7872(c)(1).
    (iv) Transactions involving certain annuity contracts. Section 483 
does not apply to any payment under an annuity contract described in 
section 1275(a)(1)(B) (relating to annuity contracts excluded from the 
definition of debt instrument).
    (v) Options. Section 483 does not apply to any payment under an 
option to buy or sell property.
    (d) Assumptions. If a debt instrument is assumed, or property is 
taken subject to a debt instrument, in connection with a sale or 
exchange of property, the debt instrument is treated for purposes of 
section 483 in a manner consistent with the rules of Sec. 1.1274-5.
    (e) Aggregation rule. For purposes of section 483, all sales or 
exchanges that are part of the same transaction (or a series of related 
transactions) are treated as a single sale or exchange, and all 
contracts calling for deferred payments arising from the same 
transaction (or a series of related transactions) are treated as a 
single contract. This rule, however, generally only applies to contracts 
and to sales or exchanges involving a single buyer and a single seller.
    (f) Effective date. This section applies to sales and exchanges that 
occur on or after April 4, 1994. Taxpayers, however, may rely on this 
section for sales and exchanges that occur after December 21, 1992, and 
before April 4, 1994.

[T.D. 8517, 59 FR 4805, Feb. 2, 1994]



Sec. 1.483-2  Unstated interest.

    (a) In general--(1) Adequate stated interest. For purposes of 
section 483, a contract has unstated interest if the contract does not 
provide for adequate stated interest. A contract does not provide for 
adequate stated interest if the sum of the deferred payments exceeds--
    (i) The sum of the present values of the deferred payments and the 
present values of any stated interest payments due under the contract; 
or
    (ii) In the case of a cash method debt instrument (within the 
meaning of section 1274A(c)(2)) received in exchange for property in a 
potentially abusive situation (as defined in Sec. 1.1274-3), the fair 
market value of the property reduced by the fair market value of any 
consideration other than the debt instrument, and reduced by the sum of 
all principal payments that are not deferred payments.
    (2) Amount of unstated interest. For purposes of section 483, 
unstated interest means an amount equal to the excess of the sum of the 
deferred payments over the amount described in paragraph (a)(1)(i) or 
(a)(1)(ii) of this section, whichever is applicable.
    (b) Operational rules--(1) In general. For purposes of paragraph (a) 
of this section, rules similar to those in Sec. 1.1274-2 apply to 
determine whether a contract has adequate stated interest and the amount 
of unstated interest, if any, on the contract.
    (2) Present value. For purposes of paragraph (a) of this section, 
the present value of any deferred payment or interest payment is 
determined by discounting the payment from the date it becomes due to 
the date of the sale or exchange at the test rate of interest applicable 
to the contract in accordance with Sec. 1.483-3.

[[Page 680]]

    (c) Examples. The following examples illustrate the rules of this 
section.

    Example 1. Contract that does not have adequate stated interest. On 
January 1, 1995, A sells B nonpublicly traded property under a contract 
that calls for a $100,000 payment of principal on January 1, 2005, and 
10 annual interest payments of $9,000 on January 1 of each year, 
beginning on January 1, 1996. Assume that the test rate of interest is 
9.2 percent, compounded annually. The contract does not provide for 
adequate stated interest because it does not provide for interest equal 
to 9.2 percent, compounded annually. The present value of the deferred 
payments is $98,727.69. As a result, the contract has unstated interest 
of $1,272.31 ($100,000 - $98,727.69).
    Example 2. Contract that does not have adequate stated interest; no 
interest for initial short period. On May 1, 1996, A sells B nonpublicly 
traded property under a contract that calls for B to make a principal 
payment of $200,000 on December 31, 1998, and semiannual interest 
payments of $9,000, payable on June 30 and December 31 of each year, 
beginning on December 31, 1996. Assume that the test rate of interest is 
9 percent, compounded semiannually. Even though the contract calls for a 
stated rate of interest no lower than the test rate of interest, the 
contract does not provide for adequate stated interest because the 
stated rate of interest does not apply for the short period from May 1, 
1996, through June 30, 1996.
    Example 3. Potentially abusive situation--(i) Facts. In a 
potentially abusive situation, a contract for the sale of nonpublicly 
traded personal property calls for the issuance of a cash method debt 
instrument (as defined in section 1274A(c)(2)) with a stated principal 
amount of $700,000, payable in 5 years. No other consideration is given. 
The debt instrument calls for annual payments of interest over its 
entire term at a rate of 9.2 percent, compounded annually (the test rate 
of interest applicable to the debt instrument). Thus, the present value 
of the deferred payment and the interest payments is $700,000. Assume 
that the fair market value of the property is $500,000.
    (ii) Amount of unstated interest. A cash method debt instrument 
received in exchange for property in a potentially abusive situation 
provides for adequate stated interest only if the sum of the deferred 
payments under the instrument does not exceed the fair market value of 
the property. Because the deferred payment ($700,000) exceeds the fair 
market value of the property ($500,000), the debt instrument does not 
provide for adequate stated interest. Therefore, the debt instrument has 
unstated interest of $200,000.
    Example 4. Variable rate debt instrument with adequate stated 
interest; variable rate as of the issue date greater than the test 
rate-- (i) Facts. A contract for the sale of nonpublicly traded property 
calls for the issuance of a debt instrument in the principal amount of 
$75,000 due in 10 years. The debt instrument calls for interest payable 
semiannually at a rate of 3 percentage points above the yield on 6-month 
Treasury bills at the mid-point of the semiannual period immediately 
preceding each interest payment date. Assume that the interest rate is a 
qualified floating rate and that the debt instrument is a variable rate 
debt instrument within the meaning of Sec. 1.1275-5.
    (ii) Adequate stated interest. Under paragraph (b)(1) of this 
section, rules similar to those in Sec. 1.1274-2(f) apply to determine 
whether the debt instrument has adequate stated interest. Assume that 
the test rate of interest applicable to the debt instrument is 9 
percent, compounded semiannually. Assume also that the yield on 6-month 
Treasury bills on the date of the sale is 8.89 percent, which is greater 
than the yield on 6-month Treasury bills on the first date on which 
there is a binding written contract that substantially sets forth the 
terms under which the sale is consummated. Under Sec. 1.1274-2(f), the 
debt instrument is tested for adequate stated interest as if it provided 
for a stated rate of interest of 11.89 percent (3 percent plus 8.89 
percent), compounded semiannually, payable over its entire term. Because 
the test rate of interest is 9 percent, compounded semiannually, and the 
debt instrument is treated as providing for stated interest of 11.89 
percent, compounded semiannually, the debt instrument provides for 
adequate stated interest.

    (d) Effective date. This section applies to sales and exchanges that 
occur on or after April 4, 1994. Taxpayers, however, may rely on this 
section for sales and exchanges that occur after December 21, 1992, and 
before April 4, 1994.

[T.D. 8517, 59 FR 4806, Feb. 2, 1994]



Sec. 1.483-3  Test rate of interest applicable to a contract.

    (a) General rule. For purposes of section 483, the test rate of 
interest for a contract is the same as the test rate that would apply 
under Sec. 1.1274-4 if the contract were a debt instrument. Paragraph 
(b) of this section, however, provides for a lower test rate in the case 
of certain sales or exchanges of land between related individuals.
    (b) Lower rate for certain sales or exchanges of land between 
related individuals--(1) Test rate. In the case of a qualified sale or 
exchange of land between related individuals (described in section 
483(e)), the test rate is not

[[Page 681]]

greater than 6 percent, compounded semiannually, or an equivalent rate 
based on an appropriate compounding period.
    (2) Special rules. The following rules and definitions apply in 
determining whether a sale or exchange is a qualified sale under section 
483(e):
    (i) Definition of family members. The members of an individual's 
family are determined as of the date of the sale or exchange. The 
members of an individual's family include those individuals described in 
section 267(c)(4) and the spouses of those individuals. In addition, for 
purposes of section 267(c)(4), full effect is given to a legal adoption, 
ancestor means parents and grandparents, and lineal descendants means 
children and grandchildren.
    (ii) $500,000 limitation. Section 483(e) does not apply to the 
extent that the stated principal amount of the debt instrument issued in 
the sale or exchange, when added to the aggregate stated principal 
amount of any other debt instruments to which section 483(e) applies 
that were issued in prior qualified sales between the same two 
individuals during the same calendar year, exceeds $500,000. See Example 
3 of paragraph (b)(3) of this section.
    (iii) Other limitations. Section 483(e) does not apply if the 
parties to a contract include persons other than the related individuals 
and the parties enter into the contract with an intent to circumvent the 
purposes of section 483(e). In addition, if the property sold or 
exchanged includes any property other than land, section 483(e) applies 
only to the extent that the stated principal amount of the debt 
instrument issued in the sale or exchange is attributable to the land 
(based on the relative fair market values of the land and the other 
property).
    (3) Examples. The following examples illustrate the rules of this 
paragraph (b).

    Example 1. On January 1, 1995, A sells land to B, A's child, for 
$650,000. The contract for sale calls for B to make a $250,000 down 
payment and issue a debt instrument with a stated principal amount of 
$400,000. Because the stated principal amount of the debt instrument is 
less than $500,000, the sale is a qualified sale and section 483(e) 
applies to the debt instrument.
    Example 2. The facts are the same as in Example 1 of paragraph 
(b)(3) of this section, except that on June 1, 1995, A sells additional 
land to B under a contract that calls for B to issue a debt instrument 
with a stated principal amount of $100,000. The stated principal amount 
of this debt instrument ($100,000) when added to the stated principal 
amount of the prior debt instrument ($400,000) does not exceed $500,000. 
Thus, section 483(e) applies to both debt instruments.
    Example 3. The facts are the same as in Example 1 of paragraph 
(b)(3) of this section, except that on June 1, 1995, A sells additional 
land to B under a contract that calls for B to issue a debt instrument 
with a stated principal amount of $150,000. The stated principal amount 
of this debt instrument when added to the stated principal amount of the 
prior debt instrument ($400,000) exceeds $500,000. Thus, for purposes of 
section 483(e), the debt instrument issued in the sale of June 1, 1995, 
is treated as two separate debt instruments: a $100,000 debt instrument 
(to which section 483(e) applies) and a $50,000 debt instrument (to 
which section 1274, if otherwise applicable, applies).

    (c) Effective date. This section applies to sales and exchanges that 
occur on or after April 4, 1994. Taxpayers, however, may rely on this 
section for sales and exchanges that occur after December 21, 1992, and 
before April 4, 1994.

[T.D. 8517, 59 FR 4807, Feb. 2, 1994]



Sec. 1.483-4  Contingent payments.

    (a) In general. This section applies to a contract for the sale or 
exchange of property (the overall contract) if the contract provides for 
one or more contingent payments and the contract is subject to section 
483. This section applies even if the contract provides for adequate 
stated interest under Sec. 1.483-2. If this section applies to a 
contract, interest under the contract is generally computed and 
accounted for using rules similar to those that would apply if the 
contract were a debt instrument subject to Sec. 1.1275-4(c). 
Consequently, all noncontingent payments under the overall contract are 
treated as if made under a separate contract, and interest accruals on 
this separate contract are computed under rules similar to those 
contained in Sec. 1.1275-4(c)(3). Each contingent payment under the 
overall contract is characterized as principal and interest under rules 
similar to those contained in Sec. 1.1275-4(c)(4). However,

[[Page 682]]

any interest, or amount treated as interest, on a contract subject to 
this section is taken into account by a taxpayer under the taxpayer's 
regular method of accounting (e.g., an accrual method or the cash 
receipts and disbursements method).
    (b) Examples. The following examples illustrate the provisions of 
paragraph (a) of this section:

    Example 1. Deferred payment sale with contingent interest--(i) 
Facts. On December 31, 1996, A sells depreciable personal property to B. 
As consideration for the sale, B issues to A a debt instrument with a 
maturity date of December 31, 2001. The debt instrument provides for a 
principal payment of $200,000 on the maturity date, and a payment of 
interest on December 31 of each year, beginning in 1997, equal to a 
percentage of the total gross income derived from the property in that 
year. However, the total interest payable on the debt instrument over 
its entire term is limited to a maximum of $50,000. Assume that on 
December 31, 1996, the short-term applicable Federal rate is 4 percent, 
compounded annually, and the mid-term applicable Federal rate is 5 
percent, compounded annually.
    (ii) Treatment of noncontingent payment as separate contract. Each 
payment of interest is a contingent payment. Accordingly, under 
paragraph (a) of this section, for purposes of applying section 483 to 
the debt instrument, the right to the noncontingent payment of $200,000 
is treated as a separate contract. The amount of unstated interest on 
this separate contract is equal to $43,295, which is the amount by which 
the payment ($200,000) exceeds the present value of the payment 
($156,705), calculated using the test rate of 5 percent, compounded 
annually. The $200,000 payment is thus treated as consisting of a 
payment of interest of $43,295 and a payment of principal of $156,705. 
The interest is includible in A's gross income, and deductible by B, 
under their respective methods of accounting.
    (iii) Treatment of contingent payments. Assume that the amount of 
the contingent payment that is paid on December 31, 1997, is $20,000. 
Under paragraph (a) of this section, the $20,000 payment is treated as a 
payment of principal of $19,231 (the present value, as of the date of 
sale, of the $20,000 payment, calculated using a test rate equal to 4 
percent, compounded annually) and a payment of interest of $769. The 
$769 interest payment is includible in A's gross income, and deductible 
by B, in their respective taxable years in which the payment occurs. The 
amount treated as principal gives B additional basis in the property on 
December 31, 1997. The remaining contingent payments on the debt 
instrument are accounted for similarly, using a test rate of 4 percent, 
compounded annually, for the payments made on December 31, 1998, and 
December 31, 1999, and a test rate of 5 percent, compounded annually, 
for the payments made on December 31, 2000, and December 31, 2001.
    Example 2. Contingent stock payout--(i) Facts. M Corporation and N 
Corporation each owns one-half of the stock of O Corporation. On 
December 31, 1996, pursuant to a reorganization qualifying under section 
368(a)(1)(B), M acquires the one-half interest of O held by N in 
exchange for 30,000 shares of M voting stock and a non-assignable right 
to receive up to 10,000 additional shares of M's voting stock during the 
next 3 years, provided the net profits of O exceed certain amounts 
specified in the contract. No interest is provided for in the contract. 
No additional shares are received in 1997 or in 1998. In 1999, the 
annual earnings of O exceed the specified amount, and, on December 31, 
1999, an additional 3,000 M voting shares are transferred to N. The fair 
market value of the 3,000 shares on December 31, 1999, is $300,000. 
Assume that on December 31, 1996, the short-term applicable Federal rate 
is 4 percent, compounded annually. M and N are calendar year taxpayers.
    (ii) Allocation of interest. Section 1274 does not apply to the 
right to receive the additional shares because the right is not a debt 
instrument for federal income tax purposes. As a result, the transfer of 
the 3,000 M voting shares to N is a deferred payment subject to section 
483 and a portion of the shares is treated as unstated interest under 
that section. The amount of interest allocable to the shares is equal to 
the excess of $300,000 (the fair market value of the shares on December 
31, 1999) over $266,699 (the present value of $300,000, determined by 
discounting the payment at the test rate of 4 percent, compounded 
annually, from December 31, 1999, to December 31, 1996). As a result, 
the amount of interest allocable to the payment of the shares is $33,301 
($300,000-$266,699). Both M and N take the interest into account in 
1999.

    (c) Effective date. This section applies to sales and exchanges that 
occur on or after August 13, 1996.

[T.D. 8674, 61 FR 30138, June 14, 1996]

 regulations applicable for taxable years beginning on or before april 
                                21, 1993



Sec. 1.482-1A  Allocation of income and deductions among taxpayers.

    (a) Definitions. When used in this section and in Sec. 1.482-2--
    (1) The term ``organization'' includes any organization of any kind, 
whether

[[Page 683]]

it be a sole proprietorship, a partnership, a trust, an estate, an 
association, or a corporation (as each is defined or understood in the 
Internal Revenue Code or the regulations thereunder), irrespective of 
the place where organized, where operated, or where its trade or 
business is conducted, and regardless of whether domestic or foreign, 
whether exempt, whether affiliated, or whether a party to a consolidated 
return.
    (2) The term ``trade'' or ``business'' includes any trade or 
business activity of any kind, regardless of whether or where organized, 
whether owned individually or otherwise, and regardless of the place 
where carried on.
    (3) The term ``controlled'' includes any kind of control, direct or 
indirect, whether legally enforceable, and however exercisable or 
exercised. It is the reality of the control which is decisive, not its 
form or the mode of its exercise. A presumption of control arises if 
income or deductions have been arbitrarily shifted.
    (4) The term ``controlled taxpayer'' means any one of two or more 
organizations, trades, or businesses owned or controlled directly or 
indirectly by the same interests.
    (5) The terms ``group'' and ``group of controlled taxpayers'' mean 
the organizations, trades, or businesses owned or controlled by the same 
interests.
    (6) The term ``true taxable income'' means, in the case of a 
controlled taxpayer, the taxable income (or, as the case may be, any 
item or element affecting taxable income) which would have resulted to 
the controlled taxpayer, had it in the conduct of its affairs (or, as 
the case may be, in the particular contract, transaction, arrangement, 
or other act) dealt with the other member or members of the group at 
arm's length. It does not mean the income, the deductions, the credits, 
the allowances, or the item or element of income, deductions, credits, 
or allowances, resulting to the controlled taxpayer by reason of the 
particular contract, transaction, or arrangement, the controlled 
taxpayer, or the interests controlling it, chose to make (even though 
such contract, transaction, or arrangement be legally binding upon the 
parties thereto).
    (b) Scope and purpose. (1) The purpose of section 482 is to place a 
controlled taxpayer on a tax parity with an uncontrolled taxpayer, by 
determining, according to the standard of an uncontrolled taxpayer, the 
true taxable income from the property and business of a controlled 
taxpayer. The interests controlling a group of controlled taxpayers are 
assumed to have complete power to cause each controlled taxpayer so to 
conduct its affairs that its transactions and accounting records truly 
reflect the taxable income from the property and business of each of the 
controlled taxpayers. If, however, this has not been done, and the 
taxable incomes are thereby understated, the district director shall 
intervene, and, by making such distributions, apportionments, or 
allocations as he may deem necessary of gross income, deductions, 
credits, or allowances, or of any item or element affecting taxable 
income, between or among the controlled taxpayers constituting the 
group, shall determine the true taxable income of each controlled 
taxpayer. The standard to be applied in every case is that of an 
uncontrolled taxpayer dealing at arm's length with another uncontrolled 
taxpayer.
    (2) Section 482 and this section apply to the case of any controlled 
taxpayer, whether such taxpayer makes a separate or a consolidated 
return. If a controlled taxpayer makes a separate return, the 
determination is of its true separate taxable income. If a controlled 
taxpayer is a party to a consolidated return, the true consolidated 
taxable income of the affiliated group and the true separate taxable 
income of the controlled taxpayer are determined consistently with the 
principles of a consolidated return.
    (3) Section 482 grants no right to a controlled taxpayer to apply 
its provisions at will, nor does it grant any right to compel the 
district director to apply such provisions. It is not intended (except 
in the case of the computation of consolidated taxable income under a 
consolidated return) to effect in any case such a distribution, 
apportionment, or allocation of gross income, deductions, credits, or 
allowances, or any item of gross income, deductions, credits, or 
allowances, as

[[Page 684]]

would produce a result equivalent to a computation of consolidated 
taxable income under subchapter A, chapter 6 of the Code.
    (c) Application. Transactions between one controlled taxpayer and 
another will be subjected to special scrutiny to ascertain whether the 
common control is being used to reduce, avoid, or escape taxes. In 
determining the true taxable income of a controlled taxpayer, the 
district director is not restricted to the case of improper accounting, 
to the case of a fraudulent, colorable, or sham transaction, or to the 
case of a device designed to reduce or avoid tax by shifting or 
distorting income, deductions, credits, or allowances. The authority to 
determine true taxable income extends to any case in which either by 
inadvertence or design the taxable income, in whole or in part, of a 
controlled taxpayer, is other than it would have been had the taxpayer 
in the conduct of his affairs been an uncontrolled taxpayer dealing at 
arm's length with another uncontrolled taxpayer.
    (d) Method of allocation. (1) The method of allocating, 
apportioning, or distributing income, deductions, credits, and 
allowances to be used by the district director in any case, including 
the form of the adjustments and the character and source of amounts 
allocated, shall be determined with reference to the substance of the 
particular transactions or arrangements which result in the avoidance of 
taxes or the failure to clearly reflect income. The appropriate 
adjustments may take the form of an increase or decrease in gross 
income, increase or decrease in deductions (including depreciation), 
increase or decrease in basis of assets (including inventory), or any 
other adjustment which may be appropriate under the circumstances. See 
Sec. 1.482-2 for specific rules relating to methods of allocation in 
the case of several types of business transactions.
    (2) Whenever the district director makes adjustments to the income 
of one member of a group of controlled taxpayers (such adjustments being 
referred to in this paragraph as ``primary'' adjustments) he shall also 
make appropriate correlative adjustments to the income of any other 
member of the group involved in the allocation. The correlative 
adjustment shall actually be made if the U.S. income tax liability of 
the other member would be affected for any pending taxable year. Thus, 
if the district director makes an allocation of income, he shall not 
only increase the income of one member of the group, but shall decrease 
the income of the other member if such adjustment would have an effect 
on the U.S. income tax liability of the other member for any pending 
taxable year. For the purposes of this subparagraph, a ``pending taxable 
year'' is any taxable year with respect to which the U.S. income tax 
return of the other member has been filed by the time the allocation is 
made, and with respect to which a credit or refund is not barred by the 
operation of any law or rule of law. If a correlative adjustment is not 
actually made because it would have no effect on the U.S. income tax 
liability of the other member involved in the allocation for any pending 
taxable year, such adjustment shall nevertheless be deemed to have been 
made for the purpose of determining the U.S. income tax liability of 
such member for a later taxable year, or for the purposes of determining 
the U.S. income tax liability of any person for any taxable year. The 
district director shall furnish to the taxpayer with respect to which 
the primary adjustment is made a written statement of the amount and 
nature of the correlative adjustment which is deemed to have been made. 
For purposes of this subparagraph, a primary adjustment shall not be 
considered to have been made (and therefore a correlative adjustment is 
not required to be made) until the first occurring of the following 
events with respect to the primary adjustment:
    (i) The date of assessment of the tax following execution by the 
taxpayer of a Form 870 (Waiver of Restrictions on Assessment and 
Collection of Deficiency in Tax and Acceptance of Overassessment) with 
respect to such adjustment,
    (ii) Acceptance of a Form 870-AD (Offer of Waiver of Restriction on 
Assessment and Collection Deficiency in Tax and Acceptance of 
Overassessment),
    (iii) Payment of the deficiency,

[[Page 685]]

    (iv) Stipulation in the Tax Court of the United States, or
    (v) Final determination of tax liability by offer-in-compromise, 
closing agreement, or court action.

The principles of this subparagraph may be illustrated by the following 
examples in each of which it is assumed that X and Y are members of the 
same group of controlled entities and that they regularly compute their 
incomes on the basis of a calendar year:

    Example (1). Assume that in 1968 the district director proposes to 
adjust X's income for 1966 to reflect an arm's length rental charge for 
Y's use of X's tangible property in 1966; that X consents to an 
assessment reflecting such adjustment by executing a Waiver, Form 870; 
and that an assessment of the tax with respect to such adjustment is 
made in 1968. The primary adjustment is therefore considered to have 
been made in 1968. Assume further that both X and Y are United States 
corporations and that Y had net operating losses in 1963, 1964, 1965, 
1966, and 1967. Although a correlative adjustment would not have an 
effect on Y's U.S. income tax liability for any pending taxable year, an 
adjustment increasing Y's net operating loss for 1966 shall be deemed to 
have been made for the purposes of determining Y's U.S. income tax 
liability for 1968 or a later taxable year to which the increased 
operating loss may be carried. The district director shall notify X in 
writing of the amount and nature of the adjustment which is deemed to 
have been made to Y.
    Example (2). Assume that X and Y are United States corporations; 
that X is in the business of rendering engineering services; that in 
1968 the district director proposes to adjust X's income for 1966 to 
reflect an arm's length fee for the rendition of engineering services by 
X in 1966 relating to the construction of Y's factory; that X consents 
to an assessment reflecting such adjustment by executing a Waiver, Form 
870; and that an assessment of the tax with respect to such adjustment 
is made in 1968. Assume further that fees for such services would 
properly constitute a capital expenditure by Y, and that Y does not 
place the factory in service until 1969. Although a correlative 
adjustment (increase in basis) would not have an effect on Y's U.S. 
income tax liability for a pending taxable year, an adjustment 
increasing the basis of Y's assets for 1966 shall be deemed to have been 
made in 1968 for the purpose of computing allowable depreciation or gain 
or loss on disposition for 1969 and any future taxable year. The 
district director shall notify X in writing of the amount and nature of 
the adjustment which is deemed to have been made to Y.
    Example (3). Assume that X is a U.S. taxpayer and Y is a foreign 
taxpayer not engaged in a trade or business in the United States; that 
in 1968 the district director proposes to adjust X's income for 1966 to 
reflect an arm's length interest charge on a loan made to Y; that X 
consents to an assessment reflecting such allocation by executing a 
Waiver, Form 870; and that an assessment of the tax with respect to such 
adjustment is made in 1968. Although a correlative adjustment would not 
have an effect on Y's U.S. income tax liability, an adjustment in Y's 
income for 1966 shall be deemed to have been made in 1968 for the 
purposes of determining the amount of Y's earnings and profits for 1966 
and subsequent years, and of any other effect it may have on any 
person's U.S. income tax liability for any taxable year. The district 
director shall notify X in writing of the amount and nature of the 
allocation which is deemed to have been made to Y.

    (3) In making distributions, apportionments, or allocations between 
two members of a group of controlled entities with respect to particular 
transactions, the district director shall consider the effect upon such 
members of an arrangement between them for reimbursement within a 
reasonable period before or after the taxable year if the taxpayer can 
establish that such an arrangement in fact existed during the taxable 
year under consideration. The district director shall also consider the 
effect of any other nonarm's length transaction between them in the 
taxable year which, if taken into account, would result in a setoff 
against any allocation which would otherwise be made, provided the 
taxpayer is able to establish with reasonable specificity that the 
transaction was not at arm's length and the amount of the appropriate 
arm's length charge. For purposes of the preceding sentence, the term 
arm's length refers to the amount which was charged or would have been 
charged in independent transactions with unrelated parties under the 
same or similar circumstances considering all the relevant facts and 
without regard to the rules found in Sec. 1.482-2 by which certain 
charges are deemed to be equal to arm's length. For example, assume that 
one member of a group performs services which benefit a second member, 
which would in itself require an allocation to reflect an arm's length 
charge for the performance of such services. Assume further that the 
first

[[Page 686]]

member can establish that during the same taxable year the second member 
engages in other nonarm's length transactions which benefit the first 
member, such as by selling products to the first member at a discount, 
or purchasing products from the first member at a premium, or paying 
royalties to the first member in an excessive amount. In such case, the 
value of the benefits received by the first member as a result of the 
other activities will be set-off against the allocation which would 
otherwise be made. If the effect of the set-off is to change the 
characterization or source of the income or deductions, or otherwise 
distort taxable income, in such a manner as to affect the United States 
tax liability of any member, allocations will be made to reflect the 
correct amount of each category of income or deductions. In order to 
establish that a set-off to the adjustments proposed by the district 
director is appropriate, the taxpayer must notify the district director 
of the basis of any claimed set-off at any time before the expiration of 
the period ending 30 days after the date of a letter by which the 
district director transmits an examination report notifying the taxpayer 
of proposed adjustments or before July 16, 1968, whichever is later. The 
principles of this subparagraph may be illustrated by the following 
examples, in each of which it is assumed that P and S are calendar year 
corporations and are both members of the same group of controlled 
entities:

    Example (1). P performs services in 1966 for the benefit of S in 
connection with S's manufacture and sale of a product. S does not pay P 
for such services in 1966, but in consideration for such services, 
agrees in 1966 to pay P a percentage of the amount of sales of the 
product in 1966 through 1970. In 1966 it appeared this agreement would 
provide adequate consideration for the services. No allocation will be 
made with respect to the services performed by P.
    Example (2). P renders services to S in connection with the 
construction of S's factory. An arm's length charge for such services, 
determined under paragraph (b) of Sec. 1.482-2, would be $100,000. 
During the same taxable year P makes available to S a machine to be used 
in such construction. P bills S $125,000 for the services, but does not 
bill for the use of the machine. No allocation will be made with respect 
to the excessive charge for services or the undercharge for the machine 
if P can establish that the excessive charge for services was equal to 
an arm's length charge for the use of the machine, and if the taxable 
income and income tax liabilities of P and S are not distorted.
    Example (3). Assume the same facts as in example (2), except that, 
if P had reported $25,000 as rental income and $25,000 less service 
income, it would have been subject to the tax on personal holding 
companies. Allocations will be made to reflect the correct amounts of 
rental income and service income.

    (4) If the members of a group of controlled taxpayers engage in 
transactions with one another, the district director may distribute, 
apportion, or allocate income, deductions, credits, or allowances to 
reflect the true taxable income of the individual members under the 
standards set forth in this section and in Sec. 1.482-2 notwithstanding 
the fact that the ultimate income anticipated from a series of 
transactions may not be realized or is realized during a later period. 
For example, if one member of a controlled group sells a product at less 
than an arm's length price to a second member of the group in one 
taxable year and the second member resells the product to an unrelated 
party in the next taxable year, the district director may make an 
appropriate allocation to reflect an arm's length price for the sale of 
the product in the first taxable year, notwithstanding that the second 
member of the group had not realized any gross income from the resale of 
the product in the first year. Similarly, if one member of a group lends 
money to a second member of the group in a taxable year, the district 
director may make an appropriate allocation to reflect an arm's length 
charge for interest during such taxable year even if the second member 
does not realize income during such year. The provisions of this 
subparagraph apply even if the gross income contemplated from a series 
of transactions is never, in fact, realized by the other members.
    (5) Section 482 may, when necessary to prevent the avoidance of 
taxes or to clearly reflect income, be applied in circumstances 
described in sections of the Code (such as section 351) providing for 
nonrecognition of gain or loss. See, for example, ``National Securities 
Corporation v. Commissioner of Internal

[[Page 687]]

Revenue'', 137 F. 2d 600 (3d Cir. 1943), cert. denied 320 U.S. 794 
(1943).
    (6) If payment or reimbursement for the sale, exchange, or use of 
property, the rendition of services, or the advance of other 
consideration among members of a group of controlled entities was 
prevented, or would have been prevented, at the time of the transaction 
because of currency or other restrictions imposed under the laws of any 
foreign country, any distributions, apportionments, or allocations which 
may be made under section 482 with respect to such transactions may be 
treated as deferrable income or deductions, providing the taxpayer has, 
for the year to which the distributions, apportionments, or allocations 
relate, elected to use a method of accounting in which the reporting of 
deferrable income is deferred until the income ceases to be deferrable 
income. Under such method of accounting, referred to in this section as 
the deferred income method of accounting, any payments or reimbursements 
which were prevented or would have been prevented, and any deductions 
attributable directly or indirectly to such payments or reimbursements, 
shall be deferred until they cease to be deferrable under such method of 
accounting. If such method of accounting has not been elected with 
respect to the taxable year to which the allocations under section 482 
relate, the taxpayer may elect such method with respect to such 
allocations (but not with respect to other deferrable income) at any 
time before the first occurring of the following events with respect to 
the allocations:
    (i) Execution by the taxpayer of Form 870 (Waiver of Restrictions on 
Assessment and Collection of Deficiency in Tax and Acceptance of 
Overassessment);
    (ii) Expiration of the period ending 30 days after the date of a 
letter by which the district director transmits an examination report 
notifying the taxpayer of proposed adjustments reflecting such 
allocations or before July 16, 1968, whichever is later; or
    (iii) Execution of a closing agreement or offer-in-compromise.

The principles of this subparagraph may be illustrated by the following 
example in which it is assumed that X, a domestic corporation, and Y, a 
foreign corporation, are members of the same group of controlled 
entities:

    Example. X, which is in the business of rendering a certain type of 
service to unrelated parties, renders such services for the benefit of Y 
in 1965. The direct and indirect costs allocable to such services are 
$60,000, and an arm's length charge for such services is $100,000. 
Assume that the district director proposes to increase X's income by 
$100,000, but that the country in which Y is located would have blocked 
payment in 1965 for such services. If, prior to the first occurring of 
the events described in subdivisions (i), (ii), or (iii) of this 
subparagraph, X elects to use the deferred income method of accounting 
with respect to such allocation, the $100,000 allocation and the $60,000 
of costs are deferrable until such amounts cease to be deferrable under 
X's method of accounting.

[T.D. 6595, 27 FR 3598, Apr. 14, 1962, as amended by T.D. 6952, 33 FR 
5848, Apr. 16, 1968. Redesignated by T.D. 8470, 58 FR 5271, Jan. 21, 
1993]



Sec. 1.482-2A  Determination of taxable income in specific situations.

    (a)-(c) For applicable rules, see Sec. 1.482-2T (a) through (c).
    (d) Transfer or use of intangible property--(1) In general. (i) 
Except as otherwise provided in subparagraph (4) of this paragraph, 
where intangible property or an interest therein is transferred, sold, 
assigned, loaned, or otherwise made available in any manner by one 
member of a group of controlled entities (referred to in this paragraph 
as the transferor) to another member of the group (referred to in this 
paragraph as the transferee) for other than an arm's length 
consideration, the district director may make appropriate allocations to 
reflect an arm's length consideration for such property or its use. 
Subparagraph (2) of this paragraph provides rules for determining the 
form an amount of an appropriate allocation, subparagraph (3) of this 
paragraph provides a definition of ``intangible property'', and 
subparagraph (4) of this paragraph provides rules with respect to 
certain cost-sharing arrangements in connection with the development of 
intangible property. For purposes of this paragraph, an interest in 
intangible property may take the form of the right to use such property.

[[Page 688]]

    (ii)(a) In the absence of a bona fide cost-sharing arrangement (as 
defined in subparagraph (4) of this paragraph), where one member of a 
group of related entities undertakes the development of intangible 
property as a developer within the meaning of (c) of this subdivision, 
no allocation with respect to such development activity shall be made 
under the rules of this paragraph or any other paragraph of this section 
(except as provided in (b) of this subdivision) until such time as any 
property developed, or any interest therein, is or is deemed to be 
transferred, sold, assigned, loaned, or otherwise made available in any 
manner by the developer to a related entity in a transfer subject to the 
rules of this paragraph. Where a member of the group other than the 
developer acquires an interest in the property developed by virtue of 
obtaining a patent or copyright, or by any other means, the developer 
shall be deemed to have transferred such interest in such property to 
the acquiring member in a transaction subject to the rules of this 
paragraph. For example, if one member of a group (the developer) 
undertakes to develop a new patentable product and the costs of 
development are incurred by that entity over a period of 3 years, no 
allocation with respect to that entity's activity shall be made during 
such period. The amount of any allocation that may be appropriate at the 
expiration of such development period when, for example, the patent on 
the product is transferred, or deemed transferred, to a related entity 
for other than an arm's length consideration, shall be determined in 
accordance with the rules of this paragraph.
    (b) Where one member of a group renders assistance in the form of 
loans, services, or the use of tangible or intangible property to a 
developer in connection with an attempt to develop intangible property, 
the amount of any allocation that may be appropriate with respect to 
such assistance shall be determined in accordance with the rules of the 
appropriate paragraph or paragraphs of this section. Thus, where one 
entity allows a related entity, which is the developer, to use tangible 
property, such as laboratory equipment, in connection with the 
development of intangible property, the amount of any allocation that 
may be appropriate with respect to such use shall be determined in 
accordance with the rules of paragraph (c) of this section. In the event 
that the district director does not exercise his discretion to make 
allocations with respect to the assistance rendered to the developer, 
the value of the assistance shall be allowed as a set-off against any 
allocation that the district director may make under this paragraph as a 
result of the transfer of the intangible property to the entity 
rendering the assistance.
    (c) The determination as to which member of a group of related 
entities is a developer and which members of the group are rendering 
assistance to the developer in connection with its development 
activities shall be based upon all the facts and circumstances of the 
individual case. Of all the facts and circumstances to be taken into 
account in making this determination, greatest weight shall be given to 
the relative amounts of all the direct and indirect costs of development 
and the corresponding risks of development borne by the various members 
of the group, and the relative values of the use of any intangible 
property of members of the group which is made available without 
adequate consideration for use in connection with the development 
activity, which property is likely to contribute to a substantial extent 
in the production of intangible property. For this purpose, the risk to 
be borne with respect to development activity is the possibility that 
such activity will not result in the production of intangible property 
or that the intangible property produced will not be of sufficient value 
to allow for the recovery of the costs of developing it. A member will 
not be considered to have borne the costs and corresponding risks of 
development unless such member is committed to bearing such costs in 
advance of, or contemporaneously with, their incurrence and without 
regard to the success of the project. Other factors that may be relevant 
in determining which member of the group is the developer include the 
location of the development activity, the capabilities of the various 
members to carry on

[[Page 689]]

the project independently, and the degree of control over the project 
exercised by the various members.
    (d) The principles of this subdivision (ii) may be illustrated by 
the following examples in which it is assumed that X and Y are corporate 
members of the same group:

    Example (1). X, at the request of Y, undertakes to develop a new 
machine which will function effectively in the climate in which Y's 
factory is located. Y agrees to bear all the direct and indirect costs 
of the project whether or not X successfully develops the machine. 
Assume that X does not make any of its own intangible property available 
for use in connection with the project. The machine is successfully 
developed and Y obtains possession of the intangible property necessary 
to produce such machine. Based on the facts and circumstances as stated, 
Y shall be considered to be the developer of the intangible property 
and, therefore, Y shall not be treated as having obtained the property 
in a transfer subject to the rules of this paragraph. Any amount which 
may be allocable with respect to the assistance rendered by X shall be 
determined in accordance with the rules of (b) of this subdivision.
    Example (2). Assume the same facts as in example (1) except that Y 
agrees to reimburse X for its costs only in the event that the property 
is successfully developed. In such case X is the developer and Y is 
deemed to have received the property in a transfer subject to the rules 
of this paragraph. Therefore, the district director may make an 
allocation to reflect an arm's length consideration for such property.
    Example (3). In 1967 X undertakes to develop product M in its 
research and development department. X incurs direct and indirect costs 
of $1 million per year in connection with the project in 1967, 1968, and 
1969. In connection with the project, X employs the formula for compound 
N, which it owns, and which is likely to contribute substantially to the 
success of the project. The value of the use of the formula for compound 
N in connection with this project is $750,000. In 1968, 4 chemists 
employed by Y spend 6 months working on the project in X's laboratory. 
The salary and other expenses connected with the chemists' employment 
for that period ($100,000) are paid by Y, for which no charge is made to 
X. In 1969, product M is perfected and Y obtains patents thereon. X is 
considered to be the developer of product M since, among other things, 
it bore the greatest relative share of the costs and risks incurred in 
connection with this project and made available intangible property 
(formula for compound N) which was likely to contribute substantially in 
the development of product M. Accordingly, no allocation with respect to 
X's development activity should be made before 1969. The property is 
deemed to have been transferred to Y at that time by virtue of the fact 
that Y obtained the patent rights to product M. In such case the 
district director may make an allocation to reflect an arm's length 
consideration for such transfer. In the event that the district director 
makes such an allocation and he has not made or does not make an 
allocation for 1968 with respect to the services of the chemists in 
accordance with the principles of paragraph (b) of this section, the 
value of the assistance shall be allowed as a set-off against the amount 
of the allocation reflecting an arm's length consideration for the 
transfer of the intangible property.

    (2) Arm's length consideration. (i) An arm's length consideration 
shall be in a form which is consistent with the form which would be 
adopted in transactions between unrelated parties under the same 
circumstances. To the extent appropriate, an arm's length consideration 
may take any one or more of the following forms:
    (a) Royalties based on the transferee's output, sales, profits, or 
any other measure;
    (b) Lump-sum payments; or
    (c) Any other form, including reciprocal licensing rights, which 
might reasonably have been adopted by unrelated parties under the 
circumstances, provided that the parties can establish that such form 
was adopted pursuant to an arrangement which in fact existed between 
them.


However, where the transferee pays nominal or no consideration for the 
property or interest therein and where the transferor has retained a 
substantial interest in the property, an allocation shall be presumed 
not to take the form of a lump-sum payment.
    (ii) In determining the amount of an arm's length consideration, the 
standard to be applied is the amount that would have been paid by an 
unrelated party for the same intangible property under the same 
circumstances. Where there have been transfers by the transferor to 
unrelated parties involving the same or similar intangible property 
under the same or similar circumstances the amount of the consideration 
for such transfers shall generally be the best indication of an arm's 
length consideration.

[[Page 690]]

    (iii) Where a sufficiently similar transaction involving an 
unrelated party cannot be found, the following factors, to the extent 
appropriate (depending upon the type of intangible property and the form 
of the transfer), may be considered in arriving at the amount of the 
arm's length consideration:
    (a) The prevailing rates in the same industry or for similar 
property,
    (b) The offers of competing transferors or the bids of competing 
transferees,
    (c) The terms of the transfer, including limitations on the 
geographic area covered and the exclusive or nonexclusive character of 
any rights granted,
    (d) The uniqueness of the property and the period for which it is 
likely to remain unique,
    (e) The degree and duration of protection afforded to the property 
under the laws of the relevant countries.
    (f) Value of services rendered by the transferor to the transferee 
in connection with the transfer within the meaning of paragraph (b)(8) 
of this section,
    (g) Prospective profits to be realized or costs to be saved by the 
transferee through its use or subsequent transfer of the property,
    (h) The capital investment and starting up expenses required of the 
transferee,
    (i) The next subdivision is (j),
    (j) The availability of substitutes for the property transferred,
    (k) The arm's length rates and prices paid by unrelated parties 
where the property is resold or sublicensed to such parties,
    (l) The costs incurred by the transferor in developing the property, 
and
    (m) Any other fact or circumstance which unrelated parties would 
have been likely to consider in determining the amount of an arm's 
length consideration for the property.
    (3) Definition of intangible property. (i) Solely for the purposes 
of this section, intangible property shall consist of the items 
described in subdivision (ii) of this subparagraph, provided that such 
items have substantial value independent of the services of individual 
persons.
    (ii) The items referred to in subdivision (i) of this subparagraph 
are as follows:
    (a) Patents, inventions, formulas, processes, designs, patterns, and 
other similar items;
    (b) Copyrights, literary, musical, or artistic compositions, and 
other similar items;
    (c) Trademarks, trade names, brand names, and other similar items;
    (d) Franchises, licenses, contracts, and other similar items;
    (e) Methods, programs, systems, procedures, campaigns, surveys, 
studies, forecasts, estimates, customer lists, technical data, and other 
similar items.
    (4) Sharing of costs and risks. Where a member of a group of 
controlled entities acquires an interest in intangible property as a 
participating party in a bona fide cost sharing arrangement with respect 
to the development of such intangible property, the district director 
shall not make allocations with respect to such acquisition except as 
may be appropriate to reflect each participant's arm's length share of 
the costs and risks of developing the property. A bona fide cost sharing 
arrangement is an agreement, in writing, between two or more members of 
a group of controlled entities providing for the sharing of the costs 
and risks of developing intangible property in return for a specified 
interest in the intangible property that may be produced. In order for 
the arrangement to qualify as a bona fide arrangement, it must reflect 
an effort in good faith by the participating members to bear their 
respective shares of all the costs and risks of development on an arm's 
length basis. In order for the sharing of costs and risk to be 
considered on an arm's length basis, the terms and conditions must be 
comparable to those which would have been adopted by unrelated parties 
similarly situated had they entered into such an arrangement. If an oral 
cost sharing arrangement, entered into prior to April 16, 1968, and 
continued in effect after that date, is otherwise in compliance with the 
standards prescribed in this subparagraph, it shall constitute a bona 
fide cost sharing arrangement if it is

[[Page 691]]

reduced to writing prior to January 1, 1969.
    (e) Sales of tangible property--(1) In general. (i) Where one member 
of a group of controlled entities (referred to in this paragraph as the 
``seller'') sells or otherwise disposes of tangible property to another 
member of such group (referred to in this paragraph as the ``buyer'') at 
other than an arm's length price (such a sale being referred to in this 
paragraph as a ``controlled sale''), the district director may make 
appropriate allocations between the seller and the buyer to reflect an 
arm's length price for such sale or disposition. An arm's length price 
is the price that an unrelated party would have paid under the same 
circumstances for the property involved in the controlled sale. Since 
unrelated parties normally sell products at a profit, an arm's length 
price normally involves a profit to the seller.
    (ii) Subparagraphs (2), (3), and (4) of this paragraph describe 
three methods of determining an arm's-length price and the standards for 
applying each method. They are, respectively, the comparable 
uncontrolled price method, the resale price method, and the cost-plus 
method. In addition, a special rule is provided in subdivision (v) of 
this subparagraph for use (notwithstanding any other provision of this 
subdivision) in determining an arm's-length price for an ore or mineral. 
If there are comparable uncontrolled sales as defined in subparagraph 
(2) of this paragraph, the comparable uncontrolled price method must be 
utilized because it is the method likely to result in the most accurate 
estimate of an arm's-length price (for the reason that it is based upon 
the price actually paid by unrelated parties for the same or similar 
products). If there are no comparable uncontrolled sales, then the 
resale price method must be utilized if the standards for its 
application are met because it is the method likely to result in the 
next most accurate estimate in such instances (for the reason that, in 
such instances, the arm's-length price determined under such method is 
based more directly upon actual arm's-length transactions than is the 
cost-plus method). A typical situation where the resale price method may 
be required is where a manufacturer sells products to a related 
distributor which, without further processing, resells the products in 
uncontrolled transactions. If all the standards for the mandatory 
application of the resale price method are not satisfied, then, as 
provided in subparagraph (3)(iii) of this paragraph, either that method 
or the cost-plus method may be used, depending upon which method is more 
feasible and is likely to result in a more accurate estimate of an 
arm's-length price. A typical situation where the cost-plus method may 
be appropriate is where a manufacturer sells products to a related 
entity which performs substantial manufacturing, assembly, or other 
processing of the product or adds significant value by reason of its 
utilization of its intangible property prior to resale in uncontrolled 
transactions.
    (iii) Where the standards for applying one of the three methods of 
pricing described in subdivision (ii) of this subparagraph are met, such 
method must, for the purposes of this paragraph, be utilized unless the 
taxpayer can establish that, considering all the facts and 
circumstances, some method of pricing other than those described in 
subdivision (ii) of this subparagraph is clearly more appropriate. Where 
none of the three methods of pricing described in subdivision (ii) of 
this subparagraph can reasonably be applied under the facts and 
circumstances as they exist in a particular case, some appropriate 
method of pricing other than those described in subdivision (ii) of this 
subparagraph, or variations on such methods, can be used.
    (iv) The methods of determining arm's length prices described in 
this section are stated in terms of their application to individual 
sales of property. However, because of the possibility that a taxpayer 
may make controlled sales of many different products, or many separate 
sales of the same product, it may be impractical to analyze every sale 
for the purposes of determining the arm's length price. It is therefore 
permissible to determine or verify arm's length prices by applying the 
appropriate methods of pricing to product lines or other groupings where 
it is impractical to ascertain an arm's length price for each product or

[[Page 692]]

sale. In addition, the district director may determine or verify the 
arm's length price of all sales to a related entity by employing 
reasonable statistical sampling techniques.
    (v) The price for a mineral product which is sold at the stage at 
which mining or extraction ends shall be determined under the provisions 
of Sec. Sec. 1.613-3 and 1.613-4.
    (2) Comparable uncontrolled price method. (i) Under the method of 
pricing described as the ``comparable uncontrolled price method'', the 
arm's length price of a controlled sale is equal to the price paid in 
comparable uncontrolled sales, adjusted as provided in subdivision (ii) 
of this subparagraph.
    (ii) ``Uncontrolled sales'' are sales in which the seller and the 
buyer are not members of the same controlled group. These include (a) 
sales made by a member of the controlled group to an unrelated party, 
(b) sales made to a member of the controlled group by an unrelated 
party, and (c) sales made in which the parties are not members of the 
controlled group and are not related to each other. However, 
uncontrolled sales do not include sales at unrealistic prices, as for 
example where a member makes uncontrolled sales in small quantities at a 
price designed to justify a nonarm's length price on a large volume of 
controlled sales. Uncontrolled sales are considered comparable to 
controlled sales if the physical property and circumstances involved in 
the uncontrolled sales are identical to the physical property and 
circumstances involved in the controlled sales, or if such properties 
and circumstances are so nearly identical that any differences either 
have no effect on price, or such differences can be reflected by a 
reasonable number of adjustments to the price of uncontrolled sales. For 
this purpose, differences can be reflected by adjusting prices only 
where such differences have a definite and reasonably ascertainable 
effect on price. If the differences can be reflected by such adjustment, 
then the price of the uncontrolled sale as adjusted constitutes the 
comparable uncontrolled sale price. Some of the differences which may 
affect the price of property are differences in the quality of the 
product, terms of sale, intangible property associated with the sale, 
time of sale, and the level of the market and the geographic market in 
which the sale takes place. Whether and to what extent differences in 
the various properties and circumstances affect price, and whether 
differences render sales noncomparable, depends upon the particular 
circumstances and property involved. The principles of this subdivision 
may be illustrated by the following examples, in each of which it is 
assumed that X makes both controlled and uncontrolled sales of the 
identical property:

    Example (1). Assume that the circumstances surrounding the 
controlled and the uncontrolled sales are identical, except for the fact 
that the controlled sales price is a delivered price and the 
uncontrolled sales are made f.o.b. X's factory. Since differences in 
terms of transportation and insurance generally have a definite and 
reasonably ascertainable effect on price, such differences do not 
normally render the uncontrolled sales noncomparable to the controlled 
sales.
    Example (2). Assume that the circumstances surrounding the 
controlled and uncontrolled sales are identical, except for the fact 
that X affixes its valuable trademark in the controlled sales, and does 
not affix its trademark in uncontrolled sales. Since the effects on 
price of differences in intangible property associated with the sale of 
tangible property, such as trademarks, are normally not reasonably 
ascertainable, such differences would normally render the uncontrolled 
sales noncomparable.
    Example (3). Assume that the circumstances surrounding the 
controlled and uncontrolled sales are identical, except for the fact 
that X, a manufacturer of business machines, makes certain minor 
modifications in the physical properties of the machines to satisfy 
safety specifications or other specific requirements of a customer in 
controlled sales, and does not make these modifications in uncontrolled 
sales. Since minor physical differences in the product generally have a 
definite and reasonably ascertainable effect on prices, such differences 
do not normally render the uncontrolled sales noncomparable to the 
controlled sales.

    (iii) Where there are two or more comparable uncontrolled sales 
susceptible of adjustment as defined in subdivision (ii) of this 
subparagraph, the comparable uncontrolled sale or sales requiring the 
fewest and simplest adjustments provided in subdivision (ii) of this 
subparagraph should generally

[[Page 693]]

be selected. Thus, for example, if a taxpayer makes comparable 
uncontrolled sales of a particular product which differ from the 
controlled sale only with respect to the terms of delivery, and makes 
other comparable uncontrolled sales of the product which differ from the 
controlled sale with respect to both terms of delivery and terms of 
payment, the comparable uncontrolled sales differing only with respect 
to terms of delivery should be selected as the comparable uncontrolled 
sale.
    (iv) One of the circumstances which may affect the price of property 
is the fact that the seller may desire to make sales at less than a 
normal profit for the primary purpose of establishing or maintaining a 
market for his products. Thus, a seller may be willing to reduce the 
price of a product, for a time, in order to introduce his product into 
an area or in order to meet competition. However, controlled sales may 
be priced in such a manner only if such price would have been charged in 
an uncontrolled sale under comparable circumstances. Such fact may be 
demonstrated by showing that the buyer in the controlled sale made 
corresponding reductions in the resale price to uncontrolled purchasers, 
or that such buyer engaged in substantially greater sales promotion 
activities with respect to the product involved in the controlled sale 
than with respect to other products. For example, assume X, a 
manufacturer of batteries, commences to sell car batteries to Y, a 
subsidiary of X, for resale in a new market. In its existing markets X's 
batteries sell to independent retailers at $20 per unit, and X sells 
them to wholesalers at $17 per unit. Y also sells X's batteries to 
independent retailers at $20 per unit. X's batteries are not known in 
the new market in which Y is operating. In order to engage competitively 
in the new market Y incurs selling and advertising costs substantially 
higher than those incurred for its sales of other products. Under these 
circumstances X may sell to Y, for a time, at less than $17 to take into 
account the increased selling and advertising activities of Y in 
penetrating and establishing the new market. This may be done even 
though it may result in a transfer price from X to Y which is below X's 
full costs of manufacturing the product.
    (3) Resale price method. (i) Under the pricing method described as 
the ``resale price method'', the arm's length price of a controlled sale 
is equal to the applicable resale price (as defined in subdivision (iv) 
or (v) of this subparagraph), reduced by an appropriate markup, and 
adjusted as provided in subdivision (ix) of this subparagraph. An 
appropriate markup is computed by multiplying the applicable resale 
price by the appropriate markup percentage as defined in subdivision 
(vi) of this subparagraph. Thus, where one member of a group of 
controlled entities sells property to another member which resells the 
property in uncontrolled sales, if the applicable resale price of the 
property involved in the uncontrolled sale is $100 and the appropriate 
markup percentage for resales by the buyer is 20 percent, the arm's 
length price of the controlled sale is $80 ($100 minus 20 percent x 
$100), adjusted as provided in subdivision (ix) of this subparagraph.
    (ii) The resale price method must be used to compute an arm's length 
price of a controlled sale if all the following circumstances exist:
    (a) There are no comparable uncontrolled sales as defined in 
subparagraph (2) of this paragraph.
    (b) An applicable resale price, as defined in subdivision (iv) or 
(v) of this subparagraph, is available with respect to resales made 
within a reasonable time before or after the time of the controlled 
sale.
    (c) The buyer (reseller) has not added more than an insubstantial 
amount to the value of the property by physically altering the product 
before resale. For this purpose packaging, repacking, labeling, or minor 
assembly of property does not constitute physical alteration.
    (d) The buyer (reseller) has not added more than an insubstantial 
amount to the value of the property by the use of intangible property. 
See Sec. 1.482-2(d)(3) for the definition of intangible property.
    (iii) Notwithstanding the fact that one or both of the requirements 
of subdivision (ii) (c) or (d) of this subparagraph may not be met, the 
resale price method may be used if such method is

[[Page 694]]

more feasible and is likely to result in a more accurate determination 
of an arm's length price than the use of the cost plus method. Thus, 
even though one of the requirements of such subdivision is not 
satisfied, the resale price method may nevertheless be more appropriate 
than the cost plus method because the computations and evaluations 
required under the former method may be fewer and easier to make than 
under the latter method. In general, the resale price method is more 
appropriate when the functions performed by the seller are more 
extensive and more difficult to evaluate than the functions performed by 
the buyer (reseller). The principle of this subdivision may be 
illustrated by the following examples in each of which it is assumed 
that corporation X developed a valuable patent covering product M which 
it manufactures and sells to corporation Y in a controlled sale, and for 
which there is no comparable uncontrolled sale:

    Example (1). Corporation Y adds a component to product M and resells 
the assembled product in an uncontrolled sale within a reasonable time 
after the controlled sale of product M. Assume further that the addition 
of the component added more than an insubstantial amount to the value of 
product M, but that Y's function in purchasing the component and 
assembling the product prior to sale was subject to reasonably precise 
valuation. Although the controlled sale and resale does not meet the 
requirements of subdivision (ii)(c) of this subparagraph, the resale 
price method may be used under the circumstances because that method 
involves computations and evaluations which are fewer and easier to make 
than under the cost plus method. This is because X's use of a patent may 
be more difficult to evaluate in determining an appropriate gross profit 
percentage under the cost plus method, than is evaluation of Y's 
assembling function in determining the appropriate markup percentage 
under the resale price method.
    Example (2). Corporation Y resells product M in an uncontrolled sale 
within a reasonable time after the controlled sale after attaching its 
valuable trademark to it. Assume further that it can be demonstrated 
through comparison with other uncontrolled sales of Y that the addition 
of Y's trademark to a product usually adds 25 percent to the markup on 
its sales. On the other hand, the effect of X's use of its patent is 
difficult to evaluate in applying the cost plus method because no 
reasonable standard of comparison is available. Although the controlled 
sale and resale does not meet the requirements of subdivision (ii)(d) of 
this subparagraph, the resale price method may be used because that 
method involves computations and evaluation which are fewer and easier 
to make than under the cost plus method. That is because, under the 
circumstances, X's use of a patent is more difficult to evaluate in 
determining an appropriate gross profit percentage under the cost plus 
method, than is evaluation of the use of Y's trademark in determining 
the appropriate markup percentage under the resale price method.

    (iv) For the purposes of this subparagraph the ``applicable resale 
price'' is the price at which it is anticipated that property purchased 
in the controlled sale will be resold by the buyer in an uncontrolled 
sale. The ``applicable resale price'' will generally be equal to either 
the price at which current resales of the same property are being made 
or the resale price of the particular item of property involved.
    (v) Where the property purchased in the controlled sale is resold in 
another controlled sale, the ``applicable resale price'' is the price at 
which such property is finally resold in an uncontrolled sale, providing 
that the series of sales as a whole meets all the requirements of 
subdivision (ii) of this subparagraph or that the resale price method is 
used pursuant to subdivision (iii) of this subparagraph. In such case, 
the determination of the appropriate markup percentage shall take into 
account the function or functions performed by all members of the group 
participating in the series of sales and resales. Thus, if X sells a 
product to Y in a controlled sale, Y sells the product to Z in a 
controlled sale, and Z sells the product in an uncontrolled sale, the 
resale price method must be used if Y and Z together have not added more 
than an insubstantial amount to the value of the product through 
physical alteration or the application of intangible property, and the 
final resale occurs within a reasonable time of the sale from X to Y. In 
such case, the applicable resale price is the price at which Z sells the 
product in the uncontrolled sale, and the appropriate markup percentage 
shall take into account the functions performed by both Y and Z.
    (vi) For the purposes of this subparagraph, the appropriate markup 
percentage is equal to the percentage of

[[Page 695]]

gross profit (expressed as a percentage of sales) earned by the buyer 
(reseller) or another party on the resale of property which is both 
purchased and resold in an uncontrolled transaction, which resale is 
most similar to the applicable resale of the property involved in the 
controlled sale. The following are the most important characteristics to 
be considered in determining the similarity of resales:
    (a) The type of property involved in the sales. For example: machine 
tools, men's furnishings, small household appliances.
    (b) The functions performed by the reseller with respect to the 
property. For example: packaging, labeling, delivering, maintenance of 
inventory, minor assembly, advertising, selling at wholesale, selling at 
retail, billing, maintenance of accounts receivable, and servicing.
    (c) The effect on price of any intangible property utilized by the 
reseller in connection with the property resold. For example: patents, 
trademarks, trade names.
    (d) The geographic market in which the functions are performed by 
the reseller.


In general, the similarity to be sought relates to the probable effect 
upon the markup percentage of any differences in such characteristics 
between the uncontrolled purchases and resales on the one hand and the 
controlled purchases and resales on the other hand. Thus, close physical 
similarity of the property involved in the sales compared is not 
required under the resale price method since a lack of close physical 
similarity is not necessarily indicative of dissimilar markup 
percentages.
    (vii) Whenever possible, markup percentages should be derived from 
uncontrolled purchases and resales of the buyer (reseller) involved in 
the controlled sale, because similar characteristics are more likely to 
be found among different resales of property made by the same reseller 
than among sales made by other resellers. In the absence of resales by 
the same buyer (reseller) which meet the standards of subdivision (vi) 
of this subparagraph, evidence of an appropriate markup percentage may 
be derived from resales by other resellers selling in the same or a 
similar market in which the controlled buyer (reseller) is selling 
providing such resellers perform comparable functions. Where the 
function performed by the reseller is similar to the function performed 
by a sales agent which does not take title, such sales agent will be 
considered a reseller for the purpose of determining an appropriate 
markup percentage under this subparagraph and the commission earned by 
such sales agent, expressed as a percentage of the sales price of the 
goods, may constitute the appropriate markup percentage. If the 
controlled buyer (reseller) is located in a foreign country and 
information on resales by other resellers in the same foreign market is 
not available, then markup percentages earned by United States resellers 
performing comparable functions may be used. In the absence of data on 
markup percentages of particular sales or groups of sales, the 
prevailing markup percentage in the particular industry involved may be 
appropriate.
    (viii) In calculating the markup percentage earned on uncontrolled 
purchases and resales, and in applying such percentage to the applicable 
resale price to determine the appropriate markup, the same elements 
which enter into the computation of the sales price and the costs of 
goods sold of the property involved in the comparable uncontrolled 
purchases and resales should enter into such computation in the case of 
the property involved in the controlled purchases and resales. Thus, if 
freight-in and packaging expense are elements of the cost of goods sold 
in comparable uncontrolled purchases, then such elements should also be 
taken into account in computing the cost of goods sold of the controlled 
purchase. Similarly, if the comparable markup percentage is based upon 
net sales (after reduction for returns and allowances) of uncontrolled 
resellers, such percentage must be applied to net sales of the buyer 
(reseller).
    (ix) In determining an arm's length price appropriate adjustment 
must be made to reflect any material differences between the 
uncontrolled purchases and resales used as the basis for the calculation 
of the appropriate markup percentage and the resales of

[[Page 696]]

property involved in the controlled sale. The differences referred to in 
this subdivision are those differences in functions or circumstances 
which have a definite and reasonably ascertainable effect on price. The 
principles of this subdivision may be illustrated by the following 
example:

    Example. Assume that X and Y are members of the same group of 
controlled entities and that Y purchases electric mixers from X and 
electric toasters from uncontrolled entities. Y performs substantially 
similar functions with respect to resales of both the mixers and the 
toasters, except that it does not warrant the toasters, but does provide 
a 90-day warranty for the mixers. Y normally earns a gross profit on 
toasters of 20 percent of gross selling price. The 20-percent gross 
profit on the resale of toasters is an appropriate markup percentage, 
but the price of the controlled sale computed with reference to such 
rate must be adjusted to reflect the difference in terms (the warranty).

    (4) Cost plus method. (i) Under the pricing method described as the 
``cost plus method'', the arm's length price of a controlled sale of 
property shall be computed by adding to the cost of producing such 
property (as computed in subdivision (ii) of this subparagraph), an 
amount which is equal to such cost multiplied by the appropriate gross 
profit percentage (as computed in subdivision (iii) of this 
subparagraph), plus or minus any adjustments as provided in subdivision 
(v) of this subparagraph.
    (ii) For the purposes of this subparagraph, the cost of producing 
the property involved in the controlled sale, and the costs which enter 
into the computation of the appropriate gross profit percentage shall be 
computed in a consistent manner in accordance with sound accounting 
practices for allocating or apportioning costs, which neither favors nor 
burdens controlled sales in comparison with uncontrolled sales. Thus, if 
the costs used in computing the appropriate gross profit percentage are 
comprised of the full cost of goods sold, including direct and indirect 
costs, then the cost of producing the property involved in the 
controlled sales must be comprised of the full cost of goods sold, 
including direct and indirect costs. On the other hand, if the costs 
used in computing the appropriate gross profit percentage are comprised 
only of direct costs, the cost of producing the property involved in the 
controlled sale must be comprised only of direct costs. The term ``cost 
of producing'', as used in this subparagraph, includes the cost of 
acquiring property which is held for resale.
    (iii) For the purposes of this subparagraph, the appropriate gross 
profit percentage is equal to the gross profit percentage (expressed as 
a percentage of cost) earned by the seller or another party on the 
uncontrolled sale or sales of property which are most similar to the 
controlled sale in question. The following are the most important 
characteristics to be considered in determining the similarity of the 
uncontrolled sale or sales:
    (a) The type of property involved in the sales. For example: machine 
tools, men's furnishings, small household appliances.
    (b) The functions performed by the seller with respect to the 
property sold. For example: contract manufacturing, product assembly, 
selling activity, processing, servicing, delivering.
    (c) The effect of any intangible property used by the seller in 
connection with the property sold. For example: patents, trademarks, 
trade names.
    (d) The geographic market in which the functions are performed by 
the seller. In general, the similarity to be sought relates to the 
probable effect upon the margin of gross profit of any differences in 
such characteristics between the uncontrolled sales and the controlled 
sale. Thus, close physical similarity of the property involved in the 
sales compared is not required under the cost plus method since a lack 
of close physical similarity is not necessarily indicative of dissimilar 
profit margins. See subparagraph (2)(iv) of this paragraph, relating to 
sales made at less than a normal profit for the primary purpose of 
establishing or maintaining a market.
    (iv) Whenever possible, gross profit percentages should be derived 
from uncontrolled sales made by the seller involved in the controlled 
sale, because similar characteristics are more likely to be found among 
sales of property made by the same seller than among sales made by other 
sellers. In the absence of such sales, evidence of an appropriate gross 
profit percentage may

[[Page 697]]

be derived from similar uncontrolled sales by other sellers whether or 
not such sellers are members of the controlled group. Where the function 
performed by the seller is similar to the function performed by a 
purchasing agent which does not take title, such purchasing agent will 
be considered a seller for the purpose of determining an appropriate 
gross profit percentage under this subparagraph and the commission 
earned by such purchasing agent, expressed as a percentage of the 
purchase price of the goods, may constitute the appropriate gross profit 
percentage. In the absence of data on gross profit percentages of 
particular sales or groups of sales which are similar to the controlled 
sale, the prevailing gross profit percentages in the particular industry 
involved may be appropriate.
    (v) Where the most similar sale or sales from which the appropriate 
gross profit percentage is derived differ in any material respect from 
the controlled sale, the arm's length price which is computed by 
applying such percentage must be adjusted to reflect such differences to 
the extent such differences would warrant an adjustment of price in 
uncontrolled transactions. The differences referred to in this 
subdivision are those differences which have a definite and reasonably 
ascertainable effect on price.

(Sec. 385 and 7805 of the Internal Revenue Code of 1954 (83 Stat. 613 
and 68A Stat. 917; 26 U.S.C. 385 and 7805))

[T.D. 6952, 33 FR 5849, Apr. 16, 1968]

    Editorial Note: For Federal Register citations affecting Sec. 
1.482-2A, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and on GPO Access.



Sec. Sec. 1.484-1.500  [Reserved]

[[Page 699]]



                              FINDING AIDS




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

  A list of CFR titles, subtitles, chapters, subchapters and parts and 
an alphabetical list of agencies publishing in the CFR are included in 
the CFR Index and Finding Aids volume to the Code of Federal Regulations 
which is published separately and revised annually.

  Table of CFR Titles and Chapters
  Alphabetical List of Agencies Appearing in the CFR
  Table of OMB Control Numbers
  List of CFR Sections Affected

[[Page 701]]



                    Table of CFR Titles and Chapters




                      (Revised as of April 1, 2006)

                      Title 1--General Provisions

         I  Administrative Committee of the Federal Register 
                (Parts 1--49)
        II  Office of the Federal Register (Parts 50--299)
        IV  Miscellaneous Agencies (Parts 400--500)

                    Title 2--Grants and Agreements

            Subtitle A--Office of Management and Budget Guidance 
                for Grants and Agreements
         I  Office of Management and Budget Governmentwide 
                Guidance for Grants and Agreements (Parts 100-199)
        II  Office of Management and Budget Circulars and Guidance 
                (200-299)
            Subtitle B--Federal Agency Regulations for Grants and 
                Agreements [Reserved]


                        Title 3--The President

         I  Executive Office of the President (Parts 100--199)

                           Title 4--Accounts

         I  Government Accountability Office (Parts 1--99)

                   Title 5--Administrative Personnel

         I  Office of Personnel Management (Parts 1--1199)
        II  Merit Systems Protection Board (Parts 1200--1299)
       III  Office of Management and Budget (Parts 1300--1399)
         V  The International Organizations Employees Loyalty 
                Board (Parts 1500--1599)
        VI  Federal Retirement Thrift Investment Board (Parts 
                1600--1699)
      VIII  Office of Special Counsel (Parts 1800--1899)
        IX  Appalachian Regional Commission (Parts 1900--1999)
        XI  Armed Forces Retirement Home (Part 2100)
       XIV  Federal Labor Relations Authority, General Counsel of 
                the Federal Labor Relations Authority and Federal 
                Service Impasses Panel (Parts 2400--2499)

[[Page 702]]

        XV  Office of Administration, Executive Office of the 
                President (Parts 2500--2599)
       XVI  Office of Government Ethics (Parts 2600--2699)
       XXI  Department of the Treasury (Parts 3100--3199)
      XXII  Federal Deposit Insurance Corporation (Part 3201)
     XXIII  Department of Energy (Part 3301)
      XXIV  Federal Energy Regulatory Commission (Part 3401)
       XXV  Department of the Interior (Part 3501)
      XXVI  Department of Defense (Part 3601)
    XXVIII  Department of Justice (Part 3801)
      XXIX  Federal Communications Commission (Parts 3900--3999)
       XXX  Farm Credit System Insurance Corporation (Parts 4000--
                4099)
      XXXI  Farm Credit Administration (Parts 4100--4199)
    XXXIII  Overseas Private Investment Corporation (Part 4301)
      XXXV  Office of Personnel Management (Part 4501)
        XL  Interstate Commerce Commission (Part 5001)
       XLI  Commodity Futures Trading Commission (Part 5101)
      XLII  Department of Labor (Part 5201)
     XLIII  National Science Foundation (Part 5301)
       XLV  Department of Health and Human Services (Part 5501)
      XLVI  Postal Rate Commission (Part 5601)
     XLVII  Federal Trade Commission (Part 5701)
    XLVIII  Nuclear Regulatory Commission (Part 5801)
         L  Department of Transportation (Part 6001)
       LII  Export-Import Bank of the United States (Part 6201)
      LIII  Department of Education (Parts 6300--6399)
       LIV  Environmental Protection Agency (Part 6401)
        LV  National Endowment for the Arts (Part 6501)
       LVI  National Endowment for the Humanities (Part 6601)
      LVII  General Services Administration (Part 6701)
     LVIII  Board of Governors of the Federal Reserve System (Part 
                6801)
       LIX  National Aeronautics and Space Administration (Part 
                6901)
        LX  United States Postal Service (Part 7001)
       LXI  National Labor Relations Board (Part 7101)
      LXII  Equal Employment Opportunity Commission (Part 7201)
     LXIII  Inter-American Foundation (Part 7301)
       LXV  Department of Housing and Urban Development (Part 
                7501)
      LXVI  National Archives and Records Administration (Part 
                7601)
     LXVII  Institute of Museum and Library Services (Part 7701)
      LXIX  Tennessee Valley Authority (Part 7901)
      LXXI  Consumer Product Safety Commission (Part 8101)
    LXXIII  Department of Agriculture (Part 8301)
     LXXIV  Federal Mine Safety and Health Review Commission (Part 
                8401)
     LXXVI  Federal Retirement Thrift Investment Board (Part 8601)

[[Page 703]]

    LXXVII  Office of Management and Budget (Part 8701)
     XCVII  Department of Homeland Security Human Resources 
                Management System (Department of Homeland 
                Security--Office of Personnel Management) (Part 
                9701)
      XCIX  Department of Defense Human Resources Management and 
                Labor Relations Systems (Department of Defense--
                Office of Personnel Management) (Part 9901)

                      Title 6--Homeland Security

         I  Department of Homeland Security, Office of the 
                Secretary (Parts 0--99)

                         Title 7--Agriculture

            Subtitle A--Office of the Secretary of Agriculture 
                (Parts 0--26)
            Subtitle B--Regulations of the Department of 
                Agriculture
         I  Agricultural Marketing Service (Standards, 
                Inspections, Marketing Practices), Department of 
                Agriculture (Parts 27--209)
        II  Food and Nutrition Service, Department of Agriculture 
                (Parts 210--299)
       III  Animal and Plant Health Inspection Service, Department 
                of Agriculture (Parts 300--399)
        IV  Federal Crop Insurance Corporation, Department of 
                Agriculture (Parts 400--499)
         V  Agricultural Research Service, Department of 
                Agriculture (Parts 500--599)
        VI  Natural Resources Conservation Service, Department of 
                Agriculture (Parts 600--699)
       VII  Farm Service Agency, Department of Agriculture (Parts 
                700--799)
      VIII  Grain Inspection, Packers and Stockyards 
                Administration (Federal Grain Inspection Service), 
                Department of Agriculture (Parts 800--899)
        IX  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Fruits, Vegetables, Nuts), Department 
                of Agriculture (Parts 900--999)
         X  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Milk), Department of Agriculture 
                (Parts 1000--1199)
        XI  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Miscellaneous Commodities), Department 
                of Agriculture (Parts 1200--1299)
       XIV  Commodity Credit Corporation, Department of 
                Agriculture (Parts 1400--1499)
        XV  Foreign Agricultural Service, Department of 
                Agriculture (Parts 1500--1599)
       XVI  Rural Telephone Bank, Department of Agriculture (Parts 
                1600--1699)
      XVII  Rural Utilities Service, Department of Agriculture 
                (Parts 1700--1799)

[[Page 704]]

     XVIII  Rural Housing Service, Rural Business-Cooperative 
                Service, Rural Utilities Service, and Farm Service 
                Agency, Department of Agriculture (Parts 1800--
                2099)
        XX  Local Television Loan Guarantee Board (Parts 2200--
                2299)
      XXVI  Office of Inspector General, Department of Agriculture 
                (Parts 2600--2699)
     XXVII  Office of Information Resources Management, Department 
                of Agriculture (Parts 2700--2799)
    XXVIII  Office of Operations, Department of Agriculture (Parts 
                2800--2899)
      XXIX  Office of Energy Policy and New Uses, Department of 
                Agriculture (Parts 2900--2999)
       XXX  Office of the Chief Financial Officer, Department of 
                Agriculture (Parts 3000--3099)
      XXXI  Office of Environmental Quality, Department of 
                Agriculture (Parts 3100--3199)
     XXXII  Office of Procurement and Property Management, 
                Department of Agriculture (Parts 3200--3299)
    XXXIII  Office of Transportation, Department of Agriculture 
                (Parts 3300--3399)
     XXXIV  Cooperative State Research, Education, and Extension 
                Service, Department of Agriculture (Parts 3400--
                3499)
      XXXV  Rural Housing Service, Department of Agriculture 
                (Parts 3500--3599)
     XXXVI  National Agricultural Statistics Service, Department 
                of Agriculture (Parts 3600--3699)
    XXXVII  Economic Research Service, Department of Agriculture 
                (Parts 3700--3799)
   XXXVIII  World Agricultural Outlook Board, Department of 
                Agriculture (Parts 3800--3899)
       XLI  [Reserved]
      XLII  Rural Business-Cooperative Service and Rural Utilities 
                Service, Department of Agriculture (Parts 4200--
                4299)

                    Title 8--Aliens and Nationality

         I  Department of Homeland Security (Immigration and 
                Naturalization) (Parts 1--499)
         V  Executive Office for Immigration Review, Department of 
                Justice (Parts 1000--1399)

                 Title 9--Animals and Animal Products

         I  Animal and Plant Health Inspection Service, Department 
                of Agriculture (Parts 1--199)
        II  Grain Inspection, Packers and Stockyards 
                Administration (Packers and Stockyards Programs), 
                Department of Agriculture (Parts 200--299)
       III  Food Safety and Inspection Service, Department of 
                Agriculture (Parts 300--599)

[[Page 705]]

                           Title 10--Energy

         I  Nuclear Regulatory Commission (Parts 0--199)
        II  Department of Energy (Parts 200--699)
       III  Department of Energy (Parts 700--999)
         X  Department of Energy (General Provisions) (Parts 
                1000--1099)
      XIII  Nuclear Waste Technical Review Board (Parts 1303--
                1399)
      XVII  Defense Nuclear Facilities Safety Board (Parts 1700--
                1799)
     XVIII  Northeast Interstate Low-Level Radioactive Waste 
                Commission (Part 1800)

                      Title 11--Federal Elections

         I  Federal Election Commission (Parts 1--9099)

                      Title 12--Banks and Banking

         I  Comptroller of the Currency, Department of the 
                Treasury (Parts 1--199)
        II  Federal Reserve System (Parts 200--299)
       III  Federal Deposit Insurance Corporation (Parts 300--399)
        IV  Export-Import Bank of the United States (Parts 400--
                499)
         V  Office of Thrift Supervision, Department of the 
                Treasury (Parts 500--599)
        VI  Farm Credit Administration (Parts 600--699)
       VII  National Credit Union Administration (Parts 700--799)
      VIII  Federal Financing Bank (Parts 800--899)
        IX  Federal Housing Finance Board (Parts 900--999)
        XI  Federal Financial Institutions Examination Council 
                (Parts 1100--1199)
       XIV  Farm Credit System Insurance Corporation (Parts 1400--
                1499)
        XV  Department of the Treasury (Parts 1500--1599)
      XVII  Office of Federal Housing Enterprise Oversight, 
                Department of Housing and Urban Development (Parts 
                1700--1799)
     XVIII  Community Development Financial Institutions Fund, 
                Department of the Treasury (Parts 1800--1899)

               Title 13--Business Credit and Assistance

         I  Small Business Administration (Parts 1--199)
       III  Economic Development Administration, Department of 
                Commerce (Parts 300--399)
        IV  Emergency Steel Guarantee Loan Board, Department of 
                Commerce (Parts 400--499)
         V  Emergency Oil and Gas Guaranteed Loan Board, 
                Department of Commerce (Parts 500--599)

[[Page 706]]

                    Title 14--Aeronautics and Space

         I  Federal Aviation Administration, Department of 
                Transportation (Parts 1--199)
        II  Office of the Secretary, Department of Transportation 
                (Aviation Proceedings) (Parts 200--399)
       III  Commercial Space Transportation, Federal Aviation 
                Administration, Department of Transportation 
                (Parts 400--499)
         V  National Aeronautics and Space Administration (Parts 
                1200--1299)
        VI  Air Transportation System Stabilization (Parts 1300--
                1399)

                 Title 15--Commerce and Foreign Trade

            Subtitle A--Office of the Secretary of Commerce (Parts 
                0--29)
            Subtitle B--Regulations Relating to Commerce and 
                Foreign Trade
         I  Bureau of the Census, Department of Commerce (Parts 
                30--199)
        II  National Institute of Standards and Technology, 
                Department of Commerce (Parts 200--299)
       III  International Trade Administration, Department of 
                Commerce (Parts 300--399)
        IV  Foreign-Trade Zones Board, Department of Commerce 
                (Parts 400--499)
       VII  Bureau of Industry and Security, Department of 
                Commerce (Parts 700--799)
      VIII  Bureau of Economic Analysis, Department of Commerce 
                (Parts 800--899)
        IX  National Oceanic and Atmospheric Administration, 
                Department of Commerce (Parts 900--999)
        XI  Technology Administration, Department of Commerce 
                (Parts 1100--1199)
      XIII  East-West Foreign Trade Board (Parts 1300--1399)
       XIV  Minority Business Development Agency (Parts 1400--
                1499)
            Subtitle C--Regulations Relating to Foreign Trade 
                Agreements
        XX  Office of the United States Trade Representative 
                (Parts 2000--2099)
            Subtitle D--Regulations Relating to Telecommunications 
                and Information
     XXIII  National Telecommunications and Information 
                Administration, Department of Commerce (Parts 
                2300--2399)

                    Title 16--Commercial Practices

         I  Federal Trade Commission (Parts 0--999)
        II  Consumer Product Safety Commission (Parts 1000--1799)

[[Page 707]]

             Title 17--Commodity and Securities Exchanges

         I  Commodity Futures Trading Commission (Parts 1--199)
        II  Securities and Exchange Commission (Parts 200--399)
        IV  Department of the Treasury (Parts 400--499)

          Title 18--Conservation of Power and Water Resources

         I  Federal Energy Regulatory Commission, Department of 
                Energy (Parts 1--399)
       III  Delaware River Basin Commission (Parts 400--499)
        VI  Water Resources Council (Parts 700--799)
      VIII  Susquehanna River Basin Commission (Parts 800--899)
      XIII  Tennessee Valley Authority (Parts 1300--1399)

                       Title 19--Customs Duties

         I  Bureau of Customs and Border Protection, Department of 
                Homeland Security; Department of the Treasury 
                (Parts 0--199)
        II  United States International Trade Commission (Parts 
                200--299)
       III  International Trade Administration, Department of 
                Commerce (Parts 300--399)
        IV  Bureau of Immigration and Customs Enforcement, 
                Department of Homeland Security (Parts 400--599)

                     Title 20--Employees' Benefits

         I  Office of Workers' Compensation Programs, Department 
                of Labor (Parts 1--199)
        II  Railroad Retirement Board (Parts 200--399)
       III  Social Security Administration (Parts 400--499)
        IV  Employees Compensation Appeals Board, Department of 
                Labor (Parts 500--599)
         V  Employment and Training Administration, Department of 
                Labor (Parts 600--699)
        VI  Employment Standards Administration, Department of 
                Labor (Parts 700--799)
       VII  Benefits Review Board, Department of Labor (Parts 
                800--899)
      VIII  Joint Board for the Enrollment of Actuaries (Parts 
                900--999)
        IX  Office of the Assistant Secretary for Veterans' 
                Employment and Training, Department of Labor 
                (Parts 1000--1099)

                       Title 21--Food and Drugs

         I  Food and Drug Administration, Department of Health and 
                Human Services (Parts 1--1299)
        II  Drug Enforcement Administration, Department of Justice 
                (Parts 1300--1399)
       III  Office of National Drug Control Policy (Parts 1400--
                1499)

[[Page 708]]

                      Title 22--Foreign Relations

         I  Department of State (Parts 1--199)
        II  Agency for International Development (Parts 200--299)
       III  Peace Corps (Parts 300--399)
        IV  International Joint Commission, United States and 
                Canada (Parts 400--499)
         V  Broadcasting Board of Governors (Parts 500--599)
       VII  Overseas Private Investment Corporation (Parts 700--
                799)
        IX  Foreign Service Grievance Board Regulations (Parts 
                900--999)
         X  Inter-American Foundation (Parts 1000--1099)
        XI  International Boundary and Water Commission, United 
                States and Mexico, United States Section (Parts 
                1100--1199)
       XII  United States International Development Cooperation 
                Agency (Parts 1200--1299)
       XIV  Foreign Service Labor Relations Board; Federal Labor 
                Relations Authority; General Counsel of the 
                Federal Labor Relations Authority; and the Foreign 
                Service Impasse Disputes Panel (Parts 1400--1499)
        XV  African Development Foundation (Parts 1500--1599)
       XVI  Japan-United States Friendship Commission (Parts 
                1600--1699)
      XVII  United States Institute of Peace (Parts 1700--1799)

                          Title 23--Highways

         I  Federal Highway Administration, Department of 
                Transportation (Parts 1--999)
        II  National Highway Traffic Safety Administration and 
                Federal Highway Administration, Department of 
                Transportation (Parts 1200--1299)
       III  National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 1300--1399)

                Title 24--Housing and Urban Development

            Subtitle A--Office of the Secretary, Department of 
                Housing and Urban Development (Parts 0--99)
            Subtitle B--Regulations Relating to Housing and Urban 
                Development
         I  Office of Assistant Secretary for Equal Opportunity, 
                Department of Housing and Urban Development (Parts 
                100--199)
        II  Office of Assistant Secretary for Housing-Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Parts 200--299)
       III  Government National Mortgage Association, Department 
                of Housing and Urban Development (Parts 300--399)
        IV  Office of Housing and Office of Multifamily Housing 
                Assistance Restructuring, Department of Housing 
                and Urban Development (Parts 400--499)
         V  Office of Assistant Secretary for Community Planning 
                and Development, Department of Housing and Urban 
                Development (Parts 500--599)

[[Page 709]]

        VI  Office of Assistant Secretary for Community Planning 
                and Development, Department of Housing and Urban 
                Development (Parts 600--699) [Reserved]
       VII  Office of the Secretary, Department of Housing and 
                Urban Development (Housing Assistance Programs and 
                Public and Indian Housing Programs) (Parts 700--
                799)
      VIII  Office of the Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Section 8 Housing Assistance 
                Programs, Section 202 Direct Loan Program, Section 
                202 Supportive Housing for the Elderly Program and 
                Section 811 Supportive Housing for Persons With 
                Disabilities Program) (Parts 800--899)
        IX  Office of Assistant Secretary for Public and Indian 
                Housing, Department of Housing and Urban 
                Development (Parts 900--1699)
         X  Office of Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Interstate Land Sales 
                Registration Program) (Parts 1700--1799)
       XII  Office of Inspector General, Department of Housing and 
                Urban Development (Parts 2000--2099)
        XX  Office of Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Parts 3200--3899)
       XXV  Neighborhood Reinvestment Corporation (Parts 4100--
                4199)

                           Title 25--Indians

         I  Bureau of Indian Affairs, Department of the Interior 
                (Parts 1--299)
        II  Indian Arts and Crafts Board, Department of the 
                Interior (Parts 300--399)
       III  National Indian Gaming Commission, Department of the 
                Interior (Parts 500--599)
        IV  Office of Navajo and Hopi Indian Relocation (Parts 
                700--799)
         V  Bureau of Indian Affairs, Department of the Interior, 
                and Indian Health Service, Department of Health 
                and Human Services (Part 900)
        VI  Office of the Assistant Secretary-Indian Affairs, 
                Department of the Interior (Parts 1000--1199)
       VII  Office of the Special Trustee for American Indians, 
                Department of the Interior (Part 1200)

                      Title 26--Internal Revenue

         I  Internal Revenue Service, Department of the Treasury 
                (Parts 1--899)

           Title 27--Alcohol, Tobacco Products and Firearms

         I  Alcohol and Tobacco Tax and Trade Bureau, Department 
                of the Treasury (Parts 1--399)

[[Page 710]]

        II  Bureau of Alcohol, Tobacco, Firearms, and Explosives, 
                Department of Justice (Parts 400--699)

                   Title 28--Judicial Administration

         I  Department of Justice (Parts 0--299)
       III  Federal Prison Industries, Inc., Department of Justice 
                (Parts 300--399)
         V  Bureau of Prisons, Department of Justice (Parts 500--
                599)
        VI  Offices of Independent Counsel, Department of Justice 
                (Parts 600--699)
       VII  Office of Independent Counsel (Parts 700--799)
      VIII  Court Services and Offender Supervision Agency for the 
                District of Columbia (Parts 800--899)
        IX  National Crime Prevention and Privacy Compact Council 
                (Parts 900--999)
        XI  Department of Justice and Department of State (Parts 
                1100--1199)

                            Title 29--Labor

            Subtitle A--Office of the Secretary of Labor (Parts 
                0--99)
            Subtitle B--Regulations Relating to Labor
         I  National Labor Relations Board (Parts 100--199)
        II  Office of Labor-Management Standards, Department of 
                Labor (Parts 200--299)
       III  National Railroad Adjustment Board (Parts 300--399)
        IV  Office of Labor-Management Standards, Department of 
                Labor (Parts 400--499)
         V  Wage and Hour Division, Department of Labor (Parts 
                500--899)
        IX  Construction Industry Collective Bargaining Commission 
                (Parts 900--999)
         X  National Mediation Board (Parts 1200--1299)
       XII  Federal Mediation and Conciliation Service (Parts 
                1400--1499)
       XIV  Equal Employment Opportunity Commission (Parts 1600--
                1699)
      XVII  Occupational Safety and Health Administration, 
                Department of Labor (Parts 1900--1999)
        XX  Occupational Safety and Health Review Commission 
                (Parts 2200--2499)
       XXV  Employee Benefits Security Administration, Department 
                of Labor (Parts 2500--2599)
     XXVII  Federal Mine Safety and Health Review Commission 
                (Parts 2700--2799)
        XL  Pension Benefit Guaranty Corporation (Parts 4000--
                4999)

[[Page 711]]

                      Title 30--Mineral Resources

         I  Mine Safety and Health Administration, Department of 
                Labor (Parts 1--199)
        II  Minerals Management Service, Department of the 
                Interior (Parts 200--299)
       III  Board of Surface Mining and Reclamation Appeals, 
                Department of the Interior (Parts 300--399)
        IV  Geological Survey, Department of the Interior (Parts 
                400--499)
       VII  Office of Surface Mining Reclamation and Enforcement, 
                Department of the Interior (Parts 700--999)

                 Title 31--Money and Finance: Treasury

            Subtitle A--Office of the Secretary of the Treasury 
                (Parts 0--50)
            Subtitle B--Regulations Relating to Money and Finance
         I  Monetary Offices, Department of the Treasury (Parts 
                51--199)
        II  Fiscal Service, Department of the Treasury (Parts 
                200--399)
        IV  Secret Service, Department of the Treasury (Parts 
                400--499)
         V  Office of Foreign Assets Control, Department of the 
                Treasury (Parts 500--599)
        VI  Bureau of Engraving and Printing, Department of the 
                Treasury (Parts 600--699)
       VII  Federal Law Enforcement Training Center, Department of 
                the Treasury (Parts 700--799)
      VIII  Office of International Investment, Department of the 
                Treasury (Parts 800--899)
        IX  Federal Claims Collection Standards (Department of the 
                Treasury--Department of Justice) (Parts 900--999)

                      Title 32--National Defense

            Subtitle A--Department of Defense
         I  Office of the Secretary of Defense (Parts 1--399)
         V  Department of the Army (Parts 400--699)
        VI  Department of the Navy (Parts 700--799)
       VII  Department of the Air Force (Parts 800--1099)
            Subtitle B--Other Regulations Relating to National 
                Defense
       XII  Defense Logistics Agency (Parts 1200--1299)
       XVI  Selective Service System (Parts 1600--1699)
     XVIII  National Counterintelligence Center (Parts 1800--1899)
       XIX  Central Intelligence Agency (Parts 1900--1999)
        XX  Information Security Oversight Office, National 
                Archives and Records Administration (Parts 2000--
                2099)
       XXI  National Security Council (Parts 2100--2199)
      XXIV  Office of Science and Technology Policy (Parts 2400--
                2499)
     XXVII  Office for Micronesian Status Negotiations (Parts 
                2700--2799)

[[Page 712]]

    XXVIII  Office of the Vice President of the United States 
                (Parts 2800--2899)

               Title 33--Navigation and Navigable Waters

         I  Coast Guard, Department of Homeland Security (Parts 
                1--199)
        II  Corps of Engineers, Department of the Army (Parts 
                200--399)
        IV  Saint Lawrence Seaway Development Corporation, 
                Department of Transportation (Parts 400--499)

                          Title 34--Education

            Subtitle A--Office of the Secretary, Department of 
                Education (Parts 1--99)
            Subtitle B--Regulations of the Offices of the 
                Department of Education
         I  Office for Civil Rights, Department of Education 
                (Parts 100--199)
        II  Office of Elementary and Secondary Education, 
                Department of Education (Parts 200--299)
       III  Office of Special Education and Rehabilitative 
                Services, Department of Education (Parts 300--399)
        IV  Office of Vocational and Adult Education, Department 
                of Education (Parts 400--499)
         V  Office of Bilingual Education and Minority Languages 
                Affairs, Department of Education (Parts 500--599)
        VI  Office of Postsecondary Education, Department of 
                Education (Parts 600--699)
        XI  National Institute for Literacy (Parts 1100--1199)
            Subtitle C--Regulations Relating to Education
       XII  National Council on Disability (Parts 1200--1299)

                          Title 35 [Reserved]

             Title 36--Parks, Forests, and Public Property

         I  National Park Service, Department of the Interior 
                (Parts 1--199)
        II  Forest Service, Department of Agriculture (Parts 200--
                299)
       III  Corps of Engineers, Department of the Army (Parts 
                300--399)
        IV  American Battle Monuments Commission (Parts 400--499)
         V  Smithsonian Institution (Parts 500--599)
       VII  Library of Congress (Parts 700--799)
      VIII  Advisory Council on Historic Preservation (Parts 800--
                899)
        IX  Pennsylvania Avenue Development Corporation (Parts 
                900--999)
         X  Presidio Trust (Parts 1000--1099)
        XI  Architectural and Transportation Barriers Compliance 
                Board (Parts 1100--1199)
       XII  National Archives and Records Administration (Parts 
                1200--1299)
        XV  Oklahoma City National Memorial Trust (Part 1501)

[[Page 713]]

       XVI  Morris K. Udall Scholarship and Excellence in National 
                Environmental Policy Foundation (Parts 1600--1699)

             Title 37--Patents, Trademarks, and Copyrights

         I  United States Patent and Trademark Office, Department 
                of Commerce (Parts 1--199)
        II  Copyright Office, Library of Congress (Parts 200--299)
       III  Copyright Royalty Board, Library of Congress (Parts 
                301--399)
        IV  Assistant Secretary for Technology Policy, Department 
                of Commerce (Parts 400--499)
         V  Under Secretary for Technology, Department of Commerce 
                (Parts 500--599)

           Title 38--Pensions, Bonuses, and Veterans' Relief

         I  Department of Veterans Affairs (Parts 0--99)

                       Title 39--Postal Service

         I  United States Postal Service (Parts 1--999)
       III  Postal Rate Commission (Parts 3000--3099)

                  Title 40--Protection of Environment

         I  Environmental Protection Agency (Parts 1--1099)
        IV  Environmental Protection Agency and Department of 
                Justice (Parts 1400--1499)
         V  Council on Environmental Quality (Parts 1500--1599)
        VI  Chemical Safety and Hazard Investigation Board (Parts 
                1600--1699)
       VII  Environmental Protection Agency and Department of 
                Defense; Uniform National Discharge Standards for 
                Vessels of the Armed Forces (Parts 1700--1799)

          Title 41--Public Contracts and Property Management

            Subtitle B--Other Provisions Relating to Public 
                Contracts
        50  Public Contracts, Department of Labor (Parts 50-1--50-
                999)
        51  Committee for Purchase From People Who Are Blind or 
                Severely Disabled (Parts 51-1--51-99)
        60  Office of Federal Contract Compliance Programs, Equal 
                Employment Opportunity, Department of Labor (Parts 
                60-1--60-999)
        61  Office of the Assistant Secretary for Veterans' 
                Employment and Training Service, Department of 
                Labor (Parts 61-1--61-999)
            Subtitle C--Federal Property Management Regulations 
                System
       101  Federal Property Management Regulations (Parts 101-1--
                101-99)
       102  Federal Management Regulation (Parts 102-1--102-299)

[[Page 714]]

       105  General Services Administration (Parts 105-1--105-999)
       109  Department of Energy Property Management Regulations 
                (Parts 109-1--109-99)
       114  Department of the Interior (Parts 114-1--114-99)
       115  Environmental Protection Agency (Parts 115-1--115-99)
       128  Department of Justice (Parts 128-1--128-99)
            Subtitle D--Other Provisions Relating to Property 
                Management [Reserved]
            Subtitle E--Federal Information Resources Management 
                Regulations System
       201  Federal Information Resources Management Regulation 
                (Parts 201-1--201-99) [Reserved]
            Subtitle F--Federal Travel Regulation System
       300  General (Parts 300-1--300-99)
       301  Temporary Duty (TDY) Travel Allowances (Parts 301-1--
                301-99)
       302  Relocation Allowances (Parts 302-1--302-99)
       303  Payment of Expenses Connected with the Death of 
                Certain Employees (Part 303-1--303-99)
       304  Payment of Travel Expenses from a Non-Federal Source 
                (Parts 304-1--304-99)

                        Title 42--Public Health

         I  Public Health Service, Department of Health and Human 
                Services (Parts 1--199)
        IV  Centers for Medicare & Medicaid Services, Department 
                of Health and Human Services (Parts 400--499)
         V  Office of Inspector General-Health Care, Department of 
                Health and Human Services (Parts 1000--1999)

                   Title 43--Public Lands: Interior

            Subtitle A--Office of the Secretary of the Interior 
                (Parts 1--199)
            Subtitle B--Regulations Relating to Public Lands
         I  Bureau of Reclamation, Department of the Interior 
                (Parts 200--499)
        II  Bureau of Land Management, Department of the Interior 
                (Parts 1000--9999)
       III  Utah Reclamation Mitigation and Conservation 
                Commission (Parts 10000--10010)

             Title 44--Emergency Management and Assistance

         I  Federal Emergency Management Agency, Department of 
                Homeland Security (Parts 0--399)
        IV  Department of Commerce and Department of 
                Transportation (Parts 400--499)

[[Page 715]]

                       Title 45--Public Welfare

            Subtitle A--Department of Health and Human Services 
                (Parts 1--199)
            Subtitle B--Regulations Relating to Public Welfare
        II  Office of Family Assistance (Assistance Programs), 
                Administration for Children and Families, 
                Department of Health and Human Services (Parts 
                200--299)
       III  Office of Child Support Enforcement (Child Support 
                Enforcement Program), Administration for Children 
                and Families, Department of Health and Human 
                Services (Parts 300--399)
        IV  Office of Refugee Resettlement, Administration for 
                Children and Families, Department of Health and 
                Human Services (Parts 400--499)
         V  Foreign Claims Settlement Commission of the United 
                States, Department of Justice (Parts 500--599)
        VI  National Science Foundation (Parts 600--699)
       VII  Commission on Civil Rights (Parts 700--799)
      VIII  Office of Personnel Management (Parts 800--899)
         X  Office of Community Services, Administration for 
                Children and Families, Department of Health and 
                Human Services (Parts 1000--1099)
        XI  National Foundation on the Arts and the Humanities 
                (Parts 1100--1199)
       XII  Corporation for National and Community Service (Parts 
                1200--1299)
      XIII  Office of Human Development Services, Department of 
                Health and Human Services (Parts 1300--1399)
       XVI  Legal Services Corporation (Parts 1600--1699)
      XVII  National Commission on Libraries and Information 
                Science (Parts 1700--1799)
     XVIII  Harry S. Truman Scholarship Foundation (Parts 1800--
                1899)
       XXI  Commission on Fine Arts (Parts 2100--2199)
     XXIII  Arctic Research Commission (Part 2301)
      XXIV  James Madison Memorial Fellowship Foundation (Parts 
                2400--2499)
       XXV  Corporation for National and Community Service (Parts 
                2500--2599)

                          Title 46--Shipping

         I  Coast Guard, Department of Homeland Security (Parts 
                1--199)
        II  Maritime Administration, Department of Transportation 
                (Parts 200--399)
       III  Coast Guard (Great Lakes Pilotage), Department of 
                Homeland Security (Parts 400--499)
        IV  Federal Maritime Commission (Parts 500--599)

                      Title 47--Telecommunication

         I  Federal Communications Commission (Parts 0--199)

[[Page 716]]

        II  Office of Science and Technology Policy and National 
                Security Council (Parts 200--299)
       III  National Telecommunications and Information 
                Administration, Department of Commerce (Parts 
                300--399)

           Title 48--Federal Acquisition Regulations System

         1  Federal Acquisition Regulation (Parts 1--99)
         2  Defense Acquisition Regulations System, Department of 
                Defense (Parts 200--299)
         3  Department of Health and Human Services (Parts 300--
                399)
         4  Department of Agriculture (Parts 400--499)
         5  General Services Administration (Parts 500--599)
         6  Department of State (Parts 600--699)
         7  United States Agency for International Development 
                (Parts 700--799)
         8  Department of Veterans Affairs (Parts 800--899)
         9  Department of Energy (Parts 900--999)
        10  Department of the Treasury (Parts 1000--1099)
        12  Department of Transportation (Parts 1200--1299)
        13  Department of Commerce (Parts 1300--1399)
        14  Department of the Interior (Parts 1400--1499)
        15  Environmental Protection Agency (Parts 1500--1599)
        16  Office of Personnel Management, Federal Employees 
                Health Benefits Acquisition Regulation (Parts 
                1600--1699)
        17  Office of Personnel Management (Parts 1700--1799)
        18  National Aeronautics and Space Administration (Parts 
                1800--1899)
        19  Broadcasting Board of Governors (Parts 1900--1999)
        20  Nuclear Regulatory Commission (Parts 2000--2099)
        21  Office of Personnel Management, Federal Employees' 
                Group Life Insurance Federal Acquisition 
                Regulation (Parts 2100--2199)
        23  Social Security Administration (Parts 2300--2399)
        24  Department of Housing and Urban Development (Parts 
                2400--2499)
        25  National Science Foundation (Parts 2500--2599)
        28  Department of Justice (Parts 2800--2899)
        29  Department of Labor (Parts 2900--2999)
        30  Department of Homeland Security, Homeland Security 
                Acquisition Regulation (HSAR) (Parts 3000--3099)
        34  Department of Education Acquisition Regulation (Parts 
                3400--3499)
        35  [Reserved]
        44  Federal Emergency Management Agency (Parts 4400--4499)
        51  Department of the Army Acquisition Regulations (Parts 
                5100--5199)

[[Page 717]]

        52  Department of the Navy Acquisition Regulations (Parts 
                5200--5299)
        53  Department of the Air Force Federal Acquisition 
                Regulation Supplement (Parts 5300--5399)
        54  Defense Logistics Agency, Department of Defense (Parts 
                5400--5499)
        57  African Development Foundation (Parts 5700--5799)
        61  General Services Administration Board of Contract 
                Appeals (Parts 6100--6199)
        63  Department of Transportation Board of Contract Appeals 
                (Parts 6300--6399)
        99  Cost Accounting Standards Board, Office of Federal 
                Procurement Policy, Office of Management and 
                Budget (Parts 9900--9999)

                       Title 49--Transportation

            Subtitle A--Office of the Secretary of Transportation 
                (Parts 1--99)
            Subtitle B--Other Regulations Relating to 
                Transportation
         I  Pipeline and Hazardous Materials Safety 
                Administration, Department of Transportation 
                (Parts 100--199)
        II  Federal Railroad Administration, Department of 
                Transportation (Parts 200--299)
       III  Federal Motor Carrier Safety Administration, 
                Department of Transportation (Parts 300--399)
        IV  Coast Guard, Department of Homeland Security (Parts 
                400--499)
         V  National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 500--599)
        VI  Federal Transit Administration, Department of 
                Transportation (Parts 600--699)
       VII  National Railroad Passenger Corporation (AMTRAK) 
                (Parts 700--799)
      VIII  National Transportation Safety Board (Parts 800--999)
         X  Surface Transportation Board, Department of 
                Transportation (Parts 1000--1399)
        XI  Research and Innovative Technology Administration, 
                Department of Transportation (Parts 1400--1499)
       XII  Transportation Security Administration, Department of 
                Homeland Security (Parts 1500--1699)

                   Title 50--Wildlife and Fisheries

         I  United States Fish and Wildlife Service, Department of 
                the Interior (Parts 1--199)
        II  National Marine Fisheries Service, National Oceanic 
                and Atmospheric Administration, Department of 
                Commerce (Parts 200--299)
       III  International Fishing and Related Activities (Parts 
                300--399)

[[Page 718]]

        IV  Joint Regulations (United States Fish and Wildlife 
                Service, Department of the Interior and National 
                Marine Fisheries Service, National Oceanic and 
                Atmospheric Administration, Department of 
                Commerce); Endangered Species Committee 
                Regulations (Parts 400--499)
         V  Marine Mammal Commission (Parts 500--599)
        VI  Fishery Conservation and Management, National Oceanic 
                and Atmospheric Administration, Department of 
                Commerce (Parts 600--699)

                      CFR Index and Finding Aids

            Subject/Agency Index
            List of Agency Prepared Indexes
            Parallel Tables of Statutory Authorities and Rules
            List of CFR Titles, Chapters, Subchapters, and Parts
            Alphabetical List of Agencies Appearing in the CFR

[[Page 719]]





           Alphabetical List of Agencies Appearing in the CFR




                      (Revised as of April 1, 2006)

                                                  CFR Title, Subtitle or 
                     Agency                               Chapter

Administrative Committee of the Federal Register  1, I
Advanced Research Projects Agency                 32, I
Advisory Council on Historic Preservation         36, VIII
African Development Foundation                    22, XV
  Federal Acquisition Regulation                  48, 57
Agency for International Development, United      22, II
     States
  Federal Acquisition Regulation                  48, 7
Agricultural Marketing Service                    7, I, IX, X, XI
Agricultural Research Service                     7, V
Agriculture Department                            5, LXXIII
  Agricultural Marketing Service                  7, I, IX, X, XI
  Agricultural Research Service                   7, V
  Animal and Plant Health Inspection Service      7, III; 9, I
  Chief Financial Officer, Office of              7, XXX
  Commodity Credit Corporation                    7, XIV
  Cooperative State Research, Education, and      7, XXXIV
       Extension Service
  Economic Research Service                       7, XXXVII
  Energy, Office of                               7, XXIX
  Environmental Quality, Office of                7, XXXI
  Farm Service Agency                             7, VII, XVIII
  Federal Acquisition Regulation                  48, 4
  Federal Crop Insurance Corporation              7, IV
  Food and Nutrition Service                      7, II
  Food Safety and Inspection Service              9, III
  Foreign Agricultural Service                    7, XV
  Forest Service                                  36, II
  Grain Inspection, Packers and Stockyards        7, VIII; 9, II
       Administration
  Information Resources Management, Office of     7, XXVII
  Inspector General, Office of                    7, XXVI
  National Agricultural Library                   7, XLI
  National Agricultural Statistics Service        7, XXXVI
  Natural Resources Conservation Service          7, VI
  Operations, Office of                           7, XXVIII
  Procurement and Property Management, Office of  7, XXXII
  Rural Business-Cooperative Service              7, XVIII, XLII
  Rural Development Administration                7, XLII
  Rural Housing Service                           7, XVIII, XXXV
  Rural Telephone Bank                            7, XVI
  Rural Utilities Service                         7, XVII, XVIII, XLII
  Secretary of Agriculture, Office of             7, Subtitle A
  Transportation, Office of                       7, XXXIII
  World Agricultural Outlook Board                7, XXXVIII
Air Force Department                              32, VII
  Federal Acquisition Regulation Supplement       48, 53
Air Transportation Stabilization Board            14, VI
Alcohol and Tobacco Tax and Trade Bureau          27, I
Alcohol, Tobacco, Firearms, and Explosives,       27, II
     Bureau of
AMTRAK                                            49, VII
American Battle Monuments Commission              36, IV
American Indians, Office of the Special Trustee   25, VII
Animal and Plant Health Inspection Service        7, III; 9, I
Appalachian Regional Commission                   5, IX

[[Page 720]]

Architectural and Transportation Barriers         36, XI
     Compliance Board
Arctic Research Commission                        45, XXIII
Armed Forces Retirement Home                      5, XI
Army Department                                   32, V
  Engineers, Corps of                             33, II; 36, III
  Federal Acquisition Regulation                  48, 51
Benefits Review Board                             20, VII
Bilingual Education and Minority Languages        34, V
     Affairs, Office of
Blind or Severely Disabled, Committee for         41, 51
     Purchase From People Who Are
Broadcasting Board of Governors                   22, V
  Federal Acquisition Regulation                  48, 19
Census Bureau                                     15, I
Centers for Medicare & Medicaid Services          42, IV
Central Intelligence Agency                       32, XIX
Chief Financial Officer, Office of                7, XXX
Child Support Enforcement, Office of              45, III
Children and Families, Administration for         45, II, III, IV, X
Civil Rights, Commission on                       45, VII
Civil Rights, Office for                          34, I
Coast Guard                                       33, I; 46, I; 49, IV
Coast Guard (Great Lakes Pilotage)                46, III
Commerce Department                               44, IV
  Census Bureau                                   15, I
  Economic Affairs, Under Secretary               37, V
  Economic Analysis, Bureau of                    15, VIII
  Economic Development Administration             13, III
  Emergency Management and Assistance             44, IV
  Federal Acquisition Regulation                  48, 13
  Fishery Conservation and Management             50, VI
  Foreign-Trade Zones Board                       15, IV
  Industry and Security, Bureau of                15, VII
  International Trade Administration              15, III; 19, III
  National Institute of Standards and Technology  15, II
  National Marine Fisheries Service               50, II, IV, VI
  National Oceanic and Atmospheric                15, IX; 50, II, III, IV, 
       Administration                             VI
  National Telecommunications and Information     15, XXIII; 47, III
       Administration
  National Weather Service                        15, IX
  Patent and Trademark Office, United States      37, I
  Productivity, Technology and Innovation,        37, IV
       Assistant Secretary for
  Secretary of Commerce, Office of                15, Subtitle A
  Technology, Under Secretary for                 37, V
  Technology Administration                       15, XI
  Technology Policy, Assistant Secretary for      37, IV
Commercial Space Transportation                   14, III
Commodity Credit Corporation                      7, XIV
Commodity Futures Trading Commission              5, XLI; 17, I
Community Planning and Development, Office of     24, V, VI
     Assistant Secretary for
Community Services, Office of                     45, X
Comptroller of the Currency                       12, I
Construction Industry Collective Bargaining       29, IX
     Commission
Consumer Product Safety Commission                5, LXXI; 16, II
Cooperative State Research, Education, and        7, XXXIV
     Extension Service
Copyright Office                                  37, II
Copyright Royalty Board                           37, III
Corporation for National and Community Service    45, XII, XXV
Cost Accounting Standards Board                   48, 99
Council on Environmental Quality                  40, V
Court Services and Offender Supervision Agency    28, VIII
     for the District of Columbia
Customs and Border Protection Bureau              19, I
Defense Contract Audit Agency                     32, I
Defense Department                                5, XXVI; 32, Subtitle A; 
                                                  40, VII

[[Page 721]]

  Advanced Research Projects Agency               32, I
  Air Force Department                            32, VII
  Army Department                                 32, V; 33, II; 36, III, 
                                                  48, 51
  Defense Acquisition Regulations System          48, II
  Defense Intelligence Agency                     32, I
  Defense Logistics Agency                        32, I, XII; 48, 54
  Engineers, Corps of                             33, II; 36, III
  National Imagery and Mapping Agency             32, I
  Navy Department                                 32, VI; 48, 52
  Secretary of Defense, Office of                 32, I
Defense Contract Audit Agency                     32, I
Defense Intelligence Agency                       32, I
Defense Logistics Agency                          32, XII; 48, 54
Defense Nuclear Facilities Safety Board           10, XVII
Delaware River Basin Commission                   18, III
District of Columbia, Court Services and          28, VIII
     Offender Supervision Agency for the
Drug Enforcement Administration                   21, II
East-West Foreign Trade Board                     15, XIII
Economic Affairs, Under Secretary                 37, V
Economic Analysis, Bureau of                      15, VIII
Economic Development Administration               13, III
Economic Research Service                         7, XXXVII
Education, Department of                          5, LIII
  Bilingual Education and Minority Languages      34, V
       Affairs, Office of
  Civil Rights, Office for                        34, I
  Educational Research and Improvement, Office    34, VII
       of
  Elementary and Secondary Education, Office of   34, II
  Federal Acquisition Regulation                  48, 34
  Postsecondary Education, Office of              34, VI
  Secretary of Education, Office of               34, Subtitle A
  Special Education and Rehabilitative Services,  34, III
       Office of
  Vocational and Adult Education, Office of       34, IV
Educational Research and Improvement, Office of   34, VII
Elementary and Secondary Education, Office of     34, II
Emergency Oil and Gas Guaranteed Loan Board       13, V
Emergency Steel Guarantee Loan Board              13, IV
Employee Benefits Security Administration         29, XXV
Employees' Compensation Appeals Board             20, IV
Employees Loyalty Board                           5, V
Employment and Training Administration            20, V
Employment Standards Administration               20, VI
Endangered Species Committee                      50, IV
Energy, Department of                             5, XXIII; 10, II, III, X
  Federal Acquisition Regulation                  48, 9
  Federal Energy Regulatory Commission            5, XXIV; 18, I
  Property Management Regulations                 41, 109
Energy, Office of                                 7, XXIX
Engineers, Corps of                               33, II; 36, III
Engraving and Printing, Bureau of                 31, VI
Environmental Protection Agency                   5, LIV; 40, I, IV, VII
  Federal Acquisition Regulation                  48, 15
  Property Management Regulations                 41, 115
Environmental Quality, Office of                  7, XXXI
Equal Employment Opportunity Commission           5, LXII; 29, XIV
Equal Opportunity, Office of Assistant Secretary  24, I
     for
Executive Office of the President                 3, I
  Administration, Office of                       5, XV
  Environmental Quality, Council on               40, V
  Management and Budget, Office of                5, III, LXXVII; 14, VI; 
                                                  48, 99
  National Drug Control Policy, Office of         21, III
  National Security Council                       32, XXI; 47, 2
  Presidential Documents                          3
  Science and Technology Policy, Office of        32, XXIV; 47, II

[[Page 722]]

  Trade Representative, Office of the United      15, XX
       States
Export-Import Bank of the United States           5, LII; 12, IV
Family Assistance, Office of                      45, II
Farm Credit Administration                        5, XXXI; 12, VI
Farm Credit System Insurance Corporation          5, XXX; 12, XIV
Farm Service Agency                               7, VII, XVIII
Federal Acquisition Regulation                    48, 1
Federal Aviation Administration                   14, I
  Commercial Space Transportation                 14, III
Federal Claims Collection Standards               31, IX
Federal Communications Commission                 5, XXIX; 47, I
Federal Contract Compliance Programs, Office of   41, 60
Federal Crop Insurance Corporation                7, IV
Federal Deposit Insurance Corporation             5, XXII; 12, III
Federal Election Commission                       11, I
Federal Emergency Management Agency               44, I
  Federal Acquisition Regulation                  48, 44
Federal Employees Group Life Insurance Federal    48, 21
     Acquisition Regulation
Federal Employees Health Benefits Acquisition     48, 16
     Regulation
Federal Energy Regulatory Commission              5, XXIV; 18, I
Federal Financial Institutions Examination        12, XI
     Council
Federal Financing Bank                            12, VIII
Federal Highway Administration                    23, I, II
Federal Home Loan Mortgage Corporation            1, IV
Federal Housing Enterprise Oversight Office       12, XVII
Federal Housing Finance Board                     12, IX
Federal Labor Relations Authority, and General    5, XIV; 22, XIV
     Counsel of the Federal Labor Relations 
     Authority
Federal Law Enforcement Training Center           31, VII
Federal Management Regulation                     41, 102
Federal Maritime Commission                       46, IV
Federal Mediation and Conciliation Service        29, XII
Federal Mine Safety and Health Review Commission  5, LXXIV; 29, XXVII
Federal Motor Carrier Safety Administration       49, III
Federal Prison Industries, Inc.                   28, III
Federal Procurement Policy Office                 48, 99
Federal Property Management Regulations           41, 101
Federal Railroad Administration                   49, II
Federal Register, Administrative Committee of     1, I
Federal Register, Office of                       1, II
Federal Reserve System                            12, II
  Board of Governors                              5, LVIII
Federal Retirement Thrift Investment Board        5, VI, LXXVI
Federal Service Impasses Panel                    5, XIV
Federal Trade Commission                          5, XLVII; 16, I
Federal Transit Administration                    49, VI
Federal Travel Regulation System                  41, Subtitle F
Fine Arts, Commission on                          45, XXI
Fiscal Service                                    31, II
Fish and Wildlife Service, United States          50, I, IV
Fishery Conservation and Management               50, VI
Food and Drug Administration                      21, I
Food and Nutrition Service                        7, II
Food Safety and Inspection Service                9, III
Foreign Agricultural Service                      7, XV
Foreign Assets Control, Office of                 31, V
Foreign Claims Settlement Commission of the       45, V
     United States
Foreign Service Grievance Board                   22, IX
Foreign Service Impasse Disputes Panel            22, XIV
Foreign Service Labor Relations Board             22, XIV
Foreign-Trade Zones Board                         15, IV
Forest Service                                    36, II
General Services Administration                   5, LVII; 41, 105
  Contract Appeals, Board of                      48, 61
  Federal Acquisition Regulation                  48, 5
  Federal Management Regulation                   41, 102

[[Page 723]]

  Federal Property Management Regulations         41, 101
  Federal Travel Regulation System                41, Subtitle F
  General                                         41, 300
  Payment From a Non-Federal Source for Travel    41, 304
       Expenses
  Payment of Expenses Connected With the Death    41, 303
       of Certain Employees
  Relocation Allowances                           41, 302
  Temporary Duty (TDY) Travel Allowances          41, 301
Geological Survey                                 30, IV
Government Accountability Office                  4, I
Government Ethics, Office of                      5, XVI
Government National Mortgage Association          24, III
Grain Inspection, Packers and Stockyards          7, VIII; 9, II
     Administration
Harry S. Truman Scholarship Foundation            45, XVIII
Health and Human Services, Department of          5, XLV; 45, Subtitle A
  Centers for Medicare & Medicaid Services        42, IV
  Child Support Enforcement, Office of            45, III
  Children and Families, Administration for       45, II, III, IV, X
  Community Services, Office of                   45, X
  Defense Acquisition Regulations System          48, 2
  Family Assistance, Office of                    45, II
  Federal Acquisition Regulation                  48, 3
  Food and Drug Administration                    21, I
  Human Development Services, Office of           45, XIII
  Indian Health Service                           25, V; 42, I
  Inspector General (Health Care), Office of      42, V
  Public Health Service                           42, I
  Refugee Resettlement, Office of                 45, IV
Homeland Security, Department of                  6, I
  Coast Guard                                     33, I; 46, I; 49, IV
  Coast Guard (Great Lakes Pilotage)              46, III
  Customs and Border Protection Bureau            19, I
  Federal Emergency Management Agency             44, I
  Immigration and Customs Enforcement Bureau      19, IV
  Immigration and Naturalization                  8, I
  Transportation Security Administration          49, XII
Housing and Urban Development, Department of      5, LXV; 24, Subtitle B
  Community Planning and Development, Office of   24, V, VI
       Assistant Secretary for
  Equal Opportunity, Office of Assistant          24, I
       Secretary for
  Federal Acquisition Regulation                  48, 24
  Federal Housing Enterprise Oversight, Office    12, XVII
       of
  Government National Mortgage Association        24, III
  Housing--Federal Housing Commissioner, Office   24, II, VIII, X, XX
       of Assistant Secretary for
  Housing, Office of, and Multifamily Housing     24, IV
       Assistance Restructuring, Office of
  Inspector General, Office of                    24, XII
  Public and Indian Housing, Office of Assistant  24, IX
       Secretary for
  Secretary, Office of                            24, Subtitle A, VII
Housing--Federal Housing Commissioner, Office of  24, II, VIII, X, XX
     Assistant Secretary for
Housing, Office of, and Multifamily Housing       24, IV
     Assistance Restructuring, Office of
Human Development Services, Office of             45, XIII
Immigration and Customs Enforcement Bureau        19, IV
Immigration and Naturalization                    8, I
Immigration Review, Executive Office for          8, V
Independent Counsel, Office of                    28, VII
Indian Affairs, Bureau of                         25, I, V
Indian Affairs, Office of the Assistant           25, VI
     Secretary
Indian Arts and Crafts Board                      25, II
Indian Health Service                             25, V; 42, I
Industry and Security, Bureau of                  15, VII
Information Resources Management, Office of       7, XXVII
Information Security Oversight Office, National   32, XX
   Archives and Records Administration
[[Page 724]]

Inspector General
  Agriculture Department                          7, XXVI
  Health and Human Services Department            42, V
  Housing and Urban Development Department        24, XII
Institute of Peace, United States                 22, XVII
Inter-American Foundation                         5, LXIII; 22, X
Interior Department
  American Indians, Office of the Special         25, VII
       Trustee
  Endangered Species Committee                    50, IV
  Federal Acquisition Regulation                  48, 14
  Federal Property Management Regulations System  41, 114
  Fish and Wildlife Service, United States        50, I, IV
  Geological Survey                               30, IV
  Indian Affairs, Bureau of                       25, I, V
  Indian Affairs, Office of the Assistant         25, VI
       Secretary
  Indian Arts and Crafts Board                    25, II
  Land Management, Bureau of                      43, II
  Minerals Management Service                     30, II
  National Indian Gaming Commission               25, III
  National Park Service                           36, I
  Reclamation, Bureau of                          43, I
  Secretary of the Interior, Office of            43, Subtitle A
  Surface Mining and Reclamation Appeals, Board   30, III
       of
  Surface Mining Reclamation and Enforcement,     30, VII
       Office of
Internal Revenue Service                          26, I
International Boundary and Water Commission,      22, XI
     United States and Mexico, United States 
     Section
International Development, United States Agency   22, II
     for
  Federal Acquisition Regulation                  48, 7
International Development Cooperation Agency,     22, XII
     United States
International Fishing and Related Activities      50, III
International Investment, Office of               31, VIII
International Joint Commission, United States     22, IV
     and Canada
International Organizations Employees Loyalty     5, V
     Board
International Trade Administration                15, III; 19, III
International Trade Commission, United States     19, II
Interstate Commerce Commission                    5, XL
James Madison Memorial Fellowship Foundation      45, XXIV
Japan-United States Friendship Commission         22, XVI
Joint Board for the Enrollment of Actuaries       20, VIII
Justice Department                                5, XXVIII; 28, I, XI; 40, 
                                                  IV
  Alcohol, Tobacco, Firearms, and Explosives,     27, II
       Bureau of
  Drug Enforcement Administration                 21, II
  Federal Acquisition Regulation                  48, 28
  Federal Claims Collection Standards             31, IX
  Federal Prison Industries, Inc.                 28, III
  Foreign Claims Settlement Commission of the     45, V
       United States
  Immigration Review, Executive Office for        8, V
  Offices of Independent Counsel                  28, VI
  Prisons, Bureau of                              28, V
  Property Management Regulations                 41, 128
Labor Department                                  5, XLII
  Benefits Review Board                           20, VII
  Employee Benefits Security Administration       29, XXV
  Employees' Compensation Appeals Board           20, IV
  Employment and Training Administration          20, V
  Employment Standards Administration             20, VI
  Federal Acquisition Regulation                  48, 29
  Federal Contract Compliance Programs, Office    41, 60
       of
  Federal Procurement Regulations System          41, 50
  Labor-Management Standards, Office of           29, II, IV
  Mine Safety and Health Administration           30, I
  Occupational Safety and Health Administration   29, XVII
  Public Contracts                                41, 50

[[Page 725]]

  Secretary of Labor, Office of                   29, Subtitle A
  Veterans' Employment and Training Service,      41, 61; 20, IX
       Office of the Assistant Secretary for
  Wage and Hour Division                          29, V
  Workers' Compensation Programs, Office of       20, I
Labor-Management Standards, Office of             29, II, IV
Land Management, Bureau of                        43, II
Legal Services Corporation                        45, XVI
Library of Congress                               36, VII
  Copyright Office                                37, II
  Copyright Royalty Board                         37, III
Local Television Loan Guarantee Board             7, XX
Management and Budget, Office of                  5, III, LXXVII; 14, VI; 
                                                  48, 99
Marine Mammal Commission                          50, V
Maritime Administration                           46, II
Merit Systems Protection Board                    5, II
Micronesian Status Negotiations, Office for       32, XXVII
Mine Safety and Health Administration             30, I
Minerals Management Service                       30, II
Minority Business Development Agency              15, XIV
Miscellaneous Agencies                            1, IV
Monetary Offices                                  31, I
Morris K. Udall Scholarship and Excellence in     36, XVI
     National Environmental Policy Foundation
National Aeronautics and Space Administration     5, LIX; 14, V
  Federal Acquisition Regulation                  48, 18
National Agricultural Library                     7, XLI
National Agricultural Statistics Service          7, XXXVI
National and Community Service, Corporation for   45, XII, XXV
National Archives and Records Administration      5, LXVI; 36, XII
  Information Security Oversight Office           32, XX
National Bureau of Standards                      15, II
National Capital Planning Commission              1, IV
National Commission for Employment Policy         1, IV
National Commission on Libraries and Information  45, XVII
     Science
National Council on Disability                    34, XII
National Counterintelligence Center               32, XVIII
National Credit Union Administration              12, VII
National Crime Prevention and Privacy Compact     28, IX
     Council
National Drug Control Policy, Office of           21, III
National Foundation on the Arts and the           45, XI
     Humanities
National Highway Traffic Safety Administration    23, II, III; 49, V
National Imagery and Mapping Agency               32, I
National Indian Gaming Commission                 25, III
National Institute for Literacy                   34, XI
National Institute of Standards and Technology    15, II
National Labor Relations Board                    5, LXI; 29, I
National Marine Fisheries Service                 50, II, IV, VI
National Mediation Board                          29, X
National Oceanic and Atmospheric Administration   15, IX; 50, II, III, IV, 
                                                  VI
National Park Service                             36, I
National Railroad Adjustment Board                29, III
National Railroad Passenger Corporation (AMTRAK)  49, VII
National Science Foundation                       5, XLIII; 45, VI
  Federal Acquisition Regulation                  48, 25
National Security Council                         32, XXI
National Security Council and Office of Science   47, II
     and Technology Policy
National Telecommunications and Information       15, XXIII; 47, III
     Administration
National Transportation Safety Board              49, VIII
National Weather Service                          15, IX
Natural Resources Conservation Service            7, VI
Navajo and Hopi Indian Relocation, Office of      25, IV
Navy Department                                   32, VI
  Federal Acquisition Regulation                  48, 52

[[Page 726]]

Neighborhood Reinvestment Corporation             24, XXV
Northeast Interstate Low-Level Radioactive Waste  10, XVIII
     Commission
Nuclear Regulatory Commission                     5, XLVIII; 10, I
  Federal Acquisition Regulation                  48, 20
Occupational Safety and Health Administration     29, XVII
Occupational Safety and Health Review Commission  29, XX
Offices of Independent Counsel                    28, VI
Oklahoma City National Memorial Trust             36, XV
Operations Office                                 7, XXVIII
Overseas Private Investment Corporation           5, XXXIII; 22, VII
Patent and Trademark Office, United States        37, I
Payment From a Non-Federal Source for Travel      41, 304
     Expenses
Payment of Expenses Connected With the Death of   41, 303
     Certain Employees
Peace Corps                                       22, III
Pennsylvania Avenue Development Corporation       36, IX
Pension Benefit Guaranty Corporation              29, XL
Personnel Management, Office of                   5, I, XXXV; 45, VIII
  Federal Acquisition Regulation                  48, 17
  Federal Employees Group Life Insurance Federal  48, 21
       Acquisition Regulation
  Federal Employees Health Benefits Acquisition   48, 16
       Regulation
Pipeline and Hazardous Materials Safety           49, I
     Administration
Postal Rate Commission                            5, XLVI; 39, III
Postal Service, United States                     5, LX; 39, I
Postsecondary Education, Office of                34, VI
President's Commission on White House             1, IV
     Fellowships
Presidential Documents                            3
Presidio Trust                                    36, X
Prisons, Bureau of                                28, V
Procurement and Property Management, Office of    7, XXXII
Productivity, Technology and Innovation,          37, IV
     Assistant Secretary
Public Contracts, Department of Labor             41, 50
Public and Indian Housing, Office of Assistant    24, IX
     Secretary for
Public Health Service                             42, I
Railroad Retirement Board                         20, II
Reclamation, Bureau of                            43, I
Refugee Resettlement, Office of                   45, IV
Regional Action Planning Commissions              13, V
Relocation Allowances                             41, 302
Research and Innovative Technology                49, XI
     Administration
Rural Business-Cooperative Service                7, XVIII, XLII
Rural Development Administration                  7, XLII
Rural Housing Service                             7, XVIII, XXXV
Rural Telephone Bank                              7, XVI
Rural Utilities Service                           7, XVII, XVIII, XLII
Saint Lawrence Seaway Development Corporation     33, IV
Science and Technology Policy, Office of          32, XXIV
Science and Technology Policy, Office of, and     47, II
     National Security Council
Secret Service                                    31, IV
Securities and Exchange Commission                17, II
Selective Service System                          32, XVI
Small Business Administration                     13, I
Smithsonian Institution                           36, V
Social Security Administration                    20, III; 48, 23
Soldiers' and Airmen's Home, United States        5, XI
Special Counsel, Office of                        5, VIII
Special Education and Rehabilitative Services,    34, III
     Office of
State Department                                  22, I; 28, XI
  Federal Acquisition Regulation                  48, 6
Surface Mining and Reclamation Appeals, Board of  30, III
Surface Mining Reclamation and Enforcement,       30, VII
     Office of
Surface Transportation Board                      49, X
Susquehanna River Basin Commission                18, VIII

[[Page 727]]

Technology Administration                         15, XI
Technology Policy, Assistant Secretary for        37, IV
Technology, Under Secretary for                   37, V
Tennessee Valley Authority                        5, LXIX; 18, XIII
Thrift Supervision Office, Department of the      12, V
     Treasury
Trade Representative, United States, Office of    15, XX
Transportation, Department of                     5, L
  Commercial Space Transportation                 14, III
  Contract Appeals, Board of                      48, 63
  Emergency Management and Assistance             44, IV
  Federal Acquisition Regulation                  48, 12
  Federal Aviation Administration                 14, I
  Federal Highway Administration                  23, I, II
  Federal Motor Carrier Safety Administration     49, III
  Federal Railroad Administration                 49, II
  Federal Transit Administration                  49, VI
  Maritime Administration                         46, II
  National Highway Traffic Safety Administration  23, II, III; 49, V
  Pipeline and Hazardous Materials Safety         49, I
       Administration
  Saint Lawrence Seaway Development Corporation   33, IV
  Secretary of Transportation, Office of          14, II; 49, Subtitle A
  Surface Transportation Board                    49, X
  Transportation Statistics Bureau                49, XI
Transportation, Office of                         7, XXXIII
Transportation Security Administration            49, XII
Transportation Statistics Bureau                  49, XI
Travel Allowances, Temporary Duty (TDY)           41, 301
Treasury Department                               5, XXI; 12, XV; 17, IV; 
                                                  31, IX
  Alcohol and Tobacco Tax and Trade Bureau        27, I
  Community Development Financial Institutions    12, XVIII
       Fund
  Comptroller of the Currency                     12, I
  Customs and Border Protection Bureau            19, I
  Engraving and Printing, Bureau of               31, VI
  Federal Acquisition Regulation                  48, 10
  Federal Law Enforcement Training Center         31, VII
  Fiscal Service                                  31, II
  Foreign Assets Control, Office of               31, V
  Internal Revenue Service                        26, I
  International Investment, Office of             31, VIII
  Monetary Offices                                31, I
  Secret Service                                  31, IV
  Secretary of the Treasury, Office of            31, Subtitle A
  Thrift Supervision, Office of                   12, V
Truman, Harry S. Scholarship Foundation           45, XVIII
United States and Canada, International Joint     22, IV
     Commission
United States and Mexico, International Boundary  22, XI
     and Water Commission, United States Section
Utah Reclamation Mitigation and Conservation      43, III
     Commission
Veterans Affairs Department                       38, I
  Federal Acquisition Regulation                  48, 8
Veterans' Employment and Training Service,        41, 61; 20, IX
     Office of the Assistant Secretary for
Vice President of the United States, Office of    32, XXVIII
Vocational and Adult Education, Office of         34, IV
Wage and Hour Division                            29, V
Water Resources Council                           18, VI
Workers' Compensation Programs, Office of         20, I
World Agricultural Outlook Board                  7, XXXVIII

[[Page 729]]







                      Table of OMB Control Numbers



The OMB control numbers for chapter I of title 26 were consolidated into 
Sec. Sec.  601.9000 and 602.101 at 50 FR 10221, Mar. 14, 1985. At 61 FR 
58008, Nov. 12, 1996, Sec.  601.9000 was removed. Section 602.101 is 
reprinted below for the convenience of the user.

Sec.  602.101  OMB Control numbers.

    (a) Purpose. This part collects and displays the control numbers 
assigned to collections of information in Internal Revenue Service 
regulations by the Office of Management and Budget (OMB) under the 
Paperwork Reduction Act of 1980. The Internal Revenue Service intends 
that this part comply with the requirements of Sec. Sec.  1320.7(f), 
1320.12, 1320.13, and 1320.14 of 5 CFR part 1320 (OMB regulations 
implementing the Paperwork Reduction Act), for the display of control 
numbers assigned by OMB to collections of information in Internal 
Revenue Service regulations. This part does not display control numbers 
assigned by the Office of Management and Budget to collections of 
information of the Bureau of Alcohol, Tobacco, and Firearms.
    (b) Display.

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
1.1(h)-1(e)................................................    1545-1654
1.23-5.....................................................    1545-0074
1.25-1T....................................................    1545-0922
                                                               1545-0930
1.25-2T....................................................    1545-0922
                                                               1545-0930
1.25-3T....................................................    1545-0922
                                                               1545-0930
1.25-4T....................................................    1545-0922
1.25-5T....................................................    1545-0922
1.25-6T....................................................    1545-0922
1.25-7T....................................................    1545-0922
1.25-8T....................................................    1545-0922
1.25A-1....................................................    1545-1630
1.28-1.....................................................    1545-0619
1.31-2.....................................................    1545-0074
1.32-2.....................................................    1545-0074
1.32-3.....................................................    1545-1575
1.37-1.....................................................    1545-0074
1.37-3.....................................................    1545-0074
1.41-2.....................................................    1545-0619
1.41-3.....................................................    1545-0619
1.41-4A....................................................    1545-0074
1.41-4 (b) and (c).........................................    1545-0074
1.41-8(b)..................................................    1545-1625
1.41-8(d)..................................................    1545-0732
1.41-9.....................................................    1545-0619
1.42-1T....................................................    1545-0984
                                                               1545-0988
1.42-2.....................................................    1545-1005
1.42-5.....................................................    1545-1357
1.42-6.....................................................    1545-1102
1.42-8.....................................................    1545-1102
1.42-10....................................................    1545-1102
1.42-13....................................................    1545-1357
1.42-14....................................................    1545-1423
1.42-17....................................................    1545-1357
1.43-3(a)(3)...............................................    1545-1292
1.43-3(b)(3)...............................................    1545-1292
1.44A-1....................................................    1545-0068
1.44A-3....................................................    1545-0074
1.44B-1....................................................    1545-0219
1.45D-1....................................................    1545-1765
1.46-1.....................................................    1545-0123
                                                               1545-0155
1.46-3.....................................................    1545-0155
1.46-4.....................................................    1545-0155
1.46-5.....................................................    1545-0155
1.46-6.....................................................    1545-0155
1.46-8.....................................................    1545-0155
1.46-9.....................................................    1545-0155
1.46-10....................................................    1545-0118
1.46-11....................................................    1545-0155
1.47-1.....................................................    1545-0166
                                                               1545-0155
1.47-3.....................................................    1545-0166
                                                               1545-0155
1.47-4.....................................................    1545-0123
1.47-5.....................................................    1545-0092
1.47-6.....................................................    1545-0099
1.48-3.....................................................    1545-0155
1.48-4.....................................................    1545-0808
                                                               1545-0155
1.48-5.....................................................    1545-0155
1.48-6.....................................................    1545-0155
1.48-12....................................................    1545-0155
                                                               1545-1783
1.50A-1....................................................    1545-0895
1.50A-2....................................................    1545-0895
1.50A-3....................................................    1545-0895
1.50A-4....................................................    1545-0895
1.50A-5....................................................    1545-0895
1.50A-6....................................................    1545-0895
1.50A-7....................................................    1545-0895
1.50B-1....................................................    1545-0895
1.50B-2....................................................    1545-0895
1.50B-3....................................................    1545-0895
1.50B-4....................................................    1545-0895
1.50B-5....................................................    1545-0895
1.51-1.....................................................    1545-0219
                                                               1545-0241
                                                               1545-0244
                                                               1545-0797
1.52-2.....................................................    1545-0219

[[Page 730]]

 
1.52-3.....................................................    1545-0219
1.56-1.....................................................    1545-0123
1.56(g)-1..................................................    1545-1233
1.56A-1....................................................    1545-0227
1.56A-2....................................................    1545-0227
1.56A-3....................................................    1545-0227
1.56A-4....................................................    1545-0227
1.56A-5....................................................    1545-0227
1.57-5.....................................................    1545-0227
1.58-1.....................................................    1545-0175
1.58-9(c)(5)(iii)(B).......................................    1545-1093
1.58-9(e)(3)...............................................    1545-1093
1.59-1.....................................................    1545-1903
1.61-2.....................................................    1545-0771
1.61-2T....................................................    1545-0771
1.61-4.....................................................    1545-0187
1.61-15....................................................    1545-0074
1.62-2.....................................................    1545-1148
1.63-1.....................................................    1545-0074
1.66-4.....................................................    1545-1770
1.67-2T....................................................    1545-0110
1.67-3.....................................................    1545-1018
1.67-3T....................................................    1545-0118
1.71-1T....................................................    1545-0074
1.72-4.....................................................    1545-0074
1.72-6.....................................................    1545-0074
1.72-9.....................................................    1545-0074
1.72-17....................................................    1545-0074
1.72-17A...................................................    1545-0074
1.72-18....................................................    1545-0074
1.74-1.....................................................    1545-1100
1.79-2.....................................................    1545-0074
1.79-3.....................................................    1545-0074
1.83-2.....................................................    1545-0074
1.83-5.....................................................    1545-0074
1.83-6.....................................................    1545-1448
1.103-10...................................................    1545-0123
                                                               1545-0940
1.103-15AT.................................................    1545-0720
1.103-18...................................................    1545-1226
1.103(n)-2T................................................    1545-0874
1.103(n)-4T................................................    1545-0874
1.103A-2...................................................    1545-0720
1.105-4....................................................    1545-0074
1.105-5....................................................    1545-0074
1.105-6....................................................    1545-0074
1.108-4....................................................    1545-1539
1.108-5....................................................    1545-1421
1.110-1....................................................    1545-1661
1.117-5....................................................    1545-0869
1.118-2....................................................    1545-1639
1.119-1....................................................    1545-0067
1.120-3....................................................    1545-0057
1.121-1....................................................    1545-0072
1.121-2....................................................    1545-0072
1.121-3....................................................    1545-0072
1.121-4....................................................    1545-0072
                                                               1545-0091
1.121-5....................................................    1545-0072
1.127-2....................................................    1545-0768
1.132-1T...................................................    1545-0771
1.132-2....................................................    1545-0771
1.132-2T...................................................    1545-0771
1.132-5....................................................    1545-0771
1.132-5T...................................................    1545-0771
                                                               1545-1098
1.132-9(b).................................................    1545-1676
1.141-1....................................................    1545-1451
1.141-12...................................................    1545-1451
1.142-2....................................................    1545-1451
1.142(f)(4)-1..............................................    1545-1730
1.148-0....................................................    1545-1098
1.148-1....................................................    1545-1098
1.148-2....................................................    1545-1098
                                                               1545-1347
1.148-3....................................................    1545-1098
                                                               1545-1347
1.148-4....................................................    1545-1098
                                                               1545-1347
1.148-5....................................................    1545-1098
                                                               1545-1490
1.148-6....................................................    1545-1098
                                                               1545-1451
1.148-7....................................................    1545-1098
                                                               1545-1347
1.148-8....................................................    1545-1098
1.148-11...................................................    1545-1098
                                                               1545-1347
1.149(e)-1.................................................    1545-0720
1.150-1....................................................    1545-1347
1.151-1....................................................    1545-0074
1.152-3....................................................    1545-0071
                                                               1545-1783
1.152-4....................................................    1545-0074
1.152-4T...................................................    1545-0074
1.162-1....................................................    1545-0139
1.162-2....................................................    1545-0139
1.162-3....................................................    1545-0139
1.162-4....................................................    1545-0139
1.162-5....................................................    1545-0139
1.162-6....................................................    1545-0139
1.162-7....................................................    1545-0139
1.162-8....................................................    1545-0139
1.162-9....................................................    1545-0139
1.162-10...................................................    1545-0139
1.162-11...................................................    1545-0139
1.162-12...................................................    1545-0139
1.162-13...................................................    1545-0139
1.162-14...................................................    1545-0139
1.162-15...................................................    1545-0139
1.162-16...................................................    1545-0139
1.162-17...................................................    1545-0139
1.162-18...................................................    1545-0139
1.162-19...................................................    1545-0139
1.162-20...................................................    1545-0139
1.162-27...................................................    1545-1466
1.163-5....................................................    1545-0786
                                                               1545-1132
1.163-8T...................................................    1545-0995
1.163-10T..................................................    1545-0074
1.163-13...................................................    1545-1491
1.163(d)-1.................................................    1545-1421
1.165-1....................................................    1545-0177
1.165-2....................................................    1545-0177
1.165-3....................................................    1545-0177
1.165-4....................................................    1545-0177
1.165-5....................................................    1545-0177
1.165-6....................................................    1545-0177
1.165-7....................................................    1545-0177
1.165-8....................................................    1545-0177
1.165-9....................................................    1545-0177
1.165-10...................................................    1545-0177
1.165-11...................................................    1545-0074
                                                               1545-0177
                                                               1545-0786
1.165-12...................................................    1545-0786
1.166-1....................................................    1545-0123
1.166-2....................................................    1545-1254
1.166-4....................................................    1545-0123
1.166-10...................................................    1545-0123
1.167(a)-5T................................................    1545-1021
1.167(a)-7.................................................    1545-0172
1.167(a)-11................................................    1545-0152
                                                               1545-0172

[[Page 731]]

 
1.167(a)-12................................................    1545-0172
1.167(d)-1.................................................    1545-0172
1.167(e)-1.................................................    1545-0172
1.167(f)-11................................................    1545-0172
1.167(l)-1.................................................    1545-0172
1.168(d)-1.................................................    1545-1146
1.168(f)(8)-1T.............................................    1545-0923
1.168(i)-1.................................................    1545-1331
1.168-5....................................................    1545-0172
1.169-4....................................................    1545-0172
1.170-1....................................................    1545-0074
1.170-2....................................................    1545-0074
1.170-3....................................................    1545-0123
1.170A-1...................................................    1545-0074
1.170A-2...................................................    1545-0074
1.170A-4(A)(b).............................................    1545-0123
1.170A-8...................................................    1545-0074
1.170A-9...................................................    1545-0052
                                                               1545-0074
1.170A-11..................................................    1545-0123
                                                               1545-0074
1.170A-11T.................................................    1545-1868
1.170A-12..................................................    1545-0020
                                                               1545-0074
1.170A-13..................................................    1545-0074
                                                               1545-0754
                                                               1545-0908
                                                               1545-1431
1.170A-13(f)...............................................    1545-1464
1.170A-14..................................................    1545-0763
1.171-4....................................................    1545-1491
1.171-5....................................................    1545-1491
1.172-1....................................................    1545-0172
1.172-13...................................................    1545-0863
1.173-1....................................................    1545-0172
1.174-3....................................................    1545-0152
1.174-4....................................................    1545-0152
1.175-3....................................................    1545-0187
1.175-6....................................................    1545-0152
1.177-1....................................................    1545-0172
1.179-2....................................................    1545-1201
1.179-3....................................................    1545-1201
1.179-5....................................................    1545-0172
                                                               1545-1201
1.180-2....................................................    1545-0074
1.182-6....................................................    1545-0074
1.183-1....................................................    1545-0195
1.183-2....................................................    1545-0195
1.183-3....................................................    1545-0195
1.183-4....................................................    1545-0195
1.190-3....................................................    1545-0074
1.194-2....................................................    1545-0735
1.194-4....................................................    1545-0735
1.195-1....................................................    1545-1582
1.197-1T...................................................    1545-1425
1.197-2....................................................    1545-1671
1.213-1....................................................    1545-0074
1.215-1T...................................................    1545-0074
1.217-2....................................................    1545-0182
1.243-3....................................................    1545-0123
1.243-4....................................................    1545-0123
1.243-5....................................................    1545-0123
1.248-1....................................................    1545-0172
1.261-1....................................................    1545-1041
1.263(a)-5.................................................    1545-1870
1.263(e)-1.................................................    1545-0123
1.263A-1...................................................    1545-0987
1.263A-1T..................................................    1545-0187
1.263A-2...................................................    1545-0987
1.263A-3...................................................    1545-0987
                                                               1545-0987
1.263A-8(b)(2)(iii)........................................    1545-1265
1.263A-9(d)(1).............................................    1545-1265
1.263A-9(f)(1)(ii).........................................    1545-1265
1.263A-9(f)(2)(iv).........................................    1545-1265
1.263A-9(g)(2)(iv)(C)......................................    1545-1265
1.263A-9(g)(3)(iv).........................................    1545-1265
1.265-1....................................................    1545-0074
1.265-2....................................................    1545-0123
1.266-1....................................................    1545-0123
1.267(f)-1.................................................    1545-0885
1.268-1....................................................    1545-0184
1.274-1....................................................    1545-0139
1.274-2....................................................    1545-0139
1.274-3....................................................    1545-0139
1.274-4....................................................    1545-0139
1.274-5....................................................    1545-0771
1.274-5A...................................................    1545-0139
                                                               1545-0771
1.274-5T...................................................    1545-0074
                                                               1545-0172
                                                               1545-0771
1.274-6....................................................    1545-0139
                                                               1545-0771
1.274-6T...................................................    1545-0074
                                                               1545-0771
1.274-7....................................................    1545-0139
1.274-8....................................................    1545-0139
1.279-6....................................................    1545-0123
1.280C-4...................................................    1545-1155
1.280F-3T..................................................    1545-0074
1.280G-1...................................................    1545-1851
1.281-4....................................................    1545-0123
1.302-4....................................................    1545-0074
1.305-3....................................................    1545-0123
1.305-5....................................................    1545-1438
1.307-2....................................................    1545-0074
1.312-15...................................................    1545-0172
1.316-1....................................................    1545-0123
1.331-1....................................................    1545-0074
1.332-4....................................................    1545-0123
1.332-6....................................................    1545-0123
1.337(d)-1.................................................    1545-1160
1.337(d)-2.................................................    1545-1160
1.337(d)-2.................................................    1545-1774
1.337(d)-4.................................................    1545-1633
1.337(d)-5.................................................    1545-1672
1.337(d)-6.................................................    1545-1672
1.337(d)-7.................................................    1545-1672
1.338-2....................................................    1545-1658
1.338-5....................................................    1545-1658
1.338-10...................................................    1545-1658
1.338(h)(10)-1.............................................    1545-1658
1.341-7....................................................    1545-0123
1.351-3....................................................    1545-0074
1.355-5....................................................    1545-0123
1.362-2....................................................    1545-0123
1.367(a)-1T................................................    1545-0026
1.367(a)-2T................................................    1545-0026
1.367(a)-3.................................................    1545-0026
                                                               1545-1478
1.367(a)-6T................................................    1545-0026
1.367(a)-8.................................................    1545-1271
1.367(b)-1.................................................    1545-1271
1.367(b)-3T................................................    1545-1666
1.367(d)-1T................................................    1545-0026
1.367(e)-1.................................................    1545-1487
1.367(e)-2.................................................    1545-1487
1.368-1....................................................    1545-1691
1.368-3....................................................    1545-0123
1.371-1....................................................    1545-0123
1.371-2....................................................    1545-0123
1.374-3....................................................    1545-0123
1.381(b)-1.................................................    1545-0123

[[Page 732]]

 
1.381(c)(4)-1..............................................    1545-0123
                                                               1545-0152
                                                               1545-0879
1.381(c)(5)-1..............................................    1545-0123
                                                               1545-0152
1.381(c)(6)-1..............................................    1545-0123
                                                               1545-0152
1.381(c)(8)-1..............................................    1545-0123
1.381(c)(10)-1.............................................    1545-0123
1.381(c)(11)-1(k)..........................................    1545-0123
1.381(c)(13)-1.............................................    1545-0123
1.381(c)(17)-1.............................................    1545-0045
1.381(c)(25)-1.............................................    1545-0045
1.382-1T...................................................    1545-0123
1.382-2....................................................    1545-0123
1.382-2T...................................................    1545-0123
1.382-3....................................................    1545-1281
                                                               1545-1345
1.382-4....................................................    1545-1120
1.382-6....................................................    1545-1381
1.382-8....................................................    1545-1434
1.382-9....................................................    1545-1260
                                                               1545-1120
                                                               1545-1275
                                                               1545-1324
1.382-91...................................................    1545-1260
                                                               1545-1324
1.383-1....................................................    1545-0074
                                                               1545-1120
1.401-1....................................................    1545-0020
                                                               1545-0197
                                                               1545-0200
                                                               1545-0534
                                                               1545-0710
1.401(a)-11................................................    1545-0710
1.401(a)-20................................................    1545-0928
1.401(a)-31................................................    1545-1341
1.401(a)-50................................................    1545-0710
1.401(a)(31)-1.............................................    1545-1341
1.401(b)-1.................................................    1545-0197
1.401(f)-1.................................................    1545-0710
1.401(k)-1.................................................    1545-1039
                                                               1545-1069
                                                               1545-1669
                                                               1545-1930
1.401(k)-2.................................................    1545-1669
1.401(k)-3.................................................    1545-1669
1.401(k)-4.................................................    1545-1669
1.401(m)-3.................................................    1545-1699
1.401(a)(9)-1..............................................    1545-1573
1.401(a)(9)-3..............................................    1545-1466
1.401(a)(9)-4..............................................    1545-1573
1.401-12(n)................................................    1545-0806
1.401-14...................................................    1545-0710
1.402(c)-2.................................................    1545-1341
1.402(f)-1.................................................    1545-1341
                                                               1545-1632
1.403(b)-1.................................................    1545-0710
1.403(b)-2.................................................    1545-1341
1.403(b)-3.................................................    1545-0996
1.404(a)-4.................................................    1545-0710
1.404(a)-12................................................    1545-0710
1.404A-2...................................................    1545-0123
1.404A-6...................................................    1545-0123
1.408-2....................................................    1545-0390
1.408-5....................................................    1545-0747
1.408-6....................................................    1545-0203
                                                               1545-0390
1.408-7....................................................    1545-0119
1.408(q)-1.................................................    1545-1841
1.408A-2...................................................    1545-1616
1.408A-4...................................................    1545-1616
1.408A-5...................................................    1545-1616
1.408A-7...................................................    1545-1616
1.410(a)-2.................................................    1545-0710
1.410(d)-1.................................................    1545-0710
1.411(a)-11................................................    1545-1471
                                                               1545-1632
1.411(d)-4.................................................    1545-1545
1.411(d)-6.................................................    1545-1477
1.412(b)-5.................................................    1545-0710
1.412(c)(1)-2..............................................    1545-0710
1.412(c)(2)-1..............................................    1545-0710
1.412(c)(3)-2..............................................    1545-0710
1.414(c)-5.................................................    1545-0797
1.414(r)-1.................................................    1545-1221
1.415-2....................................................    1545-0710
1.415-6....................................................    1545-0710
1.417(a)(3)-1..............................................    1545-0928
1.417(e)-1.................................................    1545-1471
                                                               1545-1724
1.417(e)-1T................................................    1545-1471
1.419A(f)(6)-1.............................................    1545-1795
1.422-1....................................................    1545-0820
1.441-2....................................................    1545-1748
1.442-1....................................................    1545-0074
                                                               1545-0123
                                                               1545-0134
                                                               1545-0152
                                                               1545-0820
                                                               1545-1748
1.443-1....................................................    1545-0123
1.444-3T...................................................    1545-1036
1.444-4....................................................    1545-1591
1.446-1....................................................    1545-0074
                                                               1545-0152
1.446-4(d).................................................    1545-1412
1.448-1(g).................................................    1545-0152
1.448-1(h).................................................    1545-0152
1.448-1(i).................................................    1545-0152
1.448-2T...................................................    1545-0152
                                                               1545-1855
1.451-1....................................................    1545-0091
1.451-4....................................................    1545-0123
1.451-5....................................................    1545-0074
1.451-6....................................................    1545-0074
1.451-7....................................................    1545-0074
1.453-1....................................................    1545-0152
1.453-2....................................................    1545-0152
1.453-8....................................................    1545-0152
                                                               1545-0228
1.453-10...................................................    1545-0152
1.453A-1...................................................    1545-0152
                                                               1545-1134
1.453A-2...................................................    1545-0152
                                                               1545-1134
1.453A-3...................................................    1545-0963
1.454-1....................................................    1545-0074
1.455-2....................................................    1545-0152
1.455-6....................................................    1545-0123
1.456-2....................................................    1545-0123
1.456-6....................................................    1545-0123
1.456-7....................................................    1545-0123
1.457-8....................................................    1545-1580
1.458-1....................................................    1545-0879
1.458-2....................................................    1545-0152
1.460-1....................................................    1545-1650
1.460-6....................................................    1545-1031
                                                               1545-1572
                                                               1545-1732
1.461-1....................................................    1545-0074
1.461-2....................................................    1545-0096
1.461-4....................................................    1545-0917
1.461-5....................................................    1545-0917

[[Page 733]]

 
1.463-1T...................................................    1545-0916
1.465-1T...................................................    1545-0712
1.466-1T...................................................    1545-0152
1.466-4....................................................    1545-0152
1.468A-3...................................................    1545-1269
                                                               1545-1378
                                                               1545-1511
1.468A-4...................................................    1545-0954
1.468A-7...................................................    1545-0954
1.468A-8...................................................    1545-1269
1.468B-1...................................................    1545-1631
1.468B-9...................................................    1545-1631
1.468B-1(j)................................................    1545-1299
1.468B-2(k)................................................    1545-1299
1.468B-2(l)................................................    1545-1299
1.468B-3(b)................................................    1545-1299
1.468B-3(e)................................................    1545-1299
1.468B-5(b)................................................    1545-1299
1.469-1....................................................    1545-1008
1.469-2T...................................................    1545-0712
                                                               1545-1091
1.469-4T...................................................    1545-0985
                                                               1545-1037
1.469-7....................................................    1545-1244
1.471-2....................................................    1545-0123
1.471-5....................................................    1545-0123
1.471-6....................................................    1545-0123
1.471-8....................................................    1545-0123
1.471-11...................................................    1545-0123
                                                               1545-0152
1.472-1....................................................    1545-0042
                                                               1545-0152
1.472-2....................................................    1545-0152
1.472-3....................................................    1545-0042
1.472-5....................................................    1545-0152
1.472-8....................................................    1545-0028
                                                               1545-0042
                                                               1545-1767
1.475(b)-4.................................................    1545-1496
1.481-4....................................................    1545-0152
1.481-5....................................................    1545-0152
1.482-1....................................................    1545-1364
1.482-4....................................................    1545-1364
1.482-7....................................................    1545-1364
                                                               1545-1794
1.501(a)-1.................................................    1545-0056
                                                               1545-0057
1.501(c)(3)-1..............................................    1545-0056
1.501(c)(9)-5..............................................    1545-0047
1.501(c)(17)-3.............................................    1545-0047
1.501(e)-1.................................................    1545-0814
1.503(c)-1.................................................    1545-0047
                                                               1545-0052
1.505(c)-1T................................................    1545-0916
1.507-1....................................................    1545-0052
1.507-2....................................................    1545-0052
1.508-1....................................................    1545-0052
                                                               1545-0056
1.509(a)-3.................................................    1545-0047
1.509(a)-5.................................................    1545-0047
1.509(c)-1.................................................    1545-0052
1.512(a)-1.................................................    1545-0687
1.512(a)-4.................................................    1545-0047
                                                               1545-0687
1.521-1....................................................    1545-0051
                                                               1545-0058
1.527-2....................................................    1545-0129
1.527-5....................................................    1545-0129
1.527-6....................................................    1545-0129
1.527-9....................................................    1545-0129
1.528-8....................................................    1545-0127
1.533-2....................................................    1545-0123
1.534-2....................................................    1545-0123
1.542-3....................................................    1545-0123
1.545-2....................................................    1545-0123
1.545-3....................................................    1545-0123
1.547-2....................................................    1545-0045
                                                               1545-0123
1.547-3....................................................    1545-0123
1.551-4....................................................    1545-0074
1.552-3....................................................    1545-0099
1.552-4....................................................    1545-0099
1.552-5....................................................    1545-0099
1.556-2....................................................    1545-0704
1.561-1....................................................    1545-0044
1.561-2....................................................    1545-0123
1.562-3....................................................    1545-0123
1.563-2....................................................    1545-0123
1.564-1....................................................    1545-0123
1.565-1....................................................    1545-0043
                                                               1545-0123
1.565-2....................................................    1545-0043
1.565-3....................................................    1545-0043
1.565-5....................................................    1545-0043
1.565-6....................................................    1545-0043
1.585-1....................................................    1545-0123
1.585-3....................................................    1545-0123
1.585-8....................................................    1545-1290
1.586-2....................................................    1545-0123
1.593-1....................................................    1545-0123
1.593-6....................................................    1545-0123
1.593-6A...................................................    1545-0123
1.593-7....................................................    1545-0123
1.595-1....................................................    1545-0123
1.597-2....................................................    1545-1300
1.597-4....................................................    1545-1300
1.597-6....................................................    1545-1300
1.597-7....................................................    1545-1300
1.611-2....................................................    1545-0099
1.611-3....................................................    1545-0007
                                                               1545-0099
                                                               1545-1784
1.612-4....................................................    1545-0074
1.612-5....................................................    1545-0099
1.613-3....................................................    1545-0099
1.613-4....................................................    1545-0099
1.613-6....................................................    1545-0099
1.613-7....................................................    1545-0099
1.613A-3...................................................    1545-0919
1.613A-3(e)................................................    1545-1251
1.613A-3(l)................................................    1545-0919
1.613A-5...................................................    1545-0099
1.613A-6...................................................    1545-0099
1.614-2....................................................    1545-0099
1.614-3....................................................    1545-0099
1.614-5....................................................    1545-0099
1.614-6....................................................    1545-0099
1.614-8....................................................    1545-0099
1.617-1....................................................    1545-0099
1.617-3....................................................    1545-0099
1.617-4....................................................    1545-0099
1.631-1....................................................    1545-0007
1.631-2....................................................    1545-0007
1.641(b)-2.................................................    1545-0092
1.642(c)-1.................................................    1545-0092
1.642(c)-2.................................................    1545-0092
1.642(c)-5.................................................    1545-0074
1.642(c)-6.................................................    1545-0020
                                                               1545-0074
                                                               1545-0092
1.642(g)-1.................................................    1545-0092
1.642(i)-1.................................................    1545-0092
1.645-1....................................................    1545-1578
1.663(b)-2.................................................    1545-0092

[[Page 734]]

 
1.664-1....................................................    1545-0196
1.664-1(a)(7)..............................................    1545-1536
1.664-2....................................................    1545-0196
1.664-3....................................................    1545-0196
1.664-4....................................................    1545-0020
                                                               1545-0196
1.665(a)-0A through
1.665(g)-2A................................................    1545-0192
1.666(d)-1A................................................    1545-0092
1.671-4....................................................    1545-1442
1.671-5....................................................    1545-1540
1.701-1....................................................    1545-0099
1.702-1....................................................    1545-0074
1.703-1....................................................    1545-0099
1.704-2....................................................    1545-1090
1.706-1....................................................    1545-0099
                                                               1545-0074
                                                               1545-0134
1.706-1T...................................................    1545-0099
1.707-3(c)(2)..............................................    1545-1243
1.707-5(a)(7)(ii)..........................................    1545-1243
1.707-6(c).................................................    1545-1243
1.707-8....................................................    1545-1243
1.708-1....................................................    1545-0099
1.732-1....................................................    1545-0099
                                                               1545-1588
1.736-1....................................................    1545-0074
1.743-1....................................................    1545-0074
                                                               1545-1588
1.751-1....................................................    1545-0074
                                                               1545-0099
                                                               1545-0941
1.752-5....................................................    1545-1090
1.752-7....................................................    1545-1843
1.754-1....................................................    1545-0099
1.755-1....................................................    1545-0099
1.761-2....................................................    1545-1338
1.801-1....................................................    1545-0123
                                                               1545-0128
1.801-3....................................................    1545-0123
1.801-5....................................................    1545-0128
1.801-8....................................................    1545-0128
1.804-4....................................................    1545-0128
1.811-2....................................................    1545-0128
1.812-2....................................................    1545-0128
1.815-6....................................................    1545-0128
1.818-4....................................................    1545-0128
1.818-5....................................................    1545-0128
1.818-8....................................................    1545-0128
1.819-2....................................................    1545-0128
1.821-1....................................................    1545-1027
1.821-3....................................................    1545-1027
1.821-4....................................................    1545-1027
1.822-5....................................................    1545-1027
1.822-6....................................................    1545-1027
1.822-8....................................................    1545-1027
1.822-9....................................................    1545-1027
1.823-2....................................................    1545-1027
1.823-5....................................................    1545-1027
1.823-6....................................................    1545-1027
1.825-1....................................................    1545-1027
1.826-1....................................................    1545-1027
1.826-2....................................................    1545-1027
1.826-3....................................................    1545-1027
1.826-4....................................................    1545-1027
1.826-6....................................................    1545-1027
1.831-3....................................................    1545-0123
1.831-4....................................................    1545-0123
1.832-4....................................................    1545-1227
1.832-5....................................................    1545-0123
1.848-2(g)(8)..............................................    1545-1287
1.848-2(h)(3)..............................................    1545-1287
1.848-2(i)(4)..............................................    1545-1287
1.851-2....................................................    1545-1010
1.851-4....................................................    1545-0123
1.852-1....................................................    1545-0123
1.852-4....................................................    1545-0123
                                                               1545-0145
1.852-6....................................................    1545-0123
                                                               1545-0144
1.852-7....................................................    1545-0074
1.852-9....................................................    1545-0074
                                                               1545-0123
                                                               1545-0144
                                                               1545-0145
                                                               1545-1783
1.852-11...................................................    1545-1094
1.853-3....................................................    1545-0123
1.853-4....................................................    1545-0123
1.854-2....................................................    1545-0123
1.855-1....................................................    1545-0123
1.856-2....................................................    1545-0123
                                                               1545-1004
1.856-6....................................................    1545-0123
1.856-7....................................................    1545-0123
1.856-8....................................................    1545-0123
1.857-8....................................................    1545-0123
1.857-9....................................................    1545-0074
1.858-1....................................................    1545-0123
1.860-2....................................................    1545-0045
1.860-4....................................................    1545-0045
                                                               1545-1054
                                                               1545-1057
1.860E-1...................................................    1545-1675
1.860E-2(a)(5).............................................    1545-1276
1.860E-2(a)(7).............................................    1545-1276
1.860E-2(b)(2).............................................    1545-1276
1.861-2....................................................    1545-0089
1.861-3....................................................    1545-0089
1.861-4....................................................    1545-1900
1.861-8....................................................    1545-0126
1.861-8(e)(6) and (g)......................................    1545-1224
1.861-9T...................................................    1545-0121
                                                               1545-1072
1.861-18...................................................    1545-1594
1.863-1....................................................    1545-1476
1.863-3....................................................    1545-1476
                                                               1545-1556
1.863-3A...................................................    1545-0126
1.863-4....................................................    1545-0126
1.863-7....................................................    1545-0132
1.864-4....................................................    1545-0126
1.871-1....................................................    1545-0096
1.871-6....................................................    1545-0795
1.871-7....................................................    1545-0089
1.871-10...................................................    1545-0089
                                                               1545-0165
1.874-1....................................................    1545-0089
1.881-4....................................................    1545-1440
1.882-4....................................................    1545-0126
1.883-1....................................................    1545-1677
1.883-2....................................................    1545-1677
1.883-3....................................................    1545-1677
1.883-4....................................................    1545-1677
1.883-5....................................................    1545-1677
1.884-0....................................................    1545-1070
1.884-1....................................................    1545-1070
1.884-2....................................................    1545-1070
1.884-2T...................................................    1545-0126
                                                               1545-1070
1.884-4....................................................    1545-1070
1.884-5....................................................    1545-1070
1.892-1T...................................................    1545-1053
1.892-2T...................................................    1545-1053

[[Page 735]]

 
1.892-3T...................................................    1545-1053
1.892-4T...................................................    1545-1053
1.892-5T...................................................    1545-1053
1.892-6T...................................................    1545-1053
1.892-7T...................................................    1545-1053
1.897-2....................................................    1545-0123
                                                               1545-0902
1.897-3....................................................    1545-0123
1.897-5T...................................................    1545-0902
1.897-6T...................................................    1545-0902
1.901-2....................................................    1545-0746
1.901-2A...................................................    1545-0746
1.901-3....................................................    1545-0122
1.902-1....................................................    1545-0122
                                                               1545-1458
1.904-1....................................................    1545-0121
                                                               1545-0122
1.904-2....................................................    1545-0121
                                                               1545-0122
1.904-3....................................................    1545-0121
1.904-4....................................................    1545-0121
1.904-5....................................................    1545-0121
1.904(f)-1.................................................    1545-0121
                                                               1545-0122
1.904(f)-2.................................................    1545-0121
1.904(f)-3.................................................    1545-0121
1.904(f)-4.................................................    1545-0121
1.904(f)-5.................................................    1545-0121
1.904(f)-6.................................................    1545-0121
1.904(f)-7.................................................    1545-1127
1.905-2....................................................    1545-0122
1.905-3T...................................................    1545-1056
1.905-4T...................................................    1545-1056
1.905-5T...................................................    1545-1056
1.911-1....................................................    1545-0067
                                                               1545-0070
1.911-2....................................................    1545-0067
                                                               1545-0070
1.911-3....................................................    1545-0067
                                                               1545-0070
1.911-4....................................................    1545-0067
                                                               1545-0070
1.911-5....................................................    1545-0067
                                                               1545-0070
1.911-6....................................................    1545-0067
                                                               1545-0070
1.911-7....................................................    1545-0067
                                                               1545-0070
1.913-13...................................................    1545-0067
1.921-1T...................................................    1545-0190
                                                               1545-0884
                                                               1545-0935
                                                               1545-0939
1.921-2....................................................    1545-0884
1.921-3T...................................................    1545-0935
1.923-1T...................................................    1545-0935
1.924(a)-1T................................................    1545-0935
1.925(a)-1T................................................    1545-0935
1.925(b)-1T................................................    1545-0935
1.926(a)-1T................................................    1545-0935
1.927(a)-1T................................................    1545-0935
1.927(b)-1T................................................    1545-0935
1.927(d)-1.................................................    1545-0884
1.927(d)-2T................................................    1545-0935
1.927(e)-1T................................................    1545-0935
1.927(e)-2T................................................    1545-0935
1.927(f)-1.................................................    1545-0884
1.931-1....................................................    1545-0074
                                                               1545-0123
1.934-1....................................................    1545-0782
1.935-1....................................................    1545-0074
                                                               1545-0087
                                                               1545-0803
1.936-1....................................................    1545-0215
                                                               1545-0217
1.936-4....................................................    1545-0215
1.936-5....................................................    1545-0704
1.936-6....................................................    1545-0215
1.936-7....................................................    1545-0215
1.936-10(c)................................................    1545-1138
1.937-1....................................................    1545-1930
1.952-2....................................................    1545-0126
1.953-2....................................................    1545-0126
1.954-1....................................................    1545-1068
1.954-2....................................................    1545-1068
1.955-2....................................................    1545-0123
1.955-3....................................................    1545-0123
1.955A-2...................................................    1545-0755
1.955A-3...................................................    1545-0755
1.956-1....................................................    1545-0704
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1.6411-4...................................................    1545-0582
1.6414-1...................................................    1545-0096
1.6425-1...................................................    1545-0170
1.6425-2...................................................    1545-0170
1.6425-3...................................................    1545-0170
1.6654-1...................................................    1545-0087
                                                               1545-0140
1.6654-2...................................................    1545-0087
1.6654-3...................................................    1545-0087
1.6654-4...................................................    1545-0087
1.6655-1...................................................    1545-0142
1.6655-2...................................................    1545-0142
1.6655-3...................................................    1545-0142
1.6655-7...................................................    1545-0123
1.6655(e)-1................................................    1545-1421
1.6662-3(c)................................................    1545-0889
1.6662-4(e) and (f)........................................    1545-0889
1.6662-6...................................................    1545-1426
1.6694-1...................................................    1545-0074
1.6694-2...................................................    1545-0074
1.6694-2(c)................................................    1545-1231
1.6694-3(e)................................................    1545-1231
1.6695-1...................................................    1545-0074
                                                               1545-1385
1.6695-2...................................................    1545-1570
1.6696-1...................................................    1545-0074
                                                               1545-0240
1.6851-1...................................................    1545-0086
                                                               1545-0138
1.6851-2...................................................    1545-0086
                                                               1545-0138
1.7476-1...................................................    1545-0197
1.7476-2...................................................    1545-0197
1.7519-2T..................................................    1545-1036
1.7520-1...................................................    1545-1343
1.7520-2...................................................    1545-1343
1.7520-3...................................................    1545-1343
1.7520-4...................................................    1545-1343
1.7701(l)-3................................................    1545-1642
1.7872-15..................................................    1545-1792
1.9100-1...................................................    1545-0074
1.9101-1...................................................    1545-0008
2.1-4......................................................    1545-0123
2.1-5......................................................    1545-0123
2.1-6......................................................    1545-0123
2.1-10.....................................................    1545-0123
2.1-11.....................................................    1545-0123
2.1-12.....................................................    1545-0123
2.1-13.....................................................    1545-0123
2.1-20.....................................................    1545-0123
2.1-22.....................................................    1545-0123
2.1-26.....................................................    1545-0123
3.2........................................................    1545-0123
4.954-1....................................................    1545-1068
4.954-2....................................................    1545-1068
5.6411-1...................................................    1545-0098
                                                               1545-0582
                                                               1545-0042
                                                               1545-0074
                                                               1545-0129
                                                               1545-0172
                                                               1545-0619
5c.44F-1...................................................    1545-0619
5c.128-1...................................................    1545-0123
5c.168(f)(8)-1.............................................    1545-0123
5c.168(f)(8)-2.............................................    1545-0123
5c.168(f)(8)-6.............................................    1545-0123
5c.168(f)(8)-8.............................................    1545-0123
5c.305-1...................................................    1545-0110
5c.442-1...................................................    1545-0152
5f.103-1...................................................    1545-0720
5f.103-3...................................................    1545-0720
5f.6045-1..................................................    1545-0715
6a.103A-2..................................................    1545-0123
                                                               1545-0720
6a.103A-3..................................................    1545-0720
7.465-1....................................................    1545-0712
7.465-2....................................................    1545-0712
7.465-3....................................................    1545-0712
7.465-4....................................................    1545-0712
7.465-5....................................................    1545-0712
7.936-1....................................................    1545-0217
7.999-1....................................................    1545-0216
7.6039A-1..................................................    1545-0015

[[Page 740]]

 
7.6041-1...................................................    1545-0115
11.410-1...................................................    1545-0710
11.412(c)-7................................................    1545-0710
11.412(c)-11...............................................    1545-0710
12.7.......................................................    1545-0190
12.8.......................................................    1545-0191
12.9.......................................................    1545-0195
14a.422A-1.................................................    1545-0123
15A.453-1..................................................    1545-0228
16.3-1.....................................................    1545-0159
16A.126-2..................................................    1545-0074
16A.1255-1.................................................    1545-0184
16A.1255-2.................................................    1545-0184
18.1371-1..................................................    1545-0130
18.1378-1..................................................    1545-0130
18.1379-1..................................................    1545-0130
18.1379-2..................................................    1545-0130
20.2011-1..................................................    1545-0015
20.2014-5..................................................    1545-0015
                                                               1545-0260
20.2014-6..................................................    1545-0015
20.2016-1..................................................    1545-0015
20.2031-2..................................................    1545-0015
20.2031-3..................................................    1545-0015
20.2031-4..................................................    1545-0015
20.2031-6..................................................    1545-0015
20.2031-7..................................................    1545-0020
20.2031-10.................................................    1545-0015
20.2032-1..................................................    1545-0015
20.2032A-3.................................................    1545-0015
20.2032A-4.................................................    1545-0015
20.2032A-8.................................................    1545-0015
20.2039-4..................................................    1545-0015
20.2051-1..................................................    1545-0015
20.2053-3..................................................    1545-0015
20.2053-9..................................................    1545-0015
20.2053-10.................................................    1545-0015
20.2055-1..................................................    1545-0015
20.2055-2..................................................    1545-0015
                                                               1545-0092
20.2055-3..................................................    1545-0015
20.2056(b)-4...............................................    1545-0015
20.2056(b)-7...............................................    1545-0015
                                                               1545-1612
20.2056A-2.................................................    1545-1443
20.2056A-3.................................................    1545-1360
20.2056A-4.................................................    1545-1360
20.2056A-10................................................    1545-1360
20.2106-1..................................................    1545-0015
20.2106-2..................................................    1545-0015
20.2204-1..................................................    1545-0015
20.2204-2..................................................    1545-0015
20.6001-1..................................................    1545-0015
20.6011-1..................................................    1545-0015
20.6018-1..................................................    1545-0015
                                                               1545-0531
20.6018-2..................................................    1545-0015
20.6018-3..................................................    1545-0015
20.6018-4..................................................    1545-0015
                                                               1545-0022
20.6036-2..................................................    1545-0015
20.6061-1..................................................    1545-0015
20.6065-1..................................................    1545-0015
20.6075-1..................................................    1545-0015
20.6081-1..................................................    1545-0015
                                                               1545-0181
                                                               1545-1707
20.6091-1..................................................    1545-0015
20.6161-1..................................................    1545-0015
                                                               1545-0181
20.6161-2..................................................    1545-0015
                                                               1545-0181
20.6163-1..................................................    1545-0015
20.6166-1..................................................    1545-0181
20.6166A-1.................................................    1545-0015
20.6166A-3.................................................    1545-0015
20.6324A-1.................................................    1545-0754
20.7520-1..................................................    1545-1343
20.7520-2..................................................    1545-1343
20.7520-3..................................................    1545-1343
20.7520-4..................................................    1545-1343
22.0.......................................................    1545-0015
25.2511-2..................................................    1545-0020
25.2512-2..................................................    1545-0020
25.2512-3..................................................    1545-0020
25.2512-5..................................................    1545-0020
25.2512-9..................................................    1545-0020
25.2513-1..................................................    1545-0020
25.2513-2..................................................    1545-0020
                                                               1545-0021
25.2513-3..................................................    1545-0020
25.2518-2..................................................    1545-0959
25.2522(a)-1...............................................    1545-0196
25.2522(c)-3...............................................    1545-0020
                                                               1545-0196
25.2523(a)-1...............................................    1545-0020
                                                               1545-0196
25.2523(f)-1...............................................    1545-0015
25.2701-2..................................................    1545-1241
25.2701-4..................................................    1545-1241
25.2701-5..................................................    1545-1273
25.2702-5..................................................    1545-1485
25.2702-6..................................................    1545-1273
25.6001-1..................................................    1545-0020
                                                               1545-0022
25.6011-1..................................................    1545-0020
25.6019-1..................................................    1545-0020
25.6019-2..................................................    1545-0020
25.6019-3..................................................    1545-0020
25.6019-4..................................................    1545-0020
25.6061-1..................................................    1545-0020
25.6065-1..................................................    1545-0020
25.6075-1..................................................    1545-0020
25.6081-1..................................................    1545-0020
25.6091-1..................................................    1545-0020
25.6091-2..................................................    1545-0020
25.6151-1..................................................    1545-0020
25.6161-1..................................................    1545-0020
25.7520-1..................................................    1545-1343
25.7520-2..................................................    1545-1343
25.7520-3..................................................    1545-1343
25.7520-4..................................................    1545-1343
26.2601-1..................................................    1545-0985
26.2632-1..................................................    1545-0985
                                                               1545-1892
26.2642-1..................................................    1545-0985
26.2642-2..................................................    1545-0985
26.2642-3..................................................    1545-0985
26.2642-4..................................................    1545-0985
26.2652-2..................................................    1545-0985
26.2662-1..................................................    1545-0015
                                                               1545-0985
26.2662-2..................................................    1545-0985
31.3102-3..................................................    1545-0029
                                                               1545-0059
                                                               1545-0065
31.3121(b)(19)-1...........................................    1545-0029
31.3121(d)-1...............................................    1545-0004
31.3121(i)-1...............................................    1545-0034
31.3121(k)-4...............................................    1545-0137
31.3121(r)-1...............................................    1545-0029
31.3121(s)-1...............................................    1545-0029
31.3121(v)(2)-1............................................    1545-1643
31.3302(a)-2...............................................    1545-0028

[[Page 741]]

 
31.3302(a)-3...............................................    1545-0028
31.3302(b)-2...............................................    1545-0028
31.3302(e)-1...............................................    1545-0028
31.3306(c)(18)-1...........................................    1545-0029
31.3401(a)-1...............................................    1545-0029
31.3401(a)(6)..............................................    1545-1484
31.3401(a)(6)-1............................................    1545-0029
                                                               1545-0096
                                                               1545-0795
31.3401(a)(7)-1............................................    1545-0029
31.3401(a)(8)(A)-1 ........................................    1545-0029
                                                               1545-0666
31.3401(a)(8)(C)-1 ........................................    1545-0029
31.3401(a)(15)-1...........................................    1545-0182
31.3401(c)-1...............................................    1545-0004
31.3402(b)-1...............................................    1545-0010
31.3402(c)-1...............................................    1545-0010
31.3402(f)(1)-1............................................    1545-0010
31.3402(f)(2)-1............................................    1545-0010
                                                               1545-0410
31.3402(f)(3)-1............................................    1545-0010
31.3402(f)(4)-1............................................    1545-0010
31.3402(f)(4)-2............................................    1545-0010
31.3402(f)(5)-1............................................    1545-0010
                                                               1545-1435
31.3402(h)(1)-1............................................    1545-0029
31.3402(h)(3)-1............................................    1545-0010
31.3402(h)(3)-1............................................    1545-0029
31.3402(h)(4)-1............................................    1545-0010
31.3402(i)-(1).............................................    1545-0010
31.3402(i)-(2).............................................    1545-0010
31.3402(k)-1...............................................    1545-0065
31.3402(l)-(1).............................................    1545-0010
31.3402(m)-(1).............................................    1545-0010
31.3402(n)-(1).............................................    1545-0010
31.3402(o)-2...............................................    1545-0415
31.3402(o)-3...............................................    1545-0008
                                                               1545-0010
                                                               1545-0415
                                                               1545-0717
31.3402(p)-1...............................................    1545-0415
                                                               1545-0717
31.3402(q)-1...............................................    1545-0238
                                                               1545-0239
31.3404-1..................................................    1545-0029
31.3405(c)-1...............................................    1545-1341
31.3406(a)-1...............................................    1545-0112
31.3406(a)-2...............................................    1545-0112
31.3406(a)-3...............................................    1545-0112
31.3406(a)-4...............................................    1545-0112
31.3406(b)(2)-1............................................    1545-0112
31.3406(b)(2)-2............................................    1545-0112
31.3406(b)(2)-3............................................    1545-0112
31.3406(b)(2)-4............................................    1545-0112
31.3406(b)(2)-5............................................    1545-0112
31.3406(b)(3)-1............................................    1545-0112
31.3406(b)(3)-2............................................    1545-0112
31.3406(b)(3)-3............................................    1545-0112
31.3406(b)(3)-4............................................    1545-0112
31.3406(b)(4)-1............................................    1545-0112
31.3406(c)-1...............................................    1545-0112
31.3406(d)-1...............................................    1545-0112
31.3406(d)-2...............................................    1545-0112
31.3406(d)-3...............................................    1545-0112
31.3406(d)-4...............................................    1545-0112
31.3406(d)-5...............................................    1545-0112
31.3406(e)-1...............................................    1545-0112
31.3406(f)-1...............................................    1545-0112
31.3406(g)-1...............................................    1545-0096
                                                               1545-0112
                                                               1545-1819
31.3406(g)-2...............................................    1545-0112
31.3406(g)-3...............................................    1545-0112
31.3406(h)-1...............................................    1545-0112
31.3406(h)-2...............................................    1545-0112
31.3406(h)-3...............................................    1545-0112
31.3406(i)-1...............................................    1545-0112
31.3501(a)-1T..............................................    1545-0771
31.3503-1..................................................    1545-0024
31.3504-1..................................................    1545-0029
31.6001-1..................................................    1545-0798
31.6001-2..................................................    1545-0034
                                                               1545-0798
31.6001-3..................................................    1545-0798
31.6001-4..................................................    1545-0028
31.6001-5..................................................    1545-0798
31.6001-6..................................................    1545-0029
                                                               1459-0798
31.6011(a)-1...............................................    1545-0029
                                                               1545-0034
                                                               1545-0035
                                                               1545-0059
                                                               1545-0074
                                                               1545-0718
                                                               1545-0256
31.6011(a)-2...............................................    1545-0001
                                                               1545-0002
31.6011(a)-3...............................................    1545-0028
31.6011(a)-3A..............................................    1545-0955
31.6011(a)-4...............................................    1545-0034
                                                               1545-0035
                                                               1545-0718
                                                               1545-1413
31.6011(a)-5...............................................    1545-0718
                                                               1545-0028
31.6011(a)-6...............................................    1545-0028
31.6011(a)-7...............................................    1545-0074
31.6011(a)-8...............................................    1545-0028
31.6011(a)-9...............................................    1545-0028
31.6011(a)-10..............................................    1545-0112
31.6011(b)-1...............................................    1545-0003
31.6011(b)-2...............................................    1545-0029
31.6051-1..................................................    1545-0008
                                                               1545-0182
                                                               1545-0458
                                                               1545-1729
31.6051-2..................................................    1545-0008
31.6051-3..................................................    1545-0008
31.6053-1..................................................    1545-0029
                                                               1545-0062
                                                               1545-0064
                                                               1545-0065
                                                               1545-1603
31.6053-2..................................................    1545-0008
31.6053-3..................................................    1545-0065
                                                               1545-0714
31.6053-4..................................................    1545-0065
                                                               1545-1603
31.6065(a)-1...............................................    1545-0029
31.6071(a)-1...............................................    1545-0001
                                                               1545-0028
                                                               1545-0029
31.6071(a)-1A..............................................    1545-0955
31.6081(a)-1...............................................    1545-0008
                                                               1545-0028
31.6091-1..................................................    1545-0028
                                                               1545-0029
31.6157-1..................................................    1545-0955
31.6205-1..................................................    1545-0029
31.6301(c)-1AT.............................................    1545-0035
                                                               1545-0112
                                                               1545-0257
31.6302-1..................................................    1545-1413
31.6302-2..................................................    1545-1413

[[Page 742]]

 
31.6302-3..................................................    1545-1413
31.6302-4..................................................    1545-1413
31.6302(c)-2...............................................    1545-0001
                                                               1545-0257
31.6302(c)-2A..............................................    1545-0955
31.6302(c)-3...............................................    1545-0257
31.6402(a)-2...............................................    1545-0256
31.6413(a)-1...............................................    1545-0029
31.6413(a)-2...............................................    1545-0029
                                                               1545-0256
31.6413(c)-1...............................................    1545-0029
                                                               1545-0171
31.6414-1..................................................    1545-0029
32.1.......................................................    1545-0029
                                                               1545-0415
32.2.......................................................    1545-0029
35a.3406-2.................................................    1545-0112
35a.9999-5.................................................    1545-0029
36.3121(l)(1)-1............................................    1545-0137
36.3121(l)(1)-2............................................    1545-0137
36.3121(l)(3)-1............................................    1545-0123
36.3121(1)(7)-1............................................    1545-0123
36.3121(1)(10)-1...........................................    1545-0029
36.3121(1)(10)-3...........................................    1545-0029
36.3121(1)(10)-4...........................................    1545-0257
40.6302(c)-3(b)(2)(ii).....................................    1545-1296
40.6302(c)-3(b)(2)(iii)....................................    1545-1296
40.6302(c)-3(e)............................................    1545-1296
40.6302(c)-3(f)(2)(ii).....................................    1545-1296
41.4481-1..................................................    1545-0143
41.4481-2..................................................    1545-0143
41.4483-3..................................................    1545-0143
41.6001-1..................................................    1545-0143
41.6001-2..................................................    1545-0143
41.6001-3..................................................    1545-0143
41.6071(a)-1...............................................    1545-0143
41.6081(a)-1...............................................    1545-0143
41.6091-1..................................................    1545-0143
41.6109-1..................................................    1545-0143
41.6151(a)-1...............................................    1545-0143
41.6156-1..................................................    1545-0143
41.6161(a)(1)-1............................................    1545-0143
44.4401-1..................................................    1545-0235
44.4403-1..................................................    1545-0235
44.4412-1..................................................    1545-0236
44.4901-1..................................................    1545-0236
44.4905-1..................................................    1545-0236
44.4905-2..................................................    1545-0236
44.6001-1..................................................    1545-0235
44.6011(a)-1...............................................    1545-0235
                                                               1545-0236
44.6071-1..................................................    1545-0235
44.6091-1..................................................    1545-0235
44.6151-1..................................................    1545-0235
44.6419-1..................................................    1545-0235
44.6419-1..................................................    1545-0235
44.6419-2..................................................    1545-0235
46.4371-4..................................................    1545-0023
46.4374-1..................................................    1545-0023
46.4701-1..................................................    1545-0023
                                                               1545-0257
48.4041-4..................................................    1545-0023
48.4041-5..................................................    1545-0023
48.4041-6..................................................    1545-0023
48.4041-7..................................................    1545-0023
48.4041-9..................................................    1545-0023
48.4041-10.................................................    1545-0023
48.4041-11.................................................    1545-0023
48.4041-12.................................................    1545-0023
48.4041-13.................................................    1545-0023
48.4041-18.................................................    1545-0023
48.4041-19.................................................    1545-0023
48.4041-20.................................................    1545-0023
48.4041-21.................................................    1545-1270
48.4042-2..................................................    1545-0023
48.4052-1..................................................    1545-1418
48.4061(a)-1...............................................    1545-0023
48.4061(a)-2...............................................    1545-0023
48.4061(b)-3...............................................    1545-0023
48.4064-1..................................................    1545-0014
                                                               1545-0242
48.4071-1..................................................    1545-0023
48.4073-1..................................................    1545-0023
48.4073-3..................................................    1545-0023
                                                               1545-1074
                                                               1545-1087
48.4081-2..................................................    1545-1270
                                                               1545-1418
48.4081-3..................................................    1545-1270
                                                               1545-1418
48.4081-3T.................................................    1545-1897
48.4081-4(b)(2)(ii)........................................    1545-1270
48.4081-4(b)(3)(i).........................................    1545-1270
48.4081-4(c)...............................................    1545-1270
48.4081-6(c)(1)(ii)........................................    1545-1270
48.4081-7..................................................    1545-1270
                                                               1545-1418
48.4082-1T.................................................    1545-1418
48.4082-2..................................................    1545-1418
48.4082-6..................................................    1545-1418
48.4082-7..................................................    1545-1418
48.4091-3..................................................    1545-1418
48.4101-1..................................................    1545-1418
48.4101-1T.................................................    1545-1418
48.4101-2..................................................    1545-1418
48.4161(a)-1...............................................    1545-0723
48.4161(a)-2...............................................    1545-0723
48.4161(a)-3...............................................    1545-0723
48.4161(b)-1...............................................    1545-0723
                                                               1545-0723
48.4216(a)-2...............................................    1545-0023
48.4216(a)-3...............................................    1545-0023
48.4216(c)-1...............................................    1545-0023
48.4221-1..................................................    1545-0023
48.4221-2..................................................    1545-0023
48.4221-3..................................................    1545-0023
48.4221-4..................................................    1545-0023
48.4221-5..................................................    1545-0023
48.4221-6..................................................    1545-0023
48.4221-7..................................................    1545-0023
48.4222(a)-1...............................................    1545-0023
                                                               1545-0014
48.4223-1..................................................    1545-0023
                                                               1545-0723
                                                               1545-0723
                                                               1545-0723
                                                               1545-0257
48.6302(c)-1...............................................    1545-0023
                                                               1545-0257
48.6412-1..................................................    1545-0723
48.6416(a)-1...............................................    1545-0023
                                                               1545-0723
48.6416(a)-2...............................................    1545-0723
48.6416(a)-3...............................................    1545-0723
48.6416(b)(2)-3............................................    1545-1087
48.6416(b)(1)-1............................................    1545-0723
48.6416(b)(1)-2............................................    1545-0723
48.6416(b)(1)-3............................................    1545-0723
48.6416(b)(1)-4............................................    1545-0723
48.6416(b)(2)-1............................................    1545-0723
48.6416(b)(2)-2............................................    1545-0723
48.6416(b)(2)-3............................................    1545-0723
                                                               1545-1087
48.6416(b)(2)-4............................................    1545-0723

[[Page 743]]

 
48.6416(b)(3)-1............................................    1545-0723
48.6416(b)(3)-2............................................    1545-0723
48.6416(b)(3)-3............................................    1545-0723
48.6416(b)(4)-1............................................    1545-0723
48.6416(b)(5)-1............................................    1545-0723
48.6416(c)-1...............................................    1545-0723
48.6416(e)-1...............................................    1545-0023
                                                               1545-0723
48.6416(f)-1...............................................    1545-0023
                                                               1545-0723
48.6416(g)-1...............................................    1545-0723
48.6416(h)-1...............................................    1545-0723
48.6420(c)-2...............................................    1545-0023
48.6420(f)-1...............................................    1545-0023
48.6420-1..................................................    1545-0162
                                                               1545-0723
48.6420-2..................................................    1545-0162
                                                               1545-0723
48.6420-3..................................................    1545-0162
                                                               1545-0723
48.6420-4..................................................    1545-0162
                                                               1545-0723
48.6420-5..................................................    1545-0162
                                                               1545-0723
48.6420-6..................................................    1545-0162
                                                               1545-0723
48.6421-0..................................................    1545-0162
                                                               1545-0723
48.6421-1..................................................    1545-0162
                                                               1545-0723
48.6421-2..................................................    1545-0162
                                                               1545-0723
48.6421-3..................................................    1545-0162
                                                               1545-0723
48.6421-4..................................................    1545-0162
                                                               1545-0723
48.6421-5..................................................    1545-0162
                                                               1545-0723
48.6421-6..................................................    1545-0162
                                                               1545-0723
48.6421-7..................................................    1545-0162
                                                               1545-0723
48.6424-0..................................................    1545-0723
48.6424-1..................................................    1545-0723
48.6424-2..................................................    1545-0723
48.6424-3..................................................    1545-0723
48.6424-4..................................................    1545-0723
48.6424-5..................................................    1545-0723
48.6424-6..................................................    1545-0723
48.6427-0..................................................    1545-0723
48.6427-1..................................................    1545-0023
                                                               1545-0162
                                                               1545-0723
48.6427-2..................................................    1545-0162
                                                               1545-0723
48.6427-3..................................................    1545-0723
48.6427-4..................................................    1545-0723
48.6427-5..................................................    1545-0723
48.6427-8..................................................    1545-1418
48.6427-9..................................................    1545-1418
48.6427-10.................................................    1545-1418
48.6427-11.................................................    1545-1418
49.4251-1..................................................    1545-1075
49.4251-2..................................................    1545-1075
49.4251-4(d)(2)............................................    1545-1628
49.4253-3..................................................    1545-0023
49.4253-4..................................................    1545-0023
49.4264(b)-1...............................................    1545-0023
                                                               1545-0226
                                                               1545-0226
                                                               1545-0912
                                                               1545-0912
                                                               1545-0257
                                                               1545-0230
                                                               1545-0224
                                                               1545-0225
                                                               1545-0224
                                                               1545-0230
49.4271-1(d)...............................................    1545-0685
52.4682-1(b)(2)(iii).......................................    1545-1153
52.4682-2(b)...............................................    1545-1153
                                                               1545-1361
52.4682-2(d)...............................................    1545-1153
                                                               1545-1361
52.4682-3(c)(2)............................................    1545-1153
52.4682-3(g)...............................................    1545-1153
52.4682-4(f)...............................................    1545-1153
                                                               1545-0257
52.4682-5(d)...............................................    1545-1361
52.4682-5(f)...............................................    1545-1361
53.4940-1..................................................    1545-0052
                                                               1545-0196
53.4942(a)-1...............................................    1545-0052
53.4942(a)-2...............................................    1545-0052
53.4942(a)-3...............................................    1545-0052
53.4942(b)-3...............................................    1545-0052
53.4945-1..................................................    1545-0052
53.4945-4..................................................    1545-0052
53.4945-5..................................................    1545-0052
53.4945-6..................................................    1545-0052
53.4947-1..................................................    1545-0196
53.4947-2..................................................    1545-0196
53.4948-1..................................................    1545-0052
53.4958-6..................................................    1545-1623
53.4961-2..................................................    1545-0024
53.4963-1..................................................    1545-0024
53.6001-1..................................................    1545-0052
53.6011-1..................................................    1545-0049
                                                               1545-0052
                                                               1545-0092
                                                               1545-0196
53.6065-1..................................................    1545-0052
53.6071-1..................................................    1545-0049
53.6081-1..................................................    1545-0066
                                                               1545-0148
53.6161-1..................................................    1545-0575
54.4972-1..................................................    1545-0197
54.4975-7..................................................    1545-0575
54.4977-1T.................................................    1545-0771
54.4980B-6.................................................    1545-1581
54.4980B-7.................................................    1545-1581
54.4980B-8.................................................    1545-1581
54.4980F-1.................................................    1545-1780
54.4981A-1T................................................    1545-0203
54.6011-1..................................................    1545-0575
54.6011-1T.................................................    1545-0575
54.9801-3..................................................    1545-1537
54.9801-4..................................................    1545-1537
54.9801-5..................................................    1545-1537
54.9801-6..................................................    1545-1537
55.6001-1..................................................    1545-0123
55.6011-1..................................................    1545-0999
                                                               1545-0123
                                                               1545-1016
55.6061-1..................................................    1545-0999
55.6071-1..................................................    1545-0999
56.4911-6..................................................    1545-0052
56.4911-7..................................................    1545-0052
56.4911-9..................................................    1545-0052
56.4911-10.................................................    1545-0052
56.6001-1..................................................    1545-1049
56.6011-1..................................................    1545-1049
56.6081-1..................................................    1545-1049
56.6161-1..................................................    1545-1049

[[Page 744]]

 
                                                               1545-0257
145.4051-1.................................................    1545-0745
145.4052-1.................................................    1545-0120
                                                               1545-0745
                                                               1545-1076
                                                               1545-0745
                                                               1545-1076
145.4061-1.................................................    1545-0745
                                                               1545-0257
                                                               1545-0230
                                                               1545-0224
156.6001-1.................................................    1545-1049
156.6011-1.................................................    1545-1049
156.6081-1.................................................    1545-1049
156.6161-1.................................................    1545-1049
157.6001-1.................................................    1545-1824
157.6011-1.................................................    1545-1824
157.6081-1.................................................    1545-1824
157.6161-1.................................................    1545-1824
301.6011-2.................................................    1545-0225
                                                               1545-0350
                                                               1545-0387
                                                               1545-0441
                                                               1545-0957
301.6017-1.................................................    1545-0090
301.6034-1.................................................    1545-0092
301.6035-1.................................................    1545-0123
301.6036-1.................................................    1545-0013
                                                               1545-0773
301.6047-1.................................................    1545-0367
                                                               1545-0957
301.6057-1.................................................    1545-0710
301.6057-2.................................................    1545-0710
301.6058-1.................................................    1545-0710
301.6059-1.................................................    1545-0710
301.6103(c)-1..............................................    1545-1816
301.6103(n)-1..............................................    1545-1841
301.6103(p)(2)(B)-1........................................    1545-1757
301.6104(a)-1..............................................    1545-0495
301.6104(a)-5..............................................    1545-0056
301.6104(a)-6..............................................    1545-0056
301.6104(b)-1..............................................    1545-0094
                                                               1545-0742
301.6104(d)-1..............................................    1545-1655
301.6104(d)-2..............................................    1545-1655
301.6104(d)-3..............................................    1545-1655
301.6109-1.................................................    1545-0003
                                                               1545-0295
                                                               1545-0367
                                                               1545-0387
                                                               1545-0957
                                                               1545-1461
301.6109-3.................................................    1545-1564
301.6110-3.................................................    1545-0074
301.6110-5.................................................    1545-0074
301.6111-1T................................................    1545-0865
                                                               1545-0881
301.6111-2.................................................    1545-0865
                                                               1545-1687
301.6112-1.................................................    1545-0865
                                                               1545-1686
301.6112-1T................................................    1545-0865
                                                               1545-1686
301.6114-1.................................................    1545-1126
                                                               1545-1484
301.6222(a)-2..............................................    1545-0790
301.6222(b)-1..............................................    1545-0790
301.6222(b)-2..............................................    1545-0790
301.6222(b)-3..............................................    1545-0790
301.6223(b)-1..............................................    1545-0790
301.6223(c)-1..............................................    1545-0790
301.6223(e)-2..............................................    1545-0790
301.6223(g)-1..............................................    1545-0790
301.6223(h)-1..............................................    1545-0790
301.6224(b)-1..............................................    1545-0790
301.6224(c)-1..............................................    1545-0790
301.6224(c)-3..............................................    1545-0790
301.6227(c)-1..............................................    1545-0790
301.6227(d)-1..............................................    1545-0790
301.6229(b)-2..............................................    1545-0790
301.6230(b)-1..............................................    1545-0790
301.6230(e)-1..............................................    1545-0790
301.6231(a)(1)-1...........................................    1545-0790
301.6231(a)(7)-1...........................................    1545-0790
301.6231(c)-1..............................................    1545-0790
301.6231(c)-2..............................................    1545-0790
301.6241-1T................................................    1545-0130
301.6316-4.................................................    1545-0074
301.6316-5.................................................    1545-0074
301.6316-6.................................................    1545-0074
301.6316-7.................................................    1545-0029
301.6324A-1................................................    1545-0015
301.6361-1.................................................    1545-0074
                                                               1545-0024
301.6361-2.................................................    1545-0024
301.6361-3.................................................    1545-0074
301.6402-2.................................................    1545-0024
                                                               1545-0073
                                                               1545-0091
301.6402-3.................................................    1545-0055
                                                               1545-0073
                                                               1545-0091
                                                               1545-0132
                                                               1545-1484
301.6402-5.................................................    1545-0928
301.6404-1.................................................    1545-0024
301.6404-2T................................................    1545-0024
301.6404-3.................................................    1545-0024
301.6405-1.................................................    1545-0024
301.6501(c)-1..............................................    1545-1241
                                                               1545-1637
301.6501(d)-1..............................................    1545-0074
                                                               1545-0430
301.6501(o)-2..............................................    1545-0728
301.6511(d)-1..............................................    1545-0582
                                                               1545-0024
301.6511(d)-2..............................................    1545-0582
                                                               1545-0024
301.6511(d)-3..............................................    1545-0024
                                                               1545-0582
301.6652-2.................................................    1545-0092
301.6685-1.................................................    1545-0092
301.6689-1T................................................    1545-1056
301.6707-1T................................................    1545-0865
                                                               1545-0881
301.6708-1T................................................    1545-0865
301.6712-1.................................................    1545-1126
301.6723-1A(d).............................................    1545-0909
301.6903-1.................................................    1545-0013
                                                               1545-1783
301.6905-1.................................................    1545-0074
301.7001-1.................................................    1545-0123
301.7101-1.................................................    1545-1029
301.7207-1.................................................    1545-0092
301.7216-2.................................................    1545-0074
301.7216-2(o)..............................................    1545-1209
301.7425-3.................................................    1545-0854
301.7430-2(c)..............................................    1545-1356
301.7507-8.................................................    1545-0123
301.7507-9.................................................    1545-0123
301.7513-1.................................................    1545-0429
301.7517-1.................................................    1545-0015
301.7605-1.................................................    1545-0795
301.7623-1.................................................    1545-0409

[[Page 745]]

 
                                                               1545-1534
301.7654-1.................................................    1545-0803
301.7701-3.................................................    1545-1486
301.7701-4.................................................    1545-1465
301.7701-7.................................................    1545-1600
301.7701-16................................................    1545-0795
301.7701(b)-1..............................................    1545-0089
301.7701(b)-2..............................................    1545-0089
301.7701(b)-3..............................................    1545-0089
301.7701(b)-4..............................................    1545-0089
301.7701(b)-5..............................................    1545-0089
301.7701(b)-6..............................................    1545-0089
301.7701(b)-7..............................................    1545-0089
                                                               1545-1126
301.7701(b)-9..............................................    1545-0089
301.7805-1.................................................    1545-0805
301.9001-1.................................................    1545-0220
301.9000-5.................................................    1545-1850
301.9100-2.................................................    1545-1488
301.9100-3.................................................    1545-1488
301.9100-4T................................................    1545-0016
                                                               1545-0042
                                                               1545-0074
                                                               1545-0129
                                                               1545-0172
                                                               1545-0619
301.9100-6T................................................    1545-0872
301.9100-7T................................................    1545-0982
301.9100-8.................................................    1545-1112
301.9100-11T...............................................    1545-0123
301.9100-12T...............................................    1545-0026
                                                               1545-0074
                                                               1545-0172
                                                               1545-1027
301.9100-14T...............................................    1545-0046
301.9100-15T...............................................    1545-0046
301.9100-16T...............................................    1545-0152
302.1-7....................................................    1545-0024
305.7701-1.................................................    1545-0823
305.7871-1.................................................    1545-0823
404.6048-1.................................................    1545-0160
420.0-1....................................................    1545-0710
Part 509...................................................    1545-0846
Part 513...................................................    1545-0834
Part 514...................................................    1545-0845
Part 521...................................................    1545-0848
601.104....................................................    1545-0233
601.105....................................................    1545-0091
601.201....................................................    1545-0019
                                                               1545-0819
601.204....................................................    1545-0152
601.401....................................................    1545-0257
601.504....................................................    1545-0150
601.601....................................................    1545-0800
601.602....................................................    1545-0295
                                                               1545-0387
                                                               1545-0957
601.702....................................................    1545-0429
------------------------------------------------------------------------


(26 U.S.C. 7805)

[T.D. 8011, 50 FR 10222, Mar. 14, 1985]

    Editorial Note: For Federal Register citations affecting Sec.  
602.101, see the List of CFR Sections Affected, which appears in the 
Findings Aids section of the printed volume and on GPO Access.

[[Page 747]]



List of CFR Sections Affected



All changes in sections of part 1 (Sec. Sec.  1.441 to 1.500) of title 
26 of the Code of Federal Regulations that were made by documents 
published in the Federal Register since January 1, 2001, are enumerated 
in the following list. Entries indicate the nature of the changes 
effected. Page numbers refer to Federal Register pages. The user should 
consult the entries for chapters and parts as well as sections for 
revisions.
For the period before January 1, 2001, see ``List of CFR Sections 
Affected, 1949-1963, 1964-1972, 1973-1985, 1986-2000'' published in 11 
separate volumes.

                                  2001

26 CFR
                                                                   66 FR
                                                                    Page
Chapter I
1.446-1 (c)(1)(iii) and (e)(2)(ii)(a) amended.......................2223
1.451-3 Removed.....................................................2224
1.451-5 (b)(3) amended..............................................2224
1.460-0 Amended; introductory text revised..........................2224
1.460-1 Revised.....................................................2225
    (j) corrected..................................................18357
1.460-2 Revised.....................................................2225
    (b)(2)(ii) and (c)(1) corrected................................18191
1.460-3 Revised.....................................................2225
1.460-4 (a) through (i) added.......................................2232
    (b)(3) and (g) corrected.......................................18191
1.460-5 Added.......................................................2237
1.460-6 (a)(2), (b)(1), (c)(1)(ii)(A), (B), (C)(2), (2)(v)(a), 
        (vi)(B), (C), (d)(4)(ii)(C), (e)(2), (f)(1), (2)(i) and 
        (2)(ii) amended; (c)(4)(iv) removed; (f)(3) added...........2240
1.460-7 Removed.....................................................2240
1.460-8 Removed.....................................................2240
1.467-0 Amended.....................................................1039
1.467-1 (h)(6) and (j)(2)(ii) revised...............................1039
1.467-2 (b)(3) added................................................1040
1.467-3 (b)(1)(iii) revised.........................................1040
1.468A-5 (c)(1)(ii) amended.........................................2818
1.471-10 Amended....................................................2240
1.482-7 (h)(1) amended...............................................295

                                  2002

26 CFR
                                                                   67 FR
                                                                    Page
Chapter I
1.441-0 Added......................................................35012
1.441-1 Added......................................................35012
1.441-1T Removed...................................................35019
1.441-2 Added......................................................35012
1.441-2T Removed...................................................35012
1.441-3 Added......................................................35012
1.441-3T Removed...................................................35019
1.441-4 Added......................................................35012
1.441-4T Removed...................................................35019
1.442-1 Revised....................................................35019
1.442-2T Removed...................................................35020
1.442-3T Removed...................................................35020
1.443-1 (b)(1)(ii) amended.........................................35012
1.444-1T (a)(1) amended............................................35012
1.444-2T (a) amended...............................................35012
1.444-4 Added......................................................34394
1.444-4T Removed...................................................34394
1.446-1 (c)(2)(iii) added..........................................76985
1.446-4 (d)(2), (3), (e)(7) and (9)(ii) amended....................12866
    Corrected......................................................31955
1.448-1 (h)(2)(ii)(B)(1) amended...................................35012
1.460-0 Amended....................................................34605
1.460-4 (a) amended; (k) added.....................................34605
1.460-6 (g) revised................................................34609
1.469-0 Amended....................................................54089
1.469-1 (h)(4)(ii)(D) amended......................................35012
1.469-1T (g)(2)(i) amended.........................................35012
1.469-7 Heading revised; (a) through (h) added.....................54089
1.469-11 (a)(3) amended; (a)(4) redesignated as (a)(5); new (a)(4) 
        and (c)(1)(iii) added; (c)(1) and (i) headings revised.....54093

[[Page 748]]

1.471-6 (c) and (g) amended; (f) revised...........................65698
1.472-8 (c) text redesignated as (c)(1); (b)(4), (c)(1) heading 
        and (2) added; (e)(3) and (h) revised.......................1082
    Corrected.................................................5062, 5148
1.475(b)-1 (d)(2) amended..........................................12866

                                  2003

26 CFR
                                                                   68 FR
                                                                    Page
Chapter I
1.448-2T Revised...................................................52500
    (e)(6)(iv) and (vii) corrected.................................62516
    (f) Example 4 corrected........................................66708
1.457-1 Revised....................................................41234
1.457-2 Revised....................................................41234
    (k) introductory text, (4)(i) and (ii) corrected...............51446
1.457-3 Revised....................................................41234
1.457-4 Revised....................................................41234
    (c)(1)(iv) Examples 1 and 3 corrected..........................51446
1.457-5 Added......................................................41240
    (d) Example 2 corrected........................................51446
1.457-6 Added......................................................41240
    (e)(2) corrected...............................................51446
1.457-7 Added......................................................41240
    (i) Example 1 corrected........................................51447
1.457-8 Added......................................................41240
    (b)(2) corrected...............................................51447
1.457-9 Added......................................................41240
    (a) corrected..................................................51447
1.457-10 Added.....................................................41240
    (a)(2) and (b) corrected.......................................51447
1.457-11 Added.....................................................41240
1.457-12 Added.....................................................41240
1.461-2 (a)(5) removed; (c)(1) revised; (e)(2) redesignated as 
        (e)(3) and revised; new (e)(2) added.......................65636
1.461-2T Added.....................................................65636
1.482-0 Amended....................................................51177
1.482-1 (a)(1), (b)(2)(i) and (c)(1) amended; (j)(5) added.........51177
1.482-5 (c)(2)(iv) amended.........................................51177
1.482-7 (a)(3) redesignated as (a)(4); (d)(2) redesignated as 
        (d)(3); new (a)(3), (d)(2) and (j)(2)(i)(F) added; 
        (j)(2)(i)(D) and (E) amended; (k) revised..................51177

                                  2004

26 CFR
                                                                   69 FR
                                                                    Page
Chapter I
1.446-1 (e)(2)(ii)(a), (b) and (iii) revised; (e)(2)(ii)(d) and 
        (4) added......................................................8
1.446-1T Added.........................................................8
    (e)(4)(iii) corrected...........................................5273
1.446-5 Added........................................................464
1.446-6 Added......................................................26041
1.448-1 (g)(3)(ii), (iii) and (6) removed; (g)(3)(iv) redesignated 
        as new (g)(3)(ii); (g)(2)(i), (3)(i) and new (ii) 
        introductory text revised; (i)(1) amended; (i)(5) added....33572
1.460-0 Amended....................................................42553
1.460-4 (k)(1), (3)(i) and (6) amended; (k)(3)(i)(J), (K) and (L) 
        redesignated as (k)(3)(i)(K), (L) and (M); new 
        (k)(3)(i)(J) and (k)(5) Examples 9 through 13 added; 
        (k)(2)(iv), (3)(i)(I), new (K), (iv) and (v) revised.......42553
1.460-6 (g)(3)(ii)(D) and (4) revised..............................42558
1.461-2 (c)(1), (e)(2), (3) Example 2 and (g) revised..............43303
1.461-2T Removed...................................................50069
1.461-4 (d)(4)(i) correctly revised................................44597
1.463-1T Removed...................................................42560
1.465-8 Added......................................................24079
    (b)(4) Example 1 corrected.....................................26305
1.465-20 Added.....................................................24079
1.482-7 (d)(2)(iii)(C) corrected...................................13473

                                  2005

26 CFR
                                                                   70 FR
                                                                    Page
Chapter I
1 Authority citation amended..............3476, 7176, 9217, 10320, 14399
    Technical correction.....................................4013, 10488
1.448-1T (b)(1)(iii) revised.........................................704

                                  2006

   (Regulations published from January 1, 2006, through April 1, 2006)

26 CFR
                                                                   71 FR
                                                                    Page
Chapter I
1.468B-0 Amended....................................................6200
1.468B-1 (k) redesignated as (l); new (k) added.....................6201

[[Page 749]]

1.468B-5 Heading revised; (c) added.................................6201
1.468B-6 Added......................................................6202
1.468B-7 Added......................................................6202
1.468B-8 Added......................................................6202
1.468B-9 Added......................................................6202


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