[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2023 Edition]
[From the U.S. Government Publishing Office]



[[Page i]]

          

          Title 26

Internal Revenue


________________________

Part 1 (Sec. Sec.  1.0 to 1.60)

                         Revised as of April 1, 2023

          Containing a codification of documents of general 
          applicability and future effect

          As of April 1, 2023
                    Published by the Office of the Federal Register 
                    National Archives and Records Administration as 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                                               3
  Finding Aids:
      Table of CFR Titles and Chapters........................     693
      Alphabetical List of Agencies Appearing in the CFR......     713
      Table of OMB Control Numbers............................     723
      List of CFR Sections Affected...........................     741

[[Page iv]]





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

                     Cite this Code: CFR
                     To cite the regulations in 
                       this volume use title, 
                       part and section number. 
                       Thus, 26 CFR 1.0-1 refers 
                       to title 26, part 1, 
                       section 0-1.

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

[[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, 2023), 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 
dates and effective dates are usually not the same and care must be 
exercised by the user in determining the actual effective date. In 
instances where the effective date is beyond the cut-off date for the 
Code a note has been inserted to reflect the future effective date. In 
those instances where a regulation published in the Federal Register 
states a date certain for expiration, an appropriate note will be 
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.

PAST PROVISIONS OF THE CODE

    Provisions of the Code that are no longer in force and effect as of 
the revision date stated on the cover of each volume are not carried. 
Code users may find the text of provisions in effect on any given date 
in the past by using the appropriate List of CFR Sections Affected 
(LSA). For the convenience of the reader, a ``List of CFR Sections 
Affected'' is published at the end of each CFR volume. For changes to 
the Code prior to the LSA listings at the end of the volume, consult 
previous annual editions of the LSA. For changes to the Code prior to 
2001, consult the List of CFR Sections Affected compilations, published 
for 1949-1963, 1964-1972, 1973-1985, and 1986-2000.

``[RESERVED]'' TERMINOLOGY

    The term ``[Reserved]'' is used as a place holder within the Code of 
Federal Regulations. An agency may add regulatory information at a 
``[Reserved]'' location at any time. Occasionally ``[Reserved]'' is used 
editorially to indicate that a portion of the CFR was left vacant and 
not dropped in error.

INCORPORATION BY REFERENCE

    What is incorporation by reference? Incorporation by reference was 
established by statute and allows Federal agencies to meet the 
requirement to publish regulations in the Federal Register by referring 
to materials already published elsewhere. For an incorporation to be 
valid, the Director of the Federal Register must approve it. The legal 
effect of incorporation by reference is that the material is treated as 
if it were published in full in the Federal Register (5 U.S.C. 552(a)). 
This material, like any other properly issued regulation, has the force 
of law.
    What is a proper incorporation by reference? The Director of the 
Federal Register will approve an incorporation by reference only when 
the requirements of 1 CFR part 51 are met. Some of the elements on which 
approval is based are:
    (a) The incorporation will substantially reduce the volume of 
material published in the Federal Register.
    (b) The matter incorporated is in fact available to the extent 
necessary to afford fairness and uniformity in the administrative 
process.
    (c) The incorporating document is drafted and submitted for 
publication in accordance with 1 CFR part 51.
    What if the material incorporated by reference cannot be found? If 
you have any problem locating or obtaining a copy of material listed as 
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or call 202-741-6010.

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 Authorities 
and Rules. A list of CFR titles, chapters, subchapters, 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.

[[Page vii]]

    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.

REPUBLICATION OF MATERIAL

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in the Code of Federal Regulations.

INQUIRIES

    For a legal interpretation or explanation of any regulation in this 
volume, contact the issuing agency. The issuing agency's name appears at 
the top of odd-numbered pages.
    For inquiries concerning CFR reference assistance, call 202-741-6000 
or write to the Director, Office of the Federal Register, National 
Archives and Records Administration, 8601 Adelphi Road, College Park, MD 
20740-6001 or e-mail [email protected].

SALES

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ELECTRONIC SERVICES

    The full text of the Code of Federal Regulations, the LSA (List of 
CFR Sections Affected), The United States Government Manual, the Federal 
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free). E-mail, [email protected].
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law numbers, Federal Register finding aids, and related information. 
Connect to NARA's website at www.archives.gov/federal-register.
    The eCFR is a regularly updated, unofficial editorial compilation of 
CFR material and Federal Register amendments, produced by the Office of 
the Federal Register and the Government Publishing Office. It is 
available at www.ecfr.gov.

    Oliver A. Potts,
    Director,
    Office of the Federal Register
    April 1, 2023







[[Page ix]]



                               THIS TITLE

    Title 26--Internal Revenue is composed of twenty-two volumes. The 
contents of these volumes represent all current regulations codified 
under this title by the Internal Revenue Service, Department of the 
Treasury, as of April 1, 2023. The first fifteen volumes comprise part 1 
(Subchapter A--Income Tax) and are arranged by sections as follows: 
Sec. Sec.  1.0-1.60; Sec. Sec.  1.61-1.139; Sec. Sec.  1.140-1.169; 
Sec. Sec.  1.170-1.300; Sec. Sec.  1.301-1.400; Sec. Sec.  1.401-1.409; 
Sec. Sec.  1.410-1.440; 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 of part 1. The sixteenth 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, Cheryl E. Sirofchuck was Chief Editor. The Code of 
Federal Regulations publication program is under the direction of John 
Hyrum Martinez, assisted by Stephen J. Frattini.

[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




           (This book contains part 1, Sec. Sec.  1.0 to 1.60)

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

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

[[Page 3]]



     CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY




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


  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, Mar. 31, 1980.

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

Supplementary Publications: Internal Revenue Service Looseleaf 
  Regulations System, Alcohol and Tobacco Tax Regulations, and 
  Regulations Under Tax Conventions.

  Editorial Note: Treasury Decision 6091, 19 FR 5167, Aug. 17, 1954, 
provides in part as follows:

  Paragraph 1. All regulations (including all Treasury decisions) 
prescribed by, or under authority duly delegated by, the Secretary of 
the Treasury, or jointly by the Secretary and the Commissioner of 
Internal Revenue, or by the Commissioner of Internal Revenue with the 
approval of the Secretary of the Treasury, or jointly by the 
Commissioner of Internal Revenue and the Commissioner of Customs or the 
Commissioner of Narcotics with the approval of the Secretary of the 
Treasury, applicable under any provision of law in effect on the date of 
enactment of the Code, to the extent such provision of law is repealed 
by the Code, are hereby prescribed under and made applicable to the 
provisions of the Code corresponding to the provision of law so repealed 
insofar as any such regulation is not inconsistent with the Code. Such 
regulations shall become effective as regulations under the various 
provisions of the Code as of the dates the corresponding provisions of 
law are repealed by the Code, until superseded by regulations issued 
under the Code.

  Par. 2. With respect to any provision of the Code which depends for 
its application upon the promulgation of regulations or which is to be 
applied in such manner as may be prescribed by regulations, all 
instructions or rules in effect immediately prior to the enactment of 
the Code, to the extent such instructions or rules could be prescribed 
as regulations under authority of such provision of the Code, shall be 
applied as regulations under such provision insofar as such instructions 
or rules are not inconsistent with the Code. Such instructions or rules 
shall be applied as regulations under the applicable provision of the 
Code as of the date such provision takes effect.

  Par. 3. If any election made or other act done pursuant to any 
provision of the Internal Revenue Code of 1939 or prior internal revenue 
laws would (except for the enactment of the Code) be effective for any 
period subsequent to such enactment, and if corresponding provisions are 
contained in the Code, such election or other act shall be given the 
same effect under the corresponding provisions of the Code to the extent 
not inconsistent therewith. The term ``act'' includes, but is not 
limited to, an allocation, identification, declaration, agreement, 
option, waiver, relinquishment, or renunciation.

  Par. 4. The limits of the various internal revenue districts have not 
been changed by the enactment of the Code. Furthermore, delegations of 
authority made pursuant to the provisions of Reorganization Plan No. 26 
of 1950 and Reorganization Plan No. 1 of 1952 (as well as redelegations 
thereunder), including those governing the authority of the Commissioner 
of Internal Revenue, the Regional Commissioners of Internal Revenue, or 
the District Directors of Internal Revenue, are applicable to the 
provisions of the Code to the extent consistent therewith.

[[Page 5]]



                         SUBCHAPTER A_INCOME TAX





PART 1_INCOME TAXES--Table of Contents



Sec.
1.0-1 Internal Revenue Code of 1954 and regulations.

                        Normal Taxes and Surtaxes

                     DETERMINATION OF TAX LIABILITY

                           Tax on Individuals

1.1-1 Income tax on individuals.
1.1-2 Limitation on tax.
1.1-3 Change in rates applicable to taxable year.
1.1(h)-1 Capital gains look-through rule for sales or exchanges of 
          interests in a partnership, S corporation, or trust.
1.1(i)-1T Questions and answers relating to the tax on unearned income 
          certain minor children (Temporary).
1.2-1 Tax in case of joint return of husband and wife or the return of a 
          surviving spouse.
1.2-2 Definitions and special rules.
1.3-1 Application of optional tax.
1.4-1 Number of exemptions.
1.4-2 Elections.
1.4-3 Husband and wife filing separate returns.
1.4-4 Short taxable year caused by death.

                           Tax on Corporations

1.11-1 Tax on corporations.

                 Changes in Rates During a Taxable Year

1.15-1 Changes in rate during a taxable year.
1.21-1 Expenses for household and dependent care services necessary for 
          gainful employment.
1.21-2 Limitations on amount creditable.
1.21-3 Special rules applicable to married taxpayers.
1.21-4 Payments to certain related individuals.
1.24-1 Partial credit allowed for certain other dependents.
1.25-1T Credit for interest paid on certain home mortgages (Temporary).
1.25-2T Amount of credit (Temporary).
1.25-3 Qualified mortgage credit certificate.
1.25-3T Qualified mortgage credit certificate (Temporary).
1.25-4T Qualified mortgage credit certificate program (Temporary).
1.25-5T Limitation on aggregate amount of mortgage credit certificates 
          (Temporary).
1.25-6T Form of qualified mortgage credit certificate (Temporary).
1.25-7T Public notice (Temporary).
1.25-8T Reporting requirements (Temporary).
1.25A-0 Table of contents.
1.25A-1 Calculation of education tax credit and general eligibility 
          requirements.
1.25A-2 Definitions.
1.25A-3 Hope Scholarship Credit.
1.25A-4 Lifetime Learning Credit.
1.25A-5 Special rules relating to characterization and timing of 
          payments.
1.28-0 Credit for clinical testing expenses for certain drugs for rare 
          diseases or conditions; table of contents.
1.28-1 Credit for clinical testing expenses for certain drugs for rare 
          diseases or conditions.

                           Credits Against Tax

             credits allowable under sections 30 through 45D

1.30-1 Definition of qualified electric vehicle and recapture of credit 
          for qualified electric vehicle.
1.31-1 Credit for tax withheld on wages.
1.31-2 Credit for ``special refunds'' of employee social security tax.
1.32-2 Earned income credit for taxable years beginning after December 
          31, 1978.
1.32-3 Eligibility requirements after denial of the earned income 
          credit.
1.34-1 Special rule for owners of certain business entities.
1.35-1 Partially tax-exempt interest received by individuals.
1.35-2 Taxpayers not entitled to credit.
1.36B-0 Table of contents.
1.36B-1 Premium tax credit definitions.
1.36B-2 Eligibility for premium tax credit.
1.36B-3 Computing the premium assistance credit amount.
1.36B-4 Reconciling the premium tax credit with advance credit payments.
1.36B-5 Information reporting by Exchanges.
1.36B-6 Minimum value.
1.37-1 General rules for the credit for the elderly.
1.37-2 Credit for individuals age 65 or over.
1.37-3 Credit for individuals under age 65 who have public retirement 
          system income.
1.38-1 Investment in certain depreciable property.
1.40-1 Questions and answers relating to the meaning of the term 
          ``qualified mixture'' in section 40(b)(1).
1.41-0 Table of contents.
1.41-1 Credit for increasing research activities.
1.41-2 Qualified research expenses.
1.41-3 Base amount for taxable years beginning on or after January 3, 
          2001.

[[Page 6]]

1.41-4 Qualified research for expenditures paid or incurred in taxable 
          years ending on or after December 31, 2003.
1.41-4A Qualified research for taxable years beginning before January 1, 
          1986.
1.41-5 Basic research for taxable years beginning after December 31, 
          1986. [Reserved]
1.41-5A Basic research for taxable years beginning before January 1, 
          1987.
1.41-6 Aggregation of expenditures.
1.41-7 Special rules.
1.41-8 Alternative incremental credit applicable for taxable years 
          beginning on or before December 31, 2008.
1.41-9 Alternative simplified credit.
1.42-0 Table of contents.
1.42-0T Table of contents.
1.42-1 Limitation on low-income housing credit allowed with respect to 
          qualified low-income buildings receiving housing credit 
          allocations from a State or local housing credit agency.
1.42-1T Limitation on low-income housing credit allowed with respect to 
          qualified low-income buildings receiving housing credit 
          allocations from a State or local housing credit agency 
          (temporary).
1.42-2 [Reserved]
1.42-3 Treatment of buildings financed with proceeds from a loan under 
          an Affordable Housing Program established pursuant to section 
          721 of the Financial Institutions Reform, Recovery, and 
          Enforcement Act of 1989 (FIRREA).
1.42-4 Application of not-for-profit rules of section 183 to low-income 
          housing credit activities.
1.42-5 Monitoring compliance with low-income housing credit 
          requirements.
1.42-6 Buildings qualifying for carryover allocations.
1.42-7 Substantially bond-financed buildings. [Reserved]
1.42-8 Election of appropriate percentage month.
1.42-9 For use by the general public.
1.42-10 Utility allowances.
1.42-11 Provision of services.
1.42-12 Effective dates and transitional rules.
1.42-13 Rules necessary and appropriate; housing credit agencies' 
          correction of administrative errors and omissions.
1.42-14 Allocation rules for post-2000 State housing credit ceiling 
          amount.
1.42-15 Available unit rule.
1.42-16 Eligible basis reduced by federal grants.
1.42-17 Qualified allocation plan.
1.42A-1 General tax credit for taxable years ending after December 31, 
          1975, and before January 1, 1979.
1.43-0 Table of contents.
1.43-1 The enhanced oil recovery credit--general rules.
1.43-2 Qualified enhanced oil recovery project.
1.43-3 Certification.
1.43-4 Qualified enhanced oil recovery costs.
1.43-5 At-risk limitation. [Reserved]
1.43-6 Election out of section 43.
1.43-7 Effective date of regulations.
1.44-1 Allowance of credit for purchase of new principal residence after 
          March 12, 1975, and before January 1, 1977.
1.44-2 Property to which credit for purchase of new principal residence 
          applies.
1.44-3 Certificate by seller.
1.44-4 Recapture for certain dispositions.
1.44-5 Definitions.
1.44B-1 Credit for employment of certain new employees.

   Research Credit--For Taxable Years Beginning Before January 1, 1990

1.41-0A Table of contents.
1.41-3A Base period research expense.

    rules for computing credit for investment in certain depreciable 
                                property

1.45D-0 Table of contents.
1.45D-1 New markets tax credit.
1.45G-0 Table of contents for the railroad track maintenance credit 
          rules.
1.45G-1 Railroad track maintenance credit.
1.45Q-0 Table of contents
1.45Q-1 Credit for carbon oxide sequestration.
1.45Q-2 Definitions for purposes of Sec. Sec.  1.45Q-1 through 1.45Q-5.
1.45Q-3 Secure geological storage.
1.45Q-4 Utilization of qualified carbon oxide.
1.45Q-5 Recapture of credit.
1.45R-0 Table of contents.
1.45R-1 Definitions.
1.45R-2 Eligibility for the credit.
1.45R-3 Uniform percentage of premium paid.
1.45R-4 Claiming the credit.
1.46-1 Determination of amount.
1.46-2 Carryback and carryover of unused credit.
1.46-3 Qualified investment.
1.46-4 Limitations with respect to certain persons.
1.46-5 Qualified progress expenditures.
1.46-6 Limitation in case of certain regulated companies.
1.46-7 Statutory provisions; plan requirements for taxpayers electing 
          additional investment credit, etc.
1.46-8 Requirements for taxpayers electing additional one-percent 
          investment credit (TRASOP's).
1.46-9 Requirements for taxpayers electing an extra one-half percent 
          additional investment credit.
1.46-10 [Reserved]
1.47-1 Recomputation of credit allowed by section 38.

[[Page 7]]

1.47-2 ``Disposition'' and ``cessation''.
1.47-3 Exceptions to the application of Sec.  1.47-1.
1.47-4 Electing small business corporation.
1.47-5 Estates and trusts.
1.47-6 Partnerships.
1.47-7 Rehabilitation credit allocated over a 5-year period.
1.48-1 Definition of section 38 property.
1.48-2 New section 38 property.
1.48-3 Used section 38 property.
1.48-4 Election of lessor of new section 38 property to treat lessee as 
          purchaser.
1.48-5 Electing small business corporations.
1.48-6 Estates and trusts.
1.48-9 Definition of energy property.
1.48-10 Single purpose agricultural or horticultural structures.
1.48-11 Qualified rehabilitated building; expenditures incurred before 
          January 1, 1982.
1.48-12 Qualified rehabilitated building; expenditures incurred after 
          December 31, 1981.
1.50-1 Lessee's income inclusion following election of lessor of 
          investment credit property to treat lessee as acquirer.

   rules for computing credit for expenses of work incentive programs

1.50A-1 Determination of amount.
1.50A-2 Carryback and carryover of unused credit.
1.50A-3 Recomputation of credit allowed by section 40.
1.50A-4 Exceptions to the application of Sec.  1.50A-3.
1.50A-5 Electing small business corporations.
1.50A-6 Estates and trusts.
1.50A-7 Partnerships.
1.50B-1 Definitions of WIN expenses and WIN employees.
1.50B-2 Electing small business corporations.
1.50B-3 Estates and trusts.
1.50B-4 Partnerships.
1.50B-5 Limitations with respect to certain persons.
1.51-1 Amount of credit.

                              Tax Surcharge

1.52-1 Trades or businesses that are under common control.
1.52-2 Adjustments for acquisitions and dispositions.
1.52-3 Limitations with respect to certain persons.
1.53-1 Limitation based on amount of tax.
1.53-2 Carryback and carryover of unused credit.
1.53-3 Separate rule for pass-through of jobs credit.
1.55-1 Alternative minimum taxable income.
1.56-0 Table of contents to Sec.  1.56-1, adjustment for book income of 
          corporations.

Regulations Applicable to Taxable Years Beginning in 1969 and Ending in 
                                  1970

1.56(g)-0 Table of contents.
1.56(g)-1 Adjusted current earnings.

                       Tax Preference Regulations

1.57-0 Scope.
1.57-1 Items of tax preference defined.
1.57-2--1.57-3 [Reserved]
1.57-4 Limitation on amounts treated as items of tax preference for 
          taxable years beginning before January 1, 1976.
1.57-5 Records to be kept.
1.58-1 [Reserved]
1.58-2 General rules for conduit entities; partnerships and partners.
1.58-3 Estates and trusts.
1.58-3T Treatment of non-alternative tax itemized deductions by trusts 
          and estates and their beneficiaries in taxable years beginning 
          after December 31, 1982 (temporary).
1.58-4 Electing small business corporations.
1.58-5 Common trust funds.
1.58-6 Regulated investment companies; real estate investment trusts.
1.58-7 Tax preferences attributable to foreign sources; preferences 
          other than capital gains and stock options.
1.58-8 Capital gains and stock options.
1.59-1 Optional 10-year writeoff of certain tax preferences.
1.59A-0 Table of contents.
1.59A-1 Base erosion and anti-abuse tax.
1.59A-2 Applicable taxpayer.
1.59A-3 Base erosion payments and base erosion tax benefits.
1.59A-4 Modified taxable income.
1.59A-5 Base erosion minimum tax amount.
1.59A-6 Qualified derivative payment.
1.59A-7 Application of base erosion and anti-abuse tax to partnerships.
1.59A-8 [Reserved]
1.59A-9 Anti-abuse and recharacterization rules.
1.59A-10 Applicability date.
1.60 [Reserved]

    Authority: 26 U.S.C 7805, unless otherwise noted.
    Section 1.1(h)-1 also issued under 26 U.S.C. 1(h);
    Section 1.21-1 also issued under 26 U.S.C. 21(f);
    Section 1.21-2 also issued under 26 U.S.C. 21(f);
    Section 1.21-3 also issued under 26 U.S.C. 21(f);
    Section 1.21-4 also issued under 26 U.S.C. 21(f);
    Section 1.25-1T also issued under 26 U.S.C. 25;
    Section 1.25-2T also issued under 26 U.S.C. 25;
    Section 1.25-3 also issued under 26 U.S.C. 25;

[[Page 8]]

    Section 1.25-3T also issued under 26 U.S.C. 25;
    Section 1.25-4T also issued under 26 U.S.C. 25;
    Section 1.25-5T also issued under 26 U.S.C. 25;
    Section 1.25-6T also issued under 26 U.S.C. 25;
    Section 1.25-7T also issued under 26 U.S.C. 25;
    Section 1.25-8T also issued under 26 U.S.C. 25;
    Section 1.25A-1 also issued under section 26 U.S.C. 25A(i);
    Section 1.25A-2 also issued under section 26 U.S.C. 25A(i);
    Section 1.25A-3 also issued under section 26 U.S.C. 25A(i);
    Section 1.25A-4 also issued under section 26 U.S.C. 25A(i);
    Section 1.25A-5 also issued under section 26 U.S.C. 25A(i);
    Section 1.28-0 also issued under 26 U.S.C. 28(d)(5);
    Section 1.28-1 also issued under 26 U.S.C. 28(d)(5);
    Section 1.30-1 also issued under 26 U.S.C. 30(d)(2);
    Section 1.36B-0 also issued under 26 U.S.C. 36B(g);
    Section 1.36B-4 also issued under 26 U.S.C. 36B(g);
    Section 1.36B-5 also issued under 26 U.S.C. 36B(g);
    Section 1.41-4 also issued under 26 U.S.C. 41(d)(4)(E).
    Section 1.41-6 also issued under 26 U.S.C. 41(f)(1) and 1502;
    Section 1.41-8 also issued under 26 U.S.C. 41(c)(4)(B);
    Section 1.41-8T also issued under 26 U.S.C. 41(c)(4)(B);
    Section 1.41-9 also issued under 26 U.S.C. 41(c)(5)(C);
    Section 1.41-9T also issued under 26 U.S.C. 41(c)(5)(C);
    Section 1.42-1 also issued under 26 U.S.C. 42(n);
    Section 1.42-1T also issued under 26 U.S.C. 42(n);
    Section 1.42-3 also issued under 26 U.S.C. 42(n);
    Section 1.42-4 also issued under 26 U.S.C. 42(n);
    Section 1.42-5 also issued under 26 U.S.C. 42(n);
    Sections 1.42-6, 1.42-8, 1.42-9, 1.42-10, 1.42-11, and 1.42-12, also 
issued under 26 U.S.C. 42(n);
    Section 1.42-13 also issued under 26 U.S.C. 42(n);
    Section 1.42-14 also issued under 26 U.S.C. 42(n);
    Section 1.42-15 also issued under 26 U.S.C. 42(n);
    Section 1.42-16 also issued under 26 U.S.C. 42(n);
    Section 1.42-17 also issued under 26 U.S.C. 42(n);
    Section 1.42-18 also issued under 26 U.S.C. 42(h)(6)(F) and 
42(h)(6)(K);
    Section 1.42-19 also issued under 26 U.S.C. 42(n);
    Section 1.42-19T also issued under 26 U.S.C. 42(n);
    Sections 1.43-0--1.43-7 also issued under section 26 U.S.C. 43;
    Section 1.45D-1 also issued under 26 U.S.C. 45D(e)(2) and (i);
    Section 1.45G-1 also issued under 26 U.S.C. 45G(e)(2);
    Sections 1.45Q-1, 1.45Q-2, 1.45Q-3, 1.45Q-4, and 1.45Q-5 also issued 
under 26 U.S.C. 45Q(h).
    Section 1.45Q-3 also issued under 26 U.S.C. 45Q(f)(2).
    Section 1.45Q-4 also issued under 26 U.S.C. 45Q(f)(5).
    Section 1.45Q-5 also issued under 26 U.S.C. 45Q(f)(4).
    Section 1.46-5 also issued under 26 U.S.C. 46(d)(6) and 26 U.S.C. 
47(a)(3)(C);
    Section 1.46-6 also issued under 26 U.S.C. 46(f)(7);
    Section 1.47-1 also issued under 26 U.S.C. 47(a);
    Section 1.48-9 also issued under 26 U.S.C. 38(b) (as in effect 
before the amendments made by subtitle F of the Tax Reform Act of 1984);
    Sections 1.50A--1.50B also issued under 85 Stat. 553 (26 U.S.C. 
40(b));
    Section 1.52-1 also issued under 26 U.S.C. 52(b);
    Section 1.56(g)-1 also issued under section 7611(g)(3) of the 
Omnibus Budget Reconciliation Act of 1989 (Pub. L. 101-239, 103 Stat. 
2373).
    Section 1.59A-0 also issued under 26 U.S.C. 59A(i).
    Section 1.59A-1 also issued under 26 U.S.C. 59A(i).
    Section 1.59A-2 also issued under 26 U.S.C. 59A(i).
    Section 1.59A-3 also issued under 26 U.S.C. 59A(i).
    Section 1.59A-4 also issued under 26 U.S.C. 59A(i).
    Section 1.59A-5 also issued under 26 U.S.C. 59A(i).
    Section 1.59A-6 also issued under 26 U.S.C. 59A(i).
    Section 1.59A-7 also issued under 26 U.S.C. 59A(i).
    Section 1.59A-8 also issued under 26 U.S.C. 59A(i).
    Section 1.59A-9 also issued under 26 U.S.C. 59A(i).
    Section 1.59A-10 also issued under 26 U.S.C. 59A(i).

    Source: T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 
1960, unless otherwise noted.

[[Page 9]]



Sec.  1.0-1  Internal Revenue Code of 1954 and regulations.

    (a) Enactment of law. The Internal Revenue Code of 1954 which became 
law upon enactment of Public Law 591, 83d Congress, approved August 16, 
1954, provides in part as follows:

    Be it enacted by the Senate and House of Representatives of the 
United States of America in Congress assembled, That
    (a) Citation. (1) The provisions of this Act set forth under the 
heading ``Internal Revenue Title'' may be cited as the ``Internal 
Revenue Code of 1954''
    (2) The Internal Revenue Code enacted on February 10, 1939, as 
amended, may be cited as the ``Internal Revenue Code of 1939''.
    (b) Publication. This Act shall be published as volume 68A of the 
United States Statutes at Large, with a comprehensive table of contents 
and an appendix; but without an index or marginal references. The date 
of enactment, bill number, public law number, and chapter number, shall 
be printed as a headnote.
    (c) Cross reference. For saving provisions, effective date 
provisions, and other related provisions, see chapter 80 (sec. 7801 and 
following) of the Internal Revenue Code of 1954.
    (d) Enactment of Internal Revenue Title into law. The Internal 
Revenue Title referred to in subsection (a)(1) is as follows:

                                * * * * *

In general, the provisions of the Internal Revenue Code of 1954 are 
applicable with respect to taxable years beginning after December 31, 
1953, and ending after August 16, 1954. Certain provisions of that Code 
are deemed to be included in the Internal Revenue Code of 1939. See 
section 7851.
    (b) Scope of regulations. The regulations in this part deal with (1) 
the income taxes imposed under subtitle A of the Internal Revenue Code 
of 1954, and (2) certain administrative provisions contained in subtitle 
F of such Code relating to such taxes. In general, the applicability of 
such regulations is commensurate with the applicability of the 
respective provisions of the Internal Revenue Code of 1954 except that 
with respect to the provisions of the Internal Revenue Code of 1954 
which are deemed to be included in the Internal Revenue Code of 1939, 
the regulations relating to such provisions are applicable to certain 
fiscal years and short taxable years which are subject to the Internal 
Revenue Code of 1939. Those provisions of the regulations which are 
applicable to taxable years subject to the Internal Revenue Code of 1939 
and the specific taxable years to which such provisions are so 
applicable are identified in each instance. The regulations in 26 CFR 
(1939) part 39 (Regulations 118) are continued in effect until 
superseded by the regulations in this part. See Treasury Decision 6091, 
approved August 16, 1954 (19 FR 5167, C.B. 1954-2, 47).

                        Normal Taxes and Surtaxes

                     DETERMINATION OF TAX LIABILITY

                           Tax on Individuals



Sec.  1.1-1  Income tax on individuals.

    (a) General rule. (1) Section 1 of the Code imposes an income tax on 
the income of every individual who is a citizen or resident of the 
United States and, to the extent provided by section 871(b) or 877(b), 
on the income of a nonresident alien individual. For optional tax in the 
case of taxpayers with adjusted gross income of less than $10,000 (less 
than $5,000 for taxable years beginning before January 1, 1970) see 
section 3. The tax imposed is upon taxable income (determined by 
subtracting the allowable deductions from gross income). The tax is 
determined in accordance with the table contained in section 1. See 
subparagraph (2) of this paragraph for reference guides to the 
appropriate table for taxable years beginning on or after January 1, 
1964, and before January 1, 1965, taxable years beginning after December 
31, 1964, and before January 1, 1971, and taxable years beginning after 
December 31, 1970. In certain cases credits are allowed against the 
amount of the tax. See part IV (section 31 and following), subchapter A, 
chapter 1 of the Code. In general, the tax is payable upon the basis of 
returns rendered by persons liable therefor (subchapter A (sections 6001 
and following), chapter 61 of the Code) or at the source of the income 
by withholding. For the computation of tax in the case of a joint return 
of a husband and wife, or a return of a surviving spouse, for taxable 
years beginning before January 1, 1971, see section 2. The computation 
of tax in such a case for taxable years beginning after December 31, 
1970, is determined in accordance with the table contained in section 
1(a) as amended by the Tax Reform Act of 1969. For other rates of tax on 
individuals, see section 5(a). For the imposition of an additional tax 
for the calendar years 1968, 1969, and 1970, see section 51(a).

[[Page 10]]

    (2)(i) For taxable years beginning on or after January 1, 1964, the 
tax imposed upon a single individual, a head of a household, a married 
individual filing a separate return, and estates and trusts is the tax 
imposed by section 1 determined in accordance with the appropriate table 
contained in the following subsection of section 1:

----------------------------------------------------------------------------------------------------------------
                                                                                         Taxable years beginning
                                                                                           after Dec. 31, 1970
                                       Taxable years beginning  Taxable years beginning    (references in this
                                               in 1964           after 1964 but before    column are to the Code
                                                                          1971            as amended by the Tax
                                                                                           Reform Act of 1969)
----------------------------------------------------------------------------------------------------------------
Single individual....................  Sec. 1(a)(1)...........  Sec. 1(a)(2)...........  Sec. 1(c).
Head of a household..................  Sec. 1(b)(1)...........  Sec. 1(b)(2)...........  Sec. 1(b).
Married individual filing a separate   Sec. 1(a)(1)...........  Sec. 1(a)(2)...........  Sec. 1(d).
 return.
Estates and trusts...................  Sec. 1(a)(1)...........  Sec. 1(a)(2)...........  Sec. 1(d).
----------------------------------------------------------------------------------------------------------------

    (ii) For taxable years beginning after December 31, 1970, the tax 
imposed by section 1(d), as amended by the Tax Reform Act of 1969, shall 
apply to the income effectively connected with the conduct of a trade or 
business in the United States by a married alien individual who is a 
nonresident of the United States for all or part of the taxable year or 
by a foreign estate or trust. For such years the tax imposed by section 
1(c), as amended by such Act, shall apply to the income effectively 
connected with the conduct of a trade or business in the United States 
by an unmarried alien individual (other than a surviving spouse) who is 
a nonresident of the United States for all or part of the taxable year. 
See paragraph (b)(2) of Sec.  1.871-8.
    (3) The income tax imposed by section 1 upon any amount of taxable 
income is computed by adding to the income tax for the bracket in which 
that amount falls in the appropriate table in section 1 the income tax 
upon the excess of that amount over the bottom of the bracket at the 
rate indicated in such table.
    (4) The provisions of section 1 of the Code, as amended by the Tax 
Reform Act of 1969, and of this paragraph may be illustrated by the 
following examples:

    Example 1. A, an unmarried individual, had taxable income for the 
calendar year 1964 of $15,750. Accordingly, the tax upon such taxable 
income would be $4,507.50, computed as follows from the table in section 
1(a)(1):

Tax on $14,000 (from table).................................   $3,790.00
Tax on $1,750 (at 41 percent as determined from the table)..      717.50
                                                             -----------
    Total tax on $15,750....................................    4,507.50
 

    Example 2. Assume the same facts as in example (1), except the 
figures are for the calendar year 1965. The tax upon such taxable income 
would be $4,232.50, computed as follows from the table in section 
1(a)(2):

Tax on $14,000 (from table).................................   $3,550.00
Tax on $1,750 (at 39 percent as determined from the table)..      682.50
                                                             -----------
    Total tax on $15,750....................................    4,232.50
 

    Example 3. Assume the same facts as in example (1), except the 
figures are for the calendar year 1971. The tax upon such taxable income 
would be $3,752.50, computed as follows from the table in section 1(c), 
as amended:

Tax on $14,000 (from table).................................   $3,210.00
Tax on $1,750 (at 31 percent as determined from the table)..      542.50
                                                             -----------
    Total tax on $15,750....................................    3,752.50
 

    (b) Citizens or residents of the United States liable to tax. In 
general, all citizens of the United States, wherever resident, and all 
resident alien individuals are liable to the income taxes imposed by the 
Code whether the income is received from sources within or without the 
United States. Pursuant to section 876, a nonresident alien individual 
who is a bona fide resident of a section 931 possession (as defined in 
Sec.  1.931-1(c)(1) of this chapter) or Puerto Rico during the entire 
taxable year is, except as provided in section 931 or 933 with respect 
to income from sources within such possessions, subject to taxation in 
the same manner as a resident alien individual. As to tax on nonresident 
alien individuals, see sections 871 and 877.
    (c) Who is a citizen. Every person born or naturalized in the United 
States and subject to its jurisdiction is a citizen. For other rules 
governing the acquisition of citizenship, see chapters 1 and 2

[[Page 11]]

of title III of the Immigration and Nationality Act (8 U.S.C. 1401-
1459). For rules governing loss of citizenship, see sections 349 to 357, 
inclusive, of such Act (8 U.S.C. 1481-1489), Schneider v. Rusk, (1964) 
377 U.S. 163, and Rev. Rul. 70-506, C.B. 1970-2, 1. For rules pertaining 
to persons who are nationals but not citizens at birth, e.g., a person 
born in American Samoa, see section 308 of such Act (8 U.S.C. 1408). For 
special rules applicable to certain expatriates who have lost 
citizenship with a principal purpose of avoiding certain taxes, see 
section 877. A foreigner who has filed his declaration of intention of 
becoming a citizen but who has not yet been admitted to citizenship by a 
final order of a naturalization court is an alien.
    (d) Effective/applicability date. The second sentence of paragraph 
(b) of this section applies to taxable years ending after April 9, 2008.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7332, 39 FR 
44216, Dec. 23, 1974; T.D. 9391, 73 FR 19358, Apr. 9, 2008]



Sec.  1.1-2  Limitation on tax.

    (a) Taxable years ending before January 1, 1971. For taxable years 
ending before January 1, 1971, the tax imposed by section 1 (whether by 
subsection (a) or subsection (b) thereof) shall not exceed 87 percent of 
the taxable income for the taxable year. For purposes of determining 
this limitation the tax under section 1 (a) or (b) and the tax at the 
87-percent rate shall each be computed before the allowance of any 
credits against the tax. Where the alternative tax on capital gains is 
imposed under section 1201(b), the 87-percent limitation shall apply 
only to the partial tax computed on the taxable income reduced by 50 
percent of the excess of net long-term capital gains over net short-term 
capital losses. Where, for purposes of computations under the income 
averaging provisions, section 1201(b) is treated as imposing the 
alternative tax on capital gains computed under section 1304(e)(2), the 
87-percent limitation shall apply only to the tax equal to the tax 
imposed by section 1, reduced by the amount of the tax imposed by 
section 1 which is attributable to capital gain net income for the 
computation year.
    (b) Taxable years beginning after December 31, 1970. If, for any 
taxable year beginning after December 31, 1970, an individual has earned 
taxable income which exceeds his taxable income as defined by section 
1348, the tax imposed by section 1, as amended by the Tax Reform Act of 
1969, shall not exceed the sum computed under the provisions of section 
1348. For imposition of minimum tax for tax preferences see sections 56 
through 58.

[T.D. 7117, 36 FR 9397, May 25, 1971]



Sec.  1.1-3  Change in rates applicable to taxable year.

    For computation of the tax for a taxable year during which a change 
in the tax rates occurs, see section 21 and the regulations thereunder.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960. Redesignated by T.D. 7117, 36 FR 
9397, May 25, 1971]



Sec.  1.1(h)-1  Capital gains look-through rule for sales or exchanges
of interests in a partnership, S corporation, or trust.

    (a) In general. When an interest in a partnership held for more than 
one year is sold or exchanged, the transferor may recognize ordinary 
income (e.g., under section 751(a)), collectibles gain, section 1250 
capital gain, and residual long-term capital gain or loss. When stock in 
an S corporation held for more than one year is sold or exchanged, the 
transferor may recognize ordinary income (e.g., under sections 304, 306, 
341, 1254), collectibles gain, and residual long-term capital gain or 
loss. When an interest in a trust held for more than one year is sold or 
exchanged, a transferor who is not treated as the owner of the portion 
of the trust attributable to the interest sold or exchanged (sections 
673 through 679) (a non-grantor transferor) may recognize collectibles 
gain and residual long-term capital gain or loss.
    (b) Look-through capital gain--(1) In general. Look-through capital 
gain is the share of collectibles gain allocable to an interest in a 
partnership, S corporation, or trust, plus the share of section 1250 
capital gain allocable to an interest in a partnership, determined under 
paragraphs (b)(2) and (3) of this section.

[[Page 12]]

    (2) Collectibles gain--(i) Definition. For purposes of this section, 
collectibles gain shall be treated as gain from the sale or exchange of 
a collectible (as defined in section 408(m) without regard to section 
408(m)(3)) that is a capital asset held for more than 1 year.
    (ii) Share of collectibles gain allocable to an interest in a 
partnership, S corporation, or a trust. When an interest in a 
partnership, S corporation, or trust held for more than one year is sold 
or exchanged in a transaction in which all realized gain is recognized, 
the transferor shall recognize as collectibles gain the amount of net 
gain (but not net loss) that would be allocated to that partner (taking 
into account any remedial allocation under Sec.  1.704-3(d)), 
shareholder, or beneficiary (to the extent attributable to the portion 
of the partnership interest, S corporation stock, or trust interest 
transferred that was held for more than one year) if the partnership, S 
corporation, or trust transferred all of its collectibles for cash equal 
to the fair market value of the assets in a fully taxable transaction 
immediately before the transfer of the interest in the partnership, S 
corporation, or trust. If less than all of the realized gain is 
recognized upon the sale or exchange of an interest in a partnership, S 
corporation, or trust, the same methodology shall apply to determine the 
collectibles gain recognized by the transferor, except that the 
partnership, S corporation, or trust shall be treated as transferring 
only a proportionate amount of each of its collectibles determined as a 
fraction that is the amount of gain recognized in the sale or exchange 
over the amount of gain realized in the sale or exchange. With respect 
to the transfer of an interest in a trust, this paragraph (b)(2) applies 
only to transfers by non-grantor transferors (as defined in paragraph 
(a) of this section). This paragraph (b)(2) does not apply to a 
transaction that is treated, for Federal income tax purposes, as a 
redemption of an interest in a partnership, S corporation, or trust.
    (3) Section 1250 capital gain--(i) Definition. For purposes of this 
section, section 1250 capital gain means the capital gain (not otherwise 
treated as ordinary income) that would be treated as ordinary income if 
section 1250(b)(1) included all depreciation and the applicable 
percentage under section 1250(a) were 100 percent.
    (ii) Share of section 1250 capital gain allocable to interest in 
partnership. When an interest in a partnership held for more than one 
year is sold or exchanged in a transaction in which all realized gain is 
recognized, there shall be taken into account under section 
1(h)(7)(A)(i) in determining the partner's unrecaptured section 1250 
gain the amount of section 1250 capital gain that would be allocated 
(taking into account any remedial allocation under Sec.  1.704-3(d)) to 
that partner (to the extent attributable to the portion of the 
partnership interest transferred that was held for more than one year) 
if the partnership transferred all of its section 1250 property in a 
fully taxable transaction for cash equal to the fair market value of the 
assets immediately before the transfer of the interest in the 
partnership. If less than all of the realized gain is recognized upon 
the sale or exchange of an interest in a partnership, the same 
methodology shall apply to determine the section 1250 capital gain 
recognized by the transferor, except that the partnership shall be 
treated as transferring only a proportionate amount of each section 1250 
property determined as a fraction that is the amount of gain recognized 
in the sale or exchange over the amount of gain realized in the sale or 
exchange. This paragraph (b)(3) does not apply to a transaction that is 
treated, for Federal income tax purposes, as a redemption of a 
partnership interest.
    (iii) Limitation with respect to net section 1231 gain. In 
determining a transferor partner's net section 1231 gain (as defined in 
section 1231(c)(3)) for purposes of section 1(h)(7)(B), the transferor 
partner's allocable share of section 1250 capital gain in partnership 
property shall not be treated as section 1231 gain, regardless of 
whether the partnership property is used in the trade or business (as 
defined in section 1231(b)).
    (c) Residual long-term capital gain or loss. The amount of residual 
long-term capital gain or loss recognized by a

[[Page 13]]

partner, shareholder of an S corporation, or beneficiary of a trust on 
account of the sale or exchange of an interest in a partnership, S 
corporation, or trust shall equal the amount of long-term capital gain 
or loss that the partner would recognize under section 741, that the 
shareholder would recognize upon the sale or exchange of stock of an S 
corporation, or that the beneficiary would recognize upon the sale or 
exchange of an interest in a trust (pre-look-through long-term capital 
gain or loss) minus the amount of look-through capital gain determined 
under paragraph (b) of this section.
    (d) Special rule for tiered entities. In determining whether a 
partnership, S corporation, or trust has gain from collectibles, such 
partnership, S corporation, or trust shall be treated as owning its 
proportionate share of the collectibles of any partnership, S 
corporation, or trust in which it owns an interest either directly or 
indirectly through a chain of such entities. In determining whether a 
partnership has section 1250 capital gain, such partnership shall be 
treated as owning its proportionate share of the section 1250 property 
of any partnership in which it owns an interest, either directly or 
indirectly through a chain of partnerships.
    (e) Notification requirements. Reporting rules similar to those that 
apply to the partners and the partnership under section 751(a) shall 
apply in the case of sales or exchanges of interests in a partnership, S 
corporation, or trust that cause holders of such interests to recognize 
collectibles gain and in the case of sales or exchanges of interests in 
a partnership that cause holders of such interests to recognize section 
1250 capital gain. See Sec.  1.751-1(a)(3).
    (f) Examples. The following examples illustrate the requirements of 
this section:

    Example 1. Collectibles gain. (i) A and B are equal partners in a 
personal service partnership (PRS). B transfers B's interest in PRS to T 
for $15,000 when PRS's balance sheet (reflecting a cash receipts and 
disbursements method of accounting) is as follows:

------------------------------------------------------------------------
                                                            ASSETS
                                                     -------------------
                                                      Adjusted   Market
                                                        basis     value
------------------------------------------------------------------------
Cash................................................    $3,000    $3,000
Loans Owed to Partnership...........................    10,000    10,000
  Collectibles......................................     1,000     3,000
  Other Capital Assets..............................     6,000     2,000
                                                     -------------------
Capital Assets......................................     7,000     5,000
Unrealized Receivables..............................         0    14,000
                                                     -------------------
    Total...........................................    20,000    32,000
------------------------------------------------------------------------


------------------------------------------------------------------------
                                                        LIABILITIES AND
                                                            CAPITAL
                                                     -------------------
                                                      Adjusted   Market
                                                        basis     value
------------------------------------------------------------------------
Liabilities.........................................     2,000     2,000
Capital:
  A.................................................     9,000    15,000
  B.................................................     9,000    15,000
                                                     -------------------
    Total...........................................    20,000    32,000
------------------------------------------------------------------------

    (ii) At the time of the transfer, B has held the interest in PRS for 
more than one year, and B's basis for the partnership interest is 
$10,000 ($9,000 plus $1,000, B's share of partnership liabilities). None 
of the property owned by PRS is section 704(c) property. The total 
amount realized by B is $16,000, consisting of the cash received, 
$15,000, plus $1,000, B's share of the partnership liabilities assumed 
by T. See section 752. B's undivided one-half interest in PRS includes a 
one-half interest in the partnership's unrealized receivables and a one-
half interest in the partnership's collectibles.
    (iii) If PRS were to sell all of its section 751 property in a fully 
taxable transaction for cash equal to the fair market value of the 
assets immediately prior to the transfer of B's partnership interest to 
T, B would be allocated $7,000 of ordinary income from the sale of PRS's 
unrealized receivables. Therefore, B will recognize $7,000 of ordinary 
income with respect to the unrealized receivables. The difference 
between the amount of capital gain or loss that the partner would 
realize in the absence of section 751 ($6,000) and the amount of 
ordinary income or loss determined under Sec.  1.751-1(a)(2) ($7,000) is 
the partner's capital gain or loss on the sale of the partnership 
interest under section 741. In this case, the transferor has a $1,000 
pre-look-through long-term capital loss.
    (iv) If PRS were to sell all of its collectibles in a fully taxable 
transaction for cash equal to the fair market value of the assets 
immediately prior to the transfer of B's partnership interest to T, B 
would be allocated $1,000 of gain from the sale of the collectibles. 
Therefore, B will recognize $1,000 of collectibles gain on account of 
the collectibles held by PRS.

[[Page 14]]

    (v) The difference between the transferor's pre-look-through long-
term capital gain or loss (-$1,000) and the look-through capital gain 
determined under this section ($1,000) is the transferor's residual 
long-term capital gain or loss on the sale of the partnership interest. 
Under these facts, B will recognize a $2,000 residual long-term capital 
loss on account of the sale or exchange of the interest in PRS.
    Example 2. Special allocations. Assume the same facts as in Example 
1, except that under the partnership agreement, all gain from the sale 
of the collectibles is specially allocated to B, and B transfers B's 
interest to T for $16,000. All items of income, gain, loss, or deduction 
of PRS, other than the gain from the collectibles, are divided equally 
between A and B. Under these facts, B's amount realized is $17,000, 
consisting of the cash received, $16,000, plus $1,000, B's share of the 
partnership liabilities assumed by T. See section 752. B will recognize 
$7,000 of ordinary income with respect to the unrealized receivables 
(determined under Sec.  1.751-1(a)(2)). Accordingly, B's pre-look-
through long-term capital gain would be $0. If PRS were to sell all of 
its collectibles in a fully taxable transaction for cash equal to the 
fair market value of the assets immediately prior to the transfer of B's 
partnership interest to T, B would be allocated $2,000 of gain from the 
sale of the collectibles. Therefore, B will recognize $2,000 of 
collectibles gain on account of the collectibles held by PRS. B will 
recognize a $2,000 residual long-term capital loss on account of the 
sale of B's interest in PRS.
    Example 3. Net collectibles loss ignored. Assume the same facts as 
in Example 1, except that the collectibles held by PRS have an adjusted 
basis of $3,000 and a fair market value of $1,000, and the other capital 
assets have an adjusted basis of $4,000 and a fair market value of 
$4,000. (The total adjusted basis and fair market value of the 
partnership's capital assets are the same as in Example 1.) If PRS were 
to sell all of its collectibles in a fully taxable transaction for cash 
equal to the fair market value of the assets immediately prior to the 
transfer of B's partnership interest to T, B would be allocated $1,000 
of loss from the sale of the collectibles. Because none of the gain from 
the sale of the interest in PRS is attributable to unrealized 
appreciation in the value of collectibles held by PRS, the net loss in 
collectibles held by PRS is not recognized at the time B transfers the 
interest in PRS. B will recognize $7,000 of ordinary income (determined 
under Sec.  1.751-1(a)(2)) and a $1,000 long-term capital loss on 
account of the sale of B's interest in PRS.
    Example 4. Collectibles gain in an S corporation. (i) A corporation 
(X) has always been an S corporation and is owned by individuals A, B, 
and C. In 1996, X invested in antiques. Subsequent to their purchase, 
the antiques appreciated in value by $300. A owns one-third of the 
shares of X stock and has held that stock for more than one year. A's 
adjusted basis in the X stock is $100. If A were to sell all of A's X 
stock to T for $150, A would realize $50 of pre-look-through long-term 
capital gain.
    (ii) If X were to sell its antiques in a fully taxable transaction 
for cash equal to the fair market value of the assets immediately before 
the transfer to T, A would be allocated $100 of gain on account of the 
sale. Therefore, A will recognize $100 of collectibles gain (look-
through capital gain) on account of the collectibles held by X.
    (iii) The difference between the transferor's pre-look-through long-
term capital gain or loss ($50) and the look-through capital gain 
determined under this section ($100) is the transferor's residual long-
term capital gain or loss on the sale of the S corporation stock. Under 
these facts, A will recognize $100 of collectibles gain and a $50 
residual long-term capital loss on account of the sale of A's interest 
in X.
    Example 5. Sale or exchange of partnership interest where part of 
the interest has a short-term holding period. (i) A, B, and C form an 
equal partnership (PRS). In connection with the formation, A contributes 
$5,000 in cash and a capital asset with a fair market value of $5,000 
and a basis of $2,000; B contributes $7,000 in cash and a collectible 
with a fair market value of $3,000 and a basis of $3,000; and C 
contributes $10,000 in cash. At the time of the contribution, A had held 
the contributed property for two years. Six months later, when A's basis 
in PRS is $7,000, A transfers A's interest in PRS to T for $14,000 at a 
time when PRS's balance sheet (reflecting a cash receipts and 
disbursements method of accounting) is as follows:

------------------------------------------------------------------------
                                                            ASSETS
                                                     -------------------
                                                      Adjusted   Market
                                                        basis     value
------------------------------------------------------------------------
Cash................................................   $22,000   $22,000
Unrealized Receivables..............................         0     6,000
  Capital Asset.....................................     2,000     5,000
  Collectible.......................................     3,000     9,000
Capital Assets......................................     5,000    14,000
                                                     -------------------
    Total...........................................    27,000    42,000
------------------------------------------------------------------------

    (ii) Although at the time of the transfer A has not held A's 
interest in PRS for more than one year, 50 percent of the fair market 
value of A's interest in PRS was received in exchange for a capital 
asset with a long-term holding period. Therefore, 50 percent of A's 
interest in PRS has a long-term holding period. See Sec.  1.1223-
3(b)(1).
    (iii) If PRS were to sell all of its section 751 property in a fully 
taxable transaction immediately before A's transfer of the partnership 
interest, A would be allocated $2,000 of ordinary income. Accordingly, A 
will recognize $2,000 ordinary income and $5,000 ($7,000-

[[Page 15]]

$2,000) of capital gain on account of the transfer to T of A's interest 
in PRS. Fifty percent ($2,500) of that gain is long-term capital gain 
and 50 percent ($2,500) is short-term capital gain. See Sec.  1.1223-
3(c)(1).
    (iv) If the collectible were sold or exchanged in a fully taxable 
transaction immediately before A's transfer of the partnership interest, 
A would be allocated $2,000 of gain attributable to the collectible. The 
gain attributable to the collectible that is allocable to the portion of 
the transferred interest in PRS with a long-term holding period is 
$1,000 (50 percent of $2,000). Accordingly, A will recognize $1,000 of 
collectibles gain on account of the transfer of A's interest in PRS.
    (v) The difference between the amount of pre-look-through long-term 
capital gain or loss ($2,500) and the look-through capital gain ($1,000) 
is the amount of residual long-term capital gain or loss that A will 
recognize on account of the transfer of A's interest in PRS. Under these 
facts, A will recognize a residual long-term capital gain of $1,500 and 
a short-term capital gain of $2,500.

    (g) Effective date. This section applies to transfers of interests 
in partnerships, S corporations, and trusts that occur on or after 
September 21, 2000.

[T.D. 8902, 65 FR 57096, Sept. 21, 2000]



Sec.  1.1(i)-1T  Questions and answers relating to the tax on unearned
income certain minor children (Temporary).

                               In General

    Q-1. To whom does section 1(i) apply?
    A-1. Section 1(i) applies to any child who is under 14 years of age 
at the close of the taxable year, who has at least one living parent at 
the close of the taxable year, and who recognizes over $1,000 of 
unearned income during the taxable year.
    Q-2. What is the effective date of section 1(i)?
    A-2. Section 1(i) applies to taxable years of the child beginning 
after December 31, 1986.

                           Computation of Tax

    Q-3. What is the amount of tax imposed by section 1 on a child to 
whom section 1(i) applies?
    A-3. In the case of a child to whom section 1(i) applies, the amount 
of tax imposed by section 1 equals the greater of (A) the tax imposed by 
section 1 without regard to section 1(i) or (B) the sum of the tax that 
would be imposed by section 1 if the child's taxable income was reduced 
by the child's net unearned income, plus the child's share of the 
allocable parental tax.
    Q-4. What is the allocable parental tax?
    A-4. The allocable parental tax is the excess of (A) the tax that 
would be imposed by section 1 on the sum of the parent's taxable income 
plus the net unearned income of all children of such parent to whom 
section 1(i) applies, over (B) the tax imposed by section 1 on the 
parent's taxable income. Thus, the allocable parental tax is not 
computed with reference to unearned income of a child over 14 or a child 
under 14 with less than $1,000 of unearned income. See A-10 through A-13 
for rules regarding the determination of the parent(s) whose taxable 
income is taken into account under section 1(i). See A-14 for rules 
regarding the determination of children of the parent whose net unearned 
income is taken into account under section 1(i).
    Q-5. What is the child's share of the allocable parental tax?
    A-5. The child's share of the allocable parental tax is an amount 
that bears the same ratio to the total allocable parental tax as the 
child's net unearned income bears to the total net unearned income of 
all children of such parent to whom section 1(i) applies. See A-14.

    Example 1. During 1988, D, and a 12 year old, receives $5,000 of 
unearned income and no earned income. D has no itemized deductions and 
is not eligible for a personal exemption. D's parents have two other 
children, E, a 15 year old, and F, a 10 year old. E has $10,000 of 
unearned income and F has $100 of unearned income. D's parents file a 
joint return for 1988 and report taxable income of $70,000. Neither D's 
nor his parent's taxable income is attributable to net capital gain. D's 
tax liability for 1988, determined without regard to section 1(i), is 
$675 on $4,500 of taxable income ($5,000 less $500 allowable standard 
deduction). In applying section 1(i), D's tax would be equal to the sum 
of (A) the tax that would be imposed on D's taxable income if it were 
reduced by any net unearned income, plus (B) D's share of the allocable 
parental tax. Only D's unearned income is taken into account in 
determining the allocable parental tax because E is over 14 and F has 
less than $1,000 of unearned income. See A-4. D's net unearned income is 
$4,000 ($4,500 taxable unearned income less $500). The tax imposed on 
D's taxable income as reduced by D's net

[[Page 16]]

unearned income is $75 ($500 x 15%). The allocable parental tax is 
$1,225, the excess of $16,957.50 (the tax on $74,000, the parent's 
taxable income plus D's net unearned income) over $15,732.50 (the tax on 
$70,000, the parent's taxable income). See A-4. Thus, D's tax under 
section 1(i)(1)(B) is $1,300 ($1,225 + $75). Since this amount is 
greater than the amount of D's tax liability as determined without 
regard to section 1(i), the amount of tax imposed on D for 1988 is 
$1,300. See A-3.
    Example 2. H and W have 3 children, A, B, and C, who are all under 
14 years of age. For the taxable year 1988, H and W file a joint return 
and report taxable income of $129,750. The tax imposed by section 1 on H 
and W is $35,355. A has $5,000 of net unearned income and B and C each 
have $2,500 of net unearned income during 1988. The allocable parental 
tax imposed on A, B, and C's combined net unearned income of $10,000 is 
$3,300. This tax is the excess of $38,655, which is the tax imposed by 
section 1 on $139,750 ($129,750 + 10,000), over $35,355 (the tax imposed 
by section 1 on H and W's taxable income of $129,750). See A-4. Each 
child's share of the allocable parental tax is an amount that bears the 
same ratio to the total allocable parental tax as the child's net 
unearned income bears to the total net unearned income of A, B, and C. 
Thus, A's share of the allocable parental tax is $1,650 (5,000 / 10,000 
x 3,300) and B and C's share of the tax is $825 (2,500 / 10,000 x 3,300) 
each. See A-5.

                    Definition of Net Unearned Income

    Q-6. What is net unearned income?
    A-6. Net unearned income is the excess of the portion of adjusted 
gross income for the taxable year that is not ``earned income'' as 
defined in section 911(d)(2) (income that is not attributable to wages, 
salaries, or other amounts received as compensation for personal 
services), over the sum of the standard deduction amount provided for 
under section 63 (c)(5)(A) ($500 for 1987 and 1988; adjusted for 
inflation thereafter), plus the greater of (A) $500 (adjusted for 
inflation after 1988) or (B) the amount of allowable itemized deductions 
that are directly connected with the production of unearned income. A 
child's net unearned income for any taxable year shall not exceed the 
child's taxable income for such year.

    Example 3. A is a child who is under 14 years of age at the end of 
the taxable year 1987. Both of A's parents are alive at this time. 
During 1987, A receives $3,000 of interest from a bank savings account 
and earns $1,000 from a paper route and performing odd jobs. A has no 
itemized deductions for 1987. A's standard deduction is $1,000, which is 
an amount equal to A's earned income for 1987. Of this amount, $500 is 
applied against A's unearned income and the remaining $500 is applied 
against A's earned income. Thus, A's $500 of taxable earned income 
($1,000 less the remaining $500 of the standard deduction) is taxed 
without regard to section 1 (i); A has $2,500 of taxable unearned income 
($3,000 gross unearned income less $500 of the standard deduction) of 
which $500 is taxed without regard to section 1(i). The remaining $2,000 
of taxable unearned income is A's net unearned income and is taxed under 
section 1(i).
    Example 4. B is a child who is subject to tax under section 1(i). B 
has $400 of earned income and $2,000 of unearned income. B has itemized 
deductions of $800 (net of the 2 percent of adjusted gross income (AGI) 
floor on miscellaneous itemized deductions under section 67) of which 
$200 are directly connected with the production of unearned income. The 
amount of itemized deductions that B may apply against unearned income 
is equal to the greater of $500 or the deductions directly connected 
with the production of unearned income. See A-6. Thus, $500 of B's 
itemized deductions are applied against the $2,000 of unearned income 
and the remaining $300 of deductions are applied against earned income. 
As a result, B has taxable earned income of $100 and taxable unearned 
income of $1,500. Of these amounts, all of the earned income and $500 of 
the unearned income are taxed without regard to section 1(i). The 
remaining $1,000 of unearned income is net unearned income and is taxed 
under section 1(i).

            Unearned Income Subject to tax Under Section 1(i)

    Q-7. Will a child be subject to tax under section 1(i) on net 
unearned income (as defined in section 1(i) (4) and A-6 of this section) 
that is attributable to property transferred to the child prior to 1987?
    A-7. Yes. The tax imposed by section 1(i) on a child's net unearned 
income applies to any net unearned income of the child for taxable years 
beginning after December 31, 1986, regardless of when the underlying 
assets were transferred to the child.
    Q-8. Will a child be subject to tax under section 1(i) on net 
unearned income that is attributable to gifts from persons other than 
the child's parents or attributable to assets resulting from the child's 
earned income?
    A-8. Yes. The tax imposed by section 1(i) applies to all net 
unearned income of the child, regardless of the source of

[[Page 17]]

the assets that produced such income. Thus, the rules of section 1(i) 
apply to income attributable to gifts not only from the parents but also 
from any other source, such as the child's grandparents. Section 1(i) 
also applies to unearned income derived with respect to assets resulting 
from earned income of the child, such as interest earned on bank 
deposits.

    Example 5. A is a child who is under 14 years of age at the end of 
the taxable year beginning on January 1, 1987. Both of A's parents are 
alive at the end of the taxable year. During 1987, A receives $2,000 in 
interest from his bank account and $1,500 from a paper route. Some of 
the interest earned by A from the bank account is attributable to A's 
paper route earnings that were deposited in the account. The balance of 
the account is attributable to cash gifts from A's parents and 
grandparents and interest earned prior to 1987. Some cash gifts were 
received by A prior to 1987. A has no itemized deductions and is 
eligible to be claimed as a dependent on his parent's return. Therefore, 
for the taxable year 1987, A's standard deduction is $1,500, the amount 
of A's earned income. Of this standard deduction amount, $500 is 
allocated against unearned income and $1,000 is allocated against earned 
income. A's taxable unearned income is $1,500 of which $500 is taxed 
without regard to section 1(i). The remaining taxable unearned income of 
$1,000 is net unearned income and is taxed under section 1(i). The fact 
that some of A's unearned income is attributable to interest on 
principal created by earned income and gifts from persons other than A's 
parents or that some of the unearned income is attributable to property 
transferred to A prior to 1987, will not affect the tax treatment of 
this income under section 1(i). See A-8.

    Q-9. For purposes of section 1(i), does income which is not earned 
income (as defined in section 911(d)(2)) include social security 
benefits or pension benefits that are paid to the child?
    A-9. Yes. For purposes of section 1(i), earned income (as defined in 
section 911(d)(2)) does not include any social security or pension 
benefits paid to the child. Thus, such amounts are included in unearned 
income to the extent they are includible in the child's gross income.

              Determination of the Parent's Taxable Income

    Q-10. If a child's parents file a joint return, what is the taxable 
income that must be taken into account by the child in determining tax 
liability under section 1(i)?
    A-10. In the case of parents who file a joint return, the parental 
taxable income to be taken into account in determining the tax liability 
of a child is the total taxable income shown on the joint return.
    Q-11. If a child's parents are married and file separate tax 
returns, which parent's taxable income must be taken into account by the 
child in determining tax liability under section 1(i)?
    A-11. For purposes of determining the tax liability of a child under 
section 1(i), where such child's parents are married and file separate 
tax returns, the parent whose taxable income is the greater of the two 
for the taxable year shall be taken into account.
    Q-12. If the parents of a child are divorced, legally separated, or 
treated as not married under section 7703(b), which parent's taxable 
income is taken into account in computing the child's tax liability?
    A-12. If the child's parents are divorced, legally separated, or 
treated as not married under section 7703(b), the taxable income of the 
custodial parent (within the meaning of section 152(e)) of the child is 
taken into account under section 1(i) in determining the child's tax 
liability.
    Q-13. If a parent whose taxable income must be taken into account in 
determining a child's tax liability under section 1(i) files a joint 
return with a spouse who is not a parent of the child, what taxable 
income must the child take into account?
    A-13. The amount of a parent's taxable income that a child must take 
into account for purposes of section 1(i) where the parent files a joint 
return with a spouse who is not a parent of the child is the total 
taxable income shown on such joint return.

                         Children of the Parent

    Q-14. In determining a child's share of the allocable parental tax, 
is the net unearned income of legally adopted children, children related 
to such child by half-blood, or children from a prior marriage of the 
spouse of such child's parent taken into account in addition to the 
natural children of such child's parent?
    A-14. Yes. In determining a child's share of the allocable parental 
tax, the

[[Page 18]]

net unearned income of all children subject to tax under section 1(i) 
and who use the same parent's taxable income as such child to determine 
their tax liability under section 1(i) must be taken into account. Such 
children are taken into account regardless of whether they are adopted 
by the parent, related to such child by half-blood, or are children from 
a prior marriage of the spouse of such child's parent.

        Rules Regarding Income From a Trust or Similar Instrument

    Q-15. Will the unearned income of a child who is subject to section 
1(i) that is attributable to gifts given to the child under the Uniform 
Gift to Minors Act (UGMA) be subject to tax under section 1(i)?
    A-15. Yes. A gift under the UGMA vests legal title to the property 
in the child although an adult custodian is given certain rights to deal 
with the property until the child attains majority. Any unearned income 
attributable to such a gift is the child's unearned income and is 
subject to tax under section 1(i), whether distributed to the child or 
not.
    Q-16. Will a child who is a beneficiary of a trust be required to 
take into account the income of a trust in determining the child's tax 
liability under section 1(i)?
    A-16. The income of a trust must be taken into account for purposes 
of determining the tax liability of a beneficiary who is subject to 
section 1(i) only to the extent it is included in the child's gross 
income for the taxable year under sections 652(a) or 662(a). Thus, 
income from a trust for the fiscal taxable year of a trust ending during 
1987, that is included in the gross income of a child who is subject to 
section 1(i) and who has a calendar taxable year, will be subject to tax 
under section 1(i) for the child's 1987 taxable year.

                         Subsequent Adjustments

    Q-17. What effect will a subsequent adjustment to a parent's taxable 
income have on the child's tax liability if such parent's taxable income 
was used to determine the child's tax liability under section 1(i) for 
the same taxable year?
    A-17. If the parent's taxable income is adjusted and if, for the 
same taxable year as the adjustment, the child paid tax determined under 
section 1(i) with reference to that parent's taxable income, then the 
child's tax liability under section 1(i) must be recomputed using the 
parent's taxable income as adjusted.
    Q-18. In the case where more than one child who is subject to 
section 1(i) uses the same parent's taxable income to determine their 
allocable parental tax, what effect will a subsequent adjustment to the 
net unearned income of one child have on the other child's share of the 
allocable parental tax?
    A-18. If, for the same taxable year, more than one child uses the 
same parent's taxable income to determine their share of the allocable 
parental tax and a subsequent adjustment is made to one or more of such 
children's net unearned income, each child's share of the allocable 
parental tax must be recomputed using the combined net unearned income 
of all such children as adjusted.
    Q-19. If a recomputation of a child's tax under section 1(i), as a 
result of an adjustment to the taxable income of the child's parents or 
another child's net unearned income, results in additional tax being 
imposed by section 1(i) on the child, is the child subject to interest 
and penalties on such additional tax?
    A-19. Any additional tax resulting from an adjustment to the taxable 
income of the child's parents or the net unearned income of another 
child shall be treated as an underpayment of tax and interest shall be 
imposed on such underpayment as provided in section 6601. However, the 
child shall not be liable for any penalties on the underpayment 
resulting from additional tax being imposed under section 1(i) due to 
such an adjustment.

    Example 6. D and M are the parents of C, a child under the age of 
14. D and M file a joint return for 1988 and report taxable income of 
$69,900. C has unearned income of $3,000 and no itemized deductions for 
1988. C properly reports a total tax liability of $635 for 1988. This 
amount is the sum of the allocable parental tax of $560 on C's net 
unearned income of $2,000 (the excess of $3,000 over the sum of $500 
standard deduction and the first $500 of taxable unearned income) plus 
$75 (the tax imposed on C's first $500 of taxable unearned income). See 
A-3. One year later, D and M's 1988 tax return is adjusted on audit by 
adding

[[Page 19]]

an additional $1,000 of taxable income. No adjustment is made to the 
amount reported as C's net unearned income for 1988. However, the 
adjustment to D and M's taxable income causes C's tax liability under 
section 1(i) for 1988 to be increased by $50 as a result of the phase-
out of the 15 percent rate bracket. See A-20. In addition to this 
further tax liability, C will be liable for interest on the $50. 
However, C will not have to pay any penalty on the delinquent amount.

                           Miscellaneous Rules

    Q-20. Does the phase-out of the parent's 15 percent rate bracket and 
personal exemptions under section 1(g), if applicable, have any effect 
on the calculation of the allocable parental tax imposed on a child's 
net unearned income under section 1(i)?
    A-20. Yes. Any phase-out of the parent's 15 percent rate bracket or 
personal exemptions under section 1(g) is given full effect in 
determining the tax that would be imposed on the sum of the parent's 
taxable income and the total net unearned income of all children of the 
parent. Thus, any additional tax on a child's net unearned income 
resulting from the phase-out of the 15 percent rate bracket and the 
personal exemptions is reflected in the tax liability of the child.
    Q-21. For purposes of calculating a parent's tax liability or the 
allocable parental tax imposed on a child, are other phase-outs, 
limitations, or floors on deductions or credits, such as the phase-out 
of the $25,000 passive loss allowance for rental real estate activities 
under section 469(i)(3) or the 2 percent of AGI floor on miscellaneous 
itemized deductions under section 67, affected by the addition of a 
child's net unearned income to the parent's taxable income?
    A-21. No. A child's net unearned income is not taken into account in 
computing any deduction or credit for purposes of determining the 
parent's tax liability or the child's allocable parental tax. Thus, for 
example, although the amounts allowable to the parent as a charitable 
contribution deduction, medical expense deduction, section 212 
deduction, or a miscellaneous itemized deduction are affected by the 
amount of the parent's adjusted gross income, the amount of these 
deductions that is allowed does not change as a result of the 
application of section 1(i) because the amount of the parent's adjusted 
gross income does not include the child's net unearned income. 
Similarly, the amount of itemized deductions that is allowed to a child 
does not change as a result of section 1(i) because section 1(i) only 
affects the amount of tax liability and not the child's adjusted gross 
income.
    Q-22. If a child is unable to obtain information concerning the tax 
return of the child's parents directly from such parents, how may the 
child obtain information from the parent's tax return which is necessary 
to determine the child's tax liability under section 1(i)?
    A-22. Under section 6103(e)(1)(A)(iv), a return of a parent shall, 
upon written request, be open to inspection or disclosure to a child of 
that individual (or the child's legal representative) to the extent 
necessary to comply with section 1(i). Thus, a child may request the 
Internal Revenue Service to disclose sufficient tax information about 
the parent to the child so that the child can properly file his or her 
return.

[T.D. 8158, 52 FR 33579, Sept. 4, 1987; 52 FR 36133, Sept. 25, 1987]



Sec.  1.2-1  Tax in case of joint return of husband and wife or the
return of a surviving spouse.

    (a) Taxable year ending before January 1, 1971. (1) For taxable 
years ending before January 1, 1971, in the case of a joint return of 
husband and wife, or the return of a surviving spouse as defined in 
section 2(b), the tax imposed by section 1 shall be twice the tax that 
would be imposed if the taxable income were reduced by one-half. For 
rules relating to the filing of joint returns of husband and wife, see 
section 6013 and the regulations thereunder.
    (2) The method of computing, under section 2(a), the tax of husband 
and wife in the case of a joint return, or the tax of a surviving 
spouse, is as follows:
    (i) First, the taxable income is reduced by one-half. Second, the 
tax is determined as provided by section 1 by using the taxable income 
so reduced. Third, the tax so determined, which is the tax that would be 
determined if the taxable income were reduced by one-half, is then 
multiplied by two to produce the tax imposed in the case of

[[Page 20]]

the joint return or the return of a surviving spouse, subject, however, 
to the allowance of any credits against the tax under the provisions of 
sections 31 through 38 and the regulations thereunder.
    (ii) The limitation under section 1(c) of the tax to an amount not 
in excess of a specified percent of the taxable income for the taxable 
year is to be applied before the third step above, that is, the 
limitation to be applied upon the tax is determined as the applicable 
specified percent of one-half of the taxable income for the taxable year 
(such one-half of the taxable income being the actual aggregate taxable 
income of the spouses, or the total taxable income of the surviving 
spouse, as the case may be, reduced by one-half). For the percent 
applicable in determining the limitation of the tax under section 1(c), 
see Sec.  1.1-2(a). After such limitation is applied, then the tax so 
limited is multiplied by two as provided in section 2(a) (the third step 
above).
    (iii) The following computation illustrates the method of 
application of section 2(a) in the determination of the tax of a husband 
and wife filing a joint return for the calendar year 1965. If the 
combined gross income is $8,200, and the only deductions are the two 
exemptions of the taxpayers under section 151(b) and the standard 
deduction under section 141, the tax on the joint return for 1965, 
without regard to any credits against the tax, is $1,034.20 determined 
as follows:

1. Gross income.................................   $8,200.00
2. Less:
    Standard deduction, section 141.............        $820
    Deduction for personal exemption, section          1,200    2,020.00
     151........................................
                                                 -----------------------
3. Taxable income...............................    6,180.00
4. Taxable income reduced by one-half...........    3,090.00
5. Tax computed by the tax table provided under       517.10
 section 1(a)(2) ($310 plus 19 percent of excess
 over $2,000)...................................
6. Twice the tax in item 5......................    1,034.20
 

    (b) Taxable years beginning after December 31, 1970. (1) For taxable 
years beginning after December 31, 1970, in the case of a joint return 
of husband and wife, or the return of a surviving spouse as defined in 
section 2(a) of the Code as amended by the Tax Reform Act of 1969, the 
tax shall be determined in accordance with the table contained in 
section 1(a) of the Code as so amended. For rules relating to the filing 
of joint returns of husband and wife see section 6013 as amended and the 
regulations thereunder.
    (2) The following computation illustrates the method of computing 
the tax of a husband and wife filing a joint return for calendar year 
1971. If the combined gross income is $8,200, and the only deductions 
are the two exemptions of the taxpayers under section 151(b), as 
amended, and the standard deduction under section 141, as amended, the 
tax on the joint return for 1971, without regard to any credits against 
the tax, is $968.46, determined as follows:

1. Gross income.................................   $8,200.00
2. Less:
  Standard deduction, section 141...............   $1,066.00
  Deduction for personal exemption, section 151.    1,300.00    2,366.00
                                                 -----------------------
3. Taxable income...............................    5,834.00
4. Tax computed by the tax table provided under       968.46
 section 1(a) ($620 plus 19 percent of excess
 over $4,000)...................................
 

    (3) The limitation under section 1348 with respect to the maximum 
rate of tax on earned income shall apply to a married individual only if 
such individual and his spouse file a joint return for the taxable year.
    (c) Death of a spouse. If a joint return of a husband and wife is 
filed under the provisions of section 6013 and if the husband and wife 
have different taxable years solely because of the death of either 
spouse, the taxable year of the deceased spouse covered by the joint 
return shall, for the purpose of the computation of the tax in respect 
of such joint return, be deemed to have ended on the date of the closing 
of the surviving spouse's taxable year.
    (d) Computation of optional tax. For computation of optional tax in 
the case of a joint return or the return of a surviving spouse, see 
section 3 and the regulations thereunder.
    (e) Change in rates. For treatment of taxable years during which a 
change in the tax rates occurs see section 21 and the regulations 
thereunder.

[T.D. 7117, 36 FR 9398, May 25, 1971]

[[Page 21]]



Sec.  1.2-2  Definitions and special rules.

    (a) Surviving spouse. (1) If a taxpayer is eligible to file a joint 
return under the Internal Revenue Code of 1954 without regard to section 
6013(a) (3) thereof for the taxable year in which his spouse dies, his 
return for each of the next 2 taxable years following the year of the 
death of the spouse shall be treated as a joint return for all purposes 
if all three of the following requirements are satisfied:
    (i) He has not remarried before the close of the taxable year the 
return for which is sought to be treated as a joint return, and
    (ii) He maintains as his home a household which constitutes for the 
taxable year the principal place of abode as a member of such household 
of a person who is (whether by blood or adoption) a son, stepson, 
daughter, or stepdaughter of the taxpayer, and
    (iii) He is entitled for the taxable year to a deduction under 
section 151 (relating to deductions for dependents) with respect to such 
son, stepson, daughter, or stepdaughter.
    (2) See paragraphs (c)(1) and (d) of this section for rules for the 
determination of when the taxpayer maintains as his home a household 
which constitutes for the taxable year the principal place of abode, as 
a member of such household, of another person.
    (3) If the taxpayer does not qualify as a surviving spouse he may 
nevertheless qualify as a head of a household if he meets the 
requirements of Sec.  1.2-2(b).
    (4) The following example illustrates the provisions relating to a 
surviving spouse:

    Example: Assume that the taxpayer meets the requirements of this 
paragraph for the years 1967 through 1971, and that the taxpayer, whose 
wife died during 1966 while married to him, remarried in 1968. In 1969, 
the taxpayer's second wife died while married to him, and he remained 
single thereafter. For 1967 the taxpayer will qualify as a surviving 
spouse, provided that neither the taxpayer nor the first wife was a 
nonresident alien at any time during 1966 and that she (immediately 
prior to her death) did not have a taxable year different from that of 
the taxpayer. For 1968 the taxpayer does not qualify as a surviving 
spouse because he remarried before the close of the taxable year. The 
taxpayer will qualify as a surviving spouse for 1970 and 1971, provided 
that neither the taxpayer nor the second wife was a nonresident alien at 
any time during 1969 and that she (immediately prior to her death) did 
not have a taxable year different from that of the taxpayer. On the 
other hand, if the taxpayer, in 1969, was divorced or legally separated 
from his second wife, the taxpayer will not qualify as a surviving 
spouse for 1970 or 1971, since he could not have filed a joint return 
for 1969 (the year in which his second wife died).

    (b) Head of household. (1) A taxpayer shall be considered the head 
of a household if, and only if, he is not married at the close of his 
taxable year, is not a surviving spouse (as defined in paragraph (a) of 
this section, and (i) maintains as his home a household which 
constitutes for such taxable year the principal place of abode, as a 
member of such household, of at least one of the individuals described 
in subparagraph (3), or (ii) maintains (whether or not as his home) a 
household which constitutes for such taxable year the principal place of 
abode of one of the individuals described in subparagraph (4).
    (2) Under no circumstances shall the same person be used to qualify 
more than one taxpayer as the head of a household for the same taxable 
year.
    (3) Any of the following persons may qualify the taxpayer as a head 
of a household:
    (i) A son, stepson, daughter, or stepdaughter of the taxpayer, or a 
descendant of a son or daughter of the taxpayer. For the purpose of 
determining whether any of the stated relationships exist, a legally 
adopted child of a person is considered a child of such person by blood. 
If any such person is not married at the close of the taxable year of 
the taxpayer, the taxpayer may qualify as the head of a household by 
reason of such person even though the taxpayer may not claim a deduction 
for such person under section 151, for example, because the taxpayer 
does not furnish more than half of the support of such person. However, 
if any such person is married at the close of the taxable year of the 
taxpayer, the taxpayer may qualify as the head of a household by reason 
of such person only if the taxpayer is entitled to a deduction for such 
person under section 151 and the regulations thereunder. In applying the 
preceding sentence there shall be disregarded any such person for whom a

[[Page 22]]

deduction is allowed under section 151 only by reason of section 152(c) 
(relating to persons covered by a multiple support agreement).
    (ii) Any other person who is a dependent of the taxpayer, if the 
taxpayer is entitled to a deduction for the taxable year for such person 
under section 151 and paragraphs (3) through (8) of section 152(a) and 
the regulations thereunder. Under section 151 the taxpayer may be 
entitled to a deduction for any of the following persons:
    (a) His brother, sister, stepbrother, or stepsister;
    (b) His father or mother, or an ancestor of either;
    (c) His stepfather or stepmother;
    (d) A son or a daughter of his brother or sister;
    (e) A brother or sister of his father or mother; or
    (f) His son-in-law, daughter-in-law, father-in-law, mother-in-law, 
brother- in-law, or sister-in-law;


if such person has a gross income of less than the amount determined 
pursuant to Sec.  1.151-2 applicable to the calendar year in which the 
taxable year of the taxpayer begins, if the taxpayer supplies more than 
one-half of the support of such person for such calendar year and if 
such person does not make a joint return with his spouse for the taxable 
year beginning in such calendar year. The taxpayer may not be considered 
to be a head of a household by reason of any person for whom a deduction 
is allowed under section 151 only by reason of sections 152 (a)(9), 152 
(a)(10), or 152(c) (relating to persons not related to the taxpayer, 
persons receiving institutional care, and persons covered by multiple 
support agreements).
    (4) The father or mother of the taxpayer may qualify the taxpayer as 
a head of a household, but only if the taxpayer is entitled to a 
deduction for the taxable year for such father or mother under section 
151 (determined without regard to section 152(c)). For example, an 
unmarried taxpayer who maintains a home for his widowed mother may not 
qualify as the head of a household by reason of his maintenance of a 
home for his mother if his mother has gross income equal to or in excess 
of the amount determined pursuant to Sec.  1.151-2 applicable to the 
calendar year in which the taxable year of the taxpayer begins, or if he 
does not furnish more than one-half of the support of his mother for 
such calendar year. For this purpose, a person who legally adopted the 
taxpayer is considered the father or mother of the taxpayer.
    (5) For the purpose of this paragraph, the status of the taxpayer 
shall be determined as of the close of the taxpayer's taxable year. A 
taxpayer shall be considered as not married if at the close of his 
taxable year he is legally separated from his spouse under a decree of 
divorce or separate maintenance, or if at any time during the taxable 
year the spouse to whom the taxpayer is married at the close of his 
taxable year was a nonresident alien. A taxpayer shall be considered 
married at the close of his taxable year if his spouse (other than a 
spouse who is a nonresident alien) dies during such year.
    (6) If the taxpayer is a nonresident alien during any part of the 
taxable year he may not qualify as a head of a household even though he 
may comply with the other provisions of this paragraph. See the 
regulations prescribed under section 871 for a definition of nonresident 
alien.
    (c) Household. (1) In order for a taxpayer to be considered as 
maintaining a household by reason of any individual described in 
paragraph (a)(1) or (b)(3) of this section, the household must actually 
constitute the home of the taxpayer for his taxable year. A physical 
change in the location of such home will not prevent a taxpayer from 
qualifying as a head of a household. Such home must also constitute the 
principal place of abode of at least one of the persons specified in 
such paragraph (a)(1) or (b)(3) of this section. It is not sufficient 
that the taxpayer maintain the household without being its occupant. The 
taxpayer and such other person must occupy the household for the entire 
taxable year of the taxpayer. However, the fact that such other person 
is born or dies within the taxable year will not prevent the taxpayer 
from qualifying as a head of household if the household constitutes the 
principal place of abode of such other person for the remaining or 
preceding part

[[Page 23]]

of such taxable year. The taxpayer and such other person will be 
considered as occupying the household for such entire taxable year 
notwithstanding temporary absences from the household due to special 
circumstances. A nonpermanent failure to occupy the common abode by 
reason of illness, education, business, vacation, military service, or a 
custody agreement under which a child or stepchild is absent for less 
than 6 months in the taxable year of the taxpayer, shall be considered 
temporary absence due to special circumstances. Such absence will not 
prevent the taxpayer from being considered as maintaining a household if 
(i) it is reasonable to assume that the taxpayer or such other person 
will return to the household, and (ii) the taxpayer continues to 
maintain such household or a substantially equivalent household in 
anticipation of such return.
    (2) In order for a taxpayer to be considered as maintaining a 
household by reason of any individual described in paragraph (b)(4) of 
this section, the household must actually constitute the principal place 
of abode of the taxpayer's dependent father or mother, or both of them. 
It is not, however, necessary for the purposes of such subparagraph for 
the taxpayer also to reside in such place of abode. A physical change in 
the location of such home will not prevent a taxpayer from qualifying as 
a head of a household. The father or mother of the taxpayer, however, 
must occupy the household for the entire taxable year of the taxpayer. 
They will be considered as occupying the household for such entire year 
notwithstanding temporary absences from the household due to special 
circumstances. For example, a nonpermanent failure to occupy the 
household by reason of illness or vacation shall be considered temporary 
absence due to special circumstances. Such absence will not prevent the 
taxpayer from qualifying as the head of a household if (i) it is 
reasonable to assume that such person will return to the household, and 
(ii) the taxpayer continues to maintain such household or a 
substantially equivalent household in anticipation of such return. 
However, the fact that the father or mother of the taxpayer dies within 
the year will not prevent the taxpayer from qualifying as a head of a 
household if the household constitutes the principal place of abode of 
the father or mother for the preceding part of such taxable year.
    (d) Cost of maintaining a household. A taxpayer shall be considered 
as maintaining a household only if he pays more than one-half the cost 
thereof for his taxable year. The cost of maintaining a household shall 
be the expenses incurred for the mutual benefit of the occupants thereof 
by reason of its operation as the principal place of abode of such 
occupants for such taxable year. The cost of maintaining a household 
shall not include expenses otherwise incurred. The expenses of 
maintaining a household include property taxes, mortgage interest, rent, 
utility charges, upkeep and repairs, property insurance, and food 
consumed on the premises. Such expenses do not include the cost of 
clothing, education, medical treatment, vacations, life insurance, and 
transportation. In addition, the cost of maintaining a household shall 
not include any amount which represents the value of services rendered 
in the household by the taxpayer or by a person qualifying the taxpayer 
as a head of a household or as a surviving spouse.
    (e) Certain married individuals living apart. For taxable years 
beginning after December 31, 1969, an individual who is considered as 
not married under section 143(b) shall be considered as not married for 
purposes of determining whether he or she qualifies as a single 
individual, a married individual, a head of household or a surviving 
spouse under sections 1 and 2 of the Code.

[T.D. 7117, 36 FR 9398, May 25, 1971]



Sec.  1.3-1  Application of optional tax.

    (a) General rules. (1) For taxable years ending before January 1, 
1970, an individual whose adjusted gross income is less than $5,000 (or 
a husband and wife filing a joint return whose combined adjusted gross 
income is less than $5,000) may elect to pay the tax imposed by section 
3 in place of the tax imposed by section 1 (a) or (b). For taxable years 
beginning after December 31, 1969 and before January 1, 1971 an 
individual whose adjusted gross income is less than $10,000 (or a 
husband and wife

[[Page 24]]

filing a joint return whose combined adjusted gross income is less than 
$10,000) may elect to pay the tax imposed by section 3 as amended by the 
Tax Reform Act of 1969 in place of the tax imposed by section 1 (a) or 
(b). For taxable years beginning after December 31, 1970 an individual 
whose adjusted gross income is less than $10,000 (or a husband and wife 
filing a joint return whose combined adjusted gross income is less than 
$10,000) may elect to pay the tax imposed by section 3 as amended in 
place of the tax imposed by section 1 as amended. See Sec.  1.4-2 for 
the manner of making such election. A taxpayer may make such election 
regardless of the sources from which his income is derived and 
regardless of whether his income is computed by the cash method or the 
accrual method. See section 62 and the regulations thereunder for the 
determination of adjusted gross income. For the purpose of determining 
whether a taxpayer may elect to pay the tax under section 3, the amount 
of the adjusted gross income is controlling, without reference to the 
number of exemptions to which the taxpayer may be entitled. See section 
4 and the regulations thereunder for additional rules applicable to 
section 3.
    (2) The following examples illustrate the rule that section 3 
applies only if the adjusted gross income is less than $10,000 ($5,000 
for taxable years ending before January 1, 1970).

    Example 1. A is employed at a salary of $9,200 for the calendar year 
1970. In the course of such employment, he incurred travel expenses of 
$1,500 for which he was reimbursed during the year. Such items 
constitute his sole income for 1970. In such case the gross income is 
$10,700 but the amount of $1,500 is deducted from gross income in the 
determination of adjusted gross income and thus A's adjusted gross 
income for 1970 is $9,200. Hence, the adjusted gross income being less 
than $10,000, he may elect to pay his tax for 1970 under section 3. 
Similarly, in the case of an individual engaged in trade or business 
(excluding from the term ``engaged in trade or business'' the 
performance of personal services as an employee), there may be deducted 
from gross income in ascertaining adjusted gross income those expenses 
directly relating to the carrying on of such trade or business.
    Example 2. If B has, as his only income for 1970, a salary of 
$11,600 and his spouse has no gross income, then B's adjusted gross 
income is $11,600 (not $11,600 reduced by exemptions of $1,250) and he 
is not for such year, entitled to pay his tax under section 3. If, 
however, B has for 1970 a salary of $13,000 and incident to his 
employment he incurs expenses in the amount of $3,400 for travel, meals, 
and lodging while away from home, for which he is not reimbursed, the 
adjusted gross income is $13,000 minus $3,400 or $9,600. In such case 
his adjusted gross income being less than $10,000, B may elect to pay 
the tax under section 3. However, if B's wife has adjusted gross income 
of $400, the total adjusted gross income is $10,000. In such case, if B 
and his wife file a joint return, they may not elect to pay the optional 
tax since the combined adjusted gross income is not less than $10,000. B 
may nevertheless elect to pay the optional tax, but if he makes this 
election he must file a separate return and, since his wife has gross 
income, he may not claim an exemption for her in computing the optional 
tax.

    (b) Surviving spouse. The return of a surviving spouse is treated as 
a joint return for purposes of section 3. See section 2, and the 
regulations thereunder, with respect to the qualifications of a taxpayer 
as a surviving spouse. Accordingly, if the taxpayer qualifies as a 
surviving spouse and elects to pay the optional tax, he shall use the 
column in the tax table, appropriate to his number of exemptions, 
provided for cases in which a joint return is filed.
    (c) Use of tax table. (1) To determine the amount of the tax, the 
individual ascertains the amount of his adjusted gross income, refers to 
the appropriate table set forth in section 3 or the regulations 
thereunder, ascertains the income bracket into which such income falls, 
and, using the number of exemptions applicable to his case, finds the 
tax in the vertical column having at the top thereof a number 
corresponding to the number of exemptions to which the taxpayer is 
entitled.
    (2) Section 3(b) (relating to taxable years beginning after Dec. 31, 
1964 and ending before Jan. 1, 1970) contains 5 tables for use in 
computing the tax. Table I is to be used by a single person who is not a 
head of household. Table II is to be used by a head of household. Table 
III is to be used by married persons filing joint returns and by a 
surviving spouse. Table IV is to be used by married persons filing 
separate returns

[[Page 25]]

using the 10 percent standard deduction. Table V is to be used by 
married persons filing separate returns using the minimum standard 
deduction. For an explanation of the standard deduction see section 141 
and the regulations thereunder.
    (3) 30 tables are provided for use in computing the tax under the 
Tax Reform Act of 1969. Tables I through XV apply for taxable years 
beginning after December 31, 1969 and ending before January 1, 1971. 
Tables XVI through XXX apply for taxable years beginning after December 
31, 1970. The standard deduction for Tables I through XV, applicable to 
taxable years beginning in 1970, is 10 percent. The standard deduction 
for Tables XVI through XXX, applicable to taxable years beginning in 
1971, is 13 percent. For an explanation of the standard deduction and 
the low income allowance see section 141 as amended by the Tax Reform 
Act of 1969.
    (4) In the case of married persons filing separate returns who 
qualify to use the optional tax imposed by section 3, such persons shall 
use the tax imposed by the table for the applicable year in accordance 
with the rules prescribed by sections 4(c) and 141 and the regulations 
thereunder governing the use and application of the standard deduction 
and the low income allowance.
    (5) The tax shown in the tax tables set forth in section 3 or the 
regulations thereunder reflects full income splitting in the case of a 
joint return (including the return of a surviving spouse) and lesser 
income splitting in the case of a head of household. Therefore, it is 
possible for the tax shown in the tables relating to joint returns, or 
relating to a return of a head of a household, to be lower than that 
shown in the table for separate returns even though the amounts of 
adjusted gross income and the number of exemptions are the same.

[T.D. 7117, 36 FR 9420, May 25, 1971]



Sec.  1.4-1  Number of exemptions.

    (a) For the purpose of determining the optional tax imposed under 
section 3, the taxpayer shall use the number of exemptions allowable to 
him as deductions under section 151. See sections 151, 152, and 153, and 
the regulations thereunder. In general, one exemption is allowed for the 
taxpayer; one exemption for his spouse if a joint return is made, or if 
a separate return is made by the taxpayer and his spouse has no gross 
income for the calendar year in which the taxable year of the taxpayer 
begins and is not the dependent of another taxpayer for such calendar 
year; and one exemption for each dependent whose gross income for the 
calendar year in which the taxable year of the taxpayer begins is less 
than the applicable amount determined pursuant to Sec.  1.151-2. No 
exemption is allowed for any dependent who has made a joint return with 
his spouse for the taxable year beginning in the calendar year in which 
the taxable year of the taxpayer begins. The taxpayer may, in certain 
cases, be allowed an exemption for a dependent child of the taxpayer 
notwithstanding the fact that such child has gross income equal to or in 
excess of the amount determined pursuant to Sec.  1.151-2 applicable to 
the calendar year in which the taxable year of the taxpayer begins. The 
requirements for the allowance of such an exemption are set forth in 
paragraph (c) of Sec.  1.152-1. See paragraphs (c) and (d) of Sec.  
1.151-1 with respect to additional exemptions for a taxpayer or spouse 
who has attained the age 65 years and for a blind taxpayer or blind 
spouse
    (b) The application of this section may be illustrated by the 
following examples:

    Example 1. A, a married man whose duties as an employee require 
traveling away from his home, has as his sole gross income a salary of 
$5,600 for the calendar year 1954. His traveling expenses, including 
cost of meals and lodging, amount in such year to $750, and hence, his 
adjusted gross income is $4,850. His wife, B, has as her sole income 
interest in the amount of $85, and thus the aggregate adjusted gross 
income of A and B is $4,935. A has two dependent children neither of 
whom has any income. A and B file a joint return for 1954 on Form 1040. 
In such case four exemptions are allowable. The adjusted gross income 
falls within the tax bracket $4,900-4,950. By referring to such tax 
bracket in the tax table in section 3 and to the column headed ``4'' 
therein, the tax is found to be $407.
    Example 2. C, a married man, has as his sole income in 1954 wages of 
$4,600, and has two dependent children neither of whom has any

[[Page 26]]

income. His wife, D, has adjusted gross income of $400. C files a 
separate return for 1954 and is entitled to claim three exemptions. C's 
income falls within the tax bracket $4,600-4,650 and hence, with three 
exemptions his tax is $480. No exemption is allowed with respect to 
since D has gross income and a joint return was not filed.
    Example 3. D, a married man with no dependents, attains the age of 
65 on September 1, 1954. The aggregate adjusted gross income of D and 
his wife for 1954 is $4,840. D and his wife file a joint return for 1954 
and are entitled to three exemptions, one for each taxpayer and one 
additional exemption for D because of his age. Since the adjusted gross 
income of D and his wife falls within the tax bracket $4,800-4,850, the 
tax on a joint return is $509.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7114, 36 FR 
9018, May 18, 1971]



Sec.  1.4-2  Elections.

    (a) Making of election. The election to pay the optional tax imposed 
under section 3 shall be made by (1) filing a return on Form 1040A, or 
(2) filing a return on Form 1040 and electing in such return, in 
accordance with the provisions of section 144 and the regulations 
thereunder, to take the standard deduction provided by section 141.
    (b) Election under section 3 and election of standard deduction. 
Section 144 (a) and the regulations thereunder provide rules for 
treating an election to pay the tax under section 3 as an election to 
take the standard deduction, and for treating an election to take the 
standard deduction as an election to pay the tax under section 3. For 
example, if the taxpayer's return shows $5,000 or more of adjusted gross 
income and he elects to take the standard deduction, he will be deemed 
to have elected to pay the tax under section 3 if it is subsequently 
determined that his correct adjusted gross income is less than $5,000.
    (c) [Reserved]
    (d) Change of election. For rules relating to a change of election 
to pay, or not to pay, the optional tax imposed under section 3, see 
section 144 (b) and the regulations thereunder.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6581, 26 FR 
11677, Dec. 6, 1961; T.D. 7269, 38 FR 9295, Apr. 13, 1973]



Sec.  1.4-3  Husband and wife filing separate returns.

    (a) In general. If the separate adjusted gross income of a husband 
is less than $5,000 and the separate adjusted gross income of his wife 
is less than $5,000, and if each is required to file a return, the 
husband and the wife must each elect to pay the optional tax imposed 
under section 3 or neither may so elect. If the separate adjusted gross 
income of each spouse is $5,000 or more, then neither spouse can elect 
to pay the optional tax imposed under section 3. If the adjusted gross 
income of one spouse is $5,000 or more and that of the other spouse is 
less than $5,000, the election to pay the optional tax imposed under 
section 3 may be exercised by the spouse having adjusted gross income of 
less than $5,000 only if the spouse having adjusted gross income of 
$5,000 or more, in computing taxable income, uses the standard deduction 
provided by section 141. If the spouse having adjusted gross income of 
$5,000 or more does not use the standard deduction, then the spouse 
having adjusted gross income of less than $5,000 may not elect to pay 
the optional tax and must compute taxable income without regard to the 
standard deduction. Accordingly, if the spouse having adjusted gross 
income of $5,000 or more itemizes the deductions allowed by sections 161 
and 211 in computing taxable income, the spouse having adjusted gross 
income of less than $5,000 must also compute taxable income by itemizing 
the deductions allowed by sections 161 and 211, and must pay the tax 
imposed by section 1. For rules relative to the election to take the 
standard deduction by husband and wife, see part IV (section 141 and 
following), subchapter B, chapter 1 of the Code, and the regulations 
thereunder.
    (b) Taxable years beginning after December 31, 1963, and before 
January 1, 1970. (1) In the case of a husband and wife filing a separate 
return for a taxable year beginning after December 31, 1963, and before 
January 1, 1970, the optional tax imposed by section 3 shall be--
    (i) For taxable years beginning in 1964, the lesser of the tax shown 
in Table IV (relating to the 10-percent standard deduction for married 
persons

[[Page 27]]

filing separate returns) or Table V (relating to the minimum standard 
deduction for married persons filing separate returns) of section 3(a), 
and
    (ii) For a taxable year beginning after December 31, 1964, and 
before January 1, 1970, the lesser of the tax shown in Table IV 
(relating to the 10-percent standard deduction for married persons 
filing separate returns) or Table V (relating to minimum standard 
deduction for married persons filing separate returns) of section 3(b).
    (2) If the tax of one spouse is determined with regard to the 10-
percent standard deduction provided for in Table IV of section 3(a) or 
3(b) or if such spouse in computing taxable income uses the 10-percent 
standard deduction provided for in section 141(b), then the minimum 
standard deduction provided for in Table V of section 3(a) or 3(b) shall 
not apply in the case of the other spouse, if such spouse elects to pay 
the optional tax imposed under section (3). Thus, if a husband and wife 
compute their tax with reference to the standard deduction, one cannot 
elect to use the 10-percent standard deduction and the other elect to 
use the minimum standard deduction. However, an individual described in 
section 141(d)(2) may elect pursuant to such section and the regulations 
thereunder to pay the tax shown in Table V of section 3(a) or 3(b) in 
lieu of the tax shown in Table IV of section 3(a) or 3(b). See section 
141(d) and the regulations thereunder for rules relating to the standard 
deduction in the case of married individuals filing separate returns.
    (c) Taxable years beginning after December 31, 1969. (1) In the case 
of a husband and wife filing a separate return for a taxable year 
beginning after December 31, 1969, the optional tax imposed by section 3 
shall be the lesser of the tax shown in--
    (i) The table prescribed under section 3 applicable to such taxable 
year in the case of married persons filing separate returns which 
applies the percentage standard deduction, or
    (ii) The table prescribed under section 3 applicable to such taxable 
year in the case of married persons filing separate returns which 
applies the low income allowance.
    (2) If the tax of one spouse is determined by the table described in 
subparagraph (1)(i) of this paragraph or if such spouse in computing 
taxable income uses the percentage standard deduction provided for in 
section 141(b), then the table described in subparagraph (1)(ii) of this 
paragraph shall not apply in the case of the other spouse, if such other 
spouse elects to pay the optional tax imposed under section 3. Thus, if 
a husband and wife compute the tax with reference to the standard 
deduction, one cannot elect to use the percentage standard deduction and 
the other elect to use the low income allowance. A married individual 
described in section 141(d)(2) may elect pursuant to such section and 
the regulations thereunder to pay the tax shown in the table described 
by subparagraph (1)(ii) of this paragraph in lieu of the tax shown in 
the table described by subparagraph (1)(i) of this paragraph. See 
section 141(d) and the regulations thereunder for rules relating to the 
standard deduction in the case of married individuals filing separate 
returns.
    (d) Determination of marital status. For the purpose of applying the 
restrictions upon the right of a married person to elect to pay the tax 
under section 3, (1) the determination of marital status is made as of 
the close of the taxpayer's taxable year or, if his spouse died during 
such year, as of the date of death; (2) a person legally separated from 
his spouse under a decree of divorce or separate maintenance on the last 
day of his taxable year (or the date of death of his spouse, whichever 
is applicable) is not considered as married; and (3) with respect to 
taxable years beginning after December 31, 1969, a person, although 
considered as married within the meaning of section 143(a), is 
considered as not married if he lives apart from his spouse and 
satisfies the requirements set forth in section 143(b). See section 143 
and the regulations thereunder.

[T.D. 6792, 30 FR 529, Jan. 15, 1965, as amended by T.D. 7123, 36 FR 
11084, June 9, 1971]

[[Page 28]]



Sec.  1.4-4  Short taxable year caused by death.

    An individual making a return for a period of less than 12 months on 
account of a change in his accounting period may not elect to pay the 
optional tax under section 3. However, the fact that the taxable year is 
less than 12 months does not prevent the determination of the tax for 
the taxable year under section 3 if the short taxable year results from 
the death of the taxpayer.

                           Tax on Corporations



Sec.  1.11-1  Tax on corporations.

    (a) Every corporation, foreign or domestic, is liable to the tax 
imposed under section 11 except (1) corporations specifically excepted 
under such section from such tax; (2) corporations expressly exempt from 
all taxation under subtitle A of the Code (see section 501); and (3) 
corporations subject to tax under section 511(a). For taxable years 
beginning after December 31, 1966, foreign corporations engaged in trade 
or business in the United States shall be taxable under section 11 only 
on their taxable income which is effectively connected with the conduct 
of a trade or business in the United States (see section 882(a)(1)). For 
definition of the terms ``corporations,'' ``domestic,'' and ``foreign,'' 
see section 7701(a) (3), (4), and (5), respectively. It is immaterial 
that a domestic corporation, and for taxable years beginning after 
December 31, 1966, a foreign corporation engaged in trade or business in 
the United States, which is subject to the tax imposed by section 11 may 
derive no income from sources within the United States. The tax imposed 
by section 11 is payable upon the basis of the returns rendered by the 
corporations liable thereto, except that in some cases a tax is to be 
paid at the source of the income. See subchapter A (sections 6001 and 
following), chapter 61 of the Code, and section 1442.
    (b) The tax imposed by section 11 consists of a normal tax and a 
surtax. The normal tax and the surtax are both computed upon the taxable 
income of the corporation for the taxable year, that is, upon the gross 
income of the corporation minus the deductions allowed by chapter 1 of 
the Code. However, the deduction provided in section 242 for partially 
tax-exempt interest is not allowed in computing the taxable income 
subject to the surtax.
    (c) The normal tax is at the rate of 22 percent and is applied to 
the taxable income for the taxable year. However, in the case of a 
taxable year ending after December 31, 1974, and before January 1, 1976, 
the normal tax is at the rate of 20 percent of so much of the taxable 
income as does not exceed $25,000 and at the rate of 22 percent of so 
much of the taxable income as does exceed $25,000 and is applied to the 
taxable income for the taxable year.
    (d) The surtax is at the rate of 26 percent and is upon the taxable 
income (computed without regard to the deduction, if any, provided in 
section 242 for partially tax-exempt interest) in excess of $25,000. 
However, in the case of a taxable year ending after December 31, 1974, 
and before January 1, 1976, the surtax is upon the taxable income 
(computed as provided in the preceding sentence) in excess of $50,000. 
In certain circumstances the exemption from surtax may be disallowed in 
whole or in part. See sections 269, 1551, 1561, and 1564 and the 
regulations thereunder. For purposes of sections 244, 247, 804, 907, 922 
and Sec. Sec.  1.51-1 and 1.815-4, when the phrase ``the sum of the 
normal tax rate and the surtax rate for the taxable year'' is used in 
any such section, the normal tax rate for all taxable years beginning 
after December 31, 1963, and ending before January 1, 1976, shall be 
considered to be 22 percent.
    (e) The computation of the tax on corporations imposed under section 
11 may be illustrated by the following example:

    Example. The X Corporation, a domestic corporation, has gross income 
of $86,000 for the calendar year 1964. The gross income includes 
interest of $5,000 on United States obligations for which a deduction 
under section 242 is allowable in determining taxable income subject to 
the normal tax. It has other deductions of $11,000. The tax of the X 
Corporation under section 11 for the calendar year is $28,400 ($15,400 
normal tax and $13,000 surtax) computed as follows:

                        Computation of Normal Tax
Gross income....................................     $86,000
Deductions:
  Partially tax-exempt interest.................      $5,000

[[Page 29]]

 
  Other.........................................      11,000      16,000
                                                 -----------------------
Taxable income..................................      70,000
Normal tax (22 percent of $70,000)..............      15,400
 
                          Computation of Surtax
Taxable income..................................      70,000
Add: Amount of partially tax-exempt interest           5,000
 deducted in computing taxable income...........
                                                 -------------
Taxable income subject to surtax................      75,000
Less: Exemption from surtax.....................      25,000
                                                 -------------
Excess of taxable income subject to surtax over       50,000
 exemption......................................
Surtax (26 percent of $50,000)..................      13,000
 

    (f) For special rules applicable to foreign corporations engaged in 
trade or business within the United States, see section 882 and the 
regulations thereunder. For additional tax on personal holding 
companies, see part II (section 541 and following), subchapter G, 
chapter 1 of the Code, and the regulations thereunder. For additional 
tax on corporations improperly accumulating surplus, see part I (section 
531 and following), subchapter G, chapter 1 of the Code, and the 
regulations thereunder. For treatment of China Trade Act corporations, 
see sections 941 and 942 and the regulations thereunder. For treatment 
of Western Hemisphere trade corporations, see sections 921 and 922 and 
the regulations thereunder. For treatment of capital gains and losses, 
see subchapter P (section 1201 and following), chapter 1 of the Code. 
For computation of the tax for a taxable year during which a change in 
the tax rates occurs, see section 21 and the regulations thereunder.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7293, 38 FR 
32792, Nov. 28, 1973; T.D. 74-13, 41 FR 12639, Mar. 26, 1976]

                 Changes in Rates During a Taxable Year



Sec.  1.15-1  Changes in rate during a taxable year.

    (a) Section 21 applies to all taxpayers, including individuals and 
corporations. It provides a general rule applicable in any case where 
(1) any rate of tax imposed by chapter 1 of the Code upon the taxpayer 
is increased or decreased, or any such tax is repealed, and (2) the 
taxable year includes the effective date of the change, except where 
that date is the first day of the taxable year. For example, the normal 
tax on corporations under section 11(b) was decreased from 30 percent to 
22 percent in the case of a taxable year beginning after December 31, 
1963. Accordingly, the tax for a taxable year of a corporation beginning 
on January 1, 1964, would be computed under section 11(b) at the new 
rate without regard to section 21. However, for any taxable year 
beginning before January 1, 1964, and ending on or after that date, the 
tax would be computed under section 21. For additional circumstances 
under which section 21 is not applicable, see paragraph (k) of this 
section.
    (b) In any case in which section 21 is applicable, a tentative tax 
shall be computed by applying to the taxable income for the entire 
taxable year the rate for the period within the taxable year before the 
effective date of change, and another tentative tax shall be computed by 
applying to the taxable income for the entire taxable year the rate for 
the period within the taxable year on or after such effective date. The 
tax imposed on the taxpayer is the sum of--
    (1) An amount which bears the same ratio to the tentative tax 
computed at the rate applicable to the period within the taxable year 
before the effective date of the change that the number of days in such 
period bears to the number of days in the taxable year, and
    (2) An amount which bears the same ratio to the tentative tax 
computed at the rate applicable to the period within the taxable year on 
and after the effective date of the change that the number of days in 
such period bears to the number of days in the taxable year.
    (c) If the rate of tax is changed for taxable years ``beginning 
after'' or ``ending after'' a certain date, the following day is 
considered the effective date of the change for purposes of section 21. 
If the rate is changed for taxable years ``beginning on or after'' a 
certain date, that date is considered the effective date of the change 
for purposes of section 21. This rule may be illustrated by the 
following examples:

    Example 1. Assume that the law provides that a change in a certain 
rate of tax shall be effective only with respect to taxable years 
beginning after December 31, 1969. The effective date of change for 
purposes of section 21 is January 1, 1970, and section 21 must

[[Page 30]]

be applied to any taxable year which begins before and ends on or after 
January 1, 1970.
    Example 2. Assume that the law provides that a change in a certain 
rate of tax shall be applicable only with respect to taxable years 
ending after December 31, 1970. For purposes of section 21, the 
effective date of change is January 1, 1971, and section 21 must be 
applied to any taxable year which begins before and ends on or after 
January 1, 1971.
    Example 3. Assume that the law provides that a change in a certain 
rate of tax shall be effective only with respect to taxable years 
beginning on or after January 1, 1971. The effective date of change for 
purposes of section 21 is January 1, 1971, and section 21 must be 
applied to any taxable year which begins before and ends on or after 
January 1, 1971.

    (d) If a tax is repealed, the repeal will be treated as a change of 
rate for purposes of section 21, and the rate for the period after the 
repeal (for purposes of computing the tentative tax with respect to that 
period) will be considered zero. For example, the Tax Reform Act of 1969 
repealed section 1562, which imposed a 6 percent additional tax on 
controlled corporations electing multiple surtax exemptions, effective 
for taxable years beginning after December 31, 1974. For such controlled 
corporations having taxable years beginning in 1974 and ending in 1975, 
the rate for the period ending before January 1, 1975, would be 6 
percent; the rate for the period beginning after December 31, 1974, 
would be zero. However, subject to the rules stated in this section, 
section 21 does not apply to the imposition of a new tax. For example, 
if a new tax is imposed for taxable years beginning on or after July 1, 
1972, a computation under section 21 would not be required with respect 
to such new tax in the case of taxable years beginning before July 1, 
1972, and ending on or after that date. If the effective date of the 
imposition of a new tax and the effective date of a change in rate of 
such tax fall in the same taxable year, section 21 is not applicable in 
computing the taxpayer's liability for such tax for such year unless the 
new tax is expressly imposed upon the taxpayer for a portion of his 
taxable year prior to the change in rate.
    (e) If a husband and wife have different taxable years because of 
the death of either spouse, and if a joint return is filed with respect 
to the taxable year of each, then, for purposes of section 21, the joint 
return shall be treated as if the taxable years of both spouses ended on 
the date of the closing of the surviving spouse's taxable year. See 
section 6013 (c), relating to treatment of joint return after death of 
either spouse. Accordingly, if a change in the rate of tax is effective 
during the taxable year of the surviving spouse, the tentative taxes 
with respect to the joint return shall be computed on the basis of the 
number of days during which each rate of tax was in effect for the 
taxable year of the surviving spouse.
    (f) Section 21 applies whether or not the taxpayer has a taxable 
year of less than 12 months. Moreover, section 21 applies whether or not 
the taxable income for a taxable year of less than 12 months is required 
to be placed on an annual basis under section 443. If the taxable income 
is required to be computed under section 443(b) then the tentative taxes 
under section 21 are computed as provided in paragraph (1) or (2) of 
section 443(b) and are reduced as provided in those paragraphs. The 
tentative taxes so computed and reduced are then apportioned as provided 
in section 21(a)(2) to determine the tax for such taxable year as 
computed under section 21.
    (g) If a taxpayer has made the election under section 441(f) 
(relating to computation of taxable income on the basis of an annual 
accounting period varying from 52 to 53 weeks), the rules provided in 
section 441(f)(2) shall be applicable for purposes of determining 
whether section 21 applies to the taxable year of the taxpayer. Where a 
taxpayer has made the election under section 441(f) and where section 21 
applies to the taxable year of the taxpayer the computation under 
section 21(a)(2) shall be made upon the basis of the actual number of 
days in the taxable year and in each period thereof.
    (h)(1) Section 21 is applicable only if the rate of tax imposed by 
chapter 1 changes. Sections in which rates of tax are specified or 
incorporated by reference include the following: 1, 2, 3, 11, 511, 531, 
541, 821, 831, 871, 881, 1201, and 1348 (for taxable years beginning 
after December 31, 1970). Except as provided

[[Page 31]]

in subparagraph (3) of this paragraph, section 21 is not applicable with 
respect to changes in the law relating to deductions from gross income, 
exclusions from or inclusions in gross income, or other items taken into 
account in determining the amount or character of income subject to tax. 
Moreover, section 21 is not applicable with respect to changes in the 
law relating to credits against the tax or with respect to changes in 
the law relating to limitations on the amount of tax. Section 21 is 
applicable, however, to all those computations specified in the section 
providing the rate of tax which are implicit in determining the rate. 
For example, if one of the tax brackets in the tax tables under section 
3 were to be changed, section 21 would be applicable to that change. 
Thus, if the bracket relating to ``at least $4,200 but not less than 
$4,250'' for heads of households should be changed to increase or 
decrease the last sum specified, with corresponding changes being made 
in subsequent brackets, section 21 would be applicable. The enactment of 
sections 1561 and 1562 is considered a change in section 11(d) which 
constitutes a change in rate for the period ending after December 31, 
1963. The amendment of section 1561 and the repeal of section 1562 by 
the Tax Reform Act of 1969 is considered a change in section 11(d) which 
constitutes a change in rate for the period ending after December 31, 
1974. The repeal of the 2 percent additional tax imposed under section 
1503 on corporations filing consolidated returns constitutes a change in 
rate for the period ending after December 31, 1963. The addition to the 
Code of section 1348 (relating to 50 percent maximum rate on earned 
income) is a change in rate to which section 21(a) is applicable. The 
amendment of section 11(d) by the Tax Reduction Act of 1975 which 
increases to $50,000 the surtax exemption for a taxable year ending 
during 1975 constitutes a change in rate for such portion of the taxable 
year (if less than the entire taxable year) as follows December 31, 
1974. Similarly, the return of the surtax exemption to $25,000 for a 
taxable year ending during 1976 constitutes a change in rate for such 
portion of the taxable year (if less than the entire taxable year) as 
follows December 31, 1975.
    (2) Ordinarily, both the old and the new rates are applied to the 
same amount of taxable income. However, where the rate of tax is itself 
taken into account in determining taxable income (for example, the 
special deduction for Western Hemisphere trade corporations under 
section 922), the taxable income used in determining the tentative tax 
employing the rate before the effective date of change shall be 
determined by reference to that rate of tax, and the taxable income for 
the purpose of determining the tentative tax employing the rate for the 
period on and after the effective date of the change shall be determined 
by reference to the new tax rate.
    (3) Section 21 is applicable with respect to changes in the law 
relating to the standard deduction for individuals provided in part IV 
of subchapter B and to the deduction for personal exemptions for 
individuals provided in part V of subchapter B.
    (i) If the rate of tax changes more than once during the taxable 
year, section 21 is applicable to each change in rate. For example, if 
the rate of normal tax changed for taxable years beginning on or after 
March 1, 1954, and changed again for taxable years beginning on or after 
June 1, 1954, section 21 requires computation of 3 tentative taxes for 
any taxable year which began before March 1, 1954, and ended on or after 
June 1, 1954: One tentative tax at the rate in effect before the March 1 
change; another tentative tax at the rate in effect from March 1 to May 
31; and a third tentative tax at the rate in effect from June 1 to the 
end of the taxable year. The proportion of each such tentative tax taken 
into account in determining the tax imposed on the taxpayer is computed 
by reference to the portion of the taxable year before March 1, 1954, by 
reference to the portion of the taxable year from March 1, 1954, through 
May 31, 1954, and by reference to the portion of the taxable year from 
June 1, 1954, to the end of the taxable year, respectively.
    (j)(1) If a change in the rate of one tax imposed by chapter 1 of 
the Code does not affect the amount of other taxes imposed by chapter 1 
of the Code

[[Page 32]]

the other taxes may be determined without regard to section 21 and 
section 21 will be applied only to the tax for which a change in rate is 
made. However, if the change of rate of one tax does affect the amount 
of other taxes imposed under chapter 1 of the Code, then the computation 
of the taxes under chapter 1 of the Code so affected shall be made by 
applying section 21. For example, if section 1201 applies to an 
individual taxpayer for a taxable year containing the effective date of 
a change in a rate of tax provided in section 1, then under section 21 
the taxpayer must compute a tentative tax for each period for which a 
different rate of tax is effective under section 1. The tentative tax 
for each such period as computed under section 1201 will reflect the 
rate of tax provided by section 1 for such period.
    (2) In certain cases chapter 1 of the Code provides that the 
particular tax to be imposed upon the taxpayer shall be one of several 
taxes, the basis of selection being the tax that is greater or lesser. 
See, for example, sections 821 and 1201. If in any such case the rate of 
any one of these taxes changes, then the tentative taxes computed as 
provided by section 21 for each period shall be computed employing the 
tax selected in accordance with the general rule of selection for such a 
case, at the rate of tax in effect for such period. Thus, if a change in 
the rate of the alternative tax under section 1201 is such that the 
alternative tax under section 1201 is applicable if the old rate is used 
and is not applicable if the new rate is used, one tentative tax will 
consist of the alternative tax under section 1201 and the other 
tentative tax will consist of the tax imposed by the other applicable 
sections of chapter 1 of the Code. The two tentative taxes so computed 
are then prorated in accordance with section 21(a)(2) and the sum of the 
proportionate amounts is the tax imposed for the taxable year under 
chapter 1 of the Code. See the examples in paragraph (n) of this 
section.
    (k) Section 21 does not apply in the following situations:
    (1) The provisions of section 21 do not apply to the imposition of 
the tax surcharge by section 51. The proration rules of section 51(a) 
apply in the case of a taxable year ending on or after the effective 
date of the surcharge and beginning before July 1, 1970.
    (2) The provisions of section 21 do not apply to the imposition of 
the minimum tax for tax preferences by section 56. The proration rules 
of section 301(c) of the Tax Reform Act of 1969 (83 Stat. 586) apply in 
the case of a taxable year beginning in 1969 and ending in 1970.
    (l) In computing the number of days each rate of tax is in effect 
during the taxable year for purposes of section 21(a)(2), the effective 
date of the change in rate shall be counted in the period for which the 
new rate is in effect.
    (m) Any credits against tax, and any limitation in any credit 
against tax, shall be based upon the tax computed under section 21. For 
credits against tax, see part IV (section 31 and following), subchapter 
A, chapter 1 of the Code.
    (n) The application of section 21 may be illustrated by the 
following examples: (See also the examples in Sec.  1.1561-2A(a)(3).)

    Example 1. A, a married taxpayer filing a joint return, reports his 
income on the basis of a fiscal year ending June 30. For his fiscal year 
ending June 30, 1970, A reports taxable income (exclusive of capital 
gains and losses) of $50,000 and net long-term capital gain (section 
1201 gain (net capital gain for taxable years beginning after December 
31, 1976)) of $75,000. The rate of tax on capital gains under section 
1201(b) relating to the alternative tax has been increased from 25 
percent to a maximum rate of 29\1/2\ percent with respect to gain in 
excess of $50,000 and the effective date of the change in rate is 
January 1, 1970. The income tax for the taxable year ended June 30, 
1970, would be computed under section 21 as follows:

                              Tentative Tax
Taxable income exclusive of capital      $50,000
 gains and losses...................
Long-term capital gain..............      75,000
                                     -------------
                                         125,000
Deduct 50% of long-term capital gain      37,500
                                     -------------
      Taxable income................      87,500
                                     =============
Tax under section 1 (1969 and 1970        37,690
 rates).............................
                                     =============

[[Page 33]]

 
           Alternative Tax Under Section 1201(b) (1969 Rates)
Taxable income ($50,000 + 50% of         $87,500
 $75,000)...........................
Less 50% of long-term capital gain..      37,500
                                     -------------
Taxable income exclusive of capital       50,000
 gains..............................
                                     =============
Partial tax (tax on $50,000)........      17,060
Plus 25% of $75,000.................      18,750
                                     -------------
Alternative tax under section             35,810
 1201(b) at 1969 rates..............
           Alternative Tax Under Section 1201(b) (1970 Rates)
                                 step i
Taxable income ($50,000 + 50% of         $87,500
 $75,000)...........................
Deduct 50% of net section 1201 gain       37,500
 (net capital gain for taxable years
 beginning after December 31, 1976).
                                     ------------
                                          50,000
                                     ============
Tax on $50,000 (taxable income        ..........     $17,060
 exclusive of capital gains)........
                                 step ii
(a) Net section 1201 gain (net            75,000
 capital gain for taxable years
 beginning after December 31, 1976).
(b) Subsection (d) gain.............      50,000
25% of $50,000 (lesser of (a) or      ..........      12,500
 (b))...............................
                                step iii
(c) 29\1/2\% of $25,000 (excess of         7,375
 (a) over (b))......................
                                     ============
(d) Ordinary income.................     $50,000
50% of net section 1201 gain (net         37,500
 capital gain for taxable years
 beginning after December 31, 1976).
                                     ------------
                                          87,500
                                     ============
Tax on $87,500......................     $37,690
Ordinary income.....................     $50,000
50% of subsection (d) gain..........      25,000
                                     ------------
                                          75,000
                                     ============
Tax on $75,000......................      30,470
                                     ------------
Difference..........................       7,220
                                     ============
Lesser of (c) or (d)................      $7,220
                                     -------------
Alternative tax (total of 3 steps)        36,780
 at rates effective on and after
 January 1, 1970....................
                                     =============
 


Since the alternative tax is less than the tax imposed under section 1 
for both the period in 1969 and the period in 1970, the alternative tax 
applies for both periods. Thus, since the effective date of the change 
in the rate of tax on capital gains is January 1, 1970, the old rate of 
alternative tax is effective for 184 days of the taxable year and the 
new rate of alternative tax is effective for 181 days of the taxable 
year. The alternative taxes are apportioned as follows:

1969--184/365 of $35,810....................................  $18,052.16
1970--181/365 of $36,780....................................   18,238.85
                                                             -----------
                                                               36,291.01
Tax surcharge (See Sec.   1.51-1(d)(1)(i))..................    2,729.28
                                                             -----------
      Total tax for the taxable year........................   39,020.29
 

    Example 2. B, a single individual not a head of a household, has a 
taxable year ending March 31. For the taxable year ending March 31, 
1971, B has adjusted gross income of $18,500. His computation of the tax 
imposed is as follows:

                           1970 Tentative Tax
Adjusted gross income...........................  $18,500.00
  Less:
    Standard deduction..........................   $1,000.00
    Personal exemption..........................      625.00    1,625.00
                                                 -----------------------
Taxable income under 1970 deduction provisions..   16,875.00
                                                 =============
Tax on $16,875 (1970 rates):
  Tax on first $16,000..........................    4,330.00
  42 percent of $875............................      367.50
                                                 ------------
Tentative tax at rates and deduction provisions     4,697.50
 effective on or after January 1, 1970..........
                                                 =============
 
                           1971 Tentative Tax
Adjusted gross income...........................  $18,500.00
  Less:
    Standard deduction..........................      $1,500
    Personal exemption..........................         650    2,150.00
                                                 -----------------------
Taxable income under 1971 deduction provisions..   16,350.00
                                                 =============
Tax on $16,350 (1971 rates):
  Tax on first $16,000..........................       3,830
  34 percent of $350............................         119
                                                 ------------
Tentative tax at rates and deduction provisions     3,949.00
 effective on or after Januray 1, 1971..........
                                                 =============
The 1970 and 1971 tentative taxes are
 apportioned as follows:
  1970--275/365 of $4,697.50....................    3,539.21
  1971--90/365 of $3,949.00.....................      973.73
                                                 -------------
                                                    4,512.94
Tax surcharge (see Sec.   1.51-1(d)(1)(i))......       56.26
                                                 -------------

[[Page 34]]

 
 Total tax for the taxable year.................    4,569.20
                                                 =============
 

    Example 3. H and W, husband and wife, have a foster child, C, who 
qualifies as a dependent under section 152(b)(2) for the period 
beginning after December 31, 1969. H and W file a joint return on the 
basis of a taxable year ending August 31. For the taxable year ending 
August 31, 1970, H and W have adjusted gross income of $12,500. Their 
computation of the tax imposed is as follows:

                           1969 Tentative Tax
Adjusted gross income...........................  $12,500.00
  Less:
 Standard deduction.............................   $1,000.00
 Personal exemption (2).........................    1,200.00    2,200.00
                                                 -----------------------
Taxable income under 1969 deduction provisions..   10,300.00
                                                 =============
Taxable income reduced by one-half..............  ..........    5,150.00
                                                             ===========
Tax on $5,150 (1969 rates):
  Tax on first $4,000...........................     $690.00
  22 percent of $1,150..........................      253.00      943.00
                                                 -----------------------
Twice the tax on $5,150.........................   $1,886.00
                                                 ============
Tentative tax at rates and deduction provisions     1,886.00
 effective on or after January 1, 1969..........
                                                 =============
                           1970 Tentative Tax
Adjusted gross income...........................  $12,500.00
  Less:
    Standard deduction..........................   $1,000.00
    Personal exemption (3)......................    1,875.00    2,875.00
                                                 -----------------------
Taxable income under 1970 deduction provisions..   $9,625.00
                                                 =============
Tax on $9,625 (1970 rates):
  Tax on first $8,000...........................   $1,380.00
  22 percent of $1,625..........................      357.50
                                                 ------------
Tentative tax at rates and deduction provisions     1,737.50
 effective on or after January 1, 1970..........
                                                 =============
The 1969 and 1970 tentative taxes are
 apportioned as follows:
  1969--122/365 of $1,886.......................     $630.39
  1970--243/365 of $1,737.50....................    1,156.75
                                                 -------------
                                                    1,787.14
Tax surcharge (see Sec.   1.51-1(d)(1)(i))......      104.05
                                                 -------------
  Total tax for the taxable year................    1,891.19
                                                 =============
 

    Example 4. B, a single individual with one exemption, reports his 
income on the basis of a fiscal year ending June 30. For fiscal year 
ending June 30, 1971, B reports adjusted gross income of $250,000, 
consisting of earned net income of $240,000 and investment income of 
$10,000. In addition, on April 24, 1971, stock was transferred to B 
pursuant to his exercise of a qualified stock option, and the fair 
market value of such stock at that time exceeded the option price by 
$175,000. This $175,000 constitutes an item of tax preference described 
in section 57(a)(6). B claims itemized deductions in the amount of 
$34,000. By reason of section 1348, the maximum rate of tax on earned 
taxable income for a taxable year beginning after 1970 but before 1972 
is 60 percent. The income tax for the taxable year ending June 30, 1971, 
would be computed under section 21 as follows:

                           1970 Tentative Tax
Adjusted gross income...................     $250,000.00
  Less:
    Itemized deductions.................      $34,000.00
    Personal exemption..................          625.00       34,625.00
                                         -------------------------------
Taxable income under 1970 deduction           215,375.00
 provisions.............................
                                         =================
Tax on $215,375 (1970 rates)
Tax on first $100,000...................      $55,490.00
70 percent of $115,375..................       80,762.50
                                         ----------------
Tentative tax at rates and deduction          136,252.50
 provisions effective on or after
 January 1, 1970........................
                                         =================
Minimum tax:
  Total tax preference items............      175,000.00
  Less:
    Exemption...........................      $30,000.00
    Income tax..........................      136,252.50      166,252.50
                                         -------------------------------
Subject to 10 percent tax...............        8,747.50
                                         =================
10 percent tax..........................          874.75
                                         =================
      Total tentative tax ($136,252.50 +      137,127.25
       $874.75).........................
                                         =================
                           1971 Tentative Tax
Adjusted gross income...................     $250,000.00
  Less:
    Itemized deductions.................      $34,000.00
    Personal exemption..................          650.00       34,650.00
                                         -------------------------------
Taxable income under 1971 deduction           215,350.00
 provisions.............................
                                         =================
(a) Tax on highest amount of taxable           20,190.00
 income on which rate does not exceed 60
 percent ($50,000) (1971 rates).........
(b) Earned taxable
 income:
  ($215,350 x
  $240,000/
  $250,000).............................     $206,736.00
Less: Tax
 preference offset:
 ($175,000
-$30,000)...............................      145,000.00
                                         -----------------
                                               61,736.00
                                         ================
(c) 60% of the amount by which $61,736          7,041.60
 exceeds $50,000........................

[[Page 35]]

 
(d) Tax on $215,350 (1971 rates)
  Tax on first $100,000.................       53,090.00
  70% of $115,350.......................       80,745.00
                                         ----------------
      Total.............................      133,835.00
                                         ================
(e) Tax on $61,736 (1971 rates)
  Tax on first $60,000..................       26,390.00
  64% of $1,736.........................        1,111.04
                                         ----------------
      Total.............................       27,501.04
                                         ================
(f) Excess of $133,835 over $27,501.04..      106,333.96
                                         -----------------
Tentative tax (total of Steps (a), (c),       133,565.56
 and (f)) at rates and deduction
 provisions effective on or after
 January 1, 1971........................
                                         =================
Minimum tax:
  Total tax preference items............      175,000.00
  Less:
    Exemption...........................      $30,000.00
    Income tax..........................      133,565.56      163,565.56
                                         -------------------------------
  Subject to 10 percent tax.............      $11,434.44
                                         =================
  10 percent tax........................        1,143.44
                                         =================
    Total tentative tax ($133,565.56 +        134,709.00
     $1,143.44).........................
                                         =================
The 1970 and 1971 tentative taxes are
 apportioned as follows:
  1970--184/365 of $137,127.25..........       69,127.16
  1971--181/365 of $134,709.............       66,800.90
                                         =================
    Total tax for the taxable year......      135,928.06
                                         =================
 

    Example 5. The surtax exemption of corporation M (one of 4 
subsidiary corporations of W corporation), which files its income tax 
returns on the basis of a fiscal year ending March 31, 1964, is less 
than $25,000, by reason of section 1561 of the Code applicable to 
taxable years ending after December 31, 1963, and beginning before 
January 1, 1975. The taxable income of corporation M is $100,000, and 
the amount of the surtax exemption determined under the new rule for the 
1964 taxable year is $5,000 ($25,000 / 5). M's income tax liability for 
the taxable year ending March 31, 1964, is computed as follows:

                           1963 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1963 rates) 30           $30,000
 percent of $100,000....................
Surtax on $75,000 (1963 rates and                 16,500
 $25,000 surtax exemption) 22 percent of
 $75,000................................
                                         -----------------
      Total tentative tax at rates and            46,500
       surtax exemption effective before
       January 1, 1964..................
                                         =================
                           1964 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1964 rates) 22           $22,000
 percent of $100,000....................
Surtax on $95,000 (1964 rates and a               26,600
 $5,000 surtax exemption) 28 percent of
 $95,000................................
                                         ----------------
      Total tentative tax at rates and            48,600
       surtax exemption effective after
       January 1, 1964..................
                                         =================
The 1963 and 1964 tentative taxes are
 apportioned as follows:
  1963--275/366 of $46,500..............       34,938.52
  1964--91/366 of $48,600...............       12,083.61
                                         -----------------
      Total tax for the taxable year....       47,022.13
                                         =================
     M has the same amount of taxable income in 1965. Its income tax
   liability for the fiscal year ending March 31, 1965, is computed as
                                follows:
                           1964 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1964 rates) 22           $22,000
 percent of $100,000....................
Surtax on $95,000 (1964 rates and a               26,600
 $5,000 surtax exemption) 28 percent of
 $95,000................................
                                         -----------------
      Total tentative tax at the 1964             48,600
       rates............................
                                         =================
                           1965 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1965 rates) 22           $22,000
 percent of $100,000....................
Surtax on $95,000 (1965 rates and a               24,700
 $5,000 surtax exemption) 26 percent of
 $95,000................................
                                         ----------------
      Total tentative tax at the 1965             46,700
       rates............................
                                         =================
The 1964 and 1965 tentative taxes are
 apportioned as follows:
  1964--275/365 of $48,600..............      $36,616.44
  1965--90/365 of $46,700...............       11,515.07
                                         -----------------
      Total tax for the taxable year....       48,131.51
                                         =================
 


[[Page 36]]

    Example 6. Assume the same facts as in example (5), except that M 
elected the additional tax under section 1562 for its fiscal year ending 
March 31, 1964. M's tax liability is completed as follows:

                           1963 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1963 rates) 30           $30,000
 percent of $100,000....................
Surtax on $75,000 (1963 rates and                 16,500
 $25,000 surtax exemption) 22 percent of
 $75,000................................
                                         ----------------
      Total tentative tax at rates and            46,500
       surtax exemption effective before
       January 1, 1964..................
                                         =================
                           1964 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1964 rates) 22           $22,000
 percent of $100,000....................
Surtax on $75,000 (1964 rates and                 21,000
 $25,000 surtax exemption) 28 percent of
 $75,000................................
Additional tax on $25,000 6 percent of             1,500
 $25,000................................
                                         ----------------
      Total tentative tax at rates and            44,500
       surtax exemption effective on and
       after January 1, 1964............
                                         =================
The 1963 and 1964 tentative taxes are
 apportioned as follows:
  1963--275/366 of $46,500..............      $34,938.52
  1964--91/366 of $44,500...............       11,064.21
                                         -----------------
      Total tax for the taxable year....       46,002.73
                                         =================
 

    Example 7. Corporation N files its income tax returns on the basis 
of a fiscal year ending June 30. For its taxable year ending in 1976, 
the taxable income of N is $100,000. N's income tax liability is 
determined for the period July 1, 1975, through December 31, 1975, by 
taking into account two rates of normal tax under section 11(b)(2) (A) 
and (B) and the increase to $50,000 in the surtax exemption under 
section 11(d). For the period January 1, 1976, through June 30, 1976, 
N's income tax liability is determined by taking into account the single 
normal tax rate under section 11(b)(1) and the $25,000 surtax exemption 
under section 11(d). N's tax liability for the taxable year ending June 
30, 1976, is computed as follows:

                           1975 Tentative Tax
Taxable income..........................        $100,000
                                         =================
  Normal tax on $100,000 (1975 rates) 20          $5,000
   percent of $25,000...................
  22 percent of $75,000.................          16,500
  Surtax on $50,000 (1975 rates and               13,000
   $50,000 surtax exemption) 26 percent
   of $50,000...........................
                                         ----------------
      Total tentative tax at rates and            34,500
       surtax exemption effective on and
       after January 1, 1975............
                                         =================
                           1976 Tentative Tax
Taxable income..........................        $100,000
                                         =================
  Normal tax on $100,000 (1976 rates) 22         $22,000
   percent of $100,000..................
  Surtax on $75,000 (1976 rates and               19,500
   $25,000 surtax exemption) 26 percent
   of $75,000...........................
                                         ----------------
      Total tentative tax at rates and            41,500
       surtax exemption effective on and
       after January 1, 1976............
                                         =================
The 1975 and 1976 tentative taxes are
 apportioned as follows:
  1975--184/366 of $34,500..............         $17,344
  1976--182/366 of $41,500..............          20,637
                                         -----------------
      Total tax for the taxable year....          37,981
 


(Secs. 1561(a) (83 Stat. 599; 26 U.S.C. 1561(a)) of the Internal Revenue 
Code)

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 7164, 37 FR 4190, Feb. 29, 1972; T.D. 74-13, 41 FR 
12639, Mar. 26, 1976; T.D. 7528, 42 FR 64694, Dec. 28, 1977; T.D. 7728, 
45 FR 72651, Nov. 3, 1980. Redesignated by T.D. 9354, 72 FR 45341, Aug. 
14, 2007]



Sec.  1.21-1  Expenses for household and dependent care services 
necessary for gainful employment.

    (a) In general. (1) Section 21 allows a credit to a taxpayer against 
the tax imposed by chapter 1 for employment-related expenses for 
household services and care (as defined in paragraph (d) of this 
section) of a qualifying individual (as defined in paragraph (b) of this 
section). The purpose of the expenses must be to enable the taxpayer to 
be gainfully employed (as defined in paragraph (c) of this section). For 
taxable years beginning after December 31, 2004, a qualifying individual 
must have the

[[Page 37]]

same principal place of abode (as defined in paragraph (g) of this 
section) as the taxpayer for more than one-half of the taxable year. For 
taxable years beginning before January 1, 2005, the taxpayer must 
maintain a household (as defined in paragraph (h) of this section) that 
includes one or more qualifying individuals.
    (2) The amount of the credit is equal to the applicable percentage 
of the employment-related expenses that may be taken into account by the 
taxpayer during the taxable year (but subject to the limits prescribed 
in Sec.  1.21-2). Applicable percentage means 35 percent reduced by 1 
percentage point for each $2,000 (or fraction thereof) by which the 
taxpayer's adjusted gross income for the taxable year exceeds $15,000, 
but not less than 20 percent. For example, if a taxpayer's adjusted 
gross income is $31,850, the applicable percentage is 26 percent.
    (3) Expenses may be taken as a credit under section 21, regardless 
of the taxpayer's method of accounting, only in the taxable year the 
services are performed or the taxable year the expenses are paid, 
whichever is later.
    (4) The requirements of section 21 and Sec. Sec.  1.21-1 through 
1.21-4 are applied at the time the services are performed, regardless of 
when the expenses are paid.
    (5) Examples. The provisions of this paragraph (a) are illustrated 
by the following examples.

    Example 1. In December 2007, B pays for the care of her child for 
January 2008. Under paragraph (a)(3) of this section, B may claim the 
credit in 2008, the later of the years in which the expenses are paid 
and the services are performed.
    Example 2. The facts are the same as in Example 1, except that B's 
child turns 13 on February 1, 2008, and B pays for the care provided in 
January 2008 on February 3, 2008. Under paragraph (a)(4) of this 
section, the determination of whether the expenses are employment-
related expenses is made when the services are performed. Assuming other 
requirements are met, the amount B pays will be an employment-related 
expense under section 21, because B's child is a qualifying individual 
when the services are performed, even though the child is not a 
qualifying individual when B pays the expenses.

    (b) Qualifying individual--(1) In general. For taxable years 
beginning after December 31, 2004, a qualifying individual is--
    (i) The taxpayer's dependent (who is a qualifying child within the 
meaning of section 152) who has not attained age 13;
    (ii) The taxpayer's dependent (as defined in section 152, determined 
without regard to subsections (b)(1), (b)(2), and (d)(1)(B)) who is 
physically or mentally incapable of self-care and who has the same 
principal place of abode as the taxpayer for more than one-half of the 
taxable year; or
    (iii) The taxpayer's spouse who is physically or mentally incapable 
of self-care and who has the same principal place of abode as the 
taxpayer for more than one-half of the taxable year.
    (2) Taxable years beginning before January 1, 2005. For taxable 
years beginning before January 1, 2005, a qualifying individual is--
    (i) The taxpayer's dependent for whom the taxpayer is entitled to a 
deduction for a personal exemption under section 151(c) and who is under 
age 13;
    (ii) The taxpayer's dependent who is physically or mentally 
incapable of self-care; or
    (iii) The taxpayer's spouse who is physically or mentally incapable 
of self-care.
    (3) Qualification on a daily basis. The status of an individual as a 
qualifying individual is determined on a daily basis. An individual is 
not a qualifying individual on the day the status terminates.
    (4) Physical or mental incapacity. An individual is physically or 
mentally incapable of self-care if, as a result of a physical or mental 
defect, the individual is incapable of caring for the individual's 
hygiene or nutritional needs, or requires full-time attention of another 
person for the individual's own safety or the safety of others. The 
inability of an individual to engage in any substantial gainful activity 
or to perform the normal household functions of a homemaker or care for 
minor children by reason of a physical or mental condition does not of 
itself establish that the individual is physically or mentally incapable 
of self-care.
    (5) Special test for divorced or separated parents or parents living 
apart--(i)

[[Page 38]]

Scope. This paragraph (b)(5) applies to a child (as defined in section 
152(f)(1) for taxable years beginning after December 31, 2004, and in 
section 151(c)(3) for taxable years beginning before January 1, 2005) 
who--
    (A) Is under age 13 or is physically or mentally incapable of self-
care;
    (B) Receives over one-half of his or her support during the calendar 
year from one or both parents who are divorced or legally separated 
under a decree of divorce or separate maintenance, are separated under a 
written separation agreement, or live apart at all times during the last 
6 months of the calendar year; and
    (C) Is in the custody of one or both parents for more than one-half 
of the calendar year.
    (ii) Custodial parent allowed the credit. A child to whom this 
paragraph (b)(5) applies is the qualifying individual of only one parent 
in any taxable year and is the qualifying child of the custodial parent 
even if the noncustodial parent may claim the dependency exemption for 
that child for that taxable year. See section 21(e)(5). The custodial 
parent is the parent having custody for the greater portion of the 
calendar year. See section 152(e)(4)(A).
    (6) Example. The provisions of this paragraph (b) are illustrated by 
the following examples.

    Example. C pays $420 for the care of her child, a qualifying 
individual, to be provided from January 2 through January 31, 2008 (21 
days of care). On January 20, 2008, C's child turns 13 years old. Under 
paragraph (b)(3) of this section, C's child is a qualifying individual 
from January 2 through January 19, 2008 (13 days of care). C may take 
into account $260, the pro rata amount C pays for the care of her child 
for 13 days, under section 21. See Sec.  1.21-2(a)(4).

    (c) Gainful employment--(1) In general. Expenses are employment-
related expenses only if they are for the purpose of enabling the 
taxpayer to be gainfully employed. The expenses must be for the care of 
a qualifying individual or household services performed during periods 
in which the taxpayer is gainfully employed or is in active search of 
gainful employment. Employment may consist of service within or outside 
the taxpayer's home and includes self-employment. An expense is not 
employment-related merely because it is paid or incurred while the 
taxpayer is gainfully employed. The purpose of the expense must be to 
enable the taxpayer to be gainfully employed. Whether the purpose of an 
expense is to enable the taxpayer to be gainfully employed depends on 
the facts and circumstances of the particular case. Work as a volunteer 
or for a nominal consideration is not gainful employment.
    (2) Determination of period of employment on a daily basis--(i) In 
general. Expenses paid for a period during only part of which the 
taxpayer is gainfully employed or in active search of gainful employment 
must be allocated on a daily basis.
    (ii) Exception for short, temporary absences. A taxpayer who is 
gainfully employed is not required to allocate expenses during a short, 
temporary absence from work, such as for vacation or minor illness, 
provided that the care-giving arrangement requires the taxpayer to pay 
for care during the absence. An absence of 2 consecutive calendar weeks 
is a short, temporary absence. Whether an absence longer than 2 
consecutive calendar weeks is a short, temporary absence is determined 
based on all the facts and circumstances.
    (iii) Part-time employment. A taxpayer who is employed part-time 
generally must allocate expenses for dependent care between days worked 
and days not worked. However, if a taxpayer employed part-time is 
required to pay for dependent care on a periodic basis (such as weekly 
or monthly) that includes both days worked and days not worked, the 
taxpayer is not required to allocate the expenses. A day on which the 
taxpayer works at least 1 hour is a day of work.
    (3) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. D works during the day and her husband, E, works at night 
and sleeps during the day. D and E pay for care for a qualifying 
individual during the hours when D is working and E is sleeping. Under 
paragraph (c)(1) of this section, the amount paid by D and E for care 
may be for the purpose of allowing D and E to be gainfully employed and 
may be an employment-related expense under section 21.

[[Page 39]]

    Example 2. F works at night and pays for care for a qualifying 
individual during the hours when F is working. Under paragraph (c)(1) of 
this section, the amount paid by F for care may be for the purpose of 
allowing F to be gainfully employed and may be an employment-related 
expense under section 21.
    Example 3. G, the custodial parent of two children who are 
qualifying individuals, hires a housekeeper for a monthly salary to care 
for the children while G is gainfully employed. G becomes ill and as a 
result is absent from work for 4 months. G continues to pay the 
housekeeper to care for the children while G is absent from work. During 
this 4-month period, G performs no employment services, but receives 
payments under her employer's wage continuation plan. Although G may be 
considered to be gainfully employed during her absence from work, the 
absence is not a short, temporary absence within the meaning of 
paragraph (c)(2)(ii) of this section, and her payments for household and 
dependent care services during the period of illness are not for the 
purpose of enabling her to be gainfully employed. G's expenses are not 
employment-related expenses, and she may not take the expenses into 
account under section 21.
    Example 4. To be gainfully employed, H sends his child to a 
dependent care center that complies with all state and local 
requirements. The dependent care center requires payment for days when a 
child is absent from the center. H takes 8 days off from work as 
vacation days. Because the absence is less than 2 consecutive calendar 
weeks, under paragraph (c)(2)(ii) of this section, H's absence is a 
short, temporary absence. H is not required to allocate expenses between 
days worked and days not worked. The entire fee for the period that 
includes the 8 vacation days may be an employment-related expense under 
section 21.
    Example 5. J works 3 days per week and her child attends a dependent 
care center (that complies with all state and local requirements) to 
enable her to be gainfully employed. The dependent care center allows 
payment for any 3 days per week for $150 or 5 days per week for $250. J 
enrolls her child for 5 days per week, and her child attends the care 
center for 5 days per week. Under paragraph (c)(2)(iii) of this section, 
J must allocate her expenses for dependent care between days worked and 
days not worked. Three-fifths of the $250, or $150 per week, may be an 
employment-related expense under section 21.
    Example 6. The facts are the same as in Example 5, except that the 
dependent care center does not offer a 3-day option. The entire $250 
weekly fee may be an employment-related expense under section 21.

    (d) Care of qualifying individual and household services--(1) In 
general. To qualify for the dependent care credit, expenses must be for 
the care of a qualifying individual. Expenses are for the care of a 
qualifying individual if the primary function is to assure the 
individual's well-being and protection. Not all expenses relating to a 
qualifying individual are for the individual's care. Amounts paid for 
food, lodging, clothing, or education are not for the care of a 
qualifying individual. If, however, the care is provided in such a 
manner that the expenses cover other goods or services that are 
incidental to and inseparably a part of the care, the full amount is for 
care.
    (2) Allocation of expenses. If an expense is partly for household 
services or for the care of a qualifying individual and partly for other 
goods or services, a reasonable allocation must be made. Only so much of 
the expense that is allocable to the household services or care of a 
qualifying individual is an employment-related expense. An allocation 
must be made if a housekeeper or other domestic employee performs 
household duties and cares for the qualifying children of the taxpayer 
and also performs other services for the taxpayer. No allocation is 
required, however, if the expense for the other purpose is minimal or 
insignificant or if an expense is partly attributable to the care of a 
qualifying individual and partly to household services.
    (3) Household services. Expenses for household services may be 
employment-related expenses if the services are performed in connection 
with the care of a qualifying individual. The household services must be 
the performance in and about the taxpayer's home of ordinary and usual 
services necessary to the maintenance of the household and attributable 
to the care of the qualifying individual. Services of a housekeeper are 
household services within the meaning of this paragraph (d)(3) if the 
services are provided, at least in part, to the qualifying individual. 
Such services as are performed by chauffeurs, bartenders, or gardeners 
are not household services.
    (4) Manner of providing care. The manner of providing care need not 
be the least expensive alternative available to

[[Page 40]]

the taxpayer. The cost of a paid caregiver may be an expense for the 
care of a qualifying individual even if another caregiver is available 
at no cost.
    (5) School or similar program. Expenses for a child in nursery 
school, pre-school, or similar programs for children below the level of 
kindergarten are for the care of a qualifying individual and may be 
employment-related expenses. Expenses for a child in kindergarten or a 
higher grade are not for the care of a qualifying individual. However, 
expenses for before- or after-school care of a child in kindergarten or 
a higher grade may be for the care of a qualifying individual.
    (6) Overnight camps. Expenses for overnight camps are not 
employment-related expenses.
    (7) Day camps. (i) The cost of a day camp or similar program may be 
for the care of a qualifying individual and an employment-related 
expense, without allocation under paragraph (d)(2) of this section, even 
if the day camp specializes in a particular activity. Summer school and 
tutoring programs are not for the care of a qualifying individual and 
the costs are not employment-related expenses.
    (ii) A day camp that meets the definition of dependent care center 
in section 21(b)(2)(D) and paragraph (e)(2) of this section must comply 
with the requirements of section 21(b)(2)(C) and paragraph (e)(2) of 
this section.
    (8) Transportation. The cost of transportation by a dependent care 
provider of a qualifying individual to or from a place where care of 
that qualifying individual is provided may be for the care of the 
qualifying individual. The cost of transportation not provided by a 
dependent care provider is not for the care of the qualifying 
individual.
    (9) Employment taxes. Taxes under sections 3111 (relating to the 
Federal Insurance Contributions Act) and 3301 (relating to the Federal 
Unemployment Tax Act) and similar state payroll taxes are employment-
related expenses if paid in respect of wages that are employment-related 
expenses.
    (10) Room and board. The additional cost of providing room and board 
for a caregiver over usual household expenditures may be an employment-
related expense.
    (11) Indirect expenses. Expenses that relate to, but are not 
directly for, the care of a qualifying individual, such as application 
fees, agency fees, and deposits, may be for the care of a qualifying 
individual and may be employment-related expenses if the taxpayer is 
required to pay the expenses to obtain the related care. However, 
forfeited deposits and other payments are not for the care of a 
qualifying individual if care is not provided.
    (12) Examples. The provisions of this paragraph (d) are illustrated 
by the following examples:

    Example 1. To be gainfully employed, K sends his 3-year old child to 
a pre-school. The pre-school provides lunch and snacks. Under paragraph 
(d)(1) of this section, K is not required to allocate expenses between 
care and the lunch and snacks, because the lunch and snacks are 
incidental to and inseparably a part of the care. Therefore, K may treat 
the full amount paid to the pre-school as for the care of his child.
    Example 2. L, a member of the armed forces, is ordered to a combat 
zone. To be able to comply with the orders, L places her 10-year old 
child in boarding school. The school provides education, meals, and 
housing to L's child in addition to care. Under paragraph (d)(2) of this 
section, L must allocate the cost of the boarding school between 
expenses for care and expenses for education and other services not 
constituting care. Only the part of the cost of the boarding school that 
is for the care of L's child is an employment-related expense under 
section 21.
    Example 3. To be gainfully employed, M employs a full-time 
housekeeper to care for M's two children, aged 9 and 13 years. The 
housekeeper regularly performs household services of cleaning and 
cooking and drives M to and from M's place of employment, a trip of 15 
minutes each way. Under paragraph (d)(3) of this section, the chauffeur 
services are not household services. M is not required to allocate a 
portion of the expense of the housekeeper to the chauffeur services 
under paragraph (d)(2) of this section, however, because the chauffeur 
services are minimal and insignificant. Further, no allocation under 
paragraph (d)(2) of this section is required to determine the portion of 
the expenses attributable to the care of the 13-year old child (not a 
qualifying individual) because the household expenses are in part 
attributable to the care of the 9-year-old child. Accordingly, the 
entire expense of employing the housekeeper is an employment-related 
expense. The amount that M may take into account as an employment-
related expense under section 21, however, is limited

[[Page 41]]

to the amount allowable for one qualifying individual.
    Example 4. To be gainfully employed, N sends her 9-year-old child to 
a summer day camp that offers computer activities and recreational 
activities such as swimming and arts and crafts. Under paragraph 
(d)(7)(i) of this section, the full cost of the summer day camp may be 
for care.
    Example 5. To be gainfully employed, O sends her 9-year-old child to 
a math tutoring program for two hours per day during the summer. Under 
paragraph (d)(7)(i) of this section, the cost of the tutoring program is 
not for care.
    Example 6. To be gainfully employed, P hires a full-time housekeeper 
to care for her 8-year old child. In order to accommodate the 
housekeeper, P moves from a 2-bedroom apartment to a 3-bedroom apartment 
that otherwise is comparable to the 2-bedroom apartment. Under paragraph 
(d)(10) of this section, the additional cost to rent the 3-bedroom 
apartment over the cost of the 2-bedroom apartment and any additional 
utilities attributable to the housekeeper's residence in the household 
may be employment-related expenses under section 21.
    Example 7. Q pays a fee to an agency to obtain the services of an au 
pair to care for Q's children, qualifying individuals, to enable Q to be 
gainfully employed. An au pair from the agency subsequently provides 
care for Q's children. Under paragraph (d)(11) of this section, the fee 
may be an employment-related expense.
    Example 8. R places a deposit with a pre-school to reserve a place 
for her child. R sends the child to a different pre-school and forfeits 
the deposit. Under paragraph (d)(11) of this section, the forfeited 
deposit is not an employment-related expense.

    (e) Services outside the taxpayer's household--(1) In general. The 
credit is allowable for expenses for services performed outside the 
taxpayer's household only if the care is for one or more qualifying 
individuals who are described in this section at--
    (i) Paragraph (b)(1)(i) or (b)(2)(i); or
    (ii) Paragraph (b)(1)(ii), (b)(2)(ii), (b)(1)(iii), or (b)(2)(iii) 
and regularly spend at least 8 hours each day in the taxpayer's 
household.
    (2) Dependent care centers--(i) In general. The credit is allowable 
for services performed by a dependent care center only if--
    (A) The center complies with all applicable laws and regulations, if 
any, of a state or local government, such as state or local licensing 
requirements and building and fire code regulations; and
    (B) The requirements provided in this paragraph (e) are met.
    (ii) Definition. The term dependent care center means any facility 
that provides full-time or part-time care for more than six individuals 
(other than individuals who reside at the facility) on a regular basis 
during the taxpayer's taxable year, and receives a fee, payment, or 
grant for providing services for the individuals (regardless of whether 
the facility is operated for profit). For purposes of the preceding 
sentence, a facility is presumed to provide full-time or part-time care 
for six or fewer individuals on a regular basis during the taxpayer's 
taxable year if the facility has six or fewer individuals (including the 
taxpayer's qualifying individual) enrolled for full-time or part-time 
care on the day the qualifying individual is enrolled in the facility 
(or on the first day of the taxable year the qualifying individual 
attends the facility if the qualifying individual was enrolled in the 
facility in the preceding taxable year) unless the Internal Revenue 
Service demonstrates that the facility provides full-time or part-time 
care for more than six individuals on a regular basis during the 
taxpayer's taxable year.
    (f) Reimbursed expenses. Employment-related expenses for which the 
taxpayer is reimbursed (for example, under a dependent care assistance 
program) may not be taken into account for purposes of the credit.
    (g) Principal place of abode. For purposes of this section, the term 
principal place of abode has the same meaning as in section 152.
    (h) Maintenance of a household--(1) In general. For taxable years 
beginning before January 1, 2005, the credit is available only to a 
taxpayer who maintains a household that includes one or more qualifying 
individuals. A taxpayer maintains a household for the taxable year (or 
lesser period) only if the taxpayer (and spouse, if applicable) occupies 
the household and furnishes over one-half of the cost for the taxable 
year (or lesser period) of maintaining the household. The household must 
be the principal place of abode for the taxable year of the taxpayer and 
the qualifying individual or individuals.

[[Page 42]]

    (2) Cost of maintaining a household. (i) Except as provided in 
paragraph (h)(2)(ii) of this section, for purposes of this section, the 
term cost of maintaining a household has the same meaning as in Sec.  
1.2-2(d) without regard to the last sentence thereof.
    (ii) The cost of maintaining a household does not include the value 
of services performed in the household by the taxpayer or by a 
qualifying individual described in paragraph (b) of this section or any 
expense paid or reimbursed by another person.
    (3) Monthly proration of annual costs. In determining the cost of 
maintaining a household for a period of less than a taxable year, the 
cost for the entire taxable year must be prorated on the basis of the 
number of calendar months within that period. A period of less than a 
calendar month is treated as a full calendar month.
    (4) Two or more families. If two or more families occupy living 
quarters in common, each of the families is treated as maintaining a 
separate household. A taxpayer is maintaining a household if the 
taxpayer provides more than one-half of the cost of maintaining the 
separate household. For example, if two unrelated taxpayers with their 
respective children occupy living quarters in common and each taxpayer 
pays more than one-half of the household costs for each respective 
family, each taxpayer is treated as maintaining a household.
    (i) Reserved.
    (j) Expenses qualifying as medical expenses--(1) In general. A 
taxpayer may not take an amount into account as both an employment-
related expense under section 21 and an expense for medical care under 
section 213.
    (2) Examples. The provisions of this paragraph (j) are illustrated 
by the following examples:

    Example 1. S has $6,500 of employment-related expenses for the care 
of his child who is physically incapable of self-care. The expenses are 
for services performed in S's household that also qualify as expenses 
for medical care under section 213. Of the total expenses, S may take 
into account $3,000 under section 21. S may deduct the balance of the 
expenses, or $3,500, as expenses for medical care under section 213 to 
the extent the expenses exceed 7.5 percent of S's adjusted gross income.
    Example 2. The facts are the same as in Example 1, however, S first 
takes into account the $6,500 of expenses under section 213. S deducts 
$500 as an expense for medical care, which is the amount by which the 
expenses exceed 7.5 percent of his adjusted gross income. S may not take 
into account the $6,000 balance as employment-related expenses under 
section 21, because he has taken the full amount of the expenses into 
account in computing the amount deductible under section 213.

    (k) Substantiation. A taxpayer claiming a credit for employment-
related expenses must maintain adequate records or other sufficient 
evidence to substantiate the expenses in accordance with section 6001 
and the regulations thereunder.
    (l) Effective/applicability date. This section and Sec. Sec.  1.21-2 
through 1.21-4 apply to taxable years ending after August 14, 2007.

[T.D. 9354, 72 FR 45341, Aug. 14, 2007]



Sec.  1.21-2  Limitations on amount creditable.

    (a) Annual dollar limitation. (1) The amount of employment-related 
expenses that may be taken into account under Sec.  1.21-1(a) for any 
taxable year cannot exceed--
    (i) $2,400 ($3,000 for taxable years beginning after December 31, 
2002, and before January 1, 2011) if there is one qualifying individual 
with respect to the taxpayer at any time during the taxable year; or
    (ii) $4,800 ($6,000 for taxable years beginning after December 31, 
2002, and before January 1, 2011) if there are two or more qualifying 
individuals with respect to the taxpayer at any time during the taxable 
year.
    (2) The amount determined under paragraph (a)(1) of this section is 
reduced by the aggregate amount excludable from gross income under 
section 129 for the taxable year.
    (3) A taxpayer may take into account the total amount of employment-
related expenses that do not exceed the annual dollar limitation 
although the amount of employment-related expenses attributable to one 
qualifying individual is disproportionate to the total employment-
related expenses. For example, a taxpayer with expenses

[[Page 43]]

in 2007 of $4,000 for one qualifying individual and $1,500 for a second 
qualifying individual may take into account the full $5,500.
    (4) A taxpayer is not required to prorate the annual dollar 
limitation if a qualifying individual ceases to qualify (for example, by 
turning age 13) during the taxable year. However, the taxpayer may take 
into account only amounts that qualify as employment-related expenses 
before the disqualifying event. See also Sec.  1.21-1(b)(6).
    (b) Earned income limitation--(1) In general. The amount of 
employment-related expenses that may be taken into account under section 
21 for any taxable year cannot exceed--
    (i) For a taxpayer who is not married at the close of the taxable 
year, the taxpayer's earned income for the taxable year; or
    (ii) For a taxpayer who is married at the close of the taxable year, 
the lesser of the taxpayer's earned income or the earned income of the 
taxpayer's spouse for the taxable year.
    (2) Determination of spouse. For purposes of this paragraph (b), a 
taxpayer must take into account only the earned income of a spouse to 
whom the taxpayer is married at the close of the taxable year. The 
spouse's earned income for the entire taxable year is taken into 
account, however, even though the taxpayer and the spouse were married 
for only part of the taxable year. The taxpayer is not required to take 
into account the earned income of a spouse who died or was divorced or 
separated from the taxpayer during the taxable year. See Sec.  1.21-3(b) 
for rules providing that certain married taxpayers legally separated or 
living apart are treated as not married.
    (3) Definition of earned income. For purposes of this section, the 
term earned income has the same meaning as in section 32(c)(2) and the 
regulations thereunder.
    (4) Attribution of earned income to student or incapacitated spouse. 
(i) For purposes of this section, a spouse is deemed, for each month 
during which the spouse is a full-time student or is a qualifying 
individual described in Sec.  1.21-1(b)(1)(iii) or (b)(2)(iii), to be 
gainfully employed and to have earned income of not less than--
    (A) $200 ($250 for taxable years beginning after December 31, 2002, 
and before January 1, 2011) if there is one qualifying individual with 
respect to the taxpayer at any time during the taxable year; or
    (B) $400 ($500 for taxable years beginning after December 31, 2002, 
and before January 1, 2011) if there are two or more qualifying 
individuals with respect to the taxpayer at any time during the taxable 
year.
    (ii) For purposes of this paragraph (b)(4), a full-time student is 
an individual who, during each of 5 calendar months of the taxpayer's 
taxable year, is enrolled as a student for the number of course hours 
considered to be a full-time course of study at an educational 
organization as defined in section 170(b)(1)(A)(ii). The enrollment for 
5 calendar months need not be consecutive.
    (iii) Earned income may be attributed under this paragraph (b)(4), 
in the case of any husband and wife, to only one spouse in any month.
    (c) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. In 2007, T, who is married to U, pays employment-related 
expenses of $5,000 for the care of one qualifying individual. T's earned 
income for the taxable year is $40,000 and her husband's earned income 
is $2,000. T did not exclude any dependent care assistance under section 
129. Under paragraph (b)(1) of this section, T may take into account 
under section 21 only the amount of employment-related expenses that 
does not exceed the lesser of her earned income or the earned income of 
U, or $2,000.
    Example 2. The facts are the same as in Example 1 except that U is a 
full-time student at an educational organization within the meaning of 
section 170(b)(1)(A)(ii) for 9 months of the taxable year and has no 
earned income. Under paragraph (b)(4) of this section, U is deemed to 
have earned income of $2,250. T may take into account $2,250 of 
employment-related expenses under section 21.
    Example 3. For all of 2007, V is a full-time student and W, V's 
husband, is an individual who is incapable of self-care (as defined in 
Sec.  1.21-1(b)(1)(iii)). V and W have no earned income and pay expenses 
of $5,000 for W's care. Under paragraph (b)(4) of this section, either V 
or W may be deemed to have $3,000 of earned income. However, earned 
income may be attributed to only one spouse under paragraph (b)(4)(iii) 
of this section. Under the

[[Page 44]]

limitation in paragraph (b)(1)(ii) of this section, the lesser of V's 
and W's earned income is zero. V and W may not take the expenses into 
account under section 21.

    (d) Cross-reference. For an additional limitation on the credit 
under section 21, see section 26.

[T.D. 9354, 72 FR 45341, Aug. 14, 2007]



Sec.  1.21-3  Special rules applicable to married taxpayers.

    (a) Joint return requirement. No credit is allowed under section 21 
for taxpayers who are married (within the meaning of section 7703 and 
the regulations thereunder) at the close of the taxable year unless the 
taxpayer and spouse file a joint return for the taxable year. See 
section 6013 and the regulations thereunder relating to joint returns of 
income tax by husband and wife.
    (b) Taxpayers treated as not married. The requirements of paragraph 
(a) of this section do not apply to a taxpayer who is legally separated 
under a decree of divorce or separate maintenance or who is treated as 
not married under section 7703(b) and the regulations thereunder 
(relating to certain married taxpayers living apart). A taxpayer who is 
treated as not married under this paragraph (b) is not required to take 
into account the earned income of the taxpayer's spouse for purposes of 
applying the earned income limitation on the amount of employment-
related expenses under Sec.  1.21-2(b).
    (c) Death of married taxpayer. If a married taxpayer dies during the 
taxable year and the survivor may make a joint return with respect to 
the deceased spouse under section 6013(a)(3), the credit is allowed for 
the year only if a joint return is made. If, however, the surviving 
spouse remarries before the end of the taxable year in which the 
deceased spouse dies, a credit may be allowed on the decedent spouse's 
separate return.

[T.D. 9354, 72 FR 45341, Aug. 14, 2007]



Sec.  1.21-4  Payments to certain related individuals.

    (a) In general. A credit is not allowed under section 21 for any 
amount paid by the taxpayer to an individual--
    (1) For whom a deduction under section 151(c) (relating to 
deductions for personal exemptions for dependents) is allowable either 
to the taxpayer or the taxpayer's spouse for the taxable year;
    (2) Who is a child of the taxpayer (within the meaning of section 
152(f)(1) for taxable years beginning after December 31, 2004, and 
section 151(c)(3) for taxable years beginning before January 1, 2005) 
and is under age 19 at the close of the taxable year;
    (3) Who is the spouse of the taxpayer at any time during the taxable 
year; or
    (4) Who is the parent of the taxpayer's child who is a qualifying 
individual described in Sec.  1.21-1(b)(1)(i) or (b)(2)(i).
    (b) Payments to partnerships or other entities. In general, 
paragraph (a) of this section does not apply to services performed by 
partnerships or other entities. If, however, the partnership or other 
entity is established or maintained primarily to avoid the application 
of paragraph (a) of this section to permit the taxpayer to claim the 
credit, for purposes of section 21, the payments of employment-related 
expenses are treated as made directly to each partner or owner in 
proportion to that partner's or owner's ownership interest. Whether a 
partnership or other entity is established or maintained to avoid the 
application of paragraph (a) of this section is determined based on the 
facts and circumstances, including whether the partnership or other 
entity is established for the primary purpose of caring for the 
taxpayer's qualifying individual or providing household services to the 
taxpayer.
    (c) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. During 2007, X pays $5,000 to her mother for the care of 
X's 5-year old child who is a qualifying individual. The expenses 
otherwise qualify as employment-related expenses. X's mother is not her 
dependent. X may take into account under section 21 the amounts paid to 
her mother for the care of X's child.
    Example 2. Y is divorced and has custody of his 5-year old child, 
who is a qualifying individual. Y pays $6,000 during 2007 to Z, who is 
his ex-wife and the child's mother, for the care of the child. The 
expenses otherwise qualify as employment-related expenses. Under 
paragraph (a)(4) of this section, Y may

[[Page 45]]

not take into account under section 21 the amounts paid to Z because Z 
is the child's mother.
    Example 3. The facts are the same as in Example 2, except that Z is 
not the mother of Y's child. Y may take into account under section 21 
the amounts paid to Z.

[T.D. 9354, 72 FR 45341, Aug. 14, 2007]



Sec.  1.24-1  Partial credit allowed for certain other dependents.

    (a) In general. For purposes of section 24(h)(4)(A), a taxpayer may 
be eligible to increase the credit determined under section 24(a) by 
$500 for a dependent of the taxpayer, as defined in section 152, other 
than a qualifying child described in section 24(c).
    (b) Applicability date. This section applies to taxable years 
beginning on or after October 13, 2020.

[T.D. 9913, 85 FR 64385, Oct. 13, 2020]



Sec.  1.25-1T  Credit for interest paid on certain home mortgages (Temporary).

    (a) In general. Section 25 permits States and political subdivisions 
to elect to issue mortgage credit certificates in lieu of qualified 
mortgage bonds. An individual who holds a qualified mortgage credit 
certificate (as defined in Sec.  1.25-3T) is entitled to a credit 
against his Federal income taxes. The amount of the credit depends upon 
(1) the amount of mortgage interest paid or accrued during the year and 
(2) the applicable certificate credit rate. See Sec.  1.25-2T. The 
amount of the deduction under section 163 for interest paid or accrued 
during any taxable year is reduced by the amount of the credit allowable 
under section 25 for such year. See Sec.  1.163-6T. The holder of a 
qualified mortgage credit certificate may be entitled to additional 
withholding allowances. See section 3402 (m) and the regulations 
thereunder.
    (b) Definitions. For purposes of Sec. Sec.  1.25-2T through 1.25-8T 
and this section, the following definitions apply:
    (1) Mortgage. The term ``mortgage'' includes deeds of trust, 
conditional sales contracts, pledges, agreements to hold title in 
escrow, and any other form of owner financing.
    (2) State. (i) The term ``State'' includes a possession of the 
United States and the District of Columbia.
    (ii) Mortgage credit certificates issued by or on behalf of any 
State or political subdivision (``governmental unit'') by constituted 
authorities empowered to issue such certificates are the certificates of 
such governmental unit.
    (3) Qualified home improvement loan. The term ``qualified home 
improvement loan'' has the meaning given that term under section 103A 
(1)(6) and the regulations thereunder.
    (4) Qualified rehabilitation loan. The term ``qualified 
rehabilitation loan'' has the meaning given that term under section 103A 
(1)(7)(A) and the regulations thereunder.
    (5) Single-family and owner-occupied residences. The terms ``single-
family'' and ``owner-occupied'' have the meaning given those terms under 
section 103A (1)(9) and the regulations thereunder.
    (6) Constitutional home rule city. The term ``constitutional home 
rule city'' means, with respect to any calendar year, any political 
subdivision of a State which, under a State constitution which was 
adopted in 1970 and effective on July 1, 1971, had home rule powers on 
the 1st day of the calendar year.
    (7) Targeted area residence. The term ``targeted area residence'' 
has the meaning given that term under section 103A (k) and the 
regulations thereunder.
    (8) Acquisition cost. The term ``acquisition cost'' has the meaning 
given that term under section 103A (1)(5) and the regulations 
thereunder.
    (9) Average area purchase price. The term ``average area purchase 
price'' has the meaning given that term under subparagraphs (2), (3), 
and (4) of section 103A (f) and the regulations thereunder. For purposes 
of this paragraph (b)(9), all determinations of average area purchase 
price shall be made with respect to residences as that term is defined 
in section 103A and the regulations thereunder.
    (10) Total proceeds. The ``total proceeds'' of an issue is the sum 
of the products determined by multiplying--
    (i) The certified indebtedness amount of each mortgage credit 
certificate issued pursuant to such issue, by

[[Page 46]]

    (ii) The certificate credit rate specified in such certificate.

Each qualified mortgage credit certificate program shall be treated as a 
separate issue of mortgage credit certificates.
    (11) Residence. The term ``residence'' includes stock held by a 
tenant-stockholder in a cooperative housing corporation (as those terms 
are defined in section 216(b) (1) and (2)). It does not include property 
such as an appliance, a piece of furniture, a radio, etc., which, under 
applicable local law, is not a fixture. The term also includes any 
manufactured home which has a minimum of 400 square feet of living space 
and a minimum width in excess of 102 inches and which is of a kind 
customarily used at a fixed location. The preceding sentence shall not 
apply for purposes of determining the average area purchase price for 
single-family residences, nor shall it apply for purposes of determining 
the State ceiling amount. The term ``residence'' does not, however, 
include recreational vehicles, campers, and other similar vehicles.
    (12) Related person. The term ``related person'' has the meaning 
given that term under section 103(b)(6)(C)(i) and Sec.  1.103-10(e)(1).
    (13) Date of issue. A mortgage credit certificate is considered 
issued on the date on which a closing agreement is signed with respect 
to the certified indebtedness amount.
    (c) Affidavits. For purposes of Sec. Sec.  1.25-1T through 1.25-8T, 
an affidavit filed in connection with the requirements of Sec. Sec.  
1.25-1T through 1.25-8T shall be made under penalties of perjury. 
Applicants for mortgage credit certificates who are required by a lender 
or the issuer to sign affidavits must be informed that any fraudulent 
statement will result in (1) the revocation of the individual's mortgage 
credit certificate, and (2) a $10,000 penalty under section 6709. Other 
persons required by a lender or an issuer to provide affidavits must 
receive similar notice. A person may not rely on an affidavit where that 
person knows or has reason to know that the information contained in the 
affidavit is false.

[T.D. 8023, 50 FR 19346, May 8, 1985]



Sec.  1.25-2T  Amount of credit (Temporary).

    (a) In general. Except as otherwise provided, the amount of the 
credit allowable for any taxable year to an individual who holds a 
qualified mortgage credit certificate is equal to the product of the 
certificate credit rate (as defined in paragraph (b)) and the amount of 
the interest paid or accrued by the taxpayer during the taxable year on 
the certified indebtedness amount (as defined in paragraph (c)).
    (b) Certificate credit rate--(1) In general. For purposes of 
Sec. Sec.  1.25-1T through 1.25-8T, the term ``certificate credit rate'' 
means the rate specified by the issuer on the mortgage credit 
certificate. The certificate credit rate shall not be less than 10 
percent nor more than 50 percent.
    (2) Limitation in certain States. (i) In the case of a State which--
    (A) Has a State ceiling for the calendar year in which an election 
is made that exceeds 20 percent of the average annual aggregate 
principal amount of mortgages executed during the immediately preceding 
3 calendar years for single-family owner-occupied residences located 
within the jurisdiction of such State, or
    (B) Issued qualified mortgage bonds in an aggregate amount less than 
$150 million for calendar year 1983.

the certificate credit rate for any mortgage credit certificate issued 
under such program shall not exceed 20 percent unless the issuing 
authority submits a plan to the Commissioner to ensure that the weighted 
average of the certificate credit rates in such mortgage credit 
certificate program does not exceed 20 percent and the Commissioner 
approves such plan. For purposes of determining the average annual 
aggregate principal amount of mortgages executed during the immediately 
preceding 3 calendar years for single-family owner-occupied residences 
located within the jurisdiction of such State, an issuer may rely upon 
the amount published by the Treasury Department for such calendar years. 
An issuer may rely on a different amount from that safe-harbor 
limitation where the issuer has made a more accurate and comprehensive 
determination of that amount. The weighted

[[Page 47]]

average of the certificate credit rates in a mortgage credit certificate 
program is determined by dividing the sum of the products obtained by 
multiplying the certificate credit rate of each certificate by the 
certified indebtedness amount with respect to that certificate by the 
sum of the certified indebtedness amounts of the certificates issued. 
See section 103A(g) and the regulations thereunder for the definition of 
the term ``State ceiling''.
    (ii) The following example illustrates the application of this 
paragraph (b)(2):

    Example. City Z issues four qualified mortgage credit certificates 
pursuant to its qualified mortgage credit certificate program. H 
receives a certificate with a certificate credit rate of 30 percent and 
a certified indebtedness amount of $50,000. I receives a certificate 
with a certificate credit rate of 25 percent and a certified 
indebtedness amount of $100,000. J and K each receive certificates with 
certificate credit rates of 10 percent; their certified indebtedness 
amounts are $50,000 and $100,000, respectively. The weighted average of 
the certificate credit rates is determined by dividing the sum of the 
products obtained by multiplying the certificate credit rate of each 
certificate by the certified indebtedness amount with respect to that 
certificate ((.3 x $50,000) + (.25 x $100,000) + (.1 x $50,000) + (.1 x 
$100,000)) by the sum of the certified indebtedness amounts of the 
certificates issued ($50,000 + $100,000 + $50,000 + $100,000). Thus, the 
weighted average of the certificate credit rates is 18.33 percent 
($55,000/$300,000).

    (c) Certified indebtedness amount--(1) In general. The term 
``certified indebtedness amount'' means the amount of indebtedness which 
is--
    (i) Incurred by the taxpayer--
    (A) To acquire his principal residence, Sec.  1.25-2T(c)(1)(i),
    (B) As a qualified home improvement loan, or
    (C) As a qualified rehabilitation loan, and
    (ii) Specified in the mortgage credit certificate.
    (2) Example. The following example illustrates the application of 
this paragraph:

    Example. On March 1, 1986, State X, pursuant to its qualified 
mortgage credit certificate program, provides a mortgage credit 
certificate to B. State X specifies that the maximum amount of the 
mortgage loan for which B may claim a credit is $65,000. On March 15, B 
purchases for $67,000 a single-family dwelling for use as his principal 
residence. B obtains from Bank M a mortgage loan for $60,000. State X, 
or Bank M acting on behalf of State X, indicates on B's mortgage credit 
certificate that the certified indebtedness amount of B's loan is 
$60,000. B may claim a credit under section 25 (e) based on this amount.

    (d) Limitation on credit--(1) Limitation where certificate credit 
rate exceeds 20 percent. (i) If the certificate credit rate of any 
mortgage credit certificate exceeds 20 percent, the amount of the credit 
allowed to the taxpayer by section 25(a)(1) for any year shall not 
exceed $2,000. Any amount denied under this paragraph (d)(1) may not be 
carried forward under section 25(e)(1) and paragraph (d)(2) of this 
section.
    (ii) If two or more persons hold interests in any residence, the 
limitation of paragraph (d)(1)(i) shall be allocated among such persons 
in proporation to their respective interests in the residence.
    (2) Carryforward of unused credit. (i) If the credit allowable under 
section 25 (a) and Sec.  1.25-2T for any taxable year exceeds the 
applicable tax limit for that year, the excess (the ``unused credit'') 
will be a carryover to each of the 3 succeeding taxable years and, 
subject to the limitations of paragraph (d)(2)(ii), will be added to the 
credit allowable by section 25 (a) and Sec.  1.25-2T for that succeeding 
year.
    (ii) The amount of the unused credit for any taxable year (the 
``unused credit year'') which may be taken into account under this 
paragraph (d)(2) for any subsequent taxable year may not exceed the 
amount by which the applicable tax limit for that subsequent taxable 
year exceeds the sum of (A) the amount of the credit allowable under 
section 25 (a) and Sec.  1.25-1T for the current taxable year, and (B) 
the sum of the unused credits which, by reason of this paragraph (d)(2), 
are carried to that subsequent taxable year and are attributable to 
taxable years before the unused credit year. Thus, if by reason of this 
paragraph (d)(2), unused credits from 2 prior taxable years are carried 
forward to a subsequent taxable year, the unused credit from the earlier 
of those 2 prior years must be taken into account before the unused 
credit from the later of those 2 years is taken into account.

[[Page 48]]

    (iii) For purposes of this paragraph (d)(2) the term ``applicable 
tax limit'' means the limitation imposed by section 26 (a) for the 
taxable year reduced by the sum of the credits allowable for that year 
under section 21, relating to expenses for household and dependent care 
services necessary for gainful employment, section 22, relating to the 
credit for the elderly and the permanently disabled, section 23, 
relating to the residential energy credit, and section 24, relating to 
contributions to candidates for public office. The limitation imposed by 
section 26 (a) for any taxable year is equal to the taxpayer's tax 
liability (as defined in section 26 (b)) for that year.
    (iv) The following examples illustrate the application of this 
paragraph (d)(2):

    Example 1. (i) B, a calendar year taxpayer, holds a qualified 
mortgage credit certificate. For 1986 B's applicable tax limit (i.e., 
tax liability) is $1,100. The amount of the credit under section 25 (a) 
and Sec.  1.25-2T for 1986 is $1,700. For 1986 B is not entitled to any 
of the credits described in sections 21 through 24. Under Sec.  1.25-2T 
(d)(2), B's unused credit for 1986 is $600, and B is entitled to carry 
forward that amount to the 3 succeeding years.
    (ii) For 1987 B's applicable tax limit is $1,500, the amount of the 
credit under section 25 (a) and Sec.  1.25-2T is $1,700, and the unused 
credit is $200. For 1988 B's applicable tax limit is $2,000, the amount 
of the credit under section 25 (a) and Sec.  1.25-2T is $1,300, and 
there is no unused credit. For 1987 and 1988 B is not entitled to any of 
the credits described in sections 21 through 24. No portion of the 
unused credit for 1986 my be used in 1987. For 1988 B is entitled to 
claim a credit of $2,000 under section 25 (a) and Sec.  1.25-2T, 
consisting of a $1,300 credit for 1988, the $600 unused credit for 1986, 
and $100 of the $200 unused credit for 1987. In addition, B may carry 
forward the remaining unused credit for 1987 ($100) to 1989 and 1990.
    Example 2. The facts are the same as in Example (1) except that for 
1988 B is entitled to a credit of $400 under section 23. B's applicable 
tax limit for 1988 is $1,600 ($2,000 less $400). For 1988 B is entitled 
to claim a credit of $1,600 under section 25 (a) and Sec.  1.25-2T, 
consisting of a $1,300 credit for 1988 and $300 of the unused credit for 
1986. In addition, B may carry forward the remaining unused credits of 
$300 for 1986 to 1989 and of $200 for 1987 to 1989 and 1990.

[T.D. 8023, 50 FR 19346, May 8, 1985]



Sec.  1.25-3  Qualified mortgage credit certificate.

    (a)-(g)(1)(ii) [Reserved]. For further guidance, see Sec.  1.25-
3T(a) through (g)(1)(ii).
    (g)(1)(iii) Reissued certificate exception. See paragraph (p) of 
this section for rules regarding the exception in the case of 
refinancing existing mortgages.
    (g)(2)-(o) [Reserved]. For further guidance, see Sec.  1.25-3T(g)(2) 
through (o).
    (p) Reissued certificates for certain refinancings--(1) In general. 
If the issuer of a qualified mortgage credit certificate reissues a 
certificate in place of an existing mortgage credit certificate to the 
holder of that existing certificate, the reissued certificate is treated 
as satisfying the requirements of this section. The period for which the 
reissued certificate is in effect begins with the date of the 
refinancing (that is, the date on which interest begins accruing on the 
refinancing loan).
    (2) Meaning of existing certificate. For purposes of this paragraph 
(p), a mortgage credit certificate is an existing certificate only if it 
satisfies the requirements of this section. An existing certificate may 
be the original certificate, a certificate issued to a transferee under 
Sec.  1.25-3T(h)(2)(ii), or a certificate previously reissued under this 
paragraph (p).
    (3) Limitations on reissued certificate. An issuer may reissue a 
mortgage credit certificate only if all of the following requirements 
are satisfied:
    (i) The reissued certificate is issued to the holder of an existing 
certificate with respect to the same property to which the existing 
certificate relates.
    (ii) The reissued certificate entirely replaces the existing 
certificate (that is, the holder cannot retain the existing certificate 
with respect to any portion of the outstanding balance of the certified 
mortgage indebtedness specified on the existing certificate).
    (iii) The certified mortgage indebtedness specified on the reissued 
certificate does not exceed the remaining outstanding balance of the 
certified mortgage indebtedness specified on the existing certificate.
    (iv) The reissued certificate does not increase the certificate 
credit rate specified in the existing certificate.

[[Page 49]]

    (v) The reissued certificate does not result in an increase in the 
tax credit that would otherwise have been allowable to the holder under 
the existing certificate for any taxable year. The holder of a reissued 
certificate determines the amount of tax credit that would otherwise 
have been allowable by multiplying the interest that was scheduled to 
have been paid on the refinanced loan by the certificate rate of the 
existing certificate. In the case of a series of refinancings, the tax 
credit that would otherwise have been allowable is determined from the 
amount of interest that was scheduled to have been paid on the original 
loan and the certificate rate of the original certificate.
    (A) In the case of a refinanced loan that is a fixed interest rate 
loan, the interest that was scheduled to be paid on the refinanced loan 
is determined using the scheduled interest method described in paragraph 
(p)(3)(v)(C) of this section.
    (B) In the case of a refinanced loan that is not a fixed interest 
rate loan, the interest that was scheduled to be paid on the refinanced 
loan is determined using either the scheduled interest method described 
in paragraph (p)(3)(v)(C) of this section or the hypothetical interest 
method described in paragraph (p)(3)(v)(D) of this section.
    (C) The scheduled interest method determines the amount of interest 
for each taxable year that was scheduled to have been paid in the 
taxable year based on the terms of the refinanced loan including any 
changes in the interest rate that would have been required by the terms 
of the refinanced loan and any payments of principal that would have 
been required by the terms of the refinanced loan (other than repayments 
required as a result of any refinancing of the loan).
    (D) The hypothetical interest method (which is available only for 
refinanced loans that are not fixed interest rate loans) determines the 
amount of interest treated as having been scheduled to be paid for a 
taxable year by constructing an amortization schedule for a hypothetical 
self-amortizing loan with level payments. The hypothetical loan must 
have a principal amount equal to the remaining outstanding balance of 
the certified mortgage indebtedness specified on the existing 
certificate, a maturity equal to that of the refinanced loan, and 
interest equal to the annual percentage rate (APR) of the refinancing 
loan that is required to be calculated for the Federal Truth in Lending 
Act.
    (E) A holder must consistently apply the scheduled interest method 
or the hypothetical interest method for all taxable years beginning with 
the first taxable year the tax credit is claimed by the holder based 
upon the reissued certificate.
    (4) Examples. The following examples illustrate the application of 
paragraph (p)(3)(v) of this section:

    Example 1. A holder of an existing certificate that meets the 
requirements of this section seeks to refinance the mortgage on the 
property to which the existing certificate relates. The final payment on 
the holder's existing mortgage is due on December 31, 2000; the final 
payment on the new mortgage would not be due until January 31, 2004. The 
holder requests that the issuer provide to the holder a reissued 
mortgage credit certificate in place of the existing certificate. The 
requested certificate would have the same certificate credit rate as the 
existing certificate. For each calendar year through the year 2000, the 
credit that would be allowable to the holder with respect to the new 
mortgage under the requested certificate would not exceed the credit 
allowable for that year under the existing certificate. The requested 
certificate, however, would allow the holder credits for the years 2001 
through 2004, years for which, due to the earlier scheduled retirement 
of the existing mortgage, no credit would be allowable under the 
existing certificate. Under paragraph (p)(3)(v) of this section, the 
issuer may not reissue the certificate as requested because, under the 
existing certificate, no credit would be allowable for the years 2001 
through 2004. The issuer may, however, provide a reissued certificate 
that limits the amount of the credit allowable in each year to the 
amount allowable under the existing certificate. Because the existing 
certificate would allow no credit after December 31, 2000, the reissued 
certificate could expire on December 31, 2000.
    Example 2. (a) The facts are the same as Example 1 except that the 
existing mortgage loan has a variable rate of interest and the 
refinancing loan will have a fixed rate of interest. To determine 
whether the limit under paragraph (p)(3)(v) of this section is met for 
any taxable year, the holder must calculate the amount of credit that 
otherwise would have been allowable absent the refinancing. This 
requires a determination of the amount

[[Page 50]]

of interest that would have been payable on the refinanced loan for the 
taxable year. The holder may determine this amount by--
    (1) Applying the terms of the refinanced loan, including the 
variable interest rate or rates, for the taxable year as though the 
refinanced loan continued to exist; or
    (2) Obtaining the amount of interest, and calculating the amount of 
credit that would have been available, from the schedule of equal 
payments that fully amortize a hypothetical loan with the principal 
amount equal to the remaining outstanding balance of the certified 
mortgage indebtedness specified on the existing certificate, the 
interest equal to the annual percentage rate (APR) of the refinancing 
loan, and the maturity equal to that of the refinanced loan.
    (b) The holder must apply the same method for each taxable year the 
tax credit is claimed based upon the reissued mortgage credit 
certificate.

    (5) Coordination with Section 143(m)(3). A refinancing loan 
underlying a reissued mortgage credit certificate that replaces a 
mortgage credit certificate issued on or before December 31, 1990, is 
not a federally subsidized indebtedness for the purposes of section 
143(m)(3) of the Internal Revenue Code.

[T.D. 8692, 61 FR 66214, Dec. 17, 1996]



Sec.  1.25-3T  Qualified mortgage credit certificate (Temporary).

    (a) Definition of qualified mortgage credit certificate. For 
purposes of Sec. Sec.  1.25-1T through 1.25-8T, the term ``qualified 
mortgage credit certificate'' means a certificate that meets all of the 
requirements of this section.
    (b) Qualified mortgage credit certificate program. A certificate 
meets the requirements of this paragraph if it is issued under a 
qualified mortgage credit certificate program (as defined in Sec.  1.25-
4T).
    (c) Required form and information. A certificate meets the 
requirements of this paragraph if it is in the form specified in Sec.  
1.25-6T and if all the information required by the form is specified on 
the form.
    (d) Residence requirement--(1) In general. A certificate meets the 
requirements of this paragraph only if it is provided in connection with 
the acquisition, qualified rehabilitation, or qualified home improvement 
of a residence, that is--
    (i) A single-family residence (as defined in Sec.  1.25-1T(b)(5)) 
which, at the time the financing on the residence is executed or 
assumed, can reasonably be expected by the issuer to become (or, in the 
case of a qualified home improvement loan, to continue to be) the 
principal residence (as defined in section 1034 and the regulations 
thereunder) of the holder of the certificate within a reasonable time 
after the financing is executed or assumed, and
    (ii) Located within the jurisdiction of the governmental unit 
issuing the certificate.

See section 103a(d) and the regulations thereunder for further 
definitions and requirements.
    (2) Certification procedure. The requirements of this paragraph will 
be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating his intent to use (or, in the case of a 
qualified home improvement loan, that he is currently using and intends 
to continue to use) the residence as his principal residence within a 
reasonable time (e.g., 60 days) after the mortgage credit certificate is 
issued and stating that the holder will notify the issuer of the 
mortgage credit certificate if the residence ceases to be his principal 
residence. The affidavit must also state facts that are sufficient for 
the issuer or his agent to determine whether the residence is located 
within the jurisdiction of the issuer that issued the mortgage credit 
certificate.
    (e) 3-year requirement--(1) In general. A certificate meets the 
requirements of this paragraph only if the holder of the certificate had 
no present ownership interest in a principal residence at any time 
during the 3-year period prior to the date on which the mortgage on the 
residence in connection with which the certificate is provided is 
executed. For purposes of the preceding sentence, the holder's interest 
in the residence with respect to which the certificate is being provided 
shall not be taken into account. See section 103A(e) and the regulations 
thereunder for further definitions and requirements.
    (2) Exceptions. Paragraph (e)(1) shall not apply with respect to--
    (i) Any certificate provided with respect to a targeted area 
residence (as defined in Sec.  1.25-1T(b)(7)),

[[Page 51]]

    (ii) Any qualified home improvement loan (as defined in Sec.  1.25-
1T(b)(3)), and
    (iii) Any qualified rehabilitation loan (as defined in Sec.  1.25-
1T(b)(4)).
    (3) Certification procedure. The requirements of paragraph (e)(1) 
will be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that he had no present ownership 
interest in a principal residence at any time during the 3-year period 
prior to the date of which the certificate is issued and the issuer or 
its agent obtains from the applicant copies of the applicant's Federal 
tax returns for the preceding 3 years and examines each statement to 
determine whether the applicant has claimed a deduction for taxes on 
property which was the applicant's principal residence pursuant to 
section 164(a)(1) or a deduction pursuant to section 163 for interest 
paid on a mortgage secured by property which was the applicant's 
principal residence. Where the mortgage is executed during the period 
between January 1 and February 15 and the applicant has not yet filed 
has Federal income tax return with the Internal Revenue Service, the 
issuer may, with respect to such year, rely on an affidavit of the 
applicant that the applicant is not entitled to claim deductions for 
taxes or interest on indebtedness with respect to property constituting 
his principal residence for the preceding calendar year. In the 
alternative, when applicable, the holder may provide an affidavit 
stating that one of the exceptions provided in paragraph (e)(2) applies.
    (4) Special rule. An issuer may submit a plan to the Commissioner 
for distributing certificates, in an amount not to exceed 10 percent of 
the proceeds of the issue, to individuals who do not meet the 
requirements of this paragraph. Such plan must describe a procedure for 
ensuring that no more than 10 percent of the proceeds of a such issue 
will be used to provide certificates to such individuals. If the 
Commissioner approves the issuer's plan, certificates issued in 
accordance with the terms of the plan to holders who do not meet the 3-
year requirement do not fail to satisfy the requirements of this 
paragraph.
    (f) Purchase price requirement--(1) In general. A certificate meets 
the requirements of this paragraph only if the acquisition cost (as 
defined in Sec.  1.25-1T(b)(8)) of the residence, other than a targeted 
area residence, in connection with which the certificate is provided 
does not exceed 110 percent of the average area purchase price (as 
defined in Sec.  1.25-1T(b)(9)) applicable to that residence. In the 
case of a targeted area residence (as defined in Sec.  1.251T(b)(7)) the 
acquisition cost may not exceed 120 percent of the average area purchase 
price applicable to such residence. See section 1093A(f) and the 
regulations thereunder for further definitions and requirements.
    (2) Certification procedure. The requirements of paragraph (f)(1) 
will be met if the issuer or its agent obtains affidavits executed by 
the seller and the buyer that state these requirements have been met. 
Such affidavits must include an itemized list of--
    (i) Any payments made by the buyer (or a related person) or for the 
benefit of the buyer,
    (ii) If the residence is incomplete, an estimate of the reasonable 
cost of completing the residence, and
    (iii) If the residence is purchased subject to a ground rent, the 
capitalized value of the ground rent.

The issuer or his agent must examine such affidavits and determine 
whether, on the basis of information contained therein, the purchase 
price requirement is met.
    (g) New mortgage requirement--(1) In general. (i) A certificate 
meets the requirements of this paragraph only if the certificate is not 
issued in connection with the acquisition or replacement of an existing 
mortgage. Except in the case of a qualified home improvement loan, the 
certificate must be issued to an individual who did not have a mortgage 
(whether or not paid off) on the residence with respect to which the 
certificate is issued at any time prior to the execution of the 
mortgage.
    (ii) Exceptions. For purposes of this paragraph, a certificate used 
in connection with the replacement of--
    (A) Construction period loans,
    (B) Bridge loans or similar temporary initial financing, and
    (C) In the case of a qualified rehabilitation loan, an existing 
mortgage,

[[Page 52]]


shall not be treated as being used to acquire or replace an existing 
mortgage. Generally, temporary initial financing is any financing which 
has a term of 24 months or less. See section 103A(j)(1) and the 
regulations thereunder for examples illustrating the application of 
these requirements.
    (2) Certification procedure. The requirements of paragraph (g)(1) 
will be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that the mortage being acquired in 
connection with the certificate will not be used to acquire or replace 
an existing mortgage (other than one that falls within the exceptions 
described in paragraph (g)(1)(ii)).
    (h) Transfer of mortgage credit certificates--(1) In general. A 
certificate meets the requirements of this paragraph only if it is (i) 
not transferable or (ii) transferable only with the approval of the 
issuer.
    (2) Transfer procedure. A certificate that is transferred with the 
approval of the issuer is a qualified mortgage credit certificate in the 
hands of the transferee only if each of the following requirements is 
met:
    (i) The transferee assumed liability for the remaining balance of 
the certified indebtedness amount in connection with the acquisition of 
the residence from the transferor,
    (ii) The issuer issues a new certificate to the transferee, and
    (iii) The new certificate meets each of the requirements of 
paragraphs (d), (e), (f), and (i) of this section based on the facts as 
they exist at the time of the transfer as if the mortgage credit 
certificate were being issued for the first time. For example, the 
purchase price requirement is to be determined by reference to the 
average area purchase price at the time of the assumption and not when 
the mortgage credit certificate was originally issued.
    (3) Statement on certificate. The requirements of paragraph (h)(1) 
will be met if the mortgage credit certificate states that the 
certificate may not be transferred or states that the certificate may 
not be transferred unless the issuer issues a new certificate in place 
of the original certificate.
    (i) Prohibited mortgages--(1) In general. A certificate meets the 
requirements of this paragraph only if it is issued in connection with 
the acquisition of a residence none of the financing of which is 
provided from the proceeds of--
    (i) A qualified mortgage bond (as defined under section 103A(c)(1) 
and the regulations thereunder), or
    (ii) A qualified veterans' mortgage bond (as defined under section 
103A(c)(3) and the regulations thereunder).

Thus, for example, if a mortgagor has a mortgage on his principal 
residence that was obtained from the proceeds of a qualified mortgage 
bond, a mortgage credit certificate issued to such mortgagor in 
connection with a qualified home improvement loan with respect to such 
residence is not a qualified mortgage credit certificate. If, however, 
the financing provided from the proceeds of the qualified mortgage bond 
had been paid off in full, the certificate would be a qualified mortgage 
credit certificate (assuming all the requirements of this paragraph are 
met).
    (2) Certification procedure. The requirements of paragraph (i)(1) 
will be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that no portion of the financing of the 
residence in connection with which the certificate is issued is provided 
from the proceeds of a qualified mortgage bond or a qualified veterans' 
mortgage bond.
    (j) Particular lenders--(1) In general. Except as otherwise provided 
in paragraph (j)(2), a certificate meets the requirements of this 
paragraph only if the certificate is not limited to indebtedness 
incurred from particular lenders. A certificate is limited to 
indebtedness from particular lenders if the issuer, directly or 
indirectly, prohibits the holder of a certificate from obtaining 
financing from one or more lenders or requires the holder of a 
certificate to obtain financing from one or more lenders. For purposes 
of this paragraph, a lender is any person, including an issuer of 
mortgage credit certificates, that provides financing for the 
acquisition, qualified rehabilitation, or qualified home improvement of 
a residence.
    (2) Exception. A mortgage credit certificate that is limited to 
indebtedness

[[Page 53]]

incurred from particular lenders will not cease to meet the requirements 
of this paragraph if the Commissioner approves the basis for such 
limitation. The Commissioner may approve the basis for such limitation 
if the issuer establishes to the satisfaction of the Commissioner that 
it will result in a significant economic benefit to the holders of 
mortgage credit certificates (e.g., substantially lower financing costs) 
compared to the result without such limitation.
    (3) Taxable bonds. The requirements of this paragraph do not prevent 
an issuer of mortgage credit certificates from issuing mortgage subsidy 
bonds (other than obligations described in section 103 (a)) the proceeds 
of which are to be used to provide mortgages to holders of mortgage 
credit certificates provided that the holders of such certificates are 
not required to obtain financing from the proceeds of the bond issue. 
See Sec.  1.25-4T (h) with respect to permissible fees.
    (4) Lists of participating lenders. The requirements of this 
paragraph do not prohibit an issuer from maintaining a list of lenders 
that have stated that they will make loans to qualified holders of 
mortgage credit certificates, provided that (i) the issuer solicits such 
statements in a public notice similar to the notice described in Sec.  
1.25-7T, (ii) lenders are provided a reasonable period of time in which 
to express their interest in being included in such a list, and (iii) 
holders of mortgage credit certificates are not required to obtain 
financing from the lenders on the list. If an issuer maintains such a 
list, it must update the list at least annually.
    (5) Certification procedure. The requirements of this paragraph will 
be met if (i) the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that the certificate was not limited to 
indebtedness incurred from particular lenders or (ii) the issuer obtains 
a ruling from the Commissioner under paragraph (j)(2).
    (6) Examples. The following examples illustrate the application of 
this paragraph:

    Example 1. Under its mortgage credit certificate program, County Z 
distributes all the certificates to be issued to a group of 60 
participating lenders. Residents of County Z may obtain mortgage credit 
certificates only from the participating lenders and only in connection 
with the acquisition of mortgage financing from that lender or one of 
the other participating lenders. Certificates issued under this program 
do not meet the requirements of this paragraph since the certificates 
are limited to indebtedness incurred from particular lenders. The 
certificates, therefore, are not qualified mortgage credit certificates.
    Example 2. In connection with its mortgage credit certificate 
program, County Y arranges with Bank P for a line of credit to be used 
to provide mortgage financing to holders of mortgage credit 
certificates. County Y, pursuant to paragraph (j)(4), maintains a list 
of lenders participating in the mortgage credit certificate program. 
County Y distributes the certificates directly to applicants. Holders of 
the certificates are not required to obtain mortgage financing through 
the line of credit or through a lender on the list of participating 
lenders. Certificates issued pursuant to County Y's program satisfy the 
requirements of this paragraph.

    (k) Developer certification--(1) In general. A mortgage credit 
certificate that is allocated by the issuer to any particular 
development meets the requirements of this paragraph only if the 
developer provides a certification to the purchaser of the residence and 
the issuer stating that the purchase price of that residence is not 
higher than the price would be if the issuer had not allocated mortgage 
credit certificates to the development. The certification must be made 
by the developer if a natural person or, if not, by a duly authorized 
official of the developer.
    (2) Certification procedure. The requirements of this paragraph will 
be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that he has received from the developer 
the certification described in this paragraph.
    (l) Expiration--(1) In general. A certificate meets the requirements 
of this paragraph if the certified indebtedness amount is incurred prior 
to the close of the second calendar year following the calendar year for 
which the issuer elected not to issue qualified mortgage bonds under 
Sec.  1.25-4T with respect to that issue of mortgage credit 
certificates. Thus, for example, if on October 1, 1984, an issuing 
authority elects under Sec.  1.25-4T not to issue qualified

[[Page 54]]

mortgage bonds, a mortgage credit certificate provided under that 
program does not meet the requirements of this paragraph unless the 
indebtedness is incurred on or before December 31, 1986.
    (2) Issuer-imposed expiration dates. An issuer of mortgage credit 
certificates may provide that a certificate shall expire if the holder 
of the certificate does not incure certified indebtedness by a date that 
is prior to the expiration date provided in paragraph (l)(1). A 
certificate that expires prior to the date provided in paragraph (l)(1) 
may be reissued provided that the requirements of this paragraph are 
met.
    (m) Revocation. A certificate meets the requirements of this 
paragraph only if it has not been revoked. Thus, the credit provided by 
section 25 and Sec.  1.25-1T does not apply to interest paid or accrued 
following the revocation of a certificate. A certificate is treated as 
revoked when the residence to which the certificate relates ceases to be 
the holder's principal residence. An issuer may revoke a mortgage credit 
certificate if the certificate does not meet all the requirements of 
Sec.  1.25-3T (d), (e), (f), (g), (h), (i), (j), (k), and (n). The 
certificate is revoked by the issure's notifying the holder of the 
certificate and the Internal Revenue Service that the certificate is 
revoked. The notice to the Internal Revenue Service shall be made as 
part of the report requred by Sec.  1.25-8T (b)(2).
    (n) Interest paid to related person--(1) In general. A certificate 
does not meet the requirements of this paragraph if interest on the 
certified indebtedness amount is paid to a person who is a related 
person to the holder of the certificate.
    (2) Certification procedure. The requirements of this paragraph will 
be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that a related person does not have, 
and is not expected to have, an interest as a creditor in the certified 
indebtedness amount.
    (o) Fraud. Notwithstanding any other provision of this section, a 
mortgage credit certificate does not meet the requirements of this 
section and, therefore, the certificate is not a qualified mortgage 
credit certificate for any calendar year, if the holder of the 
certificate provides a certification or any other information to the 
lender providing the mortgage or to the issuer of the certificate 
containing a material misstatement and such misstatement is due to 
fraud. In determining whether any misstatement is due to fraud, the 
rules generally applicable to underpayments of tax due to fraud 
(including rules relating to the statute of limitations) shall apply. 
See Sec.  1.6709-1T with respect to the penalty for filing negligent or 
fraudulent statements.

[T.D. 8023, 50 FR 19348, May 8, 1985, as amended at T.D. 8502, 58 FR 
67689, Dec. 22, 1993; T.D. 8692, 61 FR 66215, Dec. 17, 1996]



Sec.  1.25-4T  Qualified mortgage credit certificate program (Temporary).

    (a) In general--(1) Definition of qualified mortgage credit 
certificate program. For purposes of Sec. Sec.  1.25-1T through 1.25-8T, 
the term ``qualified mortgage credit certificate program'' means a 
program to issue qualified mortgage credit certificates which meets all 
of the requirements of paragraphs (b) through (i) of this section.
    (2) Requirements are a minimum. Except as otherwise provided in this 
section, the requirements of this section are minimum requirements. 
Issuers may establish more stringent criteria for participation in a 
qualified mortgage credit certificate program. Thus, for example, an 
issuer may target 30 percent of the proceeds of an issue of mortgage 
credit certificates to targeted areas. Further, issuers may establish 
additional eligibility criteria for participation in a qualified 
mortgage credit certificate program. Thus, for example, issuers may 
impose an income limitation designed to ensure that only those 
individuals who could not otherwise purchase a residence will benefit 
from the credit.
    (3) Except as otherwise provided in this section and Sec.  1.25-3T, 
issuers may use mortgage credit certificates in connection with other 
Federal, State, and local programs provided that such use complies with 
the requirements of Sec.  1.25-3T(j). Thus, for example, a mortgage 
credit certificate may be issued in connection with the qualified 
rehabilitation of a residence part of the cost of which will be paid 
from the proceeds of a State grant.

[[Page 55]]

    (b) Establishment of program. A program meets the requirements of 
this paragraph only if it is established by a State or political 
subdivision thereof for any calendar year for which it has the authority 
to issue qualified mortgage bonds.
    (c) Election not to issue qualified mortgage bonds--(1) In general. 
A program meets the requirements of this paragraph only if the issuer 
elects, in the time and manner specified in this paragraph, not to issue 
an amount of qualified mortgage bonds that it may otherwise issue during 
the calendar year under section 103A and the regulations thereunder.
    (2) Manner of making election. On or before the earlier of the date 
of distribution of mortgage credit certificates under a program or 
December 31, 1987, the issuer must file an election not to issue an 
amount of qualified mortgage bonds. The election (and the certification 
(or affidavit) described in paragraph (d)) shall be filed with the 
Internal Revenue Service Center, Philadelphia, Pennsylvania 19255. The 
election should be titled ``Mortgage Credit Certificate Election'' and 
must include--
    (i) The name, address, and TIN of the issuer,
    (ii) The issuer's applicable limit, as defined in section 103A (g) 
and the regulations thereunder,
    (iii) The aggregate amount of qualified mortgage bonds issued by the 
issuing authority during the calendar year,
    (iv) The amount of the issuer's applicable limit that it has 
surrendered to other issuers during the calendar year,
    (v) The date and amount of any previous elections under this 
paragraph for the calendar year, and
    (vi) The amount of qualfied mortgage bonds that the issuer elects 
not to issue.
    (3) Revocation of election. Any election made under this paragraph 
may be revoked, in whole or in part, at any time during the calendar 
year in which the election was made. The revocation, however, may not be 
made with respect to any part of the nonissued bond amount that has been 
used to issue mortgage credit certificates pursuant to the election. The 
revocation shall be filed with the Internal Revenue Service Center, 
Philadelphia, Pennsylvania 19255. The revocation should be titled 
``Revocation of Mortgage Credit Certificate Election'' and must 
include--
    (i) The name, address, and TIN of the issuer,
    (ii) The nonissued bond amount as originally elected, and
    (iii) The portion of the nonissued bond amount with respect to which 
the election is being revoked.
    (4) Special rule. If at the time that an issuer makes an election 
under this paragraph it does not know its applicable limit, the issuer 
may elect not to use all of its remaining authority to issue qualified 
mortgage bonds; this form of election will be treated as meeting the 
requirements of paragraph (c)(2) if, prior to the later of the end of 
the calendar year and December 31, 1985, the issuer amends its election 
so as to indicate the exact amount of qualified mortgage bond authority 
that it elected not to issue.
    (5) Limitation on nonissued bond amount. The amount of qualified 
mortgage bonds which an issuer elects not to issue may not exceed the 
issuer's applicable limit (as determined under section 103A (g) and the 
regulations thereunder). For example, a governmental unit that, pursuant 
to section 103A (g)(3), may issue $10 million of qualified mortgage 
bonds that elects to trade in $11 million in qualified mortgage bond 
authority has not met the requirements of this paragraph, and mortgage 
credit certificates issued pursuant to such election are not qualified 
mortgage credit certificates.
    (d) State certification requirement--(1) In general. A program meets 
the requirements of this paragraph only if the State official designated 
by law (or, where there is no State official, the Governor) certifies, 
based on facts and circumstances as of the date on which the 
certification is requested, following a request for such certification, 
that the issue meets the requirements of section 103A(g) (relating to 
volume limitation) and the regulations thereunder. A copy of the State 
certification must be attached to the issuer's election not to issue 
qualified mortgage bonds, except that, in the case of elections made 
during calendar year 1984,

[[Page 56]]

the certification may be filed with the Service prior to July 8, 1985 
provided that mortgage credit certificates may not be distributed until 
the certification is filed. In the case of any constitutional home rule 
city, the certification shall be made by the chief executive officer of 
the city.
    (2) Certification procedure. The official making the certification 
described in this paragraph (d) need not perform an independent 
investigation to determine whether the issuer has met the requirements 
of section 103A(g). In determining the aggregate amount of qualified 
mortgage bonds previously issued by that issuer during the calendar year 
the official may rely on copies of prior elections under paragraph (c) 
of this section made by the issuer for that year, together with an 
affidavit executed by an official of the issuer who is responsible for 
issuing bonds stating that the issuer has not, to date, issued any other 
issues of qualified mortgage bonds during the calendar year and stating 
the amount, if any, of the issuer's applicable limit that it has 
surrendered to other issuers during the calendar year; for any calendar 
year prior to 1985, the official may rely on an affidavit executed by a 
duly authorized official of the issuer who states the aggregate amount 
of qualified mortgage bonds issued by the issuer during the year. In 
determining the aggregate amount of qualified mortgage bonds that the 
issuer has previously elected not to issue during that calendar year, 
the official may rely on copies of any elections not to issue qualified 
mortgage bonds filed by the issuer for that calendar year, together with 
an affidavit executed by an official of the issuer responsible for 
issuing mortgage credit certificates stating that the issuer has not, to 
date, made any other elections not to issue qualified mortgage bonds. 
If, based on such information, the certifying official determines that 
the issuer has not, as of the date on which the certification is 
provided, exceeded its applicable limit for the year, the official may 
certify that the issue meets the requirements of section 103A(g). The 
fact that the certification described in this paragraph (d) is provided 
does not ensure that the issuer has met the requirements of section 
103A(g) and the regulations thereunder, nor does it preclude the 
application of the penalty for over-issuance of mortgage credit 
certificates if such over-issuance actually occurs. See Sec.  1.25-5T.
    (3) Special rule. If within 30 days after the issuer files a proper 
request for the certification described in this paragraph (d) the issuer 
has not received from the State official designated by law (or, if there 
is no State official, the Governor) certification that the issue meets 
the requirements of section 103A(g) or, in the alternative, a statement 
that the issue does not meet such requirements, the issuer may submit, 
in lieu of the certification required by this paragraph (d), an 
affidavit executed by an officer of the issuer responsible for issuing 
mortgage credit certificates stating that--
    (i) The issue meets the requirements of section 103A(g) and the 
regulations thereunder,
    (ii) At least 30 days before the execution of the affidavit the 
issuer filed a proper request for the certification described in this 
paragraph (d), and
    (iii) The State official designated by law (or, if there is no State 
official, the Governor) has not provided the certification described in 
this paragraph (d) or a statement that the issue does not meet such 
requirements.

For purposes of this paragraph, a request for certification is proper if 
the request includes the reports and affidavits described in paragraph 
(d)(2).
    (e) Information reporting requirement--(1) Reports. With respect to 
mortgage credit certificates issued after September 30, 1985, a program 
meets the requirements of this paragraph only if the issuer submits a 
report containing the information concerning the holders of certificates 
issued during the preceding reporting period required by this paragraph. 
The report must be filed for each reporting period in which certificates 
(other than transferred certificates) are issued under the program. The 
issuer is not responsible for false information provided by a holder if 
the issuer did not know or have reason to know that the information was 
false. The report must be filed on the form prescribed by the Internal 
Revenue Service. If no form is prescribed,

[[Page 57]]

or if the form prescribed is not readily available, the issuer may use 
its own form provided that such form is in the format set forth in this 
paragraph and contains the information required by this paragraph. The 
report must be titled ``Mortgage Credit Certificate Information Report'' 
and must include the name, address, and TIN of the issuer, the reporting 
period for which the information is provided, and the following tables 
containing information concerning the holders of certificates issued 
during the reporting period for which the report is filed:
    (i) A table titled ``Number of Mortgage Credit Certificates by 
Income and Acquisition Cost'' showing the number of mortgage credit 
certificates issued (other than those issued in connection with 
qualified home improvement and rehabilitation loans) according to the 
annualized gross income of the holders (categorized in the following 
intervals of income:

$0-$9,999;
$10,000-$19,999;
$20,000-$29,999;
$30,000-$39,999;
$40,000-$49,999;
$50,000-$74,999; and
$75,000 or more)


and according to the acquisition cost of the residences acquired in 
connection with the mortgage credit certificates (categorized in the 
following intervals of acquisition cost:

$0-$19,999;
$20,000-$39,999;
$40,000-$59,999;
$60,000-$79,999;
$80,000-$99,999;
$100,000-$119,999;
$120,000-$149,999;
$150,000-$199,999; and
$200,000 or more).


For each interval of income and acquisition cost the table must also be 
categorized according to--
    (A) The aggregate amount of fees charged to holders to cover any 
administrative costs incurred by the issuer in issuing mortgage credit 
certificates, and
    (B) The number of holders that--
    (1) Did not have a present ownership interest in a principal 
residence at any time during the 3-year period ending on the date the 
mortgage credit certificate is executed (i.e., satisfied the 3-year 
requirement) and purchased residences in targeted areas,
    (2) Satisfied the 3-year requirement and purchased residences not 
located in targeted areas,
    (3) Did have a present ownership interest in a principal residence 
at any time during the 3-year period ending on the date the mortgage 
credit certificate is executed (i.e., did not satisfy the 3-year 
requirement) and purchased residences in targeted areas, and
    (4) Did not satisfy the 3-year requirement and purchased residences 
not located in targeted areas.
    (ii) A table titled ``Volume of Mortgage Credit Certificates by 
Income and Acquisition Cost'' containing data on--
    (A) The total of the certified indebtedness amounts of the 
certificates issued (other than those issued in connection with 
qualified home improvement and rehabilitation loans);
    (B) The sum of the products of the certified indebtedness amount and 
the certificate credit rate for each certificate (other than those 
issued in connection with qualified home improvement and rehabilitation 
loans) according to annualized gross income (categorized in the same 
intervals of income as the preceding table) and according to the 
acquisition cost of the residences acquired in connection with mortgage 
credit certificates (categorized in the same intervals of acquisition 
cost as the preceding table); and
    (C) For each interval of income and acquisition cost, the 
information described in paragraph (e)(1)(ii) (A) and (B) categorized 
according to the holders that--
    (1) Satisfied the 3-year requirement and purchased residences in 
targeted areas,
    (2) Satisfied the 3-year requirement and purchased residences not 
located in targeted areas,
    (3) Did not satisfy the 3-year requirement and purchased residences 
in targeted areas, and
    (4) Did not satisfy the 3-year requirement and purchased residences 
not located in targeted areas.
    (iii) A table titled ``Mortgage Credit Certificates for Qualified 
Home Improvement and Rehabilitation Loans'' showing the number of 
mortgage credit

[[Page 58]]

certificates issued in connection with qualified home improvement loans 
and qualified rehabilitation loans, the total of the certified 
indebtedness amount with respect to such certificates, and the sum of 
the products of the certified indebtedness amount and the certificate 
credit rate for each certificate; the information contained in the table 
must also be categorized according to whether the residences with 
respect to which the certificates were provided are located in targeted 
areas.
    (2) Format. If no form is prescribed by the Internal Revenue 
Service, or if the prescribed form is not readily available, the issuer 
must submit the report in the format specified in this paragraph (e)(2). 
The specified format of the report is the following:

             Mortgage Credit Certificate Information Report

Name of issuer:
Address of issuer:
TIN of issuer:
Reporting period:

                                          Number of Mortgage Credit Certificates by Income and Acquisition Cost
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                         Satisfied                           Not satisfied
  3-year requirement: Annualized gross monthly income of  ----------------------------------------------------------------------------    Totals fees
                        borrowers                           Nontargeted area    Targeted area     Nontargeted area    Targeted area
--------------------------------------------------------------------------------------------------------------------------------------------------------
$0 to $9,999.............................................
$10,000 to $19,999.......................................
$20,000 to $29,999.......................................
$30,000 to $39,999.......................................
$40,000 to $49,999.......................................
$50,000 to $74,999.......................................
$75,000 or more..........................................
                                                          ----------------------------------------------------------------------------------------------
  Total..................................................
 
                     Acquisition Cost
 
0 to $19,999.............................................
$20,000 to $39,999.......................................
$40,000 to $59,999.......................................
$60,000 to $79,999.......................................
$80,000 to $99,999.......................................
$100,000 to $119,999.....................................
$120,000 to $149,999.....................................
$150,000 to $199,999.....................................
$200,000 or more.........................................
                                                          ----------------------------------------------------------------------------------------------
    Total................................................
--------------------------------------------------------------------------------------------------------------------------------------------------------


[[Page 59]]


                                                              Volume of Mortgage Credit Certificates by Income and Acouisition Cost
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                             Holders satisfying the 3-year requirement                   3-year requirement not satisfied                       Totals
                                                     -------------------------------------------------------------------------------------------------------------------------------------------
                                                           Nontargeted area              Targeted area             Nontargeted area              Targeted area
                                                     ----------------------------------------------------------------------------------------------------------------               Total sum of
                                                                       Sum of                      Sum of                      Sum of                      Sum of     Total of the   products of
     Annualized gross monthly income of holders       Total of the   products of  Total of the   products of  Total of the   products of  Total of the   products of    certified     certified
                                                        certified     certified     certified     certified     certified     certified     certified     certified   indebtedness  indebtedness
                                                      indebtedness  indebtedness  indebtedness  indebtedness  indebtedness  indebtedness  indebtedness  indebtedness     amounts     amounts and
                                                         amounts     amounts and     amounts     amounts and     amounts     amounts and     amounts     amounts and                credit rates
                                                                    credit rates                credit rates                credit rates                credit rates
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
$0 to $9,999........................................
$10,000 to $19,999..................................
$20,000 to $29,999..................................
$30,000 to $39,999..................................
$40,000 to $49,999..................................
$50,000 to $74,999..................................
$75,000 to more.....................................
                                                     -------------------------------------------------------------------------------------------------------------------------------------------
    Total...........................................
 
                  Acquisition Cost
 
$0 to $19,999.......................................
$20,000 to $39,999..................................
$40,000 to $59,999..................................
$60,000 to $79,999..................................
$80,000 to $99,999..................................
$100,000 to $119,999................................
$120,000 to $149,999................................
$150,000 to $199,999................................
$200,000 or more....................................
                                                     -------------------------------------------------------------------------------------------------------------------------------------------
    Total...........................................
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------


[[Page 60]]


     Mortgage Credit Certificates for Qualified Home Improvement and
                          Rehabilitation Loans
------------------------------------------------------------------------
                                          Nontargeted  Targeted
                                              area       area     Totals
------------------------------------------------------------------------
         Home Improvement Loans
 
Number of mortgage credit certificates..
Total of the certified indebtedness
 amounts................................
Product of certified indebtedness
 amounts and credit rates...............
 
          Rehabilitation Loans
 
Number of mortgage credit certificates..
Total of the certified indebtedness
 amounts................................
Product of certified indebtedness
 amounts and credit rates...............
------------------------------------------------------------------------

    (3) Definitions and special rules. (i) For purposes of this 
paragraph the term ``annualized gross income'' means the borrower's 
gross monthly income multiplied by 12. Gross monthly income is the sum 
of monthly gross pay, any additional income from investments, pensions, 
Veterans Administration (VA) compensation, part-time employment, 
bonuses, dividends, interest, current overtime pay, net rental income, 
etc., and other income (such as alimony and child support, if the 
borrower chooses to disclose such income). Information with respect to 
gross monthly income may be obtained from available loan documents, 
e.g., the sum of lines 23D and 23E on the Application for VA or FmHA 
Home Loan Guaranty or for HUD/FHA Insured Mortgage (VA Form 26-1802a, 
HUD 92900, Jan. 1982), or the total line from the Gross Monthly Income 
section of FHLMC Residential Loan Application form (FHLMC 65 Rev. 8/78).
    (ii) For purposes of this paragraph, the term ``reporting period'' 
means each one year period beginning July 1 and ending June 30, except 
that issuers need not provide data with respect to the period prior to 
October 1, 1985.
    (iii) For purposes of this paragraph, verification of information 
concerning a holder's gross monthly income by utilizing other available 
information concerning the holder's income (e.g., Federal income tax 
returns) is not required. In determining whether the holder of a 
mortgage credit certificate acquiring a residence in a targeted area 
satisfies the 3-year requirement, the issuer may rely on a statement 
signed by the holder.
    (4) Time for filing. The report required by this paragraph shall be 
filed not later than the 15th day of the second calendar month after the 
close of the reporting period. The Commissioner may grant an extension 
of time for the filing of a report required by this paragraph if there 
is reasonable cause for the failure to file such report in a timely 
fashion. The report may be filed at any time before such date but must 
be complete based on facts and reasonable expectations as of the date 
the report is filed. The report need not be amended to reflect 
information learned subsequent to the date of filing, or to reflect 
changed circumstances with respect to any holder.
    (5) Place for filing. The report required by this paragraph is to be 
filed at the Internal Revenue Service Center, Philadelphia, Pennsylvania 
19255.
    (f) Policy statement. A program established pursuant to an election 
under paragraph (c) made after 1984 meets the requirements of this 
paragraph only if the applicable elected representative of the 
governmental unit--
    (1) Which is the issuer, or
    (2) On whose behalf the certificates were issued,

has published (after a public hearing following reasonable public 
notice) a policy statement described in Sec.  1.103A-2(1) by the last 
day of the year preceding the year in which the election under paragraph 
(c) is made, and a copy of such report has been submitted to the 
Commissioner on or before such last day. See Sec.  1.103A-2(1) for 
further definitions and requirements.
    (g) Targeted areas requirement--(1) In general. A program meets the 
requirements of this paragraph only if--
    (i) The portion of the total proceeds of the issue specified in 
paragraph (g)(2) is made available to provide mortgage credit 
certificates in connection with owner financing of targeted area 
residents for at least 1 year after the date on which mortgage credit 
certificates are first made available with respect to targeted area 
residences, and

[[Page 61]]

    (ii) The issuer attempts with reasonable diligence to place such 
proceeds with qualified persons.


Mortgage credit certificates are considered first made available with 
respect to targeted area residences on the date on which the issuer 
first begins to accept applications for mortgage credit certificates 
provided under that issue.
    (2) Specified portion. (i) The specified portion of the total 
proceeds of an issue is the lesser of--
    (A) 20 percent of the total proceeds, or
    (B) 8 percent of the average annual aggregate principal amount of 
mortgages executed during the immediately preceding 3 calendar years for 
single-family, owner-occupied residences in targeted areas within the 
jurisdiction of the issuing authority.

For purposes of computing the required portion of the total proceeds 
specified in paragraph (g)(2)(i)(B) where such provision is applicable, 
an issuer may rely upon the safe-harbor formula provided in the 
regulations under section 103A(h).
    (ii) See Sec.  1.25-1T(b)(10)(ii) for the definition of ``total 
proceeds''.
    (h) Fees--(1) In general. A program meets the requirements of this 
paragraph only if each applicant is required to pay, directly or 
indirectly, no fee other than those fees permitted under this paragraph.
    (2) Permissible fees. Applicants may be required to pay the 
following fees provided that they are reasonable:
    (i) Points, origination fees, servicing fees, and other fees in 
amounts that are customarily charged with respect to mortgages not 
provided in connection with mortgage credit certificates,
    (ii) Application fees, survey fees, credit report fees, insurance 
fees, or similar settlement or financing costs to the extent such 
amounts do not exceed the amounts charged in the area in cases where 
mortgages are not provided in connection with mortgage credit 
certificates. For example, amounts charged for FHA, VA, or similar 
private mortgage insurance on an individual's mortgage are permissible 
so long as such amounts do not exceed the amounts charged in the area 
with respect to a similar mortgage that is not provided in connection 
with a mortgage credit certificate, and
    (iii) Other fees that, taking into account all the facts and 
circumstances, are reasonably necessary to cover any administrative 
costs incurred by the issuer or its agent in issuing mortgage credit 
certificates.
    (i) Qualified mortgage credit certificate. A program meets the 
requirements of this paragraph only if each mortgage credit certificate 
issued under the program meets each of the requirements of paragraphs 
(c) through (o) of Sec.  1.25-3T.
    (j) Good faith compliance efforts--(1) Eligibility requirements. (i) 
A program under which each of the mortgage credit certificates issued 
does not meet each of the requirements of paragraphs (c) through (o) of 
Sec.  1.25-3T shall be treated as meeting the requirements of paragraph 
(i) of this section if each of the requirements of this paragraph (j)(1) 
is satisfied. A mortgage credit certificate program meets the 
requirements of this paragraph (j)(1) only if each of the following 
provisions is met:
    (A) The issuer in good faith attempted to issue mortgage credit 
certificates only to individuals meeting each of the requirements of 
paragraphs (c) through (o) of Sec.  1.25-3T. Good faith requires that 
agreements with lenders and agents and other relevant instruments 
contain restrictions that permit the approval of mortgage credit 
certificates only in accordance with the requirements of paragraphs (c) 
through (o) of Sec.  1.25-3T. In addition, the issuer must establish 
reasonable procedures to ensure compliance with those requirements. 
Reasonable procedures include reasonable investigations by the issuer to 
determine whether individuals satisfy the requirements of paragraphs (c) 
through (o) of Sec.  1.25-3T.
    (B) 95 percent or more of the total proceeds of the issue were 
devoted to individuals with respect to whom, at the time that the 
certificate was issued, all the requirements of paragraphs (c) through 
(o) of Sec.  1.25-3T were met. If a holder of a mortgage credit 
certificate fails to meet more than one of these requirements, the 
amount of the certificate (i.e., the certificate credit rate multiplied 
by the certified

[[Page 62]]

indebtedness amount) issued to that individual will be taken into 
account only once in determining whether the 95-percent requirement is 
met. However, all of the defects in that individual's certificate must 
be corrected pursuant to paragraph (j)(1)(i)(C).
    (C) Any failure to meet the requirements of paragraphs (c) through 
(o) of Sec.  1.25-3T is corrected within a reasonable period after that 
failure is discovered. For example, if an individual fails to meet one 
or more of such requirements those failures can be corrected by revoking 
that individual's certificate.
    (ii) Examples. The following examples illustrate the application of 
this paragraph (j)(1):

    Example 1. County X only distributes mortgage credit certificates to 
individuals who have contracted to purchase a principal residence. 
County X requires that applicants for mortgage credit certificates 
present the following information:
    (i) An affidavit stating that the applicant intends to use the 
residence in connection with which the mortgage credit certificate is 
issued as his principal residence within a reasonable time after the 
certificate is issued by County X, that the applicant will notify the 
County if the residence ceases to be his principal residence, and facts 
that are sufficient for County X to determine whether the residence is 
located within the jurisdiction of County X,
    (ii) An affidavit stating that the applicant had no present 
ownership interest in a principal residence at any time during the 3-
year period prior to the date on which the certificate is issued,
    (iii) Copies of the applicant's Federal tax returns for the 
preceding 3 years,
    (iv) Affidavits from the seller of the residence with respect to 
which the certificate is issued and the applicant stating the purchase 
price of the residence, including an itemized list of (A) payments made 
by or for the benefit of the applicant, (B) if the residence is 
incomplete, an estimate of the reasonable cost of completing the 
residence, and (C) if the residence is subject to a ground rent, the 
capitalized value of the ground rent,
    (v) An affidavit executed by the applicant stating that the mortgage 
being acquired in connection with the certificate will not be used to 
acquire or replace an existing mortgage,
    (vi) An affidavit executed by the applicant stating that no portion 
of the financing for the residence in connection with which the 
certificate is issued is provided from the proceeds of a qualified 
mortgage bond or qualified veterans' mortgage bond and that no portion 
of the mortgage for the residence is provided by a person related to the 
applicant (as defined in Sec.  1.25-3T(n)),
    (vii) An affidavit executed by the applicant stating that the 
certificate was not limited to indebtedness incurred from particular 
lenders, and
    (viii) In the case of a mortgate credit certificate allocated for 
use in connection with a particular development, and affidavit executed 
by the applicant stating that the applicant received from the developer 
a certification stating that the price of the residence with respect to 
which the certificate was issued is no higher than it would be without 
the use of a mortgage credit certificate.

County X examines the information submitted by the applicant to 
determine whether the requirements of paragraphs (c), (d), (e), (f), 
(g), (i), (j), (k), and (n) of Sec.  1.25-3T are met. County X 
determines that the certificate has not expired. The mortgage credit 
certificates issued by County X are in the form prescribed by Sec.  
1.25-6T and County X provides all the required information and 
statements. After determining that the applicant meets all these 
requirements County X issues a mortgage credit certificate to the 
applicant. This procedure for issuing mortgage credit certificates is 
sufficient evidence of the good faith of County X to meet the 
requirements of Sec.  1.25-4T(j)(1)(i)(A).
    Example 2. County W distributes preliminary mortgage credit 
certificates to individuals who have not entered into contracts to 
purchase a principal residence. County W issues preliminary certificates 
in the form prescribed by Sec.  1.25-6T to those applicants that have 
submitted statements that they (i) intend to purchase a single-family 
residence located within the jurisdiction of County W which they will 
occupy as a principal residence, (ii) have had no present ownership 
interest in a principal residence within the preceding 3-year period, 
and (iii) will not use the certificate in connection with the 
acquisition or replacement of an existing mortgage. The certificates 
contain a maximum purchase price, the certificate credit rate, and a 
statement that the certificate will expire if the applicant does not 
enter into a closing agreement with respect to a loan within 6 months 
from the date of preliminary issuance. Holders of these certificates may 
apply for a mortgage loan from any lender. When the holder of the 
certificate applies for a loan the lender requires that he submit the 
following:
    (i) An affidavit stating that the applicant intends to use the 
residence in connection with which the mortgage credit certificate is 
issued as his principal residence within a reasonable time after the 
certificate is issued by County W, that the applicant will notify the 
County if the residence ceases to be his principal residence, and facts 
that are

[[Page 63]]

sufficient for County W to determine whether the residence is located 
within the jurisdication of County W,
    (ii) An affidavit stating that the applicant had no present 
ownership interest in a principal residence at any time during the 3-
year period prior to the date on which the certificate is issued,
    (iii) Copies of the applicant's Federal tax returns for the 
preceding 3 years,
    (iv) Affidavits from the seller of the residence with respect to 
which the certificate is issued and the applicant stating the purchase 
price of the residence, including an itemized list of (A) payments made 
by or for the benefit of the applicant, (B) if the residence is 
incomplete, an estimate of the reasonable cost of completing the 
residence, and (C) if the residence is subject to a ground rent, the 
capitalized value of the ground rent,
    (v) An affidavit executed by the applicant stating that the mortgage 
being acquired in connection with the certificate will not be used to 
acquire or replace an existing mortgage,
    (vi) An affidavit executed by the applicant stating that no portion 
of the financing for the residence in connection with which the 
certificate is issued in provided from the proceeds of a qualified 
mortgage bond or qualified veterans' mortgage bond and that no portion 
of the mortgage for the residence is provided by a person related to the 
applicant (as defined in Sec.  1.25-3T(n)),
    (vii) An affidavit executed by the applicant stating that the 
certificate was not limited to indebtedness incurred from particular 
lenders, and
    (viii) In the case of a mortgage credit certificate allocated for 
use in connection with a particular development, an affidavit executed 
by the applicant stating that the applicant received from the developer 
a certification stating that the price of the residence with respect to 
which the certificate was issued is no higher than it would be without 
the use of a mortgage credit certificate.

The lender then submits those affidavits, together with its statement as 
to the amount of the indebtedness incurred, to County W. After 
determining that the requirements of paragraphs (c), (d), (e), (f), (g), 
(i), (j), (k) and (n) of Sec.  1.25-3T are met and determining that the 
certificate has not expired, County W completes the mortgage credit 
certificate. This procedure for issuing mortgage credit certificates is 
sufficient evidence of the good faith of County W to meet the 
requirements of Sec.  1.25-4T(j)(1)(i)(A).

    (2) Program requirements. (i) A mortgage credit certificate program 
which fails to meet one or more of the requirements of paragraphs (b) 
through (h) of this section shall be treated as meeting such 
requirements if the requirements of this paragraph (j)(2) are satisfied. 
A mortgage credit certificate program meets the requirements of this 
paragraph (j)(2) only if each of the following provisions is met:
    (A) The issuer in good faith attempted to meet all of the 
requirements of paragraphs (b) through (h) of this section. This good 
faith requirement will be met if all reasonable steps are taken by the 
issuer to ensure that the program complies with these requirements.
    (B) Any failure to meet such requirements is due to inadvertent 
error, e.g., mathematical error, after taking reasonable steps to comply 
with such requirements.
    (ii) The following example illustrate the application of this 
paragraph (j)(2):

    Example. City X issues an issue of mortgage credit certificates. 
However, despite taking all reasonable steps to determine accurately the 
size of the applicable limit, as provided in section 103A (g)(3) and the 
regulations thereunder, the limit is exceeded because the amount of the 
mortgages, originated in the area during the past 3 years is incorrectly 
computed as a result of mathematical error. Such facts are sufficient 
evidence of the good faith of the issuer to meet the requirements of 
paragraph (j)(2).

[T.D. 8023, 50 FR 19350, May 8, 1985, as amended by T.D. 8048, 50 FR 
35538, Sept. 3, 1985]



Sec.  1.25-5T  Limitation on aggregate amount of mortgage credit
certificates (Temporary).

    (a) In general. If the aggregate amount of qualified mortgage credit 
certificates (as defined in paragraph (b)) issued by an issuer under a 
qualified mortgage credit certificate program exceeds 20 percent of the 
nonissued bond amount (as defined in paragraph (c)), the provisions of 
paragraph (d) shall apply.
    (b) Aggregate amount of mortgage credit certificates--(1) In 
general. The aggregate amount of qualified mortgage credit certificates 
issued under a qualified mortgage credit certificate program is the sum 
of the products determined by multiplying--
    (i) The certified indebtedness amount of each qualified mortgage 
credit certificate issued under that program, by
    (ii) The certificate credit rate with respect to such certificate.

[[Page 64]]

    (2) Examples. The following examples illustrate the application of 
this paragraph (b):

    Example 1. For 1986 City Q has a nonissued bond amount of $100 
million. After making a proper election, Q issues 2,000 qualified 
mortgage credit certificates each with a certificate credit rate of 20 
percent and a certified indebtedness amount of $50,000. The aggregate 
amount of qualified mortgage credit certificates is $20 million (2,000 x 
(.2 x $50,000)). Since this amount does not exceed 20 percent of the 
nonissued bond amount (.2 x $100 million = $20 million), Q has complied 
with the limitation on the aggregate amount of mortgage credit 
certificates, provided that it does not issue any additional 
certificates.
    Example 2. The facts are the same as in example (1) except that 
instead of issuing all its certificates at the 20 percent rate, Q issues 
(i) qualified mortgage credit certificates with a certificate credit 
rate of 10 percent and an aggregate principal amount of $25 million, 
(ii) qualified mortgage credit certificates with a certificate credit 
rate of 40 percent and an aggregate principal amount of $25 million, and 
(iii) qualified mortgage credit certificates with a certificate credit 
rate of 30 percent and an aggregate principal amount of $25 million. The 
aggregate amount of qualified mortgage credit certificates is $20 
million ((10 percent of $25 million) plus (40 percent of $25 million) 
plus (30 percent of $25 million)). Q has complied with the limitation on 
the aggregate amount of qualified mortgage credit certificates, provided 
that it does not issue any additional certificates pursuant to the same 
program.

    (c) Nonissued bond amount. The term ``nonissued bond amount'' means, 
with respect to any qualified mortgage credit certificate program, the 
amount of qualified mortgage bonds (as defined in section 103A(c)(1) and 
the regulations thereunder) which the issuer is otherwise authorized to 
issue and elects not to issue under section 25(c)(2) and Sec.  1.25-
4T(b). The amount of qualified mortgage bonds which an issuing authority 
is authorized to issue is determined under section 103A(g) and the 
regulations thereunder; such determination shall take into account any 
prior elections by the issuer not to issue qualified mortgage bonds, the 
amount of any reduction in the State ceiling under paragraph (d) of this 
section, and the aggregate amount of qualified mortgage bonds issued by 
the issuer prior to its election not to issue qualified mortgage bonds.
    (d) Noncompliance with limitation on aggregate amount of mortgage 
credit certificates--(1) In general. If the provisions of this paragraph 
apply, the State ceiling under section 103A(g)(4) and the regulations 
thereunder for the calendar year following the calendar year in which 
the Commissioner determines the correction amount for the State in which 
the issuer which exceeded the limitation on the aggregate amount of 
mortgage credit certificates is located shall be reduced by 1.25 times 
the correction amount with respect to such failure.
    (2) Correction amount. (i) The term ``correction amount'' means an 
amount equal to the excess credit amount divided by .20.
    (ii) The term ``excess credit amount'' means the excess of--
    (A) The credit amount for any mortgage credit certificate program, 
over
    (B) The amount which would have been the credit amount for such 
program had such program met the requirements of section 25(d)(2) and 
paragraph (a) of this section.
    (iii) The term ``credit amount'' means the sum of the products 
determined by multiplying--
    (A) The certified indebtedness amount of each qualified mortgage 
credit certificate issued under the program, by
    (B) The certificate credit rate with respect to such certificate.
    (3) Example. The following example illustrates the application of 
this paragraph:

    Example. For 1987 City R has a nonissued bond amount of $100 
million. City R issues all of its mortgage credit certificates with a 
certificate credit rate of 20 percent. City R issues certificates with 
an aggregate certified indebtedness amount of $120 million. The 
aggregate amount of mortgage credit certificates issued by City R is $24 
million, which exceeds 20 percent of the nonissued bond amount. The 
State ceiling for the calendar year following the calendar year in which 
the Commissioner determines the correction amount is reduced by $25 
million (the correction amount multiplied by 1.25). The correction 
amount is determined as follows: The credit amount is $24 million (.2 x 
$120 million); the amount which would have been the credit amount for 
the program had it met the requirements of section 25(d)(2) is $20 
million (.2 x $100 million); the excess credit amount is $4 million ($24 
million--$20

[[Page 65]]

million); therefore, the correction amount is $20 million ($4 
million/.2).

    (4) Cross-references. See section 103A(g)(4) and the regulations 
thereunder with respect to the reduction of the applicable State 
ceiling.

[T.D. 8023, 50 FR 19353, May 8, 1985]



Sec.  1.25-6T  Form of qualified mortgage credit certificate (Temporary).

    (a) In general. Qualified mortgage credit certificates are to be 
issued on the form prescribed by the Internal Revenue Service. If no 
form is prescribed by the Internal Revenue Service, or if the form 
prescribed by the Internal Revenue Service is not readily available, the 
issuer may use its own form provided that such form contains the 
information required by this section. Each mortgage credit certificate 
must be issued in a form such that there are at least three copies of 
the form. One copy of the certificate shall be retained by the issuer; 
one copy shall be retained by the lender; and one copy shall be 
forwarded to the State official who issued the certification required by 
Sec.  1.25-4T(d), unless that State official has stated in writing that 
he does not want to receive such copies.
    (b) Required information. Each qualified mortgage credit certificate 
must include the following information:
    (1) The name, address, and TIN of the issuer,
    (2) The date of the issuer's election not to issue qualified 
mortgage bonds pursuant to which the certificate is being issued,
    (3) The number assigned to the certificate,
    (4) The name, address, and TIN of the holder of the certificate,
    (5) The certificate credit rate,
    (6) The certified indebtness amount,
    (7) The acquisition cost of the residence being acquired in 
connection with the certificate,
    (8) The average area purchase price applicable to the residence,
    (9) Whether the certificate meets the requirements of Sec.  1.25-
3T(d), relating to residence requirement,
    (10) Whether the certificate meets the requirements of Sec.  1.25-
3T(e), relating to 3-year requirement,
    (11) Whether the certificate meets the requirements of Sec.  1.25-
3T(g), relating to new mortgage requirement,
    (12) Whether the certificate meets the requirements of Sec.  1.25-
3T(i), relating to prohibited mortgages,
    (13) Whether the certificate meets the requirements of Sec.  1.25-
3T(j), relating to particular lenders,
    (14) Whether the certificate meets the requirements of Sec.  1.25-
3T(k), relating to allocations to particular developments,
    (15) Whether the certificate meets the requirements of Sec.  1.25-
3T(n), relating to interest paid to related persons,
    (16) Whether the residence in connection with which the certificate 
is issued is a targeted area residence,
    (17) The date on which a closing agreement is signed with respect to 
the certified indebtness amount,
    (18) The expiration date of the certificate,
    (19) A statement that the certificate is not transferable or a 
statement that the certificate may be transferred only if the issuer 
issues a new certificate, and
    (20) A statement, signed under penalties of perjury by an authorized 
official of the issuer or its agent, that such person has made the 
determinations specified in paragraph (b) (9) through (16).

[T.D. 8023, 50 FR 19354, May 8, 1985]



Sec.  1.25-7T  Public notice (Temporary).

    (a) In general. At least 90 days prior to the issuance of any 
mortgage credit certificate under a qualified mortgage credit 
certificate program, the issuer shall provide reasonable public notice 
of--
    (1) The eligibility requirements for such certificate,
    (2) The methods by which such certificates are to be issued, and
    (3) The other information required by this section.
    (b) Reasonable public notice--(1) In general. Reasonable public 
notice means published notice which is reasonably designed to inform 
individuals who would be eligible to receive mortgage credit 
certificates of the proposed issuance. Reasonable public notice may be 
provided through newspapers of general circulation.

[[Page 66]]

    (2) Contents of notice. The public notice required by paragraph (a) 
must include a brief description of the principal residence requirement, 
3-year requirement, purchase price requirement, and new mortgage 
requirement. The notice must also provide a brief description of the 
methods by which the certificates are to be issued and the address and 
telephone number for obtaining further information.

[T.D. 8023, 50 FR 19354, May 8, 1985]



Sec.  1.25-8T  Reporting requirements (Temporary).

    (a) Lender--(1) In general. Each person who makes a loan that is a 
certified indebtedness amount with respect to any mortgage credit 
certificate must file the report described in paragraph (a)(2) and must 
retain on its books and records the information described in paragraph 
(a)(3). The report described in paragraph (a)(2) is an annual report and 
must be filed on or before January 31 of the year following the calendar 
year to which the report relates. See section 6709(c) and the 
regulations thereunder for the applicable penalties with respect to 
failure to file reports.
    (2) Information required. The report shall be submitted on Form 8329 
and shall contain the information required therein. A separate Form 8329 
shall be filed for each issue of mortgage credit certificates with 
respect to which the lender made mortgage loans during the preceding 
calendar year. Thus, for example, if during 1986 Bank M makes three 
mortgage loans which are certified indebtedness amounts with respect to 
State Z's January 15, 1986, issue of mortgage credit certificates, and 
two mortgage loans which are certified indebtedness amounts with respect 
to State Z's April 15, 1986, issue of mortgage credit certificates, and 
fifty mortgage loans which are certified indebtedness amounts with 
respect to County X's December 31, 1985, issue of mortgage credit 
certificates, Bank M must file three separate reports for calendar year 
1986. The lender must submit the Form 8329 with the information required 
therein, including--
    (i) The name, address, and TIN of the issuer of the mortgage credit 
certificates,
    (ii) The date on which the election not to issue qualified mortgage 
bonds with respect to that mortgage credit certificate was made,
    (iii) The name, address, and TIN of the lender, and
    (iv) The sum of the products determined by multiplying--
    (A) The certified indebtedness amount of each mortgage credit 
certificate issued under such program, by
    (B) The certificate credit rate with respect to such certificate.
    (3) Recordkeeping requirements. Each person who makes a loan that is 
a certified indebtedness amount with respect to any mortgage credit 
certificate must retain the information specified in this paragraph 
(a)(3) on its books and records for 6 years following the year in which 
the loan was made. With respect to each loan the lender must retain the 
following information:
    (i) The name, address, and TIN of each holder of a qualified 
mortgage credit certificate with respect to which a loan is made,
    (ii) The name, address, and TIN of the issuer of such certificate, 
and
    (iii) The date the loan for the certified indebtedness amount is 
closed, the certified indebtedness amount, and the certificate credit 
rate of such certificate.
    (b) Issuers--(1) In general. Each issuer of mortgage credit 
certificates shall file the report described in paragraph (b)(2) of this 
section.
    (2) Quarterly reports. (i) Each issuer which elects to issue 
mortgage credit certificates shall file reports on Form 8330. These 
reports shall be filed on a quarterly basis, beginning with the quarter 
in which the election is made, and are due on the following dates: April 
30 (for the quarter ending March 31), July 31 (for the quarter ending 
June 30), October 31 (for the quarter ending September 30), and January 
31 (for the quarter ending December 31). For elections made prior to May 
8, 1985, the first report need not be filed until July 31, 1985. An 
issuer shall file a separate report for each issue of mortgage credit 
certificates. In the quarter in which the last qualified mortgage credit 
certificate that may be issued under a program is issued, the issuer 
must state that fact on the report to be filed

[[Page 67]]

for that quarter; the issuer is not required to file any subsequent 
reports with respect to that program. See section 6709(c) for the 
penalties with respect to failure to file a report.
    (ii) The report shall be submitted on Form 8330 and shall contain 
the information required therein, including--
    (A) The name, address, and TIN of the issuer of the mortgage credit 
certificates,
    (B) The date of the issuer's election not to issue qualified 
mortgage bonds with respect to the mortgage credit certificate program 
and the nonissued bond amount of the program,
    (C) The sum of the products determined by multiplying--
    (1) The certified indebtedness amount of each qualified mortgage 
credit certificate issued under that program during the calendar 
quarter, by
    (2) The certificate credit rate with respect to such certificate, 
and
    (D) A listing of the name, address, and TIN of each holder of a 
qualified mortgage credit certificate which has been revoked during the 
calendar quarter.
    (c) Extensions of time for filing reports. The Commissioner may 
grant an extension of time for the filing of a report required by this 
section if there is reasonable cause for the failure to file such report 
in a timely fashion.
    (d) Place for filing. The reports required by this section are to be 
filed at the Internal Revenue Service Center, Philadelphia, Pennsylvania 
19225.
    (e) Cross reference. See section 6709 and the regulations thereunder 
with respect to the penalty for failure to file a report required by 
this section.

[T.D. 8023, 50 FR 19354, May 8, 1985]



Sec.  1.25A-0  Table of contents.

    This section lists captions contained in Sec. Sec.  1.25A-1, 1.25A-
2, 1.25A-3, 1.25A-4, and 1.25A-5.

     Sec.  1.25A-1 Calculation of Education Tax Credit and General 
                        Eligibility Requirements

    (a) Amount of education tax credit.
    (b) Coordination of Hope Scholarship Credit and Lifetime Learning 
Credit.
    (1) In general.
    (2) Hope Scholarship Credit.
    (3) Lifetime Learning Credit.
    (4) Examples.
    (c) Limitation based on modified adjusted gross income.
    (1) In general.
    (2) Modified adjusted gross income defined.
    (3) Inflation adjustment.
    (d) Election.
    (e) Identification requirement.
    (f) Claiming the credit in the case of a dependent.
    (1) In general.
    (2) Examples.
    (g) Married taxpayers.
    (h) Nonresident alien taxpayers and dependents.

                        Sec.  1.25A-2 Definitions

    (a) Claimed dependent.
    (b) Eligible educational institution.
    (1) In general.
    (2) Rules on Federal financial aid programs.
    (c) Academic period.
    (d) Qualified tuition and related expenses.
    (1) In general.
    (2) Required fees.
    (i) In general.
    (ii) Books, supplies, and equipment.
    (iii) Nonacademic fees.
    (3) Personal expenses.
    (4) Treatment of a comprehensive or bundled fee.
    (5) Hobby courses.
    (6) Examples.

                  Sec.  1.25A-3 Hope Scholarship Credit

    (a) Amount of the credit.
    (1) In general.
    (2) Maximum credit.
    (b) Per student credit.
    (1) In general.
    (2) Example.
    (c) Credit allowed for only two taxable years.
    (d) Eligible student.
    (1) Eligible student defined.
    (i) Degree requirement.
    (ii) Work load requirement.
    (iii) Year of study requirement.
    (iv) No felony drug conviction.
    (2) Examples.
    (e) Academic period for prepayments.
    (1) In general.
    (2) Example.
    (f) Effective date.

                 Sec.  1.25A-4 Lifetime Learning Credit

    (a) Amount of the credit.
    (1) Taxable years beginning before January 1, 2003.
    (2) Taxable years beginning after December 31, 2002.
    (3) Coordination with the Hope Scholarship Credit.
    (4) Examples.
    (b) Credit allowed for unlimited number of taxable years.

[[Page 68]]

    (c) Both degree and nondegree courses are eligible for the credit.
    (1) In general.
    (2) Examples.
    (d) Effective date.

 Sec.  1.25A-5 Special Rules Relating to Characterization and Timing of 
                                Payments

    (a) Educational expenses paid by claimed dependent.
    (b) Educational expenses paid by a third party.
    (1) In general.
    (2) Special rule for tuition reduction included in gross income of 
employee.
    (3) Examples.
    (c) Adjustment to qualified tuition and related expenses for certain 
excludable educational assistance.
    (1) In general.
    (2) No adjustment for excludable educational assistance attributable 
to expenses paid in a prior year.
    (3) Scholarships and fellowship grants.
    (4) Examples.
    (d) No double benefit.
    (e) Timing rules.
    (1) In general.
    (2) Prepayment rule.
    (i) In general.
    (ii) Example.
    (3) Expenses paid with loan proceeds.
    (4) Expenses paid through third party installment payment plans.
    (i) In general.
    (ii) Example.
    (f) Refund of qualified tuition and related expenses.
    (1) Payment and refund of qualified tuition and related expenses in 
the same taxable year.
    (2) Payment of qualified tuition and related expenses in one taxable 
year and refund in subsequent taxable year before return filed for prior 
taxable year.
    (3) Payment of qualified tuition and related expenses in one taxable 
year and refund in subsequent taxable year.
    (i) In general.
    (ii) Recapture amount.
    (4) Refund of loan proceeds treated as refund of qualified tuition 
and related expenses.
    (5) Excludable educational assistance received in a subsequent 
taxable year treated as a refund.
    (6) Examples.

[T.D. 9034, 67 FR 78691, Dec. 26, 2002]



Sec.  1.25A-1  Calculation of education tax credit and general
eligibility requirements.

    (a) Amount of education tax credit. An individual taxpayer is 
allowed a nonrefundable education tax credit against income tax imposed 
by chapter 1 of the Internal Revenue Code for the taxable year. The 
amount of the education tax credit is the total of the Hope Scholarship 
Credit (as described in Sec.  1.25A-3) plus the Lifetime Learning Credit 
(as described in Sec.  1.25A-4). For limitations on the credits allowed 
by subpart A of part IV of subchapter A of chapter 1 of the Internal 
Revenue Code, see section 26.
    (b) Coordination of Hope Scholarship Credit and Lifetime Learning 
Credit--(1) In general. In the same taxable year, a taxpayer may claim a 
Hope Scholarship Credit for each eligible student's qualified tuition 
and related expenses (as defined in Sec.  1.25A-2(d)) and a Lifetime 
Learning Credit for one or more other students' qualified tuition and 
related expenses. However, a taxpayer may not claim both a Hope 
Scholarship Credit and a Lifetime Learning Credit with respect to the 
same student in the same taxable year.
    (2) Hope Scholarship Credit. Subject to certain limitations, a Hope 
Scholarship Credit may be claimed for the qualified tuition and related 
expenses paid during a taxable year with respect to each eligible 
student (as defined in Sec.  1.25A-3(d)). Qualified tuition and related 
expenses paid during a taxable year with respect to one student may not 
be taken into account in computing the amount of the Hope Scholarship 
Credit with respect to any other student. In addition, qualified tuition 
and related expenses paid during a taxable year with respect to any 
student for whom a Hope Scholarship Credit is claimed may not be taken 
into account in computing the amount of the Lifetime Learning Credit.
    (3) Lifetime Learning Credit. Subject to certain limitations, a 
Lifetime Learning Credit may be claimed for the aggregate amount of 
qualified tuition and related expenses paid during a taxable year with 
respect to students for whom no Hope Scholarship Credit is claimed.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (b):

    Example 1. In 1999, Taxpayer A pays qualified tuition and related 
expenses for his dependent, B, to attend College Y during 1999. Assuming 
all other relevant requirements are met, Taxpayer A may claim either a

[[Page 69]]

Hope Scholarship Credit or a Lifetime Learning Credit with respect to 
dependent B, but not both. See Sec.  1.25A-3(a) and Sec.  1.25A-4(a).
    Example 2. In 1999, Taxpayer C pays $2,000 in qualified tuition and 
related expenses for her dependent, D, to attend College Z during 1999. 
In 1999, Taxpayer C also pays $500 in qualified tuition and related 
expenses to attend a computer course during 1999 to improve Taxpayer C's 
job skills. Assuming all other relevant requirements are met, Taxpayer C 
may claim a Hope Scholarship Credit for the $2,000 of qualified tuition 
and related expenses attributable to dependent D (see Sec.  1.25A-3(a)) 
and a Lifetime Learning Credit (see Sec.  1.25A-4(a)) for the $500 of 
qualified tuition and related expenses incurred to improve her job 
skills.
    Example 3. The facts are the same as in Example 2, except that 
Taxpayer C pays $3,000 in qualified tuition and related expenses for her 
dependent, D, to attend College Z during 1999. Although a Hope 
Scholarship Credit is available only with respect to the first $2,000 of 
qualified tuition and related expenses paid with respect to D (see Sec.  
1.25A-3(a)), Taxpayer C may not add the $1,000 of excess expenses to her 
$500 of qualified tuition and related expenses in computing the amount 
of the Lifetime Learning Credit.

    (c) Limitation based on modified adjusted gross income--(1) In 
general. The education tax credit that a taxpayer may otherwise claim is 
phased out ratably for taxpayers with modified adjusted gross income 
between $40,000 and $50,000 ($80,000 and $100,000 for married 
individuals who file a joint return). Thus, taxpayers with modified 
adjusted gross income above $50,000 (or $100,000 for joint filers) may 
not claim an education tax credit.
    (2) Modified adjusted gross income defined. The term modified 
adjusted gross income means the adjusted gross income (as defined in 
section 62) of the taxpayer for the taxable year increased by any amount 
excluded from gross income under section 911, 931, or 933 (relating to 
income earned abroad or from certain U.S. possessions or Puerto Rico).
    (3) Inflation adjustment. For taxable years beginning after 2001, 
the amounts in paragraph (c)(1) of this section will be increased for 
inflation occurring after 2000 in accordance with section 1(f)(3). If 
any amount adjusted under this paragraph (c)(3) is not a multiple of 
$1,000, the amount will be rounded to the next lowest multiple of 
$1,000.
    (d) Election. No education tax credit is allowed unless a taxpayer 
elects to claim the credit on the taxpayer's federal income tax return 
for the taxable year in which the credit is claimed. The election is 
made by attaching Form 8863, ``Education Credits (Hope and Lifetime 
Learning Credits),'' to the federal income tax return.
    (e) Identification requirement. No education tax credit is allowed 
unless a taxpayer includes on the federal income tax return claiming the 
credit the name and the taxpayer identification number of the student 
for whom the credit is claimed. For rules relating to assessment for an 
omission of a correct taxpayer identification number, see section 
6213(b) and (g)(2)(J).
    (f) Claiming the credit in the case of a dependent--(1) In general. 
If a student is a claimed dependent of another taxpayer, only that 
taxpayer may claim the education tax credit for the student's qualified 
tuition and related expenses. However, if another taxpayer is eligible 
to, but does not, claim the student as a dependent, only the student may 
claim the education tax credit for the student's qualified tuition and 
related expenses.
    (2) Examples. The following examples illustrate the rules of this 
paragraph (f):

    Example 1. In 1999, Taxpayer A pays qualified tuition and related 
expenses for his dependent, B, to attend University Y during 1999. 
Taxpayer A claims B as a dependent on his federal income tax return. 
Therefore, assuming all other relevant requirements are met, Taxpayer A 
is allowed an education tax credit on his federal income tax return, and 
B is not allowed an education tax credit on B's federal income tax 
return. The result would be the same if B paid the qualified tuition and 
related expenses. See Sec.  1.25A-5(a).
    Example 2. In 1999, Taxpayer C has one dependent, D. In 1999, D pays 
qualified tuition and related expenses to attend University Z during 
1999. Although Taxpayer C is eligible to claim D as a dependent on her 
federal income tax return, she does not do so. Therefore, assuming all 
other relevant requirements are met, D is allowed an education tax 
credit on D's federal income tax return, and Taxpayer C is not allowed 
an education tax credit on her federal income tax return, with respect 
to D's education expenses. The result would be the same if C paid the 
qualified tuition and related expenses on behalf of D. See Sec.  1.25A-
5(b).


[[Page 70]]


    (g) Married taxpayers. If a taxpayer is married (within the meaning 
of section 7703), no education tax credit is allowed to the taxpayer 
unless the taxpayer and the taxpayer's spouse file a joint Federal 
income tax return for the taxable year.
    (h) Nonresident alien taxpayers and dependents. If a taxpayer or the 
taxpayer's spouse is a nonresident alien for any portion of the taxable 
year, no education tax credit is allowed unless the nonresident alien is 
treated as a resident alien by reason of an election under section 
6013(g) or (h). In addition, if a student is a nonresident alien, a 
taxpayer may not claim an education tax credit with respect to the 
qualified tuition and related expenses of the student unless the student 
is a claimed dependent (as defined in Sec.  1.25A-2(a)).

[T.D. 9034, 67 FR 78691, Dec. 26, 2002]



Sec.  1.25A-2  Definitions.

    (a) Claimed dependent. A claimed dependent means a dependent (as 
defined in section 152) for whom a deduction under section 151 is 
allowed on a taxpayer's federal income tax return for the taxable year. 
Among other requirements under section 152, a nonresident alien student 
must be a resident of a country contiguous to the United States in order 
to be treated as a dependent.
    (b) Eligible educational institution--(1) In general. In general, an 
eligible educational institution means a college, university, vocational 
school, or other postsecondary educational institution that is--
    (i) Described in section 481 of the Higher Education Act of 1965 (20 
U.S.C. 1088) as in effect on August 5, 1997, (generally all accredited 
public, nonprofit, and proprietary postsecondary institutions); and
    (ii) Participating in a Federal financial aid program under title IV 
of the Higher Education Act of 1965 or is certified by the Department of 
Education as eligible to participate in such a program but chooses not 
to participate.
    (2) Rules on Federal financial aid programs. For rules governing an 
educational institution's eligibility to participate in Federal 
financial aid programs, see 20 U.S.C. 1070; 20 U.S.C. 1094; and 34 CFR 
600 and 668.
    (c) Academic period. Academic period means a quarter, semester, 
trimester, or other period of study as reasonably determined by an 
eligible educational institution. In the case of an eligible educational 
institution that uses credit hours or clock hours, and does not have 
academic terms, each payment period (as defined in 34 CFR 668.4, revised 
as of July 1, 2002) may be treated as an academic period.
    (d) Qualified tuition and related expenses--(1) In general. 
Qualified tuition and related expenses means tuition and fees required 
for the enrollment or attendance of a student for courses of instruction 
at an eligible educational institution.
    (2) Required fees--(i) In general. Except as provided in paragraph 
(d)(3) of this section, the test for determining whether any fee is a 
qualified tuition and related expense is whether the fee is required to 
be paid to the eligible educational institution as a condition of the 
student's enrollment or attendance at the institution.
    (ii) Books, supplies, and equipment. Qualified tuition and related 
expenses include fees for books, supplies, and equipment used in a 
course of study only if the fees must be paid to the eligible 
educational institution for the enrollment or attendance of the student 
at the institution.
    (iii) Nonacademic fees. Except as provided in paragraph (d)(3) of 
this section, qualified tuition and related expenses include fees 
charged by an eligible educational institution that are not used 
directly for, or allocated to, an academic course of instruction only if 
the fee must be paid to the eligible educational institution for the 
enrollment or attendance of the student at the institution.
    (3) Personal expenses. Qualified tuition and related expenses do not 
include the costs of room and board, insurance, medical expenses 
(including student health fees), transportation, and similar personal, 
living, or family expenses, regardless of whether the fee must be paid 
to the eligible educational institution for the enrollment or attendance 
of the student at the institution.
    (4) Treatment of a comprehensive or bundled fee. If a student is 
required to

[[Page 71]]

pay a fee (such as a comprehensive fee or a bundled fee) to an eligible 
educational institution that combines charges for qualified tuition and 
related expenses with charges for personal expenses described in 
paragraph (d)(3) of this section, the portion of the fee that is 
allocable to personal expenses is not included in qualified tuition and 
related expenses. The determination of what portion of the fee relates 
to qualified tuition and related expenses and what portion relates to 
personal expenses must be made by the institution using a reasonable 
method of allocation.
    (5) Hobby courses. Qualified tuition and related expenses do not 
include expenses that relate to any course of instruction or other 
education that involves sports, games, or hobbies, or any noncredit 
course, unless the course or other education is part of the student's 
degree program, or in the case of the Lifetime Learning Credit, the 
student takes the course to acquire or improve job skills.
    (6) Examples. The following examples illustrate the rules of this 
paragraph (d). In each example, assume that the institution is an 
eligible educational institution and that all other relevant 
requirements to claim an education tax credit are met. The examples are 
as follows:

    Example 1. University V offers a degree program in dentistry. In 
addition to tuition, all students enrolled in the program are required 
to pay a fee to University V for the rental of dental equipment. Because 
the equipment rental fee must be paid to University V for enrollment and 
attendance, the tuition and the equipment rental fee are qualified 
tuition and related expenses.
    Example 2. First-year students at College W are required to obtain 
books and other reading materials used in its mandatory first-year 
curriculum. The books and other reading materials are not required to be 
purchased from College W and may be borrowed from other students or 
purchased from off-campus bookstores, as well as from College W's 
bookstore. College W bills students for any books and materials 
purchased from College W's bookstore. The fee that College W charges for 
the first-year books and materials purchased at its bookstore is not a 
qualified tuition and related expense because the books and materials 
are not required to be purchased from College W for enrollment or 
attendance at the institution.
    Example 3. All students who attend College X are required to pay a 
separate student activity fee in addition to their tuition. The student 
activity fee is used solely to fund on-campus organizations and 
activities run by students, such as the student newspaper and the 
student government (no portion of the fee covers personal expenses). 
Although labeled as a student activity fee, the fee is required for 
enrollment or attendance at College X. Therefore, the fee is a qualified 
tuition and related expense.
    Example 4. The facts are the same as in Example 3, except that 
College X offers an optional athletic fee that students may pay to 
receive discounted tickets to sports events. The athletic fee is not 
required for enrollment or attendance at College X. Therefore, the fee 
is not a qualified tuition and related expense.
    Example 5. College Y requires all students to live on campus. It 
charges a single comprehensive fee to cover tuition, required fees, and 
room and board. Based on College Y's reasonable allocation, sixty 
percent of the comprehensive fee is allocable to tuition and other 
required fees not allocable to personal expenses, and the remaining 
forty percent of the comprehensive fee is allocable to charges for room 
and board and other personal expenses. Therefore, only sixty percent of 
College Y's comprehensive fee is a qualified tuition and related 
expense.
    Example 6. As a degree student at College Z, Student A is required 
to take a certain number of courses outside of her chosen major in 
Economics. To fulfill this requirement, Student A enrolls in a square 
dancing class offered by the Physical Education Department. Because 
Student A receives credit toward her degree program for the square 
dancing class, the tuition for the square dancing class is included in 
qualified tuition and related expenses.

[T.D. 9034, 67 FR 78691, Dec. 26, 2002]



Sec.  1.25A-3  Hope Scholarship Credit.

    (a) Amount of the credit--(1) In general. Subject to the phaseout of 
the education tax credit described in Sec.  1.25A-1(c), the Hope 
Scholarship Credit amount is the total of--
    (i) 100 percent of the first $1,000 of qualified tuition and related 
expenses paid during the taxable year for education furnished to an 
eligible student (as defined in paragraph (d) of this section) who is 
the taxpayer, the taxpayer's spouse, or any claimed dependent during any 
academic period beginning in the taxable year (or treated as beginning 
in the taxable year, see Sec.  1.25A-5(e)(2)); plus

[[Page 72]]

    (ii) 50 percent of the next $1,000 of such expenses paid with 
respect to that student.
    (2) Maximum credit. For taxable years beginning before 2002, the 
maximum Hope Scholarship Credit allowed for each eligible student is 
$1,500. For taxable years beginning after 2001, the amounts used in 
paragraph (a)(1) of this section to determine the maximum credit will be 
increased for inflation occurring after 2000 in accordance with section 
1(f)(3). If any amount adjusted under this paragraph (a)(2) is not a 
multiple of $100, the amount will be rounded to the next lowest multiple 
of $100.
    (b) Per student credit--(1) In general. A Hope Scholarship Credit 
may be claimed for the qualified tuition and related expenses of each 
eligible student (as defined in paragraph (d) of this section).
    (2) Example. The following example illustrates the rule of this 
paragraph (b). In the example, assume that all the requirements to claim 
an education tax credit are met. The example is as follows:

    Example. In 1999, Taxpayer A has two dependents, B and C, both of 
whom are eligible students. Taxpayer A pays $1,600 in qualified tuition 
and related expenses for dependent B to attend a community college. 
Taxpayer A pays $5,000 in qualified tuition and related expenses for 
dependent C to attend University X. Taxpayer A may claim a Hope 
Scholarship Credit of $1,300 ($1,000 + (.50 x $600)) for dependent B, 
and the maximum $1,500 Hope Scholarship Credit for dependent C, for a 
total Hope Scholarship Credit of $2,800.

    (c) Credit allowed for only two taxable years. For each eligible 
student, the Hope Scholarship Credit may be claimed for no more than two 
taxable years.
    (d) Eligible student--(1) Eligible student defined. For purposes of 
the Hope Scholarship Credit, the term eligible student means a student 
who satisfies all of the following requirements--
    (i) Degree requirement. For at least one academic period that begins 
during the taxable year, the student enrolls at an eligible educational 
institution in a program leading toward a postsecondary degree, 
certificate, or other recognized postsecondary educational credential;
    (ii) Work load requirement. For at least one academic period that 
begins during the taxable year, the student enrolls for at least one-
half of the normal full-time work load for the course of study the 
student is pursuing. The standard for what is half of the normal full-
time work load is determined by each eligible educational institution. 
However, the standard for half-time may not be lower than the applicable 
standard for half-time established by the Department of Education under 
the Higher Education Act of 1965 and set forth in 34 CFR 674.2(b) 
(revised as of July 1, 2002) for a half-time undergraduate student;
    (iii) Year of study requirement. As of the beginning of the taxable 
year, the student has not completed the first two years of postsecondary 
education at an eligible educational institution. Whether a student has 
completed the first two years of postsecondary education at an eligible 
educational institution as of the beginning of a taxable year is 
determined based on whether the institution in which the student is 
enrolled in a degree program (as described in paragraph (d)(1)(i) of 
this section) awards the student two years of academic credit at that 
institution for postsecondary course work completed by the student prior 
to the beginning of the taxable year. Any academic credit awarded by the 
eligible educational institution solely on the basis of the student's 
performance on proficiency examinations is disregarded in determining 
whether the student has completed two years of postsecondary education; 
and
    (iv) No felony drug conviction. The student has not been convicted 
of a Federal or State felony offense for possession or distribution of a 
controlled substance as of the end of the taxable year for which the 
credit is claimed.
    (2) Examples. The following examples illustrate the rules of this 
paragraph (d). In each example, assume that the student has not been 
convicted of a felony drug offense, that the institution is an eligible 
educational institution unless otherwise stated, that the qualified 
tuition and related expenses are paid during the same taxable year that 
the academic period begins, and that a

[[Page 73]]

Hope Scholarship Credit has not previously been claimed for the student 
(see paragraph (c) of this section). The examples are as follows:

    Example 1. Student A graduates from high school in June 1998 and is 
enrolled in an undergraduate degree program at College U for the 1998 
Fall semester on a full-time basis. For the 1999 Spring semester, 
Student A again is enrolled at College U on a full-time basis. For the 
1999 Fall semester, Student A is enrolled in less than half the normal 
full-time course work for her degree program. Because Student A is 
enrolled in an undergraduate degree program on at least a half-time 
basis for at least one academic period that begins during 1998 and at 
least one academic period that begins during 1999, Student A is an 
eligible student for taxable years 1998 and 1999 (including the 1999 
Fall semester when Student A enrolls at College U on less than a half-
time basis).
    Example 2. Prior to 1998, Student B attended college for several 
years on a full-time basis. Student B transfers to College V for the 
1998 Spring semester. College V awards Student B credit for some (but 
not all) of the courses he previously completed, and College V 
classifies Student B as a first-semester sophomore. During both the 
Spring and Fall semesters of 1998, Student B is enrolled in at least 
one-half the normal full-time work load for his degree program at 
College V. Because College V does not classify Student B as having 
completed the first two years of postsecondary education as of the 
beginning of 1998, Student B is an eligible student for taxable year 
1998.
    Example 3. The facts are the same as in Example 2. After taking 
classes on a half-time basis for the 1998 Spring and Fall semesters, 
Student B is enrolled at College V for the 1999 Spring semester on a 
full-time basis. College V classifies Student B as a second-semester 
sophomore for the 1999 Spring semester and as a first-semester junior 
for the 1999 Fall semester. Because College V does not classify Student 
B as having completed the first two years of postsecondary education as 
of the beginning of 1999, Student B is an eligible student for taxable 
year 1999. Therefore, the qualified expenses and required fees paid for 
the 1999 Spring semester and the 1999 Fall semester are taken into 
account in calculating any Hope Scholarship Credit.
    Example 4. Prior to 1998, Student C was not enrolled at another 
eligible educational institution. At the time that Student C enrolls in 
a degree program at College W for the 1998 Fall semester, Student C 
takes examinations to demonstrate her proficiency in several subjects. 
On the basis of Student C's performance on these examinations, College W 
classifies Student C as a second-semester sophomore as of the beginning 
of the 1998 Fall semester. Student C is enrolled at College W during the 
1998 Fall semester and during the 1999 Spring and Fall semesters on a 
full-time basis and is classified as a first-semester junior as of the 
beginning of the 1999 Spring semester. Because Student C was not 
enrolled in a college or other eligible educational institution prior to 
1998 (but rather was awarded three semesters of academic credit solely 
because of proficiency examinations), Student C is not treated as having 
completed the first two years of postsecondary education at an eligible 
educational institution as of the beginning of 1998 or as of the 
beginning of 1999. Therefore, Student C is an eligible student for both 
taxable years 1998 and 1999.
    Example 5. During the 1998 Fall semester, Student D is a high school 
student who takes classes on a half-time basis at College X. Student D 
is not enrolled as part of a degree program at College X because College 
X does not admit students to a degree program unless the student has a 
high school diploma or equivalent. Because Student D is not enrolled in 
a degree program at College X during 1998, Student D is not an eligible 
student for taxable year 1998.
    Example 6. The facts are the same as in Example 5. In addition, 
during the 1999 Spring semester, Student D again attends College X but 
not as part of a degree program. Student D graduates from high school in 
June 1999. For the 1999 Fall semester, Student D enrolls in College X as 
part of a degree program, and College X awards Student D credit for her 
prior course work at College X. During the 1999 Fall semester, Student D 
is enrolled in more than one-half the normal full-time work load of 
courses for her degree program at College X. Because Student D is 
enrolled in a degree program at College X for the 1999 Fall term on at 
least a half-time basis, Student D is an eligible student for all of 
taxable year 1999. Therefore, the qualified tuition and required fees 
paid for classes taken at College X during both the 1999 Spring semester 
(during which Student D was not enrolled in a degree program) and the 
1999 Fall semester are taken into account in computing any Hope 
Scholarship Credit.
    Example 7. Student E completed two years of undergraduate study at 
College S. College S is not an eligible educational institution for 
purposes of the education tax credit. At the end of 1998, Student E 
enrolls in an undergraduate degree program at College Z, an eligible 
educational institution, for the 1999 Spring semester on a full-time 
basis. College Z awards Student E two years of academic credit for his 
previous course work at College S and classifies Student E as a first-
semester junior for the 1999 Spring semester. Student E is treated as 
having completed the first two years of postsecondary education at an 
eligible educational institution as of the beginning of 1999. Therefore, 
Student E is not an eligible student for taxable year 1999.

[[Page 74]]

    Example 8. Student F received a degree in 1998 from College R. 
College R is not an eligible educational institution for purposes of the 
education tax credit. During 1999, Student F is enrolled in a graduate-
degree program at College Y, an eligible educational institution, for 
the 1999 Fall semester on a full-time basis. By admitting Student F to 
its graduate degree program, College Y treats Student F as having 
completed the first two years of postsecondary education as of the 
beginning of 1999. Therefore, Student F is not an eligible student for 
taxable year 1999.
    Example 9. Student G graduates from high school in June 2001. In 
January 2002, Student G is enrolled in a one-year postsecondary 
certificate program on a full-time basis to obtain a certificate as a 
travel agent. Student G completes the program in December 2002 and is 
awarded a certificate. In January 2003, Student G enrolls in a one-year 
postsecondary certificate program on a full-time basis to obtain a 
certificate as a computer programer. Student G meets the degree 
requirement, the work load requirement, and the year of study 
requirement for the taxable years 2002 and 2003. Therefore, Student G is 
an eligible student for both taxable years 2002 and 2003.

    (e) Academic period for prepayments--(1) In general. For purposes of 
determining whether a student meets the requirements in paragraph (d) of 
this section for a taxable year, if qualified tuition and related 
expenses are paid during one taxable year for an academic period that 
begins during January, February or March of the next taxable year (for 
taxpayers on a fiscal taxable year, use the first three months of the 
next taxable year), the academic period is treated as beginning during 
the taxable year in which the payment is made.
    (2) Example. The following example illustrates the rule of this 
paragraph (e). In the example, assume that all the requirements to claim 
a Hope Scholarship Credit are met. The example is as follows:

    Example. Student G graduates from high school in June 1998. After 
graduation, Student G works full-time for several months to earn money 
for college. Student G is enrolled on a full-time basis in an 
undergraduate degree program at University W, an eligible educational 
institution, for the 1999 Spring semester, which begins in January 1999. 
Student G pays tuition to University W for the 1999 Spring semester in 
December 1998. Because the tuition paid by Student G in 1998 relates to 
an academic period that begins during the first three months of 1999, 
Student G's eligibility to claim a Hope Scholarship Credit in 1998 is 
determined as if the 1999 Spring semester began in 1998. Thus, assuming 
Student G has not been convicted of a felony drug offense as of December 
31, 1998, Student G is an eligible student for 1998.

    (f) Effective date. The Hope Scholarship Credit is applicable for 
qualified tuition and related expenses paid after December 31, 1997, for 
education furnished in academic periods beginning after December 31, 
1997.

[T.D. 9034, 67 FR 78691, Dec. 26, 2002; 68 FR 15940, Apr. 2, 2003]



Sec.  1.25A-4  Lifetime Learning Credit.

    (a) Amount of the credit--(1) Taxable years beginning before January 
1, 2003. Subject to the phaseout of the education tax credit described 
in Sec.  1.25A-1(c), for taxable years beginning before 2003, the 
Lifetime Learning Credit amount is 20 percent of up to $5,000 of 
qualified tuition and related expenses paid during the taxable year for 
education furnished to the taxpayer, the taxpayer's spouse, and any 
claimed dependent during any academic period beginning in the taxable 
year (or treated as beginning in the taxable year, see Sec.  1.25A-
5(e)(2)).
    (2) Taxable years beginning after December 31, 2002. Subject to the 
phaseout of the education tax credit described in Sec.  1.25A-1(c), for 
taxable years beginning after 2002, the Lifetime Learning Credit amount 
is 20 percent of up to $10,000 of qualified tuition and related expenses 
paid during the taxable year for education furnished to the taxpayer, 
the taxpayer's spouse, and any claimed dependent during any academic 
period beginning in the taxable year (or treated as beginning in the 
taxable year, see Sec.  1.25A-5(e)(2)).
    (3) Coordination with the Hope Scholarship Credit. Expenses paid 
with respect to a student for whom the Hope Scholarship Credit is 
claimed are not eligible for the Lifetime Learning Credit.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (a). In each example, assume that all the requirements to 
claim a Lifetime Learning Credit or a Hope Scholarship Credit, as 
applicable, are met. The examples are as follows:


[[Page 75]]


    Example 1. In 1999, Taxpayer A pays qualified tuition and related 
expenses of $3,000 for dependent B to attend an eligible educational 
institution, and Taxpayer A pays qualified tuition and related expenses 
of $4,000 for dependent C to attend an eligible educational institution. 
Taxpayer A does not claim a Hope Scholarship Credit with respect to 
either B or C. Although Taxpayer A paid $7,000 of qualified tuition and 
related expenses during the taxable year, Taxpayer A may claim the 
Lifetime Learning Credit with respect to only $5,000 of such expenses. 
Therefore, the maximum Lifetime Learning Credit Taxpayer A may claim for 
1999 is $1,000 (.20 x $5,000).
    Example 2. In 1999, Taxpayer D pays $6,000 of qualified tuition and 
related expenses for dependent E, and $2,000 of qualified tuition and 
related expenses for dependent F, to attend eligible educational 
institutions. Dependent F has already completed the first two years of 
postsecondary education. For 1999, Taxpayer D claims the maximum $1,500 
Hope Scholarship Credit with respect to dependent E. In computing the 
amount of the Lifetime Learning Credit, Taxpayer D may not include any 
of the $6,000 of qualified tuition and related expenses paid on behalf 
of dependent E but may include the $2,000 of qualified tuition and 
related expenses of dependent F.

    (b) Credit allowed for unlimited number of taxable years. There is 
no limit to the number of taxable years that a taxpayer may claim a 
Lifetime Learning Credit with respect to any student.
    (c) Both degree and nondegree courses are eligible for the credit--
(1) In general. For purposes of the Lifetime Learning Credit, amounts 
paid for a course at an eligible educational institution are qualified 
tuition and related expenses if the course is either part of a 
postsecondary degree program or is not part of a postsecondary degree 
program but is taken by the student to acquire or improve job skills.
    (2) Examples. The following examples illustrate the rule of this 
paragraph (c). In each example, assume that all the requirements to 
claim a Lifetime Learning Credit are met. The examples are as follows:

    Example 1. Taxpayer A, a professional photographer, enrolls in an 
advanced photography course at a local community college. Although the 
course is not part of a degree program, Taxpayer A enrolls in the course 
to improve her job skills. The course fee paid by Taxpayer A is a 
qualified tuition and related expense for purposes of the Lifetime 
Learning Credit.
    Example 2. Taxpayer B, a stockbroker, plans to travel abroad on a 
``photo-safari'' for his next vacation. In preparation for the trip, 
Taxpayer B enrolls in a noncredit photography class at a local community 
college. Because Taxpayer B is not taking the photography course as part 
of a degree program or to acquire or improve his job skills, amounts 
paid by Taxpayer B for the course are not qualified tuition and related 
expenses for purposes of the Lifetime Learning Credit.

    (d) Effective date. The Lifetime Learning Credit is applicable for 
qualified tuition and related expenses paid after June 30, 1998, for 
education furnished in academic periods beginning after June 30, 1998.

[T.D. 9034, 67 FR 78691, Dec. 26, 2002]



Sec.  1.25A-5  Special rules relating to characterization and timing
of payments.

    (a) Educational expenses paid by claimed dependent. For any taxable 
year for which the student is a claimed dependent of another taxpayer, 
qualified tuition and related expenses paid by the student are treated 
as paid by the taxpayer to whom the deduction under section 151 is 
allowed.
    (b) Educational expenses paid by a third party--(1) In general. 
Solely for purposes of section 25A, if a third party (someone other than 
the taxpayer, the taxpayer's spouse if the taxpayer is treated as 
married within the meaning of section 7703, or a claimed dependent) 
makes a payment directly to an eligible educational institution to pay 
for a student's qualified tuition and related expenses, the student is 
treated as receiving the payment from the third party and, in turn, 
paying the qualified tuition and related expenses to the institution.
    (2) Special rule for tuition reduction included in gross income of 
employee. Solely for purposes of section 25A, if an eligible educational 
institution provides a reduction in tuition to an employee of the 
institution (or to the spouse or dependent child of an employee, as 
described in section 132(h)(2)) and the amount of the tuition reduction 
is included in the employee's gross income, the employee is treated as 
receiving payment of an amount equal to the tuition reduction and, in 
turn, paying such amount to the institution.

[[Page 76]]

    (3) Examples. The following examples illustrate the rules of this 
paragraph (b). In each example, assume that all the requirements to 
claim an education tax credit are met. The examples are as follows:

    Example 1. Grandparent D makes a direct payment to an eligible 
educational institution for Student E's qualified tuition and related 
expenses. Student E is not a claimed dependent in 1999. For purposes of 
claiming an education tax credit, Student E is treated as receiving the 
money from her grandparent and, in turn, paying her qualified tuition 
and related expenses.
    Example 2. Under a court-approved divorce decree, Parent A is 
required to pay Student C's college tuition. Parent A makes a direct 
payment to an eligible educational institution for Student C's 1999 
tuition. Under paragraph (b)(1) of this section, Student C is treated as 
receiving the money from Parent A and, in turn, paying the qualified 
tuition and related expenses. Under the divorce decree, Parent B has 
custody of Student C for 1999. Parent B properly claims Student C as a 
dependent on Parent B's 1999 federal income tax return. Under paragraph 
(a) of this section, expenses paid by Student C are treated as paid by 
Parent B. Thus, Parent B may claim an education tax credit for the 
qualified tuition and related expenses paid directly to the institution 
by Parent A.
    Example 3. University A, an eligible educational institution, offers 
reduced tuition charges to its employees and their dependent children. F 
is an employee of University A. F's dependent child, G, enrolls in a 
graduate-level course at University A. Section 117(d) does not apply, 
because it is limited to tuition reductions provided for education below 
the graduate level. Therefore, the amount of the tuition reduction 
received by G is treated as additional compensation from University A to 
F and is included in F's gross income. For purposes of claiming a 
Lifetime Learning Credit, F is treated as receiving payment of an amount 
equal to the tuition reduction from University A and, in turn, paying 
such amount to University A on behalf of F's child, G.

    (c) Adjustment to qualified tuition and related expenses for certain 
excludable educational assistance--(1) In general. In determining the 
amount of an education tax credit, qualified tuition and related 
expenses for any academic period must be reduced by the amount of any 
tax-free educational assistance allocable to such period. For this 
purpose, tax-free educational assistance means--
    (i) A qualified scholarship that is excludable from income under 
section 117;
    (ii) A veterans' or member of the armed forces' educational 
assistance allowance under chapter 30, 31, 32, 34 or 35 of title 38, 
United States Code, or under chapter 1606 of title 10, United States 
Code;
    (iii) Employer-provided educational assistance that is excludable 
from income under section 127; or
    (iv) Any other educational assistance that is excludable from gross 
income (other than as a gift, bequest, devise, or inheritance within the 
meaning of section 102(a)).
    (2) No adjustment for excludable educational assistance attributable 
to expenses paid in a prior year. A reduction is not required under 
paragraph (c)(1) of this section if the amount of excludable educational 
assistance received during the taxable year is treated as a refund of 
qualified tuition and related expenses paid in a prior taxable year. See 
paragraph (f)(5) of this section.
    (3) Scholarships and fellowship grants. For purposes of paragraph 
(c)(1)(i) of this section, a scholarship or fellowship grant is treated 
as a qualified scholarship excludable under section 117 except to the 
extent--
    (i) The scholarship or fellowship grant (or any portion thereof) may 
be applied, by its terms, to expenses other than qualified tuition and 
related expenses within the meaning of section 117(b)(2) (such as room 
and board) and the student reports the grant (or the appropriate portion 
thereof) as income on the student's federal income tax return if the 
student is required to file a return; or
    (ii) The scholarship or fellowship grant (or any portion thereof) 
must be applied, by its terms, to expenses other than qualified tuition 
and related expenses within the meaning of section 117(b)(2) (such as 
room and board) and the student reports the grant (or the appropriate 
portion thereof) as income on the student's federal income tax return if 
the student is required to file a return.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (c). In each example, assume that all the requirements to 
claim an education

[[Page 77]]

tax credit are met. The examples are as follows:

    Example 1. University X charges Student A, who lives on University 
X's campus, $3,000 for tuition and $5,000 for room and board. University 
X awards Student A a $2,000 scholarship. The terms of the scholarship 
permit it to be used to pay any of a student's costs of attendance at 
University X, including tuition, room and board, and other incidental 
expenses. University X applies the $2,000 scholarship against Student 
A's $8,000 total bill, and Student A pays the $6,000 balance of her bill 
from University X with a combination of savings and amounts she earns 
from a summer job. University X does not require A to pay any additional 
fees beyond the $3,000 in tuition in order to enroll in or attend 
classes. Student A does not report any portion of the scholarship as 
income on her federal income tax return. Since Student A does not report 
the scholarship as income, the scholarship is treated under paragraph 
(c)(3) of this section as a qualified scholarship that is excludable 
under section 117. Therefore, for purposes of calculating an education 
tax credit, Student A is treated as having paid only $1,000 ($3,000 
tuition-$2,000 scholarship) in qualified tuition and related expenses to 
University X.
    Example 2. The facts are the same as in Example 1, except that 
Student A reports the entire scholarship as income on the student's 
federal income tax return. Since the full amount of the scholarship may 
be applied to expenses other than qualified expenses (room and board) 
and Student A reports the scholarship as income, the exception in 
paragraph (c)(3) of this section applies and the scholarship is not 
treated as a qualified scholarship excludable under section 117. 
Therefore, for purposes of calculating an education tax credit, Student 
A is treated as having paid $3,000 of qualified tuition and related 
expenses to University X.
    Example 3. The facts are the same as in Example 1, except that the 
terms of the scholarship require it to be used to pay tuition. Under 
paragraph (c)(3) of this section, the scholarship is treated as a 
qualified scholarship excludable under section 117. Therefore, for 
purposes of calculating an education tax credit, Student A is treated as 
having paid only $1,000 ($3,000 tuition-$2,000 scholarship) in qualified 
tuition and related expenses to University X.
    Example 4. The facts are the same as in Example 1, except that the 
terms of the scholarship require it to be used to pay tuition or room 
and board charged by University X, and the scholarship amount is $6,000. 
Under the terms of the scholarship, Student A may allocate the 
scholarship between tuition and room and board in any manner. However, 
because room and board totals $5,000, that is the maximum amount that 
can be applied under the terms of the scholarship to expenses other than 
qualified expenses and at least $1,000 of the scholarship must be 
applied to tuition. Therefore, the maximum amount of the exception under 
paragraph (c)(3) of this section is $5,000 and at least $1,000 is 
treated as a qualified scholarship excludable under section 117 ($6,000 
scholarship-$5,000 room and board). If Student A reports $5,000 of the 
scholarship as income on the student's federal income tax return, then 
Student A will be treated as having paid $2,000 ($3,000 tuition-$1,000 
qualified scholarship excludable under section 117) in qualified tuition 
and related expenses to University X.
    Example 5. The facts are the same as in Example 1, except that in 
addition to the scholarship that University X awards to Student A, 
University X also provides Student A with an education loan and pays 
Student A for working in a work/study job in the campus dining hall. The 
loan is not excludable educational assistance within the meaning of 
paragraph (c) of this section. In addition, wages paid to a student who 
is performing services for the payor are neither a qualified scholarship 
nor otherwise excludable from gross income. Therefore, Student A is not 
required to reduce her qualified tuition and related expenses by the 
amounts she receives from the student loan or as wages from her work/
study job.
    Example 6. In 1999, Student B pays University Y $1,000 in tuition 
for the 1999 Spring semester. University Y does not require Student B to 
pay any additional fees beyond the $1,000 in tuition in order to enroll 
in classes. Student B is an employee of Company Z. At the end of the 
academic period and during the same taxable year that Student B paid 
tuition to University Y, Student B provides Company Z with proof that he 
has satisfactorily completed his courses at University Y. Pursuant to an 
educational assistance program described in section 127(b), Company Z 
reimburses Student B for all of the tuition paid to University Y. 
Because the reimbursement from Company Z is employer-provided 
educational assistance that is excludable from Student B's gross income 
under section 127, the reimbursement reduces Student B's qualified 
tuition and related expenses. Therefore, for purposes of calculating an 
education tax credit, Student B is treated as having paid no qualified 
tuition and related expenses to University Y during 1999.

    Example 7. The facts are the same as in Example 6 except that the 
reimbursement from Company Z is not pursuant to an educational 
assistance program described in section 127(b), is not otherwise 
excludable from Student B's gross income, and is taxed as additional 
compensation to Student B. Because the reimbursement is not excludable 
educational assistance within the meaning of

[[Page 78]]

paragraph (c)(1) of this section, Student B is not required to reduce 
his qualified tuition and related expenses by the $1,000 reimbursement 
he received from his employer. Therefore, for purposes of calculating an 
education tax credit, Student B is treated as paying $1,000 in qualified 
tuition and related expenses to University Y during 1999.

    (d) No double benefit. Qualified tuition and related expenses do not 
include any expense for which a deduction is allowed under section 162, 
section 222, or any other provision of chapter 1 of the Internal Revenue 
Code.
    (e) Timing rules--(1) In general. Except as provided in paragraph 
(e)(2) of this section, an education tax credit is allowed only for 
payments of qualified tuition and related expenses for an academic 
period beginning in the same taxable year as the year the payment is 
made. Except for certain individuals who do not use the cash receipts 
and disbursements method of accounting, qualified tuition and related 
expenses are treated as paid in the year in which the expenses are 
actually paid. See Sec.  1.461-1(a)(1).
    (2) Prepayment rule--(i) In general. If qualified tuition and 
related expenses are paid during one taxable year for an academic period 
that begins during the first three months of the taxpayer's next taxable 
year (i.e., in January, February, or March of the next taxable year for 
calendar year taxpayers), an education tax credit is allowed with 
respect to the qualified tuition and related expenses only in the 
taxable year in which the expenses are paid.
    (ii) Example. The following example illustrates the rule of this 
paragraph (e)(2). In the example, assume that all the requirements to 
claim an education tax credit are met. The example is as follows:

    Example. In December 1998, Taxpayer A, a calendar year taxpayer, 
pays College Z $1,000 in qualified tuition and related expenses to 
attend classes during the 1999 Spring semester, which begins in January 
1999. Taxpayer A may claim an education tax credit only in 1998 for 
payments made in 1998 for the 1999 Spring semester.

    (3) Expenses paid with loan proceeds. An education tax credit may be 
claimed for qualified tuition and related expenses paid with the 
proceeds of a loan only in the taxable year in which the expenses are 
paid, and may not be claimed in the taxable year in which the loan is 
repaid. Loan proceeds disbursed directly to an eligible educational 
institution will be treated as paid on the date the institution credits 
the proceeds to the student's account. For example, in the case of any 
loan issued or guaranteed as part of a Federal student loan program 
under title IV of the Higher Education Act of 1965, loan proceeds will 
be treated as paid on the date of disbursement (as defined in 34 CFR 
668.164(a), revised as of July 1, 2002) by the eligible educational 
institution. If a taxpayer does not know the date the institution 
credits the student's account, the taxpayer must treat the qualified 
tuition and related expenses as paid on the last date for payment 
prescribed by the institution.
    (4) Expenses paid through third party installment payment plans--(i) 
In general. A taxpayer, an eligible educational institution, and a third 
party installment payment company may enter into an agreement in which 
the company agrees to collect installment payments of qualified tuition 
and related expenses from the taxpayer and to remit the installment 
payments to the institution. If the third party installment payment 
company is the taxpayer's agent for purposes of paying qualified tuition 
and related expenses to the eligible educational institution, the 
taxpayer is treated as paying the qualified expenses on the date the 
company pays the institution. However, if the third party installment 
payment company is the eligible educational institution's agent for 
purposes of collecting payments of qualified tuition and related 
expenses from the taxpayer, the taxpayer is treated as paying the 
qualified expenses on the date the taxpayer pays the company.
    (ii) Example. The following example illustrates the rule of this 
paragraph (e)(4). The example is as follows:

    Example. Student A, Company B, and College C enter into a written 
agreement in which Student A agrees to pay the tuition required to 
attend College C in 10 equal monthly installments to Company B. Under 
the written agreement, Student A is not relieved of her obligation to 
pay College C until Company B remits the payments to College C. Under 
the written agreement, Company B agrees to disburse the monthly 
installment payments to College C within 30

[[Page 79]]

days of receipt. Because Company B acts as Student A's agent for 
purposes of paying qualified expenses to College C, Student A is treated 
as paying qualified expenses on the date Company B disburses payments to 
College C.

    (f) Refund of qualified tuition and related expenses--(1) Payment 
and refund of qualified tuition and related expenses in the same taxable 
year. With respect to any student, the amount of qualified tuition and 
related expenses for a taxable year is calculated by adding all 
qualified tuition and related expenses paid for the taxable year, and 
subtracting any refund of such expenses received from the eligible 
educational institution during the same taxable year (including refunds 
of loan proceeds described in paragraph (f)(4) of this section).
    (2) Payment of qualified tuition and related expenses in one taxable 
year and refund in subsequent taxable year before return filed for prior 
taxable year. If, in a taxable year, a taxpayer or someone other than 
the taxpayer receives a refund (including refunds of loan proceeds 
described in paragraph (f)(4) of this section) of qualified tuition and 
related expenses paid on behalf of a student in a prior taxable year and 
the refund is received before the taxpayer files a federal income tax 
return for the prior taxable year, the amount of the qualified tuition 
and related expenses for the prior taxable year is reduced by the amount 
of the refund.
    (3) Payment of qualified tuition and related expenses in one taxable 
year and refund in subsequent taxable year--(i) In general. If, in a 
taxable year (refund year), a taxpayer or someone other than the 
taxpayer receives a refund (including refunds of loan proceeds described 
in paragraph (f)(4) of this section) of qualified tuition and related 
expenses paid on behalf of a student for which the taxpayer claimed an 
education tax credit in a prior taxable year, the tax imposed by chapter 
1 of the Internal Revenue Code for the refund year is increased by the 
recapture amount.
    (ii) Recapture amount. The recapture amount is the difference in tax 
liability for the prior taxable year (taking into account any 
redetermination of such tax liability by audit or amended return) that 
results when the tax liability for the prior year is calculated using 
the taxpayer's redetermined credit. The redetermined credit is computed 
by reducing the amount of the qualified tuition and related expenses 
taken into account in determining any credit claimed in the prior 
taxable year by the amount of the refund of the qualified tuition and 
related expenses (redetermined qualified expenses), and computing the 
allowable credit using the redetermined qualified expenses and the 
relevant facts and circumstances of the prior taxable year, such as 
modified adjusted gross income (redetermined credit).
    (4) Refund of loan proceeds treated as refund of qualified tuition 
and related expenses. If loan proceeds used to pay qualified tuition and 
related expenses (as described in paragraph (e)(3) of this section) 
during a taxable year are refunded by an eligible educational 
institution to a lender on behalf of the borrower, the refund is treated 
as a refund of qualified tuition and related expenses for purposes of 
paragraphs (f)(1), (2), and (3) of this section.
    (5) Excludable educational assistance received in a subsequent 
taxable year treated as a refund. If, in a taxable year, a taxpayer or 
someone other than the taxpayer receives any excludable educational 
assistance (described in paragraph (c)(1) of this section) for the 
qualified tuition and related expenses paid on behalf of a student 
during a prior taxable year (or attributable to enrollment at an 
eligible educational institution during a prior taxable year), the 
educational assistance is treated as a refund of qualified tuition and 
related expenses for purposes of paragraphs (f)(2) and (3) of this 
section. If the excludable educational assistance is received before the 
taxpayer files a federal income tax return for the prior taxable year, 
the amount of the qualified tuition and related expenses for the prior 
taxable year is reduced by the amount of the excludable educational 
assistance as provided in paragraph (f)(2) of this section. If the 
excludable educational assistance is received after the taxpayer has 
filed a federal income tax return for the prior taxable year, any 
education tax credit claimed for the prior taxable year is

[[Page 80]]

subject to recapture as provided in paragraph (f)(3) of this section.
    (6) Examples. The following examples illustrate the rules of this 
paragraph (f). In each example, assume that all the requirements to 
claim an education tax credit are met. The examples are as follows:

    Example 1. In January 1998, Student A, a full-time freshman at 
University X, pays $2,000 for qualified tuition and related expenses for 
a 16-hour work load for the 1998 Spring semester. Prior to beginning 
classes, Student A withdraws from 6 course hours. On February 15, 1998, 
Student A receives a $750 refund from University X. In September 1998, 
Student A pays University X $1,000 to enroll half-time for the 1998 Fall 
semester. Prior to beginning classes, Student A withdraws from a 2-hour 
course, and she receives a $250 refund in October 1998. Student A 
computes the amount of qualified tuition and related expenses she may 
claim for 1998 by:
    (i) Adding all qualified expenses paid during the taxable year 
($2,000 + 1,000 = $3,000);
    (ii) Adding all refunds of qualified tuition and related expenses 
received during the taxable year ($750 + $250 = $1,000); and, then
    (iii) Subtracting paragraph (ii) of this Example 1 from paragraph 
(i) of this Example 1 ($3,000 -$1,000 = $2,000). Therefore, Student A's 
qualified tuition and related expenses for 1998 are $2,000.
    Example 2. (i) In December 1998, Student B, a senior at College Y, 
pays $2,000 for qualified tuition and related expenses for a 16-hour 
work load for the 1999 Spring semester. Prior to beginning classes, 
Student B withdraws from a 4-hour course. On January 15, 1999, Student B 
files her 1998 income tax return and claims a $400 Lifetime Learning 
Credit for the $2,000 qualified expenses paid in 1998, which reduces her 
tax liability for 1998 by $400. On February 15, 1999, Student B receives 
a $500 refund from College Y.
    (ii) Student B calculates the increase in tax for 1999 by--
    (A) Calculating the redetermined qualified expenses for 1998 ($2,000 
- $500 = $1,500);
    (B) Calculating the redetermined credit for the redetermined 
qualified expenses ($1,500 x .20 = $300); and
    (C) Calculating the difference in tax liability for 1998 resulting 
from the redetermined credit. Because Student B's tax liability for 1998 
was reduced by the full amount of the $400 education tax credit claimed 
on her 1998 income tax return, the difference in tax liability can be 
determined by subtracting the redetermined credit from the credit 
claimed in 1998 ($400-$300 = $100).
    (iii) Therefore, Student B must increase the tax on her 1999 federal 
income tax return by $100.
    Example 3. In September 1998, Student C pays College Z $1,200 in 
qualified tuition and related expenses to attend evening classes during 
the 1998 Fall semester. Student C is an employee of Company R. On 
January 15, 1999, Student C files a federal income tax return for 1998 
claiming a Lifetime Learning Credit of $240 (.20 x $1,200), which 
reduces Student C's tax liability for 1998 by $240. Pursuant to an 
educational assistance program described in section 127(b), Company R 
reimburses Student C in February 1999 for the $1,200 of qualified 
tuition and related expenses paid by Student C in 1998. The $240 
education tax credit claimed by Student C for 1998 is subject to 
recapture. Because Student C paid no net qualified tuition and related 
expenses for 1998, the redetermined credit for 1998 is zero. Student C 
must increase the amount of Student C's 1999 tax by the recapture 
amount, which is $240 (the difference in tax liability for 1998 
resulting from the redetermined credit for 1998 ($0)). Because the 
$1,200 reimbursement relates to expenses for which the taxpayer claimed 
an education tax credit in a prior year, the reimbursement does not 
reduce the amount of any qualified tuition and related expenses that 
Student C paid in 1999.

[T.D. 9034, 67 FR 78691, Dec. 26, 2002; 68 FR 15940, Apr. 2, 2003]



Sec.  1.28-0  Credit for clinical testing expenses for certain drugs
for rare diseases or conditions; table of contents.

    In order to facilitate use of Sec.  1.28-1, this section lists the 
paragraphs, subparagraphs, and subdivisions contained in Sec.  1.28-1.

    (a) General rule.
    (b) Qualified clinical testing expenses.
    (1) In general.
    (2) Modification of section 41(b).
    (3) Exclusion for amounts funded by another person.
    (i) In general.
    (ii) Clinical testing in which taxpayer retains no rights.
    (iii) Clinical testing in which taxpayer retains substantial rights.
    (A) In general.
    (B) Drug by drug determination.
    (iv) Funding for qualified clinical testing expenses determinable 
only in subsequent taxable years.
    (4) Special rule governing the application of section 41(b) beyond 
its expiration date.
    (c) Clinical testing.
    (1) In general.
    (2) Definition of ``human clinical testing''.
    (3) Definition of ``carried out under'' section 505(i).
    (d) Definition and special rules.

[[Page 81]]

    (1) Definition of ``rare disease or condition''.
    (i) In general.
    (ii) Cost of developing and making available the designated drug.
    (A) In general.
    (B) Exclusion of costs funded by another person.
    (C) Computation of cost.
    (D) Allocation of common costs. Costs for developing and making 
available the designated drug for both the disease or condition for 
which it is designated and one or more other diseases or conditions.
    (iii) Recovery from sales.
    (iv) Recordkeeping requirements.
    (2) Tax liability limitation.
    (i) Taxable years beginning after December 31, 1986.
    (ii) Taxable years beginning before January 1, 1987, and after 
December 31, 1983.
    (iii) Taxable years beginning before January 1, 1984.
    (3) Special limitations on foreign testing.
    (i) Clinical testing conducted outside the United States--In 
general.
    (ii) Insufficient testing population in the United States.
    (A) In general.
    (B) ``Insufficient testing population''.
    (C) ``Unrelated to the taxpayer''.
    (4) Special limitations for certain corporations.
    (i) Corporations to which section 936 applies.
    (ii) Corporations to which section 934(b) applies.
    (5) Aggregation of expenditures.
    (i) Controlled group of corporations: organizations under common 
control.
    (A) In general.
    (B) Definition of controlled group of corporations.
    (C) Definition of organization.
    (D) Determination of common control.
    (ii) Tax accounting periods used.
    (A) In general.
    (B) Special rule where the timing of clinical testing is 
manipulated.
    (iii) Membership during taxable year in more than one group.
    (iv) Intra-group transactions.
    (A) In general.
    (B) In-house research expenses.
    (C) Contract research expenses.
    (D) Lease payments.
    (E) Payments for supplies.
    (6) Allocations.
    (i) Pass-through in the case of an S corporation
    (ii) Pass-through in the case of an estate or a trust.
    (iii) Pass-through in the case of a partnership.
    (A) In general.
    (B) Certain partnership non-business expenditures.
    (C) Apportionment.
    (iv) Year in which taken into account.
    (v) Credit allowed subject to limitation.
    (7) Manner of making an election.

[T.D. 8232, 53 FR 38710, Oct. 3, 1988; 53 FR 40879, Oct. 19, 1988]



Sec.  1.28-1  Credit for clinical testing expenses for certain drugs 
for rare diseases or conditions.

    (a) General rule. Section 28 provides a credit against the tax 
imposed by chapter 1 of the Internal Revenue Code. The amount of the 
credit is equal to 50 percent of the qualified clinical testing expenses 
(as defined in paragraph (b) of this section) for the taxable year. The 
credit applies to qualified clinical testing expenses paid or incurred 
by the taxpayer after December 31, 1982, and before January 1, 1991. The 
credit may not exceed the taxpayer's tax liability for the taxable year 
(as determined under paragraph (d)(2) of this section).
    (b) Qualified clinical testing expenses--(1) In general. Except as 
otherwise provided in paragraph (b)(3) of this section, the term 
``qualified clinical testing expenses'' means the amounts which are paid 
or incurred during the taxable year which would constitute ``qualified 
research expenses'' within the meaning of section 41(b) (relating to the 
credit for increasing research activities) as modified by section 
28(b)(1)(B) and paragraph (b)(2) of this section. For example, amounts 
paid or incurred for the acquisition of depreciable property used in the 
conduct of clinical testing (as defined in paragraph (c) of this 
section) are not qualified clinical testing expenses.
    (2) Modification of section 41(b). For purposes of paragraph (b)(1) 
of this section, section 41(b) is modified by substituting ``clinical 
testing'' for ``qualified research'' each place it appears in paragraph 
(2) of section 41(b) (relating to in-house research expenses) and 
paragraph (3) of section 41(b) (relating to contract research expenses). 
In addition, ``100 percent'' is substituted for ``65 percent'' in 
paragraph (3)(A) of section 41(b).
    (3) Exclusion for amounts funded by another person--(i) In general. 
The term ``qualified clinical testing expenses'' shall not include any 
amount which would otherwise constitute qualified clinical testing 
expenses, to the extent

[[Page 82]]

such amount is funded by a grant, contract, or otherwise by another 
person (or any governmental entity). The determination of the extent to 
which an amount is funded shall be made in light of all the facts and 
circumstances. For a special rule regarding funding between commonly 
controlled businesses, see paragraph (d)(5)(iv) of Sec.  1.28-1.
    (ii) Clinical testing in which taxpayer retains no rights. If a 
taxpayer conducting clinical testing with respect to the designated drug 
for another person retains no substantial rights in the clinical testing 
under the agreement providing for the clinical testing the taxpayer's 
clinical testing expenses are treated as fully funded for purposes of 
section 28(b)(1)(C). Thus, for example, if the taxpayer incurs clinical 
testing expenses under an agreement that confers on another person the 
exclusive right to exploit the results of the clinical testing, those 
expenses do not constitute qualified clinical testing expenses because 
they are fully funded under this paragraph (b)(3)(ii). Incidental 
benefits to the taxpayer from the conduct of the clinical testing (for 
example, increased experience in the field of human clinical testing) do 
not constitute substantial rights in the clinical testing.
    (iii) Clinical testing in which taxpayer retains substantial 
rights--(A) In general. If a taxpayer conducting clinical testing with 
respect to the designated drug for another person retains substantial 
rights in the clinical testing under the agreement providing for the 
clinical testing, the clinical testing expenses are funded to the extent 
of the payments (and fair market value of any property at the time of 
transfer) to which the taxpayer becomes entitled by conducting the 
clinical testing. The taxpayer shall reduce the amount paid or incurred 
by the taxpayer for the clinical testing expenses that would, but for 
section 28(b)(1)(C) constitute qualified clinical testing expenses of 
the taxpayer by the amount of the funding determined under the preceding 
sentence. Rights retained in the clinical testing are not treated as 
property for purposes of this paragraph (b)(3)(iii)(A). If the property 
that is transferred to the taxpayer is to be consumed in the clinical 
testing (for example, supplies), the taxpayer should exclude the value 
of that property from both the payments received and the expenses paid 
or incurred for the clinical testing.
    (B) Drug by drug determination. The provisions of this paragraph 
(b)(3) shall be applied separately to each designated drug tested by the 
taxpayer.
    (iv) Funding for qualified clinical testing expenses determinable 
only in subsequent taxable years. If, at the time the taxpayer files its 
return for a taxable year, it is impossible to determine to what extent 
some or all of the qualified clinical testing expenses may be funded, 
the taxpayer shall treat the clinical testing expenses as fully funded 
for purposes of that return. When the amount of funding for qualified 
clinical testing expenses is finally determined, the taxpayer should 
amend the return and any interim returns to reflect the amount of 
funding for qualified clinical testing expenses.
    (4) Special rule governing the application of section 41(b) beyond 
its expiration date. For purposes of section 28 and this section, 
section 41(b), as amended, and the regulations thereunder shall be 
deemed to remain in effect after December 31, 1988.
    (c) Clinical testing--(1) In general. The term ``clinical testing'' 
means any human clinical testing which--
    (i) Is carried out under an exemption under section 505(i) of the 
Federal Food, Drug, and Cosmetic Act (21 U.S.C. 355(i)) and the 
regulations relating thereto (21 CFR part 312) for the purpose of 
testing a drug for a rare disease or condition as defined in paragraph 
(d)(1) of this section,
    (ii) Occurs after the date the drug is designated as a drug for a 
rare disease or condition under section 526 of the Federal Food, Drug, 
and Cosmetic Act (21 U.S.C. 360bb),
    (iii) Occurs before the date on which an application for the 
designated drug is approved under section 505(b) of the Federal Food, 
Drug, and Cosmetic Act (21 U.S.C. 355(b)) or, if the drug is a 
biological product (other than a radioactive biological product intended 
for human use), before the date on which a license for such drug is 
issued under section 351 of the Public Health Services Act (42 U.S.C. 
262), and

[[Page 83]]

    (iv) Is conducted by or on behalf of the taxpayer to whom the 
designation under section 526 of the Federal Food, Drug, and Cosmetic 
Act applies.

Human clinical testing shall be taken into account under this paragraph 
(c)(1) only to the extent that the testing relates to the use of a drug 
for the rare disease or condition for which the drug was designated 
under section 526 of the Federal Food, Drug, and Cosmetic Act. For 
purposes of paragraph (c)(1)(i) of this section the testing under 
section 505(i) exemption procedures (21 CFR part 312) of a biological 
product (other than a radioactive biological product intended for human 
use) pursuant to 21 CFR Sec.  601.21 is deemed to be carried out under 
an exemption under section 505(i) of the Federal Food, Drug, and 
Cosmetic Act.
    (2) Definition of ``human clinical testing.'' Testing is considered 
to be human clinical testing only to the extent that it uses human 
subjects to determine the effect of the designated drug on humans and is 
necessary for the designated drug either to be approved under section 
505(b) of the Federal Food, Drug, and Cosmetic Act and the regulations 
thereunder (21 CFR part 314), or if the designated drug is a biological 
product (other than a radioactive biological product intended for human 
use), to be licensed under section 351 of the Public Health Services Act 
and the regulations thereunder (21 CFR part 601). For purposes of this 
paragraph (c)(2), a human subject is an individual who is a participant 
in research, either as a recipient of the drug or as a control. A 
subject may be either a healthy individual or a patient.
    (3) Definition of ``carried out under'' section 505(i). Human 
clinical testing is not carried out under section 505(i) of the Federal 
Food, Drug, and Cosmetic Act and the regulations thereunder (21 CFR part 
312) unless the primary purpose of the human clinical testing is to 
ascertain the data necessary to qualify the designated drug for sale in 
the United States, and not to ascertain data unrelated or only 
incidentally related to that needed to qualify the designated drug. 
Whether or not this primary purpose test is met shall be determined in 
light of all of the facts and circumstances.
    (d) Definition and special rules--(1) Definition of ``rare disease 
or condition''--(i) In general. The term ``rare disease or condition'' 
means any disease or condition which--
    (A) Afflicts 200,000 or fewer persons in the United States, or
    (B) Afflicts more than 200,000 persons in the United States but for 
which there is no reasonable expectation that the cost of developing and 
making available in the United States (as defined in section 7701(a)(9)) 
a drug for such disease or condition will be recovered from sales in the 
United States (as so defined) of such drug.

Determinations under paragraph (d)(1)(i)(B) of this section with respect 
to any drug shall be made on the basis of the facts and circumstances as 
of the date such drug is designated under section 526 of the Federal 
Food, Drug, and Cosmetic Act. Examples of diseases or conditions which 
in 1987 afflicted 200,000 or fewer persons in the United States are 
Duchenne dystrophy, one of the muscular dystrophies; Huntington's 
disease, a hereditary chorea; myoclonus; Tourette's syndrome; and 
amyotrophic lateral sclerosis (ALS or Lou Gehrig's disease).
    (ii) Cost of developing and making available the designated drug--
(A) In general. Except as otherwise provided in this paragraph 
(d)(1)(ii), the taxpayer's computation of the cost of developing and 
making available in the United States the designated drug shall include 
only the costs that the taxpayer (or any person whose right to make 
sales of the drug is directly or indirectly derived from the taxpayer, 
e.g., a licensee or transferee) has incurred or reasonably expects to 
incur in developing and making available in the United States the 
designated drug for the disease or condition for which it is designated. 
For example, if, prior to designation under section 526, the taxpayer 
incurred costs of $125,000 to test the drug for the rare disease or 
condition for which it is subsequently designated and incurred $500,000 
to test the same drug for other diseases, and if, on the date of 
designation, the taxpayer expects to incur costs of $1.2 million to test 
the drug for the rare disease or condition for which it is designated, 
the taxpayer shall include in

[[Page 84]]

its cost computation both the $125,000 incurred prior to designation and 
the $1.2 million expected to be incurred after designation to test the 
drug for the rare disease or condition for which it is designated. The 
taxpayer shall not include the $500,000 incurred to test the drug for 
other diseases.
    (B) Exclusion of costs funded by another person. In computing the 
cost of developing and making available in the United States the 
designated drug, the taxpayer shall not include any cost incurred or 
expected to be incurred by the taxpayer to the extent that the cost is 
funded or is reasonably expected to be funded (determined under the 
principles of paragraph (b)(3)) by a grant, contract, or otherwise by 
another person (or any governmental entity).
    (C) Computation of cost. The cost computation shall use only 
reasonable costs incurred after the first indication of an orphan 
application for the designated drug. Such costs shall include the costs 
of obtaining data needed, and of meetings to be held, in connection with 
a request for FDA assistance under section 525 of the Federal, Food, 
Drug, and Cosmetic Act (21 U.S.C. 360aa) or a request for orphan 
designation under section 526 of that Act; costs of determining 
patentability of the drug; costs of screening, animal and clinical 
studies; costs associated with preparation of a Notice of Claimed 
Investigational Exemption for a New Drug (IND) and a New Drug 
Application (NDA); costs of possible distribution of drug under a 
``treatment'' protocol; costs of development of a dosage form; 
manufacturing costs; distribution costs; promotion costs; costs to 
maintain required records and reports; and costs of the taxpayer in 
acquiring the right to market a drug from the owner of that right prior 
to designation. The taxpayer shall also include general overhead, 
depreciation costs and premiums for insurance against liability losses 
to the extent that the taxpayer can demonstrate that these costs are 
properly allocable to the designated drug under the established 
standards of financial accounting and reporting of research and 
development costs.
    (D) Allocation of common costs. Costs for developing and making 
available the designated drug for both the disease or condition for 
which it is designated and one or more other diseases or conditions. In 
the case where the costs incurred or expected to be incurred in 
developing and making available the designated drug for the disease or 
condition for which it is designated are also incurred or expected to be 
incurred in developing and making available in the United States the 
same drug for one or more other diseases or conditions (whether or not 
they are also designated or expected to be designated), the costs shall 
be allocated between the cost of developing and making available the 
designated drug for the disease or condition for which the drug is 
designated and the cost of developing and making available the 
designated drug for the other diseases or conditions. The amount of the 
common costs to be allocated to the cost of developing and making 
available the designated drug for the disease or condition for which it 
is designated is determined by multiplying the common costs by a 
fraction the numerator of which is the sum of the expected amount of 
sales in the United States of the designated drug for the disease or 
condition for which the drug is designated and the denominator of which 
is the total expected amount of sales in the United States of the 
designated drug. For example, if prior to designation, the taxpayer 
incurs (among other costs) costs of $100,000 in testing the designated 
drug for its toxic effect on animals (without reference to any disease 
or condition), and if the taxpayer expects to recover $500,000 from 
sales in the United States of the designated drug for disease X, the 
disease for which the drug is designated, and further expects to recover 
another $1.5 million from the sales in the United States of the 
designated drug for disease Y, the taxpayer must allocate a 
proportionate amount of the common costs of $100,000 to the cost of 
developing and making available the designated drug for both disease X 
and disease Y. Since the ratio of the expected amount of sales in the 
United States of the designated drug for disease X to the total of both 
the expected amount

[[Page 85]]

of sales in the United States of the designated drug for disease X and 
the expected amount of sales in the United States of the designated drug 
for disease Y is $500,000/$2,000,000, 25% of the common costs of 
$100,000 (i.e., $25,000) is allocated to the cost of developing and 
making available the designated drug for disease X.
    (iii) Recovery from sales. In determining whether the taxpayer's 
cost described in paragraph (d)(1)(ii) of this section will be recovered 
from sales in the United States of the designated drug for the disease 
or condition for which the drug is designated, the taxpayer shall 
include anticipated sales by the taxpayer or any person whose right to 
make such sales is directly or indirectly derived from the taxpayer 
(such as a licensee or transferee). The anticipated sales shall be based 
upon the size of the anticipated patient population for which the 
designated drug would be useful, including the following factors: the 
degree of effectiveness and safety of the designated drug, if known: the 
projected fraction of the anticipated patient population expected to be 
given the designated drug and to continue to take it; other available 
agents and other types of therapy; the likelihood that superior agents 
will become available within a few years; and the number of years during 
which the designated drug would be exclusively available, e.g., under a 
patent.
    (iv) Recordkeeping requirements. The taxpayer shall keep records 
sufficient to substantiate the cost and sales estimates made pursuant to 
this paragraph (d)(1). The records required by this paragraph (d)(1)(iv) 
shall be retained so long as the contents thereof may become material in 
the administration of section 28.
    (2) Tax liability limitation--(i) Taxable years beginning after 
December 31, 1986. The credit allowed by section 28 shall not exceed the 
excess (if any) of--
    (A) The taxpayer's regular tax liability for the taxable year (as 
defined in section 26(b)), reduced by the sum of the credits allowable 
under--
    (1) Section 21 (relating to expenses for household and dependent 
care services necessary for gainful employment),
    (2) Section 22 (relating to the elderly and permanently and totally 
disabled),
    (3) Section 23 (relating to residential energy),
    (4) Section 25 (relating to interest on certain home mortgages), and
    (5) Section 27 (relating to taxes on foreign countries and 
possessions of the United States), over
    (B) The tentative minimum tax for the taxable year (as determined 
under section 55(b)(1)).
    (ii) Taxable years beginning before January 1, 1987, and after 
December 31, 1983. The credit allowed by section 28 shall not exceed the 
taxpayer's tax liability for the taxable year (as defined in section 26 
(b) prior to its amendment by the Tax Reform Act of 1986 (Pub. L. 99-
514)), reduced by the sum of the credits allowable under--
    (A) Section 21 (relating to expenses for household dependent care 
services necessary for gainful employment),
    (B) Section 22 (relating to the elderly and permanently and totally 
disabled),
    (C) Section 23 (relating to residential energy),
    (D) Section 24 (relating to contributions to candidates for public 
office),
    (E) Section 25 (relating to interest on certain home mortgages), and
    (F) Section 27 (relating to the taxes on foreign countries and 
possessions of the United States).
    (iii) Taxable years beginning before January 1, 1984. The credit 
allowed by section 28 shall not exceed the amount of the tax imposed by 
chapter 1 of the Internal Revenue Code for the taxable year, reduced by 
the sum of the credits allowable under the following sections as 
designated prior to the enactment of the Tax Reform Act of 1984 (Pub. 
Law 98-369):
    (A) Section 32 (relating to tax withheld at source on nonresident 
aliens and foreign corporations and on tax-free convenant bonds),
    (B) Sections 33 (relating to taxes of foreign countries and 
possessions of the United States),
    (C) Section 37 (relating to the retirement income),
    (D) Section 38 (relating to investment in certain depreciable 
property),
    (E) Section 40 (relating to expenses of work incentive programs).

[[Page 86]]

    (F) Section 41 (relating to contributions to candidates for public 
office).
    (G) Section 44 (relating to purchase of new principal residence).
    (H) Section 44A (relating to expenses for household and dependent 
care services necessary for gainful employment).
    (I) Section 44B (relating to employment of certain new employees).
    (J) Section 44C (relating to residential energy).
    (K) Section 44D (relating to producing fuel from a nonconventional 
source).
    (L) Section 44E (relating to alcohol used as fuel).
    (M) Section 44F (relating to increasing research activities), and
    (N) Section 44G (relating to employee stock ownership).

The term ``tax imposed by chapter 1'' as used in this paragraph 
(d)(2)(iii) does not include any tax treated as not imposed by chapter 1 
of the Internal Revenue Code under the last sentence of section 53(a).
    (3) Special limitations on foreign testing--(i) Clinical testing 
conducted outside of the United States--In general. Except as otherwise 
provided in this paragraph (d)(3), expenses paid or incurred with 
respect to clinical testing conducted outside the United States (as 
defined in section 7701(a)(9)) are not eligible for credit under this 
section. Thus, for example, wages paid an employee clinical investigator 
for clinical testing conducted in medical facilities in the United 
States and Mexico generally must be apportioned between the clinical 
testing conducted within the United States and the clinical testing 
conducted outside the United States, and only the wages apportioned to 
the clinical testing conducted within the United States are qualified 
clinical testing expenses.
    (ii) Insufficient testing population in the United States--(A) In 
general. If clinical testing is conducted outside of the United States 
because there is an insufficient testing population in the United 
States, and if the clinical testing is conducted by a United States 
person (as defined in section 7701(a)(30)) or is conducted by any other 
person unrelated to the taxpayer to whom the designation under section 
526 of the Federal Food, Drug, and Cosmetic Act applies, then the 
expenses paid or incurred for clinical testing conducted outside of the 
United States are eligible for the credit provided by section 28.
    (B) ``Insufficient testing population.'' The testing population in 
the United States is insufficient if there are not within the United 
States the number of available and appropriate human subjects needed to 
produce reliable data from the clinical investigation.
    (C) ``Unrelated to the taxpayer.'' For the purpose of determining 
whether a person is unrelated to the taxpayer to whom the designation 
under section 526 of the Federal Food, Drug, and Cosmetic Act and the 
regulations thereunder applies, the rules of section 613A(d)(3) shall 
apply except that the number ``5'' in section 613A(d)(3) (A), (B), and 
(C) shall be deleted and the number ``10'' inserted in lieu thereof.
    (4) Special limitations for certain corporations--(i) Corporations 
to which section 936 applies. Expenses paid or incurred for clinical 
testing conducted either inside or outside the United States by a 
corporation to which section 936 (relating to Puerto Rico and 
possessions tax credit) applies are not eligible for the credit under 
section 28.
    (ii) Corporations to which section 934(b) applies. For taxable years 
beginning before January 1, 1987, expenses paid or incurred for clinical 
testing conducted either inside or outside the United States by a 
corporation to which section 934(b) (relating to the limitation on 
reduction in income tax liability incurred to the Virgin Islands), as in 
effect prior to its amendment by the Tax Reform Act of 1986, applies are 
not eligible for the credit under section 28. For taxable years 
beginning after December 31, 1986, see section 1277(c)(1) of the Tax 
Reform Act of 1986 (100 Stat. 2600) which makes the rule set forth in 
the preceding sentence inapplicable with respect to corporations created 
or organized in the Virgin Islands only if (and so long as) an 
implementing agreement described in that section is in effect between 
the United States and the Virgin Islands.
    (5) Aggregation of expenditures--(i) Controlled group of 
corporations; organizations under common control--(A) In

[[Page 87]]

general. In determining the amount of the credit allowable with respect 
to an organization that at the end of its taxable year is a member of a 
controlled group of corporations or a member of a group of organizations 
under common control, all members of the group are treated as a single 
taxpayer and the credit (if any) allowable to the member is determined 
on the basis of its proportionate share of the qualified clinical 
testing expenses of the aggregated group.
    (B) Definition of controlled group of corporations. For purposes of 
this section, the term ``controlled group of corporations'' shall have 
the meaning given to the term by section 41(f)(5).
    (C) Definition of organization. For purposes of this section, an 
organization is a sole proprietorship, a partnership, a trust, an 
estate, or a corporation, that is carrying on a trade or business 
(within the meaning of section 162). For purposes of this section, any 
corporation that is a member of a commonly controlled group shall be 
deemed to be carrying on a trade or business if any other member of that 
group is carrying on any trade or business.
    (D) Determination of common control. Whether organizations are under 
common control shall be determined under the principles set forth in 
paragraphs (b) through (g) of 26 CFR 1.52-1.
    (ii) Tax accounting periods used--(A) In general. The credit 
allowable to a member of a controlled group of corporations or a group 
of organizations under common control is that member's share of the 
aggregate credit computed as of the end of such member's taxable year.
    (B) Special rule where the timing of clinical testing is 
manipulated. If the timing of clinical testing by members using 
different tax accounting periods is manipulated to generate a credit in 
excess of the amount that would be allowable if all members of the group 
used the same tax accounting period, the district director may require 
all members of the group to calculate the credit in the current taxable 
year and all future years by using the ``conformed years'' method. Each 
member computing a credit under the ``conformed years'' method shall 
compute the credit as if all members of the group had the same taxable 
year as the computing member.
    (iii) Membership during taxable year in more than one group. An 
organization may be a member of only one group for a taxable year. If, 
without application of this paragraph (d)(5)(iii), an organization would 
be a member of more than one group at the end of its taxable year, the 
organization shall be treated as a member of the group in which it was 
included for its preceding taxable year. If the organization was not 
included for its preceding taxable year in any group in which it could 
be included as of the end of its taxable year, the organization shall 
designate in its timely filed return the group in which it is being 
included. If the return for a taxable year is due before May 1, 1985, 
the organization may designate its group membership through an amended 
return for that year filed on or before April 30, 1985. If the 
organization does not so designate, then the district director with 
audit jurisdiction of the return will determine the group in which the 
business is to be included.
    (iv) Intra-group transactions--(A) In general. Because all members 
of a group under common control are treated as a single taxpayer for 
purposes of determining the credit, transactions between members of the 
group are generally disregarded.
    (B) In-house research expenses. If one member of a group conducts 
clinical testing on behalf of another member, the member conducting the 
clinical testing shall include in its qualified clinical testing 
expenses any in-house research expenses for that work and shall not 
treat any amount received or accrued from the other member as funding 
the clinical testing. Conversely, the member for whom the clinical 
testing is conducted shall not treat any part of any amount paid or 
incurred as a contract research expense. For purposes of determining 
whether the in-house research for that work is clinical testing, the 
member performing the clinical testing shall be treated as carrying on 
any trade or business carried on by the member on whose behalf the 
clinical testing is performed.

[[Page 88]]

    (C) Contract research expenses. If a member of a group pays or 
incurs contract research expenses to a person outside the group in 
carrying on the member's trade or business, that member shall include 
those expenses as qualified clinical testing expenses. However, if the 
expenses are not paid or incurred in carrying on any trade or business 
of that member, those expenses may be taken into account as contract 
research expenses by another member of the group provided that the other 
member--
    (1) Reimburses the member paying or incurring the expenses, and
    (2) Carries on a trade or business to which the clinical testing 
relates.
    (D) Lease payments. Amounts paid or incurred to another member of 
the group for the lease of personal property owned by a person outside 
the group shall be taken into account as in-house research expenses for 
purposes of section 28 only to the extent of the lesser of--
    (1) The amount paid or incurred to the other member, or
    (2) The amount of the lease expense paid to a person outside the 
group.
    The amount paid or incurred to another member of the group for the 
lease of personal property owned by a member of the group is not taken 
into account for purposes of section 28.
    (E) Payment for supplies. Amounts paid or incurred to another member 
of the group for supplies shall be taken into account as in-house 
research expenses for purposes of section 28 only to the extent of the 
lesser of--
    (1) The amount paid or incurred to the other member, or
    (2) The amount of the other member's basis in the supplies.
    (6) Allocations--(i) Pass-through in the case of an S corporation. 
In the case of an S corporation (as defined in section 1361), the amount 
of the credit for qualified clinical testing expenses computed for the 
corporation for any taxable year shall be allocated among the persons 
who are shareholders of the corporation during the taxable year 
according to the provisions of section 1366 and section 1377.
    (ii) Pass-through in the case of an estate or a trust. In the case 
of an estate or a trust, the amount of the credit for qualified clinical 
testing expenses computed for the estate or trust for any taxable year 
shall be apportioned between the estate or trust and the beneficiaries 
on the basis of the income of the estate or trust allocable to each.
    (iii) Pass-through in the case of a partnership--(A) In general. In 
the case of a partnership, the credit for qualified clinical testing 
expenses computed for the partnership for any taxable year shall be 
apportioned among the persons who are partners during the taxable year 
in accordance with section 704 and the regulations thereunder.
    (B) Certain partnership non-business expenditures. A partner's share 
of an in-house research expense or contract research expense paid or 
incurred by a partnership other than in carrying on a trade or business 
of the partnership constitutes a qualified clinical testing expense of 
the partner if--
    (1) The partner is entitled to make independent use of the result of 
the clinical testing, and
    (2) The clinical testing expense paid or incurred in carrying on the 
clinical testing would have been paid or incurred by the partner in 
carrying on a trade or business of the partner if the partner had 
carried on the clinical testing that was in fact carried on by the 
partnership.
    (C) Apportionment. Qualified clinical testing expenses to which 
paragraph (d)(6)(iii)(B) of this section applies shall be apportioned 
among the persons who are partners during the taxable year in accordance 
with section 704 and the regulations thereunder. For purposes of section 
28, these expenses shall be treated as paid or incurred directly by the 
partners rather than by the partnership. Thus, the partnership shall 
disregard these expenses in computing the credit to be apportioned under 
paragraph (d)(6)(iii)(A) of this section, and each partner shall 
aggregate the portion of these expenses allocated to the partner with 
other qualified clinical testing expenses of the partner in making the 
computations under section 28.
    (iv) Year in which taken into account. An amount apportioned to a 
person under paragraph (d)(6) of this section shall be taken into 
account by the person in the taxable year of such person

[[Page 89]]

in which or with which the taxable year of the corporation, estate, 
trust, or partnership (as the case may be) ends.
    (v) Credit allowed subject to limitation. Any person to whom any 
amount has been apportioned under paragraph (d)(6)(i), (ii), or (iii) of 
this section is allowed, subject to the limitation provided in section 
28(d)(2), a credit for that amount.
    (7) Manner of making an election. To make an election to have 
section 28 apply for its taxable year, the taxpayer shall file Form 6765 
(Credit for Increasing Research Activities (or for claiming the orphan 
drugs credit)) containing all the information required by that form.

[T.D. 8232, 53 FR 38711, Oct. 3, 1988; 53 FR 40879, Oct. 19, 1988; 53 FR 
41013, Oct. 19, 1988]

                           Credits Against Tax

             credits allowable under sections 30 through 45D



Sec.  1.30-1  Definition of qualified electric vehicle and recapture of
credit for qualified electric vehicle.

    (a) Definition of qualified electric vehicle. A qualified electric 
vehicle is a motor vehicle that meets the requirements of section 30(c). 
Accordingly, a qualified electric vehicle does not include any motor 
vehicle that has ever been used (for either personal or business use) as 
a non-electric vehicle.
    (b) Recapture of credit for qualified electric vehicle--(1) In 
general--(i) Addition to tax. If a recapture event occurs with respect 
to a taxpayer's qualified electric vehicle, the taxpayer must add the 
recapture amount to the amount of tax due in the taxable year in which 
the recapture event occurs. The recapture amount is not treated as 
income tax imposed on the taxpayer by chapter 1 of the Internal Revenue 
Code for purposes of computing the alternative minimum tax or 
determining the amount of any other allowable credits for the taxable 
year in which the recapture event occurs.
    (ii) Reduction of carryover. If a recapture event occurs with 
respect to a taxpayer's qualified electric vehicle, and if a portion of 
the section 30 credit for the cost of that vehicle was disallowed under 
section 30(b)(3)(B) and consequently added to the taxpayer's minimum tax 
credit pursuant to section 53(d)(1)(B)(iii), the taxpayer must reduce 
its minimum tax credit carryover by an amount equal to the portion of 
any minimum tax credit carryover attributable to the disallowed section 
30 credit, multiplied by the recapture percentage for the taxable year 
of recapture. Similarly, the taxpayer must reduce any other credit 
carryover amounts (such as under section 469) by the portion of the 
carryover attributable to section 30, multiplied by the recapture 
percentage.
    (2) Recapture event--(i) In general. A recapture event occurs if, 
within 3 full years from the date a qualified electric vehicle is placed 
in service, the vehicle ceases to be a qualified electric vehicle. A 
vehicle ceases to be a qualified electric vehicle if--
    (A) The vehicle is modified so that it is no longer primarily 
powered by electricity;
    (B) The vehicle is used in a manner described in section 50(b); or
    (C) The taxpayer receiving the credit under section 30 sells or 
disposes of the vehicle and knows or has reason to know that the vehicle 
will be used in a manner described in paragraph (b)(2)(i)(A) or (B) of 
this section.
    (ii) Exception for disposition. Except as provided in paragraph 
(b)(2)(i)(C) of this section, a sale or other disposition (including a 
disposition by reason of an accident or other casualty) of a qualified 
electric vehicle is not a recapture event.
    (3) Recapture amount. The recapture amount is equal to the recapture 
percentage times the decrease in the credits allowed under section 30 
for all prior taxable years that would have resulted solely from 
reducing to zero the cost taken into account under section 30 with 
respect to such vehicle, including any credits allowed attributable to 
section 30 (such as under sections 53 and 469).
    (4) Recapture date. The recapture date is the actual date of the 
recapture event unless a recapture event described in paragraph 
(b)(2)(i)(B) of this section occurs, in which case the recapture date is 
the first day of the recapture year.

[[Page 90]]

    (5) Recapture percentage. For purposes of this section, the 
recapture percentage is--
    (i) 100, if the recapture date is within the first full year after 
the date the vehicle is placed in service;
    (ii) 66\2/3\, if the recapture date is within the second full year 
after the date the vehicle is placed in service; or
    (iii) 33\1/3\, if the recapture date is within the third full year 
after the date the vehicle is placed in service.
    (6) Basis adjustment. As of the first day of the taxable year in 
which the recapture event occurs, the basis of the qualified electric 
vehicle is increased by the recapture amount and the carryover 
reductions taken into account under paragraphs (b)(1)(i) and (ii) of 
this section, respectively. For a vehicle that is of a character that is 
subject to an allowance for depreciation, this increase in basis is 
recoverable over the remaining recovery period for the vehicle beginning 
as of the first day of the taxable year of recapture.
    (7) Application of section 1245 for sales and other dispositions. 
For purposes of section 1245, the amount of the credit allowable under 
section 30(a) with respect to any qualified electric vehicle that is (or 
has been) of a character subject to an allowance for depreciation is 
treated as a deduction allowed for depreciation under section 167. 
Therefore, upon a sale or other disposition of a depreciable qualified 
electric vehicle, section 1245 will apply to any gain recognized to the 
extent the basis of the depreciable vehicle was reduced under section 
30(d)(1) net of any basis increase described in paragraph (b)(6) of this 
section.
    (8) Examples. The following examples illustrate the provisions of 
this section:

    Example 1. A, a calendar-year taxpayer, purchases and places in 
service for personal use on January 1, 1995, a qualified electric 
vehicle costing $25,000. On A's 1995 federal income tax return, A claims 
a credit of $2,500. On January 2, 1996, A sells the vehicle to an 
unrelated third party who subsequently converts the vehicle into a non-
electric vehicle on October 15, 1996. There is no recapture upon the 
sale of the vehicle by A provided A did not know or have reason to know 
that the purchaser intended to convert the vehicle to non-electric use.
    Example 2. B, a calendar-year taxpayer, purchases and places in 
service for personal use on October 11, 1994, a qualified electric 
vehicle costing $20,000. On B's 1994 federal income tax return, B claims 
a credit of $2,000, which reduces B's tax by $2,000. The basis of the 
vehicle is reduced to $18,000 ($20,000-$2,000). On March 8, 1996, B 
sells the vehicle to a tax-exempt entity. Because B knowingly sold the 
vehicle to a tax-exempt entity described in section 50(b) in the second 
full year from the date the vehicle was placed in service, B must 
recapture $1,333 ($2,000 x 66\2/3\ percent). This recapture amount 
increases B's tax by $1,333 on B's 1996 federal income tax return and is 
added to the basis of the vehicle as of January 1, 1996, the beginning 
of the taxable year in which the recapture event occurred.
    Example 3. X, a calendar-year taxpayer, purchases and places in 
service for business use on January 1, 1994, a qualified electric 
vehicle costing $30,000. On X's 1994 federal income tax return, X claims 
a credit of $3,000, which reduces X's tax by $3,000. The basis of the 
vehicle is reduced to $27,000 ($30,000-$3,000) prior to any adjustments 
for depreciation. On March 8, 1995, X converts the qualified electric 
vehicle into a gasoline-propelled vehicle. Because X modified the 
vehicle so that it is no longer primarily powered by electricity in the 
second full year from the date the vehicle was placed in service, X must 
recapture $2,000 ($3,000 x 66\2/3\ percent). This recapture amount 
increases X's tax by $2,000 on X's 1995 federal income tax return. The 
recapture amount of $2,000 is added to the basis of the vehicle as of 
January 1, 1995, the beginning of the taxable year of recapture, and to 
the extent the property remains depreciable, the adjusted basis is 
recoverable over the remaining recovery period.
    Example 4. The facts are the same as in Example 3. In 1996, X sells 
the vehicle for $31,000, recognizing a gain from this sale. Under 
paragraph (b)(7) of this section, section 1245 will apply to any gain 
recognized on the sale of a depreciable vehicle to the extent the basis 
of the vehicle was reduced by the section 30 credit net of any basis 
increase from recapture of the section 30 credit. Accordingly, the gain 
from the sale of the vehicle is subject to section 1245 to the extent of 
the depreciation allowance for the vehicle plus the credit allowed under 
section 30 ($3,000), less the previous recapture amount ($2,000). Any 
remaining amount of gain may be subject to other applicable provisions 
of the Internal Revenue Code.

    (c) Effective date. This section is effective on October 14, 1994. 
If the recapture date is before the effective date of this section, a 
taxpayer may use any reasonable method to recapture the

[[Page 91]]

benefit of any credit allowable under section 30(a) consistent with 
section 30 and its legislative history. For this purpose, the recapture 
date is defined in paragraph (b)(4) of this section.

[60 FR 39649, Aug. 3, 1995]



Sec.  1.31-1  Credit for tax withheld on wages.

    (a) The tax deducted and withheld at the source upon wages under 
chapter 24 of the Internal Revenue Code of 1954 (or in the case of 
amounts withheld in 1954, under subchapter D, chapter 9 of the Internal 
Revenue Code of 1939) is allowable as a credit against the tax imposed 
by Subtitle A of the Internal Revenue Code of 1954, upon the recipient 
of the income. If the tax has actually been withheld at the source, 
credit or refund shall be made to the recipient of the income even 
though such tax has not been paid over to the Government by the 
employer. For the purpose of the credit, the recipient of the income is 
the person subject to tax imposed under Subtitle A upon the wages from 
which the tax was withheld. For instance, if a husband and wife 
domiciled in a State recognized as a community property State for 
Federal tax purposes make separate returns, each reporting for income 
tax purposes one- half of the wages received by the husband, each spouse 
is entitled to one-half of the credit allowable for the tax withheld at 
source with respect to such wages.
    (b) The tax withheld during any calendar year shall be allowed as a 
credit against the tax imposed by Subtitle A for the taxable year of the 
recipient of the income which begins in that calendar year. If such 
recipient has more than one taxable year beginning in that calendar 
year, the credit shall be allowed against the tax for the last taxable 
year so beginning.



Sec.  1.31-2  Credit for ``special refunds'' of employee social
security tax.

    (a) In general. (1) In the case of an employee receiving wages from 
more than one employer during the calendar year, amounts may be deducted 
and withheld as employee social security tax with respect to more than 
$3,600 of wages received during the calendar year 1954, and with respect 
to more than $4,200 of wages received during a calendar year after 1954. 
For example, employee social security tax may be deducted and withheld 
on $5,000 of wages received by an employee during a particular calendar 
year if the employee is paid wages in such year in the amount of $3,000 
by one employer and in the amount of $2,000 by another employer. Section 
6413(c) (as amended by section 202 of the Social Security Amendments of 
1954 (68 Stat. 1089)), permits, under certain conditions, a so-called 
``special refund'' of the amount of employee social security tax 
deducted and withheld with respect to wages paid to an employee in a 
calendar year after 1954 in excess of $4,200 ($3,600 for the calendar 
year 1954) by reason of the employee receiving wages from more than one 
employer during the calendar year. For provisions relating to the 
imposition of the employee tax and the limitation on wages, see with 
respect to the calendar year 1954, sections 1400 and 1426(a)(1) of the 
Internal Revenue Code of 1939 and, with respect to calendar years after 
1954, sections 3101 and 3121(a)(1) of the Internal Revenue Code of 1954, 
as amended by sections 208(b) and 204(a), respectively, of the Social 
Security Amendments of 1954 (68 Stat. 1094, 1091).
    (2) An employee who is entitled to a special refund of employee tax 
with respect to wages received during a calendar year and who is also 
required to file an income tax return for such calendar year (or for his 
last taxable year beginning in such calendar year) may obtain the 
benefits of such special refund only by claiming credit for such special 
refund in the same manner as if such special refund were an amount 
deducted and withheld as income tax at the source. For provisions for 
claiming special refunds for 1955 and subsequent years in the case of 
employees not required to file income tax returns, see section 6413(c) 
and the regulations thereunder. For provisions relating to such refunds 
for 1954, see 26 CFR (1939) 408.802 (regulations 128).
    (3) The amount of the special refund allowed as a credit shall be 
considered as an amount deducted and withheld as income tax at the 
source under chapter 24 of the Internal Revenue Code of 1954 (or, in the 
case of a special refund for

[[Page 92]]

1954, subchapter D, chapter 9 of the Internal Revenue Code of 1939). If 
the amount of such special refund when added to amounts deducted and 
withheld as income tax exceeds the taxes imposed by subtitle A of the 
Internal Revenue Code of 1954, the amount of the excess constitutes an 
overpayment of income tax under Subtitle A, and interest on such 
overpayment is allowed to the extent provided under section 6611 upon an 
overpayment of income tax resulting from a credit for income tax 
withheld at source. See section 6401(b).
    (b) Federal and State employees and employees of certain foreign 
corporations. The provisions of this section shall apply to the amount 
of a special refund allowable to an employee of a Federal agency or a 
wholly owned instrumentality of the United States, to the amount of a 
special refund allowable to an employee of any State or political 
subdivision thereof (or any instrumentality of any one or more of the 
foregoing), and to the amount of a special refund allowable to employees 
of certain foreign corporations. See, with respect to such special 
refunds for 1954, section 1401(d)(4) of the Internal Revenue Code of 
1939, and with respect to such special refunds for 1955 and subsequent 
years, section 6413(c)(2) of the Internal Revenue Code of 1954, as 
amended by section 202 of the Social Security amendments of 1954.



Sec.  1.32-2  Earned income credit for taxable years beginning after
December 31, 1978.

    (a) [Reserved]
    (b) Limitations. (1) [Reserved]
    (2) Married individuals. No credit is allowed by section 32 in the 
case of an eligible individual who is married (within the meaning of 
section 7703 and the regulations thereunder) unless the individual and 
spouse file a single return jointly (a joint return) for the taxable 
year (see section 6013 and the regulations thereunder relating to joint 
returns of income tax by husband and wife). The requirements of the 
preceding sentence do not apply to an eligible individual who is not 
considered as married under section 7703(b) and the regulations 
thereunder (relating to certain married individuals living apart).
    (3) Length of taxable year. No credit is allowed by section 32 in 
the case of a taxable year covering a period of less than 12 months. 
However, the rule of the preceding sentence does not apply to a taxable 
year closed by reason of the death of the eligible individual.
    (c) Definitions. (1) [Reserved]
    (2) Earned income. For purposes of this section, earned income is 
computed without regard to any community property laws which may 
otherwise be applicable. Earned income is reduced by any net loss in 
earnings from self-employment. Earned income does not include amounts 
received as a pension, an annuity, unemployment compensation, or 
workmen's compensation, or an amount to which section 871(a) and the 
regulations thereunder apply (relating to income of nonresident alien 
individuals not connected with United States business).
    (d) [Reserved]
    (e) Coordination of credit with advance payments--(1) Recapture of 
excess advance payments. If any advance payment of earned income credit 
under section 3507 is made to an individual by an employer during any 
calendar year, then the total amount of these advance payments to the 
individual in that calendar year is treated as an additional amount of 
tax imposed (by chapter 1 of the Code) upon the individual on the tax 
return for the individual's last taxable year beginning in that calendar 
year.
    (2) Reconciliation of payments advanced and credit allowed. Any 
additional amount of tax under paragraph (e)(1) of this section is not 
treated as a tax imposed by chapter 1 of the Internal Revenue Code for 
purposes of determining the amount of any credit (other than the earned 
income credit) allowable under part IV, subchapter A, chapter 1 of the 
Internal Revenue Code.

[T.D. 7683, 45 FR 16175, Mar. 13, 1980. Redesignated by T.D. 8448, 57 FR 
54923, Nov. 23, 1992; T.D. 9045, 68 FR 10656, Mar. 6, 2003]



Sec.  1.32-3  Eligibility requirements after denial of the earned
income credit.

    (a) In general. A taxpayer who has been denied the earned income 
credit (EIC), in whole or in part, as a result of

[[Page 93]]

the deficiency procedures under subchapter B of chapter 63 (deficiency 
procedures) is ineligible to file a return claiming the EIC subsequent 
to the denial until the taxpayer demonstrates eligibility for the EIC in 
accordance with paragraph (c) of this section. If a taxpayer 
demonstrates eligibility for a taxable year in accordance with paragraph 
(c) of this section, the taxpayer need not comply with those 
requirements for any subsequent taxable year unless the Service again 
denies the EIC as a result of the deficiency procedures.
    (b) Denial of the EIC as a result of the deficiency procedures. For 
purposes of this section, denial of the EIC as a result of the 
deficiency procedures occurs when a tax on account of the EIC is 
assessed as a deficiency (other than as a mathematical or clerical error 
under section 6213(b)(1)).
    (c) Demonstration of eligibility. In the case of a taxpayer to whom 
paragraph (a) of this section applies, and except as otherwise provided 
by the Commissioner in the instructions for Form 8862, ``Information To 
Claim Earned Income Credit After Disallowance,'' no claim for the EIC 
filed subsequent to the denial is allowed unless the taxpayer properly 
completes Form 8862, demonstrating eligibility for the EIC, and 
otherwise is eligible for the EIC. If any item of information on Form 
8862 is incorrect or inconsistent with any item on the return, the 
taxpayer will be treated as not demonstrating eligibility for the EIC. 
The taxpayer must follow the instructions for Form 8862 to determine the 
income tax return to which Form 8862 must be attached. If the taxpayer 
attaches Form 8862 to an incorrect tax return, the taxpayer will not be 
relieved of the requirement that the taxpayer attach Form 8862 to the 
correct tax return and will, therefore, not be treated as meeting the 
taxpayer's obligation under paragraph (a) of this section.
    (d) Failure to demonstrate eligibility. If a taxpayer to whom 
paragraph (a) of this section applies fails to satisfy the requirements 
of paragraph (c) of this section with respect to a particular taxable 
year, the IRS can deny the EIC as a mathematical or clerical error under 
section 6213(g)(2)(K).
    (e) Special rule where one spouse denied EIC. The eligibility 
requirements set forth in this section apply to taxpayers filing a joint 
return where one spouse was denied the EIC for a taxable year prior to 
marriage and has not established eligibility as either an unmarried or 
married taxpayer for a subsequent taxable year.
    (f) Effective date. This section applies to returns claiming the EIC 
for taxable years beginning after December 31, 1997, where the EIC was 
denied for a taxable year beginning after December 31, 1996.

[T.D. 8953, 66 FR 33637, June 25, 2001]



Sec.  1.34-1  Special rule for owners of certain business entities.

    Amounts payable under sections 6420, 6421, and 6427 to a business 
entity that is treated as separate from its owner under Sec.  1.1361-
4(a)(8) (relating to certain qualified subchapter S subsidiaries) or 
Sec.  301.7701-2(c)(2)(v) of this chapter (relating to certain wholly-
owned entities) are, for purposes of section 34, treated as payable to 
the owner of that entity.

[T.D. 9356, 72 FR 45893, Aug. 16, 2007]



Sec.  1.35-1  Partially tax-exempt interest received by individuals.

    (a) The credit against tax under section 35 shall be allowed only to 
individuals and if the requirements of both paragraphs (1) and (2) of 
section 35(a) are met. Where the alternative tax on capital gains is 
imposed under section 1201(b), the taxable income for such taxable year 
is the taxable income as defined in section 63, which includes 50 
percent of the excess of net long-term capital gain over net short-term 
capital loss.
    (b) For the treatment of partially tax-exempt interest in the case 
of amounts not allocable to any beneficiary of an estate or trust, see 
section 642(a)(1), and for treatment of amounts allocable to a 
beneficiary, see sections 652 and 662. For treatment of partially tax-
exempt interest received by a partnership, see section 702(a)(7). For 
treatment of such interest received by a common trust fund, see section 
584(c)(2).

[[Page 94]]

    (c) The application of section 35 may be illustrated by the 
following example:

    Example. In his taxable year, 1955, A received $4,500 of partially 
tax-exempt interest. A's taxable income is $4,000 upon which the tax 
prior to any credits against tax is $840. His foreign tax credit under 
section 33 is $610, and his dividends received credit under section 34 
is $120. A's credit under section 35 for partially tax-exempt interest 
is $110, determined as follows:

                              Section 35(a)
 
Partially tax-exempt interest................................     $4,500
Credit computed under section 35(a); 3 percent of $4,500.....        135
                            Section 35(b)(1)
Tax imposed by chapter 1.....................................        840
Less:
  Credit allowed under section 33.................       $610
  Credit allowed under section 34.................        120
                                                         ____       $730
                                                              ----------
Limitation on credit under section 35(b)(1)..................        110
 
                            Section 35(b)(2)
 
Taxable income...............................................      4,000
Limitation on credit under section 35(b)(2); 3 percent of            120
 $4,000......................................................
 


Since of the three figures ($135, $110, and $120), the lesser is $110, 
A's credit under section 35 is limited to $110.



Sec.  1.35-2  Taxpayers not entitled to credit.

    For taxable years beginning after December 31, 1957, no credit shall 
be allowed under section 35 to a nonresident alien individual with 
respect to whom a tax is imposed for such taxable year under section 
871(a).



Sec.  1.36B-0  Table of contents.

    This section lists the captions contained in Sec. Sec.  1.36B-1 
through 1.36B-6.

              Sec.  1.36B-1 Premium tax credit definitions.

(a) In general.
(b) Affordable Care Act.
(c) Qualified health plan.
(d) Family and family size.
(1) In general.
(2) Special rule for tax years to which section 151(d)(5) applies.
(e) Household income.
(1) In general.
(2) Modified adjusted gross income.
(f) Dependent.
(g) Lawfully present.
(h) Federal poverty line.
(i) [Reserved]
(j) Advance credit payment.
(k) Exchange.
(l) Self-only coverage.
(m) Family coverage.
(n) Rating area.
(o) Applicability dates.

            Sec.  1.36B-2 Eligibility for premium tax credit.

(a) In general.
(b) Applicable taxpayer.
(1) In general.
(2) Married taxpayers must file joint return.
(i) In general.
(ii) Victims of domestic abuse and abandonment.
(iii) Domestic abuse.
(iv) Abandonment.
(v) Three-year rule.
(3) Dependents.
(4) Individuals not lawfully present or incarcerated.
(5) Individuals lawfully present.
(6) Special rule for taxpayers with household income below 100 percent 
of the Federal poverty line for the taxable year.
(i) In general.
(ii) Exceptions.
(7) Computation of premium assistance amounts for taxpayers with 
household income below 100 percent of the Federal poverty line.
(c) Minimum essential coverage.
(1) In general.
(2) Government-sponsored minimum essential coverage.
(i) In general.
(ii) Obligation to complete administrative requirements to obtain 
coverage.
(iii) Special rule for coverage for veterans and other individuals under 
chapter 17 or 18 of title 38, U.S.C.
(iv) Retroactive effect of eligibility determination.
(v) Determination of Medicaid or Children's Health Insurance Program 
(CHIP) ineligibility.
(vi) Examples.
(3) Employer-sponsored minimum essential coverage.
(i) In general.
    (A) Plans other than health reimbursement arrangements (HRAs) or 
other account-based group health plans described in paragraph 
(c)(3)(i)(B) of this section.
    (B) HRAs and other account-based group health plans integrated with 
individual health insurance coverage.
(ii) Plan year.
(iii) Eligibility for months during a plan year.
(A) Failure to enroll in plan.
(B) Waiting periods.
(C) Example.
(iv) Post employment coverage.
(v) Affordable coverage.
(A) In general.
(1) Affordability for employee.
(2) Affordability for related individual.
(3) Employee safe harbor.
(4) Wellness program incentives.

[[Page 95]]

(5) Employer contributions to health reimbursement arrangements.
(6) Employer contributions to cafeteria plans.
(7) Opt-out arrangements.
(8) Multiple offers of coverage.
(B) Affordability for part-year period.
(C) Required contribution percentage.
(D) Examples.
(vi) Minimum value.
(vii) Enrollment in eligible employer-sponsored plan.
(A) In general.
(B) Automatic enrollment.
(C) Examples.
(4) Special eligibility rules.
(i) Related individual.
(ii) Exchange unable to discontinue advance credit payments.
(A) In general.
(B) Medicaid or CHIP.
    (5) Affordable HRA or other account-based group health plan.
    (i) In general.
    (ii) Required HRA contribution.
    (iii) Monthly amounts.
    (A) Monthly lowest cost silver plan premium.
    (B) Monthly HRA amount.
    (iv) Employee safe harbor.
    (v) Amounts used for affordability determination.
    (vi) Affordability for part-year period.
    (vii) Related individual not allowed as a personal exemption 
deduction.
    (viii) Post-employment coverage.
    (ix) Examples.
(d) Applicability date.
(e) Applicability dates.

      Sec.  1.36B-3 Computing the premium assistance credit amount.

(a) In general.
(b) Definitions.
(c) Coverage month.
(1) In general.
(2) Certain individuals enrolled during a month.
(3) Premiums paid for a taxpayer.
(4) Appeals of coverage eligibility.
(5) Examples.
(d) Premium assistance amount.
(1) Premium assistance amount.
(2) Examples.
(i) In general.
(ii) Examples.
(e) Adjusted monthly premium.
(f) Applicable benchmark plan.
(1) In general.
(2) Family coverage.
(3) Silver-level plan not covering pediatric dental benefits.
(4) Family members residing in different locations.
(5) Single or multiple policies needed to cover the family.
(i) Policy covering a taxpayer's family.
(ii) Policy not covering a taxpayer's family.
(6) Plan not available for enrollment.
(7) Benchmark plan terminates or closes to enrollment during the year.
(8) Only one silver-level plan offered to the coverage family.
(9) Examples.
(g) Applicable percentage.
(1) In general.
(2) Applicable percentage table.
(3) Examples.
(h) Plan covering more than one family.
(1) In general.
(2) Example.
(i) [Reserved]
(j) Additional benefits.
(1) In general.
(2) Method of allocation.
(3) Examples.
(k) Pediatric dental coverage.
(1) In general.
(2) Method of allocation.
(3) Example.
(l) Families including individuals not lawfully present.
(1) In general.
(2) Revised household income computation.
(i) Statutory method.
(ii) Comparable method.
(m) Applicability date.
(n) Effective/applicability date.

  Sec.  1.36B-4 Reconciling the premium tax credit with advance credit 
                                payments.

(a) Reconciliation.
(1) Coordination of premium tax credit with advance credit payments.
(i) In general.
(ii) Allocation rules and responsibility for advance credit payments.
    (A) In general.
    (B) Individuals enrolled by a taxpayer and claimed by another 
taxpayer.
    (C) Responsibility for advance credit payments for an individual not 
reported on any taxpayer's return.
(iii) Advance credit payment for a month in which an issuer does not 
provide coverage.
(2) Credit computation.
(3) Limitation on additional tax.
(i) In general.
(ii) Additional tax limitation table.
(iii) Limitation on additional tax for taxpayers who claim a section 
162(l) deduction for a qualified health plan.
(A) In general.
(B) Determining the limitation amount.
(C) Requirements.
(D) Specified premiums not paid through advance credit payments.
(E) Examples.
(4) Examples.
(b) Changes in filing status.
(1) In general.
(2) Taxpayers who marry during the taxable year.
(i) In general.

[[Page 96]]

(ii) Alternative computation of additional tax liability.
(A) In general.
(B) Alternative premium assistance amounts for pre-marriage months.
(C) Premium assistance amounts for marriage months.
(3) Taxpayers not married to each other at the end of the taxable year.
(4) Taxpayers filing returns as married filing separately or head of 
household.
(i) Allocation of advance credit payments.
(ii) Allocation of premiums.
(5) Examples.
(c) Applicability dates.

            Sec.  1.36B-5 Information reporting by Exchanges.

(a) In general.
(b) Individual filing a return.
(c) Information required to be reported.
(1) Information reported annually.
(2) Information reported monthly.
(3) Special rules for information reported.
(i) Multiple families enrolled in a single qualified health plan.
(ii) Alternative to reporting applicable benchmark plan.
(iii) Partial month of coverage.
(A) In general.
(B) Certain mid-month enrollments.
(4) Exemptions.
(d) Time for reporting.
(1) Annual reporting.
(2) Monthly reporting.
(i) In general.
(ii) Initial monthly reporting in 2014.
(3) Corrections to information reported.
(e) Electronic reporting.
(f) Annual statement to be furnished to individuals.
(1) In general.
(2) Form of statements.
(3) Time and manner for furnishing statements.
(g) Electronic furnishing of statements.
(1) In general.
(2) Consent.
(i) In general.
(ii) Withdrawal of consent.
(iii) Change in hardware or software requirements.
(iv) Examples.
(3) Required disclosures.
(i) In general.
(ii) Paper statement.
(iii) Scope and duration of consent.
(iv) Post-consent request for a paper statement.
(v) Withdrawal of consent.
(vi) Notice of termination.
(vii) Updating information.
(viii) Hardware and software requirements.
(4) Format.
(5) Notice.
(i) In general.
(ii) Undeliverable electronic address.
(iii) Corrected statement.
(6) Access period.
(7) Paper statements after withdrawal of consent.

                      Sec.  1.36B-6 Minimum value.

    (a) In general.
    (1) Employees.
    (2) Related individuals
    (i) In general.
    (ii) Plans providing MV to employees.
    (b) MV standard population.
    (c) MV percentage.
    (1) In general.
    (2) Wellness program incentives.
    (i) In general.
    (ii) Example.
    (3) Employer contributions to health savings accounts.
    (4) Employer contributions to health reimbursement arrangements.
    (5) Expected spending adjustments for health savings accounts and 
health reimbursement arrangements.
    (d) Methods for determining MV.
    (e) Scope of essential health benefits and adjustment for benefits 
not included in MV Calculator.
    (f) Actuarial certification.
    (1) In general.
    (2) Membership in American Academy of Actuaries.
    (3) Actuarial analysis.
    (4) Use of MV Calculator.
    (g) Effective/applicability date.
    (1) In general.
    (2) Exceptions.

[T.D. 9590, 77 FR 30385, May 23, 2012, as amended by T.D. 9663, 79 FR 
26117, May 7, 2014; T.D. 9745, 80 FR 78974, Dec. 18, 2015; T.D. 9604, 81 
FR 91763, Dec. 19, 2016; T.D. 9822, 82 FR 34605, July 26, 2017; T.D. 
9867, 84 FR 28984, June 20, 2019; T.D. 9912, 85 FR 76978, Dec. 1, 2020; 
T.D. 9968, 87 FR 62000, Oct. 13, 2022]



Sec.  1.36B-1  Premium tax credit definitions.

    (a) In general. Section 36B allows a refundable premium tax credit 
for taxable years ending after December 31, 2013. The definitions in 
this section apply to this section and Sec. Sec.  1.36B-2 through 1.36B-
5.
    (b) Affordable Care Act. The term Affordable Care Act refers to the 
Patient Protection and Affordable Care Act, Public Law 111-148 (124 
Stat. 119 (2010)), and the Health Care and Education Reconciliation Act 
of 2010, Public Law 111-152 (124 Stat. 1029 (2010)), as amended by the 
Medicare and Medicaid Extenders Act of 2010, Public Law 111-309

[[Page 97]]

(124 Stat. 3285 (2010)), the Comprehensive 1099 Taxpayer Protection and 
Repayment of Exchange Subsidy Overpayments Act of 2011, Public Law 112-9 
(125 Stat. 36 (2011)), the Department of Defense and Full-Year 
Continuing Appropriations Act, 2011, Public Law 112-10 (125 Stat. 38 
(2011)), and the 3% Withholding Repeal and Job Creation Act, Public Law 
112-56 (125 Stat. 711 (2011)).
    (c) Qualified health plan. The term qualified health plan has the 
same meaning as in section 1301(a) of the Affordable Care Act (42 U.S.C. 
18021(a)) but does not include a catastrophic plan described in section 
1302(e) of the Affordable Care Act (42 U.S.C. 18022(e)).
    (d) Family and family size--(1) In general. A taxpayer's family 
means the individuals for whom a taxpayer properly claims a deduction 
for a personal exemption under section 151 for the taxable year. Family 
size means the number of individuals in the family. Family and family 
size may include individuals who are not subject to or are exempt from 
the penalty under section 5000A for failing to maintain minimum 
essential coverage.
    (2) Special rule for tax years to which section 151(d)(5) applies. 
For taxable years to which section 151(d)(5) applies, a taxpayer's 
family means the taxpayer, including both spouses in the case of a joint 
return, except for individuals who qualify as a dependent of another 
taxpayer under section 152, and any other individual for whom the 
taxpayer is allowed a personal exemption deduction and whom the taxpayer 
properly reports on the taxpayer's income tax return for the taxable 
year. For purposes of this paragraph (d)(2), an individual is reported 
on the taxpayer's income tax return if the individual's name and 
taxpayer identification number (TIN) are listed on the taxpayer's Form 
1040 series return. See Sec.  601.602 of this chapter.
    (e) Household income--(1) In general. Household income means the sum 
of--
    (i) A taxpayer's modified adjusted gross income (including the 
modified adjusted gross income of a child for whom an election under 
section 1(g)(7) is made for the taxable year);
    (ii) The aggregate modified adjusted gross income of all other 
individuals who--
    (A) Are included in the taxpayer's family under paragraph (d) of 
this section; and
    (B) Are required to file a return of tax imposed by section 1 for 
the taxable year.
    (2) Modified adjusted gross income. Modified adjusted gross income 
means adjusted gross income (within the meaning of section 62) increased 
by--
    (i) Amounts excluded from gross income under section 911;
    (ii) Tax-exempt interest the taxpayer receives or accrues during the 
taxable year; and
    (iii) Social security benefits (within the meaning of section 86(d)) 
not included in gross income under section 86.
    (f) Dependent. Dependent has the same meaning as in section 152.
    (g) Lawfully present. Lawfully present has the same meaning as in 45 
CFR 155.20.
    (h) Federal poverty line. The Federal poverty line means the most 
recently published poverty guidelines (updated periodically in the 
Federal Register by the Secretary of Health and Human Services under the 
authority of 42 U.S.C. 9902(2)) as of the first day of the regular 
enrollment period for coverage by a qualified health plan offered 
through an Exchange for a calendar year. Thus, the Federal poverty line 
for computing the premium tax credit for a taxable year is the Federal 
poverty line in effect on the first day of the initial or annual open 
enrollment period preceding that taxable year. See 45 CFR 155.410. If a 
taxpayer's primary residence changes during a taxable year from one 
state to a state with different Federal poverty guidelines or married 
taxpayers reside in separate states with different Federal poverty 
guidelines (for example, Alaska or Hawaii and another state), the 
Federal poverty line that applies for purposes of section 36B and the 
associated regulations is the higher Federal poverty guideline 
(resulting in a lower percentage of the Federal poverty line for the 
taxpayers' household income and family size).
    (i) [Reserved]

[[Page 98]]

    (j) Advance credit payment. Advance credit payment means an advance 
payment of the premium tax credit as provided in section 1412 of the 
Affordable Care Act (42 U.S.C. 18082).
    (k) Exchange. Exchange has the same meaning as in 45 CFR 155.20.
    (l) Self-only coverage. Self-only coverage means health insurance 
that covers one individual and provides coverage for the essential 
health benefits as defined in section 1302(b)(1) of the Affordable Care 
Act (42 U.S.C. 18022).
    (m) Family coverage. Family coverage means health insurance that 
covers more than one individual and provides coverage for the essential 
health benefits as defined in section 1302(b)(1) of the Affordable Care 
Act (42 U.S.C. 18022).
    (n) Rating area. The term rating area has the same meaning as used 
in section 2701(a)(2) of the Public Health Service Act (42 U.S.C. 
300gg(a)(2)) and 45 CFR 147.102(b).
    (o) Applicability dates. (1) Except for paragraphs (d)(2), (l), and 
(m) of this section, this section applies to taxable years ending after 
December 31, 2013.
    (2) Paragraph (d)(2) of this section applies to taxable years ending 
on or after December 31, 2020.
    (3) Paragraphs (l) and (m) of this section apply to taxable years 
beginning after December 31, 2018. Paragraphs (l) and (m) of Sec.  
1.36B-1 as contained in 26 CFR part 1 edition revised as of April 1, 
2016, apply to taxable years ending after December 31, 2013, and 
beginning before January 1, 2019.

[T.D. 9590, 77 FR 30385, May 23, 2012, as amended by T.D. 9745, 80 FR 
78974, Dec. 18, 2015; T.D. 9804, 81 FR 91763, Dec. 19, 2016; T.D. 9912, 
85 FR 76978, Dec. 1, 2020]



Sec.  1.36B-2  Eligibility for premium tax credit.

    (a) In general. An applicable taxpayer (within the meaning of 
paragraph (b) of this section) is allowed a premium assistance amount 
only for any month that one or more members of the applicable taxpayer's 
family (the applicable taxpayer or the applicable taxpayer's spouse or 
dependent)--
    (1) Is enrolled in one or more qualified health plans through an 
Exchange; and
    (2) Is not eligible for minimum essential coverage (within the 
meaning of paragraph (c) of this section) other than coverage described 
in section 5000A(f)(1)(C) (relating to coverage in the individual 
market).
    (b) Applicable taxpayer--(1) In general. Except as otherwise 
provided in this paragraph (b), an applicable taxpayer is a taxpayer 
whose household income is at least 100 percent but not more than 400 
percent of the Federal poverty line for the taxpayer's family size for 
the taxable year.
    (2) Married taxpayers must file joint return--(i) In general. Except 
as provided in paragraph (b)(2)(ii) of this section, a taxpayer who is 
married (within the meaning of section 7703) at the close of the taxable 
year is an applicable taxpayer only if the taxpayer and the taxpayer's 
spouse file a joint return for the taxable year.
    (ii) Victims of domestic abuse and abandonment. Except as provided 
in paragraph (b)(2)(v) of this section, a married taxpayer satisfies the 
joint filing requirement of paragraph (b)(2)(i) of this section if the 
taxpayer files a tax return using a filing status of married filing 
separately and the taxpayer--
    (A) Is living apart from the taxpayer's spouse at the time the 
taxpayer files the tax return;
    (B) Is unable to file a joint return because the taxpayer is a 
victim of domestic abuse, as described in paragraph (b)(2)(iii) of this 
section, or spousal abandonment, as described in paragraph (b)(2)(iv) of 
this section; and
    (C) Certifies on the return, in accordance with the relevant 
instructions, that the taxpayer meets the criteria of this paragraph 
(b)(2)(ii).
    (iii) Domestic abuse. For purposes of paragraph (b)(2)(ii) of this 
section, domestic abuse includes physical, psychological, sexual, or 
emotional abuse, including efforts to control, isolate, humiliate, and 
intimidate, or to undermine the victim's ability to reason 
independently. All the facts and circumstances are considered in 
determining whether an individual is abused, including the effects of 
alcohol or drug abuse by the victim's spouse. Depending on the facts and 
circumstances, abuse of the victim's child or another family member 
living in the

[[Page 99]]

household may constitute abuse of the victim.
    (iv) Abandonment. For purposes of paragraph (b)(2)(ii) of this 
section, a taxpayer is a victim of spousal abandonment for a taxable 
year if, taking into account all facts and circumstances, the taxpayer 
is unable to locate his or her spouse after reasonable diligence.
    (v) Three-year rule. Paragraph (b)(2)(ii) of this section does not 
apply if the taxpayer met the requirements of paragraph (b)(2)(ii) of 
this section for each of the three preceding taxable years.
    (3) Dependents. An individual is not an applicable taxpayer if 
another taxpayer may claim a deduction under section 151 for the 
individual for a taxable year beginning in the calendar year in which 
the individual's taxable year begins.
    (4) Individuals not lawfully present or incarcerated. An individual 
who is not lawfully present in the United States or is incarcerated 
(other than incarceration pending disposition of charges) is not 
eligible to enroll in a qualified health plan through an Exchange. 
However, the individual may be an applicable taxpayer if a family member 
is eligible to enroll in a qualified health plan. See sections 
1312(f)(1)(B) and 1312(f)(3) of the Affordable Care Act (42 U.S.C. 
18032(f)(1)(B) and (f)(3)) and Sec.  1.36B-3(b)(2).
    (5) Individuals lawfully present. If a taxpayer's household income 
is less than 100 percent of the Federal poverty line for the taxpayer's 
family size and the taxpayer or a member of the taxpayer's family is an 
alien lawfully present in the United States, the taxpayer is treated as 
an applicable taxpayer if--
    (i) The lawfully present taxpayer or family member is not eligible 
for the Medicaid program; and
    (ii) The taxpayer would be an applicable taxpayer if the taxpayer's 
household income for the taxable year was between 100 and 400 percent of 
the Federal poverty line for the taxpayer's family size.
    (6) Special rule for taxpayers with household income below 100 
percent of the Federal poverty line for the taxable year--(i) In 
general. A taxpayer (other than a taxpayer described in paragraph (b)(5) 
of this section) whose household income for a taxable year is less than 
100 percent of the Federal poverty line for the taxpayer's family size 
is treated as an applicable taxpayer for the taxable year if--
    (A) The taxpayer or a family member enrolls in a qualified health 
plan through an Exchange for one or more months during the taxable year;
    (B) An Exchange estimates at the time of enrollment that the 
taxpayer's household income will be at least 100 percent but not more 
than 400 percent of the Federal poverty line for the taxable year;
    (C) Advance credit payments are authorized and paid for one or more 
months during the taxable year; and
    (D) The taxpayer would be an applicable taxpayer if the taxpayer's 
household income for the taxable year was at least 100 but not more than 
400 percent of the Federal poverty line for the taxpayer's family size.
    (ii) Exceptions. This paragraph (b)(6) does not apply for an 
individual who, with intentional or reckless disregard for the facts, 
provides incorrect information to an Exchange for the year of coverage. 
A reckless disregard of the facts occurs if the taxpayer makes little or 
no effort to determine whether the information provided to the Exchange 
is accurate under circumstances that demonstrate a substantial deviation 
from the standard of conduct a reasonable person would observe. A 
disregard of the facts is intentional if the taxpayer knows the 
information provided to the Exchange is inaccurate.
    (iii) Advance credit payments are authorized and paid for one or 
more months during the taxable year; and
    (iv) The taxpayer would be an applicable taxpayer if the taxpayer's 
household income for the taxable year was between 100 and 400 percent of 
the Federal poverty line for the taxpayer's family size.
    (7) Computation of premium assistance amounts for taxpayers with 
household income below 100 percent of the Federal poverty line. If a 
taxpayer is treated as an applicable taxpayer under paragraph (b)(5) or 
(b)(6) of this section, the taxpayer's actual household income for

[[Page 100]]

the taxable year is used to compute the premium assistance amounts under 
Sec.  1.36B-3(d).
    (c) Minimum essential coverage--(1) In general. Minimum essential 
coverage is defined in section 5000A(f) and regulations issued under 
that section. As described in section 5000A(f), government-sponsored 
programs, eligible employer-sponsored plans, grandfathered health plans, 
and certain other health benefits coverage are minimum essential 
coverage.
    (2) Government-sponsored minimum essential coverage--(i) In general. 
An individual is eligible for government-sponsored minimum essential 
coverage if the individual meets the criteria for coverage under a 
government-sponsored program described in section 5000A(f)(1)(A) as of 
the first day of the first full month the individual may receive 
benefits under the program, subject to the limitation in paragraph 
(c)(2)(ii) of this section. The Commissioner may define eligibility for 
specific government-sponsored programs further in additional published 
guidance, see Sec.  601.601(d)(2) of this chapter.
    (ii) Obligation to complete administrative requirements to obtain 
coverage. An individual who meets the criteria for eligibility for 
government-sponsored minimum essential coverage must complete the 
requirements necessary to receive benefits. An individual who fails by 
the last day of the third full calendar month following the event that 
establishes eligibility under paragraph (c)(2)(i) of this section to 
complete the requirements to obtain government-sponsored minimum 
essential coverage (other than a veteran's health care program) is 
treated as eligible for government-sponsored minimum essential coverage 
as of the first day of the fourth calendar month following the event 
that establishes eligibility.
    (iii) Special rule for coverage for veterans and other individuals 
under chapter 17 or 18 of title 38, U.S.C. An individual is eligible for 
minimum essential coverage under a health care program under chapter 17 
or 18 of title 38, U.S.C. only if the individual is enrolled in a health 
care program under chapter 17 or 18 of title 38, U.S.C. identified as 
minimum essential coverage in regulations issued under section 5000A.
    (iv) Retroactive effect of eligibility determination. If an 
individual receiving advance credit payments is determined to be 
eligible for government-sponsored minimum essential coverage that is 
effective retroactively (such as Medicaid), the individual is treated as 
eligible for minimum essential coverage under that program no earlier 
than the first day of the first calendar month beginning after the 
approval.
    (v) Determination of Medicaid or Children's Health Insurance Program 
(CHIP) ineligibility. An individual is treated as not eligible for 
Medicaid, CHIP, or a similar program for a period of coverage under a 
qualified health plan if, when the individual enrolls in the qualified 
health plan, an Exchange determines or considers (within the meaning of 
45 CFR 155.302(b)) the individual to be not eligible for Medicaid or 
CHIP. This paragraph (c)(2)(v) does not apply for an individual who, 
with intentional or reckless disregard for the facts, provides incorrect 
information to an Exchange for the year of coverage. A reckless 
disregard of the facts occurs if the taxpayer makes little or no effort 
to determine whether the information provided to the Exchange is 
accurate under circumstances that demonstrate a substantial deviation 
from the standard of conduct a reasonable person would observe. A 
disregard of the facts is intentional if the taxpayer knows that 
information provided to the Exchange is inaccurate.
    (vi) Examples. The following examples illustrate the provisions of 
this paragraph (c)(2):

    Example 1. Delay in coverage effectiveness. On April 10, 2015, 
Taxpayer D applies for coverage under a government-sponsored health care 
program. D's application is approved on July 12, 2015, but her coverage 
is not effective until September 1, 2015. Under paragraph (c)(2)(i) of 
this section, D is eligible for government-sponsored minimum essential 
coverage on September 1, 2015.
    Example 2. Time of eligibility. Taxpayer E turns 65 on June 3, 2015, 
and becomes eligible for Medicare. Under section 5000A(f)(1)(A)(i), 
Medicare is minimum essential coverage. However, E must enroll in 
Medicare to receive benefits. E enrolls in Medicare in September, which 
is the last month of E's initial enrollment period. Thus, E may receive

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Medicare benefits on December 1, 2015. Because E completed the 
requirements necessary to receive Medicare benefits by the last day of 
the third full calendar month after the event that establishes E's 
eligibility (E turning 65), under paragraph (c)(2)(i) and (c)(2)(ii) of 
this section E is eligible for government-sponsored minimum essential 
coverage on December 1, 2015, the first day of the first full month that 
E may receive benefits under the program.
    Example 3. Time of eligibility, individual fails to complete 
necessary requirements. The facts are the same as in Example 2, except 
that E fails to enroll in the Medicare coverage during E's initial 
enrollment period. E is treated as eligible for government-sponsored 
minimum essential coverage under paragraph (c)(2)(ii) of this section as 
of October 1, 2015, the first day of the fourth month following the 
event that establishes E's eligibility (E turning 65).
    Example 4. Retroactive effect of eligibility. In November 2014, 
Taxpayer F enrolls in a qualified health plan for 2015 and receives 
advance credit payments. F loses her part-time employment and on April 
10, 2015 applies for coverage under the Medicaid program. F's 
application is approved on May 15, 2015, and her Medicaid coverage is 
effective as of April 1, 2015. Under paragraph (c)(2)(iv) of this 
section, F is eligible for government-sponsored minimum essential 
coverage on June 1, 2015, the first day of the first calendar month 
after approval.
    Example 5. Determination of Medicaid ineligibility. In November 
2014, Taxpayer G applies through the Exchange to enroll in health 
coverage for 2015. The Exchange determines that G is not eligible for 
Medicaid and estimates that G's household income will be 140 percent of 
the Federal poverty line for G's family size for purposes of determining 
advance credit payments. G enrolls in a qualified health plan and begins 
receiving advance credit payments. G experiences a reduction in 
household income during the year and his household income for 2015 is 
130 percent of the Federal poverty line (within the Medicaid income 
threshold). However, under paragraph (c)(2)(v) of this section, G is 
treated as not eligible for Medicaid for 2015.
    Example 6. Mid-year Medicaid eligibility redetermination. The facts 
are the same as in Example 5, except that G returns to the Exchange in 
July 2015 and the Exchange determines that G is eligible for Medicaid. 
Medicaid approves G for coverage and the Exchange discontinues G's 
advance credit payments effective August 1. Under paragraphs (c)(2)(iv) 
and (c)(2)(v) of this section, G is treated as not eligible for Medicaid 
for the months when G is covered by a qualified health plan. G is 
eligible for government-sponsored minimum essential coverage for the 
months after G is approved for Medicaid and can receive benefits, August 
through December 2015.

    (3) Employer-sponsored minimum essential coverage--(i)(A) Plans 
other than health reimbursement arrangements (HRAs) or other account-
based group health plans described in paragraph (c)(3)(i)(B) of this 
section. For purposes of section 36B, an employee who may enroll in an 
eligible employer-sponsored plan (as defined in section 5000A(f)(2) and 
the regulations under that section) that is minimum essential coverage, 
and an individual who may enroll in the plan because of a relationship 
to the employee (a related individual), are eligible for minimum 
essential coverage under the plan for any month only if the plan is 
affordable and provides minimum value. Except for the Nonappropriated 
Fund Health Benefits Program of the Department of Defense, established 
under section 349 of the National Defense Authorization Act for Fiscal 
Year 1995 (Public Law 103-337; 10 U.S.C. 1587 note), government-
sponsored minimum essential coverage is not an eligible employer-
sponsored plan. The Nonappropriated Fund Health Benefits Program of the 
Department of Defense is considered eligible employer-sponsored 
coverage, but not government-sponsored coverage, for purposes of 
determining if an individual is eligible for minimum essential coverage 
under this section.
    (B) HRAs and other account-based group health plans integrated with 
individual health insurance coverage. An employee who is offered an HRA 
or other account-based group health plan that would be integrated with 
individual health insurance coverage (or Medicare Part A and B or 
Medicare Part C), within the meaning of Sec. Sec.  54.9802-4 and 
54.9815-2711(d)(4) of this chapter, if the employee enrolls in 
individual health insurance coverage (or Medicare Part A and B or 
Medicare Part C), and an individual who is offered the HRA or other 
account-based group health plan because of a relationship to the 
employee (a related HRA individual), are eligible for minimum essential 
coverage under an eligible employer-sponsored plan for any month for 
which the HRA or other account-based group health plan is offered if the 
HRA or other account-

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based group health plan is affordable for the month under paragraph 
(c)(5) of this section or if the employee does not opt out of and waive 
future reimbursements from the HRA or other account-based group health 
plan. An HRA or other account-based group health plan described in this 
paragraph (c)(3)(i)(B) that is affordable for a month under paragraph 
(c)(5) of this section is treated as providing minimum value for the 
month. For purposes of paragraphs (c)(3) and (5) of this section, the 
definitions under Sec.  54.9815-2711(d)(6) of this chapter apply.
    (ii) Plan year. For purposes of this paragraph (c)(3), a plan year 
is an eligible employer-sponsored plan's regular 12-month coverage 
period (or the remainder of a 12-month coverage period for a new 
employee or an individual who enrolls during a special enrollment 
period). The plan year for an HRA or other account-based group health 
plan described in paragraph (c)(3)(i)(B) of this section is the plan's 
12-month coverage period (or the remainder of the 12-month coverage 
period for a newly eligible individual or an individual who enrolls 
during a special enrollment period).
    (iii) Eligibility for months during a plan year--(A) Failure to 
enroll in plan. An employee or related individual may be eligible for 
minimum essential coverage under an eligible employer-sponsored plan for 
a month during a plan year if the employee or related individual could 
have enrolled in the plan for that month during an open or special 
enrollment period for the plan year. If an enrollment period relates to 
coverage for not only the upcoming plan year (or the current plan year 
in the case of an enrollment period other than an open enrollment 
period), but also coverage in one or more succeeding plan years, this 
paragraph (c)(3)(iii)(A) applies only to eligibility for the coverage in 
the upcoming plan year (or the current plan year in the case of an 
enrollment period other than an open enrollment period).
    (B) Waiting periods. An employee or related individual is not 
eligible for minimum essential coverage under an eligible employer-
sponsored plan during a required waiting period before the coverage 
becomes effective.
    (C) Example. The following example illustrates the provisions of 
this paragraph (c)(3)(iii):

    Example. (i) Taxpayer B is an employee of Employer X. X offers its 
employees a health insurance plan that has a plan year (within the 
meaning of paragraph (c)(3)(ii) of this section) from October 1 through 
September 30. Employees may enroll during an open season from August 1 
to September 15. B does not enroll in X's plan for the plan year October 
1, 2014, to September 30, 2015. In November 2014, B enrolls in a 
qualified health plan through an Exchange for calendar year 2015.
    (ii) B could have enrolled in X's plan during the August 1 to 
September 15 enrollment period. Therefore, unless X's plan is not 
affordable for B or does not provide minimum value, B is eligible for 
minimum essential coverage under X's plan for the months that B is 
enrolled in the qualified health plan during X's plan year (January 
through September 2015).

    (iv) Post-employment coverage. A former employee (including a 
retiree), or an individual related (within the meaning of paragraph 
(c)(3)(i) of this section) to a former employee, who may enroll in 
eligible employer-sponsored coverage or in continuation coverage 
required under Federal law or a State law that provides comparable 
continuation coverage is eligible for minimum essential coverage under 
this coverage only for months that the former employee or related 
individual is enrolled in the coverage.
    (v) Affordable coverage--(A) In general--(1) Affordability for 
employee. Except as provided in paragraph (c)(3)(v)(A)(3) of this 
section, an eligible employer-sponsored plan is affordable for an 
employee if the portion of the annual premium the employee must pay, 
whether by salary reduction or otherwise (required contribution), for 
self-only coverage does not exceed the required contribution percentage 
(as defined in paragraph (c)(3)(v)(C) of this section) of the applicable 
taxpayer's household income for the taxable year. See paragraph (c)(5) 
of this section for rules for when an HRA or other account-based group 
health plan described in paragraph (c)(3)(i)(B) of this section is 
affordable for an employee for a month.
    (2) Affordability for related individual. Except as provided in 
paragraph

[[Page 103]]

(c)(3)(v)(A)(3) of this section, an eligible employer-sponsored plan is 
affordable for a related individual if the employee's required 
contribution for family coverage under the plan does not exceed the 
required contribution percentage, as defined in paragraph (c)(3)(v)(C) 
of this section, of the applicable taxpayer's household income for the 
taxable year. For purposes of this paragraph (c)(3)(v)(A)(2), an 
employee's required contribution for family coverage is the portion of 
the annual premium the employee must pay for coverage of the employee 
and all other individuals included in the employee's family, as defined 
in Sec.  1.36B-1(d), who are offered coverage under the eligible 
employer-sponsored plan.
    (3) Employee safe harbor. An eligible employer-sponsored plan is not 
affordable for an employee or a related individual for a plan year if, 
when the employee or a related individual enrolls in a qualified health 
plan for a period coinciding with the plan year (in whole or in part), 
an Exchange determines that the eligible employer-sponsored plan is not 
affordable for that plan year. This paragraph (c)(3)(v)(A)(3) does not 
apply to a determination made as part of the redetermination process 
described in 45 CFR 155.335 unless the individual receiving an Exchange 
redetermination notification affirmatively responds and provides current 
information about affordability. This paragraph (c)(3)(v)(A)(3) does not 
apply for an individual who, with intentional or reckless disregard for 
the facts, provides incorrect information to an Exchange concerning the 
portion of the annual premium for coverage for the employee or related 
individual under the plan. A reckless disregard of the facts occurs if 
the taxpayer makes little or no effort to determine whether the 
information provided to the Exchange is accurate under circumstances 
that demonstrate a substantial deviation from the standard of conduct a 
reasonable person would observe. A disregard of the facts is intentional 
if the taxpayer knows that the information provided to the Exchange is 
inaccurate. See paragraph (c)(5) of this section for an employee safe 
harbor that applies when an Exchange determines that an HRA or other 
account-based group health plan described in paragraph (c)(3)(i)(B) of 
this section is not affordable for an employee or a related HRA 
individual for the period of enrollment in a qualified health plan.
    (4) Wellness program incentives. Nondiscriminatory wellness program 
incentives offered by an eligible employer-sponsored plan that affect 
premiums are treated as earned in determining an employee's required 
contribution for purposes of affordability of an eligible employer-
sponsored plan to the extent the incentives relate exclusively to 
tobacco use. Wellness program incentives that do not relate to tobacco 
use or that include a component unrelated to tobacco use are treated as 
not earned for this purpose. For purposes of this section, the term 
wellness program incentive has the same meaning as the term reward in 
Sec.  54.9802-1(f)(1)(i) of this chapter.
    (5) Employer contributions to HRAs integrated with eligible 
employer-sponsored plans. Amounts newly made available for the current 
plan year under an HRA that an employee may use to pay premiums, or may 
use to pay cost-sharing or benefits not covered by the primary plan in 
addition to premiums, reduce the employee's required contribution if the 
HRA would be integrated, within the meaning of Sec.  54.9815-2711(d)(2) 
of this chapter, with an eligible employer-sponsored plan for an 
employee enrolled in the plan. The eligible employer-sponsored plan and 
the HRA must be offered by the same employer. Employer contributions to 
an HRA described in this paragraph (c)(3)(v)(A)(5) reduce an employee's 
required contribution only to the extent the amount of the annual 
contribution is required under the terms of the plan or otherwise 
determinable within a reasonable time before the employee must decide 
whether to enroll in the eligible employer-sponsored plan.
    (6) Employer contributions to cafeteria plans. Amounts made 
available for the current plan year under a cafeteria plan, within the 
meaning of section 125, reduce an employee's or a related individual's 
required contribution if--
    (i) The employee may not opt to receive the amount as a taxable 
benefit;

[[Page 104]]

    (ii) The employee may use the amount to pay for minimum essential 
coverage; and
    (iii) The employee may use the amount exclusively to pay for medical 
care, within the meaning of section 213.
    (7) Opt-out arrangements. [Reserved]
    (8) Multiple offers of coverage. An individual who has offers of 
coverage under eligible employer-sponsored plans from multiple 
employers, either as an employee or a related individual, has an offer 
of affordable coverage if at least one of the offers of coverage is 
affordable under paragraph (c)(3)(v)(A)(1) or (2) of this section.
    (B) Affordability for part-year period. Affordability under 
paragraph (c)(3)(v)(A) of this section is determined separately for each 
employment period that is less than a full calendar year or for the 
portions of an employer's plan year that fall in different taxable years 
of an applicable taxpayer (a part-year period). Coverage under an 
eligible employer-sponsored plan is affordable for a part-year period if 
the annualized required contribution for self-only coverage, in the case 
of an employee, or family coverage, in the case of a related individual, 
under the plan for the part-year period does not exceed the required 
contribution percentage of the applicable taxpayer's household income 
for the taxable year. The employee's annualized required contribution is 
the employee's required contribution for the part-year period times a 
fraction, the numerator of which is 12 and the denominator of which is 
the number of months in the part-year period during the applicable 
taxpayer's taxable year. Only full calendar months are included in the 
computation under this paragraph (c)(3)(v)(B).
    (C) Required contribution percentage. The required contribution 
percentage is 9.5 percent. For plan years beginning in a calendar year 
after 2014, the percentage will be adjusted by the ratio of premium 
growth to income growth for the preceding calendar year and may be 
further adjusted to reflect changes to the data used to compute the 
ratio of premium growth to income growth for the 2014 calendar year or 
the data sources used to compute the ratio of premium growth to income 
growth. Premium growth and income growth will be determined under 
published guidance, see Sec.  601.601(d)(2) of this chapter. In 
addition, the percentage may be adjusted for plan years beginning in a 
calendar year after 2018 to reflect rates of premium growth relative to 
growth in the consumer price index.
    (D) Examples. The following examples illustrate the provisions of 
this paragraph (c)(3)(v). Unless stated otherwise, in each example the 
taxpayer is single and has no dependents, the employer's plan is an 
eligible employer-sponsored plan and provides minimum value, the 
employee is not eligible for other minimum essential coverage, and the 
taxpayer, related individual, and employer-sponsored plan have a 
calendar taxable year:
    (1) Example 1: Basic determination of affordability. For all of 
2023, taxpayer C works for an employer, X, that offers its employees and 
their spouses a health insurance plan under which, to enroll in self-
only coverage, C must contribute an amount for 2023 that does not exceed 
the required contribution percentage of C's 2023 household income. 
Because C's required contribution for self-only coverage does not exceed 
the required contribution percentage of C's household income, under 
paragraph (c)(3)(v)(A)(1) of this section, X's plan is affordable for C, 
and C is eligible for minimum essential coverage for all months in 2023.
    (2) Example 2: Basic determination of affordability for a related 
individual. (i) The facts are the same as in paragraph (c)(3)(v)(D)(1) 
of this section (Example 1), except that C is married to J, they file a 
joint return, and to enroll C and J, X's plan requires C to contribute 
an amount for coverage for C and J for 2023 that exceeds the required 
contribution percentage of C's and J's household income. J does not work 
for an employer that offers employer-sponsored coverage.
    (ii) J is a member of C's family as defined in Sec.  1.36B-1(d). 
Because C's required contribution for coverage of C and J exceeds the 
required contribution percentage of C's and J's household income, under 
paragraph (c)(3)(v)(A)(2) of this section, X's plan is unaffordable for 
J. Accordingly, J is

[[Page 105]]

not eligible for minimum essential coverage for 2023. However, under 
paragraph (c)(3)(v)(A)(1) of this section, X's plan is affordable for C, 
and C is eligible for minimum essential coverage for all months in 2023.
    (3) Example 3: Multiple offers of coverage. The facts are the same 
as in paragraph (c)(3)(v)(D)(2) of this section (Example 2), except that 
J works all year for an employer that offers employer-sponsored coverage 
to employees. J's required contribution for the cost of self-only 
coverage from J's employer does not exceed the required contribution 
percentage of C's and J's household income. Although the coverage 
offered by C's employer for C and J is unaffordable for J, the coverage 
offered by J's employer is affordable for J. Consequently, under 
paragraphs (c)(3)(v)(A)(1) and (8) of this section, J is eligible for 
minimum essential coverage for all months in 2023.
    (4) Example 4: Cost of covering individuals not part of taxpayer's 
family. (i) D and E are married, file a joint return, and have two 
children, F and G, under age 26. F is a dependent of D and E, but G is 
not. D works all year for an employer that offers employer-sponsored 
coverage to employees, their spouses, and their children under age 26. 
E, F, and G do not work for employers offering coverage. D's required 
contribution for self-only coverage under D's employer's coverage does 
not exceed the required contribution percentage of D's and E's household 
income. D's required contribution for coverage of D, E, F, and G exceeds 
the required contribution percentage of D's and E's household income, 
but D's required contribution for coverage of D, E, and F does not 
exceed the required contribution percentage of the household income.
    (ii) E and F are members of D's family as defined in Sec.  1.36B-
1(d). G is not a member of D's family under Sec.  1.36B-1(d), because G 
is not D's dependent. Under paragraph (c)(3)(v)(A)(1) of this section, 
D's employer's coverage is affordable for D because D's required 
contribution for self-only coverage does not exceed the required 
contribution percentage of D's and E's household income. D's employer's 
coverage also is affordable for E and F, because, under paragraph 
(c)(3)(v)(A)(2) of this section, D's required contribution for coverage 
of D, E, and F does not exceed the required contribution percentage of 
D's and E's household income. Although D's cost to cover D, E, F, and G 
exceeds the required contribution percentage of D's and E's household 
income, under paragraph (c)(3)(v)(A)(2) of this section, the cost to 
cover G is not considered in determining whether D's employer's coverage 
is affordable for E and F, regardless of whether G actually enrolls in 
the plan, because G is not in D's family. D, E, and F are eligible for 
minimum essential coverage for all months in 2023. Under paragraph 
(c)(4)(i) of this section, G is considered eligible for the coverage 
offered by D's employer only if G enrolls in the coverage.
    (5) Example 5: More than one family member with an employer offering 
coverage. (i) K and L are married, file a joint return, and have one 
dependent child, M. K works all year for an employer that offers 
coverage to employees, spouses, and children under age 26. L works all 
year for an employer that offers coverage to employees only. K's 
required contribution for self-only coverage under K's employer's 
coverage does not exceed the required contribution percentage of K's and 
L's household income. Likewise, L's required contribution for self-only 
coverage under L's employer's coverage does not exceed the required 
contribution percentage of K's and L's household income. However, K's 
required contribution for coverage of K, L, and M exceeds the required 
contribution percentage of K's and L's household income.
    (ii) L and M are members of K's family as defined in Sec.  1.36B-
1(d). Under paragraph (c)(3)(v)(A)(1) of this section, K's employer's 
coverage is affordable for K because K's required contribution for self-
only coverage does not exceed the required contribution percentage of 
K's and L's household income. Similarly, L's employer's coverage is 
affordable for L, because L's required contribution for self-only 
coverage does not exceed the required contribution percentage of K's and 
L's household income. Thus, K and L are eligible for minimum essential 
coverage for all

[[Page 106]]

months in 2023. However, under paragraph (c)(3)(v)(A)(2) of this 
section, K's employer's coverage is unaffordable for M, because K's 
required contribution for coverage of K, L, and M exceeds the required 
contribution percentage of K's and L's household income. Accordingly, M 
is not eligible for minimum essential coverage for 2023.
    (6) Example 6: Multiple offers of coverage for a related individual. 
(i) The facts are the same as in paragraph (c)(3)(v)(D)(5) of this 
section (Example 5), except that L works all year for an employer that 
offers coverage to employees, spouses, and children under age 26. L's 
required contribution for coverage of K, L, and M does not exceed the 
required contribution percentage of K's and L's household income.
    (ii) Although M is not eligible for affordable employer coverage 
under K's employer's coverage, paragraph (c)(3)(v)(A)(8) of this section 
dictates that L's employer coverage must be evaluated to determine 
whether L's employer coverage is affordable for M. Under paragraph 
(c)(3)(v)(A)(2) of this section, L's employer's coverage is affordable 
for M, because L's required contribution for K, L, and M does not exceed 
the required contribution percentage of K's and L's household income. 
Accordingly, M is eligible for minimum essential coverage for all months 
in 2023.
    (7) Example 7: Determination of unaffordability at enrollment. (i) 
Taxpayer D is an employee of Employer X. In November 2013 the Exchange 
for D's rating area projects that D's 2014 household income will be 
$37,000. It also verifies that D's required contribution for self-only 
coverage under X's health insurance plan will be $3,700 (10 percent of 
household income). Consequently, the Exchange determines that X's plan 
is unaffordable. D enrolls in a qualified health plan and not in X's 
plan. In December 2014, X pays D a $2,500 bonus. Thus, D's actual 2014 
household income is $39,500 and D's required contribution for coverage 
under X's plan is 9.4 percent of D's household income.
    (ii) Based on D's actual 2014 household income, D's required 
contribution does not exceed 9.5 percent of household income and X's 
health plan is affordable for D. However, when D enrolled in a qualified 
health plan for 2014, the Exchange determined that X's plan was not 
affordable for D for 2014. Consequently, under paragraph (c)(3)(v)(A)(3) 
of this section, X's plan is not affordable for D and D is not eligible 
for minimum essential coverage under X's plan for 2014.
    (8) Example 8: Determination of unaffordability for plan year. The 
facts are the same as in paragraph (c)(3)(v)(D)(7) of this section 
(Example 7), except that X's employee health insurance plan year is 
September 1 to August 31. The Exchange for D's rating area determines in 
August 2014 that X's plan is unaffordable for D based on D's projected 
household income for 2014. D enrolls in a qualified health plan as of 
September 1, 2014. Under paragraph (c)(3)(v)(A)(3) of this section, X's 
plan is not affordable for D and D is not eligible for minimum essential 
coverage under X's plan for the coverage months September to December 
2014 and January through August 2015.
    (9) Example 9: No affordability information affirmatively provided 
for annual redetermination. (i) The facts are the same as in paragraph 
(c)(3)(v)(D)(7) of this section (Example 7), except the Exchange 
redetermines D's eligibility for advance credit payments for 2015. D 
does not affirmatively provide the Exchange with current information 
regarding affordability and the Exchange determines that D's coverage is 
not affordable for 2015 and approves advance credit payments based on 
information from the previous enrollment period. In 2015, D's required 
contribution for coverage under X's plan is 9.4 percent of D's household 
income.
    (ii) Because D does not respond to the Exchange notification and the 
Exchange makes an affordability determination based on information from 
an earlier year, the employee safe harbor in paragraph (c)(3)(v)(A)(3) 
of this section does not apply. D's required contribution for 2015 does 
not exceed 9.5 percent of D's household income. Thus, X's plan is 
affordable for D for 2015 and D is eligible for minimum essential 
coverage for all months in 2015.
    (10) Example 10: Determination of unaffordability for part of plan 
year (part-year period). (i) Taxpayer E is an

[[Page 107]]

employee of Employer X beginning in May 2015. X's employee health 
insurance plan year is September 1 to August 31. E's required 
contribution for self-only coverage for May through August is $150 per 
month ($1,800 for the full plan year). The Exchange for E's rating area 
projects E's household income for purposes of eligibility for advance 
credit payments as $18,000. E's actual household income for the 2015 
taxable year is $20,000.
    (ii) Under paragraph (c)(3)(v)(B) of this section, whether coverage 
under X's plan is affordable for E is determined for the remainder of 
X's plan year (May through August). E's required contribution for a full 
plan year ($1,800) exceeds 9.5 percent of E's household income (1,800/
18,000 = 10 percent). Therefore, the Exchange determines that X's 
coverage is unaffordable for May through August. Although E's actual 
household income for 2015 is $20,000 (and E's required contribution of 
$1,800 does not exceed 9.5 percent of E's household income), under 
paragraph (c)(3)(v)(A)(3) of this section, X's plan is unaffordable for 
E for the part of the plan year May through August 2015. Consequently, E 
is not eligible for minimum essential coverage under X's plan for the 
period May through August 2015.
    (11) Example 11: Affordability determined for part of a taxable year 
(part-year period). (i) Taxpayer F is an employee of Employer X. X's 
employee health insurance plan year is September 1 to August 31. F's 
required contribution for self-only coverage for the period September 
2014 through August 2015 is $150 per month or $1,800 for the plan year. 
F does not enroll in X's plan during X's open season but enrolls in a 
qualified health plan for September through December 2014. F does not 
request advance credit payments and does not ask the Exchange for his 
rating area to determine whether X's coverage is affordable for F. F's 
household income in 2014 is $18,000.
    (ii) Because F is a calendar year taxpayer and Employer X's plan is 
not a calendar year plan, F must determine the affordability of X's 
coverage for the part-year period in 2014 (September-December) under 
paragraph (c)(3)(v)(B) of this section. F determines the affordability 
of X's plan for the September through December 2014 period by comparing 
the annual premiums ($1,800) to F's 2014 household income. F's required 
contribution of $1,800 is 10 percent of F's 2014 household income. 
Because F's required contribution exceeds 9.5 percent of F's 2014 
household income, X's plan is not affordable for F for the part-year 
period September through December 2014 and F is not eligible for minimum 
essential coverage under X's plan for that period.
    (iii) F enrolls in Exchange coverage for 2015 and does not ask the 
Exchange to approve advance credit payments or determine whether X's 
coverage is affordable. F's 2015 household income is $20,000.
    (iv) F must determine if X's plan is affordable for the part-year 
period January 2015 through August 2015. F's annual required 
contribution ($1,800) is 9 percent of F's 2015 household income. Because 
F's required contribution does not exceed 9.5 percent of F's 2015 
household income, X's plan is affordable for F for the part-year period 
January through August 2015 and F is eligible for minimum essential 
coverage for that period.
    (12) Example 12: Coverage unaffordable at year end. Taxpayer G is 
employed by Employer X. In November 2014, the Exchange for G's rating 
area determines that G is eligible for affordable employer-sponsored 
coverage for 2015. G nonetheless enrolls in a qualified health plan for 
2015 but does not receive advance credit payments. G's 2015 household 
income is less than expected and G's required contribution for employer-
sponsored coverage for 2015 exceeds 9.5 percent of G's actual 2015 
household income. Under paragraph (c)(3)(v)(A)(1) of this section, G is 
not eligible for minimum essential coverage under X's plan for 2015.
    (13) Wellness program incentives: (i) Employer X offers an eligible 
employer-sponsored plan with a nondiscriminatory wellness program that 
reduces premiums by $300 for employees who do not use tobacco products 
or who complete a smoking cessation course. Premiums are reduced by $200 
if an employee completes cholesterol screening within the first six 
months of the plan year. Employee B does not use

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tobacco and the cost of his premiums is $3,700. Employee C uses tobacco 
and the cost of her premiums is $4,000.
    (ii) Under paragraph (c)(3)(v)(A)(4) of this section, only the 
incentives related to tobacco use are counted toward the premium amount 
used to determine the affordability of X's plan. C is treated as having 
earned the $300 incentive for attending a smoking cessation course 
regardless of whether C actually attends the course. Thus, the required 
contribution for determining affordability for both Employee B and 
Employee C is $3,700. The $200 incentive for completing cholesterol 
screening is treated as not earned and does not reduce their required 
contribution.
    (vi) Minimum value. See Sec.  1.36B-6 for rules for determining 
whether an eligible employer-sponsored plan provides minimum value. An 
HRA or other account-based group health plan described in paragraph 
(c)(3)(i)(B) of this section that is affordable for a month under 
paragraph (c)(5) of this section is treated as providing minimum value 
for the month.
    (vii) Enrollment in eligible employer-sponsored plan--(A) In 
general. Except as provided in paragraph (c)(3)(vii)(B) of this section, 
the requirements of affordability and minimum value do not apply for 
months that an individual is enrolled in an eligible employer-sponsored 
plan.
    (B) Automatic enrollment. An employee or related individual is 
treated as not enrolled in an eligible employer-sponsored plan for a 
month in a plan year or other period for which the employee or related 
individual is automatically enrolled if the employee or related 
individual terminates the coverage before the later of the first day of 
the second full calendar month of that plan year or other period or the 
last day of any permissible opt-out period provided by the employer-
sponsored plan or in regulations to be issued by the Department of 
Labor, for that plan year or other period.
    (C) Examples. The following examples illustrate the provisions of 
this paragraph (c)(3)(vii):

    Example 1. Taxpayer H is employed by Employer X in 2014. H's 
required contribution for self-only employer coverage exceeds 9.5 
percent of H's 2014 household income. H enrolls in X's calendar year 
plan for 2014. Under paragraph (c)(3)(vii)(A) of this section, H is 
eligible for minimum essential coverage for 2014 because H is enrolled 
in an eligible employer-sponsored plan for 2014.
    Example 2. The facts are the same as in Example 1, except that H 
terminates plan coverage on June 30, 2014. Under paragraph 
(c)(3)(vii)(A) of this section, H is eligible for minimum essential 
coverage under X's plan for January through June 2014 but is not 
eligible for minimum essential coverage under X's plan for July through 
December 2014.
    Example 3. The facts are the same as in Example 1, except that 
Employer X automatically enrolls H in the plan for calendar year 2015. H 
terminates the coverage on January 20, 2015. Under paragraph 
(c)(3)(vii)(B) of this section, H is not eligible for minimum essential 
coverage under X's plan for January 2015.

    (4) Special eligibility rules--(i) Related individual. An individual 
who may enroll in minimum essential coverage because of a relationship 
to another person eligible for the coverage, but is not included in the 
family, as defined in Sec.  1.36B-1(d), of the other eligible person, is 
treated as eligible for such minimum essential coverage only for months 
that the related individual is enrolled in the coverage.
    (ii) Exchange unable to discontinue advance credit payments--(A) In 
general. If an individual who is enrolled in a qualified health plan for 
which advance credit payments are made informs the Exchange that the 
individual is or will soon be eligible for other minimum essential 
coverage and that advance credit payments should be discontinued, but 
the Exchange does not discontinue advance credit payments for the first 
calendar month beginning after the month the individual informs the 
Exchange, the individual is treated as eligible for the other minimum 
essential coverage no earlier than the first day of the second calendar 
month beginning after the first month the individual may enroll in the 
other minimum essential coverage.
    (B) Medicaid or CHIP. If a determination is made that an individual 
who is enrolled in a qualified health plan for which advance credit 
payments are made is eligible for Medicaid or CHIP but the advance 
credit payments are not discontinued for the first calendar month 
beginning after the eligibility

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determination, the individual is treated as eligible for the Medicaid or 
CHIP no earlier than the first day of the second calendar month 
beginning after the eligibility determination.
    (5) Affordable HRA or other account-based group health plan--(i) In 
general. Except as otherwise provided in this paragraph (c)(5), an HRA 
or other account-based group health plan described in paragraph 
(c)(3)(i)(B) of this section is affordable for a month if the employee's 
required HRA contribution (as defined in paragraph (c)(5)(ii) of this 
section) for the month does not exceed 1/12 of the product of the 
employee's household income for the taxable year and the required 
contribution percentage (as defined in paragraph (c)(3)(v)(C) of this 
section).
    (ii) Required HRA contribution. An employee's required HRA 
contribution is the excess of--
    (A) The monthly premium for the lowest cost silver plan for self-
only coverage of the employee offered in the Exchange for the rating 
area in which the employee resides, over
    (B) The monthly self-only HRA or other account-based group health 
plan amount (or the monthly maximum amount available to the employee 
under the HRA or other account-based group health plan if the HRA or 
other account-based group health plan provides for reimbursements up to 
a single dollar amount regardless of whether an employee has self-only 
or other-than-self-only coverage).
    (iii) Monthly amounts--(A) Monthly lowest cost silver plan premium. 
For purposes of paragraph (c)(5)(ii)(A) of this section, the premium for 
the lowest cost silver plan is determined without regard to any wellness 
program incentive that affects premiums unless the wellness program 
incentive relates exclusively to tobacco use, in which case the 
incentive is treated as earned. If the premium differs for tobacco users 
and non-tobacco users, the premium for the lowest cost silver plan is 
the premium that applies to non-tobacco users. For the purpose of this 
paragraph (c)(5)(iii)(A), the term wellness program incentive has the 
same meaning as the term reward in 26 CFR 54.9802-1(f)(1)(i). A silver-
level qualified health plan that is used for purposes of determining a 
taxpayer's lowest cost silver plan for self-only coverage under 
paragraph (c)(5)(ii)(A) of this section does not cease to be the 
taxpayer's lowest cost silver plan for self-only coverage solely because 
the plan terminates or closes to enrollment during the taxable year.
    (B) Monthly HRA amount. For purposes of paragraph (c)(5)(ii)(B) of 
this section, the monthly self-only HRA or other account-based group 
health plan amount is the self-only HRA or other account-based group 
health plan amount newly made available under the HRA for the plan year, 
divided by the number of months in the plan year the HRA or other 
account-based group health plan is available to the employee. The 
monthly maximum amount available to the employee under the HRA or other 
account-based group health plan is the maximum amount newly made 
available for the plan year to the employee under the plan, divided by 
the number of months in the plan year the HRA or other account-based 
group health plan is available to the employee.
    (iv) Employee safe harbor. An HRA or other account-based group 
health plan described in paragraph (c)(3)(i)(B) of this section is not 
affordable for a month for an employee or a related HRA individual if, 
when the employee or related HRA individual enrolls in a qualified 
health plan for a period coinciding with the period the HRA or other 
account-based group health plan is available to the employee or related 
HRA individual (in whole or in part), an Exchange determines that the 
HRA or other account-based group health plan is not affordable for the 
period of enrollment in the qualified health plan. This paragraph 
(c)(5)(iv) does not apply to a determination made as part of the 
redetermination process described in 45 CFR 155.335 unless the 
individual receiving an Exchange redetermination notification 
affirmatively responds and provides current information about 
affordability. This paragraph (c)(5)(iv) does not apply for an 
individual who, with intentional or reckless disregard for the facts, 
provides incorrect information to an Exchange concerning the relevant 
HRA or other account-based group health plan

[[Page 110]]

amount offered by the employee's employer. A reckless disregard of the 
facts occurs if the taxpayer makes little or no effort to determine 
whether the information provided to the Exchange is accurate under 
circumstances that demonstrate a substantial deviation from the standard 
of conduct a reasonable person would observe. A disregard of the facts 
is intentional if the taxpayer knows that the information provided to 
the Exchange is inaccurate.
    (v) Amounts used for affordability determination. Only amounts that 
are newly made available for the plan year of the HRA or other account-
based group health plan described in paragraph (c)(3)(i)(B) of this 
section and determinable within a reasonable time before the beginning 
of the plan year of the HRA or other account-based health plan are 
considered in determining whether an HRA or other account-based group 
health plan described in paragraph (c)(3)(i)(B) of this section is 
affordable. Amounts made available for a prior plan year that carry over 
to the current plan year are not taken into account for purposes of this 
paragraph (c)(5). Similarly, amounts made available to account for 
amounts remaining in a different HRA or other account-based group health 
plan the employer previously provided to the employee and under which 
the employee is no longer covered are not taken into account for 
purposes of this paragraph (c)(5).
    (vi) Affordability for part-year period. Affordability under this 
paragraph (c)(5) is determined separately for each employment period 
that is less than a full calendar year or for the portions of the plan 
year of an employer's HRA or other account-based group health plan that 
fall in different taxable years of an applicable taxpayer. An HRA or 
other account-based group health plan described in paragraph 
(c)(3)(i)(B) of this section is affordable for a part-year period if the 
employee's annualized required HRA contribution for the part-year period 
does not exceed the required contribution percentage of the applicable 
taxpayer's household income for the taxable year. The employee's 
annualized required HRA contribution is the employee's required HRA 
contribution for the part-year period times a fraction, the numerator of 
which is 12 and the denominator of which is the number of months in the 
part-year period during the applicable taxpayer's taxable year. Only 
full calendar months are included in the computation under this 
paragraph (c)(5)(vi).
    (vii) Related individual not allowed as a personal exemption 
deduction. A related HRA individual is treated as ineligible for minimum 
essential coverage under an HRA or other account-based group health plan 
described in paragraph (c)(3)(i)(B) of this section for months that the 
employee opted out of and waived future reimbursements from the HRA or 
other account-based group health plan and the employee is not allowed a 
personal exemption deduction under section 151 for the related HRA 
individual.
    (viii) Post-employment coverage. An individual who is offered an HRA 
or other account-based group health plan described in paragraph 
(c)(3)(i)(B) of this section, for months after an employee terminates 
employment with the employer offering the HRA or other account-based 
group health plan, is eligible for minimum essential coverage under the 
HRA or other account-based group health plan for months after 
termination of employment only if the employee does not forfeit or opt 
out of and waive future reimbursements from the HRA or other account-
based group health plan for months after termination of employment.
    (ix) Examples. The following examples illustrate the provisions of 
this paragraph (c)(5). The required contribution percentage is defined 
in paragraph (c)(3)(v)(C) of this section and is updated annually. 
Because the required contribution percentage for 2020 has not yet been 
determined, the examples assume a required contribution percentage for 
2020 of 9.78 percent.
    (A) Example 1: Determination of affordability--(1) Facts. In 2020 
Taxpayer A is single, has no dependents, and has household income of 
$28,000. A is an employee of Employer X for all of 2020. X offers its 
employees an HRA described in paragraph (c)(3)(i)(B) of this section 
that reimburses $2,400 of medical care expenses for single employees

[[Page 111]]

with no children (the self-only HRA amount) and $4,000 for employees 
with a spouse or children for the medical expenses of the employees and 
their family members. A enrolls in a qualified health plan through the 
Exchange in the rating area in which A resides and remains enrolled for 
all of 2020. The monthly premium for the lowest cost silver plan for 
self-only coverage of A that is offered in the Exchange for the rating 
area in which A resides is $500.
    (2) Conclusion. A's required HRA contribution, as defined in 
paragraph (c)(5)(ii) of this section, is $300, the excess of $500 (the 
monthly premium for the lowest cost silver plan for self-only coverage 
of A) over $200 (1/12 of the self-only HRA amount provided by Employer X 
to its employees). In addition, 1/12 of the product of 9.78 percent and 
A's household income is $228 ($28,000 x .0978 = $2,738; $2,738/12 = 
$228). Because A's required HRA contribution of $300 exceeds $228 (1/12 
of the product of 9.78 percent and A's household income), the HRA is 
unaffordable for A for each month of 2020 under paragraph (c)(5) of this 
section. If A opts out of and waives future reimbursements from the HRA, 
A is not eligible for minimum essential coverage under the HRA for each 
month of 2020 under paragraph (c)(3)(i)(B) of this section.
    (B) Example 2: Determination of affordability for a related HRA 
individual--(1) Facts. In 2020 Taxpayer B is married and has one child 
who is a dependent of B for 2020. B has household income of $28,000. B 
is an employee of Employer X for all of 2020. X offers its employees an 
HRA described in paragraph (c)(3)(i)(B) of this section that reimburses 
$3,600 of medical care expenses for single employees with no children 
(the self-only HRA amount) and $5,000 for employees with a spouse or 
children for the medical expenses of the employees and their family 
members. B, B's spouse, and B's child enroll in a qualified health plan 
through the Exchange in the rating area in which B resides and they 
remain enrolled for all of 2020. No advance credit payments are made for 
their coverage. The monthly premium for the lowest cost silver plan for 
self-only coverage of B that is offered in the Exchange for the rating 
area in which B resides is $500.
    (2) Conclusion. B's required HRA contribution, as defined in 
paragraph (c)(5)(ii) of this section, is $200, the excess of $500 (the 
monthly premium for the lowest cost silver plan for self-only coverage 
for B) over $300 (1/12 of the self-only HRA amount provided by Employer 
X to its employees). In addition, 1/12 of the product of 9.78 percent 
and B's household income for 2020 is $228 ($28,000 x .0978 = $2,738; 
$2,738/12 = $228). Because B's required HRA contribution of $200 does 
not exceed $228 (1/12 of the product of 9.78 percent and B's household 
income for 2020), the HRA is affordable for B under paragraph (c)(5) of 
this section, and B is eligible for minimum essential coverage under an 
eligible employer-sponsored plan for each month of 2020 under paragraph 
(c)(3)(i)(B) of this section. In addition, B's spouse and child are also 
eligible for minimum essential coverage under an eligible employer-
sponsored plan for each month of 2020 under paragraph (c)(3)(i)(B) of 
this section.
    (C) Example 3: Exchange determines that HRA is unaffordable--(1) 
Facts. The facts are the same as in paragraph (c)(5)(ix)(B) of this 
section (Example 2), except that B, when enrolling in Exchange coverage 
for B's family, received a determination by the Exchange that the HRA 
was unaffordable, because B believed B's household income would be lower 
than it turned out to be. Consequently, advance credit payments were 
made for their 2020 coverage.
    (2) Conclusion. Under paragraph (c)(5)(iv) of this section, the HRA 
is considered unaffordable for B, B's spouse, and B's child for each 
month of 2020 provided that B did not, with intentional or reckless 
disregard for the facts, provide incorrect information to the Exchange 
concerning the HRA.
    (D) Example 4: Affordability determined for part of a taxable year 
(part-year period)--(1) Facts. Taxpayer C is an employee of Employer X. 
C's household income for 2020 is $28,000. X offers its employees an HRA 
described in paragraph (c)(3)(i)(B) of this section that reimburses 
medical care expenses of $3,600 for single employees without children 
(the self-only HRA amount) and $5,000 to employees with a spouse or 
children for the medical expenses of

[[Page 112]]

the employees and their family members. X's HRA plan year is September 1 
to August 31 and C is first eligible to participate in the HRA for the 
period beginning September 1, 2020. C enrolls in a qualified health plan 
through the Exchange in the rating area in which C resides for all of 
2020. The monthly premium for the lowest cost silver plan for self-only 
coverage of C that is offered in the Exchange for the rating area in 
which C resides for 2020 is $500.
    (2) Conclusion. Under paragraph (c)(3)(vi) of this section, the 
affordability of the HRA is determined separately for the period 
September 1 through December 31, 2020, and for the period January 1 
through August 31, 2021. C's required HRA contribution, as defined in 
paragraph (c)(5)(ii) of this section, for the period September 1 through 
December 31, 2020, is $200, the excess of $500 (the monthly premium for 
the lowest cost silver plan for self-only coverage for C) over $300 (1/
12 of the self-only HRA amount provided by X to its employees). In 
addition, 1/12 of the product of 9.78 percent and C's household income 
is $228 ($28,000 x .0978 = $2,738; $2,738/12 = $228). Because C's 
required HRA contribution of $200 does not exceed $228, the HRA is 
affordable for C for each month in the period September 1 through 
December 31, 2020, under paragraph (c)(5) of this section. Affordability 
for the period January 1 through August 31, 2021, is determined using 
C's 2021 household income and required HRA contribution.
    (E) Example 5: Carryover amounts ignored in determining 
affordability--(1) Facts. Taxpayer D is an employee of Employer X for 
all of 2020 and 2021. D is single. For each of 2020 and 2021, X offers 
its employees an HRA described in paragraph (c)(3)(i)(B) of this section 
that provides reimbursement for medical care expenses of $2,400 to 
single employees with no children (the self-only HRA amount) and $4,000 
to employees with a spouse or children for the medical expenses of the 
employees and their family members. Under the terms of the HRA, amounts 
that an employee does not use in a calendar year may be carried over and 
used in the next calendar year. In 2020, D used only $1,500 of her 
$2,400 maximum reimbursement and the unused $900 is carried over and may 
be used by D in 2021.
    (2) Conclusion. Under paragraph (c)(5)(v) of this section, only the 
$2,400 self-only HRA amount offered to D for 2021 is considered in 
determining whether D's HRA is affordable for D. The $900 carryover 
amount is not considered in determining the affordability of the HRA.
    (d) Applicability date. Paragraphs (b)(2) and (c)(3)(v)(C) of this 
section apply to taxable years beginning after December 31, 2013.
    (e) Applicability dates. (1) Except as provided in paragraphs (e)(2) 
through (5) of this section, this section applies to taxable years 
ending after December 31, 2013.
    (2) Paragraph (b)(6)(ii), the last three sentences of paragraph 
(c)(2)(v), paragraph (c)(3)(i), paragraph (c)(3)(iii)(A), the last three 
sentences of paragraph (c)(3)(v)(A)(3), and paragraph (c)(4) of this 
section apply to taxable years beginning after December 31, 2016. 
Paragraphs (b)(6), (c)(3)(i), (c)(3)(iii)(A), and (c)(4) of Sec.  1.36B-
2 as contained in 26 CFR part I edition revised as of April 1, 2016, 
apply to taxable years ending after December 31, 2013, and beginning 
before January 1, 2017.
    (3) Paragraphs (c)(3)(i)(B) and (c)(5) of this section, and the last 
sentences of paragraphs (c)(3)(ii), (c)(3)(v)(A)(1) through (3), and 
(c)(3)(vi) of this section apply to taxable years beginning on or after 
January 1, 2020.
    (4) Paragraph (c)(4)(i) of this section applies to taxable years 
ending on or after December 31, 2020.
    (5) The first two sentences of paragraph (c)(3)(v)(A)(2), paragraph 
(c)(3)(v)(A)(8), the second sentence of paragraph (c)(3)(v)(B), 
paragraphs (c)(3)(v)(D)(1) through (6), and the first sentences of 
paragraphs (c)(3)(v)(D)(8) and (9) of this section apply to taxable 
years beginning after December 31, 2022.

[T.D. 9590, 77 FR 30385, May 23, 2012, as amended by T.D. 9611, 78 FR 
7265, Feb. 1, 2013; T.D. 9683, 79 FR 43626, July 28, 2014; 80 FR 78974, 
Dec. 18, 2015; T.D. 9804, 81 FR 91764, Dec. 19, 2016; T.D. 9822, 82 FR 
34606, July 26, 2017; T.D. 9867, 84 FR 28984, June 20, 2019; T.D. 9912, 
85 FR 76978, Dec. 1, 2020; T.D. 9968, 87 FR 62002, Oct. 13, 2022]

[[Page 113]]



Sec.  1.36B-3  Computing the premium assistance credit amount.

    (a) In general. A taxpayer's premium assistance credit amount for a 
taxable year is the sum of the premium assistance amounts determined 
under paragraph (d) of this section for all coverage months for 
individuals in the taxpayer's family.
    (b) Definitions. For purposes of this section--
    (1) The cost of a qualified health plan is the premium the plan 
charges; and
    (2) The term coverage family means, in each month, the members of a 
taxpayer's family for whom the month is a coverage month.
    (c) Coverage month--(1) In general. A month is a coverage month for 
an individual if--
    (i) As of the first day of the month, the individual is enrolled in 
a qualified health plan through an Exchange;
    (ii) The taxpayer pays the taxpayer's share of the premium for the 
individual's coverage under the plan for the month by the unextended due 
date for filing the taxpayer's income tax return for that taxable year, 
or the full premium for the month is paid by advance credit payments; 
and
    (iii) The individual is not eligible for the full calendar month for 
minimum essential coverage (within the meaning of Sec.  1.36B-2(c)) 
other than coverage described in section 5000A(f)(1)(C) (relating to 
coverage in the individual market).
    (2) Certain individuals enrolled during a month. If an individual 
enrolls in a qualified health plan and the enrollment is effective on 
the date of the individual's birth, adoption, or placement for adoption 
or in foster care, or on the effective date of a court order, the 
individual is treated as enrolled as of the first day of that month for 
purposes of this paragraph (c).
    (3) Premiums paid for a taxpayer. Premiums another person pays for 
coverage of the taxpayer, taxpayer's spouse, or dependent are treated as 
paid by the taxpayer.
    (4) Appeals of coverage eligibility. A taxpayer who is eligible for 
advance credit payments pursuant to an eligibility appeal decision 
implemented under 45 CFR 155.545(c)(1)(ii) for coverage of a member of 
the taxpayer's coverage family who, based on the appeal decision, 
retroactively enrolls in a qualified health plan is considered to have 
met the requirement in paragraph (c)(1)(ii) of this section for a month 
if the taxpayer pays the taxpayer's share of the premiums for coverage 
under the plan for the month on or before the 120th day following the 
date of the appeals decision.
    (5) Examples. The following examples illustrate the provisions of 
this paragraph (c):

    Example 1. (i) Taxpayer M is single with no dependents. In December 
2013, M enrolls in a qualified health plan for 2014 and the Exchange 
approves advance credit payments. M pays M's share of the premiums. On 
May 15, 2014, M enlists in the U.S. Army and is eligible immediately for 
government-sponsored minimum essential coverage.
    (ii) Under paragraph (c)(1) of this section, January through May 
2014 are coverage months for M. June through December 2014 are not 
coverage months because M is eligible for minimum essential coverage for 
those months. Thus, under paragraph (a) of this section, M's premium 
assistance credit amount for 2014 is the sum of the premium assistance 
amounts for the months January through May.
    Example 2. (i) Taxpayer N has one dependent, S. S is eligible for 
government-sponsored minimum essential coverage. N is not eligible for 
minimum essential coverage. N enrolls in a qualified health plan for 
2014 and the Exchange approves advance credit payments. On August 1, 
2014, S loses eligibility for minimum essential coverage. N terminates 
enrollment in the qualified health plan that covers only N and enrolls 
in a qualified health plan that covers N and S for August through 
December 2014. N pays all premiums not covered by advance credit 
payments.
    (ii) Under paragraph (c)(1) of this section, January through 
December of 2014 are coverage months for N and August through December 
are coverage months for N and S. N's premium assistance credit amount 
for 2014 is the sum of the premium assistance amounts for these coverage 
months.
    Example 3. (i) O and P are the divorced parents of T. Under the 
divorce agreement between O and P, T resides with P and P claims T as a 
dependent. However, O must pay premiums for health insurance for T. P 
enrolls T in a qualified health plan for 2014. O pays the portion of T's 
qualified health plan premiums not covered by advance credit payments.
    (ii) Because P claims T as a dependent, P (and not O) may claim a 
premium tax credit for coverage for T. See Sec.  1.36B-2(a). Under 
paragraph (c)(2) of this section, the premiums that O pays for coverage 
for T are

[[Page 114]]

treated as paid by P. Thus, the months when T is covered by a qualified 
health plan and not eligible for other minimum essential coverage are 
coverage months under paragraph (c)(1) of this section in computing P's 
premium tax credit under paragraph (a) of this section.
    Example 4. Q, an American Indian, enrolls in a qualified health plan 
for 2014. Q's tribe pays the portion of Q's qualified health plan 
premiums not covered by advance credit payments. Under paragraph (c)(2) 
of this section, the premiums that Q's tribe pays for Q are treated as 
paid by Q. Thus, the months when Q is covered by a qualified health plan 
and not eligible for other minimum essential coverage are coverage 
months under paragraph (c)(1) of this section in computing Q's premium 
tax credit under paragraph (a) of this section.

    (d) Premium assistance amount--(1) Premium assistance amount. The 
premium assistance amount for a coverage month is the lesser of--
    (i) The premiums for the month, reduced by any amounts that were 
refunded in the same taxable year as the premium liability is incurred, 
for one or more qualified health plans in which a taxpayer or a member 
of the taxpayer's family enrolls (enrollment premiums); or
    (ii) The excess of the adjusted monthly premium for the applicable 
benchmark plan (benchmark plan premium) over \1/12\ of the product of a 
taxpayer's household income and the applicable percentage for the 
taxable year (the taxpayer's contribution amount).
    (2) Examples. The following examples illustrate the rules of 
paragraph (d)(1) of this section.

    Example 1. Taxpayer Q is single and has no dependents. Q enrolls in 
a qualified health plan with a monthly premium of $400. Q's monthly 
benchmark plan premium is $500, and his monthly contribution amount is 
$80. Q's premium assistance amount for a coverage month is $400 (the 
lesser of $400, Q's monthly enrollment premium, and $420, the difference 
between Q's monthly benchmark plan premium and Q's contribution amount).
    Example 2. (i) Taxpayer R is single and has no dependents. R enrolls 
in a qualified health plan with a monthly premium of $450. The 
difference between R's benchmark plan premium and contribution amount 
for the month is $420.
    (ii) The issuer of R's qualified health plan is notified that R died 
on September 20. The issuer terminates coverage as of that date and 
refunds the remaining portion of the September enrollment premiums 
($150) for R's coverage.
    (iii) R's premium assistance amount for each coverage month from 
January through August is $420 (the lesser of $450 and $420). Under 
paragraph (d)(1) of this section, R's premium assistance amount for 
September is the lesser of the enrollment premiums for the month, 
reduced by any amounts that were refunded ($300 ($450-$150)) or the 
difference between the benchmark plan premium and the contribution 
amount for the month ($420). R's premium assistance amount for September 
is $300, the lesser of $420 and $300.
    Example 3. The facts are the same as in Example 2 of this paragraph 
(d)(2), except that the qualified health plan issuer does not refund any 
enrollment premiums for September. Under paragraph (d)(1) of this 
section, R's premium assistance amount for September is $420, the lesser 
of $450 and $420.

    (e) Adjusted monthly premium. The adjusted monthly premium is the 
premium an issuer would charge for the applicable benchmark plan to 
cover all members of the taxpayer's coverage family, adjusted only for 
the age of each member of the coverage family as allowed under section 
2701 of the Public Health Service Act (42 U.S.C. 300gg). The adjusted 
monthly premium is determined without regard to any premium discount or 
rebate under the wellness discount demonstration project under section 
2705(d) of the Public Health Service Act (42 U.S.C. 300gg-4(d)) and may 
not include any adjustments for tobacco use. The adjusted monthly 
premium for a coverage month is determined as of the first day of the 
month.
    (f) Applicable benchmark plan--(1) In general. Except as otherwise 
provided in this paragraph (f), the applicable benchmark plan for each 
coverage month is the second-lowest-cost silver plan (as described in 
section 1302(d)(1)(B) of the Affordable Care Act (42 U.S.C. 
18022(d)(1)(B))) offered to the taxpayer's coverage family through the 
Exchange for the rating area where the taxpayer resides for--
    (i) Self-only coverage for a taxpayer--
    (A) Who computes tax under section 1(c) (unmarried individuals other 
than surviving spouses and heads of household) and is not allowed a 
deduction under section 151 for a dependent for the taxable year;

[[Page 115]]

    (B) Who purchases only self-only coverage for one individual; or
    (C) Whose coverage family includes only one individual; and
    (ii) Family coverage for all other taxpayers.
    (2) Family coverage. The applicable benchmark plan for family 
coverage is the second lowest-cost silver plan that would cover the 
members of the taxpayer's coverage family (such as a plan covering two 
adults if the members of a taxpayer's coverage family are two adults).
    (3) Silver-level plan not covering pediatric dental benefits. If one 
or more silver-level qualified health plans offered through an Exchange 
do not cover pediatric dental benefits, the premium for the applicable 
benchmark plan is determined based on the second lowest-cost option 
among--
    (i) The silver-level qualified health plans that are offered by the 
Exchange to the members of the coverage family and that provide 
pediatric dental benefits; and
    (ii) The silver-level qualified health plans that are offered by the 
Exchange to the members of the coverage family that do not provide 
pediatric dental benefits in conjunction with the second lowest-cost 
portion of the premium for a stand-alone dental plan (within the meaning 
of section 1311(d)(2)(B)(ii) of the Affordable Care Act (42 U.S.C. 
18031(d)(2)(B)(ii)) offered by the Exchange to the members of the 
coverage family that is properly allocable to pediatric dental benefits 
determined under guidance issued by the Secretary of Health and Human 
Services.
    (4) Family members residing in different locations. If members of a 
taxpayer's coverage family reside in different locations, the taxpayer's 
benchmark plan premium is the sum of the premiums for the applicable 
benchmark plans for each group of coverage family members residing in 
different locations, based on the plans offered to the group through the 
Exchange where the group resides. If all members of a taxpayer's 
coverage family reside in a single location that is different from where 
the taxpayer resides, the taxpayer's benchmark plan premium is the 
premium for the applicable benchmark plan for the coverage family, based 
on the plans offered through the Exchange to the taxpayer's coverage 
family for the rating area where the coverage family resides.
    (5) Single or multiple policies needed to cover the family--(i) 
Policy covering a taxpayer's family. If a silver-level plan or a stand-
alone dental plan offers coverage to all members of a taxpayer's 
coverage family who reside in the same location under a single policy, 
the premium (or allocable portion thereof, in the case of a stand-alone 
dental plan) taken into account for the plan for purposes of determining 
the applicable benchmark plan under paragraphs (f)(1), (f)(2), and 
(f)(3) of this section is the premium for this single policy.
    (ii) Policy not covering a taxpayer's family. If a silver-level 
qualified health plan or a stand-alone dental plan would require 
multiple policies to cover all members of a taxpayer's coverage family 
who reside in the same location (for example, because of the 
relationships within the family), the premium (or allocable portion 
thereof, in the case of a standalone dental plan) taken into account for 
the plan for purposes of determining the applicable benchmark plan under 
paragraphs (f)(1), (f)(2), and (f)(3) of this section is the sum of the 
premiums (or allocable portion thereof, in the case of a stand-alone 
dental plan) for self-only policies under the plan for each member of 
the coverage family who resides in the same location.
    (6) Plan not available for enrollment. A silver-level qualified 
health plan or a stand-alone dental plan that is not open to enrollment 
by a taxpayer or family member at the time the taxpayer or family member 
enrolls in a qualified health plan is disregarded in determining the 
applicable benchmark plan.
    (7) Benchmark plan terminates or closes to enrollment during the 
year. A silver-level qualified health plan or a stand-alone dental plan 
that is used for purposes of determining the applicable benchmark plan 
under this paragraph (f) for a taxpayer does not cease to be the 
applicable benchmark plan for a taxable year solely because the plan or 
a lower cost plan terminates or closes to enrollment during the taxable 
year.
    (8) Only one silver-level plan offered to the coverage family. If 
there is only one

[[Page 116]]

silver-level qualified health plan or one stand-alone dental plan 
offered through an Exchange that would cover all members of a taxpayer's 
coverage family who reside in the same location (whether under one 
policy or multiple policies), that plan is used for purposes of 
determining the taxpayer's applicable benchmark plan.
    (9) Examples. The following examples illustrate the rules of this 
paragraph (f). Unless otherwise stated, in each example the plans are 
open to enrollment to a taxpayer or family member at the time of 
enrollment and are offered through the Exchange for the rating area 
where the taxpayer resides:
    Example 1. Single taxpayer enrolls in Exchange coverage. Taxpayer A 
is single, has no dependents, and enrolls in a qualified health plan. 
The Exchange in the rating area in which A resides offers only silver-
level qualified health plans that provide pediatric dental benefits. 
Under paragraphs (f)(1) and (f)(2) of this section, A's applicable 
benchmark plan is the second lowest cost silver plan providing self-only 
coverage for A.
    Example 2. Single taxpayer enrolls with dependent child through an 
Exchange where all qualified health plans provide pediatric dental 
benefits. Taxpayer B is single and claims her 12-year old daughter, C, 
as a dependent. B purchases family coverage for herself and C. The 
Exchange in the rating area in which B and C reside offers qualified 
health plans that provide pediatric dental benefits but does not offer 
qualified health plans without pediatric dental benefits. Under 
paragraphs (f)(1) and (f)(2) of this section, B's applicable benchmark 
plan is the second lowest-cost silver plan providing family coverage to 
B and C.
    Example 3. Single taxpayer enrolls with dependent child through an 
Exchange where one or more qualified health plans do not provide 
pediatric dental benefits. (i) Taxpayer D is single and claims his 10-
year old son, E, as a dependent. The Exchange in the rating area in 
which D and E reside offers three silver-level qualified health plans, 
one of which provides pediatric dental benefits (S1) and two of which do 
not (S2 and S3), in which D and E may enroll. The Exchange also offers 
two stand-alone dental plans (DP1 and DP2) available to D and E. The 
monthly premiums allocable to essential health benefits for the silver-
level plans are as follows:
S1--$650
S2--$620
S3--$590
    (ii) The monthly premiums, and the portion of the premium allocable 
to pediatric dental benefits, for the two dental plans are as follows:
DP1--$50 ($20 allocable to pediatric dental benefits)
DP2--$40 ($15 allocable to pediatric dental benefits).
    (iii) Under paragraph (f)(3) of this section, D's applicable 
benchmark plan is the second lowest cost option among the following 
offered by the rating area in which D resides: Silver-level qualified 
health plans providing pediatric dental benefits ($650 for S1) and the 
silver-level qualified health plans not providing pediatric dental 
benefits, in conjunction with the second lowest-cost portion of the 
premium for a stand-alone dental plan properly allocable to pediatric 
dental benefits ($590 for S3 in conjunction with $20 for DP1 = $610 and 
$620 for S2 in conjunction with $20 for DP1 = $640). Under paragraph (e) 
of this section, the adjusted monthly premium for D's applicable 
benchmark plan is $640.
    Example 4. Single taxpayer enrolls with dependent adult through an 
Exchange where one or more qualified health plans do not provide 
pediatric dental benefits. (i) The facts are the same as in Example 3, 
except Taxpayer D's coverage family consists of D and D's 22-year old 
son, F, who is a dependent of D. The monthly premiums allocable to 
essential health benefits for the silver-level plans are as follows:
S1--$630
S2--$590
S3--$580
    (ii) Because no one in D's coverage family is eligible for pediatric 
dental benefits, $0 of the premium for a stand-alone dental plan is 
allocable to pediatric dental benefits in determining A's applicable 
benchmark plan. Consequently, under paragraphs (f)(1), (f)(2), and 
(f)(3) of this section, D's applicable benchmark plan is the second 
lowest-cost option among the following options offered by the rating 
area in which D resides: Silver-level qualified health plans providing 
pediatric dental benefits ($630 for S1) and the silver-level qualified 
health plans not providing pediatric dental benefits, in conjunction 
with the second lowest-cost portion of the premium for a stand-alone 
dental plan properly allocable to pediatric dental benefits ($580 for S3 
in conjunction with $0 for DP1 = $580 and $590 for S2 in conjunction 
with $0 for DP1 = $590). Under paragraph (e) of this section, the 
adjusted monthly premium for D's applicable benchmark plan is $590.
    Example 5. Single taxpayer enrolls with dependent and nondependent. 
Taxpayer G is single and resides with his 25-year old daughter, H, and 
with his 14-year old son, I. G may claim I, but not H, as a dependent. 
G, H, and I enroll in coverage through the Exchange in the rating area 
in which they all reside. The

[[Page 117]]

Exchange offers only silver-level plans providing pediatric dental 
benefits. Under paragraphs (f)(1) and (f)(2) of this section, G's 
applicable benchmark plan is the second lowest-cost silver plan covering 
G and I. However, H may qualify for a premium tax credit if H is 
otherwise eligible. See paragraph (h) of this section.
    Example 6. Change in coverage family. Taxpayer J is single and has 
no dependents when she enrolls in a qualified health plan. The Exchange 
in the rating area in which she resides offers only silver-level plans 
that provide pediatric dental benefits. On August 1, J has a child, K, 
whom she claims as a dependent. J enrolls in a qualified health plan 
covering J and K effective August 1. Under paragraphs (f)(1) and (f)(2) 
of this section, J's applicable benchmark plan for January through July 
is the second lowest-cost silver plan providing self-only coverage for 
J, and J's applicable benchmark plan for the months August through 
December is the second lowest-cost silver plan covering J and K.
    Example 7. Minimum essential coverage for some coverage months. 
Taxpayer L claims his 6-year old daughter, M, as a dependent. L and M 
are enrolled for the entire year in a qualified health plan that offers 
only silver-level plans that provide pediatric dental benefits. L, but 
not M, is eligible for government-sponsored minimum essential coverage 
for September to December. Thus, under paragraph (c)(1)(iii) of this 
section, January through December are coverage months for M, and January 
through August are coverage months for L. Because, under paragraphs (d) 
and (f)(1) of this section, the premium assistance amount for a coverage 
month is computed based on the applicable benchmark plan for that 
coverage month, L's applicable benchmark plan for January through August 
is the second lowest-cost option covering L and M. Under paragraph 
(f)(1)(i)(C) of this section, L's applicable benchmark plan for 
September through December is the second lowest-cost silver plan 
providing self-only coverage for M.
    Example 8. Family member eligible for minimum essential coverage for 
the taxable year. The facts are the same as in Example 7, except that L 
is not eligible for government-sponsored minimum essential coverage for 
any months and M is eligible for government sponsored minimum essential 
coverage for the entire year. Under paragraph (f)(1)(i)(C) of this 
section, L's applicable benchmark plan is the second lowest-cost silver 
plan providing self-only coverage for L.
    Example 9. Benchmark plan premium for a coverage family with family 
members who reside in different locations. (i) Taxpayer N's coverage 
family consists of N and her three dependents O, P, and Q. N, O, and P 
reside together but Q resides in a different location. The monthly 
applicable benchmark plan premium for N, O, and P is $1,000 and the 
monthly applicable benchmark plan premium for Q is $220.
    (ii) Under paragraph (f)(4) of this section, because the members of 
N's coverage family reside in different locations, the monthly premium 
for N's applicable benchmark plan is the sum of $1,000, the monthly 
premiums for the applicable benchmark plan for N, O, and P, who reside 
together, and $220, the monthly applicable benchmark plan premium for Q, 
who resides in a different location than N, O, and P. Consequently, the 
premium for N's applicable benchmark plan is $1,220.
    Example 10. Aggregation of silver-level policies for plans not 
covering a family under a single policy. (i) Taxpayers R and S are 
married and live with S's mother, T, whom they claim as a dependent. The 
Exchange for their rating area offers self-only and family coverage at 
the silver level through Issuers A, B, and C, which each offer only one 
silver-level plan. The silver-level plans offered by Issuers A and B do 
not cover R, S, and T under a single policy. The silver-level plan 
offered by Issuer A costs the following monthly amounts for self-only 
coverage of R, S, and T, respectively: $400, $450, and $600. The silver-
level plan offered by Issuer B costs the following monthly amounts for 
self-only coverage of R, S, and T, respectively: $250, $300, and $450. 
The silver-level plan offered by Issuer C provides coverage for R, S, 
and T under one policy for a $1,200 monthly premium.
    (ii) Under paragraph (f)(5) of this section, Issuer C's silver-level 
plan that covers R, S, and T under one policy ($1,200 monthly premium) 
and Issuer A's and Issuer B's silver-level plans that do not cover R, S 
and T under one policy are considered in determining R's and S's 
applicable benchmark plan. In addition, under paragraph (f)(5)(ii) of 
this section, in determining R's and S's applicable benchmark plan, the 
premium taken into account for Issuer A's plan is $1,450 (the aggregate 
premiums for self-only policies covering R ($400), S ($450), and T 
($600) and the premium taken into account for Issuer B's plan is $1,000 
(the aggregate premiums for self-only policies covering R ($250), S 
($300), and T ($450). Consequently, R's and S's applicable benchmark 
plan is the Issuer C silver-level plan covering R's and S's coverage 
family and the premium for their applicable benchmark plan is $1,200.
    Example 11. Benchmark plan premium for a taxpayer with family 
members who cannot enroll in one policy and who reside in different 
locations. (i) Taxpayer U's coverage family consists of U, U's mother, 
V, and U's two daughters, W and X. U and V reside together in Location 1 
and W and X reside together in Location 2. The Exchange in the rating 
area in which U and V reside does not offer a silver-level plan that 
covers U and V under a single policy, whereas all the silver-level plans 
offered through the Exchange in the

[[Page 118]]

rating area in which W and X reside cover W and X under a single policy. 
Both Exchanges offer only silver-level plans that provide pediatric 
dental benefits. The silver plan offered by the Exchange for the rating 
area in which U and V reside that would cover U and V under self-only 
policies with the second-lowest aggregate premium costs $400 a month for 
self-only coverage for U and $600 a month for self-only coverage for V. 
The monthly premium for the second-lowest cost silver plan covering W 
and X that is offered by the Exchange for the rating area in which W and 
X reside is $500.
    (ii) Under paragraph (f)(5)(ii) of this section, because multiple 
policies are required to cover U and V, the members of U's coverage 
family who reside together in Location 1, the premium taken into account 
in determining U's benchmark plan is $1,000, the sum of the premiums for 
the second-lowest aggregate cost of self-only policies covering U ($400) 
and V ($600) offered by the Exchange to U and V for the rating area in 
which U and V reside. Under paragraph (f)(5)(i) of this section, because 
all silver-level plans offered by the Exchange in which W and X reside 
cover W and X under a single policy, the premium for W and X's coverage 
that is taken into account in determining U's benchmark plan is $500, 
the second-lowest cost silver policy covering W and X that is offered by 
the Exchange for the rating area in which W and X reside. Under 
paragraph (f)(4) of this section, because the members of U's coverage 
family reside in different locations, U's monthly benchmark plan premium 
is $1,500, the sum of the premiums for the applicable benchmark plans 
for each group of family members residing in different locations ($1,000 
for U and V, who reside in Location 1, plus $500 for W and X, who reside 
in Location 2).
    Example 12. Qualified health plan closed to enrollment. Taxpayer Y 
has two dependents, Z and AA. Y, Z, and AA enroll in a qualified health 
plan through the Exchange for the rating area where the family resides. 
The Exchange, which offers only qualified health plans that include 
pediatric dental benefits, offers silver-level plans J, K, L, and M, 
which are, respectively, the first, second, third, and fourth lowest 
cost silver plans covering Y's family. When Y's family enrolls, Plan J 
is closed to enrollment. Under paragraph (f)(6) of this section, Plan J 
is disregarded in determining Y's applicable benchmark plan, and Plan L 
is used in determining Y's applicable benchmark plan.
    Example 13. Benchmark plan closes to new enrollees during the year. 
(i) Taxpayers BB, CC, and DD each have coverage families consisting of 
two adults. In that rating area, Plan 2 is the second lowest cost silver 
plan and Plan 3 is the third lowest cost silver plan covering the two 
adults in each coverage family offered through the Exchange. The BB and 
CC families each enroll in a qualified health plan that is not the 
applicable benchmark plan (Plan 4) in November during the annual open 
enrollment period. Plan 2 closes to new enrollees the following June. 
Thus, on July 1, Plan 3 is the second lowest cost silver plan available 
to new enrollees through the Exchange. The DD family enrolls in a 
qualified health plan in July.
    (ii) Under paragraphs (f)(1), (f)(2), (f)(3), and (f)(7) of this 
section, the silver-level plan that BB and CC use to determine their 
applicable benchmark plan for all coverage months during the year is 
Plan 2. The applicable benchmark plan that DD uses to determine DD's 
applicable benchmark plan is Plan 3, because Plan 2 is not open to 
enrollment through the Exchange when the DD family enrolls.
    Example 14. Benchmark plan terminates for all enrollees during the 
year. The facts are the same as in Example 13, except that Plan 2 
terminates for all enrollees on June 30. Under paragraphs (f)(1), 
(f)(2), (f)(3), and (f)(7) of this section, Plan 2 is the silver-level 
plan that BB and CC use to determine their applicable benchmark plan for 
all coverage months during the year, and Plan 3 is the applicable 
benchmark plan that DD uses.
    Example 15. Exchange offers only one silver-level plan. Taxpayer 
EE's coverage family consists of EE, his spouse FF, and their two 
dependent children GG and HH, who all reside together. The Exchange for 
the rating area in which they reside offers only one silver-level plan 
that EE's family may enroll in and the plan does not provide pediatric 
dental benefits. The Exchange also offers one stand-alone dental plan in 
which the family may enroll. Under paragraph (f)(8) of this section, the 
silver-level plan and the stand-alone dental plan offered by the 
Exchange are used for purposes of determining EE's applicable benchmark 
plan under paragraph (f)(3) of this section. Moreover, the lone silver-
level plan and the lone stand-alone dental plan offered by the Exchange 
are used for purposes of determining EE's applicable benchmark plan 
regardless of whether these plans cover EE's family under a single 
policy or multiples policies.

    (g) Applicable percentage--(1) In general. The applicable percentage 
multiplied by a taxpayer's household income determines the taxpayer's 
annual required share of premiums for the benchmark plan. The required 
share is divided by 12 and this monthly amount is subtracted from the 
adjusted monthly premium for the applicable benchmark plan when 
computing the premium assistance amount. The applicable percentage is 
computed by first determining the percentage that the taxpayer's 
household income bears to the

[[Page 119]]

Federal poverty line for the taxpayer's family size. The resulting 
Federal poverty line percentage is then compared to the income 
categories described in the table in paragraph (g)(2) of this section. 
An applicable percentage within an income category increases on a 
sliding scale in a linear manner and is rounded to the nearest one-
hundredth of one percent. For taxable years beginning after December 31, 
2014, the applicable percentages in the table will be adjusted by the 
ratio of premium growth to income growth for the preceding calendar year 
and may be further adjusted to reflect changes to the data used to 
compute the ratio of premium growth to income growth for the 2014 
calendar year or the data sources used to compute the ratio of premium 
growth to income growth. Premium growth and income growth will be 
determined in accordance with published guidance, see Sec.  
601.601(d)(2) of this chapter. In addition, the applicable percentages 
in the table may be adjusted for taxable years beginning after December 
31, 2018, to reflect rates of premium growth relative to growth in the 
consumer price index.
    (2) Applicable percentage table.

------------------------------------------------------------------------
 Household income percentage of Federal       Initial          Final
              poverty line                  percentage      percentage
------------------------------------------------------------------------
Less than 133%..........................             2.0             2.0
At least 133% but less than 150%........             3.0             4.0
At least 150% but less than 200%........             4.0             6.3
At least 200% but less than 250%........             6.3            8.05
At least 250% but less than 300%........            8.05             9.5
At least 300% but not more than 400%....             9.5             9.5
------------------------------------------------------------------------

    (3) Examples. The following examples illustrate the rules of this 
paragraph (g):

    Example 1. A's household income is 275 percent of the Federal 
Poverty line for A's family size for that taxable year. In the table in 
paragraph (g)(2) of this section, the initial percentage for a taxpayer 
with household income of 250 to 300 percent of the Federal poverty line 
is 8.05 and the final percentage is 9.5. A's Federal poverty line 
percentage of 275 percent is halfway between 250 percent and 300 
percent. Thus, rounded to the nearest one-hundredth of one percent, A's 
applicable percentage is 8.78, which is halfway between the initial 
percentage of 8.05 and the final percentage of 9.5.
    Example 2. (i) B's household income is 210 percent of the Federal 
poverty line for B's family size. In the table in paragraph (g)(2) of 
this section, the initial percentage for a taxpayer with household 
income of 200 to 250 percent of the Federal poverty line is 6.3 and the 
final percentage is 8.05. B's applicable percentage is 6.65, computed as 
follows.
    (ii) Determine the excess of B's Federal poverty line percentage 
(210) over the initial household income percentage in B's range (200), 
which is 10. Determine the difference between the initial household 
income percentage in the taxpayer's range (200) and the ending household 
income percentage in the taxpayer's range (250), which is 50. Divide the 
first amount by the second amount:


210 - 200 = 10
250 - 200 = 50
10 / 50 = .20

    (iii) Compute the difference between the initial premium percentage 
(6.3) and the second premium percentage (8.05) in the taxpayer's range; 
8.05-6.3 = 1.75.
    (iv) Multiply the amount in the first calculation (.20) by the 
amount in the second calculation (1.75) and add the product (.35) to the 
initial premium percentage in B's range (6.3), resulting in B's 
applicable percentage of 6.65:

.20 x 1.75 = .35
6.3 + .35 = 6.65.

    (h) Plan covering more than one family--(1) In general. If a 
qualified health plan covers more than one family under a single policy, 
each applicable taxpayer covered by the plan may claim a premium tax 
credit, if otherwise allowable. Each taxpayer computes the credit using 
that taxpayer's applicable percentage, household income, and the 
benchmark plan that applies to the taxpayer under paragraph (f) of this 
section. In determining whether the amount computed under paragraph 
(d)(1)(i) of this section (the premiums for the qualified health plan in 
which the taxpayer enrolls) is less than the amount computed under 
paragraph (d)(1)(ii) of this section (the benchmark plan premium minus 
the product of household income and the applicable percentage), the 
premiums

[[Page 120]]

paid are allocated to each taxpayer in proportion to the premiums for 
each taxpayer's applicable benchmark plan.
    (2) Example. The following example illustrates the rules of this 
paragraph (h):

    Example. (i) Taxpayers A and B enroll in a single policy under a 
qualified health plan. B is A's 25-year old child who is not A's 
dependent. B has no dependents. The plan covers A, B, and A's two 
additional children who are A's dependents. The premium for the plan in 
which A and B enroll is $15,000. The premium for the second lowest cost 
silver family plan covering only A and A's dependents is $12,000 and the 
premium for the second lowest cost silver plan providing self-only 
coverage to B is $6,000. A and B are applicable taxpayers and otherwise 
eligible to claim the premium tax credit.
    (ii) Under paragraph (h)(1) of this section, both A and B may claim 
premium tax credits. A computes her credit using her household income, a 
family size of three, and a benchmark plan premium of $12,000. B 
computes his credit using his household income, a family size of one, 
and a benchmark plan premium of $6,000.
    (iii) In determining whether the amount in paragraph (d)(1)(i) of 
this section (the premiums for the qualified health plan A and B 
purchase) is less than the amount in paragraph (d)(1)(ii) of this 
section (the benchmark plan premium minus the product of household 
income and the applicable percentage), the $15,000 premiums paid are 
allocated to A and B in proportion to the premiums for their applicable 
benchmark plans. Thus, the portion of the premium allocated to A is 
$10,000 ($15,000 x $12,000/$18,000) and the portion allocated to B is 
$5,000 ($15,000 x $6,000/$18,000).

    (i) [Reserved]
    (j) Additional benefits--(1) In general. If a qualified health plan 
offers benefits in addition to the essential health benefits a qualified 
health plan must provide under section 1302 of the Affordable Care Act 
(42 U.S.C. 18022), or a State requires a qualified health plan to cover 
benefits in addition to these essential health benefits, the portion of 
the premium for the plan properly allocable to the additional benefits 
is excluded from the monthly premiums under paragraph (d)(1)(i) or (ii) 
of this section. Premiums are allocated to additional benefits before 
determining the applicable benchmark plan under paragraph (f) of this 
section.
    (2) Method of allocation. The portion of the premium properly 
allocable to additional benefits is determined under guidance issued by 
the Secretary of Health and Human Services. See section 36B(b)(3)(D).
    (3) Examples. The following examples illustrate the rules of this 
paragraph (j):

    Example 1. (i) Taxpayer B enrolls in a qualified health plan that 
provides benefits in addition to essential health benefits (additional 
benefits). The monthly premiums for the plan in which B enrolls are 
$370, of which $35 is allocable to additional benefits. B's benchmark 
plan premium (determined after allocating premiums to additional 
benefits for all silver level plans) is $440, of which $40 is allocable 
to additional benefits. B's monthly contribution amount, which is the 
product of B's household income and the applicable percentage, is $60.
    (ii) Under this paragraph (j), B's enrollment premiums and the 
benchmark plan premium are reduced by the portion of the premium that is 
allocable to the additional benefits provided under that plan. 
Therefore, B's monthly enrollment premiums are reduced to $335 ($370 - 
$35) and B's benchmark plan premium is reduced to $400 ($440 - $40). B's 
premium assistance amount for a coverage month is $335, the lesser of 
$335 (B's enrollment premiums, reduced by the portion of the premium 
allocable to additional benefits) and $340 (B's benchmark plan premium, 
reduced by the portion of the premium allocable to additional benefits 
($400), minus B's $60 contribution amount).
    Example 2. The facts are the same as in Example 1 of this paragraph 
(j)(3), except that the plan in which B enrolls provides no benefits in 
addition to the essential health benefits required to be provided by the 
plan. Thus, under paragraph (j) of this section, B's benchmark plan 
premium ($440) is reduced by the portion of the premium allocable to 
additional benefits provided under that plan ($40). B's enrollment 
premiums ($370) are not reduced under this paragraph (j). B's premium 
assistance amount for a coverage month is $340, the lesser of $370 (B's 
enrollment premiums) and $340 (B's benchmark plan premium, reduced by 
the portion of the premium allocable to additional benefits ($400), 
minus B's $60 contribution amount).

    (k) Pediatric dental coverage--(1) In general. For purposes of 
determining the amount of the monthly premium a taxpayer pays for 
coverage under paragraph (d)(1)(i) of this section, if an individual 
enrolls in both a qualified health plan and a plan described in section 
1311(d)(2)(B)(ii) of the Affordable Care Act (42 U.S.C. 
13031(d)(2)(B)(ii)) (a stand-alone dental plan), the portion of

[[Page 121]]

the premium for the stand-alone dental plan that is properly allocable 
to pediatric dental benefits that are essential benefits required to be 
provided by a qualified health plan is treated as a premium payable for 
the individual's qualified health plan.
    (2) Method of allocation. The portion of the premium for a stand-
alone dental plan properly allocable to pediatric dental benefits is 
determined under guidance issued by the Secretary of Health and Human 
Services.
    (3) Example. The following example illustrates the rules of this 
paragraph (k):

    Example. (i) Taxpayer C and C's dependent, R, enroll in a qualified 
health plan. The premium for the plan in which C and R enroll is $7,200 
($600/month) (Amount 1). The plan does not provide dental coverage. C 
also enrolls in a stand-alone dental plan covering C and R. The portion 
of the premium for the dental plan allocable to pediatric dental 
benefits that are essential health benefits is $240 ($20 per month). The 
excess of the premium for C's applicable benchmark plan over C's 
contribution amount (the product of C's household income and the 
applicable percentage) is $7,260 ($605/month) (Amount 2).
    (ii) Under this paragraph (k), the amount C pays for premiums 
(Amount 1) for purposes of computing the premium assistance amount is 
increased by the portion of the premium for the stand-alone dental plan 
allocable to pediatric dental benefits that are essential health 
benefits. Thus, the amount of the premiums for the plan in which C 
enrolls is treated as $620 for purposes of computing the amount of the 
premium tax credit. C's premium assistance amount for each coverage 
month is $605 (Amount 2), the lesser of Amount 1 (increased by the 
premiums allocable to pediatric dental benefits) and Amount 2.

    (l) Families including individuals not lawfully present--(1) In 
general. If one or more individuals for whom a taxpayer is allowed a 
deduction under section 151 are not lawfully present (within the meaning 
of Sec.  1.36B-1(g)), the percentage a taxpayer's household income bears 
to the Federal poverty line for the taxpayer's family size for purposes 
of determining the applicable percentage under paragraph (g) of this 
section is determined by excluding individuals who are not lawfully 
present from family size and by determining household income in 
accordance with paragraph (l)(2) of this section.
    (2) Revised household income computation--(i) Statutory method. For 
purposes of paragraph (l)(1) of this section, household income is equal 
to the product of the taxpayer's household income (determined without 
regard to this paragraph (l)(2)) and a fraction--
    (A) The numerator of which is the Federal poverty line for the 
taxpayer's family size determined by excluding individuals who are not 
lawfully present; and
    (B) The denominator of which is the Federal poverty line for the 
taxpayer's family size determined by including individuals who are not 
lawfully present.
    (ii) Comparable method. The Commissioner may describe a comparable 
method in additional published guidance, see Sec.  601.601(d)(2) of this 
chapter.
    (m) Applicability date. Paragraph (g)(1) of this section applies to 
taxable years beginning after December 31, 2013.
    (n) Effective/applicability date. (1) Except as provided in 
paragraphs (n)(2) and (3) of this section, this section applies to 
taxable years ending after December 31, 2013.
    (2) Paragraphs (c)(4), (d)(1) and (d)(2) of this section apply to 
taxable years beginning after December 31, 2016. Paragraph (f) of this 
section applies to taxable years beginning after December 31, 2018. 
Paragraphs (d)(1) and (d)(2) of Sec.  1.36B-3, as contained in 26 CFR 
part I edition revised as of April 1, 2016, applies to taxable years 
ending after December 31, 2013, and beginning before January 1, 2017. 
Paragraph (f) of Sec.  1.36B-3, as contained in 26 CFR part I edition 
revised as of April 1, 2016, applies to taxable years ending after 
December 31, 2013, and beginning before January 1, 2019.
    (3) Paragraph (d)(1)(i) of this section applies to taxable years 
beginning after December 31, 2022.

[T.D. 9590, 77 FR 30385, May 23, 2012; 77 FR 41048, July 12, 2012; T.D. 
9683, 79 FR 43627, July 28, 2014; T.D. 9745, 80 FR 78975, Dec. 18, 2015; 
81 FR 2088, Jan. 15, 2016; T.D. 9804, 81 FR 91765, Dec. 19, 2016; T.D. 
9822, 82 FR 34606, July 26, 2017; T.D. 9968, 87 FR 62002, Oct. 13, 2022]

[[Page 122]]



Sec.  1.36B-4  Reconciling the premium tax credit with advance credit
payments.

    (a) Reconciliation--(1) Coordination of premium tax credit with 
advance credit payments--(i) In general. A taxpayer must reconcile the 
amount of credit allowed under section 36B with advance credit payments 
on the taxpayer's income tax return for a taxable year. A taxpayer whose 
premium tax credit for the taxable year exceeds the taxpayer's advance 
credit payments may receive the excess as an income tax refund. A 
taxpayer whose advance credit payments for the taxable year exceed the 
taxpayer's premium tax credit owes the excess as an additional income 
tax liability.
    (ii) Allocation rules and responsibility for advance credit 
payments--(A) In general. A taxpayer must reconcile all advance credit 
payments for coverage of any member of the taxpayer's family.
    (B) Individuals enrolled by a taxpayer and claimed as a personal 
exemption deduction by another taxpayer--(1) In general. If a taxpayer 
(the enrolling taxpayer) enrolls an individual in a qualified health 
plan and another taxpayer (the claiming taxpayer) claims a personal 
exemption deduction for the individual (the shifting enrollee), then for 
purposes of computing each taxpayer's premium tax credit and reconciling 
any advance credit payments, the enrollment premiums and advance credit 
payments for the plan in which the shifting enrollee was enrolled are 
allocated under this paragraph (a)(1)(ii)(B) according to the allocation 
percentage described in paragraph (a)(1)(ii)(B)(2) of this section. If 
advance credit payments are allocated under paragraph (a)(1)(ii)(B)(4) 
of this section, the claiming taxpayer and enrolling taxpayer must use 
this same allocation percentage to calculate their Sec.  1.36B-
3(d)(1)(ii) adjusted monthly premiums for the applicable benchmark plan 
(benchmark plan premiums). This paragraph (a)(1)(ii)(B) does not apply 
to amounts allocated under Sec.  1.36B-3(h) (qualified health plan 
covering more than one family) or if the shifting enrollee or enrollees 
are the only individuals enrolled in the qualified health plan. For 
purposes of this paragraph (a)(1)(ii)(B)(1), a taxpayer who is expected 
at enrollment in a qualified health plan to be the taxpayer filing an 
income tax return for the year of coverage with respect to an individual 
enrolling in the plan has enrolled that individual. For taxable years to 
which section 151(d)(5) applies, the claiming taxpayer is the taxpayer 
who properly includes the shifting enrollee in his or her family for the 
taxable year.
    (2) Allocation percentage. The enrolling taxpayer and claiming 
taxpayer may agree on any allocation percentage between zero and one 
hundred percent. If the enrolling taxpayer and claiming taxpayer do not 
agree on an allocation percentage, the percentage is equal to the number 
of shifting enrollees properly included in the enrolling taxpayer's 
family divided by the number of individuals enrolled by the enrolling 
taxpayer in the same qualified health plan as the shifting enrollee.
    (3) Allocating premiums. In computing the premium tax credit, the 
claiming taxpayer is allocated a portion of the enrollment premiums for 
the plan in which the shifting enrollee was enrolled equal to the 
enrollment premiums times the allocation percentage. The enrolling 
taxpayer is allocated the remainder of the enrollment premiums not 
allocated to one or more claiming taxpayers.
    (4) Allocating advance credit payments. In reconciling any advance 
credit payments, the claiming taxpayer is allocated a portion of the 
advance credit payments for the plan in which the shifting enrollee was 
enrolled equal to the enrolling taxpayer's advance credit payments for 
the plan times the allocation percentage. The enrolling taxpayer is 
allocated the remainder of the advance credit payments not allocated to 
one or more claiming taxpayers. This paragraph (a)(1)(ii)(B)(4) only 
applies in situations in which advance credit payments are made for 
coverage of a shifting enrollee.
    (5) Premiums for the applicable benchmark plan. If paragraph 
(a)(1)(ii)(B)(4) of this section applies, the claiming taxpayer's 
benchmark plan premium is the sum of the benchmark plan premium for the 
claiming taxpayer's coverage family, excluding the shifting enrollee or 
enrollees, and the allocable

[[Page 123]]

portion. The allocable portion for purposes of this paragraph 
(a)(1)(ii)(B)(5) is the product of the benchmark plan premium for the 
enrolling taxpayer's coverage family if the shifting enrollee was a 
member of the enrolling taxpayer's coverage family and the allocation 
percentage. If the enrolling taxpayer's coverage family is enrolled in 
more than one qualified health plan, the allocable portion is determined 
as if the enrolling taxpayer's coverage family includes only the 
coverage family members who enrolled in the same plan as the shifting 
enrollee or enrollees. The enrolling taxpayer's benchmark plan premium 
is the benchmark plan premium for the enrolling taxpayer's coverage 
family had the shifting enrollee or enrollees remained a part of the 
enrolling taxpayer's coverage family, minus the allocable portion.
    (C) Responsibility for advance credit payments for an individual not 
reported on any taxpayer's return. If advance credit payments are made 
for coverage of an individual who is not included in any taxpayer's 
family, as defined in Sec.  1.36B-1(d), the taxpayer who attested to the 
Exchange to the intention to include such individual in the taxpayer's 
family as part of the advance credit payment eligibility determination 
for coverage of the individual must reconcile the advance credit 
payments.
    (iii) Advance credit payment for a month in which an issuer does not 
provide coverage. For purposes of reconciliation, a taxpayer does not 
have an advance credit payment for a month if the issuer of the 
qualified health plan in which the taxpayer or a family member is 
enrolled does not provide coverage for that month.
    (2) Credit computation. The premium assistance credit amount is 
computed on the taxpayer's return using the taxpayer's household income 
and family size for the taxable year. Thus, the taxpayer's contribution 
amount (household income for the taxable year times the applicable 
percentage) is determined using the taxpayer's household income and 
family size at the end of the taxable year. The applicable benchmark 
plan for each coverage month is determined under Sec.  1.36B-3(f).
    (3) Limitation on additional tax--(i) In general. The additional tax 
imposed under paragraph (a)(1) of this section on a taxpayer whose 
household income is less than 400 percent of the Federal poverty line is 
limited to the amounts provided in the table in paragraph (a)(3)(ii) of 
this section (or successor tables). For taxable years beginning after 
December 31, 2014, the limitation amounts may be adjusted in published 
guidance, see Sec.  601.601(d)(2) of this chapter, to reflect changes in 
the consumer price index.
    (ii) Additional tax limitation table.

----------------------------------------------------------------------------------------------------------------
                                                                 Limitation amount for
                                                                 taxpayers whose tax is   Limitation amount for
      Household income percentage of Federal poverty line           determined under       all other taxpayers
                                                                      section 1(c)
----------------------------------------------------------------------------------------------------------------
Less than 200%................................................                     $300                     $600
At least 200% but less than 300%..............................                      750                    1,500
At least 300% but less than 400%..............................                    1,250                    2,500
----------------------------------------------------------------------------------------------------------------

    (iii) Limitation on additional tax for taxpayers who claim a section 
162(l) deduction for a qualified health plan--(A) In general. A taxpayer 
who receives advance credit payments and deducts premiums for a 
qualified health plan under section 162(l) must use paragraph 
(a)(3)(iii)(B), and paragraph (a)(3)(iii)(C) or (D), of this section to 
determine the limitation on additional tax in this paragraph (a)(3) 
(limitation amount). Taxpayers must make this determination before 
calculating their section 162(l) deduction and premium tax credit. For 
additional rules for taxpayers who may claim a deduction under section 
162(l) for a qualified health plan for which advance credit payments are 
made, see Sec.  1.162(l)-1.
    (B) Determining the limitation amount. A taxpayer described in 
paragraph (a)(3)(iii)(A) of this section must use the limitation amount 
for which the taxpayer qualifies under paragraph (a)(3)(iii)(C) or (D) 
of this section. The limitation amount determined under

[[Page 124]]

this paragraph (a)(3)(iii) replaces the limitation amount that would 
otherwise be determined under the additional tax limitation table in 
paragraph (a)(3)(ii) of this section. In applying paragraph 
(a)(3)(iii)(C) of this section, a taxpayer must first determine whether 
he or she qualifies for the limitation amount applicable to taxpayers 
with household income of less than 200 percent of the Federal poverty 
line for the taxpayer's family size. If the taxpayer does not qualify to 
use the limitation amount applicable to taxpayers with household income 
of less than 200 percent of the Federal poverty line for the taxpayer's 
family size, the taxpayer must next determine whether he or she 
qualifies for the limitation applicable to taxpayers with household 
income of less than 300 percent of the Federal poverty line for the 
taxpayer's family size. If the taxpayer does not qualify to use the 
limitation amount applicable to taxpayers with household income of less 
than 300 percent of the Federal poverty line for the taxpayer's family 
size, the taxpayer must next determine whether he or she qualifies for 
the limitation applicable to taxpayers with household income of less 
than 400 percent of the Federal poverty line for the taxpayer's family 
size. If the taxpayer does not qualify to use the limitation amount 
applicable to taxpayers with household income of less than 200 percent, 
300 percent, or 400 percent of the Federal poverty line for the 
taxpayer's family size, the limitation on additional tax under section 
36B(f)(2)(B) does not apply to the taxpayer.
    (C) Requirements. A taxpayer meets the requirements of this 
paragraph (a)(3)(iii)(C) for a limitation amount if the taxpayer's 
household income as a percentage of the Federal poverty line is less 
than or equal to the maximum household income as a percentage of the 
Federal poverty line for which that limitation is available. Household 
income for this purpose is determined by using a section 162(l) 
deduction equal to the lesser of--
    (1) The sum of the specified premiums for the plan not paid through 
advance credit payments, the limitation amount (determined without 
regard to paragraph (a)(1)(iii)(C)(2) of this section), and any 
deduction allowable under section 162(l) for premiums other than 
specified premiums, and
    (2) The earned income from the trade or business with respect to 
which the health insurance plan is established.
    (D) Specified premiums not paid through advance credit payments. For 
purposes of paragraph (a)(3)(iii)(C) of this section, specified premiums 
not paid through advance credit payments means specified premiums, as 
defined in Sec.  1.162(l)-1(a)(2), minus advance credit payments made 
with respect to the specified premiums.
    (E) Examples. For examples illustrating the rules of this paragraph 
(a)(3)(iii), see Examples 13, 14, and 15 of paragraph (a)(4) of this 
section.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (a). In each example the taxpayer enrolls in a higher cost 
qualified health plan than the applicable benchmark plan:

    Example 1. Household income increases. (i) Taxpayer A is single and 
has no dependents. The Exchange for A's rating area projects A's 2014 
household income to be $27,925 (250 percent of the Federal poverty line 
for a family of one, applicable percentage 8.05). A enrolls in a 
qualified health plan. The annual premium for the applicable benchmark 
plan is $5,200. A's advance credit payments are $2,952, computed as 
follows: benchmark plan premium of $5,200 less contribution amount of 
$2,248 (projected household income of $27,925 x .0805) = $2,952.
    (ii) A's household income for 2014 is $33,622, which is 301 percent 
of the Federal poverty line for a family of one (applicable percentage 
9.5). Consequently, A's premium tax credit for 2014 is $2,006 (benchmark 
plan premium of $5,200 less contribution amount of $3,194 (household 
income of $33,622 x .095)). Because A's advance credit payments for 2014 
are $2,952 and A's 2014 credit is $2,006, A has excess advance payments 
of $946. Under paragraph (a)(1) of this section, A's tax liability for 
2014 is increased by $946. Because A's household income is between 300 
percent and 400 percent of the Federal poverty line, if A's excess 
advance payments exceeded $1,250, under the limitation of paragraph 
(a)(3) of this section, A's additional tax liability would be limited to 
that amount.
    Example 2. Household income increases, repayment limitation applies. 
The facts are the same as in Example 1, except that A's household income 
for 2014 is $43,560 (390 percent of the Federal poverty line for a 
family of one, applicable percentage 9.5). Consequently, A's premium tax 
credit for 2014 is $1,062 ($5,200

[[Page 125]]

benchmark plan premium less contribution amount of $4,138 (household 
income of $43,560 x .095)). A's advance credit payments for 2014 are 
$2,952; therefore, A has excess advance payments of $1,890. Because A's 
household income is between 300 percent and 400 percent of the Federal 
poverty line, A's additional tax liability for the taxable year is 
$1,250 under the repayment limitation of paragraph (a)(3) of this 
section.
    Example 3. Household income decreases. The facts are the same as in 
Example 1, except that A's actual household income for 2014 is $22,340 
(200 percent of the Federal poverty line for a family of one, applicable 
percentage 6.3). Consequently, A's premium tax credit for 2014 is $3,793 
($5,200 benchmark plan premium less contribution amount of $1,407 
(household income of $22,340 x .063)). Because A's advance credit 
payments for 2014 are $2,952, A is allowed an additional credit of $841 
($3,793 less $2,952).
    Example 4. Family size decreases. (i) Taxpayers B and C are married 
and have two children, K and L (ages 17 and 20), whom they claim as 
dependents in 2013. The Exchange for their rating area projects their 
2014 household income to be $63,388 (275 percent of the Federal poverty 
line for a family of four, applicable percentage 8.78). B and C enroll 
in a qualified health plan for 2014 that covers the four family members. 
The annual premium for the applicable benchmark plan is $14,100. B's and 
C's advance credit payments for 2014 are $8,535, computed as follows: 
Benchmark plan premium of $14,100 less contribution amount of $5,565 
(projected household income of $63,388 x .0878) = $8,535.
    (ii) In 2014, B and C do not claim L as their dependent (and no 
taxpayer claims a personal exemption deduction for L). Consequently, B's 
and C's family size for 2014 is three, their household income of $63,388 
is 332 percent of the Federal poverty line for a family of three 
(applicable percentage 9.5), and the annual premium for their applicable 
benchmark plan is $12,000. Their premium tax credit for 2014 is $5,978 
($12,000 benchmark plan premium less $6,022 contribution amount 
(household income of $63,388 x .095)). Because B's and C's advance 
credit payments for 2014 are $8,535 and their 2014 credit is $5,978, B 
and C have excess advance payments of $2,557. B's and C's additional tax 
liability for 2014 under paragraph (a)(1) of this section, however, is 
limited to $2,500 under paragraph (a)(3) of this section.
    Example 5. Repayment limitation does not apply. (i) Taxpayer D is 
single and has no dependents. The Exchange for D's rating area approves 
advance credit payments for D based on 2014 household income of $39,095 
(350 percent of the Federal poverty line for a family of one, applicable 
percentage 9.5). D enrolls in a qualified health plan. The annual 
premium for the applicable benchmark plan is $5,200. D's advance credit 
payments are $1,486, computed as follows: benchmark plan premium of 
$5,200 less contribution amount of $3,714 (projected household income of 
$39,095 x .095) = $1,486.
    (ii) D's actual household income for 2014 is $44,903, which is 402 
percent of the Federal poverty line for a family of one. D is not an 
applicable taxpayer and may not claim a premium tax credit. 
Additionally, the repayment limitation of paragraph (a)(3) of this 
section does not apply. Consequently, D has excess advance payments of 
$1,486 (the total amount of the advance credit payments in 2014). Under 
paragraph (a)(1) of this section, D's tax liability for 2014 is 
increased by $1,486.
    Example 6. Coverage for less than a full taxable year. (i) Taxpayer 
F is single and has no dependents. In November 2013, the Exchange for 
F's rating area projects F's 2014 household income to be $27,925 (250 
percent of the Federal poverty line for a family of one, applicable 
percentage 8.05). F enrolls in a qualified health plan. The annual 
premium for the applicable benchmark plan is $5,200. F's monthly advance 
credit payment is $246, computed as follows: benchmark plan premium of 
$5,200 less contribution amount of $2,248 (projected household income of 
$27,925 x .0805) = $2,952; $2,952/12 = $246.
    (ii) F begins a new job in August 2014 and is eligible for employer-
sponsored minimum essential coverage for the period September through 
December 2014. F discontinues her Exchange coverage effective November 
1, 2014. F's household income for 2014 is $28,707 (257 percent of the 
Federal poverty line for a family size of one, applicable percentage 
8.25).
    (iii) Under Sec.  1.36B-3(a), F's premium assistance credit amount 
is the sum of the premium assistance amounts for the coverage months. 
Under Sec.  1.36B-3(c)(1)(iii), a month in which an individual is 
eligible for minimum essential coverage other than coverage in the 
individual market is not a coverage month. Because F is eligible for 
employer-sponsored minimum essential coverage as of September 1, only 
the months January through August of 2014 are coverage months.
    (iv) If F had 12 coverage months in 2014, F's premium tax credit 
would be $2,832 (benchmark plan premium of $5,200 less contribution 
amount of $2,368 (household income of $28,707 x .0825)). Because F has 
only eight coverage months in 2014, F's credit is $1,888 ($2,832/12 x 
8). Because F does not discontinue her Exchange coverage until November 
1, 2014, F's advance credit payments for 2014 are $2,460 ($246 x 10). 
Consequently, F has excess advance payments of $572 ($2,460 less $1,888) 
and F's tax liability for 2014 is increased by $572 under paragraph 
(a)(1) of this section.
    Example 7. Changes in coverage months and applicable benchmark plan. 
(i) Taxpayer E claims one dependent, F. E is eligible for government-
sponsored minimum essential

[[Page 126]]

coverage. E enrolls F in a qualified health plan for 2014. The Exchange 
for E's rating area projects E's 2014 household income to be $30,260 
(200 percent of the Federal poverty line for a family of two, applicable 
percentage 6.3). The annual premium for E's applicable benchmark plan is 
$5,200. E's monthly advance credit payment is $275, computed as follows: 
benchmark plan premium of $5,200 less contribution amount of $1,906 
(projected household income of $30,260 x .063) = $3,294; $3,294/12 = 
$275.
    (ii) On August 1, 2014, E loses her eligibility for government-
sponsored minimum essential coverage. E enrolls in the qualified health 
plan that covers F for August through December 2014. The annual premium 
for the applicable benchmark plan is $10,000. The Exchange computes E's 
monthly advance credit payments for the period September through 
December to be $675 as follows: benchmark plan premium of $10,000 less 
contribution amount of $1,906 (projected household income of $30,260 x 
.063) = $8,094; $8,094/12 = $675. E's household income for 2014 is 
$28,747 (190 percent of the Federal poverty line, applicable percentage 
5.84).
    (iii) Under Sec.  1.36B-3(c)(1), January through July of 2014 are 
coverage months for F and August through December are coverage months 
for E and F. Under paragraph (a)(2) of this section, E must compute her 
premium tax credit using the premium for the applicable benchmark plan 
for each coverage month. E's premium assistance credit amount for 2014 
is the sum of the premium assistance amounts for all coverage months. E 
reconciles her premium tax credit with advance credit payments as 
follows:

Advance credit payments (Jan. to July).......          $1,925  ($275 x 7)
Advance credit payments (Aug. to Dec.).......           3,375  ($675 x 5)
                                              ----------------
    Total advance credit payments............           5,300
 
Benchmark plan premium (Jan. to July)........           3,033  (($5,200/12) x 7)
Benchmark plan premium (Aug. to Dec.)........           4,167  (($10,000/12) x 5)
                                              ----------------
    Total benchmark plan premium.............           7,200
Contribution amount (taxable year household             1,679  ($28,747 x .0584)
 income x applicable percentage).
                                              ----------------
    Credit (total benchmark plan premium less           5,521
     contribution amount).
 

    (iv) E's advance credit payments for 2014 are $5,300. E's premium 
tax credit is $5,521. Thus, E is allowed an additional credit of $221.
    Example 8. Part-year coverage and changes in coverage months and 
applicable benchmark plan. (i) The facts are the same as in Example 7, 
except that F is eligible for government-sponsored minimum essential 
coverage for January and February 2014, and E enrolls F in a qualified 
health plan beginning in March 2014. Thus, March through July are 
coverage months for F and August through December are coverage months 
for E and F.
    (ii) E reconciles her premium tax credit with advance credit 
payments as follows:

Advance credit payments (March to July)......          $1,375  ($275 x 5)
Advance credit payments (Aug. to Dec.).......           3,375  ($675 x 5)
                                              ----------------
    Total advance credit payments............           4,750
 
Benchmark plan premium (March to July).......           2,167  (($5,200/12) x 5)
Benchmark plan premium (Aug. to Dec.)........           4,167  (($10,000/12) x 5)
                                              ----------------
    Total benchmark plan premium.............           6,334
Contribution amount for 10 coverage months              1,399  ($28,747 x .0584 x 10/12)
 (taxable year household income x applicable
 percentage x 10/12).
                                              ----------------
    Credit (total benchmark plan premium less           4,935
     contribution amount).
 

    (iii) E's advance credit payments for 2014 are $4,750. E's premium 
tax credit is $4,935. Thus, E is allowed an additional credit of $185.
    Example 9. Advance credit payments for months an issuer does not 
provide coverage. (i) Taxpayer F enrolls in a qualified health plan for 
2014 and the Exchange approves advance

[[Page 127]]

credit payments. F pays the portion of the premium not covered by 
advance credit payments for January through April of 2014 but fails to 
make payments in May, June, and July. As a result, the issuer of the 
qualified health plan initiates the 3-month grace period under section 
1412(c)(2)(B)(iv)(II) of the Affordable Care Act and 45 CFR 156.270(d). 
During the grace period the issuer continues to receive advance credit 
payments on behalf of F. On July 1 the issuer rescinds F's coverage 
retroactive to the end of the first month of the grace period, May 31.
    (ii) Under paragraph (a)(1)(iii) of this section, F does not take 
into account advance credit payments for June or July of 2014 when 
reconciling the premium tax credit with advance credit payments under 
paragraph (a)(1) of this section.
    Example 10. Allocation percentage, agreement on allocation. (i) 
Taxpayers G and H are divorced and have two children, J and K. G enrolls 
herself and J and K in a qualified health plan for 2014. The premium for 
the plan in which G enrolls is $13,000. The Exchange in G's rating area 
approves advance credit payments for G based on a family size of three, 
an annual benchmark plan premium of $12,000, and projected 2014 
household income of $58,590 (300 percent of the Federal poverty line for 
a family of three, applicable percentage 9.5). G's advance credit 
payments for 2014 are $6,434 ($12,000 benchmark plan premium less $5,566 
contribution amount (household income of $58,590 x .095)). G's actual 
household income for 2014 is $58,900.
    (ii) K lives with H for more than half of 2014 and H claims K as a 
dependent for 2014. G and H agree to an allocation percentage, as 
described in paragraph (a)(1)(ii)(B)(2) of this section, of 20 percent. 
Under the agreement, H is allocated 20 percent of the items to be 
allocated, and G is allocated the remainder of those items.
    (iii) If H is eligible for a premium tax credit, H takes into 
account $2,600 of the premiums for the plan in which K was enrolled 
($13,000 x .20) and $2,400 of G's benchmark plan premium ($12,000 x 
.20). In addition, H is responsible for reconciling $1,287 ($6,434 x 
.20) of the advance credit payments for K's coverage.
    (iv) G's family size for 2014 includes only G and J and G's 
household income of $58,900 is 380 percent of the Federal poverty line 
for a family of two (applicable percentage 9.5). G's benchmark plan 
premium for 2014 is $9,600 (the benchmark premium for the plan covering 
G, J, and K ($12,000), minus the amount allocated to H ($2,400). 
Consequently, G's premium tax credit is $4,004 (G's benchmark plan 
premium of $9,600 minus G's contribution amount of $5,596 ($58,900 x 
.095)). G has an excess advance payment of $1,143 (the excess of the 
advance credit payments of $5,147 ($6,434 - $1,287 allocated to H) over 
the premium tax credit of $4,004).
    Example 11. Allocation percentage, no agreement on allocation. (i) 
The facts are the same as in Example 10 of paragraph (a)(4) of this 
section, except that G and H do not agree on an allocation percentage. 
Under paragraph (a)(1)(ii)(B)(2) of this section, the allocation 
percentage is 33 percent, computed as follows: The number of shifting 
enrollees, 1 (K), divided by the number of individuals enrolled by the 
enrolling taxpayer on the same qualified health plan as the shifting 
enrollee, 3 (G, J, and K). Thus, H is allocated 33 percent of the items 
to be allocated, and G is allocated the remainder of those items.
    (ii) If H is eligible for a premium tax credit, H takes into account 
$4,290 of the premiums for the plan in which K was enrolled ($13,000 x 
.33). H, in computing H's benchmark plan premium, must include $3,960 of 
G's benchmark plan premium ($12,000 x .33). In addition, H is 
responsible for reconciling $2,123 ($6,434 x .33) of the advance credit 
payments for K's coverage.
    (iii) G's benchmark plan premium for 2014 is $8,040 (the benchmark 
premium for the plan covering G, J, and K ($12,000), minus the amount 
allocated to H ($3,960). Consequently, G's premium tax credit is $2,444 
(G's benchmark plan premium of $8,040 minus G's contribution amount of 
$5,596 ($58,900 x .095)). G has an excess advance credit payment of 
$1,867 (the excess of the advance credit payments of $4,311 ($6,434 - 
$2,123 allocated to H) over the premium tax credit of $2,444).
    Example 12. Allocations for an emancipated child. Spouses L and M 
enroll in a qualified health plan with their child, N. L and M attest 
that they will claim N as a dependent and advance credit payments are 
made for the coverage of all three family members. However, N files his 
own return and claims a personal exemption deduction for himself for the 
taxable year. Under paragraph (a)(1)(ii)(B)(1) of this section, L and M 
are enrolling taxpayers, N is a claiming taxpayer, and all are subject 
to the allocation rules in paragraph (a)(1)(ii)(B) of this section.
    Example 13. Taxpayer with advance credit payments allowed a section 
162(l) deduction but not a limitation on additional tax. (i) In 2014, B, 
B's spouse, and their two dependents enroll in the applicable second 
lowest cost silver plan with an annual premium of $14,000. B's advance 
credit payments attributable to the premiums are $8,000. B is self-
employed for all of 2014 and derives $75,000 of earnings from B's trade 
or business. B's household income without including a deduction under 
section 162(l) for specified premiums is $103,700. The Federal poverty 
line for a family the size of B's family is $23,550.
    (ii) Because B received the benefit of advance credit payments and 
deducts premiums for a qualified health plan under section 162(l), B 
must determine whether B is allowed a limitation on additional tax under 
paragraph (a)(3)(iii) of this section. B begins

[[Page 128]]

by testing eligibility for the $600 limitation amount for taxpayers with 
household income at less than 200 percent of the Federal poverty line 
for the taxpayer's family size. B determines household income as a 
percentage of the Federal poverty line by taking a section 162(l) 
deduction equal to the lesser of $6,600 (the sum of the amount of 
premiums not paid through advance credit payments, $6,000 ($14,000 - 
$8,000), and the limitation amount, $600) and $75,000 (the earned income 
from the trade or business with respect to which the health insurance 
plan is established). The result is $97,100 ($103,700 - $6,600) or 412 
percent of the Federal poverty line for B's family size. Since 412 
percent is not less than 200 percent, B may not use a $600 limitation 
amount.
    (iii) B performs the same calculation for the $1,500 ($103,700 - 
$7,500 = $96,200 or 408 percent of the Federal poverty line) and $2,500 
limitation amounts ($103,700 - $8,500 = $95,200 or 404 percent of the 
Federal poverty line), the amounts for taxpayers with household income 
of less than 300 percent or 400 percent, respectively, of the Federal 
poverty line for the taxpayer's family size, and determines that B may 
not use either of those limitation amounts. Because B does not meet the 
requirements of paragraph (a)(3)(iii) of this section for any of the 
limitation amounts in section 36B(f)(2)(B), B is not eligible for the 
limitation on additional tax for excess advance credit payments.
    (iv) Although B may not claim a limitation on additional tax for 
excess advance credit payments, B may still be eligible for a premium 
tax credit. B would determine eligibility for the premium tax credit, 
the amount of the premium tax credit, and the section 162(l) deduction 
using the rules under section 36B and section 162(l), applying no 
limitation on additional tax.
    Example 14. Taxpayer with advance credit payments allowed a section 
162(l) deduction and a limitation on additional tax. (i) The facts are 
the same as in Example 13 of paragraph (a)(4) of this section, except 
that B's household income without including a deduction under section 
162(l) for specified premiums is $78,802.
    (ii) Because B received the benefit of advance credit payments and 
deducts premiums for a qualified health plan under section 162(l), B 
must determine whether B is allowed a limitation on additional tax under 
paragraph (a)(3)(iii) of this section. B first determines that B does 
not meet the requirements of paragraph (a)(3)(iii)(C) of this section 
for using the $600 or $1,500 limitation amounts, the amounts for 
taxpayers with household income of less than 200 percent or 300 percent, 
respectively, of the Federal poverty line for the taxpayer's family 
size. That is because B's household income as a percentage of the 
Federal poverty line, determined by using a section 162(l) deduction for 
premiums for the qualified health plan equal to the lesser of the sum of 
the premiums for the plan not paid through advance credit payments and 
the limitation amount, and the earned income from the trade or business 
with respect to which the health insurance plan is established, is more 
than the maximum household income as a percentage of the Federal poverty 
line for which that limitation is available (using the $600 limitation, 
B's household income would be $72,202 ($78,802-($6,000 + $600)), which 
is 307 percent of the Federal poverty line for B's family size; and 
using the $1,500 limitation, B's household income would be $71,302 
($78,802-($6,000 + $1,500)), which is 303 percent of the Federal poverty 
line for B's family size).
    (iii) However, B meets the requirements of paragraph (a)(3)(iii)(C) 
of this section using the $2,500 limitation amount for taxpayers with 
household income of less than 400 percent of the Federal poverty line 
for the taxpayer's family size. That is because B's household income as 
a percentage of the Federal poverty line by taking a section 162(l) 
deduction equal to the lesser of $8,500 (the sum of the amount of 
premiums not paid through advance credit payments, $6,000, and the 
limitation amount, $2,500) and $75,000 (the earned income from the trade 
or business with respect to which the health insurance plan is 
established), is $70,302 (299 percent of the Federal poverty line), 
which is below 400 percent of the Federal poverty line for B's family 
size, and is less than the maximum amount for which that limitation is 
available. Thus, B uses a limitation amount of $2,500 in computing B's 
additional tax on excess advance credit payments.
    (iv) B may determine the amount of the premium tax credit and the 
section 162(l) deduction using the rules under section 36B and section 
162(l), applying the $2,500 limitation amount determined above.
    Example 15. Taxpayer with advance credit payments allowed a section 
162(l) deduction and a limitation on additional tax limited to earned 
income from trade or business. (i) In 2017, C, C's spouse, and their two 
dependents enroll in the applicable second lowest cost silver plan with 
an annual premium of $14,000. C's advance credit payments attributable 
to the premiums are $8,000. C is self-employed for all of 2017 and 
derives $3,000 of earnings from C's trade or business. C's household 
income, without including a deduction under section 162(l) for specified 
premiums, is $39,100. The Federal poverty line for a family the size of 
C's family is $24,600.
    (ii) Because C received the benefit of advance credit payments and 
deducts premiums for a qualified health plan under section 162(l), C 
must determine whether C is allowed a limitation on additional tax under 
paragraph (a)(3)(iii) of this section. C begins by testing eligibility 
for the $600 limitation

[[Page 129]]

amount for taxpayers with household income at less than 200 percent of 
the Federal poverty line for the taxpayer's family size. C determines 
household income as a percentage of the Federal poverty line by taking a 
section 162(l) deduction equal to the lesser of $6,600 (the sum of the 
amount of premiums not paid through advance credit payments, $6,000 
($14,000-$8,000), and the limitation amount, $600), and $3,000 (C's 
earned income from the trade or business with respect to which the 
health insurance plan is established). The result is $36,100 ($39,100-
$3,000) or 147 percent of the Federal poverty line for C's family size. 
Because 147 percent is less than 200 percent, the limitation amount 
under paragraph (a)(3)(iii) of this section that C uses in computing C's 
additional tax on excess advance credit payments is $600.
    (iii) C may determine the amount of the premium tax credit and the 
section 162(l) deduction using the rules under section 36B and section 
162(l), applying the $600 limitation amount determined above.

    (b) Changes in filing status--(1) In general. Except as provided in 
paragraph (b)(2) or (b)(3) of this section, a taxpayer whose marital 
status changes during the taxable year computes the premium tax credit 
by using the applicable benchmark plan or plans for the taxpayer's 
marital status as of the first day of each coverage month. The 
taxpayer's contribution amount (household income for the taxable year 
times the applicable percentage) is determined using the taxpayer's 
household income and family size at the end of the taxable year.
    (2) Taxpayers who marry during the taxable year--(i) In general. 
Taxpayers who marry during and file a joint return for the taxable year 
may compute the additional tax imposed under paragraph (a)(1) of this 
section under paragraph (b)(2)(ii) of this section. Only taxpayers who 
are unmarried at the beginning of the taxable year and are married 
(within the meaning of section 7703) at the end of the taxable year, at 
least one of whom receives advance credit payments, may use this 
alternative computation.
    (ii) Alternative computation of additional tax liability--(A) In 
general. The additional tax liability determined under this paragraph 
(b)(2)(ii) is equal to the excess of the taxpayers' advance credit 
payments for the taxable year over the amount of the alternative 
marriage-year credit. The alternative marriage-year credit is the sum of 
both taxpayers' alternative premium assistance amounts for the pre-
marriage months and the premium assistance amounts for the marriage 
months. This paragraph (b)(2)(ii) may not be used to increase the 
additional premium tax credit computed under paragraph (a)(1)(i) of this 
section.
    (B) Alternative premium assistance amounts for pre-marriage months. 
Taxpayers compute the alternative premium assistance amounts for each 
taxpayer for each full or partial month the taxpayers are unmarried as 
described in paragraph (a)(2) of this section, except that each taxpayer 
treats the amount of household income as one-half of the actual 
household income for the taxable year and treats family size as the 
number of individuals in the taxpayer's family prior to the marriage. 
The taxpayers may include a dependent of the taxpayers for the taxable 
year in either taxpayer's family size for the pre-marriage months.
    (C) Premium assistance amounts for marriage months. Taxpayers 
compute the premium assistance amounts for each full month the taxpayers 
are married as described in paragraph (a)(2) of this section.
    (3) Taxpayers not married to each other at the end of the taxable 
year. Taxpayers who are married (within the meaning of section 7703) to 
each other during a taxable year but legally separate under a decree of 
divorce or of separate maintenance during the taxable year, and who are 
enrolled in the same qualified health plan at any time during the 
taxable year must allocate the benchmark plan premiums, the enrollment 
premiums, and the advance credit payments for the period the taxpayers 
are married during the taxable year. Taxpayers must also allocate these 
items if one of the taxpayers has a dependent enrolled in the same plan 
as the taxpayer's former spouse or enrolled in the same plan as a 
dependent of the taxpayer's former spouse. The taxpayers may allocate 
these items to each former spouse in any proportion but must allocate 
all items in the same proportion. If the taxpayers do not agree on an 
allocation that is reported

[[Page 130]]

to the IRS in accordance with the relevant forms and instructions, 50 
percent of: The benchmark plan premiums; the enrollment premiums; and 
the advance credit payments for the married period, is allocated to each 
taxpayer. If for a period a plan covers only one of the taxpayers and no 
dependents, only one of the taxpayers and one or more dependents of that 
same taxpayer, or only one or more dependents of one of the taxpayers, 
then the benchmark plan premiums, the enrollment premiums, and the 
advance credit payments for that period are allocated entirely to that 
taxpayer.
    (4) Taxpayers filing returns as married filing separately or head of 
household--(i) Allocation of advance credit payments. Except as provided 
in Sec.  1.36B-2(b)(2)(ii), the premium tax credit is allowed to married 
(within the meaning of section 7703) taxpayers only if they file joint 
returns. See Sec.  1.36B-2(b)(2)(i). Taxpayers who receive advance 
credit payments as married taxpayers and who do not file a joint return 
must allocate the advance credit payments for coverage under a qualified 
health plan equally to each taxpayer for any period the plan covers and 
in which advance credit payments are made for both taxpayers, only one 
of the taxpayers and one or more dependents of the other taxpayer, or 
one or more dependents of both taxpayers. If, for a period a plan 
covers, advance credit payments are made for only one of the taxpayers 
and no dependents, only one of the taxpayers and one or more dependents 
of that same taxpayer, or only one or more dependents of one of the 
taxpayers, the advance credit payments for that period are allocated 
entirely to that taxpayer. If one or both of the taxpayers is an 
applicable taxpayer eligible for a premium tax credit for the taxable 
year, the premium tax credit is computed by allocating the enrollment 
premiums under paragraph (b)(4)(ii) of this section. The repayment 
limitation described in paragraph (a)(3) of this section applies to each 
taxpayer based on the household income and family size reported on that 
taxpayer's return. This paragraph (b)(4) also applies to taxpayers who 
receive advance credit payments as married taxpayers and file a tax 
return using the head of household filing status.
    (ii) Allocation of premiums. If taxpayers who are married within the 
meaning of section 7703, without regard to section 7703(b), do not file 
a joint return, 50 percent of the enrollment premiums are allocated to 
each taxpayer. However, all of the enrollment premiums are allocated to 
only one of the taxpayers for a period in which a qualified health plan 
covers only that taxpayer and no dependents, only that taxpayer and one 
or more dependents of that taxpayer, or only one or more dependents of 
that taxpayer.
    (5) Examples. The following examples illustrate the provisions of 
this paragraph (b). In each example the taxpayer enrolls in a higher 
cost qualified health plan than the applicable benchmark plan:

    Example 1. Taxpayers marry during the taxable year, general rule for 
computing additional tax. (i) P is a single taxpayer with no dependents. 
In 2013 the Exchange for the rating area where P resides determines that 
P's 2014 household income will be $40,000 (358 percent of the Federal 
poverty line, applicable percentage 9.5). P enrolls in a qualified 
health plan. The premium for the applicable benchmark plan is $5,200. 
P's monthly advance credit payment is $117, computed as follows: $5,200 
benchmark plan premium minus contribution amount of $3,800 ($40,000 x 
.095) equals $1,400 (total advance credit payment); $1,400/12 = $117.
    (ii) Q is a single taxpayer with two dependents. In 2013 the 
Exchange for the rating area where Q resides determines that Q's 2014 
household income will be $35,000 (183 percent of the Federal poverty 
line, applicable percentage 5.52). Q enrolls in a qualified health plan. 
The premium for the applicable benchmark plan is $10,000. Q's monthly 
advance credit payment is $672, computed as follows: $10,000 benchmark 
plan premium minus contribution amount of $1,932 ($35,000 x .0552) 
equals $8,068 (total advance credit); $8,068/12 = $672.
    (iii) P and Q marry on July 17, 2014 and enroll in a single policy 
for a qualified health plan covering four family members, effective 
August 1, 2014. The premium for the applicable benchmark plan is 
$14,000. Based on household income of $75,000 and a family size of four 
(325 percent of the Federal poverty line, applicable percentage 9.5), 
the Exchange approves advance credit payments of $573 per month, 
computed as follows: $14,000 benchmark plan premium minus contribution 
amount of $7,125 ($75,000 x .095) equals $6,875 (total advance credit); 
$6,875/12 = $573.

[[Page 131]]

    (iv) P and Q file a joint return for 2014 and report $75,000 in 
household income and a family size of four. P and Q compute their credit 
at reconciliation under paragraph (b)(1) of this section. They use the 
premiums for the applicable benchmark plans that apply for the months 
married and the months not married, and their contribution amount is 
based on their Federal poverty line percentage at the end of the taxable 
year. P and Q reconcile their premium tax credit with advance credit 
payments as follows:

Advance payments for P (Jan. to July)...................            $819
Advance payments for Q (Jan. to July)...................           4,704
Advance payments for P and Q (Aug. to Dec.).............           2,865
                                                         ---------------
    Total advance payments..............................           8,388
                                                         ===============
Benchmark plan premium for P (Jan. to July).............           3,033
Benchmark plan premium for Q (Jan. to July).............           5,833
Benchmark plan premium for P and Q (Aug. to Dec.).......           5,833
                                                         ---------------
    Total benchmark plan premium........................          14,699
                                                         ===============
Contribution amount (taxable year household income x               7,125
 applicable percentage).................................
                                                         ---------------
    Credit (total benchmark plan premium less                      7,574
     contribution amount)...............................
Additional tax..........................................             814
 

    (v) P's and Q's tax liability for 2014 is increased by $814 under 
paragraph (a)(1) of this section.
    Example 2. Taxpayers marry during the taxable year, alternative 
computation of additional tax. (i) The facts are the same as in Example 
1, except that P and Q compute their additional tax liability under 
paragraph (b)(2)(ii) of this section. P's and Q's additional tax is the 
excess of their advance credit payments for the taxable year ($8,388) 
over their alternative marriage-year credit, which is the sum of the 
alternative premium assistance amounts for the pre-marriage months and 
the premium assistance amounts for the marriage months.
    (ii) P and Q compute the alternative marriage-year credit as 
follows:

Alternative premium assistance amounts for
 pre-marriage months:
    Benchmark plan premium for P (Jan. to              $3,033  (($5,200/12) x 7)
     July).
    Contribution amount (\1/2\ taxable year             2,078  ($37,500 x .095 x 7/12)
     household income x applicable
     percentage) x 7/12).
    Alternative premium assistance amount for             955  ($3,033-$2,078)
     P's pre-marriage months.
    Benchmark plan premium for Q (Jan. to               5,833  (($10,000/12) x 7)
     July).
    Contribution amount (\1/2\ taxable year             1,339  ($37,500 x .0612 x 7/12)
     household income x applicable percentage
     x 7/12).
    Alternative premium assistance amount for           4,494  ($5,833-$1,339)
     Q's pre-marriage months.
Premium assistance amount for marriage
 months:
    Benchmark plan premium for P and Q (Aug.            5,833  (($14,000/12 x 5)
     to Dec.).
    Contribution amount (taxable year                   2,969  ($75,000 x .095 x 5/12)
     household income x applicable percentage
     x 5/12).
    Premium assistance amount for marriage              2,864  ($5,833-$2,969)
     months.
 

    Alternative marriage-year credit (sum of premium assistance amounts 
for pre-marriage months and marriage months): $955 + $4,494 + $2,864 = 
$8,313.
    (iii) P and Q reconcile their premium tax credit with advance credit 
payments by determining the excess of their advance credit

[[Page 132]]

payments ($8,388) over their alternative marriage-year credit ($8,313). 
P and Q must increase their tax liability by $75 under paragraph (a)(1) 
of this section.
    Example 3. Taxpayers marry during the taxable year, alternative 
computation of additional tax, alternative marriage-year tax credit 
exceeds advance credit payments. The facts are the same as in Example 2, 
except that the amount of P's and Q's advance credit payments is $8,301. 
Thus, their alternative marriage-year credit ($8,313) exceeds the amount 
of their advance credit payments ($8,301). Under paragraph (b)(2)(ii)(A) 
of this section, the amount of additional tax liability and additional 
tax credit that P and Q report on their tax return is $0.
    Example 4. Taxpayers marry during the taxable year, alternative 
computation of additional tax. (i) Taxpayer R is single and has no 
dependents. In 2013, the Exchange for the rating area where R resides 
determines that R's 2014 household income will be $40,000 (358 percent 
of the Federal poverty line, applicable percentage 9.5). R enrolls in a 
qualified health plan. The premium for the applicable benchmark plan is 
$5,200. R's monthly advance credit payment is $117, computed as follows: 
$5,200 benchmark plan premium minus contribution amount of $3,800 
($40,000 x .095) = $1,400 (total advance credit); $1,400/12 = $117.
    (ii) Taxpayer S is single with no dependents. In 2013, the Exchange 
for the rating area where S resides determines that S's 2014 household 
income will be $20,000 (179 percent of the Federal poverty line, 
applicable percentage 5.33). S enrolls in a qualified health plan. The 
premium for the applicable benchmark plan is $5,200. S's monthly advance 
credit payment is $345, computed as follows: $5,200 benchmark plan 
premium minus contribution amount of $1,066 ($20,000 x .0533) = $4,134 
(total advance credit); $4,134/12 = $345.
    (iii) R and S marry in September 2014 and enroll in a single policy 
for a qualified health plan covering them both, beginning October 1, 
2014. The premium for the applicable benchmark plan is $10,000. Based on 
household income of $60,000 and a family size of two (397 percent of the 
Federal poverty line, applicable percentage 9.5), R's and S's monthly 
advance credit payment is $358, computed as follows: $10,000 benchmark 
plan premium minus contribution amount of $5,700 ($60,000 x .095) = 
$4,300; $4,300/12 = $358. R's and S's advance credit payments for 2014 
are $5,232, computed as follows:

Advance payments for R (Jan. to Sept.).......          $1,053  ($117 x 9)
Advance payments for S (Jan. to Sept.).......           3,105  ($345 x 9)
Advance payments for R and S (Oct. to Dec.)..           1,074  ($358 x 3)
                                              ----------------
    Total advance payments...................           5,232
 

    (iv) R and S file a joint return for 2014 and report $62,000 in 
household income and a family size of two (410 percent of the FPL for a 
family of 2). Thus, under Sec.  1.36B-2(b)(2), R and S are not 
applicable taxpayers for 2014 and may not claim a premium tax credit for 
2014. However, they compute their additional tax liability under 
paragraph (b)(2)(ii) of this section. R's and S's additional tax is the 
excess of their advance credit payments for the taxable year ($5,232) 
over their alternative marriage-year credit, which is the sum of the 
alternative premium assistance amounts for the pre-marriage months and 
the premium assistance amounts for the marriage months. In this case, R 
and S have no premium assistance amounts for the married months because 
their household income is over 400 percent of the Federal poverty line 
for a family of 2.
    (v) R and S compute their alternative marriage-year credit as 
follows:

Premium assistance amount for pre-marriage
 months:
    Benchmark plan premium for R (Jan. to              $3,900  (($5,200/12) x 9)
     Sept.).
    Contribution amount ((\1/2\ taxable year            2,053  ($31,000 x .0883 x 9/12)
     household income x applicable
     percentage) x 9/12).
    Premium assistance amount for R's pre-              1,847  ($3,900 - $2,053)
     marriage months.
    Benchmark plan premium for S (Jan. to               3,900  (($5,200/12) x 9)
     Sept.).
    Contribution amount ((\1/2\ taxable year            2,053  ($31,000 x .0883 x 9/12)
     household income x applicable
     percentage) x 9/12).
    Premium assistance amount for S's pre-              1,847  ($3,900-$2,053)
     marriage months.
Premium assistance amount for marriage months               0
 


[[Page 133]]

    Alternative marriage-year credit (sum of premium assistance amounts 
for pre-marriage months and marriage months): $1,847 + 1,847 + 0 = 
$3,694.
    (vi) R and S reconcile their premium tax credit with advance credit 
payments by determining the excess of their advance credit payments 
($5,232) over their alternative marriage-year credit ($3,694). R and S 
must increase their tax liability by $1,538 under paragraph (a)(1) of 
this section.
    Example 5. (i) Taxpayers marry during the taxable year, no 
additional tax liability. The facts are the same as in Example 4, except 
that S has no income and is enrolled in Medicaid for January through 
September 2014 and R's and S's household income for 2014 is $37,000 (245 
percent of the Federal poverty line, applicable percentage 7.88). Their 
advance credit payments for 2014 are $2,707 ($1,053 for R for January to 
September and $1,654 for R and S for October to December). Their premium 
tax credit for 2014 is $3,484 (total benchmark premium of $6,400 less 
contribution amount of $2,916).
    (ii) Because R's and S's premium tax credit of $3,484 exceeds their 
advance credit payments of $2,707, R and S are allowed an additional 
credit of $777. Although R and S marry in 2014, paragraph (b)(2) of this 
section (the alternative computation of additional tax for taxpayers who 
marry during the taxable year) does not apply because they do not owe 
additional tax for 2014.
    Example 6. Taxpayers divorce during the taxable year, 50 percent 
allocation. (i) Taxpayers V and W are married and have two dependents. 
In 2013, the Exchange for the rating area where the family resides 
determines that their 2014 household income will be $76,000 (330 percent 
of the Federal poverty line for a family of 4, applicable percentage 
9.5). V and W enroll in a qualified health plan for 2014. The premium 
for the applicable benchmark plan is $14,100. The Exchange approves 
advance credit payments of $573 per month, computed as follows: $14,100 
benchmark plan premium minus V and W's contribution amount of $7,220 
($76,000 x .095) equals $6,880 (total advance credit); $6,880/12 = $573.
    (ii) V and W divorce on June 17, 2014, and obtain separate qualified 
health plans beginning July 1, 2014. V enrolls based on household income 
of $60,000 and a family size of three (314 percent of the Federal 
poverty line, applicable percentage 9.5). The premium for the applicable 
benchmark plan is $10,000. The Exchange approves advance credit payments 
of $358 per month, computed as follows: $10,000 benchmark plan premium 
minus V's contribution amount of $5,700 ($60,000 x .095) equals $4,300 
(total advance credit); $4,300/12 = $358.
    (iii) W enrolls based on household income of $16,420 and a family 
size of one (147 percent of the Federal poverty line, applicable 
percentage 3.82). The premium for the applicable benchmark plan is 
$5,200. The Exchange approves advance credit payments of $381 per month, 
computed as follows: $5,200 benchmark plan premium minus W's 
contribution amount of $627 ($16,420 x .0382) equals $4,573 (total 
advance credit); $4,573/12 = $381. V and W do not agree on an allocation 
of the premium for the applicable benchmark plan, the premiums for the 
plan in which they enroll, and the advance credit payments for the 
period they were married in the taxable year.
    (iv) V and W each compute their credit at reconciliation under 
paragraph (b)(1) of this section, using the premiums for the applicable 
benchmark plans that apply to them for the months married and the months 
not married, and the contribution amount based on their Federal poverty 
line percentages at the end of the taxable year. Under paragraph (b)(3) 
of this section, because V and W do not agree on an allocation, V and W 
must equally allocate the benchmark plan premium ($7,050) and the 
advance credit payments ($3,438) for the six-month period January 
through June 2014 when they are married and enrolled in the same 
qualified health plan. Thus, V and W each are allocated $3,525 of the 
benchmark plan premium ($7,050/2) and $1,719 of the advance credit 
payments ($3,438/2) for January through June.
    (v) V reports on his 2014 tax return $60,000 in household income and 
family size of three. W reports on her 2014 tax return $16,420 in 
household income and family size of one. V and W reconcile their premium 
tax credit with advance credit payments as follows:

------------------------------------------------------------------------
                                                     V            W
------------------------------------------------------------------------
Allocated advance payments (Jan. to June).....       $1,719       $1,719
Actual advance payments (July to Dec.)........        2,148        2,286
                                               -------------------------
    Total advance payments....................        3,867        4,005
 
Allocated benchmark plan premium (Jan. to             3,525        3,525
 June)........................................
Actual benchmark plan premium (July to Dec.)..        5,000        2,600
                                               -------------------------
    Total benchmark plan premium..............        8,525        6,125
 
Contribution amount (taxable year household           5,700          627
 income x applicable percentage)..............
                                               -------------------------
    Credit (total benchmark plan premium less         2,825        5,498
     contribution amount).....................
Additional credit.............................  ...........        1,493

[[Page 134]]

 
Additional tax................................        1,042  ...........
------------------------------------------------------------------------

    (vi) Under paragraph (a)(1) of this section, on their tax returns 
V's tax liability is increased by $1,042 and W is allowed $1,493 as 
additional credit.
    Example 7. Taxpayers divorce during the taxable year, allocation in 
proportion to household income. (i) The facts are the same as in Example 
6, except that V and W decide to allocate the benchmark plan premium 
($7,050) and the advance credit payments ($3,438) for January through 
June 2014 in proportion to their household incomes (79 percent and 21 
percent). Thus, V is allocated $5,570 of the benchmark plan premiums 
($7,050 x .79) and $2,716 of the advance credit payments ($3,438 x .79), 
and W is allocated $1,481 of the benchmark plan premiums ($7,050 x .21) 
and $722 of the advance credit payments ($3,438 x .21). V and W 
reconcile their premium tax credit with advance credit payments as 
follows:

------------------------------------------------------------------------
                                                     V            W
------------------------------------------------------------------------
Allocated advance payments (Jan. to June).....       $2,716         $722
Actual advance payments (July to Dec.)........        2,148        2,286
                                               -------------------------
    Total advance payments....................        4,864        3,008
 
Allocated benchmark plan premium (Jan. to             5,570        1,481
 June)........................................
Actual benchmark plan premium (July to Dec.)..        5,000        2,600
                                               -------------------------
    Total benchmark plan premium..............       10,570        4,081
 
Contribution amount (taxable year household           5,700          627
 income x applicable percentage)..............
                                               -------------------------
    Credit (total benchmark plan premium less         4,870        3,454
     contribution amount).....................
Additional credit.............................            6          446
------------------------------------------------------------------------

    (ii) Under paragraph (a)(1) of this section, on their tax returns V 
is allowed an additional credit of $6 and W is allowed an additional 
credit of $446.
    Example 8. Married taxpayers filing separate tax returns. (i) 
Taxpayers X and Y are married and have two dependents. In 2013, the 
Exchange for the rating area where the family resides determines that 
their 2014 household income will be $76,000 (330 percent of the Federal 
poverty line for a family of 4, applicable percentage 9.5). W and Y 
enroll in a qualified health plan for 2014. The premium for the 
applicable benchmark plan is $14,100. X's and Y's monthly advance credit 
payment is $573, computed as follows: $14,100 benchmark plan premium 
minus X's and Y's contribution amount of $7,220 ($76,000 x .095) equals 
$6,880 (total advance credit); $6,880/12 = $573.
    (ii) X and Y file income tax returns for 2014 using a married filing 
separately filing status. X reports household income of $60,000 and a 
family size of three (314 percent of the Federal poverty line). Y 
reports household income of $16,420 and a family size of one (147 
percent of the Federal poverty line).
    (iii) Because X and Y are married but do not file a joint return for 
2014, X and Y are not applicable taxpayers and are not allowed a premium 
tax credit for 2014. See Sec.  1.36B-2(b)(2). Under paragraph (b)(4) of 
this section, half of the advance credit payments ($6,880/2 = $3,440) is 
allocated to X and half is allocated to Y for purposes of determining 
their excess advance payments. The repayment limitation described in 
paragraph (a)(3) of this section applies to X and Y based on the 
household income and family size reported on each return. Consequently, 
X's tax liability for 2014 is increased by $2,500 and Y's tax liability 
for 2014 is increased by $600.
    Example 9. (i) The facts are the same as in Example 8 of paragraph 
(b)(5) of this section, except that X and Y live apart for over 6 months 
of the year and X properly files an income tax return as head of 
household. Under section 7703(b), X is treated as unmarried and 
therefore is not required to file a joint return. If X otherwise 
qualifies as an applicable taxpayer, X may claim the premium tax credit 
based on the household income and family size X reports on the return. Y 
is not an applicable taxpayer and is not eligible to claim the premium 
tax credit.
    (ii) X must reconcile the amount of credit with advance credit 
payments under paragraph (a) of this section. The premium for the 
applicable benchmark plan covering X and his two dependents is $9,800. 
X's premium tax credit is computed as follows: $9,800 benchmark plan 
premium minus X's contribution amount of $5,700 ($60,000 x .095) equals 
$4,100.
    (iii) Under paragraph (b)(4) of this section, half of the advance 
payments ($6,880/2 = $3,440) is allocated to X and half is allocated to 
Y. Thus, X is entitled to $660 additional premium tax credit ($4,100 - 
$3,440). Y has $3,440 excess advance payments, which is

[[Page 135]]

limited to $600 under paragraph (a)(3) of this section.
    Example 10. (i) A is married to B at the close of 2014 and they have 
no dependents. A and B are enrolled in a qualified health plan for 2014 
with an annual premium of $10,000 and advance credit payments of $6,500. 
A is not eligible for minimum essential coverage (other than coverage 
described in section 5000A(f)(1)(C)) for any month in 2014. A is a 
victim of domestic abuse as described in Sec.  1.36B-2(b)(2)(iii). At 
the time A files her tax return for 2014, A is unable to file a joint 
return with B for 2014 because of the domestic abuse. A certifies on her 
2014 return, in accordance with relevant instructions, that she is 
living apart from B and is unable to file a joint return because of 
domestic abuse. Thus, under Sec.  1.36B-2(b)(2)(ii), A satisfies the 
joint return filing requirement in section 36B(c)(1)(C) for 2014.
    (ii) A's family size for 2014 for purposes of computing the premium 
tax credit is one, and A is the only member of her coverage family. 
Thus, A's benchmark plan for all months of 2014 is the second lowest 
cost silver plan offered by the Exchange for A's rating area that covers 
A. A's household income includes only A's modified adjusted gross 
income. Under paragraph (b)(4)(ii) of this section, A takes into account 
$5,000 ($10,000 x .50) of the premiums for the plan in which she was 
enrolled in determining her premium tax credit. Further, A must 
reconcile $3,250 ($6,500 x .50) of the advance credit payments for her 
coverage under paragraph (b)(4)(i) of this section.
    (c)  Applicability dates. Paragraphs (a)(1)(ii), (a)(3)(iii), 
(a)(4), Examples 4, 10, 11, 12, 13, 14, and 15, (b)(3), (b)(4), and 
(b)(5), Examples 9 and 10 apply to taxable years beginning after 
December 31, 2013. The last sentence of paragraph (a)(1)(ii)(B)(1), 
paragraph (a)(1)(ii)(B)(2), and paragraph (a)(1)(ii)(C) of this section 
apply to taxable years ending on or after December 31, 2020.

[T.D. 9590, 77 FR 30385, May 23, 2012; 77 FR 41048, July 12, 2012; 77 FR 
41270, July 13, 2012, as amended by T.D. 9683, 79 FR 43627, July 28, 
2014; T.D. 9822, 82 FR 34607, July 26, 2017; T.D. 9912, 85 FR 76978, 
Dec. 1, 2020]



Sec.  1.36B-5  Information reporting by Exchanges.

    (a) In general. An Exchange must report to the Internal Revenue 
Service (IRS) information required by section 36B(f)(3) and this section 
relating to individual market qualified health plans in which 
individuals enroll through the Exchange. No reporting is required under 
this section for enrollment in plans through the Small Business Health 
Options Exchange.
    (b) Individual filing a return. For purposes of this section, the 
terms tax filer and responsible adult describe the individual who is 
expected to be the taxpayer filing an income tax return for the year of 
coverage with respect to individuals enrolling in a qualified health 
plan. A tax filer is an individual on behalf of whom advance payments of 
the premium tax credit are made. A responsible adult is an individual on 
behalf of whom advance payments of the premium tax credit are not made. 
An individual may be a tax filer or responsible adult whether or not 
enrolled in coverage. If more than one family (within the meaning of 
Sec.  1.36B-1(d)) enrolls in the same qualified health plan, there is a 
tax filer or responsible adult for each family.
    (c) Information required to be reported--(1) Information reported 
annually. An Exchange must report to the IRS the following information 
for each qualified health plan--
    (i) The name, address, and taxpayer identification number (TIN), or 
date of birth if a TIN is not available, of the tax filer or responsible 
adult;
    (ii) The name and TIN, or date of birth if a TIN is not available, 
of a tax filer's spouse;
    (iii) The amount of the advance credit payments paid for coverage 
under the plan each month;
    (iv) For plans for which advance credit payments are made, the 
premium (excluding the premium allocated to benefits in excess of 
essential health benefits, see Sec.  1.36B-3(j)) for the applicable 
benchmark plan for purposes of computing advance credit payments;
    (v) Except as provided in paragraph (c)(3)(ii) of this section, for 
plans for which advance credit payments are not made, the premium 
(excluding the premium allocated to benefits in excess of essential 
health benefits, see Sec.  1.36B-3(j)) for the applicable benchmark plan 
that would apply to all individuals enrolled in the qualified health 
plan if advance credit payments were made for the coverage;
    (vi) The name and TIN, or date of birth if a TIN is not available, 
and dates of coverage for each individual covered under the plan;

[[Page 136]]

    (vii) The coverage start and end dates of the qualified health plan;
    (viii) The monthly premium for the plan in which the individuals 
enroll, however--
    (A) The premium allocated to benefits in excess of essential health 
benefits is excluded, see Sec.  1.36B-3(j);
    (B) The premium for a stand-alone dental plan allocated to pediatric 
dental benefits is added, see Sec.  1.36B-3(k), but if a family (within 
the meaning of Sec.  1.36B-1(d)) is enrolled in more than one qualified 
health plan, the pediatric dental premium is added to the premium for 
only one qualified health plan; and
    (C) The amount is not reduced for advance credit payments;
    (ix) The name of the qualified health plan issuer;
    (x) The Exchange-assigned policy identification number;
    (xi) The Exchange's unique identifier; and
    (xii) Any other information specified by forms or instructions or in 
published guidance, see Sec.  601.601(d) of this chapter.
    (2) Information reported monthly. For each calendar month, an 
Exchange must report to the IRS for each qualified health plan, the 
information described in paragraph (c)(1) of this section and the 
following information--
    (i) For plans for which advance credit payments are made--
    (A) The names, TINs, or dates of birth if no TIN is available, of 
the individuals enrolled in the qualified health plan who are expected 
to be the tax filer's dependent; and
    (B) Information on employment (to the extent this information is 
provided to the Exchange) consisting of--
    (1) The name, address, and EIN of each employer of the tax filer, 
the tax filer's spouse, and each individual covered by the plan; and
    (2) An indication of whether an employer offered affordable minimum 
essential coverage that provided minimum value, and, if so, the amount 
of the employee's required contribution for self-only coverage;
    (ii) The unique identifying number the Exchange uses to report data 
that enables the IRS to associate the data with the proper account from 
month to month;
    (iii) The issuer's employer identification number (EIN); and
    (iv) Any other information specified by forms or instructions or in 
published guidance, see Sec.  601.601(d) of this chapter.
    (3) Special rules for information reported--(i) Multiple families 
enrolled in a single qualified health plan. An Exchange must report the 
information specified in paragraphs (c)(1) and (c)(2) of this section 
for each family (within the meaning of Sec.  1.36B-1(d)) enrolled in a 
qualified health plan, including families submitting a single 
application or enrolled in a single qualified health plan. If advance 
credit payments are made for coverage under the plan, the enrollment 
premiums reported to each family under paragraph (c)(1)(viii) of this 
section are the premiums allocated to the family under Sec.  1.36B-3(h) 
(allocating enrollment premiums to each taxpayer in proportion to the 
premiums for each taxpayer's applicable benchmark plan).
    (ii) Alternative to reporting applicable benchmark plan. An Exchange 
satisfies the requirement in paragraph (c)(1)(v) of this section if, on 
or before January 1 of each year after 2014, the Exchange provides a 
reasonable method that a responsible adult may use to determine the 
premium (after adjusting for benefits in excess of essential health 
benefits) for the applicable benchmark plan that applies to the 
responsible adult's coverage family for the prior calendar year for 
purposes of determining the premium tax credit on the tax return.
    (iii) Partial month of coverage.--(A) In general. Except as provided 
in paragraph (c)(3)(iii)(B) of this section, if an individual is 
enrolled in a qualified health plan after the first day of a month, the 
amount reported for that month under paragraphs (c)(1)(iv), (c)(1)(v), 
and (c)(1)(viii) of this section is $0.
    (B) Certain mid-month enrollments. For information reporting that is 
due on or after January 1, 2019, if an individual's qualified health 
plan is terminated before the last day of a month, or if an individual 
is enrolled in coverage after

[[Page 137]]

the first day of a month and the coverage is effective on the date of 
the individual's birth, adoption, or placement for adoption or in foster 
care, or on the effective date of a court order, the amount reported 
under paragraphs (c)(1)(iv) and (c)(1)(v) of this section is the premium 
for the applicable benchmark plan for a full month of coverage 
(excluding the premium allocated to benefits in excess of essential 
health benefits), and the amount reported under paragraph (c)(1)(viii) 
of this section is the enrollment premium for the month, reduced by any 
amounts that were refunded.
    (4) Exemptions. For each calendar month, an Exchange must report to 
the IRS the name and TIN, or date of birth if a TIN is not available, of 
each individual for whom the Exchange has granted an exemption from 
coverage under section 5000A(e) and the related regulations, the months 
for which the exemption is in effect, and the exemption certificate 
number.
    (d) Time for reporting--(1) Annual reporting. An Exchange must 
submit to the IRS the annual report required under paragraph (c)(1) of 
this section on or before January 31 of the year following the calendar 
year of coverage.
    (2) Monthly reporting--(i) In general. Except as provided in 
paragraph (d)(2)(ii) of this section, an Exchange must submit to the IRS 
the monthly reports required under paragraphs (c)(2) and (c)(4) of this 
section on or before the 15th day following each month of coverage.
    (ii) Initial monthly reporting in 2014. Exchanges must submit to the 
IRS the initial monthly report required under paragraphs (c)(2) and 
(c)(4) of this section on a date that the Commissioner may establish in 
other guidance, see Sec.  601.601(d) of this section, but no earlier 
than June 15, 2014. The initial report must include cumulative 
information for enrollments for the period January 1, 2014, through the 
last day of the month preceding the month for submitting the initial 
monthly report.
    (3) Corrections to information reported. In general, an Exchange 
must correct erroneous or outdated monthly-reported information in the 
next monthly report. If the information must be corrected after the 
final monthly submission on January 15 following the coverage year, 
corrections should be submitted by the 15th day of the month following 
the month in which the incorrect information is identified. However, no 
monthly report correction is permitted after April 15 following the year 
of coverage. Errors on the annual report must be corrected and reported 
to the IRS and to the individual recipient identified in paragraph (f) 
of this section as soon as possible.
    (e) Electronic reporting. An Exchange must submit the reports to the 
IRS required under this section in electronic format. The information 
reported monthly will be submitted to the IRS through the Department of 
Health and Human Services.
    (f) Annual statement to be furnished to individuals--(1) In general. 
An Exchange must furnish to each tax filer or responsible adult (the 
recipient for purposes of paragraphs (f) and (g) of this section) a 
written statement showing--
    (i) The name and address of the recipient and
    (ii) The information described in paragraph (c)(1) of this section 
for the previous calendar year.
    (2) Form of statements. A statement required under this paragraph 
(f) may be made by furnishing to the recipient identified in the annual 
report either a copy of the report filed with the IRS or a substitute 
statement. A substitute statement must include the information required 
to be shown on the report filed with the IRS and must comply with 
requirements in published guidance (see Sec.  601.601(d)(2) of this 
chapter) relating to substitute statements. A reporting entity may use 
an IRS truncated taxpayer identification number as the identification 
number for an individual in lieu of the identification number appearing 
on the corresponding information report filed with the IRS.
    (3) Time and manner for furnishing statements. An Exchange must 
furnish the statements required under this paragraph (f) on or before 
January 31 of the year following the calendar year of coverage. If 
mailed, the statement must be sent to the recipient's last known 
permanent address or, if no permanent address is known, to the 
recipient's temporary address. For purposes of this paragraph (f)(3), an 
Exchange's

[[Page 138]]

first class mailing to the last known permanent address, or if no 
permanent address is known, the temporary address, discharges the 
Exchange's requirement to furnish the statement. An Exchange may furnish 
the statement electronically in accordance with paragraph (g) of this 
section.
    (g) Electronic furnishing of statements--(1) In general. An Exchange 
required to furnish a statement under paragraph (f) of this section may 
furnish the statement to the recipient in an electronic format in lieu 
of a paper format. An Exchange that meets the requirements of paragraphs 
(g)(2) through (g)(7) of this section is treated as furnishing the 
statement in a timely manner.
    (2) Consent--(i) In general. A recipient must have affirmatively 
consented to receive the statement in an electronic format. The consent 
may be made electronically in any manner that reasonably demonstrates 
that the recipient is able to access the statement in the electronic 
format in which it will be furnished. Alternatively, the consent may be 
made in a paper document that is confirmed electronically.
    (ii) Withdrawal of consent. The consent requirement of this 
paragraph (g)(2) is not satisfied if the recipient withdraws the consent 
and the withdrawal takes effect before the statement is furnished. An 
Exchange may provide that the withdrawal of consent takes effect either 
on the date the Exchange receives it or on another date no more than 60 
days later. The Exchange may provide that a request by the recipient for 
a paper statement will be treated as a withdrawal of consent to receive 
the statement in an electronic format. If the Exchange furnishes a 
statement after the withdrawal of consent takes effect, the recipient 
has not consented to receive the statement in electronic format.
    (iii) Change in hardware or software requirements. If a change in 
the hardware or software required to access the statement creates a 
material risk that a recipient will not be able to access a statement, 
an Exchange must, prior to changing the hardware or software, notify the 
recipient. The notice must describe the revised hardware and software 
required to access the statement and inform the recipient that a new 
consent to receive the statement in the revised electronic format must 
be provided to the Exchange. After implementing the revised hardware and 
software, the Exchange must obtain a new consent or confirmation of 
consent from the recipient to receive the statement electronically.
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (g)(2):
    Example 1. Furnisher F sends Recipient R a letter stating that R may 
consent to receive the statement required under section 36B 
electronically on a Web site instead of in a paper format. The letter 
contains instructions explaining how to consent to receive the statement 
electronically by accessing the Web site, downloading and completing the 
consent document, and emailing the completed consent to F. The consent 
document posted on the Web site uses the same electronic format that F 
will use for the electronically furnished statement. R reads the 
instructions and submits the consent in the manner provided in the 
instructions. R has consented to receive the statement required under 
section 36B electronically in the manner described in paragraph 
(g)(2)(i) of this section.
    Example 2. Furnisher F sends Recipient R an email stating that R may 
consent to receive the statement required under section 36B 
electronically instead of in a paper format. The email contains an 
attachment instructing R how to consent to receive the statement 
required under section 36B electronically. The email attachment uses the 
same electronic format that F will use for the electronically furnished 
statement. R opens the attachment, reads the instructions, and submits 
the consent in the manner provided in the instructions. R has consented 
to receive the statement required under section 36B electronically in 
the manner described in paragraph (g)(2)(i) of this section.
    Example 3. Furnisher F posts a notice on its Web site stating that 
Recipient R may receive the statement required under section 36B 
electronically instead of in a paper format. The Web site contains 
instructions on how R may access a secure Web page and consent to 
receive the statements electronically. R accesses the secure Web page 
and follows the instructions for giving consent. R has consented to 
receive the statement required under section 36B electronically in the 
manner described in paragraph (g)(2)(i) of this section.
    (3) Required disclosures--(i) In general. Prior to, or at the time 
of, a recipient's consent, an Exchange must provide to the recipient a 
clear and conspicuous

[[Page 139]]

disclosure statement containing each of the disclosures described in 
paragraphs (g)(3)(ii) through (g)(3)(viii) of this section.
    (ii) Paper statement. An Exchange must inform the recipient that the 
statement will be furnished on paper if the recipient does not consent 
to receive it electronically.
    (iii) Scope and duration of consent. An Exchange must inform the 
recipient of the scope and duration of the consent. For example, the 
Exchange must inform the recipient whether the consent applies to each 
statement required to be furnished after the consent is given until it 
is withdrawn or only to the first statement required to be furnished 
following the consent.
    (iv) Post-consent request for a paper statement. An Exchange must 
inform the recipient of any procedure for obtaining a paper copy of the 
recipient's statement after giving the consent described in paragraph 
(g)(2)(i) of this section and whether a request for a paper statement 
will be treated as a withdrawal of consent.
    (v) Withdrawal of consent. An Exchange must inform the recipient 
that--
    (A) The recipient may withdraw consent by writing (electronically or 
on paper) to the person or department whose name, mailing address, 
telephone number, and email address is provided in the disclosure 
statement;
    (B) An Exchange will confirm the withdrawal and the date on which it 
takes effect in writing (either electronically or on paper); and
    (C) A withdrawal of consent does not apply to a statement that was 
furnished electronically in the manner described in this paragraph (g) 
before the date on which the withdrawal of consent takes effect.
    (vi) Notice of termination. An Exchange must inform the recipient of 
the conditions under which the Exchange will cease furnishing statements 
electronically to the recipient.
    (vii) Updating information. An Exchange must inform the recipient of 
the procedures for updating the information needed to contact the 
recipient and notify the recipient of any change in the Exchange's 
contact information.
    (viii) Hardware and software requirements. An Exchange must provide 
the recipient with a description of the hardware and software required 
to access, print, and retain the statement, and the date when the 
statement will no longer be available on the Web site. The Exchange must 
advise the recipient that the statement may be required to be printed 
and attached to a Federal, State, or local income tax return.
    (4) Format. The electronic version of the statement must contain all 
required information and comply with applicable published guidance (see 
Sec.  601.601(d) of this chapter) relating to substitute statements to 
recipients.
    (5) Notice--(i) In general. If a statement is furnished on a Web 
site, the Exchange must notify the recipient. The notice may be 
delivered by mail, electronic mail, or in person. The notice must 
provide instructions on how to access and print the statement and 
include the following statement in capital letters, ``IMPORTANT TAX 
RETURN DOCUMENT AVAILABLE.'' If the notice is provided by electronic 
mail, this statement must be on the subject line of the electronic mail.
    (ii) Undeliverable electronic address. If an electronic notice 
described in paragraph (g)(5)(i) of this section is returned as 
undeliverable, and the Exchange cannot obtain the correct electronic 
address from the Exchange's records or from the recipient, the Exchange 
must furnish the notice by mail or in person within 30 days after the 
electronic notice is returned.
    (iii) Corrected statement. An Exchange must furnish a corrected 
statement to the recipient electronically if the original statement was 
furnished electronically. If the original statement was furnished 
through a Web site posting, the Exchange must notify the recipient that 
it has posted the corrected statement on the Web site in the manner 
described in paragraph (g)(5)(i) of this section within 30 days of the 
posting. The corrected statement or the notice must be furnished by mail 
or in person if--
    (A) An electronic notice of the Web site posting of an original 
statement or the corrected statement was returned as undeliverable; and

[[Page 140]]

    (B) The recipient has not provided a new email address.
    (6) Access period. Statements furnished on a Web site must be 
retained on the Web site through October 15 of the year following the 
calendar year to which the statements relate (or the first business day 
after October 15, if October 15 falls on a Saturday, Sunday, or legal 
holiday). The furnisher must maintain access to corrected statements 
that are posted on the Web site through October 15 of the year following 
the calendar year to which the statements relate (or the first business 
day after October 15, if October 15 falls on a Saturday, Sunday, or 
legal holiday) or the date 90 days after the corrected forms are posted, 
whichever is later.
    (7) Paper statements after withdrawal of consent. An Exchange must 
furnish a paper statement if a recipient withdraws consent to receive a 
statement electronically and the withdrawal takes effect before the 
statement is furnished. A paper statement furnished under this paragraph 
(g)(7) after the statement due date is timely if furnished within 30 
days after the date the Exchange receives the withdrawal of consent.
    (h) Effective/applicability date. Except for the last sentence of 
paragraph (c)(3)(i) of this section and paragraph (c)(3)(iii) of this 
section, this section applies to taxable years ending after December 31, 
2013. The last sentence of paragraph (c)(3)(i) of this section and 
paragraph (c)(3)(iii) of this section apply to taxable years beginning 
after December 31, 2018. Paragraph (c)(3) of Sec.  1.36B-5 as contained 
in 26 CFR part I edition revised as of April 1, 2016, applies to 
information reporting for taxable years ending after December 31, 2013, 
and beginning before January 1, 2019.

[T.D. 9663, 79 FR 26117, May 7, 2014, as amended at 81 FR 91768, Dec. 
19, 2016]



Sec.  1.36B-6  Minimum value.

    (a) In general--(1) Employees. An eligible employer-sponsored plan 
provides minimum value (MV) for an employee of the employer offering the 
coverage only if--
    (i) The plan's MV percentage, as defined in paragraph (c) of this 
section, is at least 60 percent based on the plan's share of the total 
allowed costs of benefits provided to the employee; and
    (ii) The plan provides substantial coverage of inpatient hospital 
services and physician services.
    (2) Related individuals--(i) In general. An eligible employer-
sponsored plan provides MV for an individual who may enroll in the plan 
because of a relationship to an employee of the employer offering the 
coverage (a related individual) only if--
    (A) The plan's MV percentage, as defined in paragraph (c) of this 
section, is at least 60 percent based on the plan's share of the total 
allowed costs of benefits provided to the related individual; and
    (B) The plan provides substantial coverage of inpatient hospital 
services and physician services.
    (ii) Plans providing MV to employees. If an eligible employer-
sponsored plan provides MV to an employee under paragraph (a)(1) of this 
section, the plan also provides MV for related individuals if--
    (A) The scope of benefits is the same for the employee and related 
individuals; and
    (B) Cost sharing (including deductibles, co-payments, coinsurance, 
and out-of-pocket maximums) under the plan is the same for the employee 
and related individuals under the tier of coverage that would, if 
elected, include the employee and all related individuals (disregarding 
any differences in deductibles or out-of-pocket maximums that are 
attributable to a different tier of coverage, such as self plus one 
versus family coverage).
    (b) MV standard population. [Reserved]
    (c) MV percentage--(1) In general. [Reserved]
    (2) Wellness program incentives--(i) In general. Nondiscriminatory 
wellness program incentives offered by an eligible employer-sponsored 
plan that affect deductibles, copayments, or other cost-sharing are 
treated as earned in determining the plan's MV percentage if the 
incentives relate exclusively to tobacco use. Wellness program 
incentives that do not relate to tobacco use or that include a component 
unrelated to tobacco use are treated as not

[[Page 141]]

earned for this purpose. For purposes of this section, the term wellness 
program incentive has the same meaning as the term reward in Sec.  
54.9802-1(f)(1)(i) of this chapter.
    (ii) Example. The following example illustrates the rules of this 
paragraph (c)(2):

    Example. (i) Employer X offers an eligible employer-sponsored plan 
that reduces the deductible by $300 for employees who do not use tobacco 
products or who complete a smoking cessation course. The deductible is 
reduced by $200 if an employee completes cholesterol screening within 
the first six months of the plan year. Employee B does not use tobacco 
and his deductible is $3,700. Employee C uses tobacco and her deductible 
is $4,000.
    (ii) Under paragraph (c)(2)(i) of this section, only the incentives 
related to tobacco use are considered in determining the plan's MV 
percentage. C is treated as having earned the $300 incentive for 
attending a smoking cessation course regardless of whether C actually 
attends the course. Thus, the deductible for determining for the MV 
percentage for both Employees B and C is $3,700. The $200 incentive for 
completing cholesterol screening is disregarded.

    (3) Employer contributions to health savings accounts. Employer 
contributions for the current plan year to health savings accounts that 
are offered with an eligible employer-sponsored plan are taken into 
account for that plan year towards the plan's MV percentage.
    (4) Employer contributions to health reimbursement arrangements. 
Amounts newly made available for the current plan year under a health 
reimbursement arrangement that would be integrated within the meaning of 
Notice 2013-54 (2013-40 IRB 287), see Sec.  601.601(d) of this chapter, 
with an eligible employer-sponsored plan for an employee enrolled in the 
plan are taken into account for that plan year towards the plan's MV 
percentage if the amounts may be used to reduce only cost-sharing for 
covered medical expenses. A health reimbursement arrangement counts 
toward a plan's MV percentage only if the health reimbursement 
arrangement and the eligible employer-sponsored plan are offered by the 
same employer. Employer contributions to a health reimbursement 
arrangement count for a plan year towards the plan's MV percentage only 
to the extent the amount of the annual contribution is required under 
the terms of the plan or otherwise determinable within a reasonable time 
before the employee must decide whether to enroll in the eligible 
employer-sponsored plan.
    (5) Expected spending adjustments for health savings accounts and 
health reimbursement arrangements. [Reserved]
    (d) Methods for determining MV. [Reserved]
    (e) Scope of essential health benefits and adjustment for benefits 
not included in MV Calculator. [Reserved]
    (f) Actuarial certification. [Reserved]
    (1) In general. [Reserved]
    (2) Membership in American Academy of Actuaries. [Reserved]
    (3) Actuarial analysis. [Reserved]
    (4) Use of MV Calculator. [Reserved]
    (g) Effective/applicability date--in general. (1) Except as provided 
in paragraph (g)(2) of this section, this section applies for taxable 
years ending after December 31, 2013.
    (2) Exceptions. (i) Paragraph (a)(1)(ii) of this section applies for 
plan years beginning after November 3, 2014; and
    (ii) Paragraph (a)(2) of this section applies to taxable years 
beginning after December 31, 2022.

[T.D. 9745, 80 FR 78976, Dec. 18, 2015, as amended by T.D. 9968, 87 FR 
62002, Oct. 13, 2022]



Sec.  1.37-1  General rules for the credit for the elderly.

    (a) In general. In the case of an individual, section 37 provides a 
credit against the tax imposed by chapter 1 of the Internal Revenue Code 
of 1954. This section and Sec. Sec.  1.37-2 and 1.37-3 provide guidance 
in the computation of the credit for the elderly provided under section 
37 for taxable years beginning after 1975. For rules relating to the 
computation of the retirement income credit provided under section 37 
for taxable years beginning before 1976, see 26 CFR 1.37-1 through 1.37-
5 (Rev. as of April 1, 1980). Note that section 403 of the Tax Reduction 
and Simplification Act of 1977 provides that a taxpayer may elect to 
compute the credit under section 37 for the taxpayer's first taxable 
year beginning in 1976 in accordance with the rules applicable to 
taxable years beginning before 1976.

[[Page 142]]

    (b) Limitation on the amount of the credit. The credit allowed by 
section 37 for a taxable year shall not exceed the tax imposed by 
chapter 1 of the Code for the taxable year (reduced, in the case of a 
taxable year beginning before 1979, by the general tax credit allowed by 
section 42).
    (c) Married couples must file joint returns. If the taxpayer is 
married at the close of the taxable year, the credit provided by section 
37 shall be allowed only if the taxpayer and the taxpayer's spouse file 
a joint return for the taxable year. The preceding sentence shall not 
apply in the case of a husband and wife who are not members of the same 
household at any time during the taxable year. For the determination of 
marital status, see Sec. Sec.  143 and 1.143-1.
    (d) Nonresident aliens ineligible. No credit is allowed under 
section 37 to any individual for any taxable year during which that 
individual is at any time a nonresident alien unless the individual is 
treated, by reason of an election under section 6013 (g) or (h), as a 
resident of the United States for that taxable year.

[T.D. 7743, 45 FR 84049, Dec. 22, 1980]



Sec.  1.37-2  Credit for individuals age 65 or over.

    (a) In general. This section illustrates the computation of the 
credit for the elderly in the case of an individual who has attained the 
age of 65 before the close of the taxable year. This section shall not 
apply to an individual for any taxable year for which the individual 
makes the election described in section 37(e)(2) and paragraph (b) of 
Sec.  1.37-3.
    (b) Computation of credit. The credit for the elderly for an 
individual to whom this section applies equals 15 percent of the 
individual's ``section 37 amount'' for the taxable year. An individual's 
``section 37 amount'' for a taxable year is the initial amount 
determined under section 37(b)(2), reduced as provided in section 
37(b)(3) and (c)(1).
    (c) Examples. The computation of the credit for the elderly for 
individuals to whom this section applies may be illustrated by the 
following examples:

    Example 1. A, a single individual who is 67 years old, has adjusted 
gross income of $8,000 for the calendar year 1977. A also receives 
social security payments of $1,450 during 1977. A does not itemize 
deductions. A's credit for the elderly is $120, computed as follows:

Initial amount under section 37(b)(2).........................    $2,500
Reductions required by section 37 (b)(3) and (c)(1):
    Social security payments........................    $1,450
    One-half the excess of adjusted gross income           250     1,700
     over $7,500....................................
                                                     ----------
Section 37 amount.............................................       800
                                                               =========
15 pct. of $800...............................................      $120
 


A's tax from the tax tables, which reflect the allowance of the general 
tax credit, is $662. Accordingly, the limitation of section 37(c)(2) and 
paragraph (b) of Sec.  1.37-1 does not reduce A's credit for the 
elderly.
    Example 2. H and W, who have both attained the age of 65, file a 
joint return for calendar year 1977. For that year H and W have adjusted 
gross income of $8,120; H also receives a railroad retirement pension of 
$1,550, and W receives social security payments of $1,200. H and W do 
not itemize deductions. The credit for the elderly allowed to H and W 
for 1977 is $139, computed as follows:

Initial amount under section 37(b)(2).........................    $3,750
Reductions required by section 37 (b)(3):
    Railroad retirement pension.....................    $1,550
    Social Security payments........................     1,200     2,750
                                                     ----------
Section 37 amount.............................................     1,000
                                                               =========
15 pct. of $1,000.............................................       150
Limitation based upon amount of tax (derived from table             $139
 reflecting allowance of general tax credit)..................
 


Since the adjusted gross income of H and W is not greater than $10,000, 
no reduction of the initial amount is required under section 37 (c)(1).

[T.D. 7743, 45 FR 84050, Dec. 22, 1980]



Sec.  1.37-3  Credit for individuals under age 65 who have public
retirement system income.

    (a) In general. This section provides rules for the computation of 
the credit for the elderly under section 37(e) in the case of an 
individual who has not attained the age of 65 before the close of the 
taxable year and whose gross income for the taxable year includes 
retirement income within the meaning of paragraph (d)(1)(ii) of this 
section (i.e., under a public retirement system). If such an individual 
is married within the meaning of section 143 at the close of the taxable 
year and the spouse of the individual has attained the age of 65 before 
the close of the taxable year, this section shall apply to the 
individual for the taxable year only if both

[[Page 143]]

spouses make the election described in paragraph (b) of this section. If 
both spouses make the election described in paragraph (b) of this 
section for the taxable year, the credit of each spouse shall be 
determined under the rules of this section. See paragraph (f)(2) of this 
section for a limitation on the effects of community property laws in 
making determinations and computations under section 37(e) and this 
section.
    (b) Election by certain married taxpayers. If a married individual 
under age 65 at the close of the taxable year has retirement income and 
the spouse of that individual has attained the age of 65 before the 
close of the taxable year, both spouses may elect to compute the credit 
provided by section 37 under the rules of section 37(e) and this 
section. The spouses shall signify the election on the return (or 
amended return) for the taxable year in the manner prescribed in the 
instructions accompanying the return. The election may be made at any 
time before the expiration of the period of limitation for filing claim 
for credit or return for the taxable year. The election may be revoked 
without the consent of the Commissioner at any time before the 
expiration of that period by filing an amended return.
    (c) Computation of credit. The credit of an individual under section 
37(e) and this section equals 15 percent of the individual's credit base 
for the taxable year. The credit base of an individual for a taxable 
year is the lesser of--
    (1) The retirement income of the individual for the taxable year, or
    (2) The amount determined under section 37(e)(5), as modified by 
section 37(e) (6) and (7).
    (d) Retirement income--(1) General rule--(i) For individuals 65 or 
over. Section 37(e)(4)(A) enumerates the kinds of income which may be 
treated as the retirement income of an individual who has attained the 
age of 65 before the close of the taxable year. They include income from 
pensions and annuities, interest, rents, dividends, certain bonds 
received under a qualified bond purchase plan, and certain individual 
retirement accounts or annuities.
    (ii) For individuals under 65. In the case of an individual who has 
not attained the age of 65 before the close of the taxable year, 
retirement income consists only of income from pensions and annuities 
(including disability annuity payments) under a public retirement system 
which arises from services performed by that individual or by a present 
or former spouse of that individual. The term ``public retirement 
system'' means a pension, annuity, or retirement, or similar fund or 
system established by the United States, a State, a possession of the 
United States, any political subdivision of any of the foregoing, or the 
District of Columbia.
    (2) Rents. For purposes of section 37(e)(4)(A)(iii), income from 
rents shall be the gross amount received, not reduced by depreciation or 
other expenses, except that beneficiaries of a trust or estate shall 
treat as retirement income only their proportionate shares, of the 
taxable rents of the trust or estate. In the case of an amount received 
for board and lodging, only the portion of the amount received for 
lodging is income from rents.
    (3) Disability annuity payments received by individual under age 65. 
Disability annuity payments received under a public retirement system by 
an individual under age 65 at the close of the taxable year shall not be 
treated as retirement income unless the payments are for periods after 
the date on which the individual reached minimum retirement age, that 
is, the age at which the individual would be eligible to receive a 
pension or annuity without regard to disability, and any of the 
following conditions is satisfied--
    (i) The individual is precluded from seeking the benefits of section 
105(d) (relating to certain disability payments) for that taxable year 
by reason of an irrevocable election;
    (ii) The individual was not permanently and totally disabled at the 
time of retirement (and was not permanently and totally disabled either 
on January 1, 1976, or on January 1, 1977, if the individual retired 
before the later date on disability or under circumstances which 
entitled the individual to retire on disability); or
    (iii) The payments are for periods after the individual reached 
mandatory retirement age.

[[Page 144]]


For purposes of this paragraph, disability annuity payments include 
payments to an individual who retired on partial or temporary 
disability.
    (4) Compensation of personal services rendered during taxable year. 
Retirement income does not include any amount representing compensation 
for personal services rendered during the taxable year. For this 
purpose, amounts received as a pension shall not be treated as 
representing compensation for personal services rendered during the 
taxable year if the period of service during the taxable year is not 
substantial when compared with the total years of service. For example, 
an individual on the calendar year basis retires on November 30 after 5 
years of service and receives a pension during the remainder of his 
taxable year. The pension is not treated as representing compensation 
for personal services rendered during such taxable year merely because 
it is paid by reason of the services of the individual for a period of 5 
years which includes a portion of the taxable year.
    (5) Amounts not includible in gross income. Retirement income does 
not include any amount not includible in the gross income of the 
individual for the taxable year. For example, if a portion of an annuity 
is excluded from gross income under section 72, relating to annuities, 
that portion of the annuity is not retirement income; similarly, the 
portion of dividend income excluded from gross income under section 116, 
relating to the partial exclusion of dividends received by individuals 
is not retirement income.
    (e) Earned income--(1) In general. The term ``earned income'' in 
section 37(e)(5)(B) generally has the same meaning as in section 911(b), 
except that earned income does not include any amount received as a 
pension or annuity. See section 911(b) and the regulations thereunder. 
Section 911(b) provides, in general, that earned income includes wages, 
salaries, professional fees, and other amounts received as compensation 
for personal services rendered.
    (2) Earned income from self-employment. For purposes of section 
37(e)(5)(B), the earned income of a taxpayer from self-employment in a 
trade or business shall not exceed--
    (i) The taxpayer's share of the net profits from the trade or 
business if capital is not a material income-producing factor in that 
trade or business; or
    (ii) Thirty percent of the taxpayer's share of the net profits from 
the trade or business if capital is a material income-producing factor 
in that trade or business.

For other rules relating to the determination of earned income from 
self-employment in a trade or business, see section 911(b) and the 
regulations thereunder.
    (3) Disability annuity payments received by individuals under age 
65. Disability annuity payments received under a public retirement 
system by an individual under age 65 at the close of the taxable year 
shall be treated as earned income for purposes of section 37(e)(5)(B) 
unless the payments are treated as retirement income under paragraph 
(d)(3) of this section.
    (f) Computation of credit under section 37(e) in the case of joint 
returns--(1) In general. In the case of a joint return of husband and 
wife, the credit base of each spouse under section 37(e) is computed 
separately. The spouses then combine their credit bases and compute a 
single credit. The limitation in section 37(c)(2) and paragraph (b) of 
Sec.  1.37-1 on the amount of the credit is determined by reference to 
the joint tax liability of the spouses. Thus, regardless of whether a 
spouse would be liable for the tax imposed by chapter 1 of the Code if 
the joint return had not been filed, the credit base of that spouse is 
taken into account in computing the credit.
    (2) Community property laws. For taxable years beginning after 1977, 
married individuals filing joint returns shall disregard community 
property laws in making any determination or computation required under 
section 37(e) or this section. Each item of income is attributed in full 
to the spouse whose income it would have been in the absence of 
community property laws. Thus, if a 67-year old individual files a joint 
return with a 62-year old spouse for 1979 and the only income of the 
couple is from a public pension of the older

[[Page 145]]

spouse, that public pension is attributed in full to the older spouse 
for purposes of section 37(e) even though the applicable community 
property law may treat one-half of the pension as the income of the 62-
year old spouse. Since the younger spouse consequently has no retirement 
income within the meaning of paragraph (d) of this section, the couple 
may not make the election described in paragraph (b) of this section.
    (g) Examples. The computation of the credit for the elderly under 
section 37(e) and this section is illustrated by the following examples:

    Example 1. B, who is 62 years old and single, receives a fully 
taxable pension of $2,400 from a public retirement system during 1977. B 
performed the services giving rise to the pension. During that year, B 
also earns $2,650 from a part-time job. B receives no tax-exempt pension 
or annuity in 1977. Subject to the limitation of section 37(c)(2) and 
paragraph (b) of Sec.  1.37-1, B's credit for the elderly for 1977 under 
section 37(e) is $195, computed as follows:

Maximum retirement income level under section 37(e)(5)......      $2,500
Earned income offset under section
 37(e)(5)(B)(ii):
    Earned income in excess of $1,700...........        $950
    One-half of earned income in excess of               250       1,200
     $1,200, but not in excess of $1,700........
                                                 ------------
Amount determined under section 37(e)(5)....................       1,300
                                                             ===========
Retirement income...........................................       2,400
                                                             ===========
Credit for the elderly (15 pct. of $1,300)..................         195
 

    Example 2. During 1978 H, who is 67 years old, has earnings of 
$1,300 and retirement income (rents, interest, etc.) of $6,000. H also 
receives social security payments totalling $1,400. During 1978 W, who 
is 63 years old, earns $1,600 and receives a fully taxable pension of 
$1,400 from a public retirement system that constitutes retirement 
income. W performed the services giving rise to the pension. H and W 
file a joint return for 1978 and elect to compute the credit for the 
elderly under section 37(e). Under the applicable law these items of 
income are community income, and both spouses share equally in each 
item. Because H and W are filing a joint return, they disregard 
community property laws in computing their credit under section 37(e). 
The couple allocates $1,600 of the $3,750 referred to in section 
37(e)(6) to W and $2,150 to H. Subject to the limitation of section 
37(c)(2) and paragraph (b) of Sec.  1.37-1, their credit for the elderly 
is $315, computed as follows:

Credit base of H:
  Amount allocated to H under section 37(e)(6)..............      $2,150
  Reductions required by section 37(e)(5):
      Social Security payments..................      $1,400
      One-half of excess of earnings over $1,200          50       1,450
                                                 ------------
  Amount determined under section 37(e)(5)..................         700
                                                             ===========
  Retirement income.........................................       6,000
                                                             ===========
  Credit base of H..........................................         700
Credit base of W:
  Amount allocated to W under section 37(e)(6)..............      $1,600
  Reduction required by section 37(e)(5)(B):
      One-half of excess of earnings over $1,200............        $200
                                                             -----------
      Amount determined under section 37(e)(5)..............       1,400
                                                             ===========
  Retirement income.........................................       1,400
                                                             ===========
  Credit base of W..........................................       1,400
                                                             ===========
  Computation of credit:
      Credit base of H......................................         700
      Credit base of W......................................       1,400
                                                             -----------
      Combined credit base..................................       2,100
                                                             ===========
  Credit for the elderly (15 pct. of $2,100)................         315
 

    Example 3. (a) Assume the same facts as in example (2) of this 
paragraph, except that H and W live apart at all times during 1978 and 
file separate returns. Under these circumstances, H and W must give 
effect to the applicable community property law in determining their 
credits under section 37(e). Thus, each spouse must take into account 
one-half of each item of income.
    (b) Subject to the limitation of section 37(c)(2) and paragraph (b) 
of Sec.  1.37-1, H's credit for the elderly is $157.50, computed as 
follows:

Maximum retirement income level under section 37(e)(7)......      $1,875
Reductions required by section 37(e)(5):
    Social security payments....................        $700
    One-half of excess of earnings over $1,200           125         825
     (taking into account one-half of combined
     earnings of $2,900)........................
                                                 ------------
Amount determined under section 37(e)(5)....................       1,050
                                                             ===========
Retirement income...........................................       3,700
                                                             ===========
Credit of H (15 pct. of $1,050).............................      157.50
 

    (c) Subject to the limitation of section 37(c)(2) and paragraph (b) 
of Sec.  1.37-1, W's credit for the elderly is computed as follows:

Maximum retirement income level under section         $1,875
 37(e)(7).......................................

[[Page 146]]

 
Reductions required by section 37(e)(5):
    Social security payments....................        $700
    One-half of excess of earnings over $1,200..         125         825
                                                 ------------
Amount determined under section 37(e)(5)........       1,050
                                                 =============
Retirement income (limited to W's share of               700
 public pension)................................
                                                 =============
Credit of W (15 pct. of $700)...................         105
 


[T.D. 7743, 45 FR 84050, Dec. 22, 1980]



Sec.  1.38-1  Investment in certain depreciable property.

    Regulations under sections 46 through 50 are prescribed under the 
authority granted the Secretary by section 38(b) to prescribe 
regulations as may be necessary to carry out the purposes of section 38 
and subpart B, part IV, subchapter A, chapter 1 of the Code.

[44 FR 20417, Apr. 5, 1979]



Sec.  1.40-1  Questions and answers relating to the meaning of the term
``qualified mixture'' in section 40(b)(1).

    Q-1. What is a ``qualified mixture'' within the meaning of section 
40(b)(1)?
    A-1. A ``qualified mixture'' is a mixture of alcohol and gasoline or 
of alcohol and special fuel which (1) is sold by the taxpayer producing 
such mixture to any person for use as a fuel, or (2) is used as a fuel 
by the taxpayer producing such mixture.
    Q-2. Must alcohol be present in a product in order for that product 
to be considered a mixture of alcohol and either gasoline or a special 
fuel?
    A-2. No. A product is considered to be a mixture of alcohol and 
gasoline or of alcohol and a special fuel if the product is derived from 
alcohol and either gasoline or a special fuel even if the alcohol is 
chemically transformed in producing the product so that the alcohol is 
no longer present as a separate chemical in the final product, provided 
that there is no significant loss in the energy content of the alcohol. 
Thus, a product may be considered to be ``mixture of alcohol and 
gasoline or of alcohol and a special fuel'' within the meaning of 
section 40(b)(1)(B) if such product is produced in a chemical reaction 
between alcohol and either gasoline or a special fuel. Similarly a 
product may be considered to be a ``mixture of alcohol and gasoline or 
of alcohol and a special fuel'' if such product is produced by blending 
a chemical compound derived from alcohol with either gasoline or a 
special fuel.
    Thus, for example, a blend of gasoline and ethyl tertiary butyl 
ether (ETBE), a compound derived from ethanol (a qualified alcohol), in 
a chemical reaction in which there is no significant loss in the energy 
content of the ethanol, is considered for purposes of section 
40(b)(1)(B) to be a mixture of gasoline and the ethanol used to produce 
the ETBE, even though the ethanol is chemically transformed in the 
production of ETBE and is not present in the final product.

[T.D. 8291, 55 FR 8948, Mar. 9, 1990]



Sec.  1.41-0  Table of contents.

    This section lists the table of contents for Sec. Sec.  1.41-1 
through 1.41-9.

         Sec.  1.41-1 Credit for increasing research activities.

    (a) Amount of credit.
    (b) Introduction to regulations under section 41.

                Sec.  1.41-2 Qualified research expenses.

    (a) Trade or business requirement.
    (1) In general.
    (2) New business.
    (3) Research performed for others.
    (i) Taxpayer not entitled to results.
    (ii) Taxpayer entitled to results.
    (4) Partnerships.
    (i) In general.
    (ii) Special rule for certain partnerships and joint ventures.
    (b) Supplies and personal property used in the conduct of qualified 
research.
    (1) In general.
    (2) Certain utility charges.
    (i) In general.
    (ii) Extraordinary expenditures.
    (3) Right to use personal property.
    (4) Use of personal property in taxable years beginning after 
December 31, 1985.
    (c) Qualified services.
    (1) Engaging in qualified research.
    (2) Direct supervision.
    (3) Direct support.
    (d) Wages paid for qualified services.
    (1) In general.
    (2) ``Substantially all.''
    (e) Contract research expenses.
    (1) In general.
    (2) Performance of qualified research.
    (3) ``On behalf of.''

[[Page 147]]

    (4) Prepaid amounts.
    (5) Examples.

Sec.  1.41-3 Base amount for taxable years beginning on or after January 
                                3, 2001.

    (a) New taxpayers.
    (b) Special rules for short taxable years.
    (1) Short credit year.
    (2) Short taxable year preceding credit year.
    (3) Short taxable year in determining fixed-base percentage.
    (c) Definition of gross receipts.
    (1) In general.
    (2) Amounts excluded.
    (3) Foreign corporations.
    (d) Consistency requirement.
    (1) In general.
    (2) Illustrations.
    (e) Effective date.

  Sec.  1.41-4 Qualified research for expenditures paid or incurred in 
           taxable years ending on or after December 31, 2003.

    (a) Qualified research.
    (1) General rule.
    (2) Requirements of section 41(d)(1).
    (3) Undertaken for the purpose of discovering information.
    (i) In general.
    (ii) Application of the discovering information requirement.
    (iii) Patent safe harbor.
    (4) Technological in nature.
    (5) Process of experimentation.
    (i) In general.
    (ii) Qualified purpose.
    (6) Substantially all requirement.
    (7) Use of computers and information technology.
    (8) Illustrations.
    (b) Application of requirements for qualified research.
    (1) In general.
    (2) Shrinking-back rule.
    (3) Illustration.
    (c) Excluded activities.
    (1) In general.
    (2) Research after commercial production.
    (i) In general.
    (ii) Certain additional activities related to the business 
component.
    (iii) Activities related to production process or technique.
    (iv) Clinical testing.
    (3) Adaptation of existing business components.
    (4) Duplication of existing business component.
    (5) Surveys, studies, research relating to management functions, 
etc.
    (6) Internal use software.
    (i) General rule.
    (ii) Inapplicability of the high threshold of innovation test.
    (iii) Software developed primarily for internal use.
    (iv) Software not developed primarily for internal use.
    (v) Time and manner of determination.
    (vi) Software developed for both internal use and to enable 
interaction with third parties (dual function software).
    (vii) High threshold of innovation test.
    (viii) Illustrations.
    (7) Activities outside the United States, Puerto Rico, and other 
possessions.
    (i) In general.
    (ii) Apportionment of in-house research expenses.
    (iii) Apportionment of contract research expenses.
    (8) Research in the social sciences, etc.
    (9) Research funded by any grant, contract, or otherwise.
    (10) Illustrations.
    (d) Recordkeeping for the research credit.
    (e) Effective dates.

 Sec.  1.41-5 Basic research for taxable years beginning after December 
                          31, 1986. [Reserved]

                Sec.  1.41-6 Aggregation of expenditures.

    (a) Controlled groups of corporations; trades or businesses under 
common control.
    (1) In general.
    (2) Consolidated groups.
    (3) Definitions.
    (b) Computation of the group credit.
    (1) In general.
    (2) Start-up companies.
    (c) Allocation of the group credit.
    (d) Special rules for consolidated groups.
    (1) In general.
    (2) Start-up company status.
    (3) Special rule for allocation of group credit among consolidated 
group members.
    (e) Examples.
    (f) For taxable years beginning before January 1, 1990.
    (g) Tax accounting periods used.
    (1) In general.
    (2) Special rule when timing of research is manipulated.
    (h) Membership during taxable year in more than one group.
    (i) Intra-group transactions.
    (1) In general.
    (2) In-house research expenses.
    (3) Contract research expenses.
    (4) Lease payments.
    (5) Payment for supplies.
    (j) Effective/applicability dates.
    (1) In general.
    (2) Consolidated group rule.
    (3) Taxable years ending after June 9, 2011.
    (4) Taxable years beginning after December 31, 2011.
    (5) Taxable years ending before January 1, 2012.

                       Sec.  1.41-7 Special rules.

    (a) Allocations.

[[Page 148]]

    (1) Corporation making an election under subchapter S.
    (i) Pass-through, for taxable years beginning after December 31, 
1982, in the case of an S corporation.
    (ii) Pass-through, for taxable years beginning before January 1, 
1983, in the case of a subchapter S corporation.
    (2) Pass-through in the case of an estate or trust.
    (3) Pass-through in the case of a partnership.
    (i) In general.
    (ii) Certain expenditures by joint ventures.
    (4) Year in which taken into account.
    (5) Credit allowed subject to limitation.
    (b) Adjustments for certain acquisitions and dispositions--Meaning 
of terms.
    (c) Special rule for pass-through of credit.
    (d) Carryback and carryover of unused credits.

Sec.  1.41-8 Alternative incremental credit applicable for taxable years 
                beginning on or before December 31, 2008.

    (a) Determination of credit.
    (b) Election.
    (1) In general.
    (2) Time and manner of election.
    (3) Revocation.
    (4) Special rules for controlled groups.
    (i) In general.
    (ii) Designated member.
    (5) Effective/applicability dates.

               Sec.  1.41-9 Alternative simplified credit.

    (a) Determination of credit.
    (b) Election.
    (1) In general.
    (2) Time and manner of election.
    (3) Revocation.
    (4) Special rules for controlled groups.
    (i) In general.
    (ii) Designated member.
    (c) Special rules.
    (1) Qualified research expenditures (QREs) required in all years.
    (2) Section 41(c)(6) applicability.
    (3) Short taxable years.
    (i) General rule.
    (ii) Limited exception.
    (4) Controlled groups.
    (d) Effective/applicability dates.

[T.D. 8930, 65 FR 287, Jan. 3, 2001, as amended by T.D. 9104, 69 FR 26, 
Jan. 2, 2004; T.D. 9205, 70 FR 29601, May 24, 2005; T.D. 9296, 71 FR 
65725, Nov. 9, 2006; T.D. 9401, 73 FR 34187, June 17, 2008; T.D. 9528, 
76 FR 33995, June 10, 2011; 80 FR 18098, Apr. 3, 2015; T.D. 9786, 81 FR 
68306, Oct. 4, 2016]



Sec.  1.41-1  Credit for increasing research activities.

    (a) Amount of credit. The amount of a taxpayer's credit is 
determined under section 41(a). For taxable years beginning after June 
30, 1996, and at the election of the taxpayer, the portion of the credit 
determined under section 41(a)(1) may be calculated using the 
alternative incremental credit set forth in section 41(c)(4). For 
taxable years ending after December 31, 2006, and at the election of the 
taxpayer, the portion of the credit determined under section 41(a)(1) 
may be calculated using either the alternative incremental credit set 
forth in section 41(c)(4), or the alternative simplified credit set 
forth in section 41(c)(5).
    (b) Introduction to regulations under section 41. (1) Sections 1.41-
2 through 1.41-8 and 1.41-3A through 1.41-5A address only certain 
provisions of section 41. The following table identifies the provisions 
of section 41 that are addressed, and lists each provision with the 
section of the regulations in which it is covered.

------------------------------------------------------------------------
                                               Section of the Internal
         Section of the regulation                  Revenue Code
------------------------------------------------------------------------
Sec.   1.41-2.............................  41(b).
Sec.   1.41-3.............................  41(c).
Sec.   1.41-4.............................  41(d).
Sec.   1.41-5.............................  41(e).
Sec.   1.41-6.............................  41(f).
Sec.   1.41-7.............................  41(f).
                                            41(g).
Sec.   1.41-8.............................  41(c).
Sec.   1.41-3A............................  41(c) (taxable years
                                             beginning before January 1,
                                             1990).
Sec.   1.41-4A............................  41(d) (taxable years
                                             beginning before January 1,
                                             1986).
Sec.   1.41-5A............................  41(e) (taxable years
                                             beginning before January 1,
                                             1987).
------------------------------------------------------------------------

    (2) Section 1.41-3A also addresses the special rule in section 
221(d)(2) of the Economic Recovery Tax Act of 1981 relating to taxable 
years overlapping the effective dates of section 41. Section 41 was 
formerly designated as sections 30 and 44F. Sections 1.41-0 through 
1.41-8 and 1.41-0A through 1.41-5A refer to these sections as section 41 
for conformity purposes. Whether section 41, former section 30, or 
former section 44F applies to a particular expenditure depends upon when 
the expenditure was paid or incurred.

[T.D. 8930, 65 FR 288, Jan. 3, 2001, as amended by T.D. 9401, 73 FR 
34187, June 17, 2008]

[[Page 149]]



Sec.  1.41-2  Qualified research expenses.

    (a) Trade or business requirement--(1) In general. An in-house 
research expense of the taxpayer or a contract research expense of the 
taxpayer is a qualified research expense only if the expense is paid or 
incurred by the taxpayer in carrying on a trade or business of the 
taxpayer. The phrase ``in carrying on a trade or business'' has the same 
meaning for purposes of section 41(b)(1) as it has for purposes of 
section 162; thus, expenses paid or incurred in connection with a trade 
or business within the meaning of section 174(a) (relating to the 
deduction for research and experimental expenses) are not necessarily 
paid or incurred in carrying on a trade or business for purposes of 
section 41. A research expense must relate to a particular trade or 
business being carried on by the taxpayer at the time the expense is 
paid or incurred in order to be a qualified research expense. For 
purposes of section 41, a contract research expense of the taxpayer is 
not a qualified research expense if the product or result of the 
research is intended to be transferred to another in return for license 
or royalty payments and the taxpayer does not use the product of the 
research in the taxpayer's trade or business.
    (2) New business. Expenses paid or incurred prior to commencing a 
new business (as distinguished from expanding an existing business) may 
be paid or incurred in connection with a trade or business but are not 
paid or incurred in carrying on a trade or business. Thus, research 
expenses paid or incurred by a taxpayer in developing a product the sale 
of which would constitute a new trade or business for the taxpayer are 
not paid or incurred in carrying on a trade or business.
    (3) Research performed for others--(i) Taxpayer not entitled to 
results. If the taxpayer performs research on behalf of another person 
and retains no substantial rights in the research, that research shall 
not be taken into account by the taxpayer for purposes of section 41. 
See Sec.  1.41-4A(d)(2).
    (ii) Taxpayer entitled to results. If the taxpayer in carrying on a 
trade or business performs research on behalf of other persons but 
retains substantial rights in the research, the taxpayer shall take 
otherwise qualified expenses for that research into account for purposes 
of section 41 to the extent provided in Sec.  1.41-4A(d)(3).
    (4) Partnerships--(i) In general. An in-house research expense or a 
contract research expense paid or incurred by a partnership is a 
qualified research expense of the partnership if the expense is paid or 
incurred by the partnership in carrying on a trade or business of the 
partnership, determined at the partnership level without regard to the 
trade or business of any partner.
    (ii) Special rule for certain partnerships and joint ventures. (A) 
If a partnership or a joint venture (taxable as a partnership) is not 
carrying on the trade or business to which the research relates, then 
the general rule in paragraph (a)(4)(i) of this section would not allow 
any of such expenditures to qualify as qualified research expenses.
    (B) Notwithstanding paragraph (a)(4)(ii)(A) of this section, if all 
the partners or venturers are entitled to make independent use of the 
results of the research, this paragraph (a)(4)(ii) may allow a portion 
of such expenditures to be treated as qualified research expenditures by 
certain partners or venturers.
    (C) First, in order to determine the amount of credit that may be 
claimed by certain partners or venturers, the amount of qualified 
research expenditures of the partnership or joint venture is determined 
(assuming for this purpose that the partnership or joint venture is 
carrying on the trade or business to which the research relates).
    (D) Second, this amount is reduced by the proportionate share of 
such expenses allocable to those partners or venturers who would not be 
able to claim such expenses as qualified research expenditures if they 
had paid or incurred such expenses directly. For this purpose such 
partners' or venturers' proportionate share of such expenses shall be 
determined on the basis of such partners' or venturers' share of 
partnership items of income or gain (excluding gain allocated under 
section 704(c)) which results in the largest proportionate share. Where 
a partner's or venturer's share of partnership items of income or gain 
(excluding gain allocated under section 704(c)) may vary

[[Page 150]]

during the period such partner or venturer is a partner or venturer in 
such partnership or joint venture, such share shall be the highest share 
such partner or venturer may receive.
    (E) Third, the remaining amount of qualified research expenses is 
allocated among those partners or venturers who would have been entitled 
to claim a credit for such expenses if they had paid or incurred the 
research expenses in their own trade or business, in the relative 
proportions that such partners or venturers share deductions for 
expenses under section 174 for the taxable year that such expenses are 
paid or incurred.
    (F) For purposes of section 41, research expenditures to which this 
paragraph (a)(4)(ii) applies shall be treated as paid or incurred 
directly by such partners or venturers. See Sec.  1.41-7(a)(3)(ii) for 
special rules regarding these expenses.
    (iii) The following examples illustrate the application of the 
principles contained in paragraph (a)(4)(ii) of this section.

    Example 1. A joint venture (taxable as a partnership) is formed by 
corporations A, B, and C to develop and market a supercomputer. A and B 
are in the business of developing computers, and each has a 30 percent 
distributive share of each item of income, gain, loss, deduction, credit 
and basis of the joint venture. C, which is an investment banking firm, 
has a 40 percent distributive share of each item of income, gain, loss, 
deduction, credit and basis of the joint venture. The joint venture 
agreement provides that A's, B's and C's distributive shares will not 
vary during the life of the joint venture, liquidation proceeds are to 
be distributed in accordance with the partners' capital account 
balances, and any partner with a deficit in its capital account 
following the distribution of liquidation proceeds is required to 
restore the amount of such deficit to the joint venture. Assume in Year 
1 that the joint venture incurs $100x of ``qualified research 
expenses.'' Assume further that the joint venture cannot claim the 
research credit for such expenses because it is not carrying on the 
trade or business to which the research relates. In addition A, B, and C 
are all entitled to make independent use of the results of the research. 
First, the amount of qualified research expenses of the joint venture is 
$l00x. Second, this amount is reduced by the proportionate share of such 
expenses allocable to C, the venturer which would not have been able to 
claim such expenses as qualified research expenditures if it had paid or 
incurred them directly, C's proportionate share of such expenses is $40x 
(40% of $100x). The reduced amount is $60x. Third, the remaining $60x of 
qualified research expenses is allocated between A and B in the relative 
proportions that A and B share deductions for expenses under section 
174. A is entitled to treat $30x ((30%/(30% + 30%)) $60x) as a qualified 
research expense. B is also entitled to treat $30x ((30%/(30% + 30%)) 
$60x) as a qualified research expense.
    Example 2. Assume the same facts as in example (1) except that the 
joint venture agreement provides that during the first 2 years of the 
joint venture, A and B are each allocated 10 percent of each item of 
income, gain, loss, deduction, credit and basis, and C is allocated 80 
percent of each item of income, gain, loss, deduction, credit and basis. 
Thereafter the allocations are the same as in example (1). Assume for 
purposes of this example that such allocations have substantial economic 
effect for purposes of section 704 (b). C's highest share of such items 
during the life of the joint venture is 80 percent. Therefore C's 
proportionate share of the joint venture's qualified research expenses 
is $80x (80% of $100x). The reduced amount of qualified research 
expenses is $20x ($100x-$80x). A is entitled to treat $10x ((10%/(10% + 
10%)) $20x) as a qualified research expense in Year 1. B is also 
entitled to treat $10x ((10%/(10% + 10%)) $20x) as a qualified research 
expense in Year 1.

    (b) Supplies and personal property used in the conduct of qualified 
research--(1) In general. Supplies and personal property (except to the 
extent provided in paragraph (b)(4) of this section) are used in the 
conduct of qualified research if they are used in the performance of 
qualified services (as defined in section 41(b)(2)(B), but without 
regard to the last sentence thereof) by an employee of the taxpayer (or 
by a person acting in a capacity similar to that of an employee of the 
taxpayer; see example (6) of Sec.  1.41-2(e)(5)). Expenditures for 
supplies or for the use of personal property that are indirect research 
expenditures or general and administrative expenses do not qualify as 
inhouse research expenses.
    (2) Certain utility charges--(i) In general. In general, amounts 
paid or incurred for utilities such as water, electricity, and natural 
gas used in the building in which qualified research is performed are 
treated as expenditures for general and administrative expenses.
    (ii) Extraordinary expenditures. To the extent the taxpayer can 
establish that

[[Page 151]]

the special character of the qualified research required additional 
extraordinary expenditures for utilities, the additional expenditures 
shall be treated as amounts paid or incurred for supplies used in the 
conduct of qualified research. For example, amounts paid for electricity 
used for general laboratory lighting are treated as general and 
administrative expenses, but amounts paid for electricity used in 
operating high energy equipment for qualified research (such as laser or 
nuclear research) may be treated as expenditures for supplies used in 
the conduct of qualified research to the extent the taxpayer can 
establish that the special character of the research required an 
extraordinary additional expenditure for electricity.
    (3) Right to use personal property. The determination of whether an 
amount is paid to or incurred for another person for the right to use 
personal property in the conduct of qualified research shall be made 
without regard to the characterization of the transaction as a lease 
under section 168(f)(8) (as that section read before it was repealed by 
the Tax Reform Act of 1986). See Sec.  5c.168(f)(8)-1(b).
    (4) Use of personal property in taxable years beginning after 
December 31, 1985. For taxable years beginning after December 31, 1985, 
amounts paid or incurred for the use of personal property are not 
qualified research expenses, except for any amount paid or incurred to 
another person for the right to use (time-sharing) computers in the 
conduct of qualified research. The computer must be owned and operated 
by someone other than the taxpayer, located off the taxpayer's premises, 
and the taxpayer must not be the primary user of the computer.
    (c) Qualified services--(1) Engaging in qualified research. The term 
``engaging in qualified research'' as used in section 41(b)(2)(B) means 
the actual conduct of qualified research (as in the case of a scientist 
conducting laboratory experiments).
    (2) Direct supervision. The term ``direct supervision'' as used in 
section 41(b)(2)(B) means the immediate supervision (first-line 
management) of qualified research (as in the case of a research 
scientist who directly supervises laboratory experiments, but who may 
not actually perform experiments). ``Direct supervision'' does not 
include supervision by a higher-level manager to whom first-line 
managers report, even if that manager is a qualified research scientist.
    (3) Direct support. The term ``direct support'' as used in section 
41(b)(2)(B) means services in the direct support of either--
    (i) Persons engaging in actual conduct of qualified research, or
    (ii) Persons who are directly supervising persons engaging in the 
actual conduct of qualified research. For example, direct support of 
research includes the services of a secretary for typing reports 
describing laboratory results derived from qualified research, of a 
laboratory worker for cleaning equipment used in qualified research, of 
a clerk for compiling research data, and of a machinist for machining a 
part of an experimental model used in qualified research. Direct support 
of research activities does not include general administrative services, 
or other services only indirectly of benefit to research activities. For 
example, services of payroll personnel in preparing salary checks of 
laboratory scientists, of an accountant for accounting for research 
expenses, of a janitor for general cleaning of a research laboratory, or 
of officers engaged in supervising financial or personnel matters do not 
qualify as direct support of research. This is true whether general 
administrative personnel are part of the research department or in a 
separate department. Direct support does not include supervision. 
Supervisory services constitute ``qualified services'' only to the 
extent provided in paragraph (c)(2) of this section.
    (d) Wages paid for qualified services--(1) In general. Wages paid to 
or incurred for an employee constitute in-house research expenses only 
to the extent the wages were paid or incurred for qualified services 
performed by the employee. If an employee has performed both qualified 
services and nonqualified services, only the amount of wages allocated 
to the performance of qualified services constitutes an in-house 
research expense. In the absence of another method of allocation that

[[Page 152]]

the taxpayer can demonstrate to be more appropriate, the amount of in-
house research expense shall be determined by multiplying the total 
amount of wages paid to or incurred for the employee during the taxable 
year by the ratio of the total time actually spent by the employee in 
the performance of qualified services for the taxpayer to the total time 
spent by the employee in the performance of all services for the 
taxpayer during the taxable year.
    (2) ``Substantially all.'' Notwithstanding paragraph (d)(1) of this 
section, if substantially all of the services performed by an employee 
for the taxpayer during the taxable year consist of services meeting the 
requirements of section 41(b)(2)(B) (i) or (ii), then the term 
``qualified services'' means all of the services performed by the 
employee for the taxpayer during the taxable year. Services meeting the 
requirements of section 41(b)(2)(B) (i) or (ii) constitute substantially 
all of the services performed by the employee during a taxable year only 
if the wages allocated (on the basis used for purposes of paragraph 
(d)(1) of this section) to services meeting the requirements of section 
41(b)(2)(B) (i) or (ii) constitute at least 80 percent of the wages paid 
to or incurred by the taxpayer for the employee during the taxable year.
    (e) Contract research expenses--(1) In general. A contract research 
expense is 65 percent of any expense paid or incurred in carrying on a 
trade or business to any person other than an employee of the taxpayer 
for the performance on behalf of the taxpayer of--
    (i) Qualified research as defined in Sec.  1.41-4 or 1.41-4A, 
whichever is applicable, or
    (ii) Services which, if performed by employees of the taxpayer, 
would constitute qualified services within the meaning of section 
41(b)(2)(B).

Where the contract calls for services other than services described in 
this paragraph (e)(1), only 65 percent of the portion of the amount paid 
or incurred that is attributable to the services described in this 
paragraph (e)(1) is a contract research expense.
    (2) Performance of qualified research. An expense is paid or 
incurred for the performance of qualified research only to the extent 
that it is paid or incurred pursuant to an agreement that--
    (i) Is entered into prior to the performance of the qualified 
research,
    (ii) Provides that research be performed on behalf of the taxpayer, 
and
    (iii) Requires the taxpayer to bear the expense even if the research 
is not successful.

If an expense is paid or incurred pursuant to an agreement under which 
payment is contingent on the success of the research, then the expense 
is considered paid for the product or result rather than the performance 
of the research, and the payment is not a contract research expense. The 
previous sentence applies only to that portion of a payment which is 
contingent on the success of the research.
    (3) ``On behalf of.'' Qualified research is performed on behalf of 
the taxpayer if the taxpayer has a right to the research results. 
Qualified research can be performed on behalf of the taxpayer 
notwithstanding the fact that the taxpayer does not have exclusive 
rights to the results.
    (4) Prepaid amounts. Notwithstanding paragraph (e)(1) of this 
section, if any contract research expense paid or incurred during any 
taxable year is attributable to qualified research to be conducted after 
the close of such taxable year, the expense so attributable shall be 
treated for purposes of section 41(b)(1)(B) as paid or incurred during 
the period during which the qualified research is conducted.
    (5) Examples. The following examples illustrate provisions contained 
in paragraphs (e) (1) through (4) of this section.

    Example 1. A, a cash-method taxpayer using the calendar year as the 
taxable year, enters into a contract with B Corporation under which B is 
to perform qualified research on behalf of A. The contract requires A to 
pay B $300x, regardless of the success of the research. In 1982, B 
performs all of the research, and A makes full payment of $300x under 
the contract. Accordingly, during the taxable year 1982, $195x (65 
percent of the payment of $300x) constitutes a contract research expense 
of A.
    Example 2. The facts are the same as in example (1), except that B 
performs 50 percent of the research in 1983. Of the $195x of contract 
research expense paid in 1982, paragraph (e)(4) of this section provides 
that

[[Page 153]]

$97.5x (50 percent of $195x) is a contract research expense for 1982 and 
the remaining $97.5x is contract research expense for 1983.
    Example 3. The facts are the same as in example (1), except that 
instead of calling for a flat payment of $300x, the contract requires A 
to reimburse B for all expenses plus pay B $l00x. B incurs expenses 
attributable to the research as follows:

Labor..........................................................     $90x
Supplies.......................................................      20x
Depreciation on equipment......................................      50x
Overhead.......................................................      40x
                                                                --------
 
      Total....................................................     200x
 


Under this agreement A pays B $300x during 1982. Accordingly, during 
taxable year 1982, $195x (65 percent of $300x) of the payment 
constitutes a contract research expense of A.
    Example 4. The facts are the same as in example (3), except that A 
agrees to reimburse B for all expenses and agrees to pay B an additional 
amount of $100x, but the additional $100x is payable only if the 
research is successful. The research is successful and A pays B $300x 
during 1982. Paragraph (e)(2) of this section provides that the 
contingent portion of the payment is not an expense incurred for the 
performance of qualified research. Thus, for taxable year 1982, $130x 
(65 percent of the payment of $200x) constitutes a contract research 
expense of A.
    Example 5. C conducts in-house qualified research in carrying on a 
trade or business. In addition, C pays D Corporation, a provider of 
computer services, $100x to develop software to be used in analyzing the 
results C derives from its research. Because the software services, if 
performed by an employee of C, would constitute qualified services, $65x 
of the $100x constitutes a contract research expense of C.
    Example 6. C conducts in-house qualified research in carrying on C's 
trade or business. In addition, C contracts with E Corporation, a 
provider of temporary secretarial services, for the services of a 
secretary for a week. The secretary spends the entire week typing 
reports describing laboratory results derived from C's qualified 
research. C pays E $400 for the secretarial service, none of which 
constitutes wages within the meaning of section 41(b)(2)(D). These 
services, if performed by employees of C, would constitute qualified 
services within the meaning of section 41(b)(2)(B). Thus, pursuant to 
paragraph (e)(1) of this section, $260 (65 percent of $400) constitutes 
a contract research expense of C.
    Example 7. C conducts in-house qualified research in carrying on C's 
trade or business. In addition, C pays F, an outside accountant, $100x 
to keep C's books and records pertaining to the research project. The 
activity carried on by the accountant does not constitute qualified 
research as defined in section 41(d). The services performed by the 
accountant, if performed by an employee of C, would not constitute 
qualified services (as defined in section 41(b)(2)(B)). Thus, under 
paragraph (e)(1) of this section, no portion of the $100x constitutes a 
contract research expense.

[T.D. 8251, 54 FR 21204, May 17, 1989, as amended by T.D. 8930, 65 FR 
287, Jan. 3, 2001]



Sec.  1.41-3  Base amount for taxable years beginning on or after
January 3, 2001.

    (a) New taxpayers. If, with respect to any credit year, the taxpayer 
has not been in existence for any previous taxable year, the average 
annual gross receipts of the taxpayer for the four taxable years 
preceding the credit year shall be zero. If, with respect to any credit 
year, the taxpayer has been in existence for at least one previous 
taxable year, but has not been in existence for four taxable years 
preceding the taxable year, then the average annual gross receipts of 
the taxpayer for the four taxable years preceding the credit year shall 
be the average annual gross receipts for the number of taxable years 
preceding the credit year for which the taxpayer has been in existence.
    (b) Special rules for short taxable years--(1) Short credit year. If 
a credit year is a short taxable year, then the base amount determined 
under section 41(c)(1) (but not section 41(c)(2)) shall be modified by 
multiplying that amount by the number of months in the short taxable 
year and dividing the result by 12.
    (2) Short taxable year preceding credit year. If one or more of the 
four taxable years preceding the credit year is a short taxable year, 
then the gross receipts for such year are deemed to be equal to the 
gross receipts actually derived in that year multiplied by 12 and 
divided by the number of months in that year.
    (3) Short taxable year in determining fixed-base percentage. No 
adjustment shall be made on account of a short taxable year to the 
computation of a taxpayer's fixed-base percentage.
    (c) Definition of gross receipts--(1) In general. For purposes of 
section 41, gross receipts means the total amount, as determined under 
the taxpayer's method of accounting, derived by the taxpayer from all 
its activities and

[[Page 154]]

from all sources (e.g., revenues derived from the sale of inventory 
before reduction for cost of goods sold).
    (2) Amounts excluded. For purposes of this paragraph (c), gross 
receipts do not include amounts representing--
    (i) Returns or allowances;
    (ii) Receipts from the sale or exchange of capital assets, as 
defined in section 1221;
    (iii) Repayments of loans or similar instruments (e.g., a repayment 
of the principal amount of a loan held by a commercial lender);
    (iv) Receipts from a sale or exchange not in the ordinary course of 
business, such as the sale of an entire trade or business or the sale of 
property used in a trade or business as defined under section 1221(2);
    (v) Amounts received 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; and
    (vi) Amounts received by a taxpayer in a taxable year that precedes 
the first taxable year in which the taxpayer derives more than $25,000 
in gross receipts other than investment income. For purposes of this 
paragraph (c)(2)(vi), investment income is interest or distributions 
with respect to stock (other than the stock of a 20-percent owned 
corporation as defined in section 243(c)(2).
    (3) Foreign corporations. For purposes of section 41, in the case of 
a foreign corporation, gross receipts include only gross receipts that 
are effectively connected with the conduct of a trade or business within 
the United States, the Commonwealth of Puerto Rico, or other possessions 
of the United States. See section 864(c) and applicable regulations 
thereunder for the definition of effectively connected income.
    (d) Consistency requirement--(1) In general. In computing the credit 
for increasing research activities for taxable years beginning after 
December 31, 1989, qualified research expenses and gross receipts taken 
into account in computing a taxpayer's fixed-base percentage and a 
taxpayer's base amount must be determined on a basis consistent with the 
definition of qualified research expenses and gross receipts for the 
credit year, without regard to the law in effect for the taxable years 
taken into account in computing the fixed-base percentage or the base 
amount. This consistency requirement applies even if the period for 
filing a claim for credit or refund has expired for any taxable year 
taken into account in computing the fixed-base percentage or the base 
amount.
    (2) Illustrations. The following examples illustrate the application 
of the consistency rule of paragraph (d)(1) of this section:

    Example 1. (i) X, an accrual method taxpayer using the calendar year 
as its taxable year, incurs qualified research expenses in 2001. X wants 
to compute its research credit under section 41 for the tax year ending 
December 31, 2001. As part of the computation, X must determine its 
fixed-base percentage, which depends in part on X's qualified research 
expenses incurred during the fixed-base period, the taxable years 
beginning after December 31, 1983, and before January 1, 1989.
    (ii) During the fixed-base period, X reported the following amounts 
as qualified research expenses on its Form 6765:

1984...........................................................    $100x
1985...........................................................     120x
1986...........................................................     150x
1987...........................................................     180x
1988...........................................................     170x
                                                                --------
    Total......................................................     720x
 

    (iii) For the taxable years ending December 31, 1984, and December 
31, 1985, X based the amounts reported as qualified research expenses on 
the definition of qualified research in effect for those taxable years. 
The definition of qualified research changed for taxable years beginning 
after December 31, 1985. If X used the definition of qualified research 
applicable to its taxable year ending December 31, 2001, the credit 
year, its qualified research expenses for the taxable years ending 
December 31, 1984, and December 31, 1985, would be reduced to $ 80x and 
$ 100x, respectively. Under the consistency rule in section 41(c)(5) and 
paragraph (d)(1) of this section, to compute the research credit for the 
tax year ending December 31, 2001, X must reduce its qualified research 
expenses for 1984 and 1985 to reflect the change in the definition of 
qualified research for taxable years beginning after December 31, 1985. 
Thus, X's total qualified research expenses for the fixed-base period 
(1984-1988) to be used in computing the fixed-base percentage is $80 + 
100 + 150 + 180 + 170 = $680x.

[[Page 155]]

    Example 2. The facts are the same as in Example 1, except that, in 
computing its qualified research expenses for the taxable year ending 
December 31, 2001, X claimed that a certain type of expenditure incurred 
in 2001 was a qualified research expense. X's claim reflected a change 
in X's position, because X had not previously claimed that similar 
expenditures were qualified research expenses. The consistency rule 
requires X to adjust its qualified research expenses in computing the 
fixed-base percentage to include any similar expenditures not treated as 
qualified research expenses during the fixed-base period, regardless of 
whether the period for filing a claim for credit or refund has expired 
for any year taken into account in computing the fixed-base percentage.

    (e) Effective date. The rules in paragraphs (c) and (d) of this 
section are applicable for taxable years beginning on or after the date 
final regulations are published in the Federal Register.

[T.D. 8930, 66 FR 289, Jan. 3, 2001]



Sec.  1.41-4  Qualified research for expenditures paid or incurred in
taxable years ending on or after December 31, 2003.

    (a) Qualified research--(1) General rule. Research activities 
related to the development or improvement of a business component 
constitute qualified research only if the research activities meet all 
of the requirements of section 41(d)(1) and this section, and are not 
otherwise excluded under section 41(d)(3)(B) or (d)(4), or this section.
    (2) Requirements of section 41(d)(1). Research constitutes qualified 
research only if it is research--
    (i) With respect to which expenditures may be treated as expenses 
under section 174, see Sec.  1.174-2;
    (ii) That is undertaken for the purpose of discovering information 
that is technological in nature, and the application of which is 
intended to be useful in the development of a new or improved business 
component of the taxpayer; and
    (iii) Substantially all of the activities of which constitute 
elements of a process of experimentation that relates to a qualified 
purpose.
    (3) Undertaken for the purpose of discovering information--(i) In 
general. For purposes of section 41(d) and this section, research must 
be undertaken for the purpose of discovering information that is 
technological in nature. Research is undertaken for the purpose of 
discovering information if it is intended to eliminate uncertainty 
concerning the development or improvement of a business component. 
Uncertainty exists if the information available to the taxpayer does not 
establish the capability or method for developing or improving the 
business component, or the appropriate design of the business component.
    (ii) Application of the discovering information requirement. A 
determination that research is undertaken for the purpose of discovering 
information that is technological in nature does not require the 
taxpayer be seeking to obtain information that exceeds, expands or 
refines the common knowledge of skilled professionals in the particular 
field of science or engineering in which the taxpayer is performing the 
research. In addition, a determination that research is undertaken for 
the purpose of discovering information that is technological in nature 
does not require that the taxpayer succeed in developing a new or 
improved business component.
    (iii) Patent safe harbor. For purposes of section 41(d) and 
paragraph (a)(3)(i) of this section, the issuance of a patent by the 
Patent and Trademark Office under the provisions of 35 U.S.C. 151 (other 
than a patent for design issued under the provisions of 35 U.S.C. 171) 
is conclusive evidence that a taxpayer has discovered information that 
is technological in nature that is intended to eliminate uncertainty 
concerning the development or improvement of a business component. 
However, the issuance of such a patent is not a precondition for credit 
availability.
    (4) Technological in nature. For purposes of section 41(d) and this 
section, information is technological in nature if the process of 
experimentation used to discover such information fundamentally relies 
on principles of the physical or biological sciences, engineering, or 
computer science. A taxpayer may employ existing technologies and may 
rely on existing principles of the physical or biological sciences, 
engineering, or computer science to satisfy this requirement.

[[Page 156]]

    (5) Process of experimentation--(i) In general. For purposes of 
section 41(d) and this section, a process of experimentation is a 
process designed to evaluate one or more alternatives to achieve a 
result where the capability or the method of achieving that result, or 
the appropriate design of that result, is uncertain as of the beginning 
of the taxpayer's research activities. A process of experimentation must 
fundamentally rely on the principles of the physical or biological 
sciences, engineering, or computer science and involves the 
identification of uncertainty concerning the development or improvement 
of a business component, the identification of one or more alternatives 
intended to eliminate that uncertainty, and the identification and the 
conduct of a process of evaluating the alternatives (through, for 
example, modeling, simulation, or a systematic trial and error 
methodology). A process of experimentation must be an evaluative process 
and generally should be capable of evaluating more than one alternative. 
A taxpayer may undertake a process of experimentation if there is no 
uncertainty concerning the taxpayer's capability or method of achieving 
the desired result so long as the appropriate design of the desired 
result is uncertain as of the beginning of the taxpayer's research 
activities. Uncertainty concerning the development or improvement of the 
business component (e.g., its appropriate design) does not establish 
that all activities undertaken to achieve that new or improved business 
component constitute a process of experimentation.
    (ii) Qualified purpose. For purposes of section 41(d) and this 
section, a process of experimentation is undertaken for a qualified 
purpose if it relates to a new or improved function, performance, 
reliability or quality of the business component. Research will not be 
treated as conducted for a qualified purpose if it relates to style, 
taste, cosmetic, or seasonal design factors.
    (6) Substantially all requirement. In order for activities to 
constitute qualified research under section 41(d)(1), substantially all 
of the activities must constitute elements of a process of 
experimentation that relates to a qualified purpose. The substantially 
all requirement of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this 
section is satisfied only if 80 percent or more of a taxpayer's research 
activities, measured on a cost or other consistently applied reasonable 
basis (and without regard to section 1.41-2(d)(2)), constitute elements 
of a process of experimentation for a purpose described in section 
41(d)(3). Accordingly, if 80 percent (or more) of a taxpayer's research 
activities with respect to a business component constitute elements of a 
process of experimentation for a purpose described in section 41(d)(3), 
the substantially all requirement is satisfied even if the remaining 20 
percent (or less) of a taxpayer's research activities with respect to 
the business component do not constitute elements of a process of 
experimentation for a purpose described in section 41(d)(3), so long as 
these remaining research activities satisfy the requirements of section 
41(d)(1)(A) and are not otherwise excluded under section 41(d)(4). The 
substantially all requirement is applied separately to each business 
component.
    (7) Use of computers and information technology. The employment of 
computers or information technology, or the reliance on principles of 
computer science or information technology to store, collect, 
manipulate, translate, disseminate, produce, distribute, or process data 
or information, and similar uses of computers and information technology 
does not itself establish that qualified research has been undertaken.
    (8) Illustrations. The following examples illustrate the application 
of paragraph (a)(5) of this section:

    Example 1. (i) Facts. X is engaged in the business of developing and 
manufacturing widgets. X wants to change the color of its blue widget to 
green. X obtains from various suppliers several different shades of 
green paint. X paints several sample widgets, and surveys X's customers 
to determine which shade of green X's customers prefer.
    (ii) Conclusion. X's activities to change the color of its blue 
widget to green are not qualified research under section 41(d)(1) and 
paragraph (a)(5) of this section because substantially all of X's 
activities are not undertaken for a qualified purpose. All of X's 
research activities are related to style, taste, cosmetic, or seasonal 
design factors.
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that X chooses one of

[[Page 157]]

the green paints. X obtains samples of the green paint from a supplier 
and determines that X must modify its painting process to accommodate 
the green paint because the green paint has different characteristics 
from other paints X has used. X obtains detailed data on the green paint 
from X's paint supplier. X also consults with the manufacturer of X's 
paint spraying machines. The manufacturer informs X that X must acquire 
a new nozzle that operates with the green paint X wants to use. X tests 
the nozzles to ensure that they work as specified by the manufacturer of 
the paint spraying machines.
    (ii) Conclusion. X's activities to modify its painting process are a 
separate business component under section 41(d)(2)(A). X's activities to 
modify its painting process to change the color of its blue widget to 
green are not qualified research under section 41(d)(1) and paragraph 
(a)(5) of this section. X did not conduct a process of evaluating 
alternatives in order to eliminate uncertainty regarding the 
modification of its painting process. Rather, the manufacturer of the 
paint machines eliminated X's uncertainty regarding the modification of 
its painting process. X's activities to test the nozzles to determine if 
the nozzles work as specified by the manufacturer of the paint spraying 
machines are in the nature of routine or ordinary testing or inspection 
for quality control.
    Example 3. (i) Facts. X is engaged in the business of manufacturing 
food products and currently manufactures a large-shred version of a 
product. X seeks to modify its current production line to permit it to 
manufacture both a large-shred version and a fine-shred version of one 
of its food products. A smaller, thinner shredding blade capable of 
producing a fine-shred version of the food product, however, is not 
commercially available. Thus, X must develop a new shredding blade that 
can be fitted onto its current production line. X is uncertain 
concerning the design of the new shredding blade, because the material 
used in its existing blade breaks when machined into smaller, thinner 
blades. X engages in a systematic trial and error process of analyzing 
various blade designs and materials to determine whether the new 
shredding blade must be constructed of a different material from that of 
its existing shredding blade and, if so, what material will best meet 
X's functional requirements.
    (ii) Conclusion. X's activities to modify its current production 
line by developing the new shredding blade meet the requirements of 
qualified research as set forth in paragraph (a)(2) of this section. 
Substantially all of X's activities constitute elements of a process of 
experimentation because X evaluated alternatives to achieve a result 
where the method of achieving that result, and the appropriate design of 
that result, were uncertain as of the beginning of the taxpayer's 
research activities. X identified uncertainties related to the 
development of a business component, and identified alternatives 
intended to eliminate these uncertainties. Furthermore, X's process of 
evaluating identified alternatives was technological in nature, and was 
undertaken to eliminate the uncertainties.
    Example 4. (i) Facts. X is in the business of designing, developing 
and manufacturing automobiles. In response to government-mandated fuel 
economy requirements, X seeks to update its current model vehicle and 
undertakes to improve aerodynamics by lowering the hood of its current 
model vehicle. X determines, however, that lowering the hood changes the 
air flow under the hood, which changes the rate at which air enters the 
engine through the air intake system, and which reduces the 
functionality of the cooling system. X's engineers are uncertain how to 
design a lower hood to obtain the increased fuel economy, while 
maintaining the necessary air flow under the hood. X designs, models, 
simulates, tests, refines, and re-tests several alternative designs for 
the hood and associated proposed modifications to both the air intake 
system and cooling system. This process enables X to eliminate the 
uncertainties related to the integrated design of the hood, air intake 
system, and cooling system, and such activities constitute eighty-five 
percent of X's total activities to update its current model vehicle. X 
then engages in additional activities that do not involve a process of 
evaluating alternatives in order to eliminate uncertainties. The 
additional activities constitute only fifteen percent of X's total 
activities to update its current model vehicle.
    (ii) Conclusion. In general, if eighty percent or more of a 
taxpayer's research activities measured on a cost or other consistently 
applied reasonable basis constitute elements of a process of 
experimentation for a qualified purpose under section 41(d)(3)(A) and 
paragraph (a)(5)(ii) of this section, then the substantially all 
requirement of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this 
section is satisfied. Substantially all of X's activities constitute 
elements of a process of experimentation because X evaluated 
alternatives to achieve a result where the method of achieving that 
result, and the appropriate design of that result, were uncertain as of 
the beginning of X's research activities. X identified uncertainties 
related to the improvement of a business component and identified 
alternatives intended to eliminate these uncertainties. Furthermore, X's 
process of evaluating the identified alternatives was technological in 
nature and was undertaken to eliminate the uncertainties. Because 
substantially all (in this example,

[[Page 158]]

eighty-five percent) of X's activities to update its current model 
vehicle constitute elements of a process of experimentation for a 
qualified purpose described in section 41(d)(3)(A), all of X's 
activities to update its current model vehicle meet the requirements of 
qualified research as set forth in paragraph (a)(2) of this section, 
provided that X's remaining activities (in this example, fifteen percent 
of X's total activities) satisfy the requirements of section 41(d)(1)(A) 
and are not otherwise excluded under section 41(d)(4).
    Example 5. (i) Facts. X, a retail and distribution company, wants to 
upgrade its warehouse management software. X evaluates several of the 
alternative warehouse management software products available from 
vendors in the marketplace to determine which product will best serve 
X's technical requirements. X selects vendor V's software.
    (ii) Conclusion. X's activities to select the software are not 
qualified research under section 41(d)(1) and paragraph (a)(5) of this 
section. X did not conduct a process of evaluating alternatives in order 
to eliminate uncertainty regarding the development of a business 
component. X's evaluation of products available from vendors is not a 
process of experimentation.
    Example 6. (i) Facts. X wants to develop a new web application to 
allow customers to purchase its products online. X, after reviewing 
commercial software offered by various vendors, purchases a commercial 
software package of object-oriented functions from vendor Z that X can 
use in its web application (for example, a shopping cart). X evaluates 
the various object-oriented functions included in vendor Z's software 
package to determine which functions it can use. X then incorporates the 
selected software functions in its new web application software.
    (ii) Conclusion. X's activities related to selecting the commercial 
software vendor with the object-oriented functions it wanted, and then 
selecting which functions to use, are not qualified research under 
section 41(d)(1) and paragraph (a)(5) of this section. In addition, 
incorporating the selected object-oriented functions into the new web 
application software being developed by X did not involve conducting a 
process of evaluating alternatives in order to eliminate uncertainty 
regarding the development of software. X's evaluation of products 
available from vendors and selection of software functions are not a 
process of experimentation.
    Example 7. (i) Facts. In order to be more responsive to user online 
requests, X wants to develop software to balance the incoming processing 
requests across multiple web servers that run the same set of software 
applications. Without evaluating or testing any alternatives, X decides 
that a separate server will be used to distribute the workload across 
each of the web servers and that a round robin workload distribution 
algorithm is appropriate for its needs.
    (ii) Conclusion. X's activities to develop the software are 
activities relating to the development of a separate business component 
under section 41(d)(2)(A). X's activities to develop the load 
distribution function are not qualified research under section 41(d)(1) 
and paragraph (a)(5) of this section. X did not conduct a process of 
evaluating different load distribution alternatives in order to 
eliminate uncertainty regarding the development of software. X's 
selection of a separate server and a round robin distribution algorithm 
is not a process of experimentation.
    Example 8. (i) Facts. X must develop load balancing software across 
a server cluster supporting multiple web applications. X's web 
applications have high concurrency demands because of a dynamic, highly 
volatile environment. X is uncertain of the appropriate design of the 
load balancing algorithm, given that the existing evolutionary 
algorithms did not meet the demands of their highly volatile web 
environment. Therefore, X designs and systematically tests and evaluates 
several different algorithms that perform the load distribution 
functions.
    (ii) Conclusion. X's activities to develop software are activities 
to develop a separate business component under section 41(d)(2)(A). X's 
activities involving the design, evaluation, and systematic testing of 
several new load balancing algorithms meet the requirements as set forth 
in paragraph (a)(5) of this section. X's activities constitute elements 
of a process of experimentation because X identified uncertainties 
related to the development of a business component, identified 
alternatives intended to eliminate those uncertainties, and evaluated 
one or more alternatives to achieve a result where the appropriate 
design was uncertain at the beginning of X's research activities.
    Example 9. (i) Facts. X, a multinational manufacturer, wants to 
install an enterprise resource planning (ERP) system that runs off a 
single database so that X can track orders more easily, and coordinate 
manufacturing, inventory, and shipping among many different locations at 
the same time. In order to successfully install and implement ERP 
software, X evaluates its business needs and the technical requirements 
of the software, such as processing power, memory, storage, and network 
resources. X devotes the majority of its resources in implementing the 
ERP system to evaluating the available templates, reports, and other 
standard programs and choosing among these alternatives in configuring 
the system to match its business process and reengineering its business 
process to match the available alternatives in the ERP system. X also 
performs some data

[[Page 159]]

transfer from its old system, involving routine programming and one-to-
one mapping of data to be exchanged between each system.
    (ii) Conclusion. X's activities related to the ERP software 
including the data transfer are not qualified research under section 
41(d)(1) and paragraph (a)(5) of this section. X did not conduct a 
process of evaluating alternatives in order to eliminate uncertainty 
regarding the development of software. X's activities in choosing 
between available templates, reports, and other standard programs and 
conducting data transfer are not elements of a process of 
experimentation.
    Example 10. (i) Facts. Same facts as Example 9 except that X 
determines that it must interface part of its legacy software with the 
new ERP software because the ERP software does not provide a particular 
function that X requires for its business. As a result, X must develop 
an interface between its legacy software and the ERP software, and X 
evaluates several data exchange software applications and chooses one of 
the available alternatives. X is uncertain as to how to keep the data 
synchronized between the legacy and ERP systems. Thus, X engages in 
systematic trial and error testing of several newly designed data 
caching algorithms to eliminate synchronization problems.
    (ii) Conclusion. Substantially all of X's activities with respect to 
this ERP project do not satisfy the requirements for a process of 
experimentation. However, when the shrinking-back rule is applied, a 
subset of X's activities do satisfy the requirements for a process of 
experimentation. X's activities to develop the data caching software and 
keeping the data on the legacy and ERP systems synchronized meet the 
requirements of qualified research as set forth in paragraph (a)(2) of 
this section. Substantially all of X's activities to develop the 
specialized data caching and synchronization software constitute 
elements of a process of experimentation because X identified 
uncertainties related to the development of a business component, 
identified alternatives intended to eliminate those uncertainties, and 
evaluated alternatives to achieve a result where the appropriate design 
of that result was uncertain as of the beginning of the taxpayer's 
research activities.

    (b) Application of requirements for qualified research--(1) In 
general. The requirements for qualified research in section 41(d)(1) and 
paragraph (a) of this section, must be applied separately to each 
business component, as defined in section 41(d)(2)(B). In cases 
involving development of both a product and a manufacturing or other 
commercial production process for the product, research activities 
relating to development of the process are not qualified research unless 
the requirements of section 41(d) and this section are met for the 
research activities relating to the process without taking into account 
the research activities relating to development of the product. 
Similarly, research activities relating to development of the product 
are not qualified research unless the requirements of section 41(d) and 
this section are met for the research activities relating to the product 
without taking into account the research activities relating to 
development of the manufacturing or other commercial production process.
    (2) Shrinking-back rule. The requirements of section 41(d) and 
paragraph (a) of this section are to be applied first at the level of 
the discrete business component, that is, the product, process, computer 
software, technique, formula, or invention to be held for sale, lease, 
or license, or used by the taxpayer in a trade or business of the 
taxpayer. If these requirements are not met at that level, then they 
apply at the most significant subset of elements of the product, 
process, computer software, technique, formula, or invention to be held 
for sale, lease, or license. This shrinking back of the product is to 
continue until either a subset of elements of the product that satisfies 
the requirements is reached, or the most basic element of the product is 
reached and such element fails to satisfy the test. This shrinking-back 
rule is applied only if a taxpayer does not satisfy the requirements of 
section 41(d)(1) and paragraph (a)(2) of this section with respect to 
the overall business component. The shrinking-back rule is not itself 
applied as a reason to exclude research activities from credit 
eligibility.
    (3) Illustration. The following example illustrates the application 
of this paragraph (b):

    Example. X, a motorcycle engine builder, develops a new carburetor 
for use in a motorcycle engine. X also modifies an existing engine 
design for use with the new carburetor. Under the shrinking-back rule, 
the requirements of section 41(d)(1) and paragraph (a) of this section 
are applied first to the engine. If the modifications to the engine when 
viewed as a whole, including the development of the new carburetor, do 
not satisfy the requirements of section 41(d)(1) and paragraph (a) of

[[Page 160]]

this section, those requirements are applied to the next most 
significant subset of elements of the business component. Assuming that 
the next most significant subset of elements of the engine is the 
carburetor, the research activities in developing the new carburetor may 
constitute qualified research within the meaning of section 41(d)(1) and 
paragraph (a) of this section.

    (c) Excluded activities--(1) In general. Qualified research does not 
include any activity described in section 41(d)(4) and paragraph (c) of 
this section.
    (2) Research after commercial production--(i) In general. Activities 
conducted after the beginning of commercial production of a business 
component are not qualified research. Activities are conducted after the 
beginning of commercial production of a business component if such 
activities are conducted after the component is developed to the point 
where it is ready for commercial sale or use, or meets the basic 
functional and economic requirements of the taxpayer for the component's 
sale or use.
    (ii) Certain additional activities related to the business 
component. The following activities are deemed to occur after the 
beginning of commercial production of a business component--
    (A) Preproduction planning for a finished business component;
    (B) Tooling-up for production;
    (C) Trial production runs;
    (D) Trouble shooting involving detecting faults in production 
equipment or processes;
    (E) Accumulating data relating to production processes; and
    (F) Debugging flaws in a business component.
    (iii) Activities related to production process or technique. In 
cases involving development of both a product and a manufacturing or 
other commercial production process for the product, the exclusion 
described in section 41(d)(4)(A) and paragraphs (c)(2)(i) and (ii) of 
this section applies separately for the activities relating to the 
development of the product and the activities relating to the 
development of the process. For example, even after a product meets the 
taxpayer's basic functional and economic requirements, activities 
relating to the development of the manufacturing process still may 
constitute qualified research, provided that the development of the 
process itself separately satisfies the requirements of section 41(d) 
and this section, and the activities are conducted before the process 
meets the taxpayer's basic functional and economic requirements or is 
ready for commercial use.
    (iv) Clinical testing. Clinical testing of a pharmaceutical product 
prior to its commercial production in the United States is not treated 
as occurring after the beginning of commercial production even if the 
product is commercially available in other countries. Additional 
clinical testing of a pharmaceutical product after a product has been 
approved for a specific therapeutic use by the Food and Drug 
Administration and is ready for commercial production and sale is not 
treated as occurring after the beginning of commercial production if 
such clinical testing is undertaken to establish new functional uses, 
characteristics, indications, combinations, dosages, or delivery forms 
for the product. A functional use, characteristic, indication, 
combination, dosage, or delivery form shall be considered new only if 
such functional use, characteristic, indication, combination, dosage, or 
delivery form must be approved by the Food and Drug Administration.
    (3) Adaptation of existing business components. Activities relating 
to adapting an existing business component to a particular customer's 
requirement or need are not qualified research. This exclusion does not 
apply merely because a business component is intended for a specific 
customer.
    (4) Duplication of existing business component. Activities relating 
to reproducing an existing business component (in whole or in part) from 
a physical examination of the business component itself or from plans, 
blueprints, detailed specifications, or publicly available information 
about the business component are not qualified research. This exclusion 
does not apply merely because the taxpayer examines an existing business 
component in the course of developing its own business component.
    (5) Surveys, studies, research relating to management functions, 
etc. Qualified research does not include activities relating to--

[[Page 161]]

    (i) Efficiency surveys;
    (ii) Management functions or techniques, including such items as 
preparation of financial data and analysis, development of employee 
training programs and management organization plans, and management-
based changes in production processes (such as rearranging work stations 
on an assembly line);
    (iii) Market research, testing, or development (including 
advertising or promotions);
    (iv) Routine data collections; or
    (v) Routine or ordinary testing or inspections for quality control.
    (6) Internal use software--(i) General rule. Research with respect 
to software that is developed by (or for the benefit of) the taxpayer 
primarily for the taxpayer's internal use is eligible for the research 
credit only if--
    (A) The research with respect to the software satisfies the 
requirements of section 41(d)(1);
    (B) The research with respect to the software is not otherwise 
excluded under section 41(d)(4) (other than section 41(d)(4)(E)); and
    (C) The software satisfies the high threshold of innovation test of 
paragraph (c)(6)(vii) of this section.
    (ii) Inapplicability of the high threshold of innovation test. This 
paragraph (c)(6) does not apply to the following:
    (A) Software developed by (or for the benefit of) the taxpayer 
primarily for internal use by the taxpayer for use in an activity that 
constitutes qualified research (other than the development of the 
internal use software itself);
    (B) Software developed by (or for the benefit of) the taxpayer 
primarily for internal use by the taxpayer for use in a production 
process to which the requirements of section 41(d)(1) are met; and
    (C) A new or improved package of software and hardware developed 
together by the taxpayer as a single product (or to the costs to modify 
an acquired software and hardware package), of which the software is an 
integral part, that is used directly by the taxpayer in providing 
services in its trade or business. In these cases, eligibility for the 
research credit is to be determined by examining the combined hardware-
software product as a single product.
    (iii) Software developed primarily for internal use--(A) In general. 
Except as otherwise provided in paragraph (c)(6)(vi) of this section, 
software is developed by (or for the benefit of) the taxpayer primarily 
for the taxpayer's internal use if the software is developed for use in 
general and administrative functions that facilitate or support the 
conduct of the taxpayer's trade or business. Software that the taxpayer 
develops primarily for a related party's internal use will be considered 
internal use software. A related party is any corporation, trade or 
business, or other person that is treated as a single taxpayer with the 
taxpayer pursuant to section 41(f).
    (B) General and administrative functions. General and administrative 
functions are:
    (1) Financial management. Financial management functions are 
functions that involve the financial management of the taxpayer and the 
supporting recordkeeping. Financial management functions include, but 
are not limited to, functions such as accounts payable, accounts 
receivable, inventory management, budgeting, cash management, cost 
accounting, disbursements, economic analysis and forecasting, financial 
reporting, finance, fixed asset accounting, general ledger bookkeeping, 
internal audit, management accounting, risk management, strategic 
business planning, and tax.
    (2) Human resources management. Human resources management functions 
are functions that manage the taxpayer's workforce. Human resources 
management functions include, but are not limited to, functions such as 
recruiting, hiring, training, assigning personnel, and maintaining 
personnel records, payroll, and benefits.
    (3) Support services. Support services are other functions that 
support the day- to-day operations of the taxpayer. Support services 
include, but are not limited to, functions such as data processing, 
facility services (for example, grounds keeping, housekeeping, 
janitorial, and logistics), graphic services, marketing, legal services, 
government compliance services, printing and publication services, and 
security services

[[Page 162]]

(for example, video surveillance and physical asset protection from fire 
and theft).
    (iv) Software not developed primarily for internal use. Software is 
not developed primarily for the taxpayer's internal use if it is not 
developed for use in general and administrative functions that 
facilitate or support the conduct of the taxpayer's trade or business, 
such as--
    (A) Software developed to be commercially sold, leased, licensed, or 
otherwise marketed to third parties; or
    (B) Software developed to enable a taxpayer to interact with third 
parties or to allow third parties to initiate functions or review data 
on the taxpayer's system.
    (v) Time and manner of determination. For purposes of paragraphs 
(c)(6)(iii) and (iv) of this section, whether software is developed 
primarily for internal use or not developed primarily for internal use 
depends on the intent of the taxpayer and the facts and circumstances at 
the beginning of the software development. For example, software will 
not be considered internal use software solely because it is used 
internally for purposes of testing prior to commercial sale, lease, or 
license. If a taxpayer originally develops software primarily for 
internal use, but later makes improvements to the software with the 
intent to hold the improved software to be sold, leased, licensed, or 
otherwise marketed to third parties, or to interact with third parties 
or to allow third parties to initiate functions or review data on the 
taxpayer's system using the improved software, the improvements will be 
considered separate from the existing software and will not be 
considered developed primarily for internal use. Alternatively, if a 
taxpayer originally develops software to be sold, leased, licensed, or 
otherwise marketed to third parties, or to interact with third parties 
or to allow third parties to initiate functions or review data on the 
taxpayer's system, but later makes improvements to the software with the 
intent to use the software in general and administrative functions, the 
improvements will be considered separate from the existing software and 
will be considered developed primarily for internal use.
    (vi) Software developed for both internal use and to enable 
interaction with third parties (dual function software)--(A) Presumption 
of development primarily for internal use. Unless paragraph 
(c)(6)(vi)(B) or (C) of this section applies, software developed by (or 
for the benefit of) the taxpayer both for use in general and 
administrative functions that facilitate or support the conduct of the 
taxpayer's trade or business and to enable a taxpayer to interact with 
third parties or to allow third parties to initiate functions or review 
data on the taxpayer's system (dual function software) is presumed to be 
developed primarily for a taxpayer's internal use.
    (B) Identification of a subset of elements of software that only 
enables interaction with third parties. To the extent that a taxpayer 
can identify a subset of elements of dual function software that only 
enables a taxpayer to interact with third parties or allows third 
parties to initiate functions or review data (third party subset), the 
presumption under paragraph (c)(6)(vi)(A) of this section does not apply 
to such third party subset, and such third party subset is not developed 
primarily for internal use as described under paragraph (c)(6)(iv)(B) of 
this section.
    (C) Safe harbor for expenditures related to software developed for 
both internal use and to enable interaction with third parties. If, 
after the application of paragraph (c)(6)(vi)(B) of this section, there 
remains dual function software or a subset of elements of dual function 
software (dual function subset), a taxpayer may include 25 percent of 
the qualified research expenditures of such dual function software or 
dual function subset in computing the amount of the taxpayer's credit. 
This paragraph (c)(6)(vi)(C) applies only if the taxpayer's research 
activities related to the development or improvement of the dual 
function software or dual function subset constitute qualified research 
under section 41(d), without regard to section 41(d)(4)(E), and the dual 
function software or dual function subset's use by third parties or by 
the taxpayer to interact with third parties is reasonably anticipated to 
constitute at least 10 percent of the dual function

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software or the dual function subset's use. An objective, reasonable 
method within the taxpayer's industry must be used to estimate the dual 
function software or dual function subset's use by third parties or by 
the taxpayer to interact with third parties. An objective, reasonable 
method may include, but is not limited to, processing time, amount of 
data transfer, and number of software user interface screens.
    (D) Time and manner of determination. A taxpayer must apply this 
paragraph (c)(6)(vi) based on the intent of the taxpayer and the facts 
and circumstances at the beginning of the software development.
    (E) Third party. For purposes of paragraphs (c)(6)(iv), (v), and 
(vi) of this section, the term third party means any corporation, trade 
or business, or other person that is not treated as a single taxpayer 
with the taxpayer pursuant to section 41(f). Additionally, for purposes 
of paragraph (c)(6)(iv)(B) of this section, third parties do not include 
any persons that use the software to support the general and 
administrative functions of the taxpayer.
    (vii) High threshold of innovation test--(A) In general. Software 
satisfies this paragraph (c)(6)(vii) only if the taxpayer can establish 
that--
    (1) The software is innovative;
    (2) The software development involves significant economic risk; and
    (3) The software is not commercially available for use by the 
taxpayer in that the software cannot be purchased, leased, or licensed 
and used for the intended purpose without modifications that would 
satisfy the requirements of paragraphs (c)(6)(vii)(A)(1) and (2) of this 
section.
    (B) Innovative. Software is innovative if the software would result 
in a reduction in cost or improvement in speed or other measurable 
improvement, that is substantial and economically significant, if the 
development is or would have been successful. This is a measurable 
objective standard, not a determination of the unique or novel nature of 
the software or the software development process.
    (C) Significant economic risk. The software development involves 
significant economic risk if the taxpayer commits substantial resources 
to the development and if there is substantial uncertainty, because of 
technical risk, that such resources would be recovered within a 
reasonable period. The term ``substantial uncertainty'' requires a 
higher level of uncertainty and technical risk than that required for 
business components that are not internal use software. This standard 
does not require technical uncertainty regarding whether the final 
result can ever be achieved, but rather whether the final result can be 
achieved within a timeframe that will allow the substantial resources 
committed to the development to be recovered within a reasonable period. 
Technical risk arises from uncertainty that is technological in nature, 
as defined in paragraph (a)(4) of this section, and substantial 
uncertainty must exist at the beginning of the taxpayer's activities.
    (D) Application of high threshold of innovation test. The high 
threshold of innovation test of paragraph (c)(6)(vii) of this section 
takes into account only the results anticipated to be attributable to 
the development of new or improved software at the beginning of the 
software development independent of the effect of any modifications to 
related hardware or other software. The implementation of existing 
technology by itself is not evidence of innovation, but the use of 
existing technology in new ways could be evidence of a high threshold of 
innovation if it resolves substantial uncertainty as defined in 
paragraph (c)(6)(vii)(C) of this section.
    (viii) Illustrations. The following examples illustrate provisions 
contained in this paragraph (c)(6). No inference should be drawn from 
these examples concerning the application of section 41(d)(1) and 
paragraph (a) of this section to these facts.

    Example 1. Computer hardware and software developed as a single 
product--(i) Facts. X is a telecommunications company that developed 
high technology telephone switching hardware. In addition, X developed 
software that interfaces directly with the hardware to initiate and 
terminate a call, along with other functions. X designed and developed 
the hardware and software together.
    (ii) Conclusion. The telecommunications software that interfaces 
directly with the hardware is part of a package of software

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and hardware developed together by the taxpayer that is used by the 
taxpayer in providing services in its trade or business. Accordingly, 
this paragraph (c)(6) does not apply to the software that interfaces 
directly with the hardware as described in paragraph (c)(6)(ii)(C) of 
this section, and eligibility for the research credit is determined by 
examining the combined software-hardware product as a single product.
    Example 2. Internal use software; financial management--(i) Facts. 
X, a manufacturer, self-insures its liabilities for employee health 
benefits. X develops its own software to administer its self-insurance 
reserves related to employee health benefits. At the beginning of the 
development, X does not intend to develop the software for commercial 
sale, lease, license, or to be otherwise marketed to third parties or to 
enable X to interact with third parties or to allow third parties to 
initiate functions or review data on X's system.
    (ii) Conclusion. The software is developed for use in a general and 
administrative function because reserve valuation is a financial 
management function under paragraph (c)(6)(iii)(B)(1) of this section. 
Accordingly, the software is internal use software because it is 
developed for use in a general and administrative function.
    Example 3. Internal use software; human resources management--(i) 
Facts. X, a manufacturer, develops a software module that interacts with 
X's existing payroll software to allow X's employees to print pay stubs 
and make certain changes related to payroll deductions over the 
internet. At the beginning of the development, X does not intend to 
develop the software module for commercial sale, lease, license, or to 
be otherwise marketed to third parties or to enable X to interact with 
third parties or to allow third parties to initiate functions or review 
data on X's system.
    (ii) Conclusion. The employee access software module is developed 
for use in a general and administrative function because employee access 
software is a human resources management function under paragraph 
(c)(6)(iii)(B)(2) of this section. Accordingly, the software module is 
internal use software because it is developed for use in a general and 
administrative function.
    Example 4. Internal use software; support services--(i) Facts. X, a 
restaurant, develops software for a Web site that provides information, 
such as items served, price, location, phone number, and hours of 
operation for purposes of advertising. At the beginning of the 
development, X does not intend to develop the Web site software for 
commercial sale, lease, license, or to be otherwise marketed to third 
parties or to enable X to interact with third parties or to allow third 
parties to initiate functions or review data on X's system. X intends to 
use the software for marketing by allowing third parties to review 
general information on X's Web site.
    (ii) Conclusion. The software is developed for use in a general and 
administrative function because the software was developed to be used by 
X for marketing which is a support services function under paragraph 
(c)(6)(iii)(B)(3) of this section. Accordingly, the software is internal 
use software because it is developed for use in a general and 
administrative function.
    Example 5. Internal use software--(i) Facts. X, a multinational 
manufacturer with different business and financial systems in each of 
its divisions, undertakes a software development project aimed at 
integrating the majority of the functional areas of its major software 
systems (Existing Software) into a single enterprise resource management 
system supporting centralized financial systems, human resources, 
inventory, and sales. X purchases software (New Software) upon which to 
base its enterprise-wide system. X has to develop software (Developed 
Software) that transfers data from X's legacy financial, human 
resources, inventory, and sales systems to the New Software. At the 
beginning of the development, X does not intend to develop the software 
for commercial sale, lease, license, or to be otherwise marketed to 
third parties or to enable X to interact with third parties or to allow 
third parties to initiate functions or review data on X's system.
    (ii) Conclusion. The financial systems, human resource systems, 
inventory and sales systems are general and administrative functions 
under paragraph (c)(6)(iii)(B) of this section. Accordingly, the 
Developed Software is internal use software because it is developed for 
use in general and administrative functions.
    Example 6. Internal use software; definition of third party--(i) 
Facts. X develops software to interact electronically with its vendors 
to improve X's inventory management. X develops the software to enable X 
to interact with vendors and to allow vendors to initiate functions or 
review data on the taxpayer's system. X defines the electronic messages 
that will be exchanged between X and the vendors. X's software allows a 
vendor to request X's current inventory of the vendor's product, and 
allows a vendor to send a message to X which informs X that the vendor 
has just made a new shipment of the vendor's product to replenish X's 
inventory. At the beginning of development, X does not intend to develop 
the software for commercial sale, lease, license, or to be otherwise 
marketed to third parties.
    (ii) Conclusion. Under paragraph (c)(6)(vi)(E) of this section, X's 
vendors are not third parties for purposes of paragraph (c)(6)(iv) of 
this section. While X's software was developed to allow vendors to 
initiate functions or review data on the taxpayer's

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system, the software is not excluded from internal use software as set 
forth in paragraph (c)(6)(iv)(B) of this section because the software 
was developed to allow vendors to use the software to support X's 
inventory management, which is a general and administrative function of 
X.
    Example 7. Not internal use software; third party interaction--(i) 
Facts. X, a manufacturer of various products, develops software for a 
Web site with the intent to allow third parties to access data on X's 
database, to order X's products and track the status of their orders 
online. At the beginning of the development, X does not intend to 
develop the Web site software for commercial sale, lease, license, or to 
be otherwise marketed to third parties.
    (ii) Conclusion. The software is not developed primarily for 
internal use because it is not developed for use in a general and 
administrative function. X developed the software to allow third parties 
to initiate functions or review data on the taxpayer's system as 
provided under paragraph (c)(6)(iv)(B) of this section.
    Example 8. Not internal use software; third party interaction--(i) 
Facts. X developed software that allows its users to upload and modify 
photographs at no charge. X earns revenue by selling advertisements that 
are displayed while users enjoy the software that X offers for free. X 
also developed software that has interfaces through which advertisers 
can bid for the best position in placing their ads, set prices for the 
ads, or develop advertisement campaign budgets. At the beginning of the 
development, X intended to develop the software to enable X to interact 
with third parties or to allow third parties to initiate functions on 
X's system.
    (ii) Conclusion. The software for uploading and modifying 
photographs is not developed primarily for internal use because it is 
not developed for use in X's general and administrative functions under 
paragraph (c)(6)(iii)(A) of this section. The users and the advertisers 
are third parties for purposes of paragraph (c)(6)(iv) of this section. 
Furthermore, both the software for uploading and modifying photographs 
and the advertising software are not internal use software under 
paragraph (c)(6)(iv)(B) of this section because at the beginning of the 
development X developed the software with the intention of enabling X to 
interact with third parties or to allow third parties to initiate 
functions on X's system.
    Example 9. Not internal use software; commercially sold, leased, 
licensed, or otherwise marketed--(i) Facts. X is a provider of cloud-
based software. X develops enterprise application software (including 
customer relationship management, sales automation, and accounting 
software) to be accessed online and used by X's customers. At the 
beginning of development, X intended to develop the software for 
commercial sale, lease, license, or to be otherwise marketed to third 
parties.
    (ii) Conclusion. The software is not developed primarily for 
internal use because it is not developed for use in a general and 
administrative function. X developed the software to be commercially 
sold, leased, licensed, or otherwise marketed to third parties under 
paragraph (c)(6)(iv)(A) of this section.
    Example 10. Improvements to existing internal use software--(i) 
Facts. X has branches throughout the country and develops its own 
facilities services software to coordinate moves and to track 
maintenance requests for all locations. At the beginning of the 
development, X does not intend to develop the software for commercial 
sale, lease, license, or to be otherwise marketed to third parties or to 
enable X to interact with third parties or to allow third parties to 
initiate functions or review data on X's system. Several years after 
completing the development and using the software, X consults its 
business development department, which assesses the market for the 
software. X determines that the software could be sold at a profit if 
certain technical and functional enhancements are made. X develops the 
improvements to the software, and sells the improved software to third 
parties.
    (ii) Conclusion. Support services, which include facility services, 
are general and administrative functions under paragraph (c)(6)(iii)(B) 
of this section. Accordingly, the original software is developed for use 
in general and administrative functions and is, therefore, developed 
primarily for internal use. However, the improvements to the software 
are not developed primarily for internal use because the improved 
software was not developed for use in a general and administrative 
function. X developed the improved software to be commercially sold, 
leased, licensed, or otherwise marketed to third parties under 
paragraphs (c)(6)(iv)(A) and (c)(6)(v) of this section.
    Example 11. Dual function software; identification of a third party 
subset--(i) Facts. X develops software for use in general and 
administrative functions that facilitate or support the conduct of X's 
trade or business and to allow third parties to initiate functions. X is 
able to identify a third party subset. X incurs $50,000 of research 
expenditures for the software, 50% of which is allocable to the third 
party subset.
    (ii) Conclusion. The software developed by X is dual function 
software. Because X is able to identify a third party subset, the third 
party subset is not presumed to be internal use software under paragraph 
(c)(6)(vi)(A) of this section. If X's research activities related to the 
third party subset constitute qualified research under section 41(d), 
and the allocable expenditures are

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qualified research expenditures under section 41(b), $25,000 of the 
software research expenditures allocable to the third party subset may 
be included in computing the amount of X's credit, pursuant to paragraph 
(c)(6)(vi)(B) of this section. If, after the application of paragraph 
(c)(6)(vi)(B) of this section, there remains a dual function subset, X 
may determine whether paragraph (c)(6)(vi)(C) of this section applies.
    Example 12. Dual function software; application of the safe harbor--
(i) Facts. The facts are the same as in Example 11, except that X is 
unable to identify a third party subset. X uses an objective, reasonable 
method at the beginning of the software development to determine that 
the dual function software's use by third parties to initiate functions 
is reasonably anticipated to constitute 15% of the dual function 
software's use.
    (ii) Conclusion. The software developed by X is dual function 
software. The software is presumed to be developed primarily for 
internal use under paragraph (c)(6)(vi)(A) of this section. Although X 
is unable to identify a third party subset, X reasonably anticipates 
that the dual function software's use by third parties will be at least 
10% of the dual function software's use. If X's research activities 
related to the development or improvement of the dual function software 
constitute qualified research under section 41(d), without regard to 
section 41(d)(4)(E), and the allocable expenditures are qualified 
research expenditures under section 41(b), X may include $12,500 (25% of 
$50,000) of the software research expenditures of the dual function 
software in computing the amount of X's credit pursuant to paragraph 
(c)(6)(vi)(C) of this section.
    Example 13. Dual function software; safe harbor inapplicable--(i) 
Facts. The facts are the same as in Example 11, except X is unable to 
identify a third party subset. X uses an objective, reasonable method at 
the beginning of the software development to determine that the dual 
function software's use by third parties to initiate functions is 
reasonably anticipated to constitute 5% of the dual function software's 
use.
    (ii) Conclusion. The software developed by X is dual function 
software. The software is presumed to be developed primarily for X's 
internal use under paragraph (c)(6)(vi)(A) of this section. X is unable 
to identify a third party subset, and X reasonably anticipates that the 
dual function software's use by third parties will be less than 10% of 
the dual function software's use. X may only include the software 
research expenditures of the dual function software in computing the 
amount of X's credit if the software satisfies the high threshold of 
innovation test of paragraph (c)(6)(vii) of this section and X's 
research activities related to the development or improvement of the 
dual function software constitute qualified research under section 
41(d), without regard to section 41(d)(4)(E), and the allocable 
expenditures are qualified research expenditures under section 41(b).
    Example 14. Dual function software; identification of a third party 
subset and the safe harbor--(i) Facts. X develops software for use in 
general and administrative functions that facilitate or support the 
conduct of X's trade or business and to allow third parties to initiate 
functions and review data. X is able to identify a third party subset 
(Subset A). The remaining dual function subset of the software (Subset 
B) allows third parties to review data and provides X with data used in 
its general and administrative functions. X is unable to identify a 
third party subset of Subset B. X incurs $50,000 of research 
expenditures for the software, 50% of which is allocable to Subset A and 
50% of which is allocable to Subset B. X determines, at the beginning of 
the software development, that the processing time of the third party 
use of Subset B is reasonably anticipated to account for 15% of the 
total processing time of Subset B.
    (ii) Conclusion. The software developed by X is dual function 
software. Because X is able to identify a third party subset, such third 
party subset (Subset A) is not presumed to be internal use software 
under paragraph (c)(6)(vi)(A) of this section. If X's research 
activities related to the development or improvement of Subset A 
constitute qualified research under section 41(d), and the allocable 
expenditures are qualified research expenditures under section 41(b), 
the $25,000 of the software research expenditures allocable to Subset A 
may be included in computing the amount of X's credit pursuant to 
paragraph (c)(6)(vi)(B) of this section. Although X is unable to 
identify a third party subset of Subset B, 15% of Subset B's use is 
reasonably anticipated to be attributable to the use of Subset B by 
third parties. If X's research activities related to the development or 
improvement of Subset B constitute qualified research under section 
41(d), without regard to section 41(d)(4)(E), and the allocable 
expenditures are qualified research expenditures under section 41(b), X 
may include $6,250 (25% x $25,000) of the software research expenditures 
of Subset B in computing the amount of X's credit, pursuant to paragraph 
(c)(6)(vi)(C) of this section.
    Example 15. Internal use software; application of the high threshold 
of innovation test--(i) Facts. X maintained separate software 
applications for tracking a variety of human resource (HR) functions, 
including employee reviews, salary information, location within the 
hierarchy and physical location of employees, 401(k) plans, and 
insurance coverage information. X determined that improved HR efficiency 
could be achieved by redesigning its disparate software applications 
into one employee-centric system, and

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worked to develop that system. X also determined that commercially 
available database management systems did not meet all of the 
requirements of the proposed system. Rather than waiting several years 
for vendor offerings to mature and become viable for its purpose, X 
embarked upon the project utilizing older technology that was severely 
challenged with respect to data modeling capabilities. The improvements, 
if successful, would provide a reduction in cost and improvement in 
speed that is substantial and economically significant. For example, 
having one employee-centric system would remove the duplicative time and 
cost of manually entering basic employee information separately in each 
application because the information would only have to be entered once 
to be available across all applications. The limitations of the 
technology X was attempting to utilize required that X attempt to 
develop a new database architecture. X committed substantial resources 
to the project, but could not predict, because of technical risk, 
whether it could develop the database software in the timeframe 
necessary so that X could recover its resources in a reasonable period. 
Specifically, X was uncertain regarding the capability of developing, 
within a reasonable period, a new database architecture using the old 
technology that would resolve its technological issues regarding the 
data modeling capabilities and the integration of the disparate systems 
into one system. At the beginning of the development, X did not intend 
to develop the software for commercial sale, lease, license, or to be 
otherwise marketed to third parties or to enable X to interact with 
third parties or to allow third parties to initiate functions or review 
data on X's system.
    (ii) Conclusion. The software is internal use software because it is 
developed for use in a general and administrative function. However, the 
software satisfies the high threshold of innovation test set forth in 
paragraph (c)(6)(vii) of this section. The software was intended to be 
innovative in that it would provide a reduction in cost or improvement 
in speed that is substantial and economically significant. In addition, 
X's development activities involved significant economic risk in that X 
committed substantial resources to the development and there was 
substantial uncertainty, because of technical risk, that the resources 
would be recovered within a reasonable period. Finally, at the time X 
undertook the development of the system, software meeting X's 
requirements was not commercially available for use by X.
    Example 16. Internal use software; application of the high threshold 
of innovation test--(i) Facts. X undertook a software project to rewrite 
a legacy mainframe application using an object-oriented programming 
language, and to move the new application off the mainframe to a client/
server environment. Both the object-oriented language and client/server 
technologies were new to X. This project was undertaken to develop a 
more maintainable application, which X expected would significantly 
reduce the cost of maintenance, and implement new features more quickly, 
which X expected would provide both significant improvements in speed 
and reduction in cost. Thus, the improvements, if successful, would 
provide a reduction in cost and improvement in speed that is substantial 
and economically significant. X also determined that commercially 
available systems did not meet the requirements of the proposed system. 
X was certain that it would be able to overcome any technological 
uncertainties and implement the improvements within a reasonable period. 
However, X was unsure of the appropriate methodology to achieve the 
improvements. At the beginning of the development, X does not intend to 
develop the software for commercial sale, lease, license, or to be 
otherwise marketed to third parties or to enable X to interact with 
third parties or to allow third parties to initiate functions or review 
data on X's system.
    (ii) Conclusion. The software is internal use software because it is 
developed for use in a general and administrative function. X's 
activities do not satisfy the high threshold of innovation test of 
paragraph (c)(6)(vii) of this section. Although the software meets the 
requirements of paragraphs (c)(6)(vii)(A)(1) and (3) of this section, 
X's development activities did not involve significant economic risk 
under paragraph (c)(6)(vii)(A)(2) of this section. X did not have 
substantial uncertainty, because of technical risk, that the resources 
committed to the project would be recovered within a reasonable period.
    Example 17. Internal use software; application of the high threshold 
of innovation test--(i) Facts. X wants to expand its internal computing 
power, and is aware that its PCs and workstations are idle at night, on 
the weekends, and for a significant part of any business day. Because 
the general and administrative computations that X needs to make could 
be done on workstations as well as PCs, X develops a screen-saver-like 
application that runs on employee computers. When employees' computers 
have been idle for an amount of time set by each employee, X's 
application goes back to a central server to get a new job to execute. 
This job will execute on the idle employee's computer until it has 
either finished, or the employee resumes working on his computer. The 
ability to use the idle employees' computers would save X significant 
costs because X would not have to buy new hardware to expand the 
computing power. The improvements, if successful, would provide a 
reduction in cost that is substantial and economically significant. At

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the time X undertook the software development project, there was no 
commercial application available with such a capability. In addition, at 
the time X undertook the software development project, X was uncertain 
regarding the capability of developing a server application that could 
schedule and distribute the jobs across thousands of PCs and 
workstations, as well as handle all the error conditions that occur on a 
user's machine. X commits substantial resources to the project. X 
undertakes a process of experimentation to attempt to eliminate its 
uncertainty. At the beginning of the development, X does not intend to 
develop the software for commercial sale, lease, license, or to be 
otherwise marketed to third parties or to enable X to interact with 
third parties or to allow third parties to initiate functions or review 
data on X's system.
    (ii) Conclusion. The software is internal use software because it is 
developed for use in a general and administrative function. However, the 
software satisfies the high threshold of innovation test as set forth in 
paragraph (c)(6)(vii) of this section. The software was intended to be 
innovative because it would provide a reduction in cost or improvement 
in speed that is substantial and economically significant. In addition, 
X's development activities involved significant economic risk in that X 
committed substantial resources to the development and there was 
substantial uncertainty that because of technical risk, such resources 
would be recovered within a reasonable period. Finally, at the time X 
undertook the development of the system, software meeting X's 
requirements was not commercially available for use by X.
    Example 18. Internal use software; application of the high threshold 
of innovation test--(i) Facts. X, a multinational manufacturer, wants to 
install an enterprise resource planning (ERP) system that runs off a 
single database. However, to implement the ERP system, X determines that 
it must integrate part of its old system with the new because the ERP 
system does not have a particular function that X requires for its 
business. The two systems are general and administrative software 
systems. The systems have mutual incompatibilities. The integration, if 
successful, would provide a reduction in cost and improvement in speed 
that is substantial and economically significant. At the time X 
undertook this project, there was no commercial application available 
with such a capability. X is uncertain regarding the appropriate design 
of the interface software. However, X knows that given a reasonable 
period of time to experiment with various designs, X would be able to 
determine the appropriate design necessary to meet X's technical 
requirements and would recover the substantial resources that X commits 
to the development of the system within a reasonable period. At the 
beginning of the development, X does not intend to develop the software 
for commercial sale, lease, license, or to be otherwise marketed to 
third parties or to enable X to interact with third parties or to allow 
third parties to initiate functions or review data on X's system.
    (ii) Conclusion. The software is internal use software because it is 
developed for use in a general and administrative function. X's 
activities do not satisfy the high threshold of innovation test of 
paragraph (c)(6)(vii) of this section. Although the software meets the 
requirements of paragraphs (c)(6)(vii)(A)(1) and (3) of this section, 
X's development activities did not involve significant economic risk 
under paragraph (c)(6)(vii)(A)(2) of this section. X did not have 
substantial uncertainty, because of technical risk, that the resources 
committed to the project would be recovered within a reasonable period.

    (7) Activities outside the United States, Puerto Rico, and other 
possessions--(i) In general. Research conducted outside the United 
States, as defined in section 7701(a)(9), the Commonwealth of Puerto 
Rico and other possessions of the United States does not constitute 
qualified research.
    (ii) Apportionment of in-house research expenses. In-house research 
expenses paid or incurred for qualified services performed both in the 
United States, the Commonwealth of Puerto Rico and other possessions of 
the United States and outside the United States, the Commonwealth of 
Puerto Rico and other possessions of the United States must be 
apportioned between the services performed in the United States, the 
Commonwealth of Puerto Rico and other possessions of the United States 
and the services performed outside the United States, the Commonwealth 
of Puerto Rico and other possessions of the United States. Only those 
in-house research expenses apportioned to the services performed within 
the United States, the Commonwealth of Puerto Rico and other possessions 
of the United States are eligible to be treated as qualified research 
expenses, unless the in-house research expenses are wages and the 80 
percent rule of Sec.  1.41-2(d)(2) applies.
    (iii) Apportionment of contract research expenses. If contract 
research is performed partly in the United States, the Commonwealth of 
Puerto Rico and other possessions of the United States

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and partly outside the United States, the Commonwealth of Puerto Rico 
and other possessions of the United States, only 65 percent (or 75 
percent in the case of amounts paid to qualified research consortia) of 
the portion of the contract amount that is attributable to the research 
activity performed in the United States, the Commonwealth of Puerto Rico 
and other possessions of the United States may qualify as a contract 
research expense (even if 80 percent or more of the contract amount is 
for research performed in the United States, the Commonwealth of Puerto 
Rico and other possessions of the United States).
    (8) Research in the social sciences, etc. Qualified research does 
not include research in the social sciences (including economics, 
business management, and behavioral sciences), arts, or humanities.
    (9) Research funded by any grant, contract, or otherwise. Qualified 
research does not include any research to the extent funded by any 
grant, contract, or otherwise by another person (or governmental 
entity). To determine the extent to which research is so funded, Sec.  
1.41-4A(d) applies.
    (10) Illustrations. The following examples illustrate provisions 
contained in paragraphs (c)(1) through (9) (excepting paragraphs (c)(6) 
of this section) of this section. No inference should be drawn from 
these examples concerning the application of section 41(d)(1) and 
paragraph (a) of this section to these facts. The examples are as 
follows:

    Example 1. (i) Facts. X, a tire manufacturer, develops a new 
material to use in its tires. X conducts research to determine the 
changes that will be necessary for X to modify its existing 
manufacturing processes to manufacture the new tire. X determines that 
the new tire material retains heat for a longer period of time than the 
materials X currently uses for tires, and, as a result, the new tire 
material adheres to the manufacturing equipment during tread cooling. X 
evaluates several alternatives for processing the treads at cooler 
temperatures to address this problem, including a new type of belt for 
its manufacturing equipment to be used in tread cooling. Such a belt is 
not commercially available. Because X is uncertain of the belt design, X 
develops and conducts sophisticated engineering tests on several 
alternative designs for a new type of belt to be used in tread cooling 
until X successfully achieves a design that meets X's requirements. X 
then manufactures a set of belts for its production equipment, installs 
the belts, and tests the belts to make sure they were manufactured 
correctly.
    (ii) Conclusion. X's research with respect to the design of the new 
belts to be used in its manufacturing of the new tire may be qualified 
research under section 41(d)(1) and paragraph (a) of this section. 
However, X's expenses to implement the new belts, including the costs to 
manufacture, install, and test the belts were incurred after the belts 
met the taxpayer's functional and economic requirements and are excluded 
as research after commercial production under section 41(d)(4)(A) and 
paragraph (c)(2) of this section.
    Example 2. (i) Facts. For several years, X has manufactured and sold 
a particular kind of widget. X initiates a new research project to 
develop a new or improved widget.
    (ii) Conclusion. X's activities to develop a new or improved widget 
are not excluded from the definition of qualified research under section 
41(d)(4)(A) and paragraph (c)(2) of this section. X's activities 
relating to the development of a new or improved widget constitute a new 
research project to develop a new business component. X's research 
activities relating to the development of the new or improved widget, a 
new business component, are not considered to be activities conducted 
after the beginning of commercial production under section 41(d)(4)(A) 
and paragraph (c)(2) of this section.
    Example 3. (i) Facts. X, a computer software development firm, owns 
all substantial rights in a general ledger accounting software core 
program that X markets and licenses to customers. X incurs expenditures 
in adapting the core software program to the requirements of C, one of 
X's customers.
    (ii) Conclusion. Because X's activities represent activities to 
adapt an existing software program to a particular customer's 
requirement or need, X's activities are excluded from the definition of 
qualified research under section 41(d)(4)(B) and paragraph (c)(3) of 
this section.
    Example 4. (i) Facts. The facts are the same as in Example 3, except 
that C pays X to adapt the core software program to C's requirements.
    (ii) Conclusion. Because X's activities are excluded from the 
definition of qualified research under section 41(d)(4)(B) and paragraph 
(c)(3) of this section, C's payments to X are not for qualified research 
and are not considered to be contract research expenses under section 
41(b)(3)(A).
    Example 5. (i) Facts. The facts are the same as in Example 3, except 
that C's own employees adapt the core software program to C's 
requirements.
    (ii) Conclusion. Because C's employees' activities to adapt the core 
software program

[[Page 170]]

to C's requirements are excluded from the definition of qualified 
research under section 41(d)(4)(B) and paragraph (c)(3) of this section, 
the wages C paid to its employees do not constitute in-house research 
expenses under section 41(b)(2)(A).
    Example 6. (i) Facts. X manufacturers and sells rail cars. Because 
rail cars have numerous specifications related to performance, 
reliability and quality, rail car designs are subject to extensive, 
complex testing in the scientific or laboratory sense. B orders 
passenger rail cars from X. B's rail car requirements differ from those 
of X's other existing customers only in that B wants fewer seats in its 
passenger cars and a higher quality seating material and carpet that are 
commercially available. X manufactures rail cars meeting B's 
requirements.
    (ii) Conclusion. X's activities to manufacture rail cars for B are 
excluded from the definition of qualified research. The rail car sold to 
B was not a new business component, but merely an adaptation of an 
existing business component that did not require a process of 
experimentation. Thus, X's activities to manufacture rail cars for B are 
excluded from the definition of qualified research under section 
41(d)(4)(B) and paragraph (c)(3) of this section because X's activities 
represent activities to adapt an existing business component to a 
particular customer's requirement or need.
    Example 7. (i) Facts. X, a manufacturer, undertakes to create a 
manufacturing process for a new valve design. X determines that it 
requires a specialized type of robotic equipment to use in the 
manufacturing process for its new valves. Such robotic equipment is not 
commercially available, and X, therefore, purchases the existing robotic 
equipment for the purpose of modifying it to meet its needs. X's 
engineers identify uncertainty that is technological in nature 
concerning how to modify the existing robotic equipment to meet its 
needs. X's engineers develop several alternative designs, and conduct 
experiments using modeling and simulation in modifying the robotic 
equipment and conduct extensive scientific and laboratory testing of 
design alternatives. As a result of this process, X's engineers develop 
a design for the robotic equipment that meets X's needs. X constructs 
and installs the modified robotic equipment on its manufacturing 
process.
    (ii) Conclusion. X's research activities to determine how to modify 
X's robotic equipment for its manufacturing process are not excluded 
from the definition of qualified research under section 41(d)(4)(B) and 
paragraph (c)(3) of this section, provided that X's research activities 
satisfy the requirements of section 41(d)(1).
    Example 8. (i) Facts. An existing gasoline additive is manufactured 
by Y using three ingredients, A, B, and C. X seeks to develop and 
manufacture its own gasoline additive that appears and functions in a 
manner similar to Y's additive. To develop its own additive, X first 
inspects the composition of Y's additive, and uses knowledge gained from 
the inspection to reproduce A and B in the laboratory. Any differences 
between ingredients A and B that are used in Y's additive and those 
reproduced by X are insignificant and are not material to the viability, 
effectiveness, or cost of A and B. X desires to use with A and B an 
ingredient that has a materially lower cost than ingredient C. 
Accordingly, X engages in a process of experimentation to develop, 
analyze and test potential alternative formulations of the additive.
    (ii) Conclusion. X's activities in analyzing and reproducing 
ingredients A and B involve duplication of existing business components 
and are excluded from the definition of qualified research under section 
41(d)(4)(C) and paragraph (c)(4) of this section. X's experimentation 
activities to develop potential alternative formulations of the additive 
do not involve duplication of an existing business component and are not 
excluded from the definition of qualified research under section 
41(d)(4)(C) and paragraph (c)(4) of this section.
    Example 9. (i) Facts. X, a manufacturing corporation, undertakes to 
restructure its manufacturing organization. X organizes a team to design 
an organizational structure that will improve X's business operations. 
The team includes X's employees as well as outside management 
consultants. The team studies current operations, interviews X's 
employees, and studies the structure of other manufacturing facilities 
to determine appropriate modifications to X's current business 
operations. The team develops a recommendation of proposed modifications 
which it presents to X's management. X's management approves the team's 
recommendation and begins to implement the proposed modifications.
    (ii) Conclusion. X's activities in developing and implementing the 
new management structure are excluded from the definition of qualified 
research under section 41(d)(4)(D) and paragraph (c)(5) of this section. 
Qualified research does not include activities relating to management 
functions or techniques including management organization plans and 
management-based changes in production processes.
    Example 10. (i) Facts. X, an insurance company, develops a new life 
insurance product. In the course of developing the product, X engages in 
research with respect to the effect of pricing and tax consequences on 
demand for the product, the expected volatility of interest rates, and 
the expected mortality rates (based on published data and prior 
insurance claims).
    (ii) Conclusion. X's activities related to the new product represent 
research in the social

[[Page 171]]

sciences (including economics and business management) and are thus 
excluded from the definition of qualified research under section 
41(d)(4)(G) and paragraph (c)(8) of this section.

    (d) Recordkeeping for the research credit. A taxpayer claiming a 
credit under section 41 must retain records in sufficiently usable form 
and detail to substantiate that the expenditures claimed are eligible 
for the credit. For the rules governing record retention, see Sec.  
1.6001-1. To facilitate compliance and administration, the IRS and 
taxpayers may agree to guidelines for the keeping of specific records 
for purposes of substantiating research credits.
    (e) Effective/applicability dates. Other than paragraph (c)(6) of 
this section, this section is applicable for taxable years ending on or 
after December 31, 2003. Paragraph (c)(6) of this section is applicable 
for taxable years beginning on or after October 4, 2016. For any taxable 
year that both ends on or after January 20, 2015 and begins before 
October 4, 2016, the IRS will not challenge return positions consistent 
with all of paragraph (c)(6) of this section or all of paragraph (c)(6) 
of this section as contained in the Internal Revenue Bulletin (IRB) 
2015-5 (see www.irs.gov/pub/irs-irbs/irb15-05.pdf). For taxable years 
ending before January 20, 2015, taxpayers may choose to follow either 
all of Sec.  1.41-4(c)(6) as contained in 26 CFR part 1 (revised as of 
April 1, 2003) and IRB 2001-5 (see www.irs.gov/pub/irs-irbs/irb01-
05.pdf) or all of Sec.  1.41-4(c)(6) as contained in IRB 2002-4 (see 
www.irs.gov/pub/irs-irbs/irb02-04.pdf).

[T.D. 8930, 66 FR 290, Jan. 3, 2001, as amended by T.D. 9104, 69 FR 26, 
Jan. 2, 2004; T.D. 9786, 81 FR 68307, Oct. 4, 2016; 81 FR 76496, Nov. 3, 
2016]



Sec.  1.41-4A  Qualified research for taxable years beginning before
January 1, 1986.

    (a) General rule. Except as otherwise provided in section 30(d) (as 
that section read before amendment by the Tax Reform Act of 1986) and in 
this section, the term ``qualified research'' means research, 
expenditures for which would be research and experimental expenditures 
within the meaning of section 174. Expenditures that are ineligible for 
the section 174 deduction elections are not expenditures for qualified 
research. For example, expenditures for the acquisition of land or 
depreciable property used in research, and mineral exploration costs 
described in section 174(d), are not expenditures for qualified 
research.
    (b) Activities outside the United States--(1) In-house research. In-
house research conducted outside the United States (as defined in 
section 7701(a)(9)) cannot constitute qualified research. Thus, wages 
paid to an employee scientist for services performed in a laboratory in 
the United States and in a test station in Antarctica must be 
apportioned between the services performed within the United States and 
the services performed outside the United States, and only the wages 
apportioned to the services conducted within the United States are 
qualified research expenses unless the 80 percent rule of Sec.  1.41-
2(d)(2) applies.
    (2) Contract research. If contract research is performed partly 
within the United States and partly without, only 65 percent of the 
portion of the contract amount that is attributable to the research 
performed within the United States can qualify as contract research 
expense (even if 80 percent or more of the contract amount was for 
research performed in the United States).
    (c) Social sciences or humanities. Qualified research does not 
include research in the social sciences or humanities. For purposes of 
section 30(d)(2) (as that section read before amendment by the Tax 
Reform Act of 1986) and of this section, the phrase ``research in the 
social sciences or humanities'' encompasses all areas of research other 
than research in a field of laboratory science (such as physics or 
biochemistry), engineering or technology. Examples of research in the 
social sciences or humanities include the development of a new life 
insurance contract, a new economic model or theory, a new accounting 
procedure or a new cookbook.
    (d) Research funded by any grant, contract, or otherwise--(1) In 
general. Research does not constitute qualified research to the extent 
it is funded by any grant, contract, or otherwise by another person 
(including any governmental entity). All agreements (not

[[Page 172]]

only research contracts) entered into between the taxpayer performing 
the research and other persons shall be considered in determining the 
extent to which the research is funded. Amounts payable under any 
agreement that are contingent on the success of the research and thus 
considered to be paid for the product or result of the research (see 
Sec.  1.41-2(e)(2)) are not treated as funding. For special rules 
regarding funding between commonly controlled businesses, see Sec.  
1.41-6(e).
    (2) Research in which taxpayer retains no rights. If a taxpayer 
performing research for another person retains no substantial rights in 
research under the agreement providing for the research, the research is 
treated as fully funded for purposes of section 41(d)(4)(H), and no 
expenses paid or incurred by the taxpayer in performing the research are 
qualified research expenses. For example, if the taxpayer performs 
research under an agreement that confers on another person the exclusive 
right to exploit the results of the research, the taxpayer is not 
performing qualified research because the research is treated as fully 
funded under this paragraph (d)(2). Incidental benefits to the taxpayer 
from performance of the research (for example, increased experience in a 
field of research) do not constitute substantial rights in the research. 
If a taxpayer performing research for another person retains no 
substantial rights in the research and if the payments to the researcher 
are contingent upon the success of the research, neither the performer 
nor the person paying for the research is entitled to treat any portion 
of the expenditures as qualified research expenditures.
    (3) Research in which the taxpayer retains substantial rights--(i) 
In general. If a taxpayer performing research for another person retains 
substantial rights in the research under the agreement providing for the 
research, the research is funded to the extent of the payments (and fair 
market value of any property) to which the taxpayer becomes entitled by 
performing the research. A taxpayer does not retain substantial rights 
in the research if the taxpayer must pay for the right to use the 
results of the research. Except as otherwise provided in paragraph 
(d)(3)(ii) of this section, the taxpayer shall reduce the amount paid or 
incurred by the taxpayer for the research that would, but for section 
41(d)(4)(H), constitute qualified research expenses of the taxpayer by 
the amount of funding determined under the preceding sentence.
    (ii) Pro rata allocation. If the taxpayer can establish to the 
satisfaction of the district director--
    (A) The total amount of research expenses,
    (B) That the total amount of research expenses exceed the funding, 
and
    (C) That the otherwise qualified research expenses (that is, the 
expenses which would be qualified research expenses if there were no 
funding) exceed 65 percent of the funding, then the taxpayer may 
allocate the funding pro rata to nonqualified and otherwise qualified 
research expenses, rather than allocating it 100 percent to otherwise 
qualified research expenses (as provided in paragraph (d)(3)(i) of this 
section). In no event, however, shall less than 65 percent of the 
funding be applied against the otherwise qualified research expenses.
    (iii) Project-by-project determination. The provisions of this 
paragraph (d)(3) shall be applied separately to each research project 
undertaken by the taxpayer.
    (4) Independent research and development under the Federal 
Acquisition Regulations System and similar provisions. The Federal 
Acquisition Regulations System and similar rules and regulations 
relating to contracts (fixed price, cost plus, etc.) with government 
entities provide for allocation of certain ``independent research and 
development costs'' and ``bid and proposal costs'' of a contractor to 
contracts entered into with that contractor. In general, any 
``independent research and development costs'' and ``bid and proposal 
costs'' paid to a taxpayer by reason of such a contract shall not be 
treated as funding the underlying research activities except to the 
extent the ``independent research and development costs'' and ``bid and 
proposal costs'' are properly severable from the contract. See Sec.  
1.451-3(e); see also section 804(d)(2) of the Tax Reform Act of 1986.

[[Page 173]]

    (5) Funding determinable only in subsequent taxable year. If at the 
time the taxpayer files its return for a taxable year, it is impossible 
to determine to what extent particular research performed by the 
taxpayer during that year may be funded, then the taxpayer shall treat 
the research as completely funded for purposes of completing that 
return. When the amount of funding is finally determined, the taxpayer 
should amend the return and any interim returns to reflect the proper 
amount of funding.
    (6) Examples. The following examples illustrate the application of 
the principles contained in this paragraph.

    Example 1. A enters into a contract with B Corporation, a cash-
method taxpayer using the calendar year as its taxable year, under which 
B is to perform research that would, but for section 41(d)(3)(H), be 
qualified research of B. The agreement calls for A to pay B $120x, 
regardless of the outcome of the research. In 1982, A makes full payment 
of $120x under the contract, B performs all the research, and B pays all 
the expenses connected with the research, as follows:

In-house research expenses.....................................    $100x
Outside research:
  (Amount B paid to third parties for research, 65 percent of        40x
   which ($26x) is treated as a contract research expense of B)
Overhead and other expenses....................................      10x
                                                                --------
    Total......................................................     150x
 

    If B has no rights to the research, B is fully funded. 
Alternatively, assume that B retains the right to use the results of the 
research in carrying on B's business. Of B's otherwise qualified 
research expenses of $126x + $26x), $120x is treated as funded by A. 
Thus $6x ($126x - $120x) is treated as a qualified research expense of 
B. However, if B establishes the facts required under paragraph (d)(3) 
of this section, B can allocate the funding pro rata to nonqualified and 
otherwise qualified research expenses. Thus $100.8x ($120x ($126x/
$150x)) would be allocated to otherwise qualified research expenses. B's 
qualified research expenses would be $25.2x ($126x - $100.8x). For 
purposes of the following examples (2), (3) and (4) assume that B 
retains substantial rights to use the results of the research in 
carrying on B's business.
    Example 2. The facts are the same as in example (1) (assuming that B 
retains the right to use the results of the research in carrying on B's 
business) except that, although A makes full payment of $120x during 
1982, B does not perform the research or pay the associated expenses 
until 1983. The computations are unchanged. However, B's qualified 
research expenses determined in example (1) are qualified research 
expenses during 1983.
    Example 3. The facts are the same as in example (1) (assuming that B 
retains the right to use the results of the research in carrying on B's 
business) except that, although B performs the research and pays the 
associated expenses during 1982, A does not pay the $120x until 1983. 
The computations are unchanged and the amount determined in example (1) 
is a qualified research expense of B during 1982.
    Example 4. The facts are the same as in example (1) (assuming that B 
retains the right to use the results of the research in carrying on B's 
business) except that, instead of agreeing to pay B $120x, A agrees to 
pay $100x regardless of the outcome and an additional $20x only if B's 
research produces a useful product. B's research produces a useful 
product and A pays B $120x during 1982. The $20x payment that is 
conditional on the success of the research is not treated as funding. 
Assuming that B establishes to the satisfaction of the district director 
the actual research expenses, B can allocate the funding to nonqualified 
and otherwise qualified research expenses. Thus $84x ($100x ($126x/
$150x)) would be allocated to otherwise qualified research expenses. B's 
qualified research expenses would be $42x ($126x - $84x).
    Example 5. C enters into a contract with D, a cash-method taxpayer 
using the calendar year as its taxable year, under which D is to perform 
research in which both C and D will have substantial rights. C agrees to 
reimburse D for 80 percent of D's expenses for the research. D performs 
part of the research in 1982 and the rest in 1983. At the time that D 
files its return for 1982, D is unable to determine the extent to which 
the research is funded under the provisions of this paragraph. Under 
these circumstances, D may not treat any of the expenses paid by D for 
this research during 1982 as qualified research expenses on its 1982 
return. When the project is complete and D can determine the extent of 
funding, D should file an amended return for 1982 to take into account 
any qualified research expense for 1982.

[T.D. 8251, 54 FR 21204, May 17, 1989. Redesignated and amended by T.D. 
8930, 66 FR 295, Jan. 3, 2001]



Sec.  1.41-5  Basic research for taxable years beginning after 
December 31, 1986. [Reserved]



Sec.  1.41-5A  Basic research for taxable years beginning before 
January 1, 1987.

    (a) In general. The amount expended for basic research within the 
meaning of section 30(e) (before amended by the

[[Page 174]]

Tax Reform Act of 1986) equals the sum of money plus the taxpayer's 
basis in tangible property (other than land) transferred for use in the 
performance of basic research.
    (b) Trade or business requirement. Any amount treated as a contract 
research expense under section 30(e) (before amendment by the Tax Reform 
Act of 1986) shall be deemed to have been paid or incurred in carrying 
on a trade or business, if the corporation that paid or incurred the 
expenses is actually engaged in carrying on some trade or business.
    (c) Prepaid amounts--(1) In general. If any basic research expense 
paid or incurred during any taxable year is attributable to research to 
be conducted after the close of such taxable year, the expense so 
attributable shall be treated for purposes of section 30(b)(1)(B) 
(before amendment by the Tax Reform Act of 1986) as paid or incurred 
during the period in which the basic research is conducted.
    (2) Transfers of property. In the case of transfers of property to 
be used in the performance of basic research, the research in which that 
property is to be used shall be considered to be conducted ratably over 
a period beginning on the day the property is first so used and 
continuing for the number of years provided with respect to property of 
that class under section 168(c)(2) (before amendment by the Tax Reform 
Act of 1986). For example, if an item of property which is 3-year 
property under section 168(c) is transferred to a university for basic 
research on January 12, 1983, and is first so used by the university on 
March 1, 1983, then the research in which that property is used is 
considered to be conducted ratably from March 1, 1983, through February 
28, 1986.
    (d) Written research agreement--(1) In general. A written research 
agreement must be entered into prior to the performance of the basic 
research.
    (2) Agreement between a corporation and a qualified organization 
after June 30, 1983--(i) In general. A written research agreement 
between a corporation and a qualified organization (including a 
qualified fund) entered into after June 30, 1983, shall provide that the 
organization shall inform the corporation within 60 days after the close 
of each taxable year of the corporation what amount of funds provided by 
the corporation pursuant to the agreement was expended on basic research 
during the taxable year of the corporation. In determining amounts 
expended on basic research, the qualified organization shall take into 
account the exclusions specified in section 30(e)(3) (before amendment 
by the Tax Reform Act of 1986) and in paragraph (e) of this section.
    (ii) Transfers of property. In the case of transfers of property to 
be used in basic research, the agreement shall provide that 
substantially all use of the property is to be for basic research, as 
defined in section 30(e)(3) (before amendment by the Tax Reform Act of 
1986).
    (3) Agreement between a qualified fund and a qualified educational 
organization after June 30, 1983. A written research agreement between a 
qualified fund and a qualified educational organization (see section 
30(e)(4)(B)(iii) (before amendment by the Tax Reform Act of 1986)) 
entered into after June 30, 1983, shall provide that the qualified 
educational organization shall furnish sufficient information to the 
qualified fund to enable the qualified fund to comply with the written 
research agreements it has entered into with grantor corporations, 
including the requirement set forth in paragraph (d)(2) of this section.
    (e) Exclusions--(1) Research conducted outside the United States. If 
a taxpayer pays or incurs an amount for basic research to be performed 
partly within the United States and partly without, only 65 percent of 
the portion of the amount attributable to research performed within the 
United States can be treated as a contract research expense (even if 80 
percent or more of the contract amount was for basic research performed 
in the United States).
    (2) Research in the social sciences or humanities. Basic research 
does not include research in the social sciences or humanities, within 
the meaning of Sec.  1.41-4A(c).
    (f) Procedure for making an election to be treated as a qualified 
fund. In order to make an election to be treated as a qualified fund 
within the meaning of

[[Page 175]]

section 30(e)(4)(B)(iii) (before amendment by the Tax Reform Act of 
1986) or as an organization described in section 41(e)(6)(D), the 
organization shall file with the Internal Revenue Service center with 
which it files its annual return a statement that--
    (1) Sets out the name, address, and taxpayer identification number 
of the electing organization (the ``taxpayer'') and of the organization 
that established and maintains the electing organization (the 
``controlling organization''),
    (2) Identifies the election as an election under section 41(e)(6)(D) 
of the Code,
    (3) Affirms that the controlling organization and the taxpayer are 
section 501(c)(3) organizations,
    (4) Provides that the taxpayer elects to be treated as a private 
foundation for all Code purposes other than section 4940,
    (5) Affirms that the taxpayer satisfies the requirement of section 
41(e)(6)(D)(iii), and
    (6) Specifies the date on which the election is to become effective.

If an election to be treated as a qualified fund is filed before 
February 1, 1982, the election may be made effective as of any date 
after June 30, 1981, and before January 1, 1986. If an election is filed 
on or after February 1, 1982, the election may be made effective as of 
any date on or after the date on which the election is filed.

[T.D. 8251, 54 FR 21204, May 17, 1989. Redesignated and amended by T.D. 
8930, 66 FR 295, Jan. 3, 2001]



Sec.  1.41-6  Aggregation of expenditures.

    (a) Controlled group of corporations; trades or businesses under 
common control--(1) In general. To determine the amount of research 
credit (if any) allowable to a trade or business that at the end of its 
taxable year is a member of a controlled group, a taxpayer must--
    (i) Compute the group credit in the manner described in paragraph 
(b) of this section; and
    (ii) Allocate the group credit among the members of the group in the 
manner described in paragraph (c) of this section.
    (2) Consolidated groups. For special rules relating to consolidated 
groups, see paragraph (d) of this section.
    (3) Definitions. For purposes of this section--
    (i) Consolidated group has the meaning set forth in Sec.  1.1502-
1(h).
    (ii) Controlled group and group mean a controlled group of 
corporations, as defined in section 41(f)(5), or a group of trades or 
businesses under common control. For rules for determining whether 
trades or businesses are under common control, see Sec.  1.52-1 (b) 
through (g).
    (iii) Credit year means the taxable year for which the member is 
computing the credit.
    (iv) Group credit means the research credit (if any) allowable to a 
controlled group.
    (v) Trade or business means a sole proprietorship, a partnership, a 
trust, an estate, or a corporation that is carrying on a trade or 
business (within the meaning of section 162). Any corporation that is a 
member of a commonly controlled group shall be deemed to be carrying on 
a trade or business if any other member of that group is carrying on any 
trade or business.
    (b) Computation of the group credit--(1) In general. All members of 
a controlled group are treated as a single taxpayer for purposes of 
computing the research credit. The group credit is compute2d by applying 
all of the section 41 computational rules on an aggregate basis. All 
members of a controlled group must use the same method of computation: 
The method described in section 41(a)(1), the alternative incremental 
credit (AIRC) method described in section 41(c)(4) (available for years 
beginning on or before December 31, 2008), or the alternative simplified 
credit (ASC) method described in section 41(c)(5), in computing the 
group credit for a credit year.
    (2) Start-up companies--(i) In general. For purposes of computing 
the group credit, a controlled group is treated as a start-up company 
for purposes of section 41(c)(3)(B)(i) if--
    (A) There was no taxable year beginning before January 1, 1984, in 
which a member of the group had gross receipts and either the same 
member or another

[[Page 176]]

member also had qualified research expenditures (QREs); or
    (B) There were fewer than three taxable years beginning after 
December 31, 1983, and before January 1, 1989, in which a member of the 
group had gross receipts and either the same member or another member 
also had QREs.
    (ii) Example. The following example illustrates the principles of 
paragraph (b)(2)(i) of this section:

    Example. A, B, and C, all of which are calendar year taxpayers, are 
members of a controlled group. During the 1983 taxable year, A had QREs, 
but no gross receipts; B had gross receipts, but no QREs; and C had no 
QREs or gross receipts. The 1984 taxable year was the first taxable year 
for which each of A, B, and C had both QREs and gross receipts. A, B, 
and C had both QREs and gross receipts in 1985, 1986, 1987, and 1988. 
Because the first taxable year for which each of A, B, and C had both 
QREs and gross receipts began after December 31, 1983, each of A, B, and 
C is a start-up company under section 41(c)(3)(B)(i) and each is a 
start-up company for purposes of computing the stand-alone entity 
credit. During the 1983 taxable year, at least one member of the group, 
A, had QREs and at least one member of the group, B, had gross receipts, 
thus, the group had both QREs and gross receipts in 1983. Therefore, the 
controlled group is not a start-up company because the first taxable 
year for which the group had both QREs and gross receipts did not begin 
after December 31, 1983, and there were not fewer than three taxable 
years beginning after December 31, 1983, and before January 1, 1989, in 
which a member of the group had gross receipts and QREs.

    (iii) First taxable year after December 31, 1993, for which the 
controlled group had QREs. In the case of a controlled group that is 
treated as a start-up company under section 41(c)(3)(B)(i) and paragraph 
(b)(2)(i) of this section, for purposes of determining the group's 
fixed-base percentage under section 41(c)(3)(B)(ii), the first taxable 
year after December 31, 1993, for which the group has QREs is the first 
taxable year in which at least one member of the group has QREs.
    (iv) Example. The following example illustrates the principles of 
paragraph (b)(2)(iii) of this section:

    Example. D, E, and F, all of which are calendar year taxpayers, are 
members of a controlled group. The group is treated as a start-up 
company under section 41(c)(3)(B)(i) and paragraph (b)(2)(i) of this 
section. The first taxable year after December 31, 1993, for which D had 
QREs was 1994. The first taxable year after December 31, 1993, for which 
E had QREs was 1995. The first taxable year after December 31, 1993, for 
which F had QREs was 1996. Because the 1994 taxable year was the first 
taxable year after December 31, 1993, for which at least one member of 
the group, D, had QREs, for purposes of determining the group's fixed-
based percentage under section 41(c)(3)(B)(ii), the 1994 taxable year 
was the first taxable year after December 31, 1993, for which the group 
had QREs.

    (c) Allocation of the group credit. The group credit is allocated to 
each member of the controlled group on a proportionate basis to its 
share of the aggregate of the qualified research expenses, basic 
research payments, and amounts paid or incurred to energy research 
consortiums taken into account for the taxable year by such controlled 
group for purposes of the credit. For purposes of paragraphs (c), (d), 
and (e) of this section, qualified research expenses, basic research 
payments, and amounts paid or incurred to energy research consortiums 
are collectively referred to as QREs.
    (d) Special rules for consolidated groups--(1) In general. For 
purposes of applying paragraph (c) of this section, members of a 
consolidated group who are members of a controlled group are treated as 
a single member of the controlled group.
    (2) Start-up company status. A consolidated group's status as a 
start-up company and the first taxable year after December 31, 1993, for 
which a consolidated group has QREs are determined in accordance with 
the principles of paragraph (b)(2) of this section.
    (3) Special rule for allocation of group credit among consolidated 
group members. The portion of the group credit that is allocated to a 
consolidated group is allocated to each member of the consolidated group 
on a proportionate basis to its share of the aggregate of the QREs taken 
into account for the taxable year by such consolidated group for 
purposes of the credit.
    (e) Examples. The following examples illustrate the provisions of 
paragraphs (c) and (d) of this section.

    Example 1. Controlled group. A, B, and C are a controlled group. A 
had $100x, B $300x, and C $500x of qualified research expenses for the 
year, totaling $900x for the group. A, in the course of its trade or 
business, also made a

[[Page 177]]

payment of $100x to an energy research consortium for energy research. 
The group's QREs total 1,000x and the group calculated its total 
research credit to be $60x for the year. Based on each member's 
proportionate share of the controlled group's aggregate QREs, A is 
allocated $12x, B $18x, and C $30x of the credit.
    Example 2. Consolidated group is a member of controlled group. The 
controlled group's members are D, E, F, G, and H. F, G, and H file a 
consolidated return and are treated as a single member (FGH) of the 
controlled group. D had $240x, E $360x, and FGH $600x of qualified 
research expenses for the year ($1,200x aggregate). The group calculated 
its research credit to be $100x for the year. Based on the proportion of 
each member's share of QREs to the controlled group's aggregate QREs for 
the taxable year D is allocated $20x, E $30x, and FGH $50x of the 
credit. The $50x of credit allocated to FGH is then allocated to the 
consolidated group members based on the proportion of each consolidated 
group member's share of QREs to the consolidated group's aggregate QREs. 
F had $120x, G $240x, and H $240x of QREs for the year. Therefore, F is 
allocated $10x, G is allocated $20x, and H is allocated $20x.
    (f) For taxable years beginning before January 1, 1990. For taxable 
years beginning before January 1, 1990, see Sec.  1.41-6 as contained in 
26 CFR part 1, revised April 1, 2005.
    (g) Tax accounting periods used--(1) In general. The credit 
allowable to a member of a controlled group is that member's share of 
the group credit computed as of the end of that member's taxable year. 
In computing the group credit for a group whose members have different 
taxable years, a member generally should treat the taxable year of 
another member that ends with or within the credit year of the computing 
member as the credit year of that other member. For example, Q, R, and S 
are members of a controlled group of corporations. Both Q and R are 
calendar year taxpayers. S files a return using a fiscal year ending 
June 30. For purposes of computing the group credit at the end of Q's 
and R's taxable year on December 31, S's fiscal year ending June 30, 
which ends within Q's and R's taxable year, is treated as S's credit 
year.
    (2) Special rule when timing of research is manipulated. If the 
timing of research by members using different tax accounting periods is 
manipulated to generate a credit in excess of the amount that would be 
allowable if all members of the group used the same tax accounting 
period, then the appropriate Internal Revenue Service official in the 
operating division that has examination jurisdiction of the return may 
require each member of the group to calculate the credit in the current 
taxable year and all future years as if all members of the group had the 
same taxable year and base period as the computing member.
    (h) Membership during taxable year in more than one group. A trade 
or business may be a member of only one group for a taxable year. If, 
without application of this paragraph, a business would be a member of 
more than one group at the end of its taxable year, the business shall 
be treated as a member of the group in which it was included for its 
preceding taxable year. If the business was not included for its 
preceding taxable year in any group in which it could be included as of 
the end of its taxable year, the business shall designate in its timely 
filed (including extensions) return the group in which it is being 
included. If the return for a taxable year is due before July 1, 1983, 
the business may designate its group membership through an amended 
return for that year filed on or before June 30, 1983. If the business 
does not so designate, then the appropriate Internal Revenue Service 
official in the operating division that has examination jurisdiction of 
the return will determine the group in which the business is to be 
included.
    (i) Intra-group transactions--(1) In general. Because all members of 
a group under common control are treated as a single taxpayer for 
purposes of determining the research credit, transfers between members 
of the group are generally disregarded.
    (2) In-house research expenses. If one member of a group performs 
qualified research on behalf of another member, the member performing 
the research shall include in its QREs any in-house research expenses 
for that work and shall not treat any amount received or accrued as 
funding the research. Conversely, the member for whom the research is 
performed shall not treat any part of any amount paid or incurred as

[[Page 178]]

a contract research expense. For purposes of determining whether the in-
house research for that work is qualified research, the member 
performing the research shall be treated as carrying on any trade or 
business carried on by the member on whose behalf the research is 
performed.
    (3) Contract research expenses. If a member of a group pays or 
incurs contract research expenses to a person outside the group in 
carrying on the member's trade or business, that member shall include 
those expenses as QREs. However, if the expenses are not paid or 
incurred in carrying on any trade or business of that member, those 
expenses may be taken into account as contract research expenses by 
another member of the group provided that the other member--
    (i) Reimburses the member paying or incurring the expenses; and
    (ii) Carries on a trade or business to which the research relates.
    (4) Lease payments. The amount paid or incurred to another member of 
the group for the lease of personal property owned by a member of the 
group is not taken into account for purposes of section 41. Amounts paid 
or incurred to another member of the group for the lease of personal 
property owned by a person outside the group shall be taken into account 
as in-house research expenses for purposes of section 41 only to the 
extent of the lesser of--
    (i) The amount paid or incurred to the other member; or
    (ii) The amount of the lease expenses paid to the person outside the 
group.
    (5) Payment for supplies. Amounts paid or incurred to another member 
of the group for supplies shall be taken into account as in-house 
research expenses for purposes of section 41 only to the extent of the 
lesser of--
    (i) The amount paid or incurred to the other member; or
    (ii) The amount of the other member's basis in the supplies.
    (j) Effective/applicability dates--(1) In general. Except for 
paragraph (d) of this section, these regulations are applicable for 
taxable years ending on or after May 24, 2005. Generally, a taxpayer may 
use any reasonable method of computing and allocating the credit 
(including use of the consolidated group rule contained in paragraph (d) 
of this section) for taxable years ending before May 24, 2005. However, 
paragraph (b) of this section, relating to the computation of the group 
credit, and paragraph (c) of this section, relating to the allocation of 
the group credit, (applied without regard to paragraph (d) of this 
section) will apply to taxable years ending on or after December 29, 
1999, if the members of a controlled group, as a whole, claimed more 
than 100 percent of the amount that would be allowable under paragraph 
(b) of this section. In the case of a controlled group whose members 
have different taxable years and whose members use inconsistent methods 
of allocation, the members of the controlled group shall be deemed to 
have, as a whole, claimed more than 100 percent of the amount that would 
be allowable under paragraph (b) of this section.
    (2) Consolidated group rule. Paragraph (d) of this section is 
applicable for taxable years ending on or after November 9, 2006. For 
taxable years ending on or after May 24, 2005, and before November 9, 
2006, see Sec.  1.41-6T(d) as contained in 26 CFR part 1, revised April 
1, 2006.
    (3) Taxable years ending after June 9, 2011. Paragraphs (b)(1), 
(c)(2), and (e) of this section are applicable for taxable years ending 
after June 9, 2011. For taxable years ending on or before June 9, 2011, 
see Sec. Sec.  1.41-6T and 1.41-6 as contained in 26 CFR part 1, revised 
April 1, 2011.
    (4) Taxable years beginning after December 31, 2011. Paragraphs (c), 
(d)(1) and (3), (e), and (j)(4) and (5) of this section apply to taxable 
years beginning on or after April 2, 2018. For taxable years ending 
before April 2, 2018, see Sec.  1.41-6T as contained in 26 CFR part 1, 
as revised April 1, 2017.
    (5) Taxable years beginning before January 1, 2012. See Sec.  1.41-6 
as contained in 26 CFR part 1, revised April 1, 2014.

[T.D. 9296, 71 FR 65725, Nov. 9, 2006; 71 FR 70875, Dec. 7, 2006; 71 FR 
75614, Dec. 15, 2006; T.D. 9401, 73 FR 34188, June 17, 2008; T.D. 9528, 
76 FR 33995, June 10, 2011; T.D. 9717, 80 FR 18098, Apr. 3, 2015; T.D. 
9832, 83 FR 13184, Mar. 28, 2018]

[[Page 179]]



Sec.  1.41-7  Special rules.

    (a) Allocations--(1) Corporation making an election under subchapter 
S--(i) Pass-through, for taxable years beginning after December 31, 
1982, in the case of an S corporation. In the case of an S corporation 
(as defined in section 1361) the amount of research credit computed for 
the corporation shall be allocated to the shareholders according to the 
provisions of section 1366 and section 1377.
    (ii) Pass-through, for taxable years beginning before January 1, 
1983, in the case of a subchapter S corporation. In the case of an 
electing small business corporation (as defined in section 1371 as that 
section read before the amendments made by the subchapter S Revision Act 
of 1982), the amount of the research credit computed for the corporation 
for any taxable year shall be apportioned pro rata among the persons who 
are shareholders of the corporation on the last day of the corporation's 
taxable year.
    (2) Pass-through in the case of an estate or trust. In the case of 
an estate or trust, the amount of the research credit computed for the 
estate or trust for any taxable year shall be apportioned among the 
estate or trust and the beneficiaries on the basis of the income of the 
estate or trust allocable to each.
    (3) Pass-through in the case of a partnership--(i) In general. In 
the case of a partnership, the research credit computed for the 
partnership for any taxable year shall be apportioned among the persons 
who are partners during the taxable year in accordance with section 704 
and the regulations thereunder. See, for example, Sec.  1.704-
1(b)(4)(ii). Because the research credit is an expenditure-based credit, 
the credit is to be allocated among the partners in the same proportion 
as section 174 expenditures are allocated for the year.
    (ii) Certain expenditures by joint ventures. Research expenses to 
which Sec.  1.41-2(a)(4)(ii) applies shall be apportioned among the 
persons who are partners during the taxable year in accordance with the 
provisions of that section. For purposes of section 41, these expenses 
shall be treated as paid or incurred directly by the partners rather 
than by the partnership. Thus, the partnership shall disregard these 
expenses in computing the credit to be apportioned under paragraph 
(a)(3)(i) of this section, and in making the computations under section 
41 each partner shall aggregate its distributive share of these expenses 
with other research expenses of the partner. The limitation on the 
amount of the credit set out in section 41(g) and in paragraph (c) of 
this section shall not apply because the credit is computed by the 
partner, not the partnership.
    (4) Year in which taken into account. An amount apportioned to a 
person under this paragraph shall be taken into account by the person in 
the taxable year of such person which or within which the taxable year 
of the corporation, estate, trust, or partnership (as the case may be) 
ends.
    (5) Credit allowed subject to limitation. The credit allowable to 
any person to whom any amount has been apportioned under paragraph 
(a)(1), (2) or (3)(i) of this section is subject to section 41(g) and 
sections 38 and 39 of the Code, if applicable.
    (b) Adjustments for certain acquisitions and dispositions--Meaning 
of terms. For the meaning of ``acquisition,'' ``separate unit,'' and 
``major portion,'' see paragraph (b) of Sec.  1.52-2. An ``acquisition'' 
includes an incorporation or a liquidation.
    (c) Special rule for pass-through of credit. The special rule 
contained in section 41(g) for the pass-through of the credit in the 
case of an individual who owns an interest in an unincorporated trade or 
business, is a partner in a partnership, is a beneficiary of an estate 
or trust, or is a shareholder in an S corporation shall be applied in 
accordance with the principles set forth in Sec.  1.53-3.
    (d) Carryback and carryover of unused credits. The taxpayer to whom 
the credit is passed through under paragraph (c) of this section shall 
not be prevented from applying the unused portion in a carryback or 
carryover year merely because the entity that earned the credit changes 
its form of conducting business.

[T.D. 8251, 54 FR 21204, May 17, 1989. Redesignated by T.D. 8930, 66 FR 
295, Jan. 3, 2001]

[[Page 180]]



Sec.  1.41-8  Alternative incremental credit applicable for taxable years
beginning on or before December 31, 2008.

    (a) Determination of credit. At the election of the taxpayer, the 
credit determined under section 41(a)(1) equals the amount determined 
under section 41(c)(4).
    (b) Election--(1) In general. A taxpayer may elect to apply the 
provisions of the alternative incremental research credit (AIRC) in 
section 41(c)(4) for any taxable year of the taxpayer beginning after 
June 30, 1996. If a taxpayer makes an election under section 41(c)(4), 
the election applies to the taxable year for which made and all 
subsequent taxable years unless revoked in the manner prescribed in 
paragraph (b)(3) of this section.
    (2) Time and manner of election. An election under section 41(c)(4) 
is made by completing the portion of Form 6765, ``Credit for Increasing 
Research Activities,'' (or successor form) relating to the election of 
the AIRC, and attaching the completed form to the taxpayer's timely 
filed (including extensions) original return for the taxable year to 
which the election applies. An election under section 41(c)(4) may not 
be made on an amended return. An extension of time to make an election 
under section 41(c)(4) will not be granted under Sec.  301.9100-3 of 
this chapter.
    (3) Revocation. An election under this section may not be revoked 
except with the consent of the Commissioner. A taxpayer is deemed to 
have requested, and to have been granted, the consent of the 
Commissioner to revoke an election under section 41(c)(4) if the 
taxpayer completes the portion of Form 6765, ``Credit For Increasing 
Research Activities,'' (or successor form) relating to the amount 
determined under section 41(a)(1) (the regular credit) or the 
alternative simplified credit (ASC) and attaches the completed form to 
the taxpayer's timely filed (including extensions) original return for 
the year to which the revocation applies. An election under section 
41(c)(4) may not be revoked on an amended return. An extension of time 
to revoke an election under section 41(c)(4) will not be granted under 
Sec.  301.9100-3 of this chapter.
    (4) Special rules for controlled groups--(i) In general. In the case 
of a controlled group of corporations, all the members of which are not 
included on a single consolidated return, an election (or revocation) 
must be made by the designated member by satisfying the requirements of 
paragraph (b)(2) or (b)(3) of this section (whichever applies), and such 
election (or revocation) by the designated member shall be binding on 
all the members of the group for the credit year to which the election 
(or revocation) relates. If the designated member fails to timely make 
(or revoke) an election, each member of the group must compute the group 
credit using the method used to compute the group credit for the 
immediately preceding credit year.
    (ii) Designated member. For purposes of this paragraph (b)(4), for 
any credit year, the term designated member means that member of the 
group that is allocated the greatest amount of the group credit under 
Sec.  1.41-6(c) based on the amount of credit reported on the taxpayer's 
timely filed (including extensions) original Federal income tax return 
(even if that member subsequently is determined not to be the designated 
member). If the members of a group compute the group credit using 
different methods (the method described in section 41(a)(1), the AIRC 
method of section 41(c)(4) (available for years beginning on or before 
December 31, 2008), or the ASC method of section 41(c)(5)) and at least 
two members of the group qualify as the designated member, then the term 
designated member means that member that computes the group credit using 
the method that yields the greatest group credit. For example, A, B, C, 
and D are members of a controlled group but are not members of a 
consolidated group. For the 2008 taxable year (the credit year), the 
group credit using the method described in section 41(a)(1) is $10x. 
Under this method, A would be allocated $5x of the group credit, which 
would be the largest share of the group credit under this method. For 
the credit year, the group credit using the AIRC method is $15x. Under 
the AIRC method, B would be allocated $5x of the group credit, which is 
the largest share of the group

[[Page 181]]

credit computed using the AIRC method. For the credit year, the group 
credit using the ASC method is $10x. Under the ASC method, C would be 
allocated $5x of the group credit, which is the largest share of the 
group credit computed using the ASC method. Because the group credit is 
greatest using the AIRC method and B is allocated the greatest amount of 
credit under that method, B is the designated member. Therefore, if B 
makes a section 41(c)(4) election on its original timely filed return 
for the credit year, that election is binding on all members of the 
group for the credit year.
    (5) Effective/applicability dates. This section is applicable for 
taxable years ending after June 9, 2011. For taxable years ending on or 
before June 9, 2011, see Sec. Sec.  1.41-8 and 1.41-8T, as contained in 
26 CFR part 1, revised April 1, 2011.

[T.D. 9296, 71 FR 65732, Nov. 9, 2006; 71 FR 70875, Dec. 7, 2006, as 
amended by T.D. 9401, 73 FR 34189, June 17, 2008; T.D. 9528, 76 FR 
33996, June 10, 2011]



Sec.  1.41-9  Alternative simplified credit.

    (a) Determination of credit. At the election of the taxpayer, the 
credit determined under section 41(a)(1) equals the amount determined 
under section 41(c)(5).
    (b) Election--(1) In general. A taxpayer may elect to apply the 
provisions of the alternative simplified credit (ASC) in section 
41(c)(5) for any taxable year of the taxpayer ending after December 31, 
2006. If a taxpayer makes an election under section 41(c)(5), the 
election applies to the taxable year for which made and all subsequent 
taxable years unless revoked in the manner prescribed in paragraph 
(b)(3) of this section.
    (2) Time and manner of election. A taxpayer makes an election under 
section 41(c)(5) by completing the portion of Form 6765, ``Credit for 
Increasing Research Activities,'' (or successor form) relating to the 
election of the ASC, and attaching the completed form to the taxpayer's 
timely filed (including extensions) original return for the taxable year 
to which the election applies. A taxpayer may make an election under 
section 41(c)(5) for a tax year on an amended return, but only if the 
taxpayer has not previously claimed a section 41(a)(1) credit on its 
original return or an amended return for that tax year, and only if that 
tax year is not closed by the period of limitations on assessment under 
section 6501(a). An extension of time to make an election under section 
41(c)(5) will not be granted under Sec.  301.9100-3 of this chapter. A 
taxpayer that is a member of a controlled group in a tax year may not 
make an election under section 41(c)(5) for that tax year on an amended 
return if any member of the controlled group for that tax year 
previously claimed the research credit under section 41(a)(1) using a 
method other than the ASC on an original or amended return for that tax 
year. See paragraph (b)(4) of this section for additional rules 
concerning controlled groups. See also Sec.  1.41-6(b)(1) requiring that 
all members of the controlled group use the same method of computation.
    (3) Revocation. An election under this section may not be revoked 
except with the consent of the Commissioner. A taxpayer is deemed to 
have requested, and to have been granted, the consent of the 
Commissioner to revoke an election under section 41(c)(5) if the 
taxpayer completes the portion of Form 6765 (or successor form) relating 
to the credit determined under section 41(a)(1) (the regular credit) or 
the alternative incremental credit (AIRC) and attaches the completed 
form to the taxpayer's timely filed (including extensions) original 
return for the year to which the revocation applies. An election under 
section 41(c)(5) may not be revoked on an amended return. An extension 
of time to revoke an election under section 41(c)(5) will not be granted 
under Sec.  301.9100-3 of this chapter.
    (4) Special rules for controlled groups--(i) In general. In the case 
of a controlled group of corporations, all the members of which are not 
included on a single consolidated return, an election (or revocation) 
must be made by the designated member by satisfying the requirements of 
paragraphs (b)(2) or (b)(3) of this section (whichever applies), and 
such election (or revocation) by the designated member shall be binding 
on all the members of the group for the credit year to which the 
election (or revocation) relates. If the designated member fails to 
timely

[[Page 182]]

make (or revoke) an election, each member of the group must compute the 
group credit using the method used to compute the group credit for the 
immediately preceding credit year.
    (ii) Designated member. For purposes of this paragraph (b)(4), for 
any credit year, the term designated member means that member of the 
group that is allocated the greatest amount of the group credit under 
Sec.  1.41-6(c) based on the amount of credit reported on the taxpayer's 
timely filed (including extensions) original Federal income tax return 
(even if that member subsequently is determined not to be the designated 
member). If the members of a group compute the group credit using 
different methods (the method described in section 41(a)(1), the AIRC 
method of section 41(c)(4), or the ASC method of section 41(c)(5)) and 
at least two members of the group qualify as the designated member, then 
the term designated member means that member that computes the group 
credit using the method that yields the greatest group credit. For 
example, A, B, C, and D are members of a controlled group but are not 
members of a consolidated group. For the 2011 taxable year (the credit 
year), the group credit using the method described in section 41(a)(1) 
is $10x. Under this method, A would be allocated $5x of the group 
credit, which would be the largest share of the group credit under this 
method. For the credit year, the group credit using the ASC method is 
$15x. Under the ASC method, C would be allocated $5x of the group 
credit, which is the largest share of the group credit computed using 
the ASC method. Because the group credit is greatest using the ASC 
method and C is allocated the greatest amount of credit under that 
method, C is the designated member. Therefore, if C makes a section 
41(c)(5) election on its timely filed (including extensions) original 
return for the credit year, that election is binding on all members of 
the group for the credit year.
    (c) Special rules--(1) Qualified research expenses (QREs) required 
in all years. Unless a taxpayer has QREs in each of the three taxable 
years preceding the taxable year for which the credit is being 
determined, the credit equals that percentage of the QREs for the 
taxable year provided by section 41(c)(5)(B)(ii).
    (2) Section 41(c)(6) applicability. QREs for the three taxable years 
preceding the credit year must be determined on a basis consistent with 
the definition of QREs for the credit year, without regard to the law in 
effect for the three taxable years preceding the credit year. This 
consistency requirement applies even if the period for filing a claim 
for credit or refund has expired for any of the three taxable years 
preceding the credit year.
    (3) Short taxable years--(i) General rule. If one or more of the 
three taxable years preceding the credit year is a short taxable year, 
then the QREs for such year are deemed to be equal to the QREs actually 
paid or incurred in that year multiplied by 365 and divided by the 
number of days in that year. If a credit year is a short taxable year, 
then the average QREs for the three taxable years preceding the credit 
year are modified by multiplying that amount by the number of days in 
the short taxable year and dividing the result by 365.
    (ii) Limited exception. Returns filed for taxable years ending after 
December 31, 2006, and before June 9, 2011, and for which the period of 
limitations has not expired, may be amended to apply the daily 
calculation for short taxable years provided in paragraph (3)(i) of this 
section in lieu of the monthly calculation for short taxable years 
provided in Sec.  1.41-9T(c)(4).
    (4) Controlled groups. For purposes of computing the group credit 
under Sec.  1.41-6, a controlled group must apply the rules of this 
paragraph (c) on an aggregate basis. For example, if the controlled 
group has QREs in each of the three taxable years preceding the taxable 
year for which the credit is being determined, the controlled group 
applies the credit computation provided by section 41(c)(5)(A) rather 
than section 41(c)(5)(B)(ii).
    (d) Effective/applicability dates. This section is applicable for 
taxable years ending after June 9, 2011. For taxable years ending on or 
before June 9, 2011, see Sec.  1.41-9T as contained in 26 CFR part 1, 
revised April 1, 2011. Paragraph

[[Page 183]]

(b)(2) of this section applies to elections with respect to taxable 
years ending on or after February 27, 2015. For taxable years ending 
before February 27, 2015, see Sec.  1.41-9T as contained in 26 CFR part 
1, revised April 1, 2015.

[T.D. 9528, 76 FR 33996, June 10, 2011, as amended by T.D. 9666, 79 FR 
31864, June 3, 2014; T.D. 9712, 80 FR 10589, Feb. 27, 2015]



Sec.  1.42-0  Table of contents.

    This section lists the paragraphs contained in Sec. Sec.  1.42-1 
through 1.42-19 and Sec.  1.42-1T.

Sec.  1.42-1 Limitation on low-income housing credit allowed with 
          respect to qualified low-income buildings receiving housing 
          credit allocations from a State or local housing credit 
          agency.

    (a) through (g) [Reserved]
    (h) Filing of forms.
    (i) [Reserved]
    (j) Effective dates.

Sec.  1.42-1T Limitation on low-income housing credit allowed with 
          respect to qualified low income buildings receiving housing 
          credit allocations from a State or local housing credit agency 
          (temporary).

    (a) In general.
    (1) Determination of amount of low-income housing credit.
    (2) Limitation on low-income housing credit allowed.
    (b) The State housing credit ceiling.
    (c) Apportionment of State housing credit ceiling among State and 
local housing credit agencies.
    (1) In general.
    (2) Primary apportionment.
    (3) States with 1 or more constitutional home rule cities.
    (i) In general.
    (ii) Amount of apportionment to a constitutional home rule city.
    (iii) Effect of apportionment to constitutional home rule cities on 
apportionment to other housing credit agencies.
    (iv) Treatment of governmental authority within constitutional home 
rule city.
    (4) Apportionment to local housing credit agencies.
    (i) In general.
    (ii) Change in apportionment during a calendar year.
    (iii) Exchanges of apportionments.
    (iv) Written records of apportionments.
    (5) Set-aside apportionments for projects involving a qualified 
nonprofit organization.
    (i) In general.
    (ii) Projects involving a qualified nonprofit organization.
    (6) Expiration of unused apportionments.
    (d) Housing credit allocation made by State and local housing credit 
agencies.
    (1) In general.
    (2) Amount of a housing credit allocation.
    (3) Counting housing credit allocations against an agency's 
aggregate housing credit dollar amount.
    (4) Rules for when applications for housing credit allocations 
exceed an agency's aggregate housing credit dollar amount.
    (5) Reduced or additional housing credit allocations.
    (i) In general.
    (ii) Examples.
    (6) No carryover of unused aggregate housing credit dollar amount.
    (7) Effect of housing credit allocations in excess of an agency's 
aggregate housing credit dollar amount.
    (8) Time and manner for making housing credit allocations.
    (i) Time.
    (ii) Manner.
    (iii) Certification.
    (iv) Fee.
    (v) No continuing agency responsibility.
    (e) Housing credit allocation taken into account by owner of a 
qualified low-income building.
    (1) Time and manner for taking housing credit allocation into 
account.
    (2) First-year convention limitation on housing credit allocation 
taken into account.
    (3) Use of excess housing credit allocation for increases in 
qualified basis.
    (i) In general.
    (ii) Example.
    (4) Separate housing credit allocations for new buildings and 
increases in qualified basis.
    (5) Acquisition of building for which a prior housing credit 
allocation has been made.
    (6) Multiple housing credit allocations.
    (f) Exception to housing credit allocation requirement.
    (1) Tax-exempt bond financing.
    (i) In general.
    (ii) Determining use of bond proceeds.
    (iii) Example.
    (g) Termination of authority to make housing credit allocation.
    (1) In general.
    (2) Carryover of unused 1989 apportionment.
    (3) Expiration of exception for tax-exempt bond financed projects.
    (h) [Reserved]
    (i) Transitional rules.

 Sec.  1.42-2 Waiver of requirement that an existing building eligible 
 for the low-income housing credit was last placed in service more than 
             10 years prior to acquisition by the taxpayer.

    (a) Low-income housing credit for existing building
    (b) Waiver of 10-year holding period requirement
    (c) Waiver requirements

[[Page 184]]

    (1) Federally-assisted building
    (2) Federal mortgage funds at risk
    (3) Statement by the Department of Housing and Urban Development or 
the Farmers' Home Administration
    (4) No prior credit allowed
    (d) Application for waiver
    (1) Time and manner
    (2) Information required
    (3) Other rules
    (4) Effective date of waiver
    (5) Attachment to return
    (e) Effective date of regulations
Sec.  1.42-3 Treatment of buildings financed with proceeds from a loan 
          under an Affordable Housing Program established pursuant to 
          section 721 of the Financial Institutions Reform, Recovery, 
          and Enforcement Act of 1989 (FIRREA).

    (a) Treatment under sections 42(i) and 42(b).
    (b) Effective date.

Sec.  1.42-4 Application of not-for-profit rules of section 183 to low-
          income housing credit activities.

    (a) Inapplicability to section 42.
    (b) Limitation.
    (c) Effective date.

Sec.  1.42-5 Monitoring compliance with low-income housing credit 
          requirements.

    (a) Compliance monitoring requirement.
    (1) In general.
    (2) Requirements for a monitoring procedure.
    (i) In general.
    (ii) Order and form.
    (iii) [Reserved]
    (b) Recordkeeping and record retention provisions.
    (1) Recordkeeping provision.
    (2) Record retention provision.
    (3) Inspection record retention provision.
    (c) Certification and review provisions.
    (1) Certification.
    (2) Review.
    (ii)-(iii) [Reserved]
    (3) [Reserved]
    (4) Exception for certain buildings.
    (i) In general.
    (ii) Agreement and review.
    (iii) Example.
    (5) Agency reports of compliance monitoring activities.
    (d) Inspection provision.
    (1) In general.
    (2) Inspection standard.
    (3) Exception from inspection provision.
    (4) Delegation.
    (e) Notification-of-noncompliance provisions.
    (1) In general.
    (2) Notice to owner.
    (3) Notice to Internal Revenue Service.
    (i) In general.
    (ii) Agency retention of records.
    (4) Correction period.
    (f) Delegation of authority.
    (1) Agencies permitted to delegate compliance monitoring functions.
    (i) In general.
    (ii) Limitations.
    (2) Agencies permitted to delegate compliance monitoring functions 
to another Agency.
    (g) Liability.
    (h) Effective/applicability dates.
    (1) In general.
    (2) [Reserved]

Sec.  1.42-6 Buildings qualifying for carryover allocations.

    (a) Carryover allocations.
    (1) In general.
    (2) 10 percent basis requirement.
    (i) Allocation made before July 1.
    (ii) Allocation made after June 30.
    (b) Carryover-allocation basis.
    (1) In general.
    (2) Limitations.
    (i) Taxpayer must have basis in land or depreciable property related 
to the project.
    (ii) High cost areas.
    (iii) Amounts not treated as paid or incurred.
    (iv) Fees.
    (3) Reasonably expected basis.
    (4) Examples.
    (c) Verification of basis by Agency.
    (1) Verification requirement.
    (2) Manner of verification.
    (3) Time of verification.
    (i) Allocations made before July 1.
    (ii) Allocations made after June 30.
    (d) Requirements for making carryover allocations.
    (1) In general.
    (2) Requirements for allocation.
    (3) Special rules for project-based allocations.
    (i) In general.
    (ii) Requirement of section 42(h)(1)(F)(1)(III).
    (4) Recordkeeping requirements.
    (i) Taxpayer.
    (ii) Agency.
    (5) Separate procedure for election of appropriate percentage month.
    (e) Special rules.
    (1) Treatment of partnerships and other flow-through entities.
    (2) Transferees.

Sec.  1.42-7 Substantially bond-financed buildings. [Reserved]

Sec.  1.42-8 Election of appropriate percentage month.

    (a) Election under section 42(b)(2)(A)(ii)(I) to use the appropriate 
percentage for the month of a binding agreement.
    (1) In general.
    (2) Effect on state housing credit ceiling.
    (3) Time and manner of making election.
    (4) Multiple agreements.
    (i) Rescinded agreements.

[[Page 185]]

    (ii) Increases in credit.
    (5) Amount allocated.
    (6) Procedures.
    (i) Taxpayer.
    (ii) Agency.
    (7) Examples.
    (b) Election under section 42(b)(2)(A)(ii)(II) to use the 
appropriate percentage for the month tax-exempt bonds are issued.
    (1) Time and manner of making election.
    (2) Bonds issued in more than one month.
    (3) Limitations on appropriate percentage.
    (4) Procedures.
    (i) Taxpayer.
    (ii) Agency.

Sec.  1.42-9 For use by the general public.

    (a) General rule.
    (b) Limitations.
    (c) Treatment of units not for use by the general public.

Sec.  1.42-10 Utility allowances.

    (a) Inclusion of utility allowances in gross rent.
    (b) Applicable utility allowances.
    (1) Buildings assisted by the Rural Housing Service.
    (2) Buildings with Rural Housing Service assisted tenants.
    (3) Buildings regulated by the Department of Housing and Urban 
Development.
    (4) Other buildings.
    (i) Tenants receiving HUD rental assistance.
    (ii) Other tenants.
    (A) General rule.
    (B) Utility company estimate.
    (C) Agency estimate.
    (D) HUD Utility Schedule Model.
    (E) Energy consumption model.
    (c) Changes in applicable utility allowance.
    (1) In general.
    (2) Annual review.
    (d) Record retention.
    (e) Actual consumption submetering arrangements.
    (1) Definition.
    (2) Administrative fees.

Sec.  1.42-11 Provision of services.

    (a) General rule.
    (b) Services that are optional.
    (1) General rule.
    (2) Continual or frequent services.
    (3) Required services.
    (i) General rule.
    (ii) Exceptions.
    (A) Supportive services.
    (B) Specific project exception.

Sec.  1.42-12 Effective dates and transitional rules.

    (a) Effective dates.
    (1) In general.
    (2) Community Renewal Tax Relief Act of 2000.
    (i) In general.
    (3) Electronic filing simplification changes.
    (4) Utility allowances.
    (5) Additional effective dates affecting utility allowances.
    (b) Prior periods.
    (c) Carryover allocations.

Sec.  1.42-13 Rules necessary and appropriate; housing credit agencies' 
          correction of administrative errors and omissions.

    (a) Publication of guidance.
    (b) Correcting administrative errors and omissions.
    (1) In general.
    (2) Administrative errors and omissions described.
    (3) Procedures for correcting administrative errors or omissions.
    (i) In general.
    (ii) Specific procedures.
    (iii) Secretary's prior approval required.
    (iv) Requesting the Secretary's approval.
    (v) Agreement to conditions.
    (vi) Secretary's automatic approval.
    (vii) How Agency corrects errors or omissions subject to automatic 
approval.
    (viii) Other approval procedures.
    (c) Examples.
    (d) Effective date.

Sec.  1.42-14 Allocation rules for post-2000 State housing credit 
          ceiling amount.

    (a) State housing credit ceiling.
    (1) In general.
    (2) Cost-of-living adjustment.
    (i) General rule.
    (ii) Rounding.
    (b) The unused carryforward component.
    (c) The population component.
    (d) The returned credit component.
    (1) In general.
    (2) Limitations and special rules.
    (i) General limitations.
    (ii) Credit period limitation.
    (iii) Three-month rule for returned credit.
    (iv) Returns of credit.
    (A) Building not qualified within required time period.
    (B) Noncompliance with terms of the allocation.
    (C) Mutual consent.
    (D) Amount not necessary for financial feasibility.
    (3) Manner of returning credit.
    (i) Taxpayer notification.
    (ii) Internal Revenue Service notification.
    (e) The national pool component.
    (f) When the State housing credit ceiling is determined.
    (g) Stacking order.
    (h) Nonprofit set-aside.
    (1) Determination of set-aside.
    (2) Allocation rules.
    (i) National Pool.
    (1) In general.
    (2) Unused housing credit carryover.
    (3) Qualified State.
    (i) In general.
    (ii) Exceptions.
    (A) De minimis amount.

[[Page 186]]

    (B) Other circumstances.
    (iii) Time and manner for making request.
    (4) Formula for determining the National Pool.
    (j) Coordination between Agencies.
    (k) Example.
    (l) Effective dates.
    (1) In general.
    (2) Community Renewal Tax Relief Act of 2000 changes.

Sec.  1.42-15 Available unit rule.

    (a) Definitions.
    (b) General section 42(g)(2)(D)(i) rule.
    (c) Exceptions.
    (1) In general.
    (2) Rental of next available unit in case of the average income 
test.
    (i) Basic rule.
    (ii) No requirement to comply with the next available unit rule in a 
specific order.
    (iii) Deep rent skewed projects.
    (iv) Limitation.
    (d) Effect of current resident moving within building.
    (e) Available unit rule applies separately to each building in a 
project.
    (f) Result of noncompliance with available unit rule.
    (g) Relationship to tax-exempt bond provisions.
    (h) Examples.
    (i) Applicability dates.
    (1) In general.
    (2) Applicability dates under the average income test.

Sec.  1.42-16 Eligible basis reduced by federal grants.

    (a) In general.
    (b) Grants do not include certain rental assistance payments.
    (c) Qualifying rental assistance program.
    (d) Effective date.

Sec.  1.42-17 Qualified allocation plan.

    (a) Requirements.
    (1) In general [Reserved].
    (2) Selection criteria [Reserved].
    (3) Agency evaluation.
    (4) Timing of Agency evaluation.
    (i) In general.
    (ii) Time limit for placed-in-service evaluation.
    (5) Special rule for final determinations and certifications.
    (6) Bond-financed projects.
    (b) Effective date.

Sec.  1.42-18 Qualified Contracts.

    (a) Extended low-income housing commitment.
    (1) In general.
    (i) Extended use period.
    (ii) Termination of extended use period.
    (iii) Other non-acceptance.
    (iv) Eviction, gross rent increase concerning existing low-income 
tenants not permitted.
    (2) Exception.
    (b) Definitions.
    (c) Qualified contract purchase price formula.
    (1) In general.
    (i) Initial determination.
    (ii) Mandatory adjustment by the buyer and owner.
    (iii) Optional adjustment by the Agency and owner.
    (2) Low-income portion amount.
    (3) Outstanding indebtedness.
    (4) Adjusted investor equity.
    (i) Application of cost-of-living factor.
    (ii) Unadjusted investor equity.
    (iii) Qualified-contract cost-of-living adjustment.
    (iv) General rule.
    (v) Provision by the Commissioner of the qualified-contract cost-of-
living adjustment.
    (vi) Methodology.
    (vii) Example.
    (5) Other capital contributions.
    (6) Cash distributions.
    (i) In general.
    (ii) Excess proceeds.
    (iii) Anti-abuse rule.
    (d) Administrative discretion and responsibilities of the Agency.
    (1) In general.
    (2) Actual offer.
    (3) Debarment of certain appraisers.
    (e) Effective/applicability date.
Sec.  1.42-19 Average income test.

    (a) Average income set-aside.
    (b) Definition of low-income unit and qualified group of units.
    (1) Definition of low-income unit.
    (2) Definition of qualified group of units.
    (3) Identification of qualified groups of units.
    (i) Average income set-aside test.
    (ii) Applicable fraction determinations.
    (iii) Identification of units.
    (c) Procedures.
    (1)-(2) [Reserved]
    (3) Designation of imputed income limitations.
    (i) Timing of designation.
    (ii) 10-percent increments.
    (iii) Continuity.
    (iv) [Reserved]
    (4) [Reserved]
    (d) Changing a unit's designated imputed income limitation.
    (1) Permitted changes.
    (i) Federally permitted changes.
    (ii) Housing credit agency (Agency)-permitted changes.
    (iii) Certain laws.
    (iv) Tenant movement.

[[Page 187]]

    (v) Restoring compliance with average income requirements.
    (2) [Reserved]
    (e) Examples.
    (f) Applicability dates.
    (1) General rule.
    (2) Designations of occupied units.
    (3) Applicability of this section to taxable years beginning before 
January 1, 2023.

[T.D. 8302, 55 FR 21189, May 23, 1990, as amended by T.D. 9755, 81 FR 
11107, Mar. 3, 2016; T.D. 9967, 87 FR 61501, Oct. 12, 2022]



Sec.  1.42-0T  Table of contents.

    This section lists the paragraphs contained in Sec. Sec.  1.42-5T 
and 1.42-10T.

[T.D. 9755, 81 FR 11109, Mar. 3, 2016, as amended by T.D. 9848, 84 FR 
6079, Feb. 26, 2019; T.D. 9850, 84 FR 7284, Mar. 4, 2019]



Sec.  1.42-1  Limitation on low-income housing credit allowed with 
respect to qualified low-income buildings receiving housing credit
allocations from a State or local housing credit agency.

    (a)-(g) [Reserved]. For further guidance, see Sec.  1.42-1T(a) 
through (g).
    (h) Filing of forms. Unless otherwise provided in forms or 
instructions, a completed Form 8586, ``Low-Income Housing Credit,'' (or 
any successor form) must be filed with the owner's Federal income tax 
return for each taxable year the owner of a qualified low-income 
building is claiming the low-income housing credit under section 42(a). 
Unless otherwise provided in forms or instructions, a completed Form 
8609, ``Low-Income Housing Credit Allocation and Certification,'' (or 
any successor form) must be filed by the building owner with the IRS. 
The requirements for completing and filing Forms 8586 and 8609 are 
addressed in the instructions to the forms.
    (i) [Reserved]. For further guidance, see Sec.  1.42-1T(i).
    (j) Effective dates. Section 1.42-1(h) applies to forms filed on or 
after November 7, 2005. The rules that apply for forms filed before 
November 7, 2005 are contained in Sec.  1.42-1T(h) and Sec.  1.42-1(h) 
(see 26 CFR part 1 revised as of April 1, 2003, and April 1, 2005).

[T.D. 9112, 69 FR 3827, Jan. 27, 2004, as amended by T.D. 9228, 70 FR 
67356, Nov. 7, 2005]



Sec.  1.42-1T  Limitation on low-income housing credit allowed with 
respect to qualified low-income buildings receiving housing credit
allocations from a State or local housing credit agency (temporary).

    (a) In general--(1) Determination of amount of low-income housing 
credit. Section 42 provides that, for purposes of section 38, a low-
income housing credit is determined for a building in an amount equal to 
the applicable percentage of the qualified basis of the qualified low-
income building. In general, the credit may be claimed annually for a 
10-year credit period, beginning with the taxable year in which the 
building is placed in service or, at the election of the taxpayer, the 
succeeding taxable year. If, after the first year of the credit period, 
the qualified basis of a building is increased in excess of the 
qualified basis upon which the credit was initially determined, the 
allowable credit with respect to such additional qualified basis is 
determined using a credit percentage equal to two-thirds of the 
applicable percentage for the initial qualified basis. The credit for 
additions to qualified basis is generally allowable for the remaining 
years in the 15-year compliance period which begins with the first 
taxable year of the credit period for the building. In general, the low-
income housing credit is available with respect to buildings placed in 
service after December 31, 1986, in taxable years ending after that 
date. See section 42 for the definitions of ``qualified low-income 
building'', ``applicable percentage'', ``qualified basis'', ``credit 
period'', ``compliance period'', and for other rules relating to 
determination of the amount of the low-income housing credit.
    (2) Limitation on low-income housing credit allowed. Generally, the 
low-income housing credit determined under section 42 is allowed and may 
be claimed for any taxable year if, and to the extent that, the owner of 
a qualified low-income building receives a housing credit allocation 
from a State or local housing credit agency. The aggregate amount of 
housing credit allocations that may be made in any calendar year by all 
housing credit agencies within a State is limited by a

[[Page 188]]

State housing credit ceiling, or volume cap, described in paragraph (b) 
of this section. The authority to make housing credit allocations within 
the State housing credit ceiling may be apportioned among the State and 
local housing credit agencies, under the rules prescribed in paragraph 
(c) of this section. Upon apportionment of the State housing credit 
volume cap, each State or local housing credit agency receives an 
aggregate housing credit dollar amount that may be used to make housing 
credit allocations among qualified low-income buildings located within 
an agency's geographic jurisdiction. The rules governing the making of 
housing credit allocations by any state or local housing credit agency 
are provided in paragraph (d) of this section. Housing credit 
allocations are required to be taken into account by owners of qualified 
low-income buildings under the rules prescribed in paragraph (e) of this 
section. Exceptions to the requirement that a qualified low-income 
building receive a housing credit allocation from a State or local 
housing credit agency are provided in paragraph (f) of this section. 
Rules regarding termination of the authority of State and local housing 
credit agencies to make housing credit allocations after December 31, 
1989, are specified in paragraph (g) of this section. Rules concerning 
information reporting by State and local housing credit agencies and 
owners of qualified low-income buildings are provided in paragraph (h) 
of this section. Special statutory transitional rules are incorporated 
into this section of the regulations as described in paragraph (i) of 
this section.
    (b) The State housing credit ceiling. The aggregate amount of 
housing credit allocations that may be made in any calendar year by all 
State and local housing credit agencies within a State may not exceed 
the State's housing credit ceiling for such calendar year. The State 
housing credit ceiling for each State for any calendar year is equal to 
$1.25 multiplied by the State's population. A State's population for any 
calendar year is determined by reference to the most recent census 
estimate (whether final or provisional) of the resident population of 
the State released by the Bureau of the Census before the beginning of 
the calendar year for which the State's housing credit ceiling is set. 
Unless otherwise prescribed by applicable revenue procedure, 
determinations of population are based on the most recent estimates of 
population contained in the Bureau of the Census publication, ``Current 
Population Reports, Series P-25: Population Estimates and Projections, 
Estimates of the Population of States''. For purposes of this section, 
the District of Columbia and United States possessions are treated as 
States.
    (c) Apportionment of State housing credit ceiling among State and 
local housing credit agencies--(1) In general. A State's housing credit 
ceiling for any calendar year is apportioned among the State and local 
housing credit agencies within such State under the rules prescribed in 
this paragraph. A ``State housing credit agency'' is any State agency 
specifically authorized by gubernatorial act or State statute to make 
housing credit allocations on behalf of the State and to carry out the 
provisions of section 42(h). A ``local housing credit agency'' is any 
agency of a political subdivision of the State that is specifically 
authorized by a State enabling act to make housing credit allocations on 
behalf of the State or political subdivision and to carry out the 
provisions of section 42(h). A ``State enabling act'' is any 
gubernatorial act, State statute, or State housing credit agency 
regulation (if authorized by gubernatorial act or State statute). A 
State enabling act enacted on or before October 22, 1986, the date of 
enactment of the Tax Reform Act of 1986, shall be given effect for 
purposes of this paragraph if such State enabling act expressly carries 
out the provisions of section 42(h).
    (2) Primary apportionment. Except as otherwise provided in 
paragraphs (c) (3) and (4) of this section, a State's housing credit 
ceiling is apportioned in its entirety to the State housing credit 
agency. Such an apportionment is the ``primary apportionment'' of a 
State's housing credit ceiling. There shall be no primary apportionment 
of the State housing credit ceiling and no grants of housing credit 
allocations in such State until a State housing credit agency is 
authorized by gubernatorial

[[Page 189]]

act or State statute. If a State has more than one State housing credit 
agency, such agencies shall be treated as a single agency for purposes 
of the primary apportionment. In such a case, the State housing credit 
ceiling may be divided among the multiple State housing credit agencies 
pursuant to gubernatorial act or State statute.
    (3) States with 1 or more constitutional home rule cities--(i) In 
general. Notwithstanding paragraph (c)(2) of this section, in any State 
with 1 or more constitutional home rule cities, a portion of the State 
housing credit ceiling is apportioned to each constitutional home rule 
city. In such a State, except as provided in paragraph (c)(4) of this 
section, the remainder of the State housing credit ceiling is 
apportioned to the State housing credit agency under paragraph (c)(2) of 
this section. See paragraph (c)(3)(iii) of this section. The term 
``constitutional home rule city'' means, with respect to any calendar 
year, any political subdivision of a State that, under a State 
constitution that was adopted in 1970 and effective on July 1, 1971, had 
home rule powers on the first day of the calendar year.
    (ii) Amount of apportionment to a constitutional home rule city. The 
amount of the State housing credit ceiling apportioned to a 
constitutional home rule city for any calendar year is an amount that 
bears the same ratio to the State housing credit ceiling for that year 
as the population of the constitutional home rule city bears to the 
population of the entire State. The population of any constitutional 
home rule city for any calendar year is determined by reference to the 
most recent census estimate (whether final or provisional) of the 
resident population of the constitutional home rule city released by the 
Bureau of the Census before the beginning of the calendar year for which 
the State housing credit ceiling is apportioned. However, determinations 
of the population of a constitutional home rule city may not be based on 
Bureau of the Census estimates that do not contain estimates for all of 
the constitutional home rule cities within the State. If no Bureau of 
the Census estimate is available for all such constitutional home rule 
cities, the most recent decennial census of population shall be relied 
on. Unless otherwise prescribed by applicable revenue procedure, 
determinations of population for constitutional home rule cities are 
based on estimates of population contained in the Bureau of the Census 
publication, ``Current Population Reports, Series P-26: Local Population 
Estimates''.
    (iii) Effect of apportionments to constitutional home rule cities on 
apportionments to other housing credit agencies. The aggregate amounts 
of the State housing credit ceiling apportioned to constitutional home 
rule cities under this paragraph (c)(3) reduce the State housing credit 
ceiling available for apportionment under paragraph (c) (2) or (4) of 
this section. Unless otherwise provided in a State constitutional 
amendment or by law changing the home rule provisions adopted in a 
manner provided by the State constitution, the power of the governor or 
State legislature to apportion the State housing credit ceiling among 
local housing credit agencies under paragraph (c)(4) of this section 
shall not be construed as allowing any reduction of the portion of the 
State housing credit ceiling apportioned to a constitutional home rule 
city under this paragraph (c)(3). However, any constitutional home rule 
city may agree to a reduction in its apportionment of the State housing 
credit ceiling under this paragraph (c)(3), in which case the amount of 
the State housing credit ceiling not apportioned to the constitutional 
home rule city shall be available for apportionment under paragraph (c) 
(2) or (4) of this section.
    (iv) Treatment of governmental authority within constitutional home 
rule city. For purposes of determining which agency within a 
constitutional home rule city receives the apportionment of the State 
housing credit ceiling under this paragraph (c)(3), the rules of this 
paragraph (c) shall be applied by treating the constitutional home rule 
city as a ``State'', the chief executive officer of a constitutional 
home rule city as a ``governor'', and a city council as a ``State 
legislature''. A constitutional home rule city is also treated as a 
``State'' for purposes of the set-aside requirement for housing credit 
allocations to projects involving a qualified

[[Page 190]]

nonprofit organization. See paragraph (c)(5) of this section for rules 
governing set-aside requirements. In this connection, a constitutional 
home rule city may agree with the State housing credit agency to 
exchange an apportionment set aside for projects involving a qualified 
nonprofit organization for an apportionment that is not so restricted. 
In such a case, the authorizing gubernatorial act, State statute, or 
State housing credit agency regulation (if authorized by gubernatorial 
act or State statute) must ensure that the set-aside apportionment 
transferred to the State housing credit agency be used for the purposes 
described in paragraph (c)(5) of this section.
    (4) Apportionment to local housing credit agencies--(i) In general. 
In lieu of the primary apportionment under paragraph (c)(2) of this 
section, all or a portion of the State housing credit ceiling may be 
apportioned among housing credit agencies of governmental subdivisions. 
Apportionments of the State housing credit ceiling to local housing 
credit agencies must be made pursuant to a State enabling act as defined 
in paragraph (c)(1) of this section. Apportionments of the State housing 
credit ceiling may be made to housing credit agencies of constitutional 
home rule cities under this paragraph (c)(4), in addition to 
apportionments made under paragraph (c)(3) of this section. 
Apportionments of the State housing credit ceiling under this paragraph 
(c)(4) need not be based on the population of political subdivisions and 
may, but are not required to, give balanced consideration to the low-
income housing needs of the entire State.
    (ii) Change in apportionments during a calendar year. The 
apportionment of the State housing credit ceiling among State and local 
housing credit agencies under this paragraph (c)(4) may be changed after 
the beginning of a calendar year, pursuant to a State enabling act. No 
change in apportionments shall retroactively reduce the housing credit 
allocations made by any agency during such year. Any change in the 
apportionment of the State housing credit ceiling under this paragraph 
(c)(4) that occurs during a calendar year is effective only to the 
extent housing credit agencies have not previously made housing credit 
allocations during such year from their original apportionments of the 
State housing credit ceiling for such year. To the extent apportionments 
of the State housing credit ceiling to local housing credit agencies 
made pursuant to this paragraph (c)(4) for any calendar year are not 
used by such local agencies before a certain date (e.g., November 1) to 
make housing credit allocations in such year, the amount of unused 
apportionments may revert back to the State housing credit agency for 
reapportionment. Such reversion must be specifically authorized by the 
State enabling act.
    (iii) Exchanges of apportionments. Any State or local housing credit 
agency that receives an apportionment of the State housing credit 
ceiling for any calendar year under this paragraph (c)(4) may exchange 
part or all of such apportionment with another State or local housing 
credit agency to the extent no housing credit allocations have been made 
in such year from the exchanged portions. Such exchanges must be made 
with another housing credit agency in the same State and must be 
consistent with the State enabling act. If an apportionment set aside 
for projects involving a qualified nonprofit organization is transferred 
or exchanged, the transferee housing credit agency shall be required to 
use the set-aside apportionment for the purposes described in paragraph 
(c)(5) of this section.
    (iv) Written records of apportionments. All apportionments, 
exchanges of apportionments, and reapportionments of the State housing 
credit ceiling which are authorized by this paragraph (c)(4) must be 
evidenced in the written records maintained by each State and local 
housing credit agency.
    (5) Set-aside apportionments for projects involving a qualified 
nonprofit organization--(i) In general. Ten percent of the State housing 
credit ceiling for a calendar year must be set aside exclusively for 
projects involving a qualified nonprofit organization (as defined in 
paragraph (c)(5)(ii) of this section). Thus, at least 10 percent of 
apportionments of the State housing credit ceiling under paragraphs (c) 
(2) and (3) of this section must be used only to make

[[Page 191]]

housing credit allocations to buildings that are part of projects 
involving a qualified nonprofit organization. In the case of 
apportionments of the State housing credit ceiling under paragraph 
(c)(4) of this section, the State enabling act must ensure that the 
apportionment of at least 10 percent of the State housing credit ceiling 
be used exclusively to make housing credit allocations to buildings that 
are part of projects involving a qualified nonprofit organization. The 
State enabling act shall prescribe which housing credit agencies in the 
State receive apportionments that must be set aside for making housing 
credit allocations to buildings that are part of projects involving a 
qualified nonprofit organization. These set-aside apportionments may be 
distributed disproportionately among the State or local housing credit 
agencies receiving apportionments under paragraph (c)(4) of this 
section. The 10-percent set-aside requirement of this paragraph (c)(4) 
is a minimum requirement, and the State enabling act may set aside more 
than 10 percent of the State housing credit ceiling for apportionment to 
housing credit agencies for exclusive use in making housing credit 
allocations to buildings that are part of projects involving a qualified 
nonprofit organization.
    (ii) Projects involving a qualified nonprofit organization. The term 
``projects involving a qualified nonprofit organization'' means projects 
with respect to which a qualified nonprofit organization is to 
materially participate (within the meaning of section 469(h)) in the 
development and continuing operation of the project throughout the 15-
year compliance period. The term ``qualified nonprofit organization'' 
means any organization that is described in section 501(c) (3) or (4), 
is exempt from tax under section 501(a), and includes as one of its 
exempt purposes the fostering of low-income housing.
    (6) Expiration of unused apportionments. Apportionments of the State 
housing credit ceiling under this paragraph (c) for any calendar year 
may be used by housing credit agencies to make housing credit 
allocations only in such calendar year. Any part of an apportionment of 
the State housing credit ceiling for any calendar year that is not used 
for housing credit allocations in such year expires as of the end of 
such year and does not carry over to any other year. However, any part 
of an apportionment for 1989 that is not used to make a housing credit 
allocation in 1989 may be carried over to 1990 and used to make a 
housing credit allocation to a qualified low-income building described 
in section 42(n)(2)(B). See paragraph (g)(2) of this section.
    (d) Housing credit allocations made by State and local housing 
credit agencies--(1) In general. This paragraph governs State and local 
housing credit agencies in making housing credit allocations to 
qualified low-income buildings. The amount of the apportionment of the 
State housing credit ceiling for any calendar year received by any State 
or local housing credit agency under paragraph (c) of this section 
constitutes the agency's aggregate housing credit dollar amount for such 
year. The aggregate amount of housing credit allocations made in any 
calendar year by a State or local housing credit agency may not exceed 
such agency's aggregate housing credit dollar amount for such year. A 
State or local housing credit agency may make housing credit allocations 
only to qualified low-income buildings located within the agency's 
geographic jurisdiction.
    (2) Amount of a housing credit allocation. In making a housing 
credit allocation, a State or local housing credit agency must specify a 
credit percentage, not to exceed the building's applicable percentage 
determined under section 42(b), and a qualified basis amount. The amount 
of the housing credit allocation for any building is the product of the 
specified credit percentage and the specified qualified basis amount. In 
specifying the credit percentage and qualified basis amount, the State 
or local housing credit agency shall not take account of the first-year 
conventions described in section 42(f) (2)(A) and (3)(B). A State or 
local housing credit agency may adopt rules or regulations governing 
conditions for specification of less than the maximum credit percentage 
and qualified basis amount allowable under section 42 (b) and (c), 
respectively. For example, an agency may specify a credit percentage

[[Page 192]]

and a qualified basis amount of less than the maximum credit percentage 
and qualified basis amount allowable under section 42 (b) and (c), 
respectively, when the financing and rental assistance from all sources 
for the project of which the building is a part is sufficient to provide 
the continuing operation of the building without the maximum credit 
amount allowable under section 42.
    (3) Counting housing credit allocations against an agency's 
aggregate housing credit dollar amount. The aggregate amount of housing 
credit allocations made in any calendar year by a State or local housing 
credit agency may not exceed such agency's aggregate housing credit 
dollar amount (i.e., the agency's apportionment of the State housing 
credit ceiling for such year). This limitation on the aggregate dollar 
amount of housing credit allocations shall be computed separately for 
set-aside apportionments received pursuant to paragraph (c)(5) of this 
section. Housing credit allocations count against an agency's aggregate 
housing credit dollar amount without regard to the amount of credit 
allowable to or claimed by an owner of a building in the taxable year in 
which the allocation is made or in any subsequent year. Thus, housing 
credit allocations (which are computed without regard to the first-year 
conventions as provided in paragraph (d)(2) of this section) count in 
full against an agency's aggregate housing credit dollar amount, even 
though the first-year conventions described in section 42(f) (2)(A) and 
(3)(B) may reduce the amount of credit claimed by a taxpayer in the 
first year in which a credit is allowable. See also paragraph (e)(2) of 
this section. Housing credit allocations count against an agency's 
aggregate housing credit dollar amount only in the calendar year in 
which made and not in subsequent taxable years in the credit period or 
compliance period during which a taxpayer may claim a credit based on 
the original housing credit allocation. Since the aggregate amount of 
housing credit allocations made in any calendar year by a State or local 
housing credit agency may not exceed such agency's aggregate housing 
credit dollar amount, an agency shall at all times during a calendar 
year maintain a record of its cumulative allocations made during such 
year and its remaining unused aggregate housing credit dollar amount.
    (4) Rules for when applications for housing credit allocations 
exceed an agency's aggregate housing credit dollar amount. A State or 
local housing credit agency may adopt rules or regulations governing the 
awarding of housing credit allocations when an agency expects that 
applicants during a calendar year will seek aggregate allocations in 
excess of the agency's aggregate housing credit dollar amount. The State 
enabling act may provide uniform standards for the awarding of housing 
credit allocations when there is actual or anticipated excess demand 
from applicants in any calendar year.
    (5) Reduced or additional housing credit allocations--(i) In 
general. A State or local housing credit agency may not reduce or 
rescind a housing credit allocation made to a qualified low-income 
building in the manner prescribed in paragraph (d)(8) of this section. 
Thus, a housing credit agency may not reduce or rescind a housing credit 
allocation made to a qualified low-income building which is acquired by 
a new owner who is entitled to a carryover of the allowable credit for 
such building under section 42(d)(7). A housing credit agency may make 
additional housing credit allocations to a building in any year in the 
building's compliance period, whether or not there are additions to 
qualified basis for which an increased credit is allowable under section 
42(f)(3). Each additional housing credit allocation made to a building 
is treated as a separate allocation and is subject to the rules and 
requirements of this section. However, in the case of an additional 
housing credit allocation made with respect to additions to qualified 
basis for which an increased credit is allowable under section 42(f)(3), 
the amount of the allocation that counts against the agency's aggregate 
housing credit dollar amount shall be computed as if the specified 
credit percentage were unreduced in the manner prescribed in section 
42(f)(3)(A) and the specified qualified basis amount were unreduced by 
the first-year convention prescribed in section 42(f)(3)(B).

[[Page 193]]

    (ii) Examples. The rules of paragraph (d)(5)(i) of this section may 
be illustrated by the following examples:

    Example 1. For 1987, the County L Housing Credit Agency has an 
aggregate housing credit dollar amount of $2 million. D, an individual, 
places in service on July 1, 1987, a new qualified low-income building. 
As of the close of each month in 1987 in which the building is in 
service, the building consists of 100 residential rental units, of which 
20 units are both rent-restricted and occupied by individuals whose 
income is 50 percent or less of area median gross income. The total 
floor space of the residential rental units is 120,000 square feet, and 
the total floor space of the low-income units is 20,000 square feet. The 
building is not Federally subsidized within the meaning of section 
42(i)(2). As of the end of 1987, the building has eligible basis under 
section 42(d) of $1 million. Thus, the qualified basis of the building 
determined without regard to the first-year convention provided in 
section 42(f) is $166,666.67 (i.e., $1 million eligible basis times \1/
6\, the floor space fraction which is required to be used instead of the 
larger unit fraction). However, the amount of the low-income housing 
credit determined for 1987 under section 42 reflects the first-year 
convention provided in section 42(f)(2). Since the building has the same 
floor space and unit fractions as of the close of each of the six months 
in 1987 during which it is in service, upon applying the first-year 
convention in section 42(f)(2), the qualified basis of the building in 
1987 is $83,333.33 (i.e., $1 million eligible basis times \1/12\, the 
fraction determined under section 42(f)(2)(A)). Under paragraph (d)(2) 
of this section, the County L Housing Credit Agency may make a housing 
credit allocation by specifying a credit percentage, not to exceed 9 
percent, and a qualified basis amount, which may be greater or less than 
the qualified basis of the building in 1987 as determined under section 
42(c), without regard to the first-year convention provided in section 
42(f)(2). If the County L Housing Credit Agency specifies a credit 
percentage of 8 percent and a qualified basis amount of $100,000, the 
amount of the housing credit allocation is $8,000. Under paragraph 
(d)(3) of this section, the County L Housing Credit Agency's aggregate 
housing credit dollar amount for 1987 is reduced by $8,000, 
notwithstanding that D is entitled to claim less than $8,000 of the 
credit in 1987 under the rules in paragraph (e) of this section. Under 
paragraph (e)(2) of this section, in 1987 D is entitled to claim only 
$4,000 of the credit, determined by applying the first-year convention 
of \6/12\ to the specified qualified basis amount contained in the 
housing credit allocation (i.e., .08 x $100,000 x (\6/12\)).
    Example 2. The facts are the same as in Example 1 except that on 
July 1, 1988, the number of occupied low-income units increases to 50 
units and the floor space of the occupied low-income units increases to 
48,000 square feet. These occupancy fractions remain unchanged as of the 
close of each month remaining in 1988. Under section 42(c), the 
qualified basis of the building in 1988, without regard to the first-
year convention in section 42(f)(3)(B), is $400,000 (i.e., $1 million 
eligible basis times .4, the floor space fraction which is required to 
be used instead of the larger unit fraction). D's 1987 housing credit 
allocation from the County L Housing Credit Agency remains effective in 
1988 and entitles D to a credit of $8,000 (i.e., .08, the specified 
credit percentage, times $100,000, the specified qualified basis 
amount). With respect to the additional $300,000 of qualified basis 
which the 1987 housing credit allocation does not cover, D must apply to 
the County L Housing Credit Agency for an additional housing credit 
allocation. Assume that the County L Housing Credit Agency has a 
sufficient aggregate housing credit dollar amount for 1988 to make a 
housing credit allocation to D in 1988 by specifying a credit percentage 
of 9 percent and a qualified basis amount of $300,000. The amount of the 
housing credit allocation that counts against the County L Housing 
Credit Agency's aggregate housing credit dollar amount is $27,000 (i.e., 
the amount counted (.09 times $300,000) is unreduced in the manner 
prescribed in section 42(f)(3) (A) and (B)). Since D's qualified basis 
in 1987 was $166,666.67, D is entitled to claim a credit in 1988 with 
respect to such basis of $14,000 (i.e., .08 x $100,000, the 1987 credit 
allocation, + .09 x $66,666.67, the 1988 credit allocation). In 
addition, D is entitled to claim a credit in 1988 and subsequent years 
in the 15-year compliance period with respect to the additional 
$233,333.33 of qualified basis covered by the 1988 housing credit 
allocation. However, the allowable credit for 1988 with respect to this 
amount of additional qualified basis is subject to reductions prescribed 
in section 42(f)(3) (A) and (B). Thus, D is entitled in 1988 to a credit 
at a 6-percent rate applied to $116,666.67 of additional qualified 
basis, which is reduced to reflect the first-year convention. D's total 
allowable low-income housing credit in 1988 is $21,000 (i.e., $14,000 
with respect to original qualified basis + $7,000 with respect to 1988 
additions to qualified basis). If the County L Housing Credit Agency had 
specified an 8-percent credit percentage in 1988 with respect to the 
qualified basis not covered by the 1987 housing credit allocation to D, 
D's allowable credit with respect to the $233,333.33 of additions to 
qualified basis would not exceed, in 1988 and subsequent years, an 
amount determined by applying a specified credit percentage of 5.33 
percent (i.e., two-thirds of 8 percent). In 1988, D's specified 
qualified basis amount would be adjusted for the first-year convention.


[[Page 194]]


    (6) No carryover of unused aggregate housing credit dollar amount. 
Any portion of a State or local housing credit agency's aggregate 
housing credit dollar amount for any calendar year that is not used to 
make a housing credit allocation in such year may not be carried over to 
any other year, except as provided in paragraph (g) of this section. An 
agency may not permit owners of qualified low-income buildings to 
transfer housing credit allocations to other buildings. However, an 
agency may provide a procedure whereby owners may return to the agency, 
prior to the end of the calendar year in which housing credit 
allocations are made, unusable portions of such allocations. In such a 
case, an owner's housing credit allocation is deemed reduced by the 
amount of the allocation returned to the agency, and the agency may 
reallocate such amount to other qualified low-income buildings prior to 
the end of the year.
    (7) Effect of housing credit allocations in excess of an agency's 
aggregate housing credit dollar amount. In the event that a State or 
local housing credit agency makes housing credit allocations in excess 
of its aggregate housing credit dollar amount for any calendar year, the 
allocations shall be deemed reduced (to the extent of such excess) for 
buildings in the reverse order in which such allocations were made 
during such year.
    (8) Time and manner for making housing credit allocations--(i) Time. 
Housing credit allocations are effective for the calendar year in which 
made in the manner prescribed in paragraph (d)(8)(ii) of this section. A 
State or local housing credit agency may not make a housing credit 
allocation to a qualified low-income building prior to the calendar year 
in which such building is placed in service. An agency may adopt its own 
procedures for receiving applications for housing credit allocations 
from owners of qualified low-income buildings. An agency may provide a 
procedure for making, in advance of a building's being placed in 
service, a binding commitment (e.g., by contract, inducement, 
resolution, or other means) to make a housing credit allocation in the 
calendar year in which a qualified low-income building is placed in 
service or in a subsequent calendar year. Any advance commitment shall 
not constitute a housing credit allocation for purposes of this section.
    (ii) Manner. Housing credit allocations are deemed made when part I 
of IRS Form 8609, Low-Income Housing Credit Allocation Certification, is 
completed and signed by an authorized official of the housing credit 
agency and mailed to the owner of the qualified low-income building. A 
copy of all completed (as to part I) Form 8609 allocations along with a 
single completed Form 8610, Annual Low-Income Housing Credit Agencies 
Report, must also be mailed to the Internal Revenue Service not later 
than the 28th day of the second calendar month after the close of the 
calendar year in which the housing credit was allocated to the qualified 
low-income building. Housing credit allocations to a qualified low-
income building must be made on Form 8609 and must include--
    (A) The address of the building;
    (B) The name, address, and taxpayer identification number of the 
housing credit agency making the housing credit allocation;
    (C) The name, address, and taxpayer identification number of the 
owner of the qualified low-income building;
    (D) The date of the allocation of housing credit;
    (E) The housing credit dollar amount allocated to the building on 
such date;
    (F) The specified maximum applicable credit percentage allocated to 
the building on such date;
    (G) The specified maximum qualified basis amount;
    (H) The percentage of the aggregate basis financed by tax-exempt 
bonds taken into account for purposes of the volume cap under section 
146;
    (I) A certification under penalties of perjury by an authorized 
State or local housing credit agency official that the allocation is 
made in compliance with the requirements of section 42(h); and
    (J) Any additional information that may be required by Form 8609 or 
by an applicable revenue procedure.

See paragraph (h) of this section for additional rules concerning filing 
of forms.

[[Page 195]]

    (iii) Certification. The certifying official for the State or local 
housing credit agency need not perform an independent investigation of 
the qualified low-income building in order to certify on part I of Form 
8609 that the housing credit allocation meets the requirements of 
section 42(h). For example, the certifying official may rely on 
information contained in an application for a low-income housing credit 
allocation submitted by the building owner which sets forth facts 
necessary to determine that the building is eligible for the low-income 
housing credit under section 42.
    (iv) Fee. A State or local housing credit agency may charge building 
owners applying for housing credit allocations a reasonable fee to cover 
the agency's administrative expenses for processing applications.
    (v) No continuing agency responsibility. The State or local housing 
credit agency need not monitor or investigate the continued compliance 
of a qualified low-income building with the requirements of section 42 
throughout the applicable compliance period.
    (e) Housing credit allocation taken into account by owner of a 
qualified low-income building--(1) Time and manner for taking housing 
credit allocation into account. An owner of a qualified low-income 
building may not claim a low-income housing credit determined under 
section 42 in any year in excess of an effective housing credit 
allocation received from a State or local housing credit agency. A 
housing credit allocation made to a qualified low-income building is 
effective with respect to any owner of the building beginning with the 
owner's taxable year in which the housing credit allocation is received. 
A housing credit allocation is deemed received in a taxable year, except 
as modified in the succeeding sentence, if that allocation is made (in 
the manner described in paragraph (d)(8) of this section) not later than 
the earlier of (i) the 60th day after the close of the taxable year, or 
(ii) the close of the calendar year in which such taxable year ends. A 
housing credit allocation is deemed received in a taxable year ending in 
1987, if such allocation is made (in the manner described in paragraph 
(d)(8) of this section) on or before December 31, 1987. A housing credit 
allocation is not effective for any taxable year if received in a 
calendar year which ends prior to when the qualified low-income building 
is placed in service. A housing credit allocation made to a qualified 
low-income building remains effective for all taxable years in the 
compliance period.
    (2) First-year convention limitation on housing credit allocation 
taken into account. For purposes of the limitation that the allowable 
low-income housing credit may not exceed the effective housing credit 
allocation received from a State or local housing credit agency, as 
provided in paragraph (e)(1) of this section, the amount of the 
effective housing credit allocation shall be adjusted by applying the 
first-year convention provided in section 42(f)(2)(A) and (3)(B) and the 
percentage credit reduction provided in section 42(f)(3)(A). Under 
paragraphs (d) (2) and (5) of this section, the State or local housing 
credit agency must specify the credit percentage and qualified basis 
amount, the product of which is the amount of the housing credit 
allocation, without taking account of the first-year convention 
described in section 42(f)(2)(A) and (3)(B) or the percentage credit 
reduction prescribed in section 42(f)(3)(A). However, for purposes of 
the limitation on the amount of the allowable low-income housing credit, 
as provided in paragraph (e)(1) of this section, in a taxable year in 
which the first-year convention applies to the amount of credit 
determined under section 42(a), the specified qualified basis amount 
shall be adjusted by the first-year convention fraction which is equal 
to the number of full months (during the first taxable year) in which 
the building was in service divided by 12. In addition, for purposes of 
the limitation on the amount of the allowable low-income housing credit, 
as provided in paragraph (e)(1) of this section, in a taxable year in 
which the reduction in credit percentage applies to additions to 
qualified basis, as prescribed in section 42(f)(3), the specified credit 
percentage shall be reduced by one-third. See examples in paragraphs 
(d)(5)(ii) and (e)(3)(ii) of this section.
    (3) Use of excess housing credit allocation for increases in 
qualified basis--(i) In

[[Page 196]]

general. If the housing credit allocation made to a qualified low-income 
building exceeds the amount of credit allowable with respect to such 
building in any taxable year (without regard to the first-year 
conventions under section 42(f)), such excess is not transferable to 
another qualified low-income building. However, if in a subsequent year 
there are increases in the qualified basis for which an increased credit 
is allowable under section 42(f)(3) at a reduced credit percentage, the 
original housing credit allocation (including the specified credit 
percentage and qualified basis amount) would be effective with respect 
to such increased credit.
    (ii) Example. The provisions of this paragraph (e)(3) may be 
illustrated by the following example:

    Example. In 1987, a newly-constructed qualified low-income building 
receives a housing credit allocation of $90,000 based on a specified 
credit percentage of 9 percent and a specified qualified basis amount of 
$1,000,000. The building is placed in service in 1987, but the qualified 
basis in such year is only $800,000, resulting in an allowable credit in 
1987 (determined without regard to the first-year conventions) of 
$72,000. In 1988, the qualified basis is increased to $1,100,000, 
resulting in an additional credit allowable under section 42(f)(3) 
(without regard to the first-year conventions) of $18,000 (i.e., 
$300,000 x .06, or \2/3\ of .09). The unused portion of the 1987 housing 
credit allocation ($18,000) is effective in 1988 and in each subsequent 
year in the compliance period only with respect to the specified 
qualified basis for the 1987 housing credit allocation ($1,000,000). 
Thus, the owner is allowed to claim a credit in 1988 and in each 
subsequent year (without regard to the first-year conventions), based on 
the effective housing credit allocation from 1987, of $84,000 (i.e., 
$72,000 + ($200,000 x .06)). The owner of the qualified low-income 
building must obtain a new housing credit allocation in 1988 with 
respect to the additional $100,000 of qualified basis in order to claim 
a credit on such basis in 1988 and in each subsequent year. If the 
applicable first-year convention under section 42(f)(3)(B) entitled the 
owner in 1988 to only \1/2\ of the otherwise applicable credit for the 
additions to qualified basis, under paragraph (e)(2) of this section the 
owner is allowed to claim a credit in 1988, based on the effective 
housing credit allocation from 1987, of $78,000 (i.e., $72,000 + 
($200,000 x .06 x .5)).

    (4) Separate housing credit allocations for new buildings and 
increases in qualified basis. Separate housing credit allocations must 
be received for each building with respect to which a housing credit may 
be claimed. Rehabilitation expenditures with respect to a qualified low-
income building are treated as a separate new building under section 
42(e) and must receive a separate housing credit allocation. Increases 
in qualified basis in a qualified low-income building are not generally 
treated as a new building for purposes of section 42. To the extent that 
a prior housing credit allocation received with respect to a qualified 
low-income building does not allow an increased credit with respect to 
an increase in the qualified basis of such building, an additional 
housing credit allocation must be received in order to claim a credit 
with respect to that portion of increase in qualified basis. See 
paragraph (e)(3) of this section. The amount of credit allowable with 
respect to an increase in qualified basis is subject to the credit 
percentage limitation of section 42(f)(3)(A) and the first-year 
convention of section 42(f)(3)(B). See paragraph (d)(5) of this section 
for a rule requiring that the State or local housing credit agency count 
a housing credit allocation made with respect to an increase in 
qualified basis as if the specified credit percentage were unreduced in 
the manner prescribed in section 42(f)(3) and the specified basis amount 
were unreduced by the first-year convention prescribed in section 
42(f)(3)(B).
    (5) Acquisition of building for which a prior housing credit 
allocation has been made. If a carryover credit would be allowable to an 
acquirer of a qualified low-income building under section 42(d)(7), such 
acquirer need not obtain a new housing credit allocation with respect to 
such building. Under section 42(d)(7), the acquirer would be entitled to 
claim only such credits as would have been allowable to the prior owner 
of the building.
    (6) Multiple housing credit allocations. A qualified low-income 
building may receive multiple housing credit allocations from different 
housing credit agencies having overlapping jurisdictions. A qualified 
low-income building that receives a housing credit allocation set aside 
exclusively for projects

[[Page 197]]

involving a qualified nonprofit organization may also receive a housing 
credit allocation from a housing credit agency's aggregate housing 
credit dollar amount that is not so set aside.
    (f) Exception to housing credit allocation requirement--(1) Tax-
exempt bond financing--(i) In general. No housing credit allocation is 
required in order to claim a credit under section 42 with respect to 
that portion of the eligible basis (as defined in section 42(d)) of a 
qualified low-income building that is financed with the proceeds of an 
obligation described in section 103(a) (``tax-exempt bond'') which is 
taken into account for purposes of the volume cap under section 146. In 
addition, no housing credit allocation is required in order to claim a 
credit under section 42 with respect to the entire qualified basis (as 
defined in section 42(c)) of a qualified low-income building if 70 
percent or more of the aggregate basis of the building and the land on 
which the building is located is financed with the proceeds of tax-
exempt bonds which are taken into account for purposes of the volume cap 
under section 146. For purposes of this paragraph, ``land on which the 
building is located'' includes only land that is functionally related 
and subordinate to the qualified low-income building. See Sec.  1.103-
8(b)(4)(iii) for the meaning of the term ``functionally related and 
subordinate''. For purposes of this paragraph, the basis of the land 
shall be determined using principles that are consistent with the rules 
contained in section 42(d).
    (ii) Determining use of bond proceeds. For purposes of determining 
the portion of proceeds of an issue of tax-exempt bonds used to finance 
(A) the eligible basis of a qualified low-income building, and (B) the 
aggregate basis of the building and the land on which the building is 
located, the proceeds of the issue must be allocated in the bond 
indenture or a related document (as defined in Sec.  1.103-13(b)(8)) in 
a manner consistent with the method used to allocate the net proceeds of 
the issue for purposes of determining whether 95 percent or more of the 
net proceeds of the issue are to be used for the exempt purpose of the 
issue. If the issuer is not consistent in making this allocation 
throughout the bond indenture and related documents, or if neither the 
bond indenture nor a related document provides an allocation, the 
proceeds of the issue will be allocated on a pro rata basis to all of 
the property financed by the issue, based on the relative cost of the 
property.
    (iii) Example. The provisions of this paragraph may be illustrated 
by the following example:

    Example. In 1987, County K assigns $500,000 of its volume cap for 
private activity bonds under section 146 to a $500,000 issue of exempt 
facility bonds to provide a qualified residential rental project to be 
owned by A, an individual. The aggregate basis of the building and the 
land on which the building is located is $700,000. Under the terms of 
the bond indenture, the net proceeds of the issue are to be used to 
finance $490,000 of the eligible basis of the building. More than 70 
percent of the aggregate basis of the qualified low-income building and 
the land on which the building is located is financed with the proceeds 
of tax-exempt bonds to which a portion of the volume cap under section 
146 was allocated. Accordingly, A may claim a credit under section 42 
without regard to whether any housing credit dollar amount was allocated 
to that building. If, instead, the aggregate basis of the building and 
land were $800,000, A would be able to claim the credit under section 42 
without receiving a housing credit allocation for the building only to 
the extent that the credit was attributable to eligible basis of the 
building financed with tax-exempt bonds.

    (g) Termination of authority to make housing credit allocation--(1) 
In general. No State or local housing credit agency shall receive an 
apportionment of a State housing credit ceiling for calendar years after 
1989. Consequently, no housing credit allocations may be made after 
1989, except as provided in paragraph (g)(2) of this section. Housing 
credit allocations made prior to January 1, 1990, remain effective after 
such date.
    (2) Carryover of unused 1989 apportionment. Any State or local 
housing credit agency that has an unused portion of its apportionment of 
the State housing credit ceiling for 1989 from which housing credit 
allocations have not been made in 1989 may carry over such unused 
portion into 1990. Such carryover portion of the 1989 apportionment 
shall be treated as the agency's apportionment for 1990. From this 1990 
apportionment, the State or local housing

[[Page 198]]

credit agency may make housing credit allocations only to a qualified 
low-income building meeting the following requirements:
    (i) The building must be constructed, reconstructed, or 
rehabilitated by the taxpayer seeking the allocation;
    (ii) More than 10 percent of the reasonably anticipated cost of such 
construction, reconstruction, or rehabilitation must have been incurred 
as of January 1, 1989; and
    (iii) The building must be placed in service before January 1, 1991.
    (3) Expiration of exception for tax-exempt bond financed projects. 
The exception to the requirement that a housing credit allocation be 
received with respect to any portion of the eligible basis of a 
qualified low-income building, as provided in paragraph (f) of this 
section, shall not apply to any building placed in service after 1989, 
unless such building is described in paragraphs (g)(2) (i), (ii), and 
(iii) of this section.
    (h) Filing of forms. For further guidance, see Sec.  1.42-1(h).
    (i) Transitional rules. The transitional rules contained in section 
252(f)(1) of the Tax Reform Act of 1986 are incorporated into this 
section of the regulations for purposes of determining whether a 
qualified low-income building is entitled to receive a housing credit 
allocation or is excepted from the requirement that a housing credit 
allocation be received. Housing credit allocations made to qualified 
low-income buildings described in section 252(f)(1) shall not count 
against the State or local housing credit agency's aggregate housing 
credit dollar amount. The transitional rules contained in section 
252(f)(2) of the Tax Reform Act of 1986 are incorporated into this 
section of the regulations for purposes of determining amounts available 
to certain State or local housing credit agencies for the making of 
housing credit allocations to certain qualified low-income housing 
projects. Amounts available to housing credit agencies under section 
252(f)(2) shall be treated as special apportionments unavailable for 
housing credit allocations to qualified low-income buildings not 
described in section 252(f)(2). Housing credit allocations made from the 
special apportionments shall not count against the State or local credit 
agency's aggregate housing credit dollar amount. The set-aside 
requirements shall not apply to these special apportionments. The 
transitional rules contained in section 252(f)(3) of the Tax Reform Act 
1986 are incorporated in this section of the regulations for purposes of 
determining the amount of housing credit allocations received by certain 
qualified low-income buildings. Housing credit allocations deemed 
received under section 252(f)(3) shall not count against the State or 
local housing credit agency's aggregate housing credit dollar amount.

[T.D. 8144, 52 FR 23433, June 22, 1987; 52 FR 24583, July 1, 1987, as 
amended by T.D. 9112, 69 FR 3827, Jan. 27, 2004]



Sec.  1.42-2  [Reserved]



Sec.  1.42-3  Treatment of buildings financed with proceeds from a 
loan under an Affordable Housing Program established pursuant to
section 721 of the Financial Institutions Reform, Recovery, and Enforcement
Act of 1989 (FIRREA).

    (a) Treatment under sections 42(i) and 42(b). A below market loan 
funded in whole or in part with funds from an Affordable Housing Program 
established under section 721 of FIRREA is not, solely by reason of the 
Affordable Housing Program funds, a below market Federal loan as defined 
in section 42(i)(2)(D). Thus, any building with respect to which the 
proceeds of the loan are used during the tax year is not, solely by 
reason of the Affordable Housing Program funds, treated as a federally 
subsidized building for that tax year and subsequent tax years for 
purposes of determining the applicable percentage for the building under 
section 42(b).
    (b) Effective date. The rules set forth in paragraph (a) of this 
section are effective for loans made after August 8, 1989.

[56 FR 48734, Sept. 26, 1991]



Sec.  1.42-4  Application of not-for-profit rules of section 183 to
low-income housing credit activities.

    (a) Inapplicability to section 42. In the case of a qualified low-
income building with respect to which the low-income

[[Page 199]]

housing credit under section 42 is allowable, section 183 does not apply 
to disallow losses, deductions, or credits attributable to the ownership 
and operation of the building.
    (b) Limitation. Notwithstanding paragraph (a) of this section, 
losses, deductions, or credits attributable to the ownership and 
operation of a qualified low-income building with respect to which the 
low-income housing credit under section 42 is allowable may be limited 
or disallowed under other provisions of the Code or principles of tax 
law. See, e.g., sections 38(c), 163(d), 465, 469; Knetsch v. United 
States, 364 U.S. 361 (1960), 1961-1 C.B. 34 (``sham'' or ``economic 
substance'' analysis); and Frank Lyon Co. v. Commissioner, 435 U.S. 561 
(1978), 1978-1 C.B. 46 (``ownership'' analysis).
    (c) Effective date. The rules set forth in paragraphs (a) and (b) of 
this section are effective with respect to buildings placed in service 
after December 31, 1986.

[T.D. 8420, 57 FR 24729, June 11, 1992]



Sec.  1.42-5  Monitoring compliance with low-income housing credit
requirements.

    (a) Compliance monitoring requirement--(1) In general. Under section 
42(m)(1)(B)(iii), an allocation plan is not qualified unless it contains 
a procedure that the State or local housing credit agency (``Agency'') 
(or an agent of, or other private contractor hired by, the Agency) will 
follow in monitoring for noncompliance with the provisions of section 42 
and in notifying the Internal Revenue Service of any noncompliance of 
which the Agency becomes aware. These regulations only address 
compliance monitoring procedures required of Agencies. The regulations 
do not address forms and other records that may be required by the 
Service on examination or audit. For example, if a building is sold or 
otherwise transferred by the owner, the transferee should obtain from 
the transferor information related to the first year of the credit 
period so that the transferee can substantiate credits claimed.
    (2) Requirements for a monitoring procedure--(i) In general. A 
procedure for monitoring for noncompliance under section 
42(m)(1)(B)(iii) must include--
    (A) The recordkeeping and record retention provisions of paragraph 
(b) of this section;
    (B) The certification and review provisions of paragraph (c) of this 
section;
    (C) The inspection provision of paragraph (d) of this section; and
    (D) The notification-of-noncompliance provisions of paragraph (e) of 
this section.
    (ii) Order and form. A monitoring procedure will meet the 
requirements of section 42 (m)(1)(B)(iii) if it contains the substance 
of these provisions. The particular order and form of the provisions in 
the allocation plan is not material. A monitoring procedure may contain 
additional provisions or requirements.
    (b) Recordkeeping and record retention provisions--(1) Recordkeeping 
provision. Under the recordkeeping provision, the owner of a low-income 
housing project must be required to keep records for each qualified low-
income building in the project that show for each year in the compliance 
period--
    (i) The total number of residential rental units in the building 
(including the number of bedrooms and the size in square feet of each 
residential rental unit);
    (ii) The percentage of residential rental units in the building that 
are low-income units;
    (iii) The rent charged on each residential rental unit in the 
building (including any utility allowances);
    (iv) The number of occupants in each low-income unit, but only if 
rent is determined by the number of occupants in each unit under section 
42(g)(2) (as in effect before the amendments made by the Omnibus Budget 
Reconciliation Act of 1989);
    (v) The low-income unit vacancies in the building and information 
that shows when, and to whom, the next available units were rented;
    (vi) The annual income certification of each low-income tenant per 
unit. For an exception to this requirement, see section 42(g)(8)(B) 
(which provides a special rule for a 100 percent low-income building);

[[Page 200]]

    (vii) Documentation to support each low-income tenant's income 
certification (for example, a copy of the tenant's federal income tax 
return, Forms W-2, or verifications of income from third parties such as 
employers or state agencies paying unemployment compensation). For an 
exception to this requirement, see section 42(g)(8)(B) (which provides a 
special rule for a 100 percent low-income building). Tenant income is 
calculated in a manner consistent with the determination of annual 
income under section 8 of the United States Housing Act of 1937 
(``Section 8''), not in accordance with the determination of gross 
income for federal income tax liability. In the case of a tenant 
receiving housing assistance payments under Section 8, the documentation 
requirement of this paragraph (b)(1)(vii) is satisfied if the public 
housing authority provides a statement to the building owner declaring 
that the tenant's income does not exceed the applicable income limit 
under section 42 (g);
    (viii) The eligible basis and qualified basis of the building at the 
end of the first year of the credit period; and
    (ix) The character and use of the nonresidential portion of the 
building included in the building's eligible basis under section 42 (d) 
(e.g., tenant facilities that are available on a comparable basis to all 
tenants and for which no separate fee is charged for use of the 
facilities, or facilities reasonably required by the project).
    (2) Record retention provision. Under the record retention 
provision, the owner of a low-income housing project must be required to 
retain the records described in paragraph (b)(1) of this section for at 
least 6 years after the due date (with extensions) for filing the 
federal income tax return for that year. The records for the first year 
of the credit period, however, must be retained for at least 6 years 
beyond the due date (with extensions) for filing the federal income tax 
return for the last year of the compliance period of the building.
    (3) Inspection record retention provision. Under the inspection 
record retention provision, the owner of a low-income housing project 
must be required to retain the original local health, safety, or 
building code violation reports or notices that were issued by the State 
or local government unit (as described in paragraph (c)(1)(vi) of this 
section) for the Agency's inspection under paragraph (d) of this 
section. Retention of the original violation reports or notices is not 
required once the Agency reviews the violation reports or notices and 
completes its inspection, unless the violation remains uncorrected.
    (c) Certification and review provisions--(1) Certification. Under 
the certification provision, the owner of a low-income housing project 
must be required to certify at least annually to the Agency that, for 
the preceding 12-month period--
    (i) The project met the requirements of:
    (A) The 20-50 test under section 42 (g)(1)(A), the 40-60 test under 
section 42 (g)(1)(B), or the 25-60 test under sections 42 (g)(4) and 142 
(d)(6) for New York City, whichever minimum set-aside test was 
applicable to the project; and
    (B) If applicable to the project, the 15-40 test under sections 
42(g)(4) and 142 (d)(4)(B) for ``deep rent skewed'' projects;
    (ii) There was no change in the applicable fraction (as defined in 
section 42(c)(1)(B)) of any building in the project, or that there was a 
change, and a description of the change;
    (iii) The owner has received an annual income certification from 
each low-income tenant, and documentation to support that certification; 
or, in the case of a tenant receiving Section 8 housing assistance 
payments, the statement from a public housing authority described in 
paragraph (b)(1)(vii) of this section. For an exception to this 
requirement, see section 42(g)(8)(B) (which provides a special rule for 
a 100 percent low-income building);
    (iv) Each low-income unit in the project was rent-restricted under 
section 42(g)(2);
    (v) All units in the project were for use by the general public (as 
defined in Sec.  1.42-9), including the requirement that no finding of 
discrimination under the Fair Housing Act, 42 U.S.C. 3601-3619, occurred 
for the project. A finding

[[Page 201]]

of discrimination includes an adverse final decision by the Secretary of 
the Department of Housing and Urban Development (HUD), 24 CFR 180.680, 
an adverse final decision by a substantially equivalent state or local 
fair housing agency, 42 U.S.C. 3616a(a)(1), or an adverse judgment from 
a federal court;
    (vi) The buildings and low-income units in the project were suitable 
for occupancy, taking into account local health, safety, and building 
codes (or other habitability standards), and the State or local 
government unit responsible for making local health, safety, or building 
code inspections did not issue a violation report for any building or 
low-income unit in the project. If a violation report or notice was 
issued by the governmental unit, the owner must attach a statement 
summarizing the violation report or notice or a copy of the violation 
report or notice to the annual certification submitted to the Agency 
under paragraph (c)(1) of this section. In addition, the owner must 
state whether the violation has been corrected;
    (vii) There was no change in the eligible basis (as defined in 
section 42(d)) of any building in the project, or if there was a change, 
the nature of the change (e.g., a common area has become commercial 
space, or a fee is now charged for a tenant facility formerly provided 
without charge);
    (viii) All tenant facilities included in the eligible basis under 
section 42(d) of any building in the project, such as swimming pools, 
other recreational facilities, and parking areas, were provided on a 
comparable basis without charge to all tenants in the building;
    (ix) If a low-income unit in the project became vacant during the 
year, that reasonable attempts were or are being made to rent that unit 
or the next available unit of comparable or smaller size to tenants 
having a qualifying income before any units in the project were or will 
be rented to tenants not having a qualifying income;
    (x) If the income of tenants of a low-income unit in the building 
increased above the limit allowed in section 42(g)(2)(D)(ii), the next 
available unit of comparable or smaller size in the building was or will 
be rented to tenants having a qualifying income;
    (xi) An extended low-income housing commitment as described in 
section 42(h)(6) was in effect (for buildings subject to section 
7108(c)(1) of the Omnibus Budget Reconciliation Act of 1989, 103 Stat. 
2106, 2308-2311), including the requirement under section 
42(h)(6)(B)(iv) that an owner cannot refuse to lease a unit in the 
project to an applicant because the applicant holds a voucher or 
certificate of eligibility under section 8 of the United States Housing 
Act of 1937, 42 U.S.C. 1437f (for buildings subject to section 
13142(b)(4) of the Omnibus Budget Reconciliation Act of 1993, 107 Stat. 
312, 438-439); and
    (xii) All low-income units in the project were used on a 
nontransient basis (except for transitional housing for the homeless 
provided under section 42(i)(3)(B)(iii) or single-room-occupancy units 
rented on a month-by-month basis under section 42(i)(3)(B)(iv)).
    (2) Review. The review provision must--
    (i) Require that the Agency review the certifications submitted 
under paragraph (c)(1) of this section for compliance with the 
requirements of section 42;
    (ii) Require that, with respect to each low-income housing project, 
the Agency conduct on-site inspections and review low-income 
certifications (including in that term the documentation supporting the 
low-income certifications and the rent records for tenants).
    (iii) Require that the on-site inspections that the Agency must 
conduct satisfy both the requirements of Sec.  1.42-5(d) and the 
requirements in paragraph (c)(2)(iii)(A) through (D) of this section, 
and require that the low-income certification review that the Agency 
must perform satisfies the requirements in paragraphs (c)(2)(iii)(A) 
through (D) of this section. Paragraph (c)(2)(iii)(A) through (D) of 
this section provides rules determining how these on-site inspection 
requirements and how these low-income certification review requirements 
may be satisfied by an inspection or review, as the case may be, that 
includes only a sample of the low-income units.

[[Page 202]]

    (A) Timing. The Agency must conduct on-site inspections of all 
buildings in the low-income housing project and must review low-income 
certifications of the low-income housing project--
    (1) By the end of the second calendar year following the year the 
last building in the low-income housing project is placed in service; 
and
    (2) At least once every 3 years thereafter.
    (B) Number of low-income units. The Agency must conduct on-site 
inspections and low-income certification review of not fewer than the 
minimum number of low-income units for the corresponding number of low-
income units in the low-income housing project set forth in the table to 
paragraph (c)(2)(iii).

                     Table to Paragraph (c)(2)(iii)
------------------------------------------------------------------------
                                                    Number of low-income
                                                     units selected for
   Number of low-income units in the low-income    inspection or for low-
                 housing project                    income certification
                                                    review (minimum unit
                                                        sample size)
------------------------------------------------------------------------
1................................................                     1
2................................................                     2
 3...............................................                     3
4................................................                     4
5-6..............................................                     5
7................................................                     6
8-9..............................................                     7
10-11............................................                     8
12-13............................................                     9
14-16............................................                    10
17-18............................................                    11
19-21............................................                    12
22-25............................................                    13
26-29............................................                    14
30-34............................................                    15
35-40............................................                    16
41-47............................................                    17
48-56............................................                    18
57-67............................................                    19
68-81............................................                    20
82-101...........................................                    21
102-130..........................................                    22
131-175..........................................                    23
176-257..........................................                    24
258-449..........................................                    25
450-1,461........................................                    26
1,462-9,999......................................                    27
------------------------------------------------------------------------

    (C) Selection of low-income units for inspection and low-income 
certifications for review--(1) Random selection. The Agency must select 
in a random manner the low-income units to be inspected and the units 
whose low-income certifications are to be reviewed. Agencies generally 
may not select the same low-income units of a low-income housing project 
for on-site inspections and low-income certification review, because 
doing so would usually give prohibited advance notice. See paragraph 
(c)(2)(iii)(C)(2) of this section. An Agency may choose a different 
number of units for on-site inspections and for low-income certification 
review, provided the Agency chooses at least the minimum number of low-
income units in each case. The Agency must select the units for 
inspections or low-income certification review separately and in a 
random manner.
    (2) Advance notification limited to reasonable notice. The Agency 
must select the low-income units to inspect and low-income 
certifications to review in a manner that does not give advance notice 
that a particular low-income unit (or low-income certifications for a 
particular low-income unit) will or will not be inspected (or reviewed) 
for a particular year. The Agency may notify the owner of the low-income 
units for on-site inspection only on the day of inspection. However, the 
Agency may give an owner reasonable notice that an inspection of the 
project and of not-yet-identified low-income units or review of low-
income certifications will occur. The notice serves to enable the owner 
to assemble needed documentation for low-income certifications for 
review and to notify tenants of the possibility of physical inspection 
of their units.
    (3) Meaning of reasonable notice. For purposes of paragraph 
(c)(2)(iii)(C)(2) of this section, reasonable notice is generally no 
more than 15 days. The notice period begins on the date the Agency 
informs the owner that an on-site inspection of a project and low-income 
units or low-income certification review will occur. Notice of more than 
15 days, however, may be reasonable in extraordinary circumstances that 
are beyond an Agency's control and that prevent an Agency from carrying 
out within 15 days an on-site inspection or low-income certification 
review. Extraordinary circumstances include, but are not limited to, 
natural disasters and severe weather conditions. In the event of 
extraordinary circumstances that result in a reasonable-notice period 
longer than 15 days, an Agency

[[Page 203]]

must select the relevant units and conduct the same-day on-site 
inspection or low-income certification review as soon as practicable.
    (4) Alternative means of conducting on-site inspections--Use of the 
REAC protocol. An Agency may satisfy the requirements of paragraphs 
(c)(2)(ii) and (iii) of this section if the inspection is performed 
under the Department of Housing and Urban Development (HUD) Real Estate 
Assessment Center (REAC) protocol and the inspection satisfies the 
following requirements:
    (i) Both vacant and occupied low-income units in a low-income 
housing project are included in the population of units from which units 
are selected for inspection;
    (ii) The inspection complies with the procedural and substantive 
requirements of the REAC protocol, including the requirements of the 
most recent REAC Uniform Physical Condition Standards (UPCS) inspection 
software, or software accepted by HUD;
    (iii) The inspection is performed by HUD or HUD-Certified REAC 
inspectors;
    (iv) The inspection results are sent to HUD, the results are 
reviewed and scored within HUD's secure system without any involvement 
of the inspector who conducted the inspection, and HUD makes its 
inspection report available.
    (5) HUD Inspections that comply with the requirements of the REAC 
Protocol. If, consistent with the requirements of paragraph 
(c)(2)(iii)(4) of this section, an Agency conducts on-site inspections 
under the REAC protocol, then--
    (i) Paragraph (c)(2)(iii)(A) of this section is applied as if it did 
not contain the word ``all'';
    (ii) The number of low-income units required to be inspected under 
the REAC protocol satisfies the requirements of paragraph (c)(2)(iii)(B) 
of this section concerning the number of low-income units an Agency must 
inspect; and
    (iii) The manner in which the low-income units are selected for 
inspection under the REAC protocol satisfies the requirements of 
paragraph (c)(2)(iii)(C) of this section.
    (6) Income Certification Requirements for HUD Inspections that 
comply with the requirements of the REAC Protocol. An agency that 
conducts on-site inspections under the REAC protocol is not excused from 
reviewing low-income certifications in accordance with paragraphs 
(c)(2)(ii) and (iii) of this section.
    (7) Applicability of reasonable notice limitation when the same 
units are chosen for inspection and file review. If the Agency chooses 
to select the same units for on-site inspections and low-income 
certification review, the Agency must complete both the inspections and 
review before the end of the day on which the units are selected. See 
paragraph (c)(2)(iii)(C)(1) and (2) of this section.
    (D) Method of low-income certification review. The Agency may review 
the low-income certifications wherever the owner maintains or stores the 
records (either on-site or off-site).
    (3) Frequency and form of certification. A monitoring procedure must 
require that the certifications and reviews of Sec.  1.42-5(c)(1) and 
(c)(2)(i) be made at least annually covering each year of the 15-year 
compliance period under section 42(i)(1). The certifications must be 
made under penalties of perjury. A monitoring procedure may require 
certifications and reviews more frequently than every 12 months, 
provided that all months within each 12-month period are subject to 
certification.
    (4) Exception for certain buildings--(i) In general. The review 
requirements under paragraph (c)(2)(ii) of this section may provide that 
owners are not required to submit, and the Agency is not required to 
review, the tenant income certifications, supporting documentation, and 
rent records for buildings financed by the Rural Housing Service (RHS), 
formerly known as Farmers Home Administration, under the section 515 
program, or buildings of which 50 percent or more of the aggregate basis 
(taking into account the building and the land) is financed with the 
proceeds of obligations the interest on which is exempt from tax under 
section 103 (tax-exempt bonds). In order for a monitoring procedure to 
except these buildings, the Agency must meet the requirements of 
paragraph (c)(4)(ii) of this section.
    (ii) Agreement and review. The Agency must enter into an agreement 
with the

[[Page 204]]

RHS or tax-exempt bond issuer. Under the agreement, the RHS or tax-
exempt bond issuer must agree to provide information concerning the 
income and rent of the tenants in the building to the Agency. The Agency 
may assume the accuracy of the information provided by RHS or the tax-
exempt bond issuer without verification. The Agency must review the 
information and determine that the income limitation and rent 
restriction of section 42 (g)(1) and (2) are met. However, if the 
information provided by the RHS or tax-exempt bond issuer is not 
sufficient for the Agency to make this determination, the Agency must 
request the necessary additional income or rent information from the 
owner of the buildings. For example, because RHS determines tenant 
eligibility based on its definition of ``adjusted annual income,'' 
rather than ``annual income'' as defined under Section 8, the Agency may 
have to calculate the tenant's income for section 42 purposes and may 
need to request additional income information from the owner.
    (iii) Example. The exception permitted under paragraph (c)(4)(i) and 
(ii) of this section is illustrated by the following example.

    Example. An Agency selects for review buildings financed by the RHS. 
The Agency has entered into an agreement described in paragraph 
(c)(4)(ii) of this section with the RHS with respect to those buildings. 
In reviewing the RHS-financed buildings, the Agency obtains the tenant 
income and rent information from the RHS for 20 percent of the low-
income units in each of those buildings. The Agency calculates the 
tenant income and rent to determine whether the tenants meet the income 
and rent limitation of section 42 (g)(1) and (2). In order to make this 
determination, the Agency may need to request additional income or rent 
information from the owners of the RHS buildings if the information 
provided by the RHS is not sufficient.

    (5) Agency reports of compliance monitoring activities. The Agency 
must report its compliance monitoring activities annually on Form 8610, 
``Annual Low-Income Housing Credit Agencies Report.''
    (d) Inspection provision--(1) In general. Under the inspection 
provision, the Agency must have the right to perform an on-site 
inspection of any low-income housing project at least through the end of 
the compliance period of the buildings in the project. The inspection 
provision of this paragraph (d) is a separate requirement from any 
tenant file review under paragraph (c)(2)(ii) of this section.
    (2) Inspection standard. For the on-site inspections of buildings 
and low-income units required by paragraph (c)(2)(ii) of this section, 
the Agency must review any local health, safety, or building code 
violations reports or notices retained by the owner under paragraph 
(b)(3) of this section and must determine--
    (i) Whether the buildings and units are suitable for occupancy, 
taking into account local health, safety, and building codes (or other 
habitability standards); or
    (ii) Whether the buildings and units satisfy, as determined by the 
Agency, the uniform physical condition standards for public housing 
established by HUD (24 CFR 5.703). The HUD physical condition standards 
do not supersede or preempt local health, safety, and building codes. A 
low-income housing project under section 42 must continue to satisfy 
these codes and, if the Agency becomes aware of any violation of these 
codes, the Agency must report the violation to the Service. However, 
provided the Agency determines by inspection that the HUD standards are 
met, the Agency is not required under this paragraph (d)(2)(ii) to 
determine by inspection whether the project meets local health, safety, 
and building codes.
    (3) Exception from inspection provision. An Agency is not required 
to inspect a building under this paragraph (d) if the building is 
financed by the RHS under the section 515 program, the RHS inspects the 
building (under 7 CFR part 1930), and the RHS and Agency enter into a 
memorandum of understanding, or other similar arrangement, under which 
the RHS agrees to notify the Agency of the inspection results.
    (4) Delegation. An Agency may delegate inspection under this 
paragraph (d) to an Authorized Delegate retained under paragraph (f) of 
this section. Such Authorized Delegate, which may

[[Page 205]]

include HUD or a HUD-approved inspector, must notify the Agency of the 
inspection results.
    (e) Notification-of-noncompliance provision--(1) In general. Under 
the notification-of-noncompliance provisions, the Agency must be 
required to give the notice described in paragraph (e)(2) of this 
section to the owner of a low-income housing project and the notice 
described in paragraph (e)(3) of this section to the Service.
    (2) Notice to owner. The Agency must be required to provide prompt 
written notice to the owner of a low-income housing project if the 
Agency does not receive the certification described in paragraph (c)(1) 
of this section, or does not receive or is not permitted to inspect the 
tenant income certifications, supporting documentation, and rent records 
described in paragraph (c)(2)(ii) of this section, or discovers by 
inspection, review, or in some other manner, that the project is not in 
compliance with the provisions of section 42.
    (3) Notice to Internal Revenue Service--(i) In general. The Agency 
must be required to file Form 8823, ``Low-Income Housing Credit Agencies 
Report of Noncompliance,'' with the Service no later than 45 days after 
the end of the correction period (as described in paragraph (e)(4) of 
this section, including extensions permitted under that paragraph) and 
no earlier than the end of the correction period, whether or not the 
noncompliance or failure to certify is corrected. The Agency must 
explain on Form 8823 the nature of the noncompliance or failure to 
certify and indicate whether the owner has corrected the noncompliance 
or failure to certify. Any change in either the applicable fraction or 
eligible basis under paragraph (c)(1)(ii) and (vii) of this section, 
respectively, that results in a decrease in the qualified basis of the 
project under section 42 (c)(1)(A) is noncompliance that must be 
reported to the Service under this paragraph (e)(3). If an Agency 
reports on Form 8823 that a building is entirely out of compliance and 
will not be in compliance at any time in the future, the Agency need not 
file Form 8823 in subsequent years to report that building's 
noncompliance. If the noncompliance or failure to certify is corrected 
within 3 years after the end of the correction period, the Agency is 
required to file Form 8823 with the Service reporting the correction of 
the noncompliance or failure to certify.
    (ii) Agency retention of records. An Agency must retain records of 
noncompliance or failure to certify for 6 years beyond the Agency's 
filing of the respective Form 8823. In all other cases, the Agency must 
retain the certifications and records described in paragraph (c) of this 
section for 3 years from the end of the calendar year the Agency 
receives the certifications and records.
    (4) Correction period. The correction period shall be that period 
specified in the monitoring procedure during which an owner must supply 
any missing certifications and bring the project into compliance with 
the provisions of section 42. The correction period is not to exceed 90 
days from the date of the notice to the owner described in paragraph 
(e)(2) of this section. An Agency may extend the correction period for 
up to 6 months, but only if the Agency determines there is good cause 
for granting the extension.
    (f) Delegation of Authority--(1) Agencies permitted to delegate 
compliance monitoring functions--(i) In general. An Agency may retain an 
agent or other private contractor (``Authorized Delegate'') to perform 
compliance monitoring. The Authorized Delegate must be unrelated to the 
owner of any building that the Authorized Delegate monitors. The 
Authorized Delegate may be delegated all of the functions of the Agency, 
except for the responsibility of notifying the Service under paragraphs 
(c)(5) and (e)(3) of this section. For example, the Authorized Delegate 
may be delegated the responsibility of reviewing tenant certifications 
and documentation under paragraph (c) (1) and (2) of this section, the 
right to inspect buildings and records as described in paragraph (d) of 
this section, and the responsibility of notifying building owners of 
lack of certification or noncompliance under paragraph (e)(2) of this 
section. The Authorized Delegate must notify the Agency of any 
noncompliance or failure to certify.

[[Page 206]]

    (ii) Limitations. An Agency that delegates compliance monitoring to 
an Authorized Delegate under paragraph (f)(1)(i) of this section must 
use reasonable diligence to ensure that the Authorized Delegate properly 
performs the delegated monitoring functions. Delegation by an Agency of 
compliance monitoring functions to an Authorized Delegate does not 
relieve the Agency of its obligation to notify the Service of any 
noncompliance of which the Agency becomes aware.
    (2) Agencies permitted to delegate compliance monitoring functions 
to another Agency. An Agency may delegate all or some of its compliance 
monitoring responsibilities for a building to another Agency within the 
State. This delegation may include the responsibility of notifying the 
Service under paragraph (e)(3) of this section.
    (g) Liability. Compliance with the requirements of section 42 is the 
responsibility of the owner of the building for which the credit is 
allowable. The Agency's obligation to monitor for compliance with the 
requirements of section 42 does not make the Agency liable for an 
owner's noncompliance.
    (h) Effective/applicability dates--(1) In general. Allocation plans 
must comply with these regulations by June 30, 1993. The requirement of 
section 42 (m)(1)(B)(iii) that allocation plans contain a procedure for 
monitoring for noncompliance becomes effective on January 1, 1992, and 
applies to buildings for which a low-income housing credit is, or has 
been, allowable at any time. Thus, allocation plans must comply with 
section 42(m)(1)(B)(iii) prior to June 30, 1993, the effective date of 
these regulations. An allocation plan that complies with these 
regulations, with the notice of proposed rulemaking published in the 
Federal Register on December 27, 1991, or with a reasonable 
interpretation of section 42(m)(1)(B)(iii) will satisfy the requirements 
of section 42(m)(1)(B)(iii) for periods before June 30, 1993. Section 
42(m)(1)(B)(iii) and these regulations do not require monitoring for 
whether a building or project is in compliance with the requirements of 
section 42 prior to January 1, 1992. However, if an Agency becomes aware 
of noncompliance that occurred prior to January 1, 1992, the Agency is 
required to notify the Service of that noncompliance. In addition, the 
requirements in paragraphs (b)(3) and (c)(1)(v), (vi), and (xi) of this 
section (involving recordkeeping and annual owner certifications) and 
paragraphs (c)(2)(ii)(B), (c)(2)(iii), and (d) of this section 
(involving tenant file reviews and physical inspections of existing 
projects, and the physical inspection standard) are applicable January 
1, 2001. The requirement in paragraph (c)(2)(ii)(A) of this section 
(involving tenant file reviews and physical inspections of new projects) 
is applicable for buildings placed in service on or after January 1, 
2001. The requirements in paragraph (c)(5) of this section (involving 
Agency reporting of compliance monitoring activities to the Service) and 
paragraph (e)(3)(i) of this section (involving Agency reporting of 
corrected noncompliance or failure to certify within 3 years after the 
end of the correction period) are applicable January 14, 2000.
    (2) Applicability dates. The requirements in paragraphs (c)(2)(ii) 
and (iii) and (c)(3) of this section apply beginning on February 26, 
2019. A state housing credit agency is allowed a reasonable period of 
time to amend its qualified allocation plan, but must amend its 
qualified allocation plan no later than December 31, 2020.

[T.D. 8430, 57 FR 40121, Sept. 2, 1992; 57 FR 57280, Dec. 3, 1992; 58 FR 
7748, Feb. 9, 1993; T.D. 8563, 59 FR 50163, Oct. 3, 1994; T.D. 8859, 65 
FR 2326, Jan. 14, 2000; 65 FR 16317, Mar. 28, 2000; T.D. 9753, 81 FR 
9336, Feb. 25, 2016; T.D. 9848, 84 FR 6079, Feb. 26, 2019]



Sec.  1.42-6  Buildings qualifying for carryover allocations.

    (a) Carryover allocations--(1) In general. A carryover allocation is 
an allocation that meets the requirements of section 42(h)(1)(E) or (F). 
If the requirements of section Sec.  42(h)(1)(E) or (F) that are 
required to be satisfied by the close of a calendar year are not 
satisfied, the allocation is not valid and is treated as if it had not 
been made for that calendar year. For example, if a carryover allocation 
fails to satisfy a requirement in Sec.  1.42-6(d) for making an 
allocation, such as failing to be signed or

[[Page 207]]

dated by an authorized official of an allocating agency by the close of 
a calendar year, the allocation is not valid and is treated as if it had 
not been made for that calendar year.
    (2) 10 percent basis requirement. A carryover allocation may only be 
made with respect to a qualified building. A qualified building is any 
building which is part of a project if, by the date specified under 
paragraph (a)(2)(i) or (ii) of this section, a taxpayer's basis in the 
project is more than 10 percent of the taxpayer's reasonably expected 
basis in the project as of the close of the second calendar year 
following the calendar year the allocation is made. For purposes of 
meeting the 10 percent basis requirement, the determination of whether a 
building is part of a single-building project or multi-building project 
is based on whether the carryover allocation is made under section 
42(h)(1)(E) (building-based allocation) or section 42(h)(1)(F) (project-
based allocation). In the case of a multi-building project that receives 
an allocation under section 42(h)(1)(F), the 10 percent basis 
requirement is satisfied by reference to the entire project.
    (i) Allocation made before July 1. If a carryover allocation is made 
before July 1 of a calendar year, a taxpayer must meet the 10 percent 
basis requirement by the close of that calendar year. If a taxpayer does 
not meet the 10 percent basis requirement by the close of the calendar 
year, the carryover allocation is not valid and is treated as if it had 
not been made.
    (ii) Allocation made after June 30. If a carryover allocation is 
made after June 30 of a calendar year, a taxpayer must meet the 10 
percent basis requirement by the close of the date that is 6 months 
after the date the allocation was made. If a taxpayer does not meet the 
10 percent basis requirement by the close of the required date, the 
carryover allocation must be returned to the Agency. Unlike a carryover 
allocation made before July 1, if a taxpayer does not meet the 10 
percent basis requirement by the close of the required date, the 
carryover allocation is treated as a valid allocation for the calendar 
year of allocation, but is included in the ``returned credit component'' 
for purposes of determining the State housing credit ceiling under 
section 42(h)(3)(C) for the calendar year following the calendar year of 
the allocation. See Sec.  1.42-14(d)(1).
    (b) Carryover-allocation basis--(1) In general. Subject to the 
limitations of paragraph (b)(2) of this section, a taxpayer's basis in a 
project for purposes of section 42(h)(1) (E)(ii) or (F) (carryover-
allocation basis) is the taxpayer's adjusted basis in land or 
depreciable property that is reasonably expected to be part of the 
project, whether or not these amounts are includible in eligible basis 
under section 42(d). Thus, for example, if the project is to include 
property that is not residential rental property, such as commercial 
space, the basis attributable to the commercial space, although not 
includible in eligible basis, is includible in carryover-allocation 
basis. The adjusted basis of land and depreciable property is determined 
under sections 1012 and 1016, and generally includes the direct and 
indirect costs of acquiring, constructing, and rehabilitating the 
property. Costs otherwise includible in carryover-allocation basis are 
not excluded by reason of having been incurred prior to the calendar 
year in which the carryover allocation is made.
    (2) Limitations--For purposes of determining carryover-allocation 
basis under paragraph (b)(1) of this section, the following limitations 
apply.
    (i) Taxpayer must have basis in land or depreciable property related 
to the project. A taxpayer has carryover-allocation basis to the extent 
that it has basis in land or depreciable property and the land or 
depreciable property is reasonably expected to be part of the project 
for which the carryover allocation is made. This basis includes all 
items that are properly capitalizable with respect to the land or 
depreciable property. For example, a nonrefundable downpayment for, or 
an amount paid to acquire an option to purchase, land or depreciable 
property may be included in carryover-allocation basis if properly 
capitalizable into the basis of land or depreciable property that is 
reasonably expected to be part of a project.
    (ii) High cost areas. Any increase in eligible basis that may result 
under

[[Page 208]]

section 42(d)(5)(C) from a building's location in a qualified census 
tract or difficult development area is not taken into account in 
determining carryover-allocation basis or reasonably expected basis.
    (iii) Amounts not treated as paid or incurred. An amount is not 
includible in carryover-allocation basis unless it is treated as paid or 
incurred under the method of accounting used by the taxpayer. For 
example, a cash method taxpayer cannot include construction costs in 
carryover-allocation basis unless the costs have been paid, and an 
accrual method taxpayer cannot include construction costs in carryover- 
allocation basis unless they have been properly accrued. See paragraph 
(b)(2)(iv) of this section for a special rule for fees.
    (iv) Fees. A fee is includible in carryover-allocation basis only to 
the extent the requirements of paragraph (b)(2)(iii) of this section are 
met and--
    (A) The fee is reasonable;
    (B) The taxpayer is legally obligated to pay the fee;
    (C) The fee is capitalizable as part of the taxpayer's basis in land 
or depreciable property that is reasonably expected to be part of the 
project;
    (D) The fee is not paid (or to be paid) by the taxpayer to itself; 
and
    (E) If the fee is paid (or to be paid) by the taxpayer to a related 
person, and the taxpayer uses the cash method of accounting, the 
taxpayer could properly accrue the fee under the accrual method of 
accounting (considering, for example, the rules of section 461(h)). A 
person is a related person if the person bears a relationship to the 
taxpayer specified in sections 267(b) or 707(b)(1), or if the person and 
the taxpayer are engaged in trades or businesses under common control 
(within the meaning of subsections (a) and (b) of section 52).
    (3) Reasonably expected basis. Rules similar to the rules of 
paragraphs (a) and (b) of this section apply in determining the 
taxpayer's reasonably expected basis in a project (land and depreciable 
basis) as of the close of the second calendar year following the 
calendar year of the allocation.
    (4) Examples. The following examples illustrate the rules of 
paragraphs (a) and (b) of this section.

    Example 1. (i) Facts. C, an accrual-method taxpayer, receives a 
carryover allocation from Agency, the state housing credit agency, in 
May of 2003. As of that date, C has not begun construction of the low-
income housing building C plans to build. However, C has owned the land 
on which C plans to build the building since 1985. C's basis in the land 
is $100,000. C reasonably expects that by the end of 2005, C's basis in 
the project of which the building is to be a part will be $2,000,000. C 
also expects that because the project is located in a qualified census 
tract, C will be able to increase its basis in the project to 
$2,600,000. Before the close of 2003, C incurs $150,000 of costs for 
architects' fees and site preparation. C properly accrues these costs 
under its method of accounting and capitalizes the costs.
    (ii) Determination of carryover-allocation basis. C's $100,000 basis 
in the land is includible in carryover-allocation basis even though C 
has owned the land since 1985. The $150,000 of costs C has incurred for 
architects' fees and site preparation are also includible in carryover-
allocation basis. The expected increase in basis due to the project's 
location in a qualified census tract is not taken into account in 
determining C's carryover-allocation basis. Accordingly, C's carryover-
allocation basis in the project of which the building is a part is 
$250,000.
    (iii) Determination of whether building is qualified. C's reasonably 
expected basis in the project at the close of the second calendar year 
following the calendar year of allocation is $2,000,000. The expected 
increase in eligible basis due to the project's location in a qualified 
census tract is not taken into account in determining this amount. 
Because C's carryover-allocation basis is more than 10 percent of C's 
reasonably expected basis in the project of which the building is a 
part, the building for which C received the carryover allocation is a 
qualified building for purposes of section 42(h)(1)(E)(ii) and paragraph 
(a) of this section.
    Example 2. (i) Facts. D, an accrual-method taxpayer, received a 
carryover allocation from Agency, the state housing credit agency of 
State X, on September 12, 2003. As of that date, D has not begun 
construction of the low-income housing building D plans to build and D 
does not have basis in the land on which D plans to build the building. 
From September 12, 2003, to the close of March 12, 2004, D incurs some 
costs related to the planned building, including architects' fees. As of 
the close of March 12, 2004, these costs do not exceed 10 percent of D's 
reasonably expected basis in the single-building project as of the close 
of 2005.
    (ii) Determination of whether building is qualified. Because D's 
carryover-allocation basis as of the close of March 12, 2004, is not 
more than 10 percent of D's reasonably expected basis in the single-
building project,

[[Page 209]]

the building is not a qualified building for purposes of section 
42(h)(1)(E)(ii) and paragraph (a) of this section. Accordingly, the 
carryover allocation to D must be returned to the Agency. The allocation 
is valid for purposes of determining the amount of credit allocated by 
Agency from State X's 2003 State housing credit ceiling, but is included 
in the returned credit component of State X's 2004 housing credit 
ceiling.

    (c) Verification of basis by Agency--(1) Verification requirement. 
An Agency that makes a carryover allocation to a taxpayer must verify 
that the taxpayer has met the 10 percent basis requirement of paragraph 
(a)(2) of this section.
    (2) Manner of verification. An Agency may verify that a taxpayer has 
incurred more than 10 percent of its reasonably expected basis in a 
project by obtaining a certification from the taxpayer, in writing and 
under penalty of perjury, that the taxpayer has incurred by the close of 
the calendar year of the allocation (for allocations made before July 1) 
or by the close of the date that is 6 months after the date the 
allocation is made (for allocations made after June 30) more than 10 
percent of the reasonably expected basis in the project. The 
certification must be accompanied by supporting documentation that the 
Agency must review. Supporting documentation may include, for example, 
copies of checks or other records of payments. Alternatively, an Agency 
may verify that the taxpayer has incurred adequate basis by requiring 
that the taxpayer obtain from an attorney or certified public accountant 
a written certification to the Agency, that the attorney or accountant 
has examined all eligible costs incurred with respect to the project and 
that, based upon this examination, it is the attorney's or accountant's 
belief that the taxpayer has incurred more than 10 percent of its 
reasonably expected basis in the project by the close of the calendar 
year of the allocation (for allocations made before July 1) or by the 
close of the date that is 6 months after the date the allocation is made 
(for allocations made after June 30).
    (3) Time of verification--(i) Allocations made before July 1. For a 
carryover allocation made before July 1, an Agency may require that the 
basis certification be submitted to or received by the Agency prior to 
the close of the calendar year of allocation or within a reasonable time 
following the close of the calendar year of allocation. The Agency will 
need to verify basis as provided in paragraph (c)(2) of this section to 
accurately complete the Form 8610, ``Annual Low-Income Housing Credit 
Agencies Report,'' and the Schedule A (Form 8610), ``Carryover 
Allocation of Low-Income Housing Credit,'' for the calendar year of the 
allocation. If the basis certification is not timely made, or supporting 
documentation is lacking, inadequate, or does not actually support the 
certification, the Agency should notify the taxpayer and try to get 
adequate documentation. If the Agency cannot verify before the Form 8610 
is filed that the taxpayer has satisfied the 10 percent basis 
requirement for a carryover allocation made before July 1, the 
allocation is not valid and is treated as if it had not been made and 
the carryover allocation should not be reported on the Schedule A (Form 
8610).
    (ii) Allocations made after June 30. An Agency may require that the 
basis certification be submitted to or received by the Agency prior to 
the close of the date that is 6 months after the date the allocation was 
made or within a reasonable period of time following the close of the 
date that is 6 months after the date the allocation was made. The Agency 
will need to verify basis as provided in paragraph (c)(2) of this 
section. If the basis certification is not timely made, or supporting 
documentation is lacking, inadequate, or does not actually support the 
certification, the Agency should notify the taxpayer and try to get 
adequate documentation. If the Agency cannot verify that the taxpayer 
has satisfied the 10 percent basis requirement for a carryover 
allocation made after June 30, the allocation must be returned to the 
Agency. The carryover allocation is a valid allocation for the calendar 
year of the allocation, but is included in the returned credit component 
of the State housing credit ceiling for the calendar year following the 
calendar year of the allocation.
    (d) Requirements for making carryover allocations--(1) In general. 
Generally, an allocation is made when an Agency issues the Form 8609, 
`Low-Income

[[Page 210]]

Housing Credit Allocation Certification,' for a building. See Sec.  
1.42-1T(d)(8)(ii). An Agency does not issue the Form 8609 for a building 
until the building is placed in service. However, in cases where 
allocations of credit are made pursuant to section 42(h)(1)(E) (relating 
to carryover allocations for buildings) or section 42(h)(1)(F) (relating 
to carryover allocations for multiple-building projects), Form 8609 is 
not used as the allocating document because the buildings are not yet in 
service. When an allocation is made pursuant to section 42(h)(1) (E) or 
(F), the allocating document is the document meeting the requirements of 
paragraph (d)(2) of this section. In addition, when an allocation is 
made pursuant to section 42(h)(1)(F), the requirements of paragraph 
(d)(3) of this section must be met for the allocation to be valid. An 
allocation pursuant to section 42(h)(1) (E) or (F) reduces the state 
housing credit ceiling for the year in which the allocation is made, 
whether or not the Form 8609 is also issued in that year.
    (2) Requirements for allocation. An allocation pursuant to section 
42(h)(1) (E) or (F) is made when an allocation document containing the 
following information is completed, signed, and dated by an authorized 
official of the Agency--
    (i) The address of each building in the project, or if none exists, 
a specific description of the location of each building;
    (ii) The name, address, and taxpayer identification number of the 
taxpayer receiving the allocation;
    (iii) The name and address of the Agency;
    (iv) The taxpayer identification number of the Agency;
    (v) The date of the allocation;
    (vi) The housing credit dollar amount allocated to the building or 
project, as applicable;
    (vii) The taxpayer's reasonably expected basis in the project (land 
and depreciable basis) as of the close of the second calendar year 
following the calendar year in which the allocation is made;
    (viii) For carryover allocations made before July 1, the taxpayer's 
basis in the project (land and depreciable basis) as of the close of the 
calendar year of the allocation and the percentage that basis bears to 
the reasonably expected basis in the project (land and depreciable 
basis) as of the close of the second calendar year following the 
calendar year of allocation;
    (ix) The date that each building in the project is expected to be 
placed in service; and
    (x) The Building Identification Number (B.I.N.) to be assigned to 
each building in the project. The B.I.N. must reflect the year an 
allocation is first made to the building, regardless of the year that 
the building is placed in service. This B.I.N. must be used for all 
allocations of credit for the building. For example, rehabilitation 
expenditures treated as a separate new building under section 42(e) 
should not have a separate B.I.N. if the building to which the 
rehabilitation expenditures are made has a B.I.N. In this case, the 
B.I.N. used for the rehabilitation expenditures shall be the B.I.N. 
previously assigned to the building, although the rehabilitation 
expenditures must have a separate Form 8609 for the allocation. 
Similarly, a newly constructed building that receives an allocation of 
credit in different calendar years must have a separate Form 8609 for 
each allocation. The B.I.N. assigned to the building for the first 
allocation must be used for the subsequent allocation.
    (3) Special rules for project-based allocations--(i) In general. An 
allocation pursuant to section 42(h)(1)(F) (a project-based allocation) 
must meet the requirements of this section as well as the requirements 
of section 42(h)(1)(F), including the minimum basis requirement of 
section 42(h)(1)(E)(ii).
    (ii) Requirement of section 42(h)(1)(F)(i)(III). An allocation 
satisfies the requirement of section 42(h)(1)(F)(i)(III) if the Form 
8609 that is issued for each building that is placed in service in the 
project states the portion of the project-based allocation that is 
applied to that building.
    (4) Recordkeeping requirements--(i) Taxpayer. When an allocation is 
made pursuant to section 42(h)(1)(E) or (F), the taxpayer must retain a 
copy of the allocation document. The Form 8609

[[Page 211]]

that reflects the allocation must be filed for the first taxable year 
that the credit is claimed and for each taxable year thereafter 
throughout the compliance period, whether or not a credit is claimed for 
the taxable year.
    (ii) Agency. The Agency must retain the original carryover 
allocation document made under paragraph (d)(2) of this section and file 
Schedule A (Form 8610) with the Agency's Form 8610 for the year the 
allocation is made. The Agency must also retain a copy of the Form 8609 
that is issued to the taxpayer and file the original with the Agency's 
Form 8610 that reflects the year the form is issued.
    (5) Separate procedure for election of appropriate percentage month. 
If a taxpayer receives an allocation under section 42(h)(1) (E) or (F) 
and wishes to elect under section 42(b)(2)(A)(ii) to use the appropriate 
percentage for a month other than the month in which a building is 
placed in service, the requirements specified in Sec.  1.42-8 must be 
met for the election to be effective.
    (e) Special rules. The following rules apply for purposes of this 
section.
    (1) Treatment of partnerships and other flow-through entities. With 
respect to taxpayers that own projects through partnerships or other 
flow-through entities (e.g., S corporations, estates, or trusts), 
carryover-allocation basis is determined at the entity level using the 
rules provided by this section. In addition, the entity is responsible 
for providing to the Agency the certification and documentation required 
under the basis verification requirement in paragraph (c) of this 
section.
    (2) Transferees. If land or depreciable property that is expected to 
be part of a project is transferred after a carryover allocation has 
been made for a building that is reasonably expected to be part of the 
project, but before the close of the calendar year of the allocation 
(for allocations made before July 1) or by the close of the date that is 
6 months after the date the allocation is made (for allocations made 
after June 30), the transferee's carryover-allocation basis is 
determined under the principles of this section and section 42(d)(7). 
See also Rev. Rul. 91-38, 1991-2 C.B. 3 (see Sec.  601.601(d)(2)(ii)(b) 
of this chapter). In addition, the transferee is treated as the taxpayer 
for purposes of the basis verification requirement of this section, and 
therefore, is responsible for providing to the Agency the required 
certifications and documentation.

[T.D. 8520, 59 FR 10069, Mar. 3, 1994, as amended by T.D. 8859, 65 FR 
2328, Jan. 14, 2000; 65 FR 16317, Mar. 28, 2000; T.D. 9110, 69 FR 502, 
Jan. 6, 2004]



Sec.  1.42-7  Substantially bond-financed buildings. [Reserved]



Sec.  1.42-8  Election of appropriate percentage month.

    (a) Election under section 42(b)(2)(A)(ii)(I) to use the appropriate 
percentage for the month of a binding agreement--(1) In general. For 
purposes of section 42(b)(2)(A)(ii)(I), an agreement between a taxpayer 
and an Agency as to the housing credit dollar amount to be allocated to 
a building is considered binding if it--
    (i) Is in writing;
    (ii) Is binding under state law on the Agency, the taxpayer, and all 
successors in interest;
    (iii) Specifies the type(s) of building(s) to which the housing 
credit dollar amount applies (i.e., a newly constructed or existing 
building, or substantial rehabilitation treated as a separate new 
building under section 42(e));
    (iv) Specifies the housing credit dollar amount to be allocated to 
the building(s); and
    (v) Is dated and signed by the taxpayer and the Agency during the 
month in which the requirements of paragraphs (a)(1) (i) through (iv) of 
this section are met.
    (2) Effect on state housing credit ceiling. Generally, a binding 
agreement described in paragraph (a)(1) of this section is an agreement 
by the Agency to allocate credit to the taxpayer at a future date. The 
binding agreement may include a reservation of credit or a binding 
commitment (under section 42(h)(1)(C)) to allocate credit in a future 
taxable year. A reservation or a binding commitment to allocate credit 
in a future year has no effect on the state housing credit ceiling until 
the year the Agency actually makes an allocation. However, if the 
binding agreement is also a carryover allocation

[[Page 212]]

under section 42(h)(1) (E) or (F), the state housing credit ceiling is 
reduced by the amount allocated by the Agency to the taxpayer in the 
year the carryover allocation is made. For a binding agreement to be a 
valid carryover allocation, the requirements of paragraph (a)(1) of this 
section and Sec.  1.42-6 must be met.
    (3) Time and manner of making election. An election under section 
42(b)(2)(A)(ii)(I) may be made either as part of the binding agreement 
under paragraph (a)(1) of this section to allocate a specific housing 
credit dollar amount or in a separate document that references the 
binding agreement. In either case, the election must--
    (i) Be in writing;
    (ii) Reference section 42(b)(2)(A)(ii)(I);
    (iii) Be signed by the taxpayer;
    (iv) If it is in a separate document, reference the binding 
agreement that meets the requirements of paragraph (a)(1) of this 
section; and
    (v) Be notarized by the 5th day following the end of the month in 
which the binding agreement was made.
    (4) Multiple agreements--(i) Rescinded agreements. A taxpayer may 
not make an election under section 42(b)(2)(A)(ii)(I) for a building if 
an election has previously been made for the building for a different 
month. For example, assume a taxpayer entered into a binding agreement 
for allocation of a specific housing credit dollar amount to a building 
and made the election under section 42(b)(2)(A)(ii)(I) to apply the 
appropriate percentage for the month of the binding agreement. If the 
binding agreement subsequently is rescinded under state law, and the 
taxpayer enters into a new binding agreement for allocation of a 
specific housing credit dollar amount to the building, the taxpayer must 
apply to the building the appropriate percentage for the elected month 
of the rescinded binding agreement. However, if no prior election was 
made with respect to the rescinded binding agreement, the taxpayer may 
elect the appropriate percentage for the month of the new binding 
agreement.
    (ii) Increases in credit. The election under section 
42(b)(2)(A)(ii)(I), once made, applies to any increase in the credit 
amount allocated for a building, whether the increase occurs in the same 
or in a subsequent year. However, in the case of a binding agreement (or 
carryover allocation that is treated as a binding agreement) to allocate 
a credit amount under section 42(e)(1) for substantial rehabilitation 
treated as a separate new building, a taxpayer may make the election 
under section 42(b)(2)(A)(ii)(I) notwithstanding that a prior election 
under section 42(b)(2)(A)(ii)(I) is in effect for a prior allocation of 
credit for a substantial rehabilitation that was previously placed in 
service under section 42(e).
    (5) Amount allocated. The housing credit dollar amount eventually 
allocated to a building may be more or less than the amount specified in 
the binding agreement. Depending on the Agency's determination pursuant 
to section 42(m)(2) as to the financial feasibility of the building (or 
project), the Agency may allocate a greater housing credit dollar amount 
to the building (provided that the Agency has additional housing credit 
dollar amounts available to allocate for the calendar year of the 
allocation) or the Agency may allocate a lesser housing credit dollar 
amount. Under section 42(h)(7)(D), in allocating a housing credit dollar 
amount, the Agency must specify the applicable percentage and maximum 
qualified basis of the building. The applicable percentage may be less, 
but not greater than, the appropriate percentage for the month the 
building is placed in service, or the month elected by the taxpayer 
under section 42(b)(2)(A)(ii)(I). Whether the appropriate percentage is 
the appropriate percentage for the 70-percent present value credit or 
the 30-percent present value credit is determined under section 42(i)(2) 
when the building is placed in service.
    (6) Procedures--(i) Taxpayer. The taxpayer must give the original 
notarized election statement to the Agency before the close of the 5th 
calendar day following the end of the month in which the binding 
agreement is made. The taxpayer must retain a copy of the binding 
agreement and the election statement.
    (ii) Agency. The Agency must retain the original of the binding 
agreement

[[Page 213]]

and election statement and, to the extent required by Schedule A (Form 
8610), ``Carryover Allocation of Low-Income Housing Credit,'' account 
for the binding agreement and election statement on that schedule.
    (7) Examples. The following examples illustrate the provisions of 
this section. In each example, X is the taxpayer, Agency is the state 
housing credit agency, and the carryover allocations meet the 
requirements of Sec.  1.42-6 and are otherwise valid.

    Example 1. (i) In August 2003, X and Agency enter into an agreement 
that Agency will allocate $100,000 of housing credit dollar amount for 
the low-income housing building X is constructing. The agreement is 
binding and meets all the requirements of paragraph (a)(1) of this 
section. The agreement is a reservation of credit, not an allocation, 
and therefore, has no effect on the state housing credit ceiling. On or 
before September 5, 2003, X signs and has notarized a written election 
statement that meets the requirements of paragraph (a)(3) of this 
section. The applicable percentage for the building is the appropriate 
percentage for the month of August 2003.
    (ii) Agency makes a carryover allocation of $100,000 of housing 
credit dollar amount for the building on October 2, 2003. The carryover 
allocation reduces Agency's state housing credit ceiling for 2003. Due 
to unexpectedly high construction costs, when X places the building in 
service in July 2004, the product of the building's qualified basis and 
the applicable percentage for the building (the appropriate percentage 
for the month of August 2003) is $150,000, rather than $100,000. 
Notwithstanding that only $100,000 of credit was allocated for the 
building in 2003, Agency may allocate an additional $50,000 of housing 
credit dollar amount for the building from its state housing credit 
ceiling for 2004. The appropriate percentage for the month of August 
2003 is the applicable percentage for the building for the entire 
$150,000 of credit allocated for the building, even though separate 
allocations were made in 2003 and 2004. Because allocations were made 
for the building in two separate calendar years, Agency must issue two 
Forms 8609, ``Low-Income Housing Credit Allocation Certification,'' to 
X. One Form 8609 must reflect the $100,000 allocation made in 2003, and 
the other Form 8609 must reflect the $50,000 allocation made in 2004.
    (iii) X gives the original notarized statement to Agency on or 
before September 5, 2003, and retains a copy of the binding agreement, 
election statement, and carryover allocation document.
    (iv) Agency retains the original of the binding agreement, election 
statement, and 2003 carryover allocation document. Agency accounts for 
the binding agreement, election statement, and 2003 carryover allocation 
on the Schedule A (Form 8610) that it files for the 2003 calendar year. 
After the building is placed in service in 2004, and assuming other 
necessary requirements for issuing a Form 8609 are met (for example, 
taxpayer has certified all sources and uses of funds and development 
costs for the building under Sec.  1.42-17), Agency issues to X a copy 
of the Form 8609 reflecting the 2003 carryover allocation of $100,000. 
Agency files the original of this Form 8609 with the Form 8610, ``Annual 
Low-Income Housing Credit Agencies Report,'' that it files for the 2004 
calendar year. Agency also issues to X a copy of the Form 8609 
reflecting the 2004 allocation of $50,000 and files the original of this 
Form 8609 with the Form 8610 that it files for the 2004 calendar year. 
Agency retains copies of the Forms 8609 that are issued to X.
    Example 2. (i) In September 2003, X and Agency enter into an 
agreement that Agency will allocate $70,000 of housing credit dollar 
amount for rehabilitation expenditures that X is incurring and that X 
will treat as a new low-income housing building under section 42(e)(1). 
The agreement is binding and meets all the requirements of paragraph 
(a)(1) of this section. The agreement is a reservation of credit, not an 
allocation, and therefore, has no effect on Agency's state housing 
credit ceiling. On or before October 5, 2003, X signs and has notarized 
a written election statement that meets the requirements of paragraph 
(a)(3) of this section. The applicable percentage for the building is 
the appropriate percentage for the month of September 2003. Agency makes 
a carryover allocation of $70,000 of housing credit dollar amount for 
the building on November 15, 2003. The carryover allocation reduces by 
$70,000 Agency's state housing credit ceiling for 2003.
    (ii) In October 2004, X and Agency enter into another binding 
agreement meeting the requirements of paragraph (a)(1) of this section. 
Under the agreement, Agency will allocate $50,000 of housing credit 
dollar amount for additional rehabilitation expenditures by X that 
qualify as a second separate new building under section 42(e)(1). On or 
before November 5, 2004, X signs and has notarized a written election 
statement meeting the requirements of paragraph (a)(3) of this section. 
On December 1, 2004, X receives a carryover allocation under section 
42(h)(1)(E) for $50,000. The carryover allocation reduces by $50,000 
Agency's state housing credit ceiling for 2004. The applicable 
percentage for the rehabilitation expenditures treated as the second 
separate new building is the appropriate percentage for the month of 
October 2004,

[[Page 214]]

not September 2003. The appropriate percentage for the month of 
September 2003 still applies to the allocation of $70,000 for the 
rehabilitation expenditures treated as the first separate new building. 
Because allocations were made for the building in two separate calendar 
years, Agency must issue two Forms 8609 to X. One Form 8609 must reflect 
the $70,000 allocation made in 2003, and the other Form 8609 must 
reflect the $50,000 allocation made in 2004.
    (iii) X gives the first original notarized statement to Agency on or 
before October 5, 2003, and retains a copy of the first binding 
agreement, election statement, and carryover allocation document issued 
in 2003. X gives the second original notarized statement to Agency on or 
before November 5, 2004, and retains a copy of the second binding 
agreement, election statement, and carryover allocation document issued 
in 2004.
    (iv) Agency retains the original of the binding agreements, election 
statements, and carryover allocation documents. Agency accounts for the 
binding agreement, election statement, and 2003 carryover allocation on 
the Schedule A (Form 8610) that it files for the 2003 calendar year. 
Agency also accounts for the binding agreement, election statement, and 
2004 carryover allocation on the Schedule A (Form 8610) that it files 
for the 2004 calendar year. After each separate new building is placed 
in service, and assuming other necessary requirements for issuing a Form 
8609 are met (for example, taxpayer has certified all sources and uses 
of funds and development costs for the building under Sec.  1.42-17), 
the Agency will issue to X a copy of the Form 8609 reflecting the 2003 
carryover allocation of $70,000 and a copy of the Form 8609 reflecting 
the 2004 carryover allocation of $50,000, respectively. Agency files the 
original of each Form 8609 with the Form 8610 that reflects the calendar 
year each Form 8609 is issued. Agency retains copies of the Forms 8609 
that are issued to X.

    (b) Election under section 42(b)(2)(A)(ii)(II) to use the 
appropriate percentage for the month tax-exempt bonds are issued--(1) 
Time and manner of making election. In the case of any building to which 
section 42(h)(4)(B) applies, an election under section 
42(b)(2)(A)(ii)(II) to use the appropriate percentage for the month tax-
exempt bonds are issued must--
    (i) Be in writing;
    (ii) Reference section 42(b)(2)(A)(ii)(II);
    (iii) Specify the percentage of the aggregate basis of the building 
and the land on which the building is located that is financed with the 
proceeds of obligations described in section 42(h)(4)(A) (tax-exempt 
bonds);
    (iv) State the month in which the tax-exempt bonds are issued;
    (v) State that the month in which the tax-exempt bonds are issued is 
the month elected for the appropriate percentage to be used for the 
building;
    (vi) Be signed by the taxpayer; and
    (vii) Be notarized by the 5th day following the end of the month in 
which the bonds are issued.
    (2) Bonds issued in more than one month. If a building described in 
section 42(h)(4)(B) (substantially bond-financed building) is financed 
with tax-exempt bonds issued in more than one month, the taxpayer may 
elect the appropriate percentage for any month in which the bonds are 
issued. Once the election is made, the appropriate percentage elected 
applies for the building even if all bonds are not issued in that month. 
The requirements of this paragraph (b), including the time limitation 
contained in paragraph (b)(1)(vii) of this section, must also be met.
    (3) Limitations on appropriate percentage. Under section 
42(m)(2)(D), the credit allowable for a substantially bond- financed 
building is limited to the amount necessary to assure the project's 
feasibility. Accordingly, in making the determination under section 
42(m)(2), an Agency may use an applicable percentage that is less, but 
not greater than, the appropriate percentage for the month the building 
is placed in service, or the month elected by the taxpayer under section 
42(b)(2)(A)(ii)(II).
    (4) Procedures--(i) Taxpayer. The taxpayer must provide the original 
notarized election statement to the Agency before the close of the 5th 
calendar day following the end of the month in which the bonds are 
issued. If an authority other than the Agency issues the tax-exempt 
bonds, the taxpayer must also give the Agency a signed statement from 
the issuing authority that certifies the information described in 
paragraphs (b)(1)(iii) and (iv) of this section. The taxpayer must also 
retain a copy of the election statement.
    (ii) Agency. The Agency must retain the original of the election 
statement

[[Page 215]]

and a copy of the Form 8609 that reflects the election statement. The 
Agency must file an additional copy of the Form 8609 with the Agency's 
Form 8610 that reflects the calendar year the Form 8609 is issued.

[T.D. 8520, 59 FR 10071, Mar. 3, 1994, as amended by T.D. 9110, 69 FR 
504, Jan. 6, 2004]



Sec.  1.42-9  For use by the general public.

    (a) General rule. If a residential rental unit in a building is not 
for use by the general public, the unit is not eligible for a section 42 
credit. A residential rental unit is for use by the general public if 
the unit is rented in a manner consistent with housing policy governing 
non-discrimination, as evidenced by rules or regulations of the 
Department of Housing and Urban Development (HUD) (24 CFR subtitle A and 
chapters I through XX). See HUD Handbook 4350.3 (or its successor). A 
copy of HUD Handbook 4350.3 may be requested by writing to: HUD, 
Directives Distribution Section, room B-100, 451 7th Street, SW., 
Washington, DC 20410.
    (b) Limitations. Notwithstanding paragraph (a) of this section, if a 
residential rental unit is provided only for a member of a social 
organization or provided by an employer for its employees, the unit is 
not for use by the general public and is not eligible for credit under 
section 42. In addition, any residential rental unit that is part of a 
hospital, nursing home, sanitarium, lifecare facility, trailer park, or 
intermediate care facility for the mentally and physically handicapped 
is not for use by the general public and is not eligible for credit 
under section 42.
    (c) Treatment of units not for use by the general public. The costs 
attributable to a residential rental unit that is not for use by the 
general public are not excludable from eligible basis by reason of the 
unit's ineligibility for the credit under this section. However, in 
calculating the applicable fraction, the unit is treated as a 
residential rental unit that is not a low-income unit.

[T.D. 8520, 59 FR 10073, Mar. 3, 1994]



Sec.  1.42-10  Utility allowances.

    (a) Inclusion of utility allowances in gross rent. If the cost of 
any utility (other than telephone, cable television, or Internet) for a 
residential rental unit is paid directly by the tenant(s), and not by or 
through the owner of the building, the gross rent for that unit includes 
the applicable utility allowance determined under this section. For 
purposes of the preceding sentence, if the cost of a particular utility 
for a residential unit is paid pursuant to an actual-consumption 
submetering arrangement within the meaning of paragraph (e)(1) of this 
section, then that cost is treated as being paid directly by the 
tenant(s) and not by or through the owner of the building. This section 
only applies for purposes of determining gross rent under section 
42(g)(2)(B)(ii) as to rent-restricted units.
    (b) Applicable utility allowances--(1) Buildings assisted by the 
Rural Housing Service. If a building receives assistance from the Rural 
Housing Service (RHS-assisted building), the applicable utility 
allowance for all rent-restricted units in the building is the utility 
allowance determined under the method prescribed by the Rural Housing 
Service (RHS) for the building (whether or not the building or its 
tenants also receive other state or federal assistance).
    (2) Buildings with Rural Housing Service assisted tenants. If any 
tenant in a building receives RHS rental assistance payments (RHS tenant 
assistance), the applicable utility allowance for all rent-restricted 
units in the building (including any units occupied by tenants receiving 
rental assistance payments from the Department of Housing and Urban 
Development (HUD)) is the applicable RHS utility allowance.
    (3) Buildings regulated by the Department of Housing and Urban 
Development. If neither a building nor any tenant in the building 
receives RHS housing assistance, and the rents and utility allowances of 
the building are regulated by HUD (HUD-regulated buildings), the 
applicable utility allowance for all rent-restricted units in the 
building is the applicable HUD utility allowance.
    (4) Other buildings. If a building is neither an RHS-assisted nor a 
HUD-regulated building, and no tenant in the building receives RHS 
tenant assistance, the applicable utility allowance for rent-restricted 
units in the

[[Page 216]]

building is determined under the following methods.
    (i) Tenants receiving HUD rental assistance. The applicable utility 
allowance for any rent-restricted units occupied by tenants receiving 
HUD rental assistance payments (HUD tenant assistance) is the applicable 
Public Housing Authority (PHA) utility allowance established for the 
Section 8 Existing Housing Program.
    (ii) Other tenants--(A) General rule. If none of the rules of 
paragraphs (b)(1), (2), (3), and (4)(i) of this section apply to 
determine the appropriate utility allowance for a rent-restricted unit, 
then the appropriate utility allowance for the unit is the applicable 
PHA utility allowance. However, if a local utility company estimate is 
obtained for any unit in the building in accordance with paragraph 
(b)(4)(ii)(B) of this section, that estimate becomes the appropriate 
utility allowance for all rent-restricted units of similar size and 
construction in the building. This local utility company estimate 
procedure is not available for and does not apply to units to which the 
rules of paragraphs (b) (1), (2), (3), or (4)(i) of this section apply. 
However, if a local utility company estimate is obtained for any unit in 
the building under paragraph (b)(4)(ii)(B) of this section, a State or 
local housing credit agency (Agency) provides a building owner with an 
estimate for any unit in a building under paragraph (b)(4)(ii)(C) of 
this section, a cost estimate is calculated using the HUD Utility 
Schedule Model under paragraph (b)(4)(ii)(D) of this section, or a cost 
estimate is calculated by an energy consumption model under paragraph 
(b)(4)(ii)(E) of this section, then the estimate under paragraph 
(b)(4)(ii)(B), (C), (D), or (E) becomes the applicable utility allowance 
for all rent-restricted units of similar size and construction in the 
building. Paragraphs (b)(4)(ii)(B), (C), (D), and (E) of this section do 
not apply to units to which the rules of paragraphs (b)(1), (2), (3), or 
(4)(i) of this section apply.
    (B) Utility company estimate. Any interested party (including a low-
income tenant, a building owner, or an Agency) may obtain a local 
utility company estimate for a unit. The estimate is obtained when the 
interested party receives, in writing, information from a local utility 
company providing the estimated cost of that utility for a unit of 
similar size and construction for the geographic area in which the 
building containing the unit is located. In the case of deregulated 
utility services, the interested party is required to obtain an estimate 
only from one utility company even if multiple companies can provide the 
same utility service to a unit. However, the utility company must offer 
utility services to the building in order for that utility company's 
rates to be used in calculating utility allowances. The estimate should 
include all component deregulated charges for providing the utility 
service. The local utility company estimate may be obtained by an 
interested party at any time during the building's extended use period 
(see section 42(h)(6)(D)) or, if the building does not have an extended 
use period, during the building's compliance period (see section 
42(i)(1)). Unless the parties agree otherwise, costs incurred in 
obtaining the estimate are borne by the initiating party. The interested 
party that obtains the local utility company estimate (the initiating 
party) must retain the original of the utility company estimate and must 
furnish a copy of the local utility company estimate to the owner of the 
building (where the initiating party is not the owner), and the Agency 
that allocated credit to the building (where the initiating party is not 
the Agency). The owner of the building must make available copies of the 
utility company estimate to the tenants in the building.
    (C) Agency estimate. A building owner may obtain a utility estimate 
for each unit in the building from the Agency that has jurisdiction over 
the building provided the Agency agrees to provide the estimate. The 
estimate is obtained when the building owner receives, in writing, 
information from the Agency providing the estimated per-unit cost of the 
utilities for units of similar size and construction for the geographic 
area in which the building containing the units is located. The Agency 
estimate may be obtained by a building owner at any time during the 
building's extended use period (see section 42(h)(6)(D)). Costs incurred 
in obtaining

[[Page 217]]

the estimate are borne by the building owner. In establishing an 
accurate utility allowance estimate for a particular building, an Agency 
(or an agent or other private contractor of the Agency that is a 
qualified professional within the meaning of paragraph (b)(4)(ii)(E) of 
this section) must take into account, among other things, local utility 
rates, property type, climate and degree-day variables by region in the 
State, taxes and fees on utility charges, building materials, and 
mechanical systems. If the Agency uses an agent or other private 
contractor to calculate the utility estimates, the agent or contractor 
and the owner must not be related within the meaning of section 267(b) 
or 707(b). An Agency may also use actual utility company usage data and 
rates for the building. However, use of the Agency estimate is limited 
to the building's consumption data for the twelve-month period ending no 
earlier than 60 days prior to the beginning of the 90-day period under 
paragraph (c)(1) of this section and utility rates used for the Agency 
estimate must be no older than the rates in place 60 days prior to the 
beginning of the 90-day period under paragraph (c)(1) of this section. 
In the case of newly constructed or renovated buildings with less than 
12 months of consumption data, the Agency (or an agent or other private 
contractor of the Agency that is a qualified professional within the 
meaning of paragraph (b)(4)(ii)(E) of this section) may use consumption 
data for the 12-month period of units of similar size and construction 
in the geographic area in which the building containing the units is 
located.
    (D) HUD Utility Schedule Model. A building owner may calculate a 
utility estimate using the ``HUD Utility Schedule Model'' that can be 
found on the Low-Income Housing Tax Credits page at http://
www.huduser.org/datasets/lihtc.html (or successor URL). Utility rates 
used for the HUD Utility Schedule Model must be no older than the rates 
in place 60 days prior to the beginning of the 90-day period under 
paragraph (c)(1) of this section.
    (E) Energy consumption model. A building owner may calculate utility 
estimates using an energy and water and sewage consumption and analysis 
model (energy consumption model). The energy consumption model must, at 
a minimum, take into account specific factors including, but not limited 
to, unit size, building orientation, design and materials, mechanical 
systems, appliances, characteristics of the building location, and 
available historical data. The utility consumption estimates must be 
calculated by a properly licensed engineer or other qualified 
professional. The qualified professional and the building owner must not 
be related within the meaning of section 267(b) or 707(b). If a 
qualified professional is not a properly licensed engineer and if the 
building owner wants to utilize that qualified professional to calculate 
utility consumption estimates, then the owner must obtain approval from 
the Agency that has jurisdiction over the building. Further, regardless 
of the type of qualified professional, the Agency may approve or 
disapprove of the energy consumption model or require information before 
permitting its use. In addition, utility rates used for the energy 
consumption model must be no older than the rates in place 60 days prior 
to the beginning of the 90-day period under paragraph (c)(1) of this 
section.
    (c) Changes in applicable utility allowance--(1) In general. If, at 
any time during the building's extended use period (as defined in 
section 42(h)(6)(D)), the applicable utility allowance for units 
changes, the new utility allowance must be used to compute gross rents 
of the units due 90 days after the change (the 90-day period). For 
example, if rent must be lowered because a local utility company 
estimate is obtained that shows a higher utility cost than the otherwise 
applicable PHA utility allowance, the lower rent must be in effect for 
rent due at the end of the 90-day period. A building owner using a 
utility company estimate under paragraph (b)(4)(ii)(B) of this section, 
the HUD Utility Schedule Model under paragraph (b)(4)(ii)(D) of this 
section, or an energy consumption model under paragraph (b)(4)(ii)(E) of 
this section must submit copies of the utility estimates to the Agency 
that has jurisdiction over the building and make the estimates available 
to all tenants in the

[[Page 218]]

building at the beginning of the 90-day period before the utility 
allowances can be used in determining the gross rent of rent-restricted 
units. An Agency may require additional information from the owner 
during the 90-day period. Any utility estimates obtained under the 
Agency estimate under paragraph (b)(4)(ii)(C) of this section must also 
be made available to all tenants in the building at the beginning of the 
90-day period. The building owner must pay for all costs incurred in 
obtaining the estimates under paragraphs (b)(4)(ii)(B), (C), (D), and 
(E) of this section and providing the estimates to the Agency and the 
tenants. The building owner is not required to review the utility 
allowances, or implement new utility allowances, until the building has 
achieved 90 percent occupancy for a period of 90 consecutive days or the 
end of the first year of the credit period, whichever is earlier.
    (2) Annual review. A building owner must review at least once during 
each calendar year the basis on which utility allowances have been 
established and must update the applicable utility allowance in 
accordance with paragraph (c)(1) of this section. The review must take 
into account any changes to the building such as any energy conservation 
measures that affect energy consumption and changes in utility rates.
    (d) Record retention. The building owner must retain any utility 
consumption estimates and supporting data as part of the taxpayer's 
records for purposes of Sec.  1.6001-1(a).
    (e) Actual-consumption submetering arrangements--(1) Definition. For 
purposes of this section, an actual-consumption submetering arrangement 
for a utility in a residential unit possesses all of the following 
attributes:
    (i) The utility consumed in the unit is described in paragraph 
(e)(1)(i)(A) or (e)(1)(i)(B) of this section;
    (A) The utility is purchased from or through a local utility company 
by the building owner (or its agent or other party acting on behalf of 
the building owner).
    (B) The utility is not purchased from or through a local utility 
company and is produced from a renewable source (within the meaning of 
paragraph (e)(1)(i)(C) of this section).
    (C) For purposes of paragraph (e)(1)(i)(B) of this section, a 
utility is produced from a renewable source if--
    (1) It is energy that is produced from energy property described in 
section 48;
    (2) It is energy that is produced from a facility described in 
section 45(d)(1), (2), (3), (4), (6), (9), or (11); or
    (3) It is a utility that is described in guidance published for this 
purpose in the Internal Revenue Bulletin (see Sec.  601.601(d)(2)(ii) of 
this chapter).
    (D) Determinations under paragraphs (e)(1)(i)(C)(1) and (2) of this 
section take into account only the manner in which the energy is 
produced and not who owns the energy property or the facility or whether 
the applicability of relevant portions of sections 45 and 48 has 
expired.
    (ii) The tenants in the unit are billed for, and pay the building 
owner (or its agent or other party acting on behalf of the building 
owner) for, the unit's consumption of the utility;
    (iii) The billed amount reflects the unit's actual consumption of 
the utility. In the case of sewerage charges, however, if the unit's 
sewerage charges are combined on the bill with water charges and the 
sewerage charges are determined based on the actual water consumption of 
the unit, then the bill is treated as reflecting the actual sewerage 
consumption of the unit; and
    (iv) The rate at which the building owner bills for the utility 
satisfies the following requirements:
    (A) To the extent that the utility consumed is described in 
paragraph (e)(1)(i)(A) of this section, the utility rate charged to the 
tenants of the unit does not exceed the rate incurred by the building 
owner for that utility; and
    (B) To the extent that the utility consumed is described in 
paragraph (e)(1)(i)(B) of this section, the utility rate charged to the 
tenants of the unit does not exceed the highest rate that the tenants 
would have paid if they had obtained the utility from a local utility 
company. In determining whether a rate satisfies the preceding sentence, 
a building owner may rely on the rates published by local utility 
companies.

[[Page 219]]

    (2) Administrative fees. If the owner charges a unit's tenants a fee 
for administering an actual-consumption submetering arrangement, the fee 
is not considered gross rent for purposes of section 42(g)(2). The 
preceding sentence, however, does not apply unless the fee is computed 
in the same manner for every unit receiving the same submetered utility 
service, nor does it apply to any amount by which the aggregate monthly 
fee or fees for all of the unit's utilities under one or more actual-
consumption submetering arrangements exceed the greater of--
    (i) Five dollars per month;
    (ii) An amount (if any) designated by publication in the Internal 
Revenue Bulletin (see Sec.  601.601(d)(2)(ii) of this chapter); or
    (iii) The lesser of--
    (A) The dollar amount (if any) specifically prescribed under a State 
or local law; or
    (B) A maximum amount (if any) designated by publication in the 
Internal Revenue Bulletin (see Sec.  601.601(d)(2)(ii) of this chapter).

[T.D. 8520, 59 FR 10073, Mar. 3, 1994, as amended by T.D. 9420, 73 FR 
43867, July 29, 2008; T.D. 9755, 81 FR 11109, Mar. 3, 2016; T.D. 9850, 
84 FR 7284, Mar. 4, 2019]



Sec.  1.42-11  Provision of services.

    (a) General rule. The furnishing to tenants of services other than 
housing (whether or not the services are significant) does not prevent 
the units occupied by the tenants from qualifying as residential rental 
property eligible for credit under section 42. However, any charges to 
low-income tenants for services that are not optional generally must be 
included in gross rent for purposes of section 42(g).
    (b) Services that are optional--(1) General rule. A service is 
optional if payment for the service is not required as a condition of 
occupancy. For example, for a qualified low-income building with a 
common dining facility, the cost of meals is not included in gross rent 
for purposes of section 42(g)(2)(A) if payment for the meals in the 
facility is not required as a condition of occupancy and a practical 
alternative exists for tenants to obtain meals other than from the 
dining facility.
    (2) Continual or frequent services. If continual or frequent 
nursing, medical, or psychiatric services are provided, it is presumed 
that the services are not optional and the building is ineligible for 
the credit, as is the case with a hospital, nursing home, sanitarium, 
lifecare facility, or intermediate care facility for the mentally and 
physically handicapped. See also Sec.  1.42-9(b).
    (3) Required services--(i) General rule. The cost of services that 
are required as a condition of occupancy must be included in gross rent 
even if federal or state law requires that the services be offered to 
tenants by building owners.
    (ii) Exceptions--(A) Supportive services. Section 42(g)(2)(B)(iii) 
provides an exception for certain fees paid for supportive services. For 
purposes of section 42(g)(2)(B)(iii), a supportive service is any 
service provided under a planned program of services designed to enable 
residents of a residential rental property to remain independent and 
avoid placement in a hospital, nursing home, or intermediate care 
facility for the mentally or physically handicapped. For a building 
described in section 42(i)(3)(B)(iii) (relating to transitional housing 
for the homeless) or section 42(i)(3)(B)(iv) (relating to single-room 
occupancy), a supportive service includes any service provided to assist 
tenants in locating and retaining permanent housing.
    (B) Specific project exception. Gross rent does not include the cost 
of mandatory meals in any federally-assisted project for the elderly and 
handicapped (in existence on or before January 9, 1989) that is 
authorized by 24 CFR 278 to provide a mandatory meals program.

[T.D. 8520, 59 FR 10074, Mar. 3, 1994, as amended by T.D. 8859, 65 FR 
2328, Jan. 14, 2000]



Sec.  1.42-12  Effective dates and transitional rules.

    (a) Effective dates--(1) In general. Except as provided in 
paragraphs (a)(2) and (a)(3) of this section, the rules set forth in 
Sec. Sec.  1.42-6 and 1.42-8 through 1.42-12 are applicable on May 2, 
1994. However, binding agreements, election statements, and carryover 
allocation documents entered into before May 2, 1994, that follow the 
guidance set forth in Notice 89-1, 1989-1 C.B. 620 (see

[[Page 220]]

Sec.  601.601(d)(2)(ii)(b) of this chapter) need not be changed to 
conform to the rules set forth in Sec. Sec.  1.42-6 and 1.42-8 through 
1.42-12.
    (2) Community Renewal Tax Relief Act of 2000--(i) In general. 
Section 1.42-6 (a), (b)(4)(iii) Example 1 and Example 2, (c), 
(d)(2)(viii), and (e)(2) are applicable for housing credit dollar 
amounts allocated after January 6, 2004. However, the rules in Sec.  
1.42-6 (a), (b)(4)(iii) Example 1 and Example 2, (c), (d)(2)(viii), and 
(e)(2) may be applied by Agencies and taxpayers for housing credit 
dollar amounts allocated after December 31, 2000, and on or before 
January 6, 2004. Otherwise, subject to the applicable effective dates of 
the corresponding statutory provisions, the rules that apply for housing 
credit dollar amounts allocated on or before January 6, 2004, are 
contained in Sec.  1.42-6 in effect on and before January 6, 2004 (see 
26 CFR part 1 revised as of April 1, 2003).
    (3) Electronic filing simplification changes. Sections 1.42-6(d)(4) 
and 1.42-8(a)(6)(i), (a)(6)(ii), (a)(7) Example 1 and Example 2, 
(b)(4)(i), and (b)(4)(ii) are applicable for forms filed after January 
6, 2004. The rules that apply for forms filed on or before January 6, 
2004, are contained in Sec.  1.42-6 and Sec.  1.42-8 in effect on and 
before January 6, 2004 (see 26 CFR part 1 revised as of April 1, 2003).
    (4) Utility allowances. The first sentence in Sec.  1.42-10(a), 
Sec.  1.42-10(b)(1), (2), (3), and (4), the last two sentences in Sec.  
1.42-10(b)(4)(ii)(A), the third, fourth, and fifth sentences in Sec.  
1.42-10(b)(4)(ii)(B), Sec.  1.42-10(b)(4)(ii)(C), (D), and (E), and 
Sec.  1.42-10(c) and (d) are applicable to a building owner's taxable 
years beginning on or after July 29, 2008. Taxpayers may rely on these 
provisions before the beginning of the building owner's taxable year 
beginning on or after July 29, 2008 provided that any utility allowances 
calculated under these provisions are effective no earlier than the 
first day of the building owner's taxable year beginning on or after 
July 29, 2008. The utility allowances provisions that apply to taxable 
years beginning before July 29, 2008 are contained in Sec.  1.42-10 (see 
26 CFR part 1 revised as of April 1, 2008).
    (5) Additional effective dates affecting utility allowances. (i) The 
following provisions apply to a building owner's taxable years beginning 
on or after March 3, 2016--
    (A) The second sentence in Sec.  1.42-10(a);
    (B) Section 1.42-10(b)(3);
    (C) The first sentence in Sec.  1.42-10(b)(4)(ii)(A);
    (D) Section 1.42-10(b)(4)(ii)(E); and
    (E) Section 1.42-10(e), except as provided in paragraph (a)(5)(iii) 
of this section.
    (ii) Except as provided in paragraph (a)(5)(iii) of this section, a 
building owner may apply the provisions described in paragraphs 
(a)(5)(i)(A) through (E) of this section to the building owner's taxable 
years beginning before March 3, 2016. Otherwise, the utility allowance 
provisions that apply to those taxable years are contained in Sec.  
1.42-10, as contained in 26 CFR part 1, revised as of April 1, 2015.
    (iii) The provisions in Sec.  1.42-10(e)(1)(i) introductory text, 
(e)(1)(i)(B) through (D), and (e)(1)(iv)(B) apply to a building owner's 
taxable years beginning on or after March 4, 2019. A building owner, 
however, may apply these provisions to earlier taxable years. Otherwise, 
the submetering provisions that apply to taxable years beginning after 
March 3, 2016, and before March 4, 2019, are contained in Sec.  1.42-10 
and Sec.  1.42-10T as contained in 26 CFR part 1 revised as of April 1, 
2016. In addition, a building owner may apply those submetering 
provisions to taxable years beginning before March 3, 2016.
    (b) Prior periods. Notice 89-1, 1989-1 C.B. 620 and Notice 89-6, 
1989-1 C.B. 625 (see Sec.  601.601(d)(2)(ii)(b) of this chapter) may be 
applied for periods prior to May 2, 1994.
    (c) Carryover allocations. The rule set forth in Sec.  1.42-
6(d)(4)(ii) relating to the requirement that state and local housing 
agencies file Schedule A (Form 8610), ``Carryover Allocation of the Low-
Income Housing Credit,'' is applicable for carryover allocations made 
after December 31, 1999.

[T.D. 8520, 59 FR 10074, Mar. 3, 1994; 59 FR 15501, Apr. 1, 1994, as 
amended by T.D. 8859, 65 FR 2328, Jan. 14, 2000; T.D. 9110, 69 FR 504, 
Jan. 6, 2004; T.D. 9420, 73 FR 43868, July 29, 2008; T.D. 9755, 81 FR 
11110, Mar. 3, 2016; T.D. 9850, 84 FR 7285, Mar. 4, 2019]

[[Page 221]]



Sec.  1.42-13  Rules necessary and appropriate; housing credit agencies' 
correction of administrative errors and omissions.

    (a) Publication of guidance. Under section 42(n), the Secretary has 
authority to prescribe regulations as may be necessary or appropriate to 
carry out the purposes of section 42. The Secretary may also provide 
guidance through various publications in the Internal Revenue Bulletin. 
(See Sec.  601.601(d)(2)(ii)(b) of this chapter.)
    (b) Correcting administrative errors and omissions--(1) In general. 
An Agency may correct an administrative error or omission with respect 
to allocations and recordkeeping, as described in paragraph (b)(2) of 
this section, within a reasonable period after the Agency discovers the 
administrative error or omission. Whether a correction is made within a 
reasonable period depends on the facts and circumstances of each 
situation. Except as provided in paragraph (b)(3)(iii) of this section, 
an Agency need not obtain the prior approval of the Secretary to correct 
an administrative error or omission, if the correction is made in 
accordance with paragraph (b)(3)(i) of this section. The administrative 
errors and omissions to which this paragraph (b) applies are strictly 
limited to those described in paragraph (b)(2) of this section, and, 
thus, do not include, for example, any misinterpretation of the 
applicable rules and regulations under section 42. Accordingly, an 
Agency's allocation of a particular calendar year's low-income housing 
credit dollar amount made after the close of that calendar year, or the 
use of an incorrect population amount in calculating a State's housing 
credit ceiling for a calendar year are not administrative errors that 
can be corrected under this paragraph (b).
    (2) Administrative errors and omissions described. An administrative 
error or omission is a mistake that results in a document that 
inaccurately reflects the intent of the Agency at the time the document 
is originally completed or, if the mistake affects a taxpayer, a 
document that inaccurately reflects the intent of the Agency and the 
affected taxpayer at the time the document is originally completed. 
Administrative errors and omissions described in this paragraph (b)(2) 
include the following--
    (i) A mathematical error;
    (ii) An entry on a document that is inconsistent with another entry 
on the same or another document regarding the same property, or 
taxpayer;
    (iii) A failure in tracking the housing credit dollar amount an 
Agency has allocated (or that remains to be allocated) in the current 
calendar year (e.g., a failure to include in its State housing credit 
ceiling a previously allocated credit dollar amount that has been 
returned by a taxpayer);
    (iv) An omission of information that is required on a document; and
    (v) Any other type of error or omission identified by guidance 
published in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter) as an administrative error or 
omission covered by this paragraph (b).
    (3) Procedures for correcting administrative errors or omissions--
(i) In general. An Agency's correction of an administrative error or 
omission, as described in paragraph (b)(2) of this section, must amend 
the document so that the corrected document reflects the original intent 
of the Agency, or the Agency and the affected taxpayer, and complies 
with applicable rules and regulations under section 42.
    (ii) Specific procedures. If a document corrects a document 
containing an administrative error or omission that has not yet been 
filed with the Internal Revenue Service, the Agency, or the Agency and 
the affected taxpayer, should complete and file the corrected document 
as the original. When a document containing an administrative error or 
omission has already been filed with the Service, the Agency, or the 
Agency and the affected taxpayer, should refile a copy of the document 
containing the administrative error or omission, and prominently and 
clearly note the correction thereon or on an attached new document. The 
Agency should indicate at the top of the document(s) that the correction 
is being made under Sec.  1.42-13 of the Income Tax Regulations.
    (iii) Secretary's prior approval required. Except as provided in 
paragraph (b)(3)(vi) of this section, an Agency

[[Page 222]]

must obtain the Secretary's prior approval to correct an administrative 
error or omission, as described in paragraph (b)(2) of this section, if 
the correction is not made before the close of the calendar year of the 
error or omission and the correction--
    (A) Is a numerical change to the housing credit dollar amount 
allocated for the building or project;
    (B) Affects the determination of any component of the State's 
housing credit ceiling under section 42(h)(3)(C); or
    (C) Affects the State's unused housing credit carryover that is 
assigned to the Secretary under section 42(h)(3)(D).
    (iv) Requesting the Secretary's approval. To obtain the Secretary's 
approval under paragraph (b)(3)(iii) of this section, an Agency must 
submit a request for the Secretary's approval within a reasonable period 
after discovering the administrative error or omission, and must agree 
to any conditions that may be required by the Secretary under paragraph 
(b)(3)(v) of this section. When requesting the Secretary's approval, the 
Agency, or the Agency and the affected taxpayer, must file an 
application that complies with the requirements of this paragraph 
(b)(3)(iv). For further information on the application procedure see 
Rev. Proc. 93-1, 1993-1 I.R.B. 10 (or any subsequent applicable revenue 
procedure). (See Sec.  601.601(d)(2)(ii)(b) of this chapter.) The 
application requesting the Secretary's approval must contain the 
following information--
    (A) The name, address, and identification number of each affected 
taxpayer;
    (B) The Building Identification Number (B.I.N.) and address of each 
building or project affected by the administrative error or omission;
    (C) A statement explaining the administrative error or omission and 
the intent of the Agency, or of the Agency and the affected taxpayer, 
when the document was originally completed;
    (D) Copies of any supporting documentation;
    (E) A statement explaining the effect, if any, that a correction of 
the administrative error or omission would have on the housing credit 
dollar amount allocated for any building or project; and
    (F) A statement explaining the effect, if any, that a correction of 
the administrative error or omission would have on the determination of 
the components of the State's housing credit ceiling under section 
42(h)(3)(C) or on the State's unused housing credit carryover that is 
assigned to the Secretary under section 42(h)(3)(D).
    (v) Agreement to conditions. To obtain the Secretary's approval 
under paragraph (b)(3)(iii) of this section, an Agency, or the Agency 
and the affected taxpayer, must agree to the conditions the Secretary 
considers appropriate.
    (vi) Secretary's automatic approval. The Secretary grants automatic 
approval to correct an administrative error or omission described in 
paragraph (b)(2) of this section if--
    (A) The correction is not made before the close of the calendar year 
of the error or omission and the correction is a numerical change to the 
housing credit dollar amount allocated for the building or multiple-
building project;
    (B) The administrative error or omission resulted in an allocation 
document (the Form 8609, ``Low-Income Housing Credit Allocation 
Certification,'' or the allocation document under the requirements of 
section 42(h)(1)(E) or (F), and Sec.  1.42-6(d)(2)) that either did not 
accurately reflect the number of buildings in a project (for example, an 
allocation document for a 10-building project only references 8 
buildings instead of 10 buildings), or the correct information (other 
than the amount of credit allocated on the allocation document);
    (C) The administrative error or omission does not affect the 
Agency's ranking of the building(s) or project and the total amount of 
credit the Agency allocated to the building(s) or project; and
    (D) The Agency corrects the administrative error or omission by 
following the procedures described in paragraph (b)(3)(vii) of this 
section.
    (vii) How Agency corrects errors or omissions subject to automatic 
approval. An Agency corrects an administrative error or omission 
described in paragraph (b)(3)(vi) of this section by--
    (A) Amending the allocation document described in paragraph 
(b)(3)(vi)(B) of this section to correct the administrative error or 
omission.

[[Page 223]]

The Agency will indicate on the amended allocation document that it is 
making the ``correction under Sec.  1.42-13(b)(3)(vii).'' If correcting 
the allocation document requires including any additional B.I.N.(s) in 
the document, the document must include any B.I.N.(s) already existing 
for buildings in the project. If possible, the additional B.I.N.(s) 
should be sequentially numbered from the existing B.I.N.(s);
    (B) Amending, if applicable, the Schedule A (Form 8610), ``Carryover 
Allocation of the Low-Income Housing Credit,'' and attaching a copy of 
this schedule to Form 8610, ``Annual Low-Income Housing Credit Agencies 
Report,'' for the year the correction is made. The Agency will indicate 
on the schedule that it is making the ``correction under Sec.  1.42-
13(b)(3)(vii).'' For a carryover allocation made before January 1, 2000, 
the Agency must complete Schedule A (Form 8610), and indicate on the 
schedule that it is making the ``correction under Sec.  1.42-
13(b)(3)(vii)'';
    (C) Amending, if applicable, the Form 8609 and attaching the 
original of this amended form to Form 8610 for the year the correction 
is made. The Agency will indicate on the Form 8609 that it is making the 
``correction under Sec.  1.42-13(b)(3)(vii)''; and
    (D) Mailing or otherwise delivering a copy of any amended allocation 
document and any amended Form 8609 to the affected taxpayer.
    (viii) Other approval procedures. The Secretary may grant automatic 
approval to correct other administrative errors or omissions as 
designated in one or more documents published either in the Federal 
Register or in the Internal Revenue Bulletin (see Sec.  601.601(d)(2) of 
this chapter).
    (c) Examples. The following examples illustrate the scope of this 
section:

    Example 1. Individual B applied to Agency X for a reservation of a 
low-income housing credit dollar amount for a building that is part of a 
low-income housing project. When applying for the low-income housing 
credit dollar amount, B informed Agency X that B intended to form 
Partnership Y to finance the project. After receiving the reservation 
letter and prior to receiving an allocation, B formed Partnership Y and 
sold partnership interests to a number of limited partners. B 
contributed the low-income housing project to Partnership Y in exchange 
for a partnership interest. B and Partnership Y informed Agency X of the 
ownership change. When actually allocating the housing credit dollar 
amount, Agency X sent Partnership Y a document listing B, rather than 
Partnership Y, as the building's owner. Partnership Y promptly notified 
Agency X of the error. After reviewing related documents, Agency X 
determined that it had incorrectly listed B as the building's owner on 
the allocation document. Since the parties originally intended that 
Partnership Y would receive the allocation as the owner of the building, 
Agency X may correct the error without obtaining the Secretary's 
approval, and insert Partnership Y as the building's owner on the 
allocation document.
    Example 2. Agency Y allocated a lower low-income housing credit 
dollar amount for a low-income housing building than Agency Y originally 
intended. After the close of the calendar year of the allocation, B, the 
building's owner, discovered the error and promptly notified Agency Y. 
Agency Y reviewed relevant documents and agreed that an error had 
occurred. Agency Y and B must apply, as provided in paragraph (b)(3)(iv) 
of this section, for the Secretary's approval before Agency Y may 
correct the error.

    (d) Effective date. This section is effective February 24, 1994. 
However, an Agency may elect to apply these regulations to 
administrative errors or omissions that occurred before the publication 
of these regulations. Any reasonable method used by a State or local 
housing credit agency to correct an administrative error or omission 
prior to February 24, 1994, will be considered proper, provided that the 
method is consistent with the rules of section 42. Paragraphs 
(b)(3)(vi), (vii), and (viii) of this section are effective January 14, 
2000.

[T.D. 8521, 59 FR 8861, Feb. 24, 1994, as amended by T.D. 8859, 65 FR 
2328, Jan. 14, 2000]



Sec.  1.42-14  Allocation rules for post-2000 State housing credit 
ceiling amount.

    (a) State housing credit ceiling--(1) In general. The State housing 
credit ceiling for a State for any calendar year after 2000 is comprised 
of four components. The four components are--
    (i) The unused State housing credit ceiling, if any, of the State 
for the preceding calendar year (the unused carryforward component);
    (ii) The greater of--
    (A) $1.75 ($1.50 for calendar year 2001) multiplied by the State 
population; or

[[Page 224]]

    (B) $2,000,000 (the population component);
    (iii) The amount of State housing credit ceiling returned in the 
calendar year (the returned credit component); plus
    (iv) The amount, if any, allocated to the State by the Secretary 
under section 42(h)(3)(D) from a national pool of unused credit (the 
national pool component).
    (2) Cost-of-living adjustment--(i) General rule. For any calendar 
year after 2002, the $2,000,000 and $1.75 amounts in paragraph 
(a)(1)(ii) of this section are each increased by an amount equal to--
    (A) The dollar amount; multiplied by
    (B) The cost-of-living adjustment determined under section 1(f)(3) 
for the calendar year by substituting ``calendar year 2001'' for 
``calendar year 1992'' in section 1(f)(3)(B).
    (ii) Rounding. Any increase resulting from the application of 
paragraph (a)(2)(i) of this section which, in the case of the $2,000,000 
amount, is not a multiple of $5,000, is rounded to the next lowest 
multiple of $5,000, and which, in the case of the $1.75 amount, is not a 
multiple of 5 cents, is rounded to the next lowest multiple of 5 cents.
    (b) The unused carryforward component. The unused carryforward 
component of the State housing credit ceiling for any calendar year is 
the unused State housing credit ceiling, if any, of the State for the 
preceding calendar year. The unused State housing credit ceiling for any 
calendar year is the excess, if any, of--
    (1) The sum of the population, returned credit, and national pool 
components for the calendar year; over
    (2) The aggregate housing credit dollar amount allocated for the 
calendar year reduced by the housing credit dollar amounts allocated 
from the unused carryforward component for the calendar year.
    (c) The population component. The population component of the State 
housing credit ceiling of a State for any calendar year is determined 
pursuant to section 146(j). Thus, a State's population for any calendar 
year is determined by reference to the most recent census estimate, 
whether final or provisional, of the resident population of the State 
released by the Bureau of the Census before the beginning of the 
calendar year for which the State's housing credit ceiling is set. 
Unless otherwise prescribed by applicable revenue procedure, 
determinations of population are based on the most recent estimates of 
population contained in the Bureau of the Census publication, Current 
Population Report, Series P-25; Population Estimates and Projections, 
Estimates of the Population of States. For convenience, the Internal 
Revenue Service publishes the population estimates annually in the 
Internal Revenue Bulletin. (See Sec.  601.601(d)(2)(ii)(b)).
    (d) The returned credit component--(1) In general. The returned 
credit component of the State housing credit ceiling of a State for any 
calendar year equals the housing credit dollar amount returned during 
the calendar year that was validly allocated within the State in a prior 
calendar year to any project that does not become a qualified low-income 
housing project within the period required by section 42, or as required 
by the terms of the allocation. The returned credit component also 
includes credit allocated in a prior calendar year that is returned as a 
result of the cancellation of an allocation by mutual consent or by an 
Agency's determination that the amount allocated is not necessary for 
the financial feasibility of the project. For purposes of this section, 
credit is allocated within a State if it is allocated from the State's 
housing credit ceiling by an Agency of the State or of a constitutional 
home rule city in the State.
    (2) Limitations and special rules. The following limitations and 
special rules apply for purposes of this paragraph (d).
    (i) General limitations. Notwithstanding any other provision of this 
paragraph (d), returned credit does not include any credit that was--
    (A) Allocated prior to calendar year 1990;
    (B) Allowable under section 42(h)(4) (relating to the portion of 
credit attributable to eligible basis financed by certain tax-exempt 
bonds under section 103); or
    (C) Allocated during the same calendar year that it is received back 
by the Agency.

[[Page 225]]

    (ii) Credit period limitation. Notwithstanding any other provision 
of this paragraph (d), an allocation of credit may not be returned any 
later than 180 days following the close of the first taxable year of the 
credit period for the building that received the allocation. After this 
date, credit that might otherwise be returned expires, and cannot be 
returned to or reallocated by any Agency.
    (iii) Three-month rule for returned credit. An Agency may, in its 
discretion, treat any portion of credit that is returned from a project 
after September 30 of a calendar year and that is not reallocated by the 
close of the calendar year as returned on January 1 of the succeeding 
calendar year. In this case, the returned credit becomes part of the 
returned credit component of the State housing credit ceiling for the 
succeeding calendar year. Any portion of credit that is returned from a 
project after September 30 of a calendar year that is reallocated by the 
close of the calendar year is treated as part of the returned credit 
component of the State housing credit ceiling for the calendar year that 
the credit was returned.
    (iv) Returns of credit. Subject to the limitations of paragraphs 
(d)(2) (i) and (ii) of this section, credit is returned to the Agency in 
the following instances in the manner described in paragraph (d)(3) of 
this section.
    (A) Building not qualified within required time period. If a 
building is not a qualified building within the time period required by 
section 42, it loses its credit allocation and the credit is returned. 
For example, a building is not qualified within the required time period 
if it is not placed in service within the period required by section 42 
or if the project of which the building is a part fails to meet the 
minimum set-aside requirements of section 42(g)(1) by the close of the 
first year of the credit period. Also, a building that has received a 
post-June 30 carryover allocation is not qualified within the required 
time period if the taxpayer does not meet the 10 percent basis 
requirement by the date that is 6 months after the date the allocation 
was made (as described in Sec.  1.42-6(a)(2)(ii)).
    (B) Noncompliance with terms of the allocation. If a building does 
not comply with the terms of its allocation, it loses the credit 
allocation and the credit is returned. The terms of an allocation are 
the written conditions agreed to by the Agency and the allocation 
recipient in the allocation document.
    (C) Mutual consent. If the Agency and the allocation recipient 
cancel an allocation of an amount of credit by mutual consent, that 
amount of credit is returned.
    (D) Amount not necessary for financial feasibility. If an Agency 
determines under section 42(m)(2) that an amount of credit allocated to 
a project is not necessary for the financial feasibility of the project 
and its viability as a qualified low-income housing project throughout 
the credit period, that amount of credit is returned.
    (3) Manner of returning credit--( i) Taxpayer notification. After an 
Agency determines that a building or project no longer qualifies under 
paragraph (d)(2)(iv)(A), (B), or (D) of this section for all or part of 
the allocation it received, the Agency must provide written notification 
to the allocation recipient, or its successor in interest, that all or 
part of the allocation is no longer valid. The notification must also 
state the amount of the allocation that is no longer valid. The date of 
the notification is the date the credit is returned to the Agency. If an 
allocation is cancelled by mutual consent under paragraph (d)(2)(iv)(C) 
of this section, there must be a written agreement signed by the Agency, 
and the allocation recipient, or its successor in interest, indicating 
the amount of the allocation that is returned to the Agency. The 
effective date of the agreement is the date the credit is returned to 
the Agency.
    (ii) Internal Revenue Service notification. If a credit is returned 
within 180 days following the close of the first taxable year of a 
building's credit period as provided in paragraph (d)(2)(ii) of this 
section, and a Form 8609, Low-Income Housing Credit Allocation 
Certification, has been issued for the building, the Agency must notify 
the Internal Revenue Service that the credit has been returned. If only 
part of the credit

[[Page 226]]

has been returned, this notification requirement is satisfied when the 
Agency attaches to an amended Form 8610, Annual Low- Income Housing 
Credit Agencies Report, the original of an amended Form 8609 reflecting 
the correct amount of credit attributed to the building together with an 
explanation for the filing of the amended Forms. The Agency must send a 
copy of the amended Form 8609 to the taxpayer that owns the building. If 
the building is not issued an amended Form 8609 because all of the 
credit allocated to the building is returned, notification to the 
Internal Revenue Service is satisfied by following the requirements 
prescribed in Sec.  1.42-5(e)(3) for filing a Form 8823, Low-Income 
Housing Credit Agencies Report of Noncompliance.
    (e) The national pool component. The national pool component of the 
State housing credit ceiling of a State for any calendar year is the 
portion of the National Pool allocated to the State by the Secretary for 
the calendar year. The national pool component for any calendar year is 
zero unless a State is a qualified State. (See paragraph (i) of this 
section for rules regarding the National Pool and the description of a 
qualified State.) A national pool component credit that is allocated 
during a calendar year and returned after the close of the calendar year 
may qualify as part of the returned credit component of the State 
housing credit ceiling for the calendar year that the credit is 
returned.
    (f) When the State housing credit ceiling is determined. For 
purposes of accounting for the State housing credit ceiling on Form 8610 
and for purposes of determining the set-aside apportionment for projects 
involving qualified nonprofit organizations described in section 
42(h)(5) and Sec.  1.42-1T(c)(5), the State housing credit ceiling for 
any calendar year is determined at the close of the calendar year.
    (g) Stacking order. Credit is treated as allocated from the various 
components of the State housing credit ceiling in the following order. 
The first credit allocated for any calendar year is treated as credit 
from the unused carryforward component of the State housing credit 
ceiling for the calendar year. After all of the credit in the unused 
carryforward component has been allocated, any credit allocated is 
treated as allocated from the sum of the population, returned credit, 
and national pool components of the State housing credit ceiling.
    (h) Nonprofit set-aside--(1) Determination of set-aside. Under 
section 42(h)(5) and Sec.  1.42-1T(c)(5), at least 10 percent of a State 
housing credit ceiling in any calendar year must be set aside 
exclusively for projects involving qualified nonprofit organizations 
(the nonprofit set-aside). However, credit allocated from the nonprofit 
set-aside in a calendar year and returned in a subsequent calendar year 
does not retain its nonprofit set-aside character. The credit becomes 
part of the returned credit component of the State housing credit 
ceiling for the calendar year that the credit is returned and must be 
included in determining the nonprofit set-aside of the State housing 
credit ceiling for that calendar year. Similarly, credit amounts that 
are not allocated from the nonprofit set-aside in a calendar year and 
are returned in a subsequent calendar year become part of the returned 
credit component of the State housing credit ceiling for that year and 
are also included in determining the set-aside for that year.
    (2) Allocation rules. An Agency may allocate credit from any 
component of the State housing credit ceiling as part of the nonprofit 
set-aside and need not reserve 10 percent of each component for the 
nonprofit set-aside. Thus, an Agency may satisfy the nonprofit set-aside 
requirement of section 42(h)(5) and Sec.  1.42-1T(c)(5) in any calendar 
year by setting aside for allocation an amount equal to at least 10 
percent of the total State housing credit ceiling for the calendar year.
    (i) National Pool--(1) In general. The unused housing credit 
carryover of a State for any calendar year is assigned to the Secretary 
for inclusion in a national pool of unused housing credit carryovers 
(National Pool) that is reallocated among qualified States the 
succeeding calendar year. The assignment to the Secretary is made on 
Form 8610.
    (2) Unused housing credit carryover. The unused housing credit 
carryover of

[[Page 227]]

a State for any calendar year is the excess, if any, of--
    (i) The unused carryforward component of the State housing credit 
ceiling for the calendar year; over
    (ii) The total housing credit dollar amount allocated for the 
calendar year.
    (3) Qualified State--(i) In general. The term qualified State means, 
with respect to any calendar year, any State that has allocated its 
entire State housing credit ceiling for the preceding calendar year and 
for which a request is made by the State, not later than May 1 of the 
calendar year, to receive an allocation of credit from the National Pool 
for that calendar year. Except as provided in paragraph (i)(3)(ii) of 
this section, a State is not a qualified State in a calendar year if 
there remains any unallocated credit in its State housing credit ceiling 
at the close of the preceding calendar year that was apportioned to any 
Agency within the State for the calendar year.
    (ii) Exceptions--(A) De minimis amount. If the amount remaining 
unallocated at the close of a calendar year is only a de minimis amount 
of credit, the State is a qualified State eligible to participate in the 
National Pool. For that purpose, a credit amount is de minimis if it 
does not exceed 1 percent of the aggregate State housing credit ceiling 
of the State for the calendar year.
    (B) Other circumstances. Pursuant to the authority under section 
42(n), the Internal Revenue Service may determine that a State is a 
qualified State eligible to participate in the National Pool even though 
the State's unallocated credit is in excess of the 1 percent safe harbor 
set forth in paragraph (A) of this section. The Internal Revenue Service 
will make this determination based on all the facts and circumstances, 
weighing heavily the interests of the States who would otherwise qualify 
for the National Pool. The Internal Revenue Service will generally grant 
relief under this paragraph only where a State's unallocated credit is 
not substantial.
    (iii) Time and manner for making request. For further guidance as to 
the time and manner for making a request of housing credit dollar 
amounts from the National Pool by a qualified State, see Rev. Proc. 92-
31, 1992-1 C.B. 775. (See 601.601(d)(2)(ii)(b)).
    (4) Formula for determining the National Pool. The amount allocated 
to a qualified State in any calendar year is an amount that bears the 
same ratio to the aggregate unused housing credit carryovers of all 
States for the preceding calendar year as that State's population for 
the calendar year bears to the population of all qualified States for 
the calendar year.
    (j) Coordination between Agencies. The Agency responsible for filing 
Form 8610 on behalf of all Agencies within a State and making any 
request on behalf of the State for credit from the National Pool (the 
Filing Agency) must coordinate with each Agency within the State to 
ensure that the various requirements of this section are complied with. 
For example, the Filing Agency of a State must ensure that all Agencies 
within the State that were apportioned a credit amount for the calendar 
year have allocated all of their respective credit amounts for the 
calendar year before the Filing Agency can make a request on behalf of 
the State for a distribution of credit from the National Pool.
    (k) Example. (1) The operation of the rules of this section is 
illustrated by the following examples. Unless otherwise stated in an 
example, Agency A is the sole Agency authorized to make allocations of 
housing credit dollar amounts in State M, all of Agency A's allocations 
are valid, and for calendar year 2003, Agency A has available for 
allocation a State housing credit ceiling consisting of the following 
housing credit dollar amounts:

A. Unused carryforward component..............................       $50
B. Population component.......................................       110
C. Returned credit component..................................        10
D. National pool component....................................         0
                                                               ---------
    Total.....................................................       170
                                                               =========
 

    (2) In addition, the $10 of returned credit component was returned 
before October 1, 2003.

    Example 1: (i) Additional facts. By the close of 2003, Agency A had 
allocated $80 of the State M housing credit ceiling. Of the $80 
allocated, $17 was allocated to projects involving qualified nonprofit 
organizations.
    (ii) Application of stacking rules. The $80 of allocated credit is 
first treated as allocated

[[Page 228]]

from the unused carryforward component of the State housing credit 
ceiling. The $80 of allocated credit exceeds the $50 attributable to the 
unused carryforward component by $30. Because the unused carryforward 
component is fully utilized no credit will be forfeited by State M to 
the 2004 National Pool. The remaining $30 of allocated credit will next 
be treated as allocated from the $120 in credit determined by 
aggregating the population, returned credit, and national pool 
components ($110 + 10 + 0 = $120). The $90 of unallocated credit 
remaining in State M's 2003 State housing credit ceiling ($120 - 30 = 
$90) represents the unused carryforward component of State M's 2004 
State housing credit ceiling. Under paragraph (i)(3) of this section, 
State M does not qualify for credit from the 2004 National Pool.
    (iii) Nonprofit set-aside. Agency A allocated exactly the amount of 
credit to projects involving qualified nonprofit organizations as 
necessary to meet the nonprofit set-aside requirement ($17, 10% of the 
$170 ceiling).
    Example 2: (i) Additional facts. By the close of 2003, Agency A had 
allocated $40 of the State M housing credit ceiling. Of the $40 
allocated, $20 was allocated to projects involving qualified nonprofit 
organizations.
    (ii) Application of stacking rules. The $40 of allocated credit is 
first treated as allocated from the unused carryforward component of the 
State housing credit ceiling. Because the $40 of allocated credit does 
not exceed the $50 attributable to the unused carryforward component, 
the remaining components of the State housing credit ceiling are 
unaffected. The $10 remaining in the unused carryforward component is 
assigned to the Secretary for inclusion in the 2004 National Pool. The 
$120 in credit determined by aggregating the population, returned 
credit, and national pool components becomes the unused carryforward 
component of State M's 2004 State housing credit ceiling. Under 
paragraph (i)(3) of this section, State M does not qualify for credit 
from the 2004 National Pool.
    (iii) Nonprofit set-aside. Agency A allocated $3 more credit to 
projects involving qualified nonprofit organizations than necessary to 
meet the nonprofit set-aside requirement. This does not reduce the 
application of the 10% nonprofit set-aside requirement to the State M 
housing credit ceiling for calendar year 2004.
    Example 3: (i) Additional fact. None of the applications for credit 
that Agency A received for 2003 are for projects involving qualified 
nonprofit organizations.
    (ii) Nonprofit set-aside. Because at least 10% of the State housing 
credit ceiling must be set aside for projects involving a qualified 
nonprofit organization, Agency A can allocate only $153 of the $170 
State housing credit ceiling for calendar year 2003 ($170 -17 = $153). 
If Agency A allocates $153 of credit, the credit is treated as allocated 
$50 from the unused carryforward component and $103 from the sum of the 
population, returned credit, and national pool components. The $17 of 
unallocated credit that is set aside for projects involving qualified 
nonprofit organizations becomes the unused carryforward component of 
State M's 2004 State housing credit ceiling. Under paragraph (i)(3) of 
this section, State M does not qualify for credit from the 2004 National 
Pool.
    Example 4: (i) Additional facts. The $10 of returned credit 
component was returned prior to October 1, 2003. However, a $40 credit 
that had been allocated in calendar year 2002 to a project involving a 
qualified nonprofit organization was returned to the Agency by a mutual 
consent agreement dated November 15, 2003. By the close of 2003, Agency 
A had allocated $170 of the State M's housing credit ceiling, including 
$17 of credit to projects involving qualified nonprofit organizations.
    (ii) Effect of three-month rule. Under the three-month rule of 
paragraph (d)(2)(iii) of this section, Agency A may treat all or part of 
the $40 of previously allocated credit as returned on January 1, 2004. 
If Agency A treats all of the $40 amount as having been returned in 
calendar year 2004, the State M housing credit ceiling for 2003 is $170. 
This entire amount, including the $17 nonprofit set-aside, has been 
allocated in 2003. Under paragraph (i)(3) of this section, State M 
qualifies for the 2004 National Pool.
    (iii) If three-month rule not used. If Agency A treats all of the 
$40 of previously allocated credit as returned in calendar year 2003, 
the State housing credit ceiling for the 2003 calendar year will be $210 
of which $50 will be attributable to the returned credit component ($10 
+ $40 = $50). Because credit amounts allocated to a qualified nonprofit 
organization in a prior calendar year that are returned in a subsequent 
calendar year do not retain their nonprofit character, the nonprofit 
set-aside for calendar year 2003 is $21 (10% of the $210 State housing 
credit ceiling). The $170 that Agency A allocated during 2003 is first 
treated as allocated from the unused carryforward component of the State 
housing credit ceiling. The $170 of allocated credit exceeds the $50 
attributable to the unused carryforward component by $120. Because the 
unused carryforward component is fully utilized no credit will be 
forfeited by State M to the 2004 National Pool. The remaining $120 of 
allocated credit will next be treated as allocated from the $160 in 
credit determined by aggregating the population, returned credit, and 
national pool components ($110 + 50 + 0 = $160). The $40 of unallocated 
credit (which includes $4 of unallocated credit from the $21 nonprofit 
set-aside) remaining in State M's 2003 housing credit ceiling ($160-120 
= $40) represents the unused carryforward component of State M's 2004 
housing credit ceiling. Under paragraph (i)(3) of this section, State

[[Page 229]]

M does not qualify for credit from the 2004 National Pool.

    (l) Effective dates--(1) In general. Except as provided in paragraph 
(l)(2) of this section, the rules set forth in Sec.  1.42-14 are 
applicable on January 1, 1994.
    (2) Community Renewal Tax Relief Act of 2000 changes. Paragraphs 
(a), (b), (c), (e), (i)(2) and (k) of this section are applicable for 
housing credit dollar amounts allocated after January 6, 2004. However, 
paragraphs (a), (b), (c), (e), (i)(2) and (k) of this section may be 
applied by Agencies and taxpayers for housing credit dollar amounts 
allocated after December 31, 2000, and on or before January 6, 2004. 
Otherwise, subject to the applicable effective dates of the 
corresponding statutory provisions, the rules that apply for housing 
credit dollar amounts allocated on or before January 6, 2004, are 
contained in this section in effect on and before January 6, 2004 (see 
26 CFR part 1 revised as of April 1, 2003).

[T.D. 8563, 59 FR 50163, Oct. 3, 1994; 60 FR 3345, Jan. 17, 1995, as 
amended by T.D. 9110, 69 FR 504, Jan. 6, 2004; 69 FR 8331, Feb. 24, 
2004]



Sec.  1.42-15  Available unit rule.

    (a) Definitions. The following definitions apply to this section:
    Applicable income limitation means the limitation applicable under 
section 42(g)(1) or, for deep rent skewed projects described in section 
142(d)(4)(B), 40 percent of area median gross income.
    Available unit rule means the rule in section 42(g)(2)(D)(ii).
    Comparable unit means a residential unit in a low-income building 
that is comparably sized or smaller than an over-income unit or, for 
deep rent skewed projects described in section 142(d)(4)(B), any low-
income unit. For purposes of determining whether a residential unit is 
comparably sized, a comparable unit must be measured by the same method 
used to determine qualified basis for the credit year in which the 
comparable unit became available.
    Current resident means a person who is living in the low-income 
building.
    Low-income unit is defined by section 42(i)(3)(A).
    Nonqualified resident means a new occupant or occupants whose 
aggregate income exceeds the applicable income limitation.
    Over-income unit means, in the case of a project with respect to 
which the taxpayer elects the requirements of section 42(g)(1)(A) or (B) 
(that is, the 20-50 or 40-60 tests), a low-income unit in which the 
aggregate income of the occupants of the unit increases above 140 
percent of the applicable income limitation under section 42(g)(1)(A) 
and (B), or above 170 percent of the applicable income limitation for 
deep rent skewed projects described in section 142(d)(4)(B). In the case 
of a project with respect to which the taxpayer elects the requirements 
of section 42(g)(1)(C) (that is, the average income test), over-income 
unit means a residential unit described in Sec.  1.42-19(b)(1)(i) 
through (iii) in which the aggregate income of the occupants of the unit 
increases above 140 percent (170 percent in case of deep rent skewed 
projects described in section 142(d)(4)(B)) of the greater of 60 percent 
of area median gross income or the imputed income limitation designated 
with respect to the unit under Sec.  1.42-19(b).
    Qualified resident means an occupant either whose aggregate income 
(combined with the income of all other occupants of the unit) does not 
exceed the applicable income limitation and who is otherwise a low-
income resident under section 42, or who is a current resident.
    (b) General section 42(g)(2)(D)(i) rule. Except as provided in 
paragraph (c) of this section, notwithstanding an increase in the income 
of the occupants of a low-income unit above the applicable income 
limitation, if the income of the occupants initially met the applicable 
income limitation, and the unit continues to be rent-restricted--
    (1) The unit continues to be treated as a low-income unit; and
    (2) The unit continues to be included in the numerator and the 
denominator of the ratio used to determine whether a project satisfies 
the applicable minimum set-aside requirement of section 42(g)(1).
    (c) Exceptions--(1) In general. A unit ceases to be treated as a 
low-income unit if it becomes an over-income unit

[[Page 230]]

and a nonqualified resident occupies any comparable unit that is 
available or that subsequently becomes available in the same low-income 
building. In other words, the owner of a low-income building must rent 
to qualified residents all comparable units that are available or that 
subsequently become available in the same building to continue treating 
the over-income unit as a low-income unit. Once the percentage of low-
income units in a building (excluding the over-income units) equals the 
percentage of low-income units on which the credit is based, failure to 
maintain the over-income units as low-income units has no immediate 
significance. The failure to maintain the over-income units as low-
income units, however, may affect the decision of whether or not to rent 
a particular available unit at market rate at a later time. A unit is 
not available for purposes of the available unit rule when the unit is 
no longer available for rent due to contractual arrangements that are 
binding under local law (for example, a unit is not available if it is 
subject to a preliminary reservation that is binding on the owner under 
local law prior to the date a lease is signed or the unit is occupied).
    (2) Rental of next available unit in case of the average income 
test--(i) Basic rule. In the case of a project with respect to which the 
taxpayer elects the average income test, if a unit becomes an over-
income unit within the meaning of paragraph (a) of this section, that 
unit ceases to be described in Sec.  1.42-19(b)(1)(ii) if--
    (A) Any residential rental unit (of a size comparable to, or smaller 
than, the over-income unit) is available, or subsequently becomes 
available, in the same low-income building; and
    (B) That available unit is occupied by a new resident whose income 
exceeds the limitation described in paragraph (c)(2)(iv) of this 
section.
    (ii) No requirement to comply with the next available unit rule in a 
specific order. Where multiple units in a building are over-income units 
at the same time--
    (A) The order in which available units are occupied makes no 
difference for purposes of complying with the rules in this section 
(next available unit rule); and
    (B) In making imputed income limitation designations, the taxpayer 
must take into account the limitations described in paragraphs 
(c)(2)(iii) and (iv) of this section.
    (iii) Deep rent skewed projects. In the case of a project described 
in section 142(d)(4)(B) with respect to which the taxpayer elects the 
average income test, if a unit becomes an over-income unit within the 
meaning of paragraph (a) of this section, that unit ceases to be a unit 
described in Sec.  1.42-19(b)(1)(ii) if--
    (A) Any residential unit described in Sec.  1.42-19(b)(1)(i) through 
(iii) is available, or subsequently becomes available, in the same low-
income building; and
    (B) That unit is occupied by a new resident whose income exceeds the 
lesser of 40 percent of area median gross income or the imputed income 
limitation designated with respect to that unit.
    (iv) Limitation. The limitation described in this paragraph 
(c)(2)(iv) is--
    (A) In the case of a unit that was described in Sec.  1.42-
19(b)(1)(i) through (iii) prior to becoming vacant, the imputed income 
limitation designated with respect to the available unit for the average 
income test under Sec.  1.42-19(b); and
    (B) In the case of any other unit, the highest imputed income 
limitation that could be designated (consistent with section 
42(g)(1)(C)(ii)(III)) for that available unit under Sec.  1.42-19(c) 
such that the average of all imputed income designations of residential 
units in the project does not exceed 60 percent of area median gross 
income (AMGI).
    (v) Example. The operation of paragraph (c)(2) of this section (that 
is, the next available unit rule for the average income test) is 
illustrated by the following example.
    (A) Facts. (1) A single-building housing project received an 
allocation of housing credit dollar amount for 10 low-income units. The 
taxpayer who owns the project constructs the building with 10 
identically sized units and elects the average income test. In the first 
year, the taxpayer intended to have 8 units that will qualify as low-
income units (within the meaning of

[[Page 231]]

Sec.  1.42-19(b)(1)), and 2 units that are market-rate units. The 
taxpayer properly and timely designates the imputed income limitations 
for the 8 units as follows: 4 units at 80 percent of AMGI; and 4 units 
at 40 percent of AMGI.

                  Table 1 to Paragraph (c)(2)(v)(A)(1)
------------------------------------------------------------------------
                                       Imputed income  limitation of the
              Unit No.                               unit
------------------------------------------------------------------------
1...................................  80 percent of AMGI.
2...................................  80 percent of AMGI.
3...................................  80 percent of AMGI.
4...................................  80 percent of AMGI.
5...................................  Market Rate.
6...................................  40 percent of AMGI.
7...................................  40 percent of AMGI.
8...................................  40 percent of AMGI.
9...................................  40 percent of AMGI.
10..................................  Market Rate.
------------------------------------------------------------------------

    (2) In the first taxable year of the credit period (Year 1), the 
project is fully leased and occupied by income-qualified residents in 
Units 1-4 and 6-9. In Year 2, Unit 1 and Unit 6 become over-income. 
The tenant residing in Unit 5 vacated that unit. Taxpayer then 
designated an imputed income limitation of 40 percent of AMGI for Unit 
5. Later in Year 2, the tenant residing in Unit 10 vacated that unit. 
Taxpayer designated an imputed income limitation of 80 percent of AMGI 
for Unit 10. After those designations, Unit 10 was occupied by a new 
income-qualified tenant, and then later, Unit 5 was occupied by a new 
income-qualified resident.
    (B) Analysis. Taxpayer sought to maintain the status of the over-
income units (Unit 1 and Unit 6) as units described in Sec.  1.42-
19(b)(1)(ii). As the then-market rate units (Units 5 and 10) became 
available to rent, Taxpayer designated imputed income limitations for 
them at 40 percent and 80 percent of AMGI, respectively. Immediately 
after each designation, the average of the designations in the project 
does not exceed 60 percent AMGI. Pursuant to the rule in paragraph 
(c)(2)(ii) of this section, when there are multiple over-income units, 
Taxpayer is not required to rent the next-available units in a specific 
order, even though they may have different imputed income limitations. 
Thus, Taxpayer complied with the rules of the next available unit rule, 
and Unit 1 and Unit 6 maintain status as units described in Sec.  
1.42-19(b)(1)(ii).
    (d) Effect of current resident moving within building. When a 
current resident moves to a different unit within the building, the 
newly occupied unit adopts the status of the vacated unit. Thus, if a 
current resident, whose income exceeds the applicable income limitation, 
moves from an over-income unit to a vacant unit in the same building, 
the newly occupied unit is treated as an over-income unit. The vacated 
unit assumes the status the newly occupied unit had immediately before 
it was occupied by the current resident.
    (e) Available unit rule applies separately to each building in a 
project. In a project containing more than one low-income building, the 
available unit rule applies separately to each building.
    (f) Result of noncompliance with available unit rule. If any 
comparable unit that is available or that subsequently becomes available 
is rented to a nonqualified resident, all over-income units for which 
the available unit was a comparable unit within the same building lose 
their status as low-income units; thus, comparably sized or larger over-
income units would lose their status as low-income units.
    (g) Relationship to tax-exempt bond provisions. Financing 
arrangements that purport to be exempt-facility bonds under section 142 
must meet the requirements of sections 103 and 141 through 150 for 
interest on the obligations to be excluded from gross income under 
section 103(a). This section is not intended as an interpretation under 
section 142.
    (h) Examples. The following examples illustrate this section:

    Example 1. This example illustrates noncompliance with the available 
unit rule in a low-income building containing three over-income units. 
On January 1, 1998, a qualified low-income housing project, consisting 
of one building containing ten identically sized residential units, 
received a housing credit dollar amount allocation from a state housing 
credit agency for five low-income units. By the close of 1998, the first 
year of the credit period, the project satisfied the minimum set-aside 
requirement of section 42(g)(1)(B). Units 1, 2, 3, 4, and 5 were 
occupied by individuals whose incomes did not exceed the income 
limitation applicable

[[Page 232]]

under section 42(g)(1) and were otherwise low-income residents under 
section 42. Units 6, 7, 8, and 9 were occupied by market-rate tenants. 
Unit 10 was vacant. To avoid recapture of credit, the project owner must 
maintain five of the units as low-income units. On November 1, 1999, the 
certificates of annual income state that annual incomes of the 
individuals in Units 1, 2, and 3 increased above 140 percent of the 
income limitation applicable under section 42(g)(1), causing those units 
to become over-income units. On November 30, 1999, Units 8 and 9 became 
vacant. On December 1, 1999, the project owner rented Units 8 and 9 to 
qualified residents who were not current residents at rates meeting the 
rent restriction requirements of section 42(g)(2). On December 31, 1999, 
the project owner rented Unit 10 to a market-rate tenant. Because Unit 
10, an available comparable unit, was leased to a market-rate tenant, 
Units 1, 2, and 3 ceased to be treated as low-income units. On that 
date, Units 4, 5, 8, and 9 were the only remaining low-income units. 
Because the project owner did not maintain five of the residential units 
as low-income units, the qualified basis in the building is reduced, and 
credit must be recaptured. If the project owner had rented Unit 10 to a 
qualified resident who was not a current resident, eight of the units 
would be low-income units. At that time, Units 1, 2, and 3, the over-
income units, could be rented to market-rate tenants because the 
building would still contain five low-income units.
    Example 2. This example illustrates the provisions of paragraph (d) 
of this section. A low-income project consists of one six-floor 
building. The residential units in the building are identically sized. 
The building contains two over-income units on the sixth floor and two 
vacant units on the first floor. The project owner, desiring to maintain 
the over-income units as low-income units, wants to rent the available 
units to qualified residents. J, a resident of one of the over-income 
units, wishes to occupy a unit on the first floor. J's income has 
recently increased above the applicable income limitation. The project 
owner permits J to move into one of the units on the first floor. 
Despite J's income exceeding the applicable income limitation, J is a 
qualified resident under the available unit rule because J is a current 
resident of the building. The unit newly occupied by J becomes an over-
income unit under the available unit rule. The unit vacated by J assumes 
the status the newly occupied unit had immediately before J occupied the 
unit. The over-income units in the building continue to be treated as 
low-income units.

    (i) Applicability dates--(1) In general. Except for paragraph (c)(2) 
of this section, this section applies to leases entered into or renewed 
on and after September 26, 1997.
    (2) Applicability dates under the average income test. The 
requirements of the second sentence of the definition of over-income 
unit in paragraph (a) of this section and paragraph (c)(2) of this 
section apply to taxable years beginning after December 31, 2022. A 
taxpayer may choose to apply this section to a taxable year beginning 
after October 12, 2022, and before January 1, 2023, provided that the 
taxpayer chooses to apply Sec.  1.42-19 to the same taxable year.

[T.D. 8732, 62 FR 50505, Sept. 26, 1997, as amended by T.D. 9967, 87 FR 
61501, Oct. 12, 2022]



Sec.  1.42-16  Eligible basis reduced by federal grants.

    (a) In general. If, during any taxable year of the compliance period 
(described in section 42(i)(1)), a grant is made with respect to any 
building or the operation thereof and any portion of the grant is funded 
with federal funds (whether or not includible in gross income), the 
eligible basis of the building for the taxable year and all succeeding 
taxable years is reduced by the portion of the grant that is so funded.
    (b) Grants do not include certain rental assistance payments. A 
federal rental assistance payment made to a building owner on behalf or 
in respect of a tenant is not a grant made with respect to a building or 
its operation if the payment is made pursuant to--
    (1) Section 8 of the United States Housing Act of 1937 (42 U.S.C. 
1437f)
    (2) A qualifying program of rental assistance administered under 
section 9 of the United States Housing Act of 1937 (42 U.S.C. 1437g); or
    (3) A program or method of rental assistance 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).
    (c) Qualifying rental assistance program. For purposes of paragraph 
(b)(2) of this section, payments are made pursuant to a qualifying 
rental assistance program administered under section 9 of the United 
States Housing Act of 1937 to the extent that the payments--

[[Page 233]]

    (1) Are made to a building owner pursuant to a contract with a 
public housing authority with respect to units the owner has agreed to 
maintain as public housing units (PH-units) in the building;
    (2) Are made with respect to units occupied by public housing 
tenants, provided that, for this purpose, units may be considered 
occupied during periods of short term vacancy (not to exceed 60 days); 
and
    (3) Do not exceed the difference between the rents received from a 
building's PH-unit tenants and a pro rata portion of the building's 
actual operating costs that are reasonably allocable to the PH-units 
(based on square footage, number of bedrooms, or similar objective 
criteria), and provided that, for this purpose, operating costs do not 
include any development costs of a building (including developer's fees) 
or the principal or interest of any debt incurred with respect to any 
part of the building.
    (d) Effective date. This section is effective September 26, 1997.

[T.D. 8731, 62 FR 50503, Sept. 26, 1997]



Sec.  1.42-17  Qualified allocation plan.

    (a) Requirements--(1) In general. [Reserved]
    (2) Selection criteria. [Reserved]
    (3) Agency evaluation. Section 42(m)(2)(A) requires that the housing 
credit dollar amount allocated to a project is not to exceed the amount 
the Agency determines is necessary for the financial feasibility of the 
project and its viability as a qualified low-income housing project 
throughout the credit period. In making this determination, the Agency 
must consider--
    (i) The sources and uses of funds and the total financing planned 
for the project. The taxpayer must certify to the Agency the full extent 
of all federal, state, and local subsidies that apply (or which the 
taxpayer expects to apply) to the project. The taxpayer must also 
certify to the Agency all other sources of funds and all development 
costs for the project. The taxpayer's certification should be 
sufficiently detailed to enable the Agency to ascertain the nature of 
the costs that will make up the total financing package, including 
subsidies and the anticipated syndication or placement proceeds to be 
raised. Development cost information, whether or not includible in 
eligible basis under section 42(d), that should be provided to the 
Agency includes, but is not limited to, site acquisition costs, 
construction contingency, general contractor's overhead and profit, 
architect's and engineer's fees, permit and survey fees, insurance 
premiums, real estate taxes during construction, title and recording 
fees, construction period interest, financing fees, organizational 
costs, rent-up and marketing costs, accounting and auditing costs, 
working capital and operating deficit reserves, syndication and legal 
fees, and developer fees;
    (ii) Any proceeds or receipts expected to be generated by reason of 
tax benefits;
    (iii) The percentage of the housing credit dollar amount used for 
project costs other than the costs of intermediaries. This requirement 
should not be applied so as to impede the development of projects in 
hard-to-develop areas under section 42(d)(5)(C); and
    (iv) The reasonableness of the developmental and operational costs 
of the project.
    (4) Timing of Agency evaluation--(i) In general. The financial 
determinations and certifications required under paragraph (a)(3) of 
this section must be made as of the following times--
    (A) The time of the application for the housing credit dollar 
amount;
    (B) The time of the allocation of the housing credit dollar amount; 
and
    (C) The date the building is placed in service.
    (ii) Time limit for placed-in-service evaluation. For purposes of 
paragraph (a)(4)(i)(C) of this section, the evaluation for when a 
building is placed in service must be made not later than the date the 
Agency issues the Form 8609, ``Low-Income Housing Credit Allocation 
Certification.'' The Agency must evaluate all sources and uses of funds 
under paragraph (a)(3)(i) of this section paid, incurred, or committed 
by the taxpayer for the project up until date the Agency issues the Form 
8609.
    (5) Special rule for final determinations and certifications. For 
the Agency's evaluation under paragraph (a)(4)(i)(C)

[[Page 234]]

of this section, the taxpayer must submit a schedule of project costs. 
Such schedule is to be prepared on the method of accounting used by the 
taxpayer for federal income tax purposes, and must detail the project's 
total costs as well as those costs that may qualify for inclusion in 
eligible basis under section 42(d). For projects with more than 10 
units, the schedule of project costs must be accompanied by a Certified 
Public Accountant's audit report on the schedule (an Agency may require 
an audited schedule of project costs for projects with fewer than 11 
units). The CPA's audit must be conducted in accordance with generally 
accepted auditing standards. The auditor's report must be unqualified.
    (6) Bond-financed projects. A project qualifying under section 
42(h)(4) is not entitled to any credit unless the governmental unit that 
issued the bonds (or on behalf of which the bonds were issued), or the 
Agency responsible for issuing the Form(s) 8609 to the project, makes 
determinations under rules similar to the rules in paragraphs (a) (3), 
(4), and (5) of this section.
    (b) Effective date. This section is effective on January 1, 2001.

[T.D. 8859, 65 FR 2329, Jan. 14, 2000]



Sec.  1.42-18  Qualified contracts.

    (a) Extended low-income housing commitment--(1) In general. No 
credit under section 42(a) is allowed by reason of section 42 with 
respect to any building for the taxable year unless an extended low-
income housing commitment (commitment) (as defined in section 
42(h)(6)(B)) is in effect as of the end of such taxable year. A 
commitment must be in effect for the extended use period (as defined in 
paragraph (a)(1)(i) of this section).
    (i) Extended use period. The term extended use period means the 
period beginning on the first day in the compliance period (as defined 
in section 42(i)(1)) on which the building is part of a qualified low-
income housing project (as defined in section 42(g)(1)) and ending on 
the later of--
    (A) The date specified by the low-income housing credit agency 
(Agency) in the commitment; or
    (B) The date that is 15 years after the close of the compliance 
period.
    (ii) Termination of extended use period. The extended use period for 
any building will terminate--
    (A) On the date the building is acquired by foreclosure (or 
instrument in lieu of foreclosure) unless the Commissioner determines 
that such acquisition is part of an arrangement with the taxpayer (``the 
owner'') a purpose of which is to terminate such period; or
    (B) On the last day of the one-year period beginning on the date 
(after the 14th year of the compliance period) on which the owner 
submits a written request to the Agency to find a person to acquire the 
owner's interest in the low-income portion of the building if the Agency 
is unable to present during such period a qualified contract for the 
acquisition of the low-income portion of the building by any person who 
will continue to operate such portion as a qualified low-income building 
(as defined in section 42(c)(2)).
    (iii) Owner non-acceptance. If the Agency provides a qualified 
contract within the one-year period and the owner rejects or fails to 
act upon the contract, the building remains subject to the existing 
commitment.
    (iv) Eviction, gross rent increase concerning existing low-income 
tenants not permitted. Prior to the close of the three year period 
following the termination of a commitment, no owner shall be permitted 
to evict or terminate the tenancy (other than for good cause) of an 
existing tenant of any low-income unit, or increase the gross rent for 
such unit in a manner or amount not otherwise permitted by section 42.
    (2) Exception. Paragraph (a)(1)(ii)(B) of this section shall not 
apply to the extent more stringent requirements are provided in the 
commitment or under State law.
    (b) Definitions. For purposes of this section, the following terms 
are defined:
    (1) As provided by section 42(h)(6)(G)(iii), base calendar year 
means the calendar year with or within which the first taxable year of 
the credit period ends.
    (2) The low-income portion of a building is the portion of the 
building equal to the applicable fraction (as defined in section 
42(c)(1)(B)) specified in the commitment for the building.

[[Page 235]]

    (3) The fair market value of the non-low-income portion of the 
building is determined at the time of the Agency's offer of sale of the 
building to the general public. The fair market value of the non-low-
income portion also includes the fair market value of the land 
underlying the entire building (both the non-low-income portion and the 
low-income portion). This valuation must take into account the existing 
and continuing requirements contained in the commitment for the 
building. The fair market value of the non-low-income portion also 
includes the fair market value of items of personal property not 
included in eligible basis under section 42(d) that convey under the 
contract with the building.
    (4) Qualifying building costs include--
    (i) Costs that are included in eligible basis of a low-income 
housing building under section 42(d) and that are included in the 
adjusted basis of depreciable property that is subject to section 168 
and that is residential rental property for purposes of section 142(d) 
and Sec.  1.103-8(b);
    (ii) Costs that are included in eligible basis of a low-income 
housing building under section 42(d) and that are included in the 
adjusted basis of depreciable property that is subject to section 168 
and that is used in a common area or is provided as a comparable amenity 
to all residential rental units in the building; and
    (iii) Costs of the type described in paragraph (b)(4)(i) and (ii) of 
this section incurred after the first year of the low-income housing 
building's credit period under section 42(f).
    (5) The qualified contract amount is the sum of the fair market 
value of the non-low-income portion of the building (within the meaning 
of section 42(h)(6)(F) and paragraph (b)(3) of this section) and the 
price for the low-income portion of the building (within the meaning of 
section 42(h)(6)(F) and paragraph (b)(2) of this section) as calculated 
in paragraph (c)(2) of this section. If this sum is not a multiple of 
$1,000, then when the Agency offers the building for sale to the general 
public, the Agency may round up the offering price to the next highest 
multiple of $1,000.
    (c) Qualified contract purchase price formula--(1) In general. For 
purposes of this section, qualified contract means a bona fide contract 
to acquire the building (within a reasonable period after the contract 
is entered into) for the qualified contract amount.
    (i) Initial determination. The qualified contract amount is 
determined at the time of the Agency's offer of sale of the building to 
the general public.
    (ii) Mandatory adjustment by the buyer and owner. The buyer and 
owner under a qualified contract must adjust the amount of the low-
income portion of the qualified contract formula to reflect changes in 
the components of the qualified contract formula such as mortgage 
payments that reduce outstanding indebtedness between the time of the 
Agency's offer of sale to the general public and the building's actual 
sale closing date.
    (iii) Optional adjustment by the Agency and owner. The Agency and 
owner may agree to adjust the fair market value of the non low-income 
portion of the building after the Agency's offer of sale of the building 
to the general public and before the close of the one-year period 
described in paragraph (a)(1)(ii)(B) of this section. If no agreement 
between the Agency and owner is reached, the fair market value of the 
non-low-income portion of the building determined at the time of the 
Agency's offer of sale of the building to the general public remains 
unchanged.
    (2) Low-income portion amount. The low-income portion amount is an 
amount not less than the applicable fraction specified in the 
commitment, as defined in section 42(h)(6)(B)(i), multiplied by the 
total of--
    (i) The outstanding indebtedness for the building (as defined in 
paragraph (c)(3) of this section); plus
    (ii) The adjusted investor equity in the building for the calendar 
year (as defined in paragraph (c)(4) of this section); plus
    (iii) Other capital contributions (as defined in paragraph (c)(5) of 
this section), not including any amounts described in paragraphs 
(c)(2)(i) and (ii) of this section; minus
    (iv) Cash distributions from (or available for distribution from) 
the building

[[Page 236]]

(as defined in paragraph (c)(6) of this section).
    (3) Outstanding indebtedness. For purposes of paragraph (c)(2)(i) of 
this section, outstanding indebtedness means the remaining stated 
principal balance (which is initially determined at the time of the 
Agency's offer of sale of the building to the general public) of any 
indebtedness secured by, or with respect to, the building that does not 
exceed the amount of qualifying building costs described in paragraph 
(b)(4) of this section. Thus, any refinancing indebtedness or additional 
mortgages in excess of such qualifying building costs are not 
outstanding indebtedness for purposes of section 42(h)(6)(F) and this 
section. Examples of outstanding indebtedness include certain mortgages 
and developer fee notes (excluding developer service costs not included 
in eligible basis). Outstanding indebtedness does not include debt used 
to finance nondepreciable land costs, syndication costs, legal and 
accounting costs, and operating deficit payments. Outstanding 
indebtedness includes only obligations that are indebtedness under 
general principles of Federal income tax law and that are actually paid 
to the lender upon the sale of the building or are assumed by the buyer 
as part of the sale of the building.
    (4) Adjusted investor equity--(i) Application of cost-of-living 
factor. For purposes of paragraph (c)(2)(ii) of this section, the 
adjusted investor equity for any calendar year equals the unadjusted 
investor equity, as described in paragraph (c)(4)(ii) of this section, 
multiplied by the qualified-contract cost-of-living adjustment for that 
year, as defined in paragraph (c)(4)(iii) of this section.
    (ii) Unadjusted investor equity. For purposes of this paragraph 
(c)(4), unadjusted investor equity means the aggregate amount of cash 
invested by owners for qualifying building costs described in paragraph 
(b)(4)(i) and (ii) of this section. Thus, equity paid for land, credit 
adjuster payments, Agency low-income housing credit application and 
allocation fees, operating deficit contributions, and legal, 
syndication, and accounting costs all are examples of cost payments that 
do not qualify as unadjusted investor equity. Unadjusted investor equity 
takes an amount into account only to the extent that, as of the 
beginning of the low-income building's credit period (as defined in 
section 42(f)(1)), there existed an obligation to invest the amount. 
Unadjusted investor equity does not include amounts included in the 
calculation of outstanding indebtedness as defined in paragraph (c)(3) 
of this section.
    (iii) Qualified-contract cost-of-living adjustment. For purposes of 
this paragraph (c)(4), the qualified-contract cost-of-living adjustment 
for a calendar year is the number that is computed under the general 
rule in paragraph (c)(4)(iv) of this section or a number that may be 
provided by the Commissioner as described in paragraph (c)(4)(v) of this 
section.
    (iv) General rule. Except as provided in paragraph (c)(4)(v) of this 
section, the qualified-contract cost-of-living adjustment is the 
quotient of--
    (A) The sum of the 12 monthly Consumer Price Index (CPI) values 
whose average is the CPI for the calendar year that precedes the 
calendar year in which the Agency offers the building for sale to the 
general public (The term ``CPI for a calendar year'' has the meaning 
given to it by section 1(f)(4) for purposes of computing annual 
inflation adjustments to the rate brackets.); divided by
    (B) The sum of the 12 monthly CPI values whose average is the CPI 
for the base calendar year (within the meaning of section 1(f)(4)), 
unless that sum has been increased under paragraph (c)(4)(iii)(D) of 
this section.
    (v) Provision by the Commissioner of the qualified-contract cost-of-
living adjustment. The Commissioner may publish in the Internal Revenue 
Bulletin (see Sec.  601.601(d)(2) of this chapter) a process pursuant to 
which the Internal Revenue Service will compute the qualified-contract 
cost-of-living adjustment for a calendar year and make available the 
results of that computation.
    (vi) Methodology. The calculations in paragraph (c)(4)(iv) of this 
section are to be made in the following manner:
    (A) The CPI data to be used for purposes of this paragraph (c)(4) 
are the not seasonally adjusted values of the CPI for all urban 
consumers. (The U.S. Department of Labor's Bureau of Labor

[[Page 237]]

Statistics (BLS) sometimes refers to these values as ``CPI-U.'') The BLS 
publishes the CPI data on-line (including a History Table that contains 
monthly CPI-U values for all years back to 1913). See www.BLS.gov/data.
    (B) The quotient is to be carried out to 10 decimal places.
    (C) The Agency may round adjusted investor equity to the nearest 
dollar.
    (D) If the CPI for any calendar year (within the meaning of section 
1(f)(4)) during the extended use period after the base calendar year 
exceeds by more than 5 percent the CPI for the preceding calendar year 
(within the meaning of section 1(f)(4)), then the sum described in 
paragraph (c)(4)(i)(B) is to be increased so that the excess is never 
taken into account under this paragraph (c)(4).
    (vii) Example. The following example illustrates the calculations 
described in this paragraph (c)(4):

    Example. (i) Facts. Owner contributed $20,000,000 in equity to a 
building in 1997, which was the first year of the credit period for the 
building. In 2011, Owner requested Agency to find a buyer to purchase 
the building, and Agency offered the building for sale to the general 
public during 2011. The CPI for 1997 (within the meaning of section 
1(f)(4)) is the average of the Consumer Price Index as of the close of 
the 12-month period ending on August 31, 1997. The sum of the CPI values 
for the twelve months from September 1996 through August 1997 is 1913.9. 
The CPI for 2010 (within the meaning of section 1(f)(4)) is the average 
of the Consumer Price Index as of the close of the 12-month period 
ending August 31, 2010. The sum of the CPI values for the twelve months 
from September 2009 through August 2010 is 2605.959. At no time during 
this period (after the base calendar year) did the CPI for any calendar 
year exceed the CPI for the preceding calendar year by more than 5 
percent.
    (ii) Determination of adjusted investor equity. The qualified-
contract cost-of-living adjustment is 1.3615962171 (the quotient of 
2605.959, divided by 1913.9). Owner's adjusted investor equity, 
therefore, is $27,231,924, which is $20,000,000, multiplied by 
1.3615962171, rounded to the nearest dollar.

    (5) Other capital contributions. For purposes of paragraph 
(c)(2)(iii) of this section, other capital contributions to a low-income 
building are qualifying building costs described in paragraph (b)(4)(ii) 
of this section paid or incurred by the owner of the low-income building 
other than amounts included in the calculation of outstanding 
indebtedness or adjusted investor equity as defined in this section. For 
example, other capital contributions may include amounts incurred to 
replace a furnace after the first year of a low-income housing credit 
building's credit period under section 42(f), provided any loan used to 
finance the replacement of the furnace is not secured by the furnace or 
the building. Other capital contributions do not include expenditures 
for land costs, operating deficit payments, credit adjuster payments, 
and payments for legal, syndication, and accounting costs.
    (6) Cash distributions--(i) In general. For purposes of paragraph 
(c)(2)(iv) of this section, the term cash distributions from (or 
available for distribution from) the building include--
    (A) All distributions from the building to the owners or to persons 
whose relationship to the owner is described in section 267(b) or 
section 707(b)(1)), including distributions under section 301 (relating 
to distributions by a corporation), section 731 (relating to 
distributions by a partnership), or section 1368 (relating to 
distributions by an S corporation); and
    (B) All cash and cash equivalents available for distribution at, or 
before, the time of sale, including, for example, reserve funds whether 
operating or replacement reserves, unless the reserve funds are legally 
required by mortgage restrictions, regulatory agreements, or third party 
contractual agreements to remain with the building following the sale.
    (ii) Excess proceeds. For purposes of paragraph (c)(6)(i) of this 
section, proceeds from the refinancing of indebtedness or additional 
mortgages that are in excess of qualifying building costs are not 
considered cash available for distribution.
    (iii) Anti-abuse rule. The Commissioner will interpret and apply the 
rules in this paragraph (c)(6) as necessary and appropriate to prevent 
manipulation of the qualified contract amount. For example, cash 
distributions include payments to owners or persons whose relation to 
owners is described in section 267(b) or section

[[Page 238]]

707(b) for any operating expenses in excess of amounts reasonable under 
the circumstances.
    (d) Administrative discretion and responsibilities of the Agency--
(1) In general. An Agency may exercise administrative discretion in 
evaluating and acting upon an owner's request to find a buyer to acquire 
the building. An Agency may establish reasonable requirements for 
written requests and may determine whether failure to follow one or more 
applicable requirements automatically prevents a purported written 
request from beginning the one-year period described in section 
42(h)(6)(I). If the one-year-period has already begun, the Agency may 
determine whether failure to follow one or more requirements suspends 
the running of that period. Examples of Agency administrative discretion 
include, but are not limited to, the following:
    (i) Concluding that the owner's request lacks essential information 
and denying the request until such information is provided.
    (ii) Refusing to consider an owner's representations without 
substantiating documentation verified with the Agency's records.
    (iii) Determining how many, if any, subsequent requests to find a 
buyer may be submitted if the owner has previously submitted a request 
for a qualified contract and then rejected or failed to act upon a 
qualified contract presented by the Agency.
    (iv) Assessing and charging the owner certain administrative fees 
for the performance of services in obtaining a qualified contract (for 
example, real estate appraiser costs).
    (v) Requiring all appraisers involved in the qualified contract 
process to be State certified general appraisers that are acceptable to 
the Agency.
    (vi) Specifying other conditions applicable to the qualified 
contract consistent with section 42 and this section.
    (2) Actual offer. Upon receipt of a written request from the owner 
to find a person to acquire the building, the Agency must offer the 
building for sale to the general public, based on reasonable efforts, at 
the determined qualified contract amount in order for the qualified 
contract to satisfy the requirements of this section unless the Agency 
has already identified a willing buyer who submitted a qualified 
contract to purchase the project.
    (3) Debarment of certain appraisers. Agencies shall not utilize any 
individual or organization as an appraiser if that individual or 
organization is currently on any list for active suspension or 
revocation for performing appraisals in any State or is listed on the 
Excluded Parties Lists System (EPLS) maintained by the General Services 
Administration for the United States Government found at www.epls.gov.
    (e) Effective date/applicability date. These regulations are 
applicable to owner requests to housing credit agencies on or after May 
3, 2012 to obtain a qualified contract for the acquisition of a low-
income housing credit building.

[T.D. 9587, 77 FR 26178, May 3, 2012]



Sec.  1.42-19  Average income test.

    (a) Average income set-aside. A project for residential rental 
property satisfies the average income test in section 42(g)(1)(C) for a 
taxable year if the project contains a qualified group of units (within 
the meaning of paragraph (b)(2) of this section) that constitutes 40 
percent or more of the residential units in the project. (In the case of 
a project described in section 142(d)(6), ``40 percent'' in the 
preceding sentence is replaced with ``25 percent.'')
    (b) Definition of low-income unit and qualified group of units--(1) 
Definition of low-income unit. For purposes of this section, a 
residential unit is a low-income unit if and only if -
    (i) Such unit is rent-restricted (as defined in section 42(g)(2));
    (ii) The individuals occupying such unit satisfy the imputed income 
limitation of that unit designated by the taxpayer in accordance with 
paragraphs (c)(3) and (d) of this section and with Sec.  1.42-19T(c) and 
(d), or the unit meets the requirements under section 42(g)(2)(D);
    (iii) No provision in section 42 (including section 42(i)(3)(B)-(E)) 
or in the regulations under section 42 denies low-income status to that 
unit; and
    (iv) The unit is part of a qualified group of units under paragraph 
(b)(2) of this section.

[[Page 239]]

    (2) Definition of qualified group of units. A group of residential 
units is a qualified group of units for a taxable year if and only if--
    (i) Each unit in the group satisfies the requirements of paragraphs 
(b)(1)(i) through (iii) of this section; and
    (ii) The average of the imputed income limitations of all of the 
units in the group does not exceed 60 percent of area median gross 
income (AMGI).
    (3) Identification of qualified groups of units--(i) Average income 
set-aside test. For each taxable year in the extended use period, the 
taxpayer must identify a qualified group of units that constitute 40 
percent or more of the residential units in the project. The 
requirements in paragraph (b)(3)(iii) of this section apply to these 
identifications.
    (ii) Applicable fraction determinations. For each taxable year in 
the extended use period, the taxpayer must identify a qualified group of 
units to be used in determining the applicable fractions for the 
buildings in the project.
    (A) Identification of the units in the qualified group of units used 
for determining applicable fractions. The residential units that are 
identified for purposes of this paragraph (b)(3)(ii) include the units 
that, under paragraph (b)(3)(i) of this section, are included in the 
qualified group of units identified for purposes of the set-aside 
qualification of the project. The taxpayer may identify additional units 
for inclusion in the group of units used in determining the applicable 
fractions for buildings in the project provided that the resulting group 
is a qualified group of units within the meaning of paragraph (b)(2) of 
this section.
    (B) Computing applicable fractions of buildings. For a taxable year, 
the applicable fraction of a building in a project is computed using the 
units that are in the particular building and that are also in the 
qualified group of units for the project identified for purposes of this 
paragraph (b)(3)(ii). The units included in the applicable fraction of a 
building do not have to be a qualified group of units on their own. See 
Example 4 of paragraph (e) of this section.
    (iii) Identification of units. The recordkeeping and reporting 
requirements in Sec.  1.42-19T(c)(1) apply both to the identification of 
units that is required by paragraph (b)(3)(i) of this section and the 
identification of units that is described in paragraph (b)(3)(ii) of 
this section.
    (c) Procedures. (1)-(2) [Reserved]
    (3) Designation of imputed income limitations--(i) Timing of 
designation. (A) Before a unit is first occupied as a low-income unit, 
or, except as provided in paragraph (c)(3)(i)(B) of this section, is 
first occupied under a changed income limit, the taxpayer must designate 
the unit's imputed income limitation or changed imputed income 
limitation.
    (B) For an occupied unit that is subject to a change in imputed 
income limitation pursuant to paragraph (d) of this section, the 
taxpayer must designate the unit's changed imputed income limitation not 
later than the end of the taxable year in which the change occurs.
    (ii) 10-percent increments. Under section 42(g)(1)(C)(ii)(III), a 
designation is valid only if it is one of the following: 20 percent, 30 
percent, 40 percent, 50 percent, 60 percent, 70 percent, or 80 percent 
of AMGI.
    (iii) Continuity. Except as provided in paragraph (d) of this 
section, the imputed income limitation of a residential unit does not 
change.
    (iv) [Reserved]
    (4) [Reserved]
    (d) Changing a unit's designated imputed income limitation--(1) 
Permitted changes. Notwithstanding paragraph (c)(3)(iii) of this 
section, the taxpayer may change the imputed income limitation of a unit 
in the following circumstances subject to the timing of designation 
requirement in paragraph (c)(3)(i)(B) of this section.
    (i) Federally permitted changes. Permission for the change is 
contained in IRS forms, instructions, or guidance published in the 
Internal Revenue Bulletin pursuant to Sec.  601.601(d)(2)(ii)(b) of this 
chapter.
    (ii) Housing credit agency (Agency)-permitted changes. The Agency 
with jurisdiction of the project has issued public written guidance that 
provides conditions for a permitted change and that applies to all 
average income test projects under the jurisdiction of the Agency.

[[Page 240]]

    (iii) Certain laws. The change in designation is required or 
appropriate to enhance protections contained in the following, as 
amended--
    (A) The Americans with Disabilities Act of 1990 (ADA), Pub. L. 101-
336, 104 Stat. 328, 42 U.S.C. 12101, et seq.;
    (B) The Fair Housing Amendments Act of 1988, Pub. L. 100-430, 102 
Stat.1619, 42 U.S.C. 3601, et. seq.;
    (C) The Violence Against Women Act of 1994, Pub. L. 103-322, 108 
Stat. 1902, 34 U.S.C. 12291, et. seq.;
    (D) The Rehabilitation Act of 1973, Pub. L. 93-112, 87 Stat. 394, 29 
U.S.C. 701, et seq.; or
    (E) Any other State, Federal, or local law or program that protects 
tenants and that is identified pursuant to paragraph (d)(1)(i) or (ii) 
of this section.
    (iv) Tenant movement. If a current income-qualified tenant moves to 
a different unit in the project--
    (A) The unit to which the tenant moves has its imputed income 
designation, if any, changed to the limitation of the unit from which 
the tenant is moving; and
    (B) The vacated unit takes on the prior limitation, if any, of the 
tenant's new unit.
    (v) Restoring compliance with average income requirements. If one or 
more units lose low-income status or if there is a change in the imputed 
income limitation of some unit and if either event would cause a 
previously qualifying group of units to cease to be described in 
paragraph (b)(2)(ii) of this section, then the taxpayer may designate an 
imputed income limitation for a market-rate unit or may reduce the 
existing imputed income limitations of one or more other units in the 
project in order to restore compliance with the average income 
requirement. The rule in this paragraph (d)(1)(v) may be applied to 
market-rate, vacant, or low-income units, but, in the case of occupied 
units, the current tenants must qualify under the new, lower imputed 
income limitation.
    (2) [Reserved]
    (e) Examples. The operation of this section is illustrated by the 
following examples.
    (1) Example 1--(i) Facts. (A) A single-building housing project 
received an allocation of housing credit dollar amount. The taxpayer who 
owns the project elects the average income test, intending for the 10-
unit building to have 100 percent low-income occupancy. The taxpayer 
properly and timely designates the imputed income limitations for the 10 
units as follows: 5 units at 80 percent of AMGI; and 5 units at 40 
percent of AMGI. Also, for the first credit year, the taxpayer follows 
proper procedure in identifying 4 units as the qualified group of units 
that are to be used for qualifying under the average income set-aside 
(Units 1, 2, 6, and 7). Additionally, for the first credit year, the 
taxpayer follows proper procedure in identifying all 10 units as the 
qualified group of units that are to be used for the applicable fraction 
determination. All of the units in the project are described in 
paragraphs (b)(1)(i) through (iii) of this section.

                    Table 1 to Paragraph (e)(1)(i)(A)
------------------------------------------------------------------------
                                       Imputed income  limitation of the
              Unit No.                               unit
------------------------------------------------------------------------
1...................................  80 percent of AMGI.
2...................................  80 percent of AMGI.
3...................................  80 percent of AMGI.
4...................................  80 percent of AMGI.
5...................................  80 percent of AMGI.
6...................................  40 percent of AMGI.
7...................................  40 percent of AMGI.
8...................................  40 percent of AMGI.
9...................................  40 percent of AMGI.
10..................................  40 percent of AMGI.
------------------------------------------------------------------------

    (B) In the first taxable year of the credit period (Year 1), the 
project is fully leased and occupied.
    (ii) Analysis. The identified groups are qualified groups under 
paragraph (b)(2) of this section. All units in both of the groups are 
described in paragraphs (b)(1)(i) through (iii) of this section, and the 
averages of the imputed income limitations of both the 4-unit group 
(Units 1, 2, 6, and 7) and the 10-unit group do not exceed 60 percent 
of AMGI.
    (A) Average income set-aside. The project qualifies under the 
average income set-aside because the identified group of 4 units (Units 
1, 2, 6, and 7) is a qualified group of units that comprise at least 
40% of the residential units in the project.
    (B) Qualified basis. All 10 units in the identified qualified group 
of units are

[[Page 241]]

used in the applicable fraction determination when calculating qualified 
basis for purposes of determining the annual credit amount under section 
42(a).
    (2) Example 2--(i) Facts. Assume the same facts as Example 1 of 
paragraph (e)(1) of this section. In Year 2, Unit 6 (which has a 
designated imputed income limitation of 40 percent of AMGI) becomes 
uninhabitable. Repair work on Unit 6 is completed in Year 3. For Year 
2, Taxpayer identifies the following as a qualified group of units that 
are to be used for both the set-aside requirement and the applicable 
fraction determination: Units 1-4 and 7-10. For Year 3, Taxpayer 
identifies all 10 units as the qualified group of units that are to be 
used for the set-aside requirement and the applicable fraction 
determination.
    (ii) Analysis. For Year 2, the identified group is a qualified group 
under paragraph (b)(2) of this section. All 8 units in the group are 
described in paragraphs (b)(1)(i) through (iii) of this section, and the 
average of the imputed income limitations of the 8 units in the group of 
units does not exceed 60 percent of AMGI.
    (A) Average income set-aside. For Year 2, the project qualifies for 
the average income set-aside because the project contains a qualified 
group of units that comprises at least 40% of the residential units in 
the project.
    (B) Qualified basis. To determine qualified basis in Year 2, the 8 
units in the identified qualified group of units are used in the 
applicable fraction determination when calculating qualified basis for 
purposes of determining the annual credit amount under section 42(a). 
Unit 6 could not have been identified in the qualified group of units 
for use in the applicable fraction determination because its lack of 
habitability prevents it from being a low-income unit. Further, Taxpayer 
could not have identified all 9 of the habitable units to be used in the 
qualified group of units for the applicable fraction determination 
because the average of imputed income limitations of those 9 exceeds 60 
percent of AMGI. Taxpayer had a choice of which of Units 1-5 it was 
going to not identify for use in the applicable fraction determination. 
Omitting any one of them reduces the average limitation of the remaining 
group of 8 units to an amount that does not exceed 60 percent of AMGI. 
Given taxpayer's decision to leave out Unit 5, Units 1, 2, 3, 4, 7, 
8, 9, and 10 are taken into account in the applicable fraction.
    (C) Recapture. At the close of Year 2, Unit 6's unsuitability for 
occupancy precludes it from being described in paragraph (b)(1)(iii) of 
this section. Unit 6's resulting failure to be a low-income unit 
prevents it from being in a qualified group for purposes of computing 
the applicable fraction. The decline in the applicable fraction yields a 
decline in qualified basis, which results in credit recapture under 
section 42(j) for Year 2. Additionally, Unit 5 is not a low-income unit 
because the taxpayer did not include it in the qualified group of units 
identified for determining the building's applicable fraction. The 
exclusion of Unit 5 from the qualified group of units further reduces 
the applicable fraction for Year 2 and so reduces qualified basis for 
that year as well. Thus, this exclusion increases the credit recapture 
amount under section 42(j).
    (D) Restoration of habitability and of qualified basis. As described 
in the facts in paragraph (e)(2)(i) of this section, in Year 3, after 
repair work is complete, the formerly uninhabitable Unit 6 is again 
occupied by a qualified tenant at the same imputed income limitation, 
and the Taxpayer identifies all 10 units as the qualified group of units 
that are to be used for the set-aside requirement and the applicable 
fraction determination. The identified group is a qualified group under 
paragraph (b)(2) of this section. All 10 units in the group are 
described in paragraphs (b)(1)(i) through (iii) of this section, and the 
average of the imputed income limitations of the 10 units in the group 
of units does not exceed 60 percent of AMGI. For Year 3, all 10 units 
are included in the qualified group of units for purposes of the average 
income set-aside test and are a qualified group of units for the 
applicable fraction determination.
    (3) Example 3--(i) Facts. Assume the same facts as Example 2 of 
paragraph (e)(2) of this section, except that the

[[Page 242]]

income for the tenant residing in Unit 5 has declined so that tenant's 
income does not exceed 60 percent of AMGI. For Year 2, taxpayer timely 
redesignates Unit 5 pursuant to the rule in paragraph (d)(1)(v) of this 
section so that the imputed income limitation is 60 percent of AMGI 
instead of 80 percent of AMGI. Taxpayer also makes revisions so that 
Unit 5 is rent-restricted under the redesignated imputed income 
limitation. Taxpayer identifies 9 units (Units 1-5 and 7-10) as the 
qualified group of units that are to be used for the set-aside 
requirement and the applicable fraction determination.
[GRAPHIC] [TIFF OMITTED] TR30NO22.005

    (ii) Analysis. For Year 2, the identified group is a qualified group 
under paragraph (b)(2) of this section. All 9 units in the group are 
described in paragraphs (b)(1)(i) through (iii) of this section, and the 
average of the imputed income limitations of the 9 units in the group of 
units does not exceed 60 percent of AMGI.
    (A) Average income set-aside. For Year 2, project contains a 
qualified group of units that comprises at least 40% of the residential 
units in the project.
    (B) Qualified basis. To determine qualified basis, all 9 units in 
the identified qualified group of units are used in the applicable 
fraction determination when calculating qualified basis for

[[Page 243]]

purposes of determining the annual credit amount under section 42(a). 
Unit 6 could not have been identified in the qualified group of units 
for use in the applicable fraction determination because its lack of 
habitability prevents it from being a low-income unit. Thus, Units 1, 
2, 3, 4, 5, 7, 8, 9, and 10 are taken into account in the applicable 
fraction determination.
    (C) Recapture. At the close of Year 2, the amount of the qualified 
basis is less than the amount of the qualified basis at the close of 
Year 1, because Unit 6's unsuitability for occupancy prohibits it from 
being a low-income unit. Unit 6's failure to be a low-income unit 
results in a credit recapture amount under section 42(j) for Year 2 
related to Unit 6. Because Units 1-5 and 7-10 are all included in the 
qualified group of units for use in the applicable fraction 
determination, Units 1-5 and 7-10 are included in qualified basis for 
Year 2 when determining the recapture amount.
    (4) Example 4--(i) Facts. (A) A multiple-building housing project 
consisting of two buildings received an allocation of housing credit 
dollar amount, and the taxpayer who owns the project elects the average 
income test. The taxpayer intends for the buildings (each containing 5 
units) to have 100 percent low-income occupancy. The taxpayer properly 
and timely designates the imputed income limitations for the 10 units in 
Buildings 1 and 2 as follows: Building A contains 2 units at 80 percent 
of AMGI and 3 units at 40 percent of AMGI; and Building B contains 2 
units at 40 percent of AMGI and 3 units at 80 percent of AMGI.

                    Table 3 to Paragraph (e)(4)(i)(A)
------------------------------------------------------------------------
                                       Imputed income  limitation of the
        Building A, Unit No.                         unit
------------------------------------------------------------------------
    A1..............................  80 percent of AMGI.
    A2..............................  80 percent of AMGI.
    A3..............................  40 percent of AMGI.
    A4..............................  40 percent of AMGI.
    A5..............................  40 percent of AMGI.
------------------------------------------------------------------------
Building B, Unit No.
------------------------------------------------------------------------
    B1..............................  40 percent of AMGI.
    B2..............................  40 percent of AMGI.
    B3..............................  80 percent of AMGI.
    B4..............................  80 percent of AMGI.
    B5..............................  80 percent of AMGI.
------------------------------------------------------------------------

    (B) In the first taxable year of the credit period (Year 1), the 
project is fully leased and occupied. Also, for the first credit year, 
the taxpayer follows proper procedure in identifying all 10 units as a 
qualified group of units for the minimum set-aside and the applicable 
fraction determination.
    (ii) Analysis. For Year 1, the identified group is a qualified group 
under paragraph (b)(2) of this section. All 10 units in the group are 
described in paragraphs (b)(1)(i) through (iii) of this section, and the 
average of the imputed income limitations of the 10 units in the group 
of units does not exceed 60 percent of AMGI.
    (A) Average income test. The multiple-building project meets the 
average income test as the project contains a qualified group of units 
that comprises at least 40% of the residential units in the project. The 
fact that the average of the income limitations of the units in Building 
B exceeds 60 percent of AMGI does not impact this result.
    (B) Qualified basis. To determine qualified basis, all 10 units in 
the identified qualified group of units across Building A and Building B 
are used in the applicable fraction determination when calculating 
qualified basis of each building for purposes of determining the annual 
credit amount under section 42(a). The fact that the average of the 
units in Building B exceeds 60 percent of AMGI does not impact the 
applicable fraction of Building B because the average of the identified 
group of units across both buildings does not exceed 60 percent of AMGI.
    (5) Example 5--(i) Facts. A single-building housing project received 
an allocation of housing credit dollar amount, and the taxpayer who owns 
the project elects the average income test. During Year 2 of the credit 
period, the tenant residing in a unit with a designated imputed income 
limitation of 40 percent of AMGI moves to a market-rate unit within the 
same project. The tenant's income continues to be at or below 40 percent 
of AMGI.
    (ii) Analysis. Under the rule in paragraph (d)(1)(iv) of this 
section, when the current income-qualified tenant moves to a different 
unit in the project, the unit to which the tenant moves is eligible for 
the taxpayer to

[[Page 244]]

designate as a unit with a designated imputed income limitation of 40 
percent of AMGI. If the taxpayer makes those designations, the unit 
vacated by the tenant takes on the prior limitation, if any, of the 
tenant's new unit. In this situation, the vacated unit formerly occupied 
by the tenant is now a market-rate unit.
    (6) Example 6--(i) Facts. A single-building housing project received 
an allocation of housing credit dollar amount, and the taxpayer who owns 
the project elects the average income test. During Year 2 of the credit 
period, the disability status under the ADA of a tenant changes, and 
therefore under the provisions of the ADA, the tenant now needs to 
reside in a different unit with different accommodations. The tenant 
currently resides in a unit with a designated imputed income limitation 
of 40 percent of AMGI. A unit that would meet the tenant's needs is 
available on the first-floor of the building, but it was previously a 
low-income unit with a designated imputed income limitation of 70 
percent of AMGI and thus a higher maximum gross rent than the tenant's 
current unit. The tenant moves to the first-floor unit.
    (ii) Analysis. The tenant's move was required under the ADA. 
Accordingly, the taxpayer is permitted to change the designation of the 
imputed income limitation of the first-floor unit so that the unit's 
designation is 40 percent of AMGI. Under paragraph (d)(1)(iv) of this 
section, the vacated unit takes on the prior limitation of 70 percent of 
AMGI of the tenant's new unit.
    (f) Applicability dates-(1) In general. Except as provided in 
paragraph (f)(3) of this section, this section applies to taxable years 
beginning after December 31, 2022.
    (2) Designations of occupied units. (i) If a residential unit is 
occupied at the end of the most recent taxable year ending before the 
first taxable year to which this section applies and if the unit is to 
be taken into account as a low-income unit under this section as of the 
beginning of the first taxable year to which this section applies, then 
not later than the first day of such first taxable year, the taxpayer 
must designate an imputed income limitation for the unit. The first 
taxable year to which this section applies means the first taxable year 
beginning after December 31, 2022, if paragraph (f)(1) of this section 
applies, or the taxable year described in paragraph (f)(3) of this 
section if the taxpayer chooses to apply paragraph (f)(3) of this 
section.
    (ii) The designation required by paragraph (f)(2)(i) of this section 
must comply with paragraph (c)(3)(ii) of this section and Sec.  1.42-
19T(c)(3)(iv), without taking into account Sec.  1.42-19T(c)(4). Section 
1.42-19T(c)(2) applies to these designations, except that the Agency may 
allow the notification to be made along with any other notifications for 
the first taxable year beginning after December 31, 2022.
    (iii) The designated imputed income limitation for the unit may not 
be less than the income that the current occupant of the unit had when 
that occupancy began.
    (3) Applicability of this section to taxable years beginning before 
January 1, 2023. A taxpayer may choose to apply this section to a 
taxable year beginning after October 12, 2022, and before January 1, 
2023, provided that the taxpayer chooses to apply Sec.  1.42-15 to the 
same taxable year.

[T.D. 9967, 87 FR 61501, Oct. 12, 2022, as amended at 87 FR 68048, Nov. 
14, 2022; T.D. 9967, 87 FR 73458, Nov. 30, 2022]



Sec.  1.42-19T  Average income test (temporary).

    (a)-(b) [Reserved]
    (c) Procedures--(1) Identification of low-income units for use in 
the average income set-aside test or the applicable fraction 
determination--(i) In general. For a taxable year, a taxpayer must 
follow the procedures described in paragraph (c)(1)(ii) of this section 
to identify--
    (A) A qualified group of units that satisfy the average income set-
aside test; and
    (B) A qualified group of units used to determine the applicable 
fraction.
    (ii) Recording and communicating. The procedures described in this 
paragraph (c)(1)(ii) are--
    (A) Recording the identification in its books and records, where the 
identification must be retained for a period

[[Page 245]]

not shorter than the record retention requirement under Sec.  1.42-
5(b)(2); and
    (B) Communicating the annual identifications to the applicable 
housing credit agency (Agency) as provided in paragraph (c)(2) of this 
section.
    (2) Notifications to the Agency with jurisdiction over a project--
(i) Agency flexibility. An Agency may establish the time and manner in 
which information is annually provided to it.
    (ii) Example. An Agency may allow a taxpayer to describe a current 
year's information by reporting differences from the previous year's 
information or by reporting that there are no such differences. Various 
Agencies may choose to apply this manner of reporting to the identity of 
a qualified group of units for use in the average income set-aside or 
applicable fraction determination, or the imputed income limits 
designated for the various units in a project.
    (3) Designation of imputed income limitations. (i)-(iii) [Reserved]
    (iv) Recording, retention, and annual communications related to 
designations. A taxpayer designates a unit's imputed income limitation 
by recording the limitation in its books and records, where it must be 
retained for a period not shorter than the record retention requirement 
under Sec.  1.42-5(b)(2). The preceding sentence applies both to units 
whose first occupancy is as a low-income unit and to previously market-
rate units that are converted to low-income status. The designation must 
also be communicated annually to the applicable Agency as provided in 
paragraph (c)(2) of this section.
    (4) Waiver for failure to comply with procedural requirements. On a 
case-by-case basis, the Agency has the discretion to waive in writing 
any failure to comply with the requirements of paragraph (c)(1) or (2) 
or (c)(3)(iv) of this section up to 180 days after discovery of the 
failure, whether by taxpayer or Agency. If an Agency exercises this 
discretion, then the relevant requirements are treated as having been 
satisfied. In such a case, the tax consequences under this section 
correspond to that deemed satisfaction.
    (d) Changing a unit's designated imputed income limitation. (1) 
[Reserved]
    (2) Process for changing a unit's designated imputed income 
limitation. The taxpayer effects a change in a unit's imputed income 
limitation by recording the limitation in its books and records, where 
it must be retained for a period not shorter than the record retention 
requirement under Sec.  1.42-5(b)(2). The new designation must also be 
communicated to the applicable Agency as provided in paragraph (c)(2) of 
this section and must become part of the annual report to the Agency of 
income designations. The prior designation must be retained in the books 
and records for the period specified in paragraph (c)(3)(iv) of this 
section. A designation under this paragraph (d)(2) is considered to be 
made in a manner consistent with paragraph (c)(3) of this section.
    (e) [Reserved]
    (f) Applicability dates--(1) In general. Except as provided in 
paragraph (f)(3) of this section, this section applies to taxable years 
beginning after December 31, 2022.
    (2) Designations of occupied units. (i) If a residential unit is 
occupied at the end of the most recent taxable year ending before the 
first taxable year to which this section applies and if the unit is to 
be taken into account as a low-income unit under this section as of the 
beginning of the first taxable year to which this section applies, then 
not later than the first day of such first taxable year, the taxpayer 
must designate an imputed income limitation for the unit. The first 
taxable year to which this section applies means the first taxable year 
beginning after December 31, 2022, if paragraph (f)(1) of this section 
applies, or the taxable year described in paragraph (f)(3) of this 
section if the taxpayer chooses to apply paragraph (f)(3) of this 
section.
    (ii) The designation required by paragraph (f)(2)(i) of this section 
must comply with Sec.  1.42-19(c)(3)(ii) and paragraph (c)(3)(iv) of 
this section, without taking into account paragraph (c)(4) of this 
section. Paragraph (c)(2) of this section applies to these designations, 
except that the Agency may allow the notification to be made along with 
any other notifications for the first taxable year beginning after 
December 31, 2022.

[[Page 246]]

    (iii) The designated imputed income limitation for the unit may not 
be less than the income that the current occupant of the unit had when 
that occupancy began.
    (3) Applicability of this section to taxable years beginning before 
January 1, 2023. A taxpayer may choose to apply this section to a 
taxable year beginning after October 12, 2022, and before January 1, 
2023, provided that the taxpayer chooses to apply Sec.  1.42-15 to the 
same taxable year.
    (4) Expiration date. The applicability of this section expires on 
October 7, 2025.

[T.D. 9967, 87 FR 61505, Oct. 12, 2022]



Sec.  1.42A-1  General tax credit for taxable years ending after 
December 31, 1975, and before January 1, 1979.

    (a)(1) Allowance of credit for taxable years ending after December 
31, 1975, and beginning before January 1, 1977. Subject to the special 
rules of paragraphs (b)(1), (c) and (d) and the limitation of paragraph 
(e)(1) of this section, an individual is allowed as a credit against the 
tax imposed by chapter 1 for the taxable year in the case of taxable 
years ending after December 31, 1975, and beginning before January 1, 
1977, an amount equal to the greater of--
    (i) 2 percent of so much of the individual's taxable income as does 
not exceed $9,000, or
    (ii) $35 multiplied by the total number of deductions for personal 
exemptions to which the individual is entitled for the taxable year 
under section 151 (b) and (e) and the regulations thereunder (relating 
to allowance of deductions for personal exemptions with respect to the 
individual, the individual's spouse, and dependents).

For purposes of applying subdivision (ii) of this paragraph (a)(1), the 
total number of deductions for personal exemptions shall not include any 
additional exemptions to which the individual or his spouse may be 
entitled based upon age of 65 or more or blindness under section 151 (c) 
or (d) and the regulations thereunder.y
    (2) Allowance of credit for taxable years beginning after December 
31, 1976, and ending before January 1, 1979. Subject to the special 
rules of paragraphs (b)(2), (c) and (d) and the limitation of paragraph 
(e)(2) of this section, an individual is allowed as a credit against the 
tax imposed by section 1, or against the tax imposed in lieu of the tax 
imposed by section 1, for the taxable year in the case of taxable years 
beginning after December 31, 1976, and ending before January 1, 1979, an 
amount equal to the greater of--
    (i) 2 percent of so much of the individual's taxable income for the 
taxable year, reduced by the zero bracket amount determined under 
section 63 (d), as does not exceed $9,000, or
    (ii) $35 multiplied by the total number of deductions for personal 
exemptions to which the individual is entitled for the taxable year 
under section 151 and the regulations thereunder (relating to allowance 
of deductions for personal exemptions).
    (b) Married individuals filing separate returns--(1) For taxable 
years ending after December 31, 1975, and beginning before January 1, 
1977. In the case of taxable years ending after December 31, 1975, and 
beginning before January 1, 1977, a married individual who files a 
separate return for the taxable year is allowed as a credit for the 
taxable year an amount equal to either--
    (i) 2 percent of so much of the individual's taxable income as does 
not exceed $4,500, or
    (ii) $35 multiplied by the total number of deductions for personal 
exemptions to which the individual is entitled for the taxable year 
under section 151 (b) and (e) and the regulations thereunder, but only 
if both the individual and the individual's spouse elect to have the 
credit determined in the manner described in this subdivision (ii) for 
their corresponding taxable years. The elections shall be made by both 
married individuals separately calculating and claiming the credit in 
the manner and amount described in this subdivision (ii) on their 
separate returns for their corresponding taxable years. The rules of 
section 142 (a) and the regulations thereunder (relating to individuals 
not eligible for the standard deduction) in effect for taxable years 
beginning before January 1, 1977, apply to determine whether the taxable 
years of the individual and the individual's spouse correspond to each 
other.

[[Page 247]]

For purposes of applying this subdivision (ii), the total number of 
deductions for personal exemptions shall not include any additional 
exemptions to which the individual may be entitled based upon age of 65 
or more or blindness under section 151 (c) or (d) and the regulations 
thereunder.
    (2) For taxable years beginning after December 31, 1976, and ending 
before January 1, 1979. In the case of taxable years beginning after 
December 31, 1976, and ending before January 1, 1979, a married 
individual who files a separate return for the taxable year shall 
determine the amount of the credit for the taxable year under section 
42(a)(2) and Sec.  1.42A-1(a)(2)(ii).
    (3) Determination of marital status. For purposes of this paragraph, 
the determination of marital status shall be made as provided by section 
143 and the regulations thereunder (relating to the determination of 
marital status).
    (c) Return for short period on change of annual accounting period. 
In computing the credit provided by section 42 and this section for a 
period of less than 12 months (hereinafter referred to as a ``short 
period''), where income is to be annualized under section 443(b)(1) in 
order to determine the tax--
    (1) The credit allowed by paragraphs (a) (1)(i) and (2)(i) of this 
section shall be computed based upon the amount of the taxable income 
annualized under the rules of section 443(b)(1) and Sec.  1.443-1(b)(1), 
or
    (2)(i) The credit allowed by paragraph (a)(1)(ii) of this section 
shall be computed based upon the total number of deductions for personal 
exemptions to which the individual is entitled for the short period 
under section 151 (b) and (e) and the regulations thereunder (relating 
to allowance of deductions for personal exemptions with respect to the 
individual, the individual's spouse, and dependents), and
    (ii) The credit allowed by paragraph (a)(2)(ii) of this section 
shall be computed based upon the total number of deductions for personal 
exemptions to which the individual is entitled for the short period 
under section 151 and the regulations thereunder (relating to allowance 
of deductions for personal exemptions).

As so computed, the credit allowed by section 42 and this section shall 
be allowed against the tax computed on the basis of the annualized 
taxable income. See Sec.  1.443-1(b)(1)(vi).
    (d) Certain persons not eligible--(1) Estates and trusts. The credit 
provided by section 42 and this section shall not be allowed in the case 
of any estate or trust. Thus, the credit shall not be allowed to an 
estate of an individual in bankruptcy or to an estate of a deceased 
individual. However, in the case of a deceased individual, the credit 
shall be allowed on the decedent's final return filed by his executor or 
other representative. Also, the credit provided by section 42 and this 
section shall be allowed in the case of a return filed by an estate of 
an infant, incompetent, or an individual under a disability.
    (2) Nonresident alien individuals. The credit provided by section 42 
and this section shall not be allowed in the case of any nonresident 
alien individual. As used in this subparagraph, the term ``nonresident 
alien individual'' has the meaning provided by Sec.  1.871-2. See, 
however, section 6013(g) for election to treat nonresident alien 
individual as resident of the United States. The credit shall be allowed 
to an alien individual who is a resident of the United States for part 
of the taxable year. See Sec.  1.871-2(b) for rules relating to the 
determination of residence of an alien individual. For purposes of 
paragraphs (a) (1)(i) and (2)(i) of this section, the credit allowed 
shall be computed by taking into account only that portion of the 
individual's taxable income which is attributable to the period of his 
residence in the United States. For purposes of paragraph (a)(1)(ii) of 
this section, the credit allowed shall be computed by taking into 
account only the total number of deductions for personal exemptions to 
which the individual is entitled under section 151 (b) and (e) for the 
period of his residence in the United States. For purposes of paragraph 
(a)(2)(ii) of this section, the credit allowed shall be computed by 
taking into account only the total number of deductions for personal 
exemptions to which the individual is entitled under section 151 for the 
period of his residence in the United States.

[[Page 248]]

See Sec.  1.871-13 for rules relating to changes of residence status 
during a taxable year.
    (e) Limitation--(1) For taxable years ending after December 31, 
1975, and beginning before January 1, 1977. For taxable years ending 
after December 31, 1975, and beginning before January 1, 1977, the 
credit allowed by section 42 and this section shall not exceed the 
amount of tax imposed by chapter 1 for the taxable year. In the case of 
an alien individual who is a resident of the United States for a part of 
the taxable year, the credit allowed by section 42 and this section 
shall not exceed the amount of tax imposed by chapter 1 for that portion 
of the taxable year during which the alien individual was a resident of 
the United States. See Sec.  1.871-13.
    (2) For taxable years beginning after December 31, 1976, and ending 
before January 1, 1979. For taxable years beginning after December 31, 
1976, and ending before January 1, 1979, the credit allowed by section 
42 and this section shall not exceed the amount of tax imposed by 
section 1, or the amount of tax imposed in lieu of the tax imposed by 
section 1, for the taxable year. In the case of an alien individual who 
is a resident of the United States for a part of the taxable year, the 
credit allowed by section 42 and this section shall not exceed the 
amount of tax imposed by section 1, or the amount of tax imposed in lieu 
of the tax imposed by section 1, for that portion of the taxable year 
during which the alien individual was a resident of the United States. 
See Sec.  1.871-13.
    (f) Application with other credits. In determining the credits 
allowed under--
    (1) Section 33 (relating to foreign tax credit),
    (2) Section 37 (relating to credit for the elderly),
    (3) Section 38 (relating to investment in certain depreciable 
property),
    (4) Section 40 (relating to expenses of work incentive programs), 
and
    (5) Section 41 (relating to contributions to candidates for public 
office),

the tax imposed for the taxable year shall first be reduced (before any 
other reduction) by the credit allowed by section 42 and this section 
for the taxable year.
    (g) Income tax tables to reflect credit. The tables prescribed under 
section 3 shall reflect the credit allowed by section 42 and this 
section.
    (h) Effective dates. The credit allowed by section 42 and this 
section applies only for taxable years ending after December 31, 1975, 
and before January 1, 1979.

[T.D. 7547, 43 FR 19653, May 8, 1978]



Sec.  1.43-0  Table of contents.

    This section lists the captions contained in Sec. Sec.  1.43-0 
through 1.43-7.

      Sec.  1.43-1 The enhanced oil recovery credit--general rules.

(a) Claiming the credit.
    (1) In general.
    (2) Examples.
(b) Amount of the credit.
(c) Phase-out of the credit as crude oil prices increase.
    (1) In general.
    (2) Inflation adjustment.
    (3) Examples.
(d) Reduction of associated deductions.
    (1) In general.
    (2) Certain deductions by an integrated oil company.
(e) Basis adjustment.
(f) Passthrough entity basis adjustment.
    (1) Partners' interests in a partnership.
    (2) Shareholders' stock in an S corporation.
(g) Examples.

          Sec.  1.43-2 Qualified enhanced oil recovery project.

(a) Qualified enhanced oil recovery project.
(b) More than insignificant increase.
(c) First injection of liquids, gases, or other matter.
    (1) In general.
    (2) Example.
(d) Significant expansion exception.
    (1) In general.
    (2) Substantially unaffected reservoir volume.
    (3) Terminated projects.
    (4) Change in tertiary recovery method.
    (5) Examples.
(e) Qualified tertiary recovery methods.
    (1) In general.
    (2) Tertiary recovery methods that qualify.
    (3) Recovery methods that do not qualify.
    (4) Examples.

                       Sec.  1.43-3 Certification.

(a) Petroleum engineer's certification of a project.
    (1) In general.
    (2) Timing of certification.
    (3) Content of certification.

[[Page 249]]

(b) Operator's continued certification of a project.
    (1) In general.
    (2) Timing of certification.
    (3) Content of certification.
(c) Notice of project termination.
    (1) In general.
    (2) Timing of notice.
    (3) Content of notice.
(d) Failure to submit certification.
(e) Effective date.

           Sec.  1.43-4 Qualified enhanced oil recovery costs.

(a) Qualifying costs.
    (1) In general.
    (2) Costs paid or incurred for an asset which is used to implement 
more than one qualified enhanced oil recovery project or for other 
activities.
(b) Costs defined.
    (1) Qualified tertiary injectant expenses.
    (2) Intangible drilling and development costs.
    (3) Tangible property costs.
    (4) Examples.
(c) Primary purpose.
    (1) In general.
    (2) Tertiary injectant costs.
    (3) Intangible drilling and development costs.
    (4) Tangible property costs.
    (5) Offshore drilling platforms.
    (6) Examples.
(d) Costs paid or incurred prior to first injection.
    (1) In general.
    (2) First injection after filing of return for taxable year costs 
are allowable.
    (3) First injection more than 36 months after close of taxable year 
costs are paid or incurred.
    (4) Injections in volumes less than the volumes specified in the 
project plan.
    (5) Examples.
(e) Other rules.
    (1) Anti-abuse rule.
    (2) Costs paid or incurred to acquire a project.
    (3) Examples.

                    Sec.  1.43-5 At-risk limitation.

                Sec.  1.43-6 Election out of section 43.

(a) Election to have the credit not apply.
    (1) In general.
    (2) Time for making the election.
    (3) Manner of making the election.
(b) Election by partnerships and S corporations.

               Sec.  1.43-7 Effective date of regulations.

[T.D. 8448, 57 FR 54923, Nov. 23, 1992]



Sec.  1.43-1  The enhanced oil recovery credit--general rules.

    (a) Claiming the credit--(1) In general. The enhanced oil recovery 
credit (the ``credit'') is a component of the section 38 general 
business credit. A taxpayer that owns an operating mineral interest (as 
defined in Sec.  1.614-2(b)) in a property may claim the credit for 
qualified enhanced oil recovery costs (as described in Sec.  1.43-4) 
paid or incurred by the taxpayer in connection with a qualified enhanced 
oil recovery project (as described in Sec.  1.43-2) undertaken with 
respect to the property. A taxpayer that does not own an operating 
mineral interest in a property may not claim the credit. To the extent a 
credit included in the current year business credit under section 38(b) 
is unused under section 38, the credit is carried back or forward under 
the section 39 business credit carryback and carryforward rules.
    (2) Examples. The following examples illustrate the principles of 
this paragraph (a).

    Example 1. Credit for operating mineral interest owner. In 1992, A, 
the owner of an operating mineral interest in a property, begins a 
qualified enhanced oil recovery project using cyclic steam. B, who owns 
no interest in the property, purchases and places in service a steam 
generator. B sells A steam, which A uses as a tertiary injectant 
described in section 193. Because A owns an operating mineral interest 
in the property with respect to which the project is undertaken, A may 
claim a credit for the cost of the steam. Although B owns the steam 
generator used to produce steam for the project, B may not claim a 
credit for B's costs because B does not own an operating mineral 
interest in the property.
    Example 2. Credit for operating mineral interest owner. C and D are 
partners in CD, a partnership that owns an operating mineral interest in 
a property. In 1992, CD begins a qualified enhanced oil recovery project 
using cyclic steam. D purchases a steam generator and sells steam to CD. 
Because CD owns an operating mineral interest in the property with 
respect to which the project is undertaken, CD may claim a credit for 
the cost of the steam. Although D owns the steam generator used to 
produce steam for the project, D may not claim a credit for the costs of 
the steam generator because D paid these costs in a capacity other than 
that of an operating mineral interest owner.

    (b) Amount of the credit. A taxpayer's credit is an amount equal to 
15 percent

[[Page 250]]

of the taxpayer's qualified enhanced oil recovery costs for the taxable 
year, reduced by the phase-out amount, if any, determined under 
paragraph (c) of this section.
    (c) Phase-out of the credit as crude oil prices increase--(1) In 
general. The amount of the credit (determined without regard to this 
paragraph (c)) for any taxable year is reduced by an amount which bears 
the same ratio to the amount of the credit (determined without regard to 
this paragraph (c)) as--
    (i) The amount by which the reference price determined under section 
29(d)(2)(C) for the calendar year immediately preceding the calendar 
year in which the taxable year begins exceeds $28 (as adjusted under 
paragraph (c)(2) of this section); bears to
    (ii) $6.
    (2) Inflation adjustment--(i) In general. For any taxable year 
beginning in a calendar year after 1991, an amount equal to $28 
multiplied by the inflation adjustment factor is substituted for the $28 
amount under paragraph (c)(1)(i) of this section.
    (ii) Inflation adjustment factor. For purposes of this paragraph 
(c), the inflation adjustment factor for any calendar year is a 
fraction, the numerator of which is the GNP implicit price deflator for 
the preceding calendar year and the denominator of which is the GNP 
implicit price deflator for 1990. The ``GNP implicit price deflator'' is 
the first revision of the implicit price deflator for the gross national 
product as computed and published by the Secretary of Commerce. As early 
as practicable, the inflation adjustment factor for each calendar year 
will be published by the Internal Revenue Service in the Internal 
Revenue Bulletin.
    (3) Examples. The following examples illustrate the principles of 
this paragraph (c).

    Example 1. Reference price exceeds $28. In 1992, E, the owner of an 
operating mineral interest in a property, incurs $100 of qualified 
enhanced oil recovery costs. The reference price for 1991 determined 
under section 29(d)(2)(C) is $30 and the inflation adjustment factor for 
1992 is 1. E's credit for 1992 determined without regard to the phase-
out for crude oil price increases is $15 ($100 x 15%). In determining 
E's credit, the credit is reduced by $5 ($15 x ($30 - ($28 x 1))/6). 
Accordingly, E's credit for 1992 is $10 ($15 - $5).
    Example 2. Inflation adjustment. In 1993, F, the owner of an 
operating mineral interest in a property, incurs $100 of qualified 
enhanced oil recovery costs. The 1992 reference price is $34, and the 
1993 inflation adjustment factor is 1.10. F's credit for 1993 determined 
without regard to the phase-out for crude oil price increases is $15 
($100 x 15%). In determining F's credit, $30.80 (1.10 x $28) is 
substituted for $28, and the credit is reduced by $8 ($15 x ($34 - 
$30.80)/6). Accordingly, F's credit for 1993 is $7 ($15 - $8).

    (d) Reduction of associated deductions--(1) In general. Any 
deduction allowable under chapter 1 for an expenditure taken into 
account in computing the amount of the credit determined under paragraph 
(b) of this section is reduced by the amount of the credit attributable 
to the expenditure.
    (2) Certain deductions by an integrated oil company. For purposes of 
determining the intangible drilling and development costs that an 
integrated oil company must capitalize under section 291(b), the amount 
allowable as a deduction under section 263(c) is the deduction allowable 
after paragraph (d)(1) of this section is applied. See Sec.  1.43-
4(b)(2) (extent to which integrated oil company intangible drilling and 
development costs are qualified enhanced oil recovery costs).
    (e) Basis adjustment. For purposes of subtitle A, the increase in 
the basis of property which would (but for this paragraph (e)) result 
from an expenditure with respect to the property is reduced by the 
amount of the credit determined under paragraph (b) of this section 
attributable to the expenditure.
    (f) Passthrough entity basis adjustment--(1) Partners' interests in 
a partnership. To the extent a partnership expenditure is not deductible 
under paragraph (d)(1) of this section or does not increase the basis of 
property under paragraph (e) of this section, the expenditure is treated 
as an expenditure described in section 705(a)(2)(B) (concerning 
decreases to basis of partnership interests). Thus, the adjusted bases 
of the partners' interests in the partnership are decreased (but not 
below zero).

[[Page 251]]

    (2) Shareholders' stock in an S corporation. To the extent an S 
corporation expenditure is not deductible under paragraph (d)(1) of this 
section or does not increase the basis of property under paragraph (e) 
of this section, the expenditure is treated as an expenditure described 
in section 1367(a)(2)(D) (concerning decreases to basis of S corporation 
stock). Thus, the bases of the shareholders' S corporation stock are 
decreased (but not below zero).
    (g) Examples. The following examples illustrate the principles of 
paragraphs (d) through (f) of this section.

    Example 1. Deductions reduced for credit amount. In 1992, G, the 
owner of an operating mineral interest in a property, incurs $100 of 
intangible drilling and development costs in connection with a qualified 
enhanced oil recovery project undertaken with respect to the property. G 
elects under section 263(c) to deduct these intangible drilling and 
development costs. The amount of the credit determined under paragraph 
(b) of this section attributable to the $100 of intangible drilling and 
development costs is $15 ($100 x 15%). Therefore, G's otherwise 
allowable deduction of $100 for the intangible drilling and development 
costs is reduced by $15. Accordingly, in 1992, G may deduct under 
section 263(c) only $85 ($100 - $15) for these costs.
    Example 2. Integrated oil company deduction reduced. The facts are 
the same as in Example 1, except that G is an integrated oil company. As 
in Example 1, the amount of the credit determined under paragraph (b) of 
this section attributable to the $100 of intangible drilling and 
development costs is $15, and G's allowable deduction under section 
263(c) is $85. Because G is an integrated oil company, G must capitalize 
25.50 ($85 x 30%) under section 291(b). Therefore, in 1992, G may deduct 
under section 263(c) only $59.50 ($85 - $25.50) for these intangible 
drilling and development costs.
    Example 3. Basis of property reduced. In 1992, H, the owner of an 
operating mineral interest in a property, pays $100 to purchase tangible 
property that is an integral part of a qualified enhanced oil recovery 
project undertaken with respect to the property. The amount of the 
credit determined under paragraph (b) of this section attributable to 
the $100 is $15 ($100 x 15%). Therefore, for purposes of subtitle A, H's 
basis in the tangible property is $85 ($100 - $15).
    Example 4. Basis of interest in passthrough entity reduced. In 1992, 
I is a $50% partner in IJ, a partnership that owns an operating mineral 
interest in a property. IJ pays $200 to purchase tangible property that 
is an integral part of a qualified enhanced oil recovery project 
undertaken with respect to the property. The amount of the credit 
determined under paragraph (b) of this section attributable to the $200 
is $30 ($200 x 15%). Therefore, for purposes of subtitle A, IJ's basis 
in the tangible property is $170 ($200 - $30). Under paragraph (f) of 
this section, the amount of the purchase price that does not increase 
the basis of the property ($30) is treated as an expenditure described 
in section 705(a)(2)(B). Therefore, I's basis in the partnership 
interest is reduced by $15 (I's allocable share of the section 
705(a)(2)(B) expenditure ($30 x 50%)).

[T.D. 8448, 57 FR 54923, Nov. 23, 1992; 58 FR 7987, Feb. 11, 1993]



Sec.  1.43-2  Qualified enhanced oil recovery project.

    (a) Qualified enhanced oil recovery project. A ``qualified enhanced 
oil recovery project'' is any project that meets all of the following 
requirements--
    (1) The project involves the application (in accordance with sound 
engineering principles) of one or more qualified tertiary recovery 
methods (as described in paragraph (e) of this section) that is 
reasonably expected to result in more than an insignificant increase in 
the amount of crude oil that ultimately will be recovered;
    (2) The project is located within the United States (within the 
meaning of section 638(1));
    (3) The first injection of liquids, gases, or other matter for the 
project (as described in paragraph (c) of this section) occurs after 
December 31, 1990; and
    (4) The project is certified under Sec.  1.43-3.
    (b) More than insignificant increase. For purposes of paragraph 
(a)(1) of this section, all the facts and circumstances determine 
whether the application of a tertiary recovery method can reasonably be 
expected to result in more than an insignificant increase in the amount 
of crude oil that ultimately will be recovered. Certain information 
submitted as part of a project certification is relevant to this 
determination. See Sec.  1.43-3(a)(3)(i)(D). In no event is the 
application of a recovery method that merely accelerates the recovery of 
crude oil considered an application of one or more qualified tertiary 
recovery

[[Page 252]]

methods that can reasonably be expected to result in more than an 
insignificant increase in the amount of crude oil that ultimately will 
be recovered.
    (c) First injection of liquids, gases, or other matter--(1) In 
general. The ``first injection of liquids, gases, or other matter'' 
generally occurs on the date a tertiary injectant is first injected into 
the reservoir. The ``first injection of liquids, gases, or other 
matter'' does not include--
    (i) The injection into the reservoir of any liquids, gases, or other 
matter for the purpose of pretreating or preflushing the reservoir to 
enhance the efficiency of the tertiary recovery method; or
    (ii) Test or experimental injections.
    (2) Example. The following example illustrates the principles of 
this paragraph (c).

    Example. Injections to pretreat the reservoir. In 1989, A, the owner 
of an operating mineral interest in a property, began injecting water 
into the reservoir for the purpose of elevating reservoir pressure to 
obtain miscibility pressure to prepare for the injection of miscible gas 
in connection with an enhanced oil recovery project. In 1992, A obtains 
miscibility pressure in the reservoir and begins injecting miscible gas 
into the reservoir. The injection of miscible gas, rather than the 
injection of water, is the first injection of liquids, gases, or other 
matter into the reservoir for purposes of determining whether the first 
injection of liquids, gases, or other matter occurs after December 31, 
1990.

    (d) Significant expansion exception--(1) In general. If a project 
for which the first injection of liquids, gases, or other matter (within 
the meaning of paragraph (c)(1) of this section) occurred before January 
1, 1991, is significantly expanded after December 31, 1990, the 
expansion is treated as a separate project for which the first injection 
of liquids, gases, or other matter occurs after December 31, 1990.
    (2) Substantially unaffected reservoir volume. A project is 
considered significantly expanded if the injection of liquids, gases, or 
other matter after December 31, 1990, is reasonably expected to result 
in more than an insignificant increase in the amount of crude oil that 
ultimately will be recovered from reservoir volume that was 
substantially unaffected by the injection of liquids, gases, or other 
matter before January 1, 1991.
    (3) Terminated projects. Except as otherwise provided in this 
paragraph (d)(3), a project is considered significantly expanded if each 
qualified tertiary recovery method implemented in the project prior to 
January 1, 1991, terminated more than 36 months before implementing an 
enhanced oil recovery project that commences after December 31, 1990. 
Notwithstanding the provisions of the preceding sentence, if a project 
implemented prior to January 1, 1991, is terminated for less than 36 
months before implementing an enhanced oil recovery project that 
commences after December 31, 1990, a taxpayer may request permission to 
treat the project that commences after December 31, 1990, as a 
significant expansion. Permission will not be granted if the Internal 
Revenue Service determines that a project was terminated to make an 
otherwise nonqualifying project eligible for the credit. For purposes of 
section 43, a qualified tertiary recovery method terminates at the point 
in time when the method no longer results in more than an insignificant 
increase in the amount of crude oil that ultimately will be recovered. 
All the facts and circumstances determine whether a tertiary recovery 
method has terminated. Among the factors considered is the project plan, 
the unit plan of development, or other similar plan. A tertiary recovery 
method is not necessarily terminated merely because the injection of the 
tertiary injectant has ceased. For purposes of this paragraph (d)(1), a 
project is implemented when costs that will be taken into account in 
determining the credit with respect to the project are paid or incurred.
    (4) Change in tertiary recovery method. If the application of a 
tertiary recovery method or methods with respect to an enhanced oil 
recovery project for which the first injection of liquids, gases, or 
other matter occurred before January 1, 1991, has not been terminated 
for more than 36 months, a taxpayer may request a private letter ruling 
from the Internal Revenue Service whether the

[[Page 253]]

application of a different tertiary recovery method or methods after 
December 31, 1990, that does not affect reservoir volume substantially 
unaffected by the previous tertiary recovery method or methods, is 
treated as a significant expansion. All the facts and circumstances 
determine whether a change in tertiary recovery method is treated as a 
significant expansion. Among the factors considered are whether the 
change in tertiary recovery method is in accordance with sound 
engineering principles and whether the change in method will result in 
more than an insignificant increase in the amount of crude oil that 
would be recovered using the previous method. A more intensive 
application of a tertiary recovery method after December 31, 1990, is 
not treated as a significant expansion.
    (5) Examples. The following examples illustrate the principles of 
this paragraph (d).

    Example 1. Substantially unaffected reservoir volume. In January 
1988, B, the owner of an operating mineral interest in a property, began 
injecting steam into the reservoir in connection with a cyclic steam 
enhanced oil recovery project. The project affected only a portion of 
the reservoir volume. In 1992, B begins cyclic steam injections with 
respect to reservoir volume that was substantially unaffected by the 
previous cyclic steam project. Because the injection of steam into the 
reservoir in 1992 affects reservoir volume that was substantially 
unaffected by the previous cyclic steam injection, the cyclic steam 
injection in 1992 is treated as a separate project for which the first 
injection of liquids, gases, or other matter occurs after December 31, 
1990.
    Example 2. Tertiary recovery method terminated more than 36 months. 
In 1982, C, the owner of an operating mineral interest in a property, 
implemented a tertiary recovery project using cyclic steam injection as 
a method for the recovery of crude oil. The project was certified as a 
tertiary recovery project for purposes of the windfall profit tax. In 
May 1988, the application of the cyclic steam tertiary recovery method 
terminated. In July 1992, C begins drilling injection wells as part of a 
project to apply the steam drive tertiary recovery method with respect 
to the same project area affected by the cyclic steam method. C begins 
steam injections in September 1992. Because C commences an enhanced oil 
recovery project more than 36 months after the previous tertiary 
recovery method was terminated, the project is treated as a separate 
project for which the first injection of liquids, gases, or other matter 
occurs after December 31, 1990.
    Example 3. Change in tertiary recovery method affecting 
substantially unaffected reservoir volume. In 1984, D, the owner of an 
operating mineral interest in a property, implemented a tertiary 
recovery project using cyclic steam as a method for the recovery of 
crude oil. The project was certified as a tertiary recovery project for 
purposes of the windfall profit tax. D continued the cyclic steam 
injection until 1992, when the tertiary recovery method was changed from 
cyclic steam injection to steam drive. The steam drive affects reservoir 
volume that was substantially unaffected by the cyclic steam injection. 
Because the steam drive affects reservoir volume that was substantially 
unaffected by the cyclic steam injection, the steam drive is treated as 
a separate project for which the first injection of liquids, gases, or 
other matter occurs after December 31, 1990.
    Example 4. Change in tertiary recovery method not affecting 
substantially unaffected reservoir volume. In 1988, E, the owner of an 
operating mineral interest in a property, undertook an immiscible 
nitrogen enhanced oil recovery project that resulted in more than an 
insignificant increase in the ultimate recovery of crude oil from the 
property. E continued the immiscible nitrogen project until 1992, when 
the project was converted from immiscible nitrogen displacement to 
miscible nitrogen displacement by increasing the injection of nitrogen 
to increase reservoir pressure. The miscible nitrogen displacement 
affects the same reservoir volume that was affected by the immiscible 
nitrogen displacement. Because the miscible nitrogen displacement does 
not affect reservoir volume that was substantially unaffected by the 
immiscible nitrogen displacement nor was the immiscible nitrogen 
displacement project terminated for more than 36 months before the 
miscible nitrogen displacement project was implemented, E must obtain a 
ruling whether the change from immiscible nitrogen displacement to 
miscible nitrogen displacement is treated as a separate project for 
which the first injection of liquids, gases, or other matter occurs 
after December 31, 1990. If E does not receive a ruling, the miscible 
nitrogen displacement project is not a qualified project.
    Example 5. More intensive application of a tertiary recovery method. 
In 1989, F, the owner of an operating mineral interest in a property, 
undertook an immiscible carbon dioxide displacement enhanced oil 
recovery project. F began injecting carbon dioxide into the reservoir 
under immiscible conditions. The injection of carbon dioxide under 
immiscible conditions resulted in more than an insignificant increase in 
the ultimate recovery of crude oil from the property. F continues to 
inject the same amount of carbon

[[Page 254]]

dioxide into the reservoir until 1992, when new engineering studies 
indicate that an increase in the amount of carbon dioxide injected is 
reasonably expected to result in a more than insignificant increase in 
the amount of crude oil that would be recovered from the property as a 
result of the previous injection of carbon dioxide. The increase in the 
amount of carbon dioxide injected affects the same reservoir volume that 
was affected by the previous injection of carbon dioxide. Because the 
additional carbon dioxide injected in 1992 does not affect reservoir 
volume that was substantially unaffected by the previous injection of 
carbon dioxide and the previous immiscible carbon dioxide displacement 
method was not terminated for more than 36 months before additional 
carbon dioxide was injected, the increase in the amount of carbon 
dioxide injected into the reservoir is not a significant expansion. 
Therefore, it is not a separate project for which the first injection of 
liquids, gases, or other matter occurs after December 31, 1990.

    (e) Qualified tertiary recovery methods--(1) In general. For 
purposes of paragraph (a)(1) of this section, a ``qualified tertiary 
recovery method'' is any one or any combination of the tertiary recovery 
methods described in paragraph (e)(2) of this section. To account for 
advances in enhanced oil recovery technology, the Internal Revenue 
Service may by revenue ruling prescribe that a method not described in 
paragraph (e)(2) of this section is a ``qualified tertiary recovery 
method.'' In addition, a taxpayer may request a private letter ruling 
that a method not described in paragraph (e)(2) of this section or in a 
revenue ruling is a qualified tertiary recovery method. Generally, the 
methods identified in revenue rulings or private letter rulings will be 
limited to those methods that involve the displacement of oil from the 
reservoir rock by means of modifying the properties of the fluids in the 
reservoir or providing the energy and drive mechanism to force the oil 
to flow to a production well. The recovery methods described in 
paragraph (e)(3) of this section are not ``qualified tertiary recovery 
methods.''
    (2) Tertiary recovery methods that qualify--(i) Thermal recovery 
methods--(A) Steam drive injection. The continuous injection of steam 
into one set of wells (injection wells) or other injection source to 
effect oil displacement toward and production from a second set of wells 
(production wells);
    (B) Cyclic steam injection--The alternating injection of steam and 
production of oil with condensed steam from the same well or wells; and
    (C) In situ combustion. The combustion of oil or fuel in the 
reservoir sustained by injection of air, oxygen-enriched air, oxygen, or 
supplemental fuel supplied from the surface to displace unburned oil 
toward producing wells. This process may include the concurrent, 
alternating, or subsequent injection of water.
    (ii) Gas Flood recovery methods--(A) Miscible fluid displacement. 
The injection of gas (e.g., natural gas, enriched natural gas, a 
liquified petroleum slug driven by natural gas, carbon dioxide, 
nitrogen, or flue gas) or alcohol into the reservoir at pressure levels 
such that the gas or alcohol and reservoir oil are miscible;
    (B) Carbon dioxide augmented waterflooding. The injection of 
carbonated water, or water and carbon dioxide, to increase waterflood 
efficiency;
    (C) Immiscible carbon dioxide displacement. The injection of carbon 
dioxide into an oil reservoir to effect oil displacement under 
conditions in which miscibility with reservoir oil is not obtained. This 
process may include the concurrent, alternating, or subsequent injection 
of water; and
    (D) Immiscible nonhydrocarbon gas displacement. The injection of 
nonhydrocarbon gas (e.g., nitrogen) into an oil reservoir, under 
conditions in which miscibility with reservoir oil is not obtained, to 
obtain a chemical or physical reaction (other than pressure) between the 
oil and the injected gas or between the oil and other reservoir fluids. 
This process may include the concurrent, alternating, or subsequent 
injection of water.
    (iii) Chemical flood recovery methods--(A) Microemulsion flooding. 
The injection of a surfactant system (e.g., a surfactant, hydrocarbon, 
cosurfactant, electrolyte, and water) to enhance the displacement of oil 
toward producing wells; and
    (B) Caustic flooding--The injection of water that has been made 
chemically basic by the addition of alkali metal

[[Page 255]]

hydroxides, silicates, or other chemicals.
    (iv) Mobility control recovery method--Polymer augmented 
waterflooding. The injection of polymeric additives with water to 
improve the areal and vertical sweep efficiency of the reservoir by 
increasing the viscosity and decreasing the mobility of the water 
injected. Polymer augmented waterflooding does not include the injection 
of polymers for the purpose of modifying the injection profile of the 
wellbore or the relative permeability of various layers of the 
reservoir, rather than modifying the water-oil mobility ratio.
    (3) Recovery methods that do not qualify. The term ``qualified 
tertiary recovery method'' does not include--
    (i) Waterflooding--The injection of water into an oil reservoir to 
displace oil from the reservoir rock and into the bore of the producing 
well;
    (ii) Cyclic gas injection--The increase or maintenance of pressure 
by injection of hydrocarbon gas into the reservoir from which it was 
originally produced;
    (iii) Horizontal drilling--The drilling of horizontal, rather than 
vertical, wells to penetrate hydrocarbon bearing formations;
    (iv) Gravity drainage--The production of oil by gravity flow from 
drainholes that are drilled from a shaft or tunnel dug within or below 
the oil bearing zones; and
    (v) Other methods--Any recovery method not specifically designated 
as a qualified tertiary recovery method in either paragraph (e)(2) of 
this section or in a revenue ruling or private letter ruling described 
in paragraph (e)(1) of this section.
    (4) Examples. The following examples illustrate the principles of 
this paragraph (e).

    Example 1. Polymer augmented waterflooding. In 1992 G, the owner of 
an operating mineral interest in a property, begins a waterflood project 
with respect to the property. To reduce the relative permeability in 
certain areas of the reservoir and minimize water coning, G injects 
polymers to plug thief zones and improve the areal and vertical sweep 
efficiency of the reservoir. The injection of polymers into the 
reservoir does not modify the water-oil mobility ratio. Accordingly, the 
injection of polymers into the reservoir in connection with the 
waterflood project does not constitute polymer augmented waterflooding 
and the project is not a qualified enhanced oil recovery project.
    Example 2. Polymer augmented waterflooding. In 1993 H, the owner of 
an operating mineral interest in a property, begins a caustic flooding 
project with respect to the property. Engineering studies indicate that 
the relative permeability of various layers of the reservoir may result 
in the loss of the injectant to thief zones, thereby reducing the areal 
and vertical sweep efficiency of the reservoir. As part of the caustic 
flooding project, H injects polymers to plug the thief zones and improve 
the areal and vertical sweep efficiency of the reservoir. Because the 
polymers are injected into the reservoir to improve the effectiveness of 
the caustic flooding project, the project is a qualified enhanced oil 
recovery project.

[T.D. 8448, 57 FR 54925, Nov. 23, 1992; 58 FR 6678, Feb. 1, 1993]



Sec.  1.43-3  Certification

    (a) Petroleum engineer's certification of a project--(1) In general. 
A petroleum engineer must certify, under penalties of perjury, that an 
enhanced oil recovery project meets the requirements of section 
43(c)(2)(A). A petroleum engineer's certification must be submitted for 
each project. The petroleum engineer certifying a project must be duly 
registered or certified in any State.
    (2) Timing of certification. The operator of an enhanced oil 
recovery project or any other operating mineral interest owner 
designated by the operator (``designated owner'') must submit a 
petroleum engineer's certification to the Internal Revenue Service 
Center, Austin, Texas, or such other place as may be designated by 
revenue procedure or other published guidance, not later than the last 
date prescribed by law (including extensions) for filing the operator's 
or designated owner's federal income tax return for the first taxable 
year for which the enhanced oil recovery credit (the ``credit'') is 
allowable. The operator may designate any other operating mineral 
interest owner (the ``designated owner'') to file the petroleum 
engineer's certification.
    (3) Content of certification--(i) In general. A petroleum engineer's 
certification must contain the following information--
    (A) The name and taxpayer identification number of the operator or 
the

[[Page 256]]

designated owner submitting the certification;
    (B) A statement identifying the project, including its geographic 
location;
    (C) A statement that the project involves a tertiary recovery method 
(as defined in section 43(c)(2)(A)(i)) and a description of the process 
used, including--
    (1) A description of the implementation and operation of the project 
sufficient to establish that it is implemented and operated in 
accordance with sound engineering practices;
    (2) If the project involves the application of a tertiary recovery 
method approved in a private letter ruling described in paragraph (e)(1) 
of Sec.  1.43-2, a copy of the private letter ruling, and
    (3) The date on which the first injection of liquids, gases, or 
other matter occurred or is expected to occur.
    (D) A statement that the application of a qualified tertiary 
recovery method or methods is expected to result in more than an 
insignificant increase in the amount of crude oil that ultimately will 
be recovered, including--
    (1) Data on crude oil reserve estimates covering the project area 
with and without the enhanced oil recovery process,
    (2) Production history prior to implementation of the project and 
estimates of production after implementation of the project, and
    (3) An adequate delineation of the reservoir, or portion of the 
reservoir, from which the ultimate recovery of crude oil is expected to 
be increased as a result of the implementation and operation of the 
project; and
    (E) A statement that the petroleum engineer believes that the 
project is a qualified enhanced oil recovery project within the meaning 
of section 43(c)(2)(A).
    (ii) Additional information for significantly expanded projects. The 
petroleum engineer's certification for a project that is significantly 
expanded must in addition contain--
    (A) If the expansion affects reservoir volume that was substantially 
unaffected by a previously implemented project, an adequate delineation 
of the reservoir volume affected by the previously implemented project;
    (B) If the expansion involves the implementation of an enhanced oil 
recovery project more than 36 months after the termination of a 
qualified tertiary recovery method that was applied before January 1, 
1991, the date on which the previous tertiary recovery method terminated 
and an explanation of the data or assumptions relied upon to determine 
the termination date;
    (C) If the expansion involves the implementation of an enhanced oil 
recovery project less than 36 months after the termination of a 
qualified tertiary recovery method that was applied before January 1, 
1991, a copy of a private letter ruling from the Internal Revenue 
Service that the project implemented after December 31, 1990 is treated 
as a significant expansion; or
    (D) If the expansion involves the application after December 31, 
1990, of a tertiary recovery method or methods that do not affect 
reservoir volume that was substantially unaffected by the application of 
a different tertiary recovery method or methods before January 1, 1991, 
a copy of a private letter ruling from the Internal Revenue Service that 
the change in tertiary recovery method is treated as a significant 
expansion.
    (b) Operator's continued certification of a project--(1) In general. 
For each taxable year following the taxable year for which the petroleum 
engineer's certification is submitted, the operator or designated owner 
must certify, under penalties of perjury, that an enhanced oil recovery 
project continues to be implemented substantially in accordance with the 
petroleum engineer's certification submitted for the project. An 
operator's certification must be submitted for each project.
    (2) Timing of certification. The operator or designated owner of an 
enhanced oil recovery project must submit an operator's certification to 
the Internal Revenue Service Center, Austin, Texas, or such other place 
as may be designated by revenue procedure or other published guidance, 
not later than the last date prescribed by law (including extensions) 
for filing the operator's or designated owner's federal income tax 
return for any taxable year

[[Page 257]]

after the taxable year for which the petroleum engineer's certification 
is filed.
    (3) Content of certification. An operator's certification must 
contain the following information--
    (i) The name and taxpayer identification number of the operator or 
the designated owner submitting the certification;
    (ii) A statement identifying the project including its geographic 
location and the date on which the petroleum engineer's certification 
was filed;
    (iii) A statement that the project continues to be implemented 
substantially in accordance with the petroleum engineer's certification 
(as described in paragraph (a) of this section) submitted for the 
project; and
    (iv) A description of any significant change or anticipated change 
in the information submitted under paragraph (a)(3) of this section, 
including a change in the date on which the first injection of liquids, 
gases, or other matter occurred or is expected to occur.
    (c) Notice of project termination--(1) In general. If the 
application of a tertiary recovery method is terminated, the operator or 
designated owner must submit a notice of project termination to the 
Internal Revenue Service.
    (2) Timing of notice. The operator or designated owner of an 
enhanced oil recovery project must submit the notice of project 
termination to the Internal Revenue Service Center, Austin, Texas, or 
such other place as may be designated by revenue procedure or other 
published guidance, not later than the last date prescribed by law 
(including extensions) for filing the operator's or designated owner's 
federal income tax return for the taxable year in which the project 
terminates.
    (3) Content of notice. A notice of project termination must contain 
the following information--
    (i) The name and taxpayer identification number of the operator or 
the designated owner submitting the notice;
    (ii) A statement identifying the project including its geographic 
location and the date on which the petroleum engineer's certification 
was filed; and
    (iii) The date on which the application of the tertiary recovery 
method was terminated.
    (d) Failure to submit certification. If a petroleum engineer's 
certification (as described in paragraph (a) of this section) or an 
operator's certification (as described in paragraph (b) of this section) 
is not submitted in the time or manner prescribed by this section, the 
credit will be allowed only after the appropriate certifications are 
submitted.

[T.D. 8384, 56 FR 67177, Dec. 30, 1991; 57 FR 6074, Feb. 20, 1992; 57 FR 
6353, Feb. 24, 1992. Redesignated and amended by T.D. 8448, 57 FR 54927, 
Nov. 23, 1992]



Sec.  1.43-4  Qualified enhanced oil recovery costs.

    (a) Qualifying costs--(1) In general. Except as provided in 
paragraph (e) of this section, amounts paid or incurred in any taxable 
year beginning after December 31, 1990, that are qualified tertiary 
injectant expenses (as described in paragraph (b)(1) of this section), 
intangible drilling and development costs (as described in paragraph 
(b)(2) of this section), and tangible property costs (as described in 
paragraph (b)(3) of this section) are ``qualified enhanced oil recovery 
costs'' if the amounts are paid or incurred with respect to an asset 
which is used for the primary purpose (as described in paragraph (c) of 
this section) of implementing an enhanced oil recovery project. Any 
amount paid or incurred in any taxable year beginning before January 1, 
1991, in connection with an enhanced oil recovery project is not a 
qualified enhanced oil recovery cost.
    (2) Costs paid or incurred for an asset which is used to implement 
more than one qualified enhanced oil recovery project or for other 
activities. Any cost paid or incurred during the taxable year for an 
asset which is used to implement more than one qualified enhanced oil 
recovery project is allocated among the projects in determining the 
qualified enhanced oil recovery costs for each qualified project for the 
taxable year. Similarly, any cost paid or incurred during the taxable 
year for an asset which is used to implement a qualified enhanced oil 
recovery project and which is also used for other activities (for 
example, an enhanced oil recovery

[[Page 258]]

project that is not a qualified enhanced oil recovery project) is 
allocated among the qualified enhanced oil recovery project and the 
other activities to determine the qualified enhanced oil recovery costs 
for the taxable year. See Sec.  1.613-5(a). Any cost paid or incurred 
for an asset which is used to implement a qualified enhanced oil 
recovery project and which is also used for other activities is not 
required to be allocated under this paragraph (a)(2) if the use of the 
property for nonqualifying activities is de minimis (e.g., not greater 
than 10%). Costs are allocated under this paragraph (a)(2) only if the 
asset with respect to which the costs are paid or incurred is used for 
the primary purpose of implementing an enhanced oil recovery project. 
See paragraph (c) of this section. Any reasonable allocation method may 
be used. A method that allocates costs based on the anticipated use in a 
project or activity is a reasonable method.
    (b) Costs defined--(1) Qualified tertiary injectant expenses. For 
purposes of this section, ``qualified tertiary injectant expenses'' 
means any costs that are paid or incurred in connection with a qualified 
enhanced oil recovery project and that are deductible under section 193 
for the taxable year. See section 193 and Sec.  1.193-1. Qualified 
tertiary injectant expenses are taken into account in determining the 
credit with respect to the taxable year in which the tertiary injectant 
expenses are deductible under section 193.
    (2) Intangible drilling and development costs. For purposes of this 
section, ``intangible drilling and development costs'' means any 
intangible drilling and development costs that are paid or incurred in 
connection with a qualified enhanced oil recovery project and for which 
the taxpayer may make an election under section 263(c) for the taxable 
year. Intangible drilling and development costs are taken into account 
in determining the credit with respect to the taxable year in which the 
taxpayer may deduct the intangible drilling and development costs under 
section 263(c). For purposes of this paragraph (b)(2), the amount of the 
intangible drilling and development costs for which an integrated oil 
company may make an election under section 263(c) is determined without 
regard to section 291(b).
    (3) Tangible property costs--(i) In general. For purposes of this 
section, ``tangible property costs'' means an amount paid or incurred 
during a taxable year for tangible property that is an integral part of 
a qualified enhanced oil recovery project and that is depreciable or 
amortizable under chapter 1. An amount paid or incurred for tangible 
property is taken into account in determining the credit with respect to 
the taxable year in which the cost is paid or incurred.
    (ii) Integral part. For purposes of this paragraph (b), tangible 
property is an integral part of a qualified enhanced oil recovery 
project if the property is used directly in the project and is essential 
to the completeness of the project. All the facts and circumstances 
determine whether tangible property is used directly in a qualified 
enhanced oil recovery project and is essential to the completeness of 
the project. Generally, property used to acquire or produce the tertiary 
injectant or property used to transport the tertiary injectant to a 
project site is property that is an integral part of the project.
    (4) Examples. The following examples illustrate the principles of 
this paragraph (b). Assume for each of these examples that the qualified 
enhanced oil recovery costs are paid or incurred with respect to an 
asset which is used for the primary purpose of implementing an enhanced 
oil recovery project.

    Example 1. Qualified costs--in general. (i) In 1992, X, a 
corporation, acquires an operating mineral interest in a property and 
undertakes a cyclic steam enhanced oil recovery project with respect to 
the property. X pays a fee to acquire a permit to drill and hires a 
contractor to drill six wells. As part of the project implementation, X 
constructs a building to serve as an office on the property and 
purchases equipment, including downhole equipment (e.g., casing, tubing, 
packers, and sucker rods), pumping units, a steam generator, and 
equipment to remove gas and water from the oil after it is produced. X 
constructs roads to transport the equipment to the wellsites and incurs 
costs

[[Page 259]]

for clearing and draining the ground in preparation for the drilling of 
the wells. X purchases cars and trucks to provide transportation for 
monitoring the wellsites. In addition, X contracts with Y for the 
delivery of water to produce steam to be injected in connection with the 
cyclic steam project, and purchases storage tanks to store the water.
    (ii) The leasehold acquisition costs are not qualified enhanced oil 
recovery costs. However, the costs of the permit to drill are intangible 
drilling and development costs that are qualified costs. The costs 
associated with hiring the contractor to drill, constructing roads, and 
clearing and draining the ground are intangible drilling and development 
costs that are qualified enhanced oil recovery costs. The downhole 
equipment, the pumping units, the steam generator, and the equipment to 
remove the gas and water from the oil after it is produced are used 
directly in the project and are essential to the completeness of the 
project. Therefore, this equipment is an integral part of the project 
and the costs of the equipment are qualified enhanced oil recovery 
costs. Although the building that X constructs as an office and the cars 
and trucks X purchases to provide transportation for monitoring the 
wellsites are used directly in the project, they are not essential to 
the completeness of the project. Therefore, the building and the cars 
and trucks are not an integral part of the project and their costs are 
not qualified enhanced oil recovery costs. The cost of the water X 
purchases from Y is a tertiary injectant expense that is a qualified 
enhanced oil recovery cost. The storage tanks X acquires to store the 
water are required to provide a proximate source of water for the 
production of steam. Therefore, the water storage tank are an integral 
part of the project and the costs of the water storage tanks are 
qualified enhanced oil recovery costs.
    Example 2. Diluent storage tanks. In 1992, A, the owner of an 
operating mineral interest, undertakes a qualified enhanced oil recovery 
project with respect to the property. A acquires diluent to be used in 
connection with the project. A stores the diluent in a storage tank that 
A acquires for that purpose. The storage tank provides a proximate 
source of diluent to be used in the tertiary recovery method. Therefore, 
the storage tank is used directly in the project and is essential to the 
completeness of the project. Accordingly, the storage tanks is an 
integral part of the project and the cost of the storage tank is a 
qualified enhanced oil recovery cost.
    Example 3. Oil storage tanks. In 1992, Z, a corporation and the 
owner of an operating mineral interest in a property, undertakes a 
qualified enhanced oil recovery project with respect to the property. Z 
acquires storage tanks that Z will use solely to store the crude oil 
that is produced from the enhanced oil recovery project. The storage 
tanks are not used directly in the project and are not essential to the 
completeness of the project. Therefore, the storage tanks are not an 
integral part of the enhanced oil recovery project and the costs of the 
storage tanks are not qualified enhanced oil recovery costs.
    Example 4. Oil refinery. B, the owner of an operating mineral 
interest in a property, undertakes a qualified enhanced oil recovery 
project with respect to the property. Located on B's property is an oil 
refinery where B will refine the crude oil produced from the project. 
The refinery is not used directly in the project and is not essential to 
the completeness of the project. Therefore, the refinery is not an 
integral part of the enhanced oil recovery project.
    Example 5. Gas processing plant. C, the owner of an operating 
mineral interest in a property, undertakes a qualified enhanced oil 
recovery project with respect to the property. A gas processing plant 
where C will process gas produced in the project is located on C's 
property. The gas processing plant is not used directly in the project 
and is not essential to the completeness of the project. Therefore, the 
gas processing plant is not an integral part of the enhanced oil 
recovery project.
    Example 6. Gas processing equipment. The facts are the same as in 
Example 5 except that C uses a portion of the gas processing plant to 
separate and recycle the tertiary injectant. The gas processing 
equipment used to separate and recycle the tertiary injectant is used 
directly in the project and is essential to the completeness of the 
project. Therefore, the gas processing equipment used to separate and 
recycle the tertiary injectant is an integral part of the enhanced oil 
recovery project and the costs of this equipment are qualified enhanced 
oil recovery costs.
    Example 7. Steam generator costs allocated. In 1988, D, the owner of 
an operating mineral interest in a property, undertook a steam drive 
project with respect to the property. In 1992, D decides to undertake a 
steam drive project with respect to reservoir volume that was 
substantially unaffected by the 1988 project. The 1992 project is a 
significant expansion that is a qualified enhanced oil recovery project. 
D purchases a new steam generator with sufficient capacity to provide 
steam for both the 1988 project and the 1992 project. The steam 
generator is used directly in the 1992 project and is essential to the 
completeness of the 1992 project. Accordingly, the steam generator is an 
integral part of the 1992 project. Because the steam generator is also 
used to provide steam for the 1988 project, D must allocate the cost of 
the steam generator to the 1988 project and the 1992 project. Only the 
portion of the cost of the steam generator that is allocable to

[[Page 260]]

the 1992 project is a qualified enhanced oil recovery cost.
    Example 8. Carbon dioxide pipeline. In 1992, E, the owner of an 
operating mineral interest in a property, undertakes an immiscible 
carbon dioxide displacement project with respect to the property. E 
constructs a pipeline to convey carbon dioxide to the project site. E 
contracts with F, a producer of carbon dioxide, to purchase carbon 
dioxide to be injected into injection wells in E's enhanced oil recovery 
project. The cost of the carbon dioxide is a tertiary injectant expense 
that is a qualified enhanced oil recovery cost. The pipeline is used by 
E to transport the tertiary injectant, that is, the carbon dioxide to 
the project site. Therefore, the pipeline is an integral part of the 
project. Accordingly, the cost of the pipeline is a qualified enhanced 
oil recovery cost.
    Example 9. Water source wells. In 1992, G the owner of an operating 
mineral interest in a property, undertakes a polymer augmented 
waterflood project with respect to the property. G drills water wells to 
provide water for injection in connection with the project. The costs of 
drilling the water wells are intangible drilling and development costs 
that are paid or incurred in connection with the project. Therefore, the 
costs of drilling the water wells are qualified enhanced oil recovery 
costs.
    Example 10. Leased equipment. In 1992, H, the owner of an operating 
mineral interest in a property undertakes a steam drive project with 
respect to the property. H contracts with I, a driller, to drill 
injection wells in connection with the project. H also leases a steam 
generator to provide steam for injection in connection with the project. 
The drilling costs are intangible drilling and development costs that 
are paid in connection with the project and are qualified enhanced oil 
recovery costs. The steam generator is used to produce the tertiary 
injectant. The steam generator is used directly in the project and is 
essential to the completeness of the project; therefore, it is an 
integral part of the project. The costs of leasing the steam generator 
are tangible property costs that are qualified enhanced oil recovery 
costs.

    (c) Primary purpose--(1) In general. For purposes of this section, a 
cost is a qualified enhanced oil recovery cost only if the cost is paid 
or incurred with respect to an asset which is used for the primary 
purpose of implementing one or more enhanced oil recovery projects, at 
least one of which is a qualified enhanced oil recovery project. All the 
facts and circumstances determine whether an asset is used for the 
primary purpose of implementing an enhanced oil recovery project. For 
purposes of this paragraph (c), an enhanced oil recovery project is a 
project that satisfies the requirements of paragraphs (a) (1) and (2) of 
section 1.43-2.
    (2) Tertiary injectant costs. Tertiary injectant costs generally 
satisfy the primary purpose test of this paragraph (c).
    (3) Intangible drilling and development costs. Intangible drilling 
and development costs paid or incurred with respect to a well that is 
used in connection with the recovery of oil by primary or secondary 
methods are not qualified enhanced oil recovery costs. Except as 
provided in this paragraph (c)(3), a well used for primary or secondary 
recovery is not used for the primary purpose of implementing an enhanced 
oil recovery project. A well drilled for the primary purpose of 
implementing an enhanced oil recovery project is not considered to be 
used for primary or secondary recovery, notwithstanding that some 
primary or secondary production may result when the well is drilled, 
provided that such primary or secondary production is consistent with 
the unit plan of development or other similar plan. All the facts and 
circumstances determine whether primary or secondary recovery is 
consistent with the unit plan of development or other similar plan.
    (4) Tangible property costs. Tangible property costs must be paid or 
incurred with respect to property which is used for the primary purpose 
of implementing an enhanced oil recovery project.
    If tangible property is used partly in a qualified enhanced oil 
recovery project and partly in another activity, the property must be 
primarily used to implement the qualified enhanced oil recovery project.
    (5) Offshore drilling platforms. Amounts paid or incurred in 
connection with the acquisition, construction, transportation, erection, 
or installation of an offshore drilling platform (regardless of whether 
the amounts are intangible drilling and development costs) that is used 
in connection with the recovery of oil by primary or secondary methods 
are not qualified enhanced oil recovery costs. An offshore drilling 
platform used for primary or secondary recovery is not used for the

[[Page 261]]

primary purpose of implementing an enhanced oil recovery project.
    (6) Examples. The following examples illustrate the principles of 
this paragraph (c).

    Example 1. Intangible drilling and development costs. In 1992, J 
incurs intangible drilling and development costs in drilling a well. J 
intends to use the well as an injection well in connection with an 
enhanced oil recovery project in 1994, but in the meantime will use the 
well in connection with a secondary recovery project. J may not take the 
intangible drilling and development costs into account in determining 
the credit because the primary purpose of a well used for secondary 
recovery is not to implement a qualified enhanced oil recovery project.
    Example 2. Offshore drilling platform. K, the owner of an operating 
mineral interest in an offshore oil field located within the United 
States, constructs an offshore drilling platform that is designed to 
accommodate the primary, secondary, and tertiary development of the 
field. Subsequent to primary and secondary development of the field, K 
commences an enhanced oil recovery project that involves the application 
of a qualified tertiary recovery method. As part of the enhanced oil 
recovery project, K drills injection wells from the offshore drilling 
platform K used in the primary and secondary development of the field 
and installs an additional separator on the platform.
    Because the offshore drilling platform was used in the primary and 
secondary development of the field and was not used for the primary 
purpose of implementing tertiary development of the field, costs 
incurred by K in connection with the acquisition, construction, 
transportation, erection, or installation of the offshore drilling 
platform are not qualified enhanced oil recovery costs. However, the 
costs K incurs for the additional separator are qualified enhanced oil 
recovery costs because the separator is used for the primary purpose of 
implementing tertiary development of the field. In addition, the 
intangible drilling and development costs K incurs in connection with 
drilling the injection wells are qualified enhanced oil recovery costs 
with respect to which K may claim the enhanced oil recovery credit.

    (d) Costs paid or incurred prior to first injection--(1) In general. 
Qualified enhanced oil recovery costs may be paid or incurred prior to 
the date of the first injection of liquids, gases, or other matter 
(within the meaning of Sec.  1.43-2(c)). If the first injection of 
liquids, gases, or other matter occurs on or before the date the 
taxpayer files the taxpayer's federal income tax return for the taxable 
year with respect to which the costs are allowable, the costs may be 
taken into account on that return. If the first injection of liquids, 
gases, or other matter is expected to occur after the date the taxpayer 
files that return, costs may be taken into account on that return if the 
Internal Revenue Service issues a private letter ruling to the taxpayer 
that so permits.
    (2) First injection after filing of return for taxable year costs 
are allowable. Except as provided in paragraph (d)(3) of this section, 
if the first injection of liquids, gases, or other matter occurs or is 
expected to occur after the date the taxpayer files the taxpayer's 
federal income tax return for the taxable year with respect to which the 
costs are allowable, the costs may be taken into account on an amended 
return (or in the case of a Coordinated Examination Program taxpayer, on 
a written statement treated as a qualified return) after the earlier 
of--
    (i) The date the first injection of liquids, gases, or other matter 
occurs; or
    (ii) The date the Internal Revenue Service issues a private letter 
ruling that provides that the taxpayer may take costs into account prior 
to the first injection of liquids, gases, or other matter.
    (3) First injection more than 36 months after close of taxable year 
costs are paid or incurred. If the first injection of liquids, gases, or 
other matter occurs more than 36 months after the close of the taxable 
year in which costs are paid or incurred, the taxpayer may take the 
costs into account in determining the credit only if the Internal 
Revenue Service issues a private letter ruling to the taxpayer that so 
provides.
    (4) Injections in volumes less than the volumes specified in the 
project plan. For purposes of this paragraph (d), injections in volumes 
significantly less than the volumes specified in the project plan, the 
unit plan of development, or another similar plan do not constitute the 
first injection of liquids, gases, or other matter.
    (5) Examples. The following examples illustrate the provisions of 
paragraph (d) of this section.

    Example 1. First injection before return filed. In 1992, L, a 
calendar year taxpayer, undertakes a qualified enhanced oil recovery

[[Page 262]]

project on a property in which L owns an operating mineral interest. L 
incurs $1,000 of intangible drilling and development costs, which L may 
elect to deduct under section 263(c) for 1992. The first injection of 
liquids, gases, or other matter (within the meaning of Sec.  1.43-2(c)) 
occurs in March 1993. L files a 1992 federal income tax return in April 
1993. Because the first injection occurs before the filing of L's 1992 
federal income tax return, L may take the $1,000 of intangible drilling 
and development costs into account in determining the credit for 1992 on 
that return.
    Example 2. First injection after return filed. In 1993, M, a 
calendar year taxpayer, undertakes a qualified enhanced oil recovery 
project on a property in which M owns an operating mineral interest. M 
incurs $2,000 of intangible drilling and development costs, which M 
elects to deduct under section 263(c) for 1993. The first injection of 
liquids, gases, or other matter is expected to occur in 1995. M files a 
1993 federal income tax return in April 1994. Because the first 
injection of liquids, gases, or other matter occurs after the date on 
which M's 1993 federal income tax return is filed in April 1994, M may 
take the $2,000 of intangible drilling and development costs into 
account on an amended return for 1993 after the earlier of the date the 
first injection of liquids, gases, or other matter occurs, or the date 
the Internal Revenue Service issues a private letter ruling that 
provides that M may take the $2,000 into account prior to first 
injection.
    Example 3. First injection more than 36 months after taxable year. 
N, a calendar year taxpayer, owns an operating mineral interest in a 
property on which N undertakes an immiscible carbon dioxide displacement 
project. In 1994, N incurs $5,000 in connection with the construction of 
a pipeline to transport carbon dioxide to the project site. The first 
injection of liquids, gases, or other matter is expected to occur after 
the pipeline is completed in 1998. Because the first injection of 
liquids, gases, or other matter occurs more than 36 months after the 
close of the taxable year in which the $5,000 is incurred, N may take 
the $5,000 into account in determining the credit only if N receives a 
private letter ruling from the Internal Revenue Service that provides 
that N may take the $5,000 into account prior to first injection.

    (e) Other rules--(1) Anti-abuse rule. Costs paid or incurred with 
respect to an asset that is acquired, used, or transferred in a manner 
designed to duplicate or otherwise unreasonably increase the amount of 
the credit are not qualified enhanced oil recovery costs, regardless of 
whether the costs would otherwise be creditable for a single taxpayer or 
more than one taxpayer.
    (2) Costs paid or incurred to acquire a project. A purchaser of an 
existing qualified enhanced oil recovery project may claim the credit 
for any section 43 costs in excess of the acquisition cost. However, 
costs paid or incurred to acquire an existing qualified enhanced oil 
recovery project (or an interest in an existing qualified enhanced oil 
recovery project) are not eligible for the credit.
    (3) Examples. The following examples illustrate the principles of 
paragraph (e) of this section.

    Example 1. Duplicating or unreasonably increasing the credit. O owns 
an operating mineral interest in a property with respect to which a 
qualified enhanced oil recovery project is implemented. O acquires 
pumping units, rods, casing, and separators for use in connection with 
the project from an unrelated equipment dealer in an arm's length 
transaction. The equipment is used for the primary purpose of 
implementing the project. Some of the equipment acquired by O is used 
equipment. The costs paid by O for the used equipment are qualified 
enhanced oil recovery costs. O does not need to determine whether the 
equipment has been previously used in an enhanced oil recovery project.
    Example 2. Duplicating or unreasonably increasing the credit. P and 
Q are co-owners of an oil property with respect to which a qualified 
enhanced oil recovery project is implemented. In 1992, P and Q jointly 
purchase a nitrogen plant to supply the tertiary injectant used in the 
project. P and Q claim the credit for their respective costs for the 
plant. In 1994, X, a corporation unrelated to P or Q, purchases the 
nitrogen plant and enters into an agreement to sell nitrogen to P and Q. 
Because this transaction duplicates or otherwise unreasonably increases 
the credit, the credit is not allowable for the amounts incurred by P 
and Q for the nitrogen purchased from X.
    Example 3. Duplicating or unreasonably increasing the credit. The 
facts are the same as in Example 2. In addition, in 1995, P and Q 
reacquire the nitrogen plant from X. This constitutes the acquisition of 
property in a manner designed to duplicate or otherwise unreasonably 
increase the amount of the credit. Therefore, the credit is not 
allowable for amounts incurred by P and Q for the nitrogen plant 
purchased from X.
    Example 4. Duplicating or unreasonably increasing the credit. R owns 
an operating mineral interest in a property with respect to which a 
qualified enhanced oil recovery project is implemented. R acquires a 
pump that is installed at the site of the project. After the pump has 
been placed in service for

[[Page 263]]

6 months, R transfers the pump to a secondary recovery project and 
acquires a replacement pump for the tertiary project. The original pump 
is suited to the needs of the secondary recovery project and could have 
been installed there initially. The pumps have been acquired in a manner 
designed to duplicate or otherwise unreasonably increase the amount of 
the credit. Depending on the facts, the cost of one pump or the other 
may be a qualified enhanced oil recovery cost; however, R may not claim 
the credit with respect to the cost of both pumps.
    Example 5. Acquiring a project. In 1993, S purchases all of T's 
interest in a qualified enhanced oil recovery project, including all of 
T's interest in tangible property that is an integral part of the 
project and all of T's operating mineral interest. In 1994, S incurs 
costs for additional tangible property that is an integral part of the 
project and which is used for the primary purpose of implementing the 
project. S also incurs costs for tertiary injectants that are injected 
in connection with the project. In determining the credit for 1994, S 
may take into account costs S incurred for tangible property and 
tertiary injectants. However, S may not take into account any amount 
that S paid for T's interest in the project in determining S's credit 
for any taxable year.

[T.D. 8448, 57 FR 54927, Nov. 23, 1992; 58 FR 7987, Feb. 11, 1993]



Sec.  1.43-5  At-risk limitation. [Reserved]



Sec.  1.43-6  Election out of section 43.

    (a) Election to have the credit not apply--(1) In general. A 
taxpayer may elect to have section 43 not apply for any taxable year. 
The taxpayer may revoke an election to have section 43 not apply for any 
taxable year. An election to have section 43 not apply (or a revocation 
of an election to have section 43 not apply) for any taxable year is 
effective only for the taxable year to which the election relates.
    (2) Time for making the election. A taxpayer may make an election 
under paragraph (a) of this section to have section 43 not apply (or 
revoke an election to have section 43 not apply) for any taxable year at 
any time before the expiration of the 3-year period beginning on the 
last date prescribed by law (determined without regard to extensions) 
for filing the return for the taxable year. The time for making the 
election (or revoking the election) is prescribed by section 43(e)(2) 
and may not be extended under Sec.  1.9100-1.
    (3) Manner of making the election. An election (or revocation) under 
paragraph (a)(1) of this section is made by attaching a statement to the 
taxpayer's federal income tax return or an amended return (or, in the 
case of a Coordinated Examination Program taxpayer, on a written 
statement treated as a qualified amended return) for the taxable year 
for which the election (or revocation) applies. The taxpayer must 
indicate whether the taxpayer is electing to not have section 43 apply 
or is revoking such an election and designate the project or projects to 
which the election (or revocation) applies. For any taxable year, the 
last election (or revocation) made by a taxpayer within the period 
prescribed in paragraph (a)(2) of this section determines whether 
section 43 applies for that taxable year.
    (b) Election by partnerships and S corporations. For partnerships 
and S corporations, an election to have section 43 not apply (or a 
revocation of an election to have section 43 not apply) for any taxable 
year is made, in accordance with the requirements of paragraph (a) of 
this section, by the partnership or S corporation with respect to the 
qualified enhanced oil recovery costs paid or incurred by the 
partnership or S corporation for the taxable year to which the election 
relates.

[T.D. 8448, 57 FR 54930, Nov. 23, 1992]



Sec.  1.43-7  Effective date of regulations.

    The provisions of Sec. Sec.  1.43-1, 1.43-2 and 1.43-4 through 1.43-
7 are effective with respect to costs paid or incurred after December 
31, 1991, in connection with a qualified enhanced oil recovery project. 
The provisions of Sec.  1.43-3 are effective for taxable years beginning 
after December 31, 1990. For costs paid or incurred after December 31, 
1990, and before January 1, 1992, in connection with a qualified 
enhanced oil recovery project, taxpayers must take reasonable return 
positions taking into consideration the statute and its legislative 
history.

[T.D. 8448, 57 FR 54931, Nov. 23, 1992]

[[Page 264]]



Sec.  1.44-1  Allowance of credit for purchase of new principal
residence after March 12, 1975, and before January 1, 1977.

    (a) General rule. Section 44 provides a credit against the tax 
imposed by chapter 1 of the Internal Revenue Code of 1954 in the case of 
an individual who purchases a new principal residence (as defined in 
paragraph (a) of Sec.  1.44-5) which is property to which section 44 
applies (as provided in Sec.  1.44-2). Subject to the limitations set 
forth in paragraph (b) of this section, the credit is in an amount equal 
to 5 percent of the purchase price (as defined in paragraph (b) of Sec.  
1.44-5).
    (b) Limitations--(1) Maximum credit. The credit allowed under 
section 44 and this section may not exceed $2,000.
    (2) Limitation to one residence. Such credit shall be allowed with 
respect to only one residence of the taxpayer; the combined purchase 
prices of more than one new principal residence cannot be aggregated to 
increase the credit allowed.
    (3) Married individuals. In the case of a husband and wife who file 
a joint return under section 6013, the maximum credit allowed on the 
joint return is $2,000. In the case of married individuals filing 
separate returns the maximum credit allowable to each spouse is $1,000. 
Where a husband and wife do not make equal contributions with respect to 
the purchase price of the new principal residence, allocation of the 
credit is to be made in proportion to their respective ownership 
interests in such residence. For this purpose, tenants by the entirety 
or joint tenants with right of survivorship are treated as equal owners.
    (4) Certain other taxpayers. Where a new principal residence is 
purchased by two or more taxpayers (other than a husband and wife), the 
amount of the credit allowed will be allocated among the taxpayers in 
proportion to their respective ownership interests in such residence, 
with the limitation that the sum of the credits allowed to all such 
taxpayers shall not exceed $2,000. For this purpose, joint tenants with 
right of survivorship are treated as equal owners. For an example of the 
operation of this provision see Example (2) of Sec.  1.44-5(b)(2)(ii).
    (5) Application with other credits. The credit allowed by this 
section shall not exceed the amount of the tax imposed by chapter 1 of 
the Code for the taxable year, reduced by the sum of the credits 
allowable under--
    (i) Section 33 (relating to taxes of foreign countries and 
possessions of the United States),
    (ii) Section 37 (relating to retirement income),
    (iii) Section 38 (relating to investment in certain depreciable 
property),
    (iv) Section 40 (relating to expenses of work incentive program),
    (v) Section 41 (relating to contributions to candidates for public 
office), and
    (vi) Section 42 (relating to personal exemptions).

[T.D. 7391, 40 FR 55851, Dec. 2, 1975]



Sec.  1.44-2  Property to which credit for purchase of new principal
residence applies.

    The provisions of section 44 and the regulations thereunder apply to 
a new principal residence which satisfies the following conditions:
    (a) Construction. The construction of the residence must have begun 
before March 26, 1975. For this purpose construction is considered to 
have commenced in the following circumstances:
    (1)(i) Except as provided in subparagraph (2) of this paragraph, 
construction is considered to commence when actual physical work of a 
significant amount has occurred on the building site of the residence. A 
significant amount of construction requires more than drilling to 
determine soil conditions, preparation of an architect's sketches, 
securing of a building permit, or grading of the land. Land preparation 
and improvements such as the clearing and grading (excavation or 
filling), construction of roads and sidewalks, and installation of 
sewers and utilities are not considered commencement of construction of 
the residence even though they might involve a significant expenditure. 
However, driving pilings for the foundation, digging of the footings, 
excavation of the building foundation, pouring of floor slabs, or 
construction of compacted earthen pads when specifically prepared and 
designed for a particular residential

[[Page 265]]

structure and not merely as a part of the overall land preparation, 
constitute a significant amount of construction of the residence. In the 
case of a housing or condominium development construction of 
recreational facilities no matter how extensive does not by itself 
constitute commencement of construction of any residential unit. 
However, where residential units are part of a building structure, as in 
the case of certain condominium and cooperative housing units, then 
digging of the footings or excavation of the building foundation 
constitutes commencement of construction for all units in that building.
    (ii) The rules in subdivision (i) of this subparagraph are 
illustrated by the following examples:

    Example 1. A location chosen for a housing development has extremely 
hilly terrain. In order to make the location suitable for development, 
the builder moves large amounts of earth and places it elsewhere on the 
location. In addition, the earth material which has been moved must be 
compacted according to government specifications in order to provide a 
stable base. Such activities constitute land preparation and, therefore, 
do not constitute the commencement of construction.
    Example 2. A location chosen for a housing development has swampy 
and marshy terrain. In order to make the location suitable for 
development the builder utilizes large quantities of fill. This activity 
constitutes land preparation and does not constitute commencement of 
construction.
    Example 3. Assume the same facts as in either Example 1 or Example 2 
except that the builder also constructs an earthen pad of compacted fill 
specifically prepared for a particular residential structure and not 
merely as a part of the overall land preparation. Construction of the 
compacted earthen pad is considered in the same light as excavation of 
the building foundation and accordingly constitutes commencement of 
construction.

    (2) Construction of a factory-made home (as defined in paragraph (e) 
of Sec.  1.44-5) is considered to have commenced when construction of 
important parts of the factory-made home has commenced. For this 
purpose, commencement of construction of important parts means the 
cutting and shaping or welding of structural components for a specific 
identifiable factory-made home, whether the work was done by the 
manufacturer of the home or by a subcontractor thereof.
    (b) Acquisition and occupancy. The residence must be acquired and 
occupied by the taxpayer after March 12, 1975, and before January 1, 
1977. For this purpose a taxpayer ``acquires'' a residence when legal 
title to it is conveyed to him at settlement, or he has possession of it 
pursuant to a binding purchase contract under which he makes periodic 
payments until he becomes entitled under the contract to demand 
conveyance of title. A taxpayer ``occupies'' a residence when he or his 
spouse physically occupies it. Thus, for example, moving of furniture or 
other household effects into the residence or physical occupancy by a 
dependent child of the taxpayer is not ``occupancy'' for purposes of 
this paragraph. The credit may be claimed when both the acquisition and 
occupancy tests have been satisfied. Thus, where a taxpayer meets the 
acquisition and occupancy tests set forth above after March 12, 1975, 
and before January 1, 1976, the credit is allowable for 1975. Where a 
taxpayer occupied a residence prior to March 13, 1975, without having 
acquired it (as where his occupancy was pursuant to a leasing 
arrangement pending settlement under a binding contract to purchase or 
pursuant to a leasing arrangement where a written option to purchase was 
contained in the original lease agreement) he will nonetheless satisfy 
the acquisition and occupancy tests set forth above if he acquires the 
residence and continues to occupy it after March 12, 1975, and before 
January 1, 1977.
    (c) Binding contract. Except in the case of self-construction, the 
new principal residence must be acquired by the taxpayer (within the 
meaning of paragraph (b) of this section) under a binding contract 
entered into by the taxpayer before January 1, 1976. An otherwise 
binding contract for the purchase of a residence which is conditioned 
upon the purchaser's obtaining a loan for the purchase of the residence 
(including conditions as to the amount or interest rate of such loan) is 
considered binding notwithstanding that condition.
    (d) Self-constructed residence. A self-constructed residence (as 
defined in

[[Page 266]]

paragraph (d) of Sec.  1.44-5) must be occupied by the taxpayer before 
January 1, 1977. Where self-construction of a principal residence was 
begun before March 13, 1975, only that portion of the basis of the 
property allocable to construction after March 12, 1975, and before 
January 1, 1977, shall be taken into consideration in determining the 
amount of the credit allowable. For this purpose, the portion of the 
basis attributable to the pre-March 13 period includes the total cost of 
land acquired (as defined in paragraph (b) of this section) prior to 
March 13, 1975, on which the new principal residence is constructed and 
the cost of expenditures with respect to construction work performed 
prior to March 13, 1975. The costs incurred in stockpiling materials for 
later stages of construction, however, are not allocated to the pre-
March 13 period. Thus, for example, if prior to March 13, 1975, a 
taxpayer who qualifies for the credit has constructed a portion of a 
residence at a cost of $10,000 (including the cost of the land purchased 
prior to March 13, 1975) and the total cost of the residence is $40,000 
and the taxpayer's basis after the application of section 1034(e) 
(relating to the reduction of basis of new principal residence where 
gain is not recognized upon the sale of the old residence) is $36,000, 
the amount subject to the credit will be $27,000:

($30,000 / $40,000) x $36,000.

[T.D. 7391, 40 FR 55852, Dec. 2, 1975; 40 FR 58138, Dec. 15, 1975]



Sec.  1.44-3  Certificate by seller.

    (a) Requirement of certification by seller. Taxpayers claiming the 
credit should attach Form 5405, Credit for Purchase or Construction of 
New Principal Residence, to their tax returns on which the credit is 
claimed. Except in the case of self-construction (as defined in Sec.  
1.44-5(d)), taxpayers must attach a certification by the seller that 
construction of the residence began before March 26, 1975, and that the 
purchase price is the lowest price at which the residence was offered 
for sale after February 28, 1975. For purposes of section 44(e)(4) and 
this section, the term ``price'' generally does not include costs of 
acquisition other than the amount of the consideration from the 
purchaser to the seller. However, for rules relating to adjustments in 
price due to changes in financing terms and closing costs see paragraph 
(d)(2) of this section.
    (b) Form of certification. The following form of the certification 
statement is suggested:

    I certify that the construction of the residence at (specify 
address) was begun before March 26, 1975, and that this residence has 
not been offered for sale after February 28, 1975 in a listing, a 
written private offer, or an offer by means of advertisement at a lower 
purchase price than (state price), the price at which I sold the 
residence to (state name, present address, and social security number of 
purchaser) by contract dated (give date).
    (Date, seller's signature and taxpayer identification number.)


However, any written certification filed by the taxpayer will be 
accepted provided that such certification is signed by the seller and 
states that construction of the residence began before March 26, 1975, 
and that the purchase price of the residence is the lowest price at 
which the residence was offered for sale after February 28, 1975. With 
regard to factory-made homes the seller, in the absence of his own 
knowledge as to the commencement of construction, may attach to his own 
certification a certification from the manufacturer that construction 
began before March 26, 1975, and may certify based on the manufacturer's 
certification. It is suggested that both certifications include the 
serial number, if any, of the residence.
    (c) Offer to sell. (1) For purposes of section 44(e)(4) and this 
section, an offer to sell is limited to an offer to sell a specified 
residence at a specified purchase price.
    (2) An ``offer'' includes any written offer, whether made to a 
particular purchaser or to the public, and any offer by means of 
advertising. Advertising includes an offer to sell published by 
billboards, flyers, brochures, price lists (unless the lists are 
exclusively for the internal use of the seller and are not made 
available to the public), mailings, newspapers, periodicals, radio, or 
television. The listing of a property with a real estate agency, the

[[Page 267]]

filing of a prospectus and the registration of construction plans and 
price lists with the appropriate authorities (in the case of 
condominiums or cooperative housing developments) are to be considered 
offers made to the public.
    (3) An offer to sell a specified residence includes:
    (i) Both an offer to sell an existing residence and an offer to 
build and sell a residence of substantially the same design or model as 
that purchased by the taxpayer on the same lot as that on which the 
taxpayer's new principal residence was constructed. It does not include 
an offer to sell the same model residence on a different lot. Where a 
residence of a particular design or model is offered at a specific base 
price, additions of property to the residence, no matter how extensive, 
will not result in the residence being treated as a different residence 
for the purpose of determining the lowest offer (as defined in paragraph 
(f) of Sec.  1.44-5).
    (ii) In the case of a condominium or cooperative housing development 
where units are offered for sale on the basis of models (e.g., all Model 
C two-bedroom apartments sell at a specified base price), an offer to 
sell a specified residence includes an offer to sell a specific type of 
unit (with appropriate adjustments to be made for the location of such 
unit and as provided in paragraph (d) of this section).
    (iii) In the case of a factory-made home, an offer to sell a 
specified residence includes an offer to sell the same model home as 
that purchased by the taxpayer, provided that the offer is made after 
the seller has the right to sell the home purchased by the taxpayer 
(i.e., has that specific home in his inventory). However, it does not 
include an offer to sell such home with land which is not included in 
the taxpayer's purchase nor an offer to sell such home without land 
which is included in the taxpayer's purchase. Appropriate adjustments to 
a prior offer shall be made as provided in paragraph (d) of this 
section, including adjustments for any delivery and installation charges 
as provided in paragraph (d)(3).
    (iv) The rules of this subparagraph may be illustrated by the 
following examples:

    Example 1. In March 1975 A advertised colonial-style homes on 
section I of subdivision C at a base price of $40,000. At the time none 
of the homes had been completed but construction of all homes on section 
I was commenced before March 26, 1975. After one-half of the homes were 
sold, A offers to sell the remaining homes in May 1975 at a base price 
of $45,000. Under the facts above the base price of $45,000 is not the 
lowest offer since the seller had offered to sell the same model home on 
the same lot at a lower purchase price after February 28, 1975.
    Example 2. In June 1975 A offers houses, otherwise qualifying, on 
section II for the first time for a base price of $50,000. They are 
colonial homes and substantially the same as the homes he previously 
offered on section I. Under the facts stated above the base price of 
$50,000 is the lowest offer since the same model home on the same lot 
was not previously offered for sale.
    Example 3. In March 1975 B, a condominium developer, offers to sell 
any two-bedroom unit in a particular high rise condominium for $45,000 
with an added $5,000 for units with a lakefront view and an additional 
$2,000 for units on higher floors. With regard to all two-bedroom units 
in the condominium an offer to sell a specified residence at a specified 
purchase price has been made. This is true even though at the time of 
the offer construction had not reached the floor on which the particular 
unit will be located.

    (4) A specified purchase price means a stated definite price for a 
particular residence or a specific base price for a residence of a 
particular model or design. An offer to sell for an indefinite price 
(e.g., an advertisement that all houses sell in the $40,000's) is not 
considered an offer to sell at a specified purchase price.
    (5) An offer to sell includes an offer to sell subject to special 
conditions imposed by the seller. Thus, if the lowest price at which a 
house was advertised was ``at $40,000 for March only'', the $40,000 
price would be the lowest offer. However, certain conditions may 
necessitate adjustments in determining the lowest offer. See paragraph 
(d) of this section.
    (6) An offer to sell two or more residences together as for example, 
in a bulk sale shall be disregarded, even though each residence is 
assigned a specific purchase price for the purpose of such a sale. With 
regard to factory-made homes an offer to sell does not include an offer 
made by the manufacturer to a dealer in such homes.

[[Page 268]]

    (7)(i) Where new residences are purchased at a foreclosure sale 
(including a conveyance by the owner in lieu of foreclosure) and prior 
to the foreclosure sale such residences had been offered for sale by the 
foreclosure seller at specified prices, the foreclosure purchaser is 
bound by such prices in determining the lowest offer. He is not bound by 
the prices paid to the foreclosure seller since such prices do not 
constitute voluntary offers.
    (ii) For this purpose, if the foreclosure seller and foreclosure 
purchaser are not related parties (as defined in subdivision (iii) of 
this subparagraph), and if the foreclosure purchaser does not have 
knowledge of the date of commencement of construction and the lowest 
offer made by such seller with respect to each of the foreclosed 
residences, the foreclosure purchaser must request and try to obtain 
from the foreclosure seller a certificate specifying such facts. Upon a 
subsequent sale of a particular residence by the foreclosure purchaser, 
he must certify whether the price is the lowest offer for that 
particular residence based on the certification of the foreclosure 
seller, a copy of which must be attached to the certification of the 
foreclosure purchaser. If the foreclosure seller refuses to so certify, 
the foreclosure purchaser must make a reasonable effort to determine the 
date construction commenced and the lowest offer made by the foreclosure 
seller. For this purpose, reasonable effort includes the effort to 
locate and examine advertising and listings published or used by the 
foreclosure seller. If the foreclosure seller and foreclosure purchaser 
are related parties (as defined in subdivision (iii) of this 
subparagraph), the foreclosure purchaser will be considered as having 
knowledge of the date of the commencement of construction and the lowest 
offer made by such seller with respect to each of the foreclosed 
residences, and, upon a subsequent sale of a particular residence by the 
foreclosure purchaser, he must comply with the certification 
requirements prescribed by paragraphs (a) and (b) of this section.
    (iii) For purposes of this subparagraph related parties shall 
include the relationships described in subparagraph (2) of Sec.  1.44-
5(c), and the constructive ownership rules of section 318 shall apply, 
but family members for this purpose shall include spouses, ancestors, 
and lineal descendants.
    (d) Adjustments in determining lowest price. (1)(i) In determining 
whether a residence was sold at the lowest offer appropriate adjustment 
shall be made for differences in the property offered and in the terms 
of the sale. Where the sale to the taxpayer includes property which was 
not the subject of the prior offer or excludes property which was 
included in the prior offer, the amount of the prior offer shall be 
adjusted to reflect the fair market value of such property, provided 
that, in the case of property included in the sale which was not a part 
of the residence at the time of execution of the contract of purchase, 
the taxpayer had the option to require inclusion or exclusion of such 
property. The fair market value of any excluded property is to be 
determined at the time of the prior offer, while all additions are to be 
valued at their fair market value on the date of execution of the 
contract of sale. If a seller increases his present offer to include 
financing or other costs of the seller in connection with his ownership 
of the residence, the present offer does not qualify as being the lowest 
offer.
    (ii) The rules in subdivision (i) of this subparagraph are 
illustrated by the following examples:

    Example 1. A offered to sell a new home without a garage for 
$35,000. Having found no buyers A added a garage and sold the home for 
$40,000. At the time the contract of sale was executed the fair market 
value of the garage was $5,000. The offer to sell for $40,000 qualifies 
since it equals the seller's lowest offer plus the fair market value of 
the garage.
    Example 2. B, unable to sell colonial-style homes presently under 
construction and previously offered for sale for $40,000, makes 
extensive changes in decor and identifies the homes as his new 
Williamsburg model. The Williamsburg models are not different residences 
for purposes of this section. To the extent that the additions have not 
yet been added at the time of execution of a contract of sale, in order 
to qualify for the credit the taxpayer must have the option as to 
whether to include these additions, and if these additions are included 
B must charge no more than the fair market value of the additions

[[Page 269]]

on that date of execution of the contract of sale.

    (2) Appropriate adjustment to a prior offer to sell shall be made 
for differences in financing terms and closing costs which increase the 
seller's actual net proceeds and the purchaser's actual costs. A seller 
may pass on to the purchaser without affecting the purchase price only 
those additional amounts he is required to expend in connection with 
such differences. The seller may not by changing the financing terms or 
closing costs indirectly increase the purchase price. For these purposes 
closing costs include all charges paid at settlement for obtaining the 
mortgage loan and transferring real estate title. Thus, for example, 
where a seller previously offered a residence for sale for $40,000 and 
agreed to pay financing ``points'' required by the mortgagee, and now 
offers the same residence also for $40,000 but requires the purchaser to 
pay the points, the present offer does not constitute the lowest offer. 
On the other hand, a prior offer to sell based upon a large down payment 
by the prospective purchaser may be adjusted to reflect the additional 
costs to the seller of accepting a small down payment from the taxpayer. 
For purposes of determining the seller's net proceeds, proceeds received 
by all related parties within the meaning of section 318 must be taken 
into account. For purposes of determining the lowest offer, where an 
offer provided for a rebate (e.g., of cash or of a contribution toward 
mortgage payments) or included, without additional charge or at less 
than fair market value, property not normally included in the sale of a 
residence (e.g., an automobile), such offer must be reduced by the 
amount of such rebate or by the amount by which the fair market value of 
such property at the time of the offer exceeds the amount paid for it by 
the purchaser. Thus, where a residence was advertised for sale at 
$40,000, but the seller agreed to pay $200 a month on the purchaser's 
mortgage for 10 months, such residence is considered to have been 
offered for sale at $38,000.
    (3) In the case of a factory-made home, where delivery and 
installation costs are included in the specified base price of such home 
an appropriate adjustment is to be made in such specified base price for 
differences in the fair market value of the delivery and installation in 
determining the lowest offer.
    (e) Civil and criminal penalties. If a person certifies that the 
price for which the residence was sold does not exceed the lowest offer 
and if it is found that the price for which the residence was sold 
exceeded the lowest offer, then such person is liable (under section 
208(b) of the Tax Reduction Act of 1975) to the purchaser for damages in 
an amount equal to three times the excess of the certified price over 
the lowest offer plus reasonable attorney's fees. No income tax 
deduction shall be allowed for two-thirds of any amount paid or incurred 
pursuant to a judgment entered against any person in a suit based on 
such liability. However, attorney's fees, court costs, and other such 
amounts paid or incurred with respect to such suit which meet the 
requirements of section 162 are deductible under that section. In 
addition, an individual who falsely certifies may be subject to criminal 
penalties. For example, section 1001 of title 18 of the United States 
Code provides as follows:
Sec.  1001
Statements or entries generally.
    Whoever, in any matter within the jurisdiction of any department or 
agency of the United States knowingly and willfully falsifies, conceals 
or covers up by any trick, scheme, or device a material fact, or makes 
any false, fictitious or fraudulent statements or representations, or 
makes or uses any false writing or document knowing the same to contain 
any false, fictitious or fraudulent statement or entry, shall be fined 
not more than $10,000 or imprisoned not more than five years, or both.


The treble damages and criminal sanctions provided under this paragraph 
apply only with regard to false certification as to the lowest offer, 
not to false certification as to commencement of construction. However, 
with regard to false certification as to commencement of construction 
there may exist contractual or tort remedies under State law.
    (f) Denial of credit. In the absence of the taxpayer's participation 
in, or knowledge of, a false certification by the seller, the credit is 
not denied to a taxpayer who otherwise qualifies for

[[Page 270]]

the credit solely because the seller has falsely certified that the new 
principal residence was sold at the lowest offer. However, if 
certification as to the commencement of construction is false, no credit 
is allowed since such residence does not qualify as a new principal 
residence construction of which began before March 26, 1975.

[T.D. 7391, 40 FR 55852, Dec. 2, 1975]



Sec.  1.44-4  Recapture for certain dispositions.

    (a) In general. (1) Under section 44(d) except as provided in 
paragraphs (b) and (c) of this section, if the taxpayer disposes of 
property, with respect to the purchase of which a credit was allowed 
under section 44(a), at any time within 36 months after the date on 
which he acquired it (or, in the case of construction by the taxpayer, 
the date on which he first occupied it as his principal residence), then 
the tax imposed under chapter 1 of the Code for the taxable year in 
which the replacement period (as provided under subparagraph (2) of this 
paragraph) terminates is increased by an amount equal to the amount 
allowed as a credit for the purchase of such property.
    (2) The replacement period is the period provided for purchase of a 
new principal residence under section 1034 of the Code without 
recognition of gain on the sale of the old residence. In the case of 
residences sold or exchanged after December 31, 1974, it is generally 18 
months in the case of acquisition by purchase and 2 years in the case of 
construction by the taxpayer provided, however, that such construction 
has commenced within the 18-month period. Thus, a calendar-year taxpayer 
who disposes of his old principal residence in December 1975 and does 
not qualify under paragraph (b) or (c) of this section will include the 
amount previously allowed as additional tax on his 1977 tax return.
    (3) Except as provided in paragraphs (b) and (c) of this section, 
section 44(d) applies to all dispositions of property, including sales 
(including foreclosure sales), exchanges (including tax-free exchanges 
such as those under sections 351, 721, and 1031), and gifts.
    (4) In the case of a husband and wife who were allowed a credit 
under section 44(a) claimed on a joint return, for the purpose of 
section 44(d) and this section the credit shall be allocated between the 
spouses in accordance with the provisions of paragraph (b)(3) of Sec.  
1.44-1.
    (b) Acquisition of a new residence. (1) Section 44(d)(1) and 
paragraph (a) of this section shall not apply to a disposition of 
property with respect to the purchase of which a credit was allowed 
under section 44(a) in the case of a taxpayer who purchases or 
constructs a new principal residence (within the meaning of Sec.  1.44-
5(a)) within the applicable replacement period provided in section 1034. 
In determining whether a new principal residence qualifies for purposes 
of this section the rules relating to construction, acquisition, and 
occupancy under Sec.  1.44-2 do not apply. Where a disposition has 
occurred and the taxpayer's purchase (or construction) costs of a new 
principal residence are less than the adjusted sales price (as defined 
in section 1034(b)) of the old residence, the tax imposed by chapter 1 
of the Code for the taxable year following the taxable year during which 
disposition occurs is increased by an amount which bears the same ratio 
to the amount allowed as a credit for the purchase of the old residence 
as (i) the adjusted sales price of the old residence (within the meaning 
of section 1034), reduced (but not below zero) by the taxpayer's cost of 
purchasing (or constructing) the new residence (within the meaning of 
such section) bears to (ii) the adjusted sales price of the old 
residence.
    (2) The rules of subparagraph (1) of this paragraph may be 
illustrated by the following example:

    Example. On July 15, 1975, A purchases a new principal residence for 
a total purchase price of $40,000. The property meets the tests of Sec.  
1.44-2, and A is allowed a credit of $2,000 on his 1975 tax return. On 
January 15, 1977 (within 36 months after acquisition) A sells his 
residence for an adjusted sales price of $50,000 and on March 15, 1977, 
purchases a new principal residence at a cost of $40,000. Since the new 
principal residence was purchased within the 18-month replacement period 
(provided in section 1034), the amount recaptured is limited to $400, 
determined by multiplying the amount of the credit allowed ($2,000) by a 
fraction, the numerator of which is $10,000 (determined by reducing the 
adjusted sales price of the old residence

[[Page 271]]

($50,000) by A's cost of purchasing the new principal residence 
($40,000)) and the denominator of which is $50,000 (the adjusted sales 
price). Therefore, A's tax liability for 1978, the year following the 
taxable year in which the disposition occurred, is increased by $400.

    (c) Certain involuntary dispositions. Section 44(d)(1) and paragraph 
(a) of this section shall not apply to the following:
    (1) A disposition of a residence made on account of the death of any 
individual having a legal or equitable interest therein occurring during 
the 36-month period described in paragraph (a) of this section,
    (2) A disposition of the residence if it is substantially or 
completely destroyed by a casualty described in section 165(c)(3),
    (3) A disposition of the residence if it is compulsorily and 
involuntarily converted within the meaning of section 1033(a), or
    (4) A disposition of the residence pursuant to a settlement in a 
divorce or legal separation proceeding where the other spouse retains 
the residence as principal residence (as defined in Sec.  1.44-5(a)).

[T.D. 7391, 40 FR 55854, Dec. 2, 1975; 40 FR 58138, Dec. 15, 1975]



Sec.  1.44-5  Definitions.

    For purposes of section 44 and the regulations thereunder--
    (a) New principal residence. The term ``new principal residence'' 
means a principal residence, the original use of which commences with 
the taxpayer. The term ``principal residence'' has the same meaning as 
under section 1034 of the Code. For this purpose, the term ``residence'' 
includes, without being limited to, a single family structure, a 
residential unit in a condominium or cooperative housing project, a 
townhouse, and a factory-made home. In the case of a tenant-stockholder 
in a cooperative housing corporation references to property used by the 
taxpayer as his principal residence and references to the residence of a 
taxpayer shall include stock held by the tenant-stockholder in a 
cooperative housing project provided, however, that the taxpayer used as 
his principal residence the house or apartment which he was entitled as 
such stockholder to occupy. ``Original use'' of the new principal 
residence by the taxpayer means that such residence has never been used 
as a residence prior to its use as such by the taxpayer. For this 
purpose, a residence will qualify if the first occupancy was by the 
taxpayer pursuant to a lease arrangement pending settlement under a 
binding contract to purchase or pursuant to a lease arrangement where a 
written option to purchase the then existing residence was contained in 
the original lease agreement.

A renovated building does not qualify as new, regardless of the extent 
of the renovation nor does a condominium conversion qualify.
    (b) Purchase price--(1) General rule. For purposes of section 44(a) 
and Sec.  1.44-1, the term ``purchase price'' means the adjusted basis 
of the new principal residence on the date of acquisition and includes 
all amounts attributable to the acquisition or construction, but only to 
the extent that such amounts constitute capital expenditures and are not 
allowable as deductions in computing taxable income. Such capital 
expenditures include but are not limited to the cost of acquisition or 
construction, title insurance, attorney's fees, transfer taxes, and 
other costs of transfer. For these purposes the adjusted basis of a 
factory-made home includes the cost of moving the home and setting it up 
as the taxpayer's principal residence only where such cost is included 
in the base price of the residence; it also includes the purchase price 
of the land on which the home is located, but only if such land was 
purchased by the taxpayer after March 12, 1975 and only if the taxpayer 
acquired the land prior to or in conjunction with the acquisition of 
such factory-made home. However, the adjusted basis does not include any 
expenditures involved in connection with the leasing of land on which 
the factory-made home is located. In the case of factory-made homes the 
adjusted basis includes furniture only where it is included in the base 
price of the unit.
    (2) Sale of old principal residence. (i) The adjusted basis is 
reduced by any gain from the sale or involuntary conversion of an old 
principal residence, which is not recognized due to the application of 
section 1033 or section 1034.

[[Page 272]]

However, no reduction will be made for any gain excluded from tax by 
reason of the special treatment provided under the tax laws in the case 
of a sale by a taxpayer who has attained age 65 (section 121 of the 
code).
    (ii) The rules in subdivision (i) of this subparagraph are 
illustrated by the following examples:

    Example 1. A sells an old principal residence for $30,000 which has 
an adjusted basis of $20,000. A reinvests the proceeds by purchasing a 
new principal residence for $40,000 (including settlement costs which 
are capital in nature), and this purchase satisfies the statutory 
criteria under section 1034 for nonrecognition of gain. The credit under 
section 44 applies with respect to $30,000 ($40,000 costs minus $10,000 
unrecognized gain) of the cost of the new principal residence.
    Example 2. B and C, two sisters, purchase a new principal residence 
as joint tenants with the right of survivorship for a total purchase 
price of $40,000. B has previously sold her old principal residence for 
$25,000 and a $10,000 gain on the sale has qualified for nonrecognition 
under section 1034. B contributes $25,000 and C contributes $15,000. The 
adjusted basis of the new principal residence is $30,000 representing 
the total purchase price of $40,000 less $10,000 representing 
unrecognized gain under section 1034. The total credit allowable, 
therefore, is $1,500. Since joint tenants are treated as equal owners 
and since allocation of the credit is made in proportion to the 
taxpayer's respective ownership interests in such residence B and C each 
will receive a credit of $750.
    Example 3. Taxpayer D is 65 years old and sells his old principal 
residence for $20,000 excluding all gain under section 121. He then 
purchases a new principal residence for $30,000. D's adjusted basis in 
his new principal residence is $30,000, and he is allowed a credit of 
$1,500.

    (3) Tie-in sales. In the case of a purchase of a new principal 
residence which is tied in to the transfer of other property by the 
seller to the purchaser, whether purportedly by sale or gift, the 
adjusted basis of the residence is reduced by the amount of the excess 
of the fair market value of such other property received over the 
amount, if any, purportedly paid for it by the purchaser of the 
residence. For example, if a taxpayer receives a new car with a fair 
market value of $2,500 upon the purchase of a condominium apartment for 
a total purchase price of $40,000 (including settlement costs which are 
capital in nature) his adjusted basis in the residence for computation 
of the credit is $37,500.
    (4) Basis of new principal residence. The taxpayer's basis in his 
new principal residence is not in any way affected by the allowance of 
the credit.
    (c) Purchase--(1) General rule. Except as provided in subparagraph 
(2) of this paragraph, the term ``purchase'' means any acquisition of 
property.
    (2) Exceptions. (i) An acquisition does not qualify as a purchase 
for the purpose of this paragraph if the property is acquired from a 
person whose relationship to the person acquiring it would result in the 
disallowance of losses under section 267 or 707(b). Such persons 
include--
    (A) The purchaser's spouse, ancestors and lineal descendants,
    (B) Related corporations as provided under section 267(b)(2),
    (C) Related trusts as provided under section 267(b), (4), (5), (6), 
and (7),
    (D) Related charitable organizations as provided under section 
267(b)(9), and
    (E) Related partnerships as provided under section 707(b)(1).

For purposes of this subdivision the constructive ownership rules of 
section 267(c) shall apply except that paragraph (4) of section 267(c) 
shall be treated as providing that the family of an individual shall 
include only his spouse, ancestors, and lineal descendants.
    (ii) An acquisition does not qualify as a purchase for the purpose 
of this paragraph if the basis of the property in the hands of the 
person acquiring such property is determined--
    (A) In whole or in part by reference to the adjusted basis of such 
property in the hands of the person from whom acquired (e.g., a gift 
under section 1015), or
    (B) Under section 1014(a) (relating to property acquired from a 
decedent).
    (d) Self-construction. The term ``self-construction'' means the 
construction of a residence (other than a factory-made home) to the 
taxpayer's specifications on land already owned or leased by the 
taxpayer at the time of commencement of construction. Thus, where a 
taxpayer purchases land and either builds a residence himself or hires 
an architect and a contractor to

[[Page 273]]

build a residence on that land, the taxpayer has ``self-constructed'' 
the residence.
    (e) Factory-made home. The term ``factory-made homes'' includes 
mobile homes, houseboats and prefabricated and modular homes.
    (f) Lowest offer. The term ``lowest offer'' means the lowest price 
at which the residence was offered for sale after February 28, 1975.

[T.D. 7391, 40 FR 55855, Dec. 2, 1975]



Sec.  1.44B-1  Credit for employment of certain new employees.

    (a) In general--(1) Targeted jobs credit. Under section 44B a 
taxpayer may elect to claim a credit for wages (as defined in section 
51(c) paid or incurred to members of a targeted group (as defined in 
section 51(d)). Generally, to qualify for the credit, the wages must be 
paid or incurred to members of a targeted group first hired after 
September 26, 1978. However, wages paid of incurred to a vocational 
rehabilitation referral (as defined in section 51(d)(2)) hired before 
September 27, 1978, may qualify for the credit if a credit under section 
44B (as in effect prior to enactment of the Revenue Act of 1978) was 
claimed for the individual by the taxpayer for a taxable year beginning 
before January 1, 1979. The amount of the credit shall be determined 
under section 51. Section 280C(b) (relating to the requirement that the 
deduction for wages be reduced by the amount of the credit) and the 
regulations thereunder will not apply to taxpayers who do not elect to 
claim the credit.
    (2) New jobs credit. Under section 44B (as in effect prior to 
enactment of the Revenue Act of 1978) a taxpayer may elect to claim as a 
credit the amount determined under sections 51, 52, and 53 (as in effect 
prior to enactment of the Revenue Act of 1978). Section 280C(b) 
(relating to the requirement that the deduction for wages be reduced by 
the amount of the credit) and the regulations thereunder will not apply 
to taxpayers who do not elect to claim the credit.
    (b) Time and manner of making election. The election to claim the 
targeted jobs credit and the new jobs credit is made by claiming the 
credit on an original return, or on an amended return, at any time 
before the expiration of the 3-year period beginning on the last date 
prescribed by law for filing the return for the taxable year (determined 
without regard to extensions). The election may be revoked within the 
above-described 3-year period by filing an amended return on which the 
credit is not claimed.
    (c) Election by partnership, electing small business corporation, 
and members of a controlled group. In the case of a partnership, the 
election shall be made by the partnership. In the case of an electing 
small business corporation (as defined in section 1371(a)), the election 
shall be made by the corporation. In the case of a controlled group of 
corporations (within the meaning of section 52(a) and the regulations 
issued thereunder) not filing a consolidlated return under section 1501, 
the election shall be made by each member of the group. In the case of 
an affiliated group filing a consolidated return under section 1501, the 
election shall be made by the group.

(Secs. 44B, 381, and 7805 of the Internal Revenue Code of 1954 (92 Stat. 
2834, 26 U.S.C. 44B; 91 Stat. 148, 26 U.S.C. 381(c)(26); 68A Stat. 917, 
26 U.S.C. 7805)

[T.D. 7921, 48 FR 52904, Nov. 23, 1983]

   Research Credit--For Taxable Years Beginning Before January 1, 1990



Sec.  1.41-0A  Table of contents.

    This section lists the paragraphs contained in Sec. Sec.  1.41-0A, 
1.41-3A, 1.41-4A and 1.41-5A.

                    Sec.  1.41-0A Table of contents.

               Sec.  1.41-3A Base period research expense.

    (a) Number of years in base period.
    (b) New taxpayers.
    (c) Definition of base period research expenses.
    (d) Special rules for short taxable years.
    (1) Short determination year.
    (2) Short base period year.
    (3) Years overlapping the effective dates of section 41 (section 
44F).
    (i) Determination years.
    (ii) Base period years.
    (4) Number of months in a short taxable year.
    (e) Examples.

[[Page 274]]

  Sec.  1.41-4A Qualified research for taxable years beginning before 
                            January 1, 1986.

    (a) General rule.
    (b) Activities outside the United States.
    (1) In-house research.
    (2) Contract research.
    (c) Social sciences or humanities.
    (d) Research funded by any grant, contract, or otherwise.
    (1) In general.
    (2) Research in which taxpayer retains no rights.
    (3) Research in which the taxpayer retains substantial rights.
    (i) In general.
    (ii) Pro rata allocation.
    (iii) Project-by-project determination.
    (4) Independent research and development under the Federal 
Acquisition Regulations System and similar provisions.
    (5) Funding determinable only in subsequent taxable year.
    (6) Examples.

Sec.  1.41-5A Basic research for taxable years beginning before January 
                                1, 1987.

    (a) In general.
    (b) Trade or business requirement.
    (c) Prepaid amounts.
    (1) In general.
    (2) Transfers of property.
    (d) Written research agreement.
    (1) In general.
    (2) Agreement between a corporation and a qualified organization 
after June 30, 1983.
    (i) In general.
    (ii) Transfers of property.
    (3) Agreement between a qualified fund and a qualified educational 
organization after June 30, 1983.
    (e) Exclusions.
    (1) Research conducted outside the United States.
    (2) Research in the social sciences or humanities.
    (f) Procedure for making an election to be treated as a qualified 
fund.

[T.D. 8930, 66 FR 295, Jan. 3, 2001]



Sec.  1.41-3A  Base period research expense.

    (a) Number of years in base period. The term ``base period'' 
generally means the 3 taxable years immediately preceding the year for 
which a credit is being determined (``determination year''). However, if 
the first taxable year of the taxpayer ending after June 30, 1981, ends 
in 1981 or 1982, then with respect to that taxable year the term ``base 
period'' means the immediately preceding taxable year. If the second 
taxable year of the taxpayer ending after June 30, 1981, ends in 1982 or 
1983, then with respect to that taxable year the term ``base period'' 
means the 2 immediately preceding taxable years.
    (b) New taxpayers. If, with respect to any determination year, the 
taxpayer has not been in existence for the number of preceding taxable 
years that are included under paragraph (a) of this section in the base 
period for that year, then for purposes of paragraph (c)(1) of this 
section (relating to the determination of average qualified research 
expenses during the base period), the taxpayer shall be treated as--
    (1) Having been in existence for that number of additional 12-month 
taxable years that is necessary to complete the base period specified in 
paragraph (a) of this section, and
    (2) Having had qualified research expenses of zero in each of those 
additional years.
    (c) Definition of base period research expenses. For any 
determination year, the term ``base period research expenses'' means the 
greater of--
    (1) The average qualified research expenses for taxable years during 
the base period, or
    (2) Fifty percent of the qualified research expenses for the 
determination year.
    (d) Special rules for short taxable years--(1) Short determination 
year. If the determination year for which a research credit is being 
taken is a short taxable year, the amount taken into account under 
paragraph (c)(1) of this section shall be modified by multiplying that 
amount by the number of months in the short taxable year and dividing 
the result by 12.
    (2) Short base period year. For purposes of paragraph (c)(1) of this 
section, if a year in the base period is a short taxable year, the 
qualified research expenses paid or incurred in the short taxable year 
are deemed to be equal to the qualified research expenses actually paid 
or incurred in that year multiplied by 12 and divided by the number of 
months in that year.
    (3) Years overlapping the effective dates of section 41 (section 
44F)--(i) Determination years. If a determination year includes months 
before July 1981, the determination year is deemed to be a short taxable 
year including only the months after June 1981. Accordingly,

[[Page 275]]

paragraph (d)(1) of this section is applied for purposes of determining 
the base period expenses for such year. See section 221(d)(2) of the 
Economic Recovery Tax Act of 1981.
    (ii) Base period years. No adjustment is required in the case of a 
base period year merely because it overlaps June 30, 1981.
    (4) Number of months in a short taxable year. The number of months 
in a short taxable year is equal to the number of whole calendar months 
contained in the year plus fractions for any partially included months. 
The fraction for a partially included month is equal to the number of 
days in the month that are included in the short taxable year divided by 
the total number of days in that month. Thus, if a short taxable year 
begins on January 1, 1982, and ends on June 9, 1982, it consists of 5 
and 9/30 months.
    (e) Examples. The following examples illustrate the application of 
this section.

    Example 1. X Corp., an accrual-method taxpayer using the calendar 
year as its taxable year, is organized and begins carrying on a trade or 
business during 1979 and subsequently incurs qualified research expenses 
as follows:

1979...........................................................     $10x
1980...........................................................     150x
1/1/81-6/30/81.................................................      90x
7/1/81-12/31/81................................................     110x
1982...........................................................     250x
1983...........................................................     450x
 

    (i) Determination year 1981. For determination year 1981, the base 
period consists of the immediately preceding taxable year, calendar year 
1980. Because the determination year includes months before July 1981, 
paragraph (d)(3)(i) of this section requires that the determination year 
be treated as a short taxable year. Thus, for purposes of paragraph 
(c)(1) of this section, as modified by paragraph (d)(1) of this section, 
the average qualified research expenses for taxable years during the 
base period are $75x ($150x, the average qualified research expenses for 
the base period, multiplied by 6, the number of months in the 
determination year after June 30, 1981, and divided by 12). Because this 
amount is greater than the amount determined under paragraph (c)(2) of 
this section (50 percent of the determination year's qualified research 
expense of $110x, or $55x), the amount of base period research expenses 
is $75x. The credit for determination year 1981 is equal to 25 percent 
of the excess of $110x (the qualified research expenditures incurred 
during the determination year including only expenditures accrued on or 
after July 1, 1981, through the end of the determination year) over $75x 
(the base period research expenses).
    (ii) Determination year 1982. For determination year 1982, the base 
period consists of the 2 immediately preceding taxable years, 1980 and 
1981. The amount determined under paragraph (c)(1) of this section (the 
average qualified research expenses for taxable years during the base 
period) is $175x (($150x + $90x + $110x)/2). This amount is greater than 
the amount determined under paragraph (c)(2) of this section, (50 
percent of $250x, or $125x). Accordingly, the amount of base period 
research expenses is $175x. The credit for determination year 1982 is 
equal to 25 percent of the excess of $250x (the qualified research 
expenses incurred during the determination year) over $175x (the base 
period research expenses).
    (iii) Determination year 1983. For determination year 1983, the base 
period consists of the 3 immediately preceding taxable years 1980, 1981 
and 1982. The amount determined under paragraph (c)(1) of this section 
(the average qualified research expenses for taxable years during the 
base period) is $200x (($150x + $200x + $250x)/3). The amount determined 
under paragraph (c)(2) of this section is $225x (50 percent of the $450x 
of qualified research expenses in 1983). Accordingly, the amount of base 
period research expenses is $225x. The credit for determination year 
1983 is equal to 25 percent of the excess of $450x (the qualified 
research expenses incurred during the determination year) over $225x 
(the base period research expenses).
    Example 2. Y, an accrual-basis corporation using the calendar year 
as its taxable year comes into existence and begins carrying on a trade 
or business on July 1, 1983. Y incurs qualified research expenses as 
follows:

7/1/83--12/31/83...............................................     $80x
1984...........................................................     200x
1985...........................................................     200x
 

    (i) Determination year 1983. For determination year 1983, the base 
period consists of the 3 immediately preceding taxable years: 1980, 1981 
and 1982. Although Y was not in existence during 1980, 1981 and 1982, Y 
is treated under paragraph (b) of this section as having been in 
existence during those years with qualified research expenses of zero. 
Thus, the amount determined under paragraph (c)(1) of this section (the 
average qualified research expenses for taxable years during the base 
period) is $0x (($0x + $0x + $0x)/3). The amount determined under 
paragraph (c)(2) of this section is $40x (50 percent of $80x). 
Accordingly, the amount of base period research expenses is $40x. The 
credit for determination year 1983 is equal to 25 percent of the excess 
of $80x (the qualified research expenses incurred during the 
determination

[[Page 276]]

year) over $40x (the base period research expenses).
    (ii) Determination year 1984. For determination year 1984, the base 
period consists of the 3 immediately preceding taxable years: 1981, 
1982, and 1983. Under paragraph (b) of this section, Y is treated as 
having been in existence during years 1981 and 1982 with qualified 
research expenses of zero. Because July 1 through December 31, 1983 is a 
short taxable year, paragraph (d)(2) of this section requires that the 
qualified research expenses for that year be adjusted to $160x for 
purposes of determining the average qualified research expenses during 
the base period. The $160x results from the actual qualified research 
expenses for that year ($80x) multiplied by 12 and divided by 6 (the 
number of months in the short taxable year). Accordingly, the amount 
determined under paragraph (c)(1) of this section (the average qualified 
research expenses for taxable years during the base period) is $53\1/3\x 
(($0x + $0x + $160x)/3). The amount determined under paragraph (c)(2) of 
this section is $100x (50 percent of $200x). The amount of base period 
research expenses is $100x. The credit for determination year 1984 is 
equal to 25 percent of the excess of $200x (the qualified research 
expenses incurred during the determination year) over $100x (the base 
period research expenses).
    (iii) Determination year 1985. For determination year 1985, the base 
period consists of the 3 immediately preceding taxable years: 1982, 
1983, and 1984. Pursuant to paragraph (b) of this section, Y is treated 
as having been in existence during 1982 with qualified research expenses 
of zero. Because July 1 through December 31, 1982, is a short taxable 
year, paragraph (d)(2) of this section requires that the qualified 
research expense for that year be adjusted to $160x for purposes of 
determining the average qualified research expenses for taxable years 
during the base period. This $160x is the actual qualified research 
expense for that year ($80x) multiplied by 12 and divided by 6 (the 
number of months in the short taxable year). Accordingly, the amount 
determined under paragraph (c)(1) of this section (the average qualified 
research expenses for taxable years during the base period) is $120x 
(($0x + $160x + $200x)/3). The amount determined under paragraph (c)(2) 
of this section is $100x (50 percent of $200x). The amount of base 
period research expenses is $120x. The credit for determination year 
1985 is equal to 25 percent of the excess of $200x (the qualified 
research expenses incurred during the determination year) over $120x 
(the base period research expenses).

[T.D. 8251, 54 FR 21204, May 17, 1989. Redesignated by T.D. 8930, 66 FR 
289, Jan. 3, 2001]

    rules for computing credit for investment in certain depreciable 
                                property



Sec.  1.45D-0  Table of contents.

    This section lists the paragraphs contained in Sec.  1.45D-1.

    (a) Current year credit.
    (b) Allowance of credit.
    (1) In general.
    (2) Credit allowance date.
    (3) Applicable percentage.
    (4) Amount paid at original issue.
    (c) Qualified equity investment.
    (1) In general.
    (2) Equity investment.
    (3) Equity investments made prior to allocation.
    (i) In general.
    (ii) Exceptions.
    (A) Allocation applications submitted by August 29, 2002.
    (B) Other allocation applications.
    (iii) Failure to receive allocation.
    (iv) Initial investment date.
    (4) Limitations.
    (i) In general.
    (ii) Allocation limitation.
    (5) Substantially all.
    (i) In general.
    (ii) Direct-tracing calculation.
    (iii) Safe harbor calculation.
    (iv) Time limit for making investments.
    (v) Reduced substantially-all percentage.
    (vi) Examples.
    (6) Aggregation of equity investments.
    (7) Subsequent purchasers.
    (8) Non-real estate qualified equity investment.
    (d) Qualified low-income community investments.
    (1) In general.
    (i) Investment in a qualified active low-income community business 
or a non-real estate qualified active low-income community business.
    (ii) Purchase of certain loans from CDEs.
    (A) In general.
    (B) Certain loans made before CDE certification.
    (C) Intermediary CDEs.
    (D) Examples.
    (iii) Financial counseling and other services.
    (iv) Investments in other CDEs.
    (A) In general.
    (B) Examples.
    (2) Payments of, or for, capital, equity or principal.
    (i) In general.
    (ii) Subsequent reinvestments.
    (iii) Special rule for loans.
    (iv) Example.
    (3) Special rule for reserves.
    (4) Qualified active low-income community business.

[[Page 277]]

    (i) In general.
    (A) Gross-income requirement.
    (B) Use of tangible property.
    (1) In general.
    (2) Example.
    (C) Services performed.
    (D) Collectibles.
    (E) Nonqualified financial property.
    (1) In general.
    (2) Construction of real property.
    (ii) Proprietorships.
    (iii) Portions of business.
    (A) In general.
    (B) Examples.
    (iv) Active conduct of a trade or business.
    (A) Special rule.
    (B) Example.
    (5) Qualified business.
    (i) In general.
    (ii) Rental of real property.
    (iii) Exclusions.
    (A) Trades or businesses involving intangibles.
    (B) Certain other trades or businesses.
    (C) Farming.
    (6) Qualifications.
    (i) In general.
    (ii) Control.
    (A) In general.
    (B) Definition of control.
    (C) Disregard of control.
    (7) Financial counseling and other services.
    (8) Special rule for certain loans.
    (i) In general.
    (ii) Example.
    (9) Targeted populations.
    (i) Low-income persons.
    (A) Definition.
    (1) In general.
    (2) Area median family income.
    (3) Individual's family income.
    (B) Qualified active low-income community business requirements for 
low-income targeted populations.
    (1) In general.
    (2) Employee.
    (3) Owner.
    (4) Derived from.
    (5) Fair market value of sales, rentals, services, or other 
transactions.
    (C) 120-percent-income restriction.
    (1) In general.
    (2) Population census tract location.
    (D) Rental of real property for low-income targeted populations.
    (1) In general.
    (2) Special rule for entities whose sole business is the rental to 
others of real property.
    (ii) Individuals who otherwise lack adequate access to loans or 
equity investments.
    (A) In general.
    (B) GO Zone Targeted Population.
    (C) Qualified active low-income community business requirements for 
the GO Zone Targeted Population.
    (1) In general.
    (2) Location.
    (i) In general.
    (ii) Determination.
    (D) 200-percent-income restriction.
    (1) In general.
    (2) Population census tract location.
    (E) Rental of real property for the GO Zone Targeted Population.
    (10) Non-real estate qualified active low-income community business.
    (i) Definition.
    (ii) Payments of, or for, capital, equity or principal with respect 
to a non-real estate qualified active low-income community business.
    (A) In general.
    (B) Seventh year of the 7-year credit period.
    (C) Amounts received from a qualifying entity.
    (D) Definition of qualifying entity.
    (e) Recapture.
    (1) In general.
    (2) Recapture event.
    (3) Redemption.
    (i) Equity investment in a C corporation.
    (ii) Equity investment in an S corporation.
    (iii) Capital interest in a partnership.
    (4) Bankruptcy.
    (5) Waiver of requirement or extension of time.
    (i) In general.
    (ii) Manner for requesting a waiver or extension.
    (iii) Terms and conditions.
    (6) Cure period.
    (7) Example.
    (f) Basis reduction.
    (1) In general.
    (2) Adjustment in basis of interest in partnership or S corporation.
    (g) Other rules.
    (1) Anti-abuse.
    (2) Reporting requirements.
    (i) Notification by CDE to taxpayer.
    (A) Allowance of new markets tax credit.
    (B) Recapture event.
    (ii) CDE reporting requirements to Secretary.
    (iii) Manner of claiming new markets tax credit.
    (iv) Reporting recapture tax.
    (3) Other Federal tax benefits.
    (i) In general.
    (ii) Low-income housing credit.
    (4) Bankruptcy of CDE.
    (h) Effective/applicability dates.
    (1) In general.
    (2) Exception for certain provisions.
    (3) Targeted populations.
    (4) Investments in non-real estate businesses.

[T.D. 9560, 76 FR 75777, Dec. 5, 2011, as amended by T.D. 9600, 77 FR 
59546, Sept. 28, 2012]

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Sec.  1.45D-1  New markets tax credit.

    (a) Current year credit. The current year general business credit 
under section 38(b)(13) includes the new markets tax credit under 
section 45D(a).
    (b) Allowance of credit--(1) In general. A taxpayer holding a 
qualified equity investment on a credit allowance date which occurs 
during the taxable year may claim the new markets tax credit determined 
under section 45D(a) and this section for such taxable year in an amount 
equal to the applicable percentage of the amount paid to a qualified 
community development entity (CDE) for such investment at its original 
issue. Qualified equity investment is defined in paragraph (c) of this 
section. Credit allowance date is defined in paragraph (b)(2) of this 
section. Applicable percentage is defined in paragraph (b)(3) of this 
section. A CDE is a qualified community development entity as defined in 
section 45D(c). The amount paid at original issue is determined under 
paragraph (b)(4) of this section.
    (2) Credit allowance date. The term credit allowance date means, 
with respect to any qualified equity investment--
    (i) The date on which the investment is initially made; and
    (ii) Each of the 6 anniversary dates of such date thereafter.
    (3) Applicable percentage. The applicable percentage is 5 percent 
for the first 3 credit allowance dates and 6 percent for the other 4 
credit allowance dates.
    (4) Amount paid at original issue. The amount paid to the CDE for a 
qualified equity investment at its original issue consists of all 
amounts paid by the taxpayer to, or on behalf of, the CDE (including any 
underwriter's fees) to purchase the investment at its original issue.
    (c) Qualified equity investment--(1) In general. The term qualified 
equity investment means any equity investment (as defined in paragraph 
(c)(2) of this section) in a CDE if--
    (i) The investment is acquired by the taxpayer at its original issue 
(directly or through an underwriter) solely in exchange for cash;
    (ii) Substantially all (as defined in paragraph (c)(5) of this 
section) of such cash is used by the CDE to make qualified low-income 
community investments (as defined in paragraph (d)(1) of this section); 
and
    (iii) The investment is designated for purposes of section 45D and 
this section as a qualified equity investment or a non-real estate 
qualified equity investment (as defined in paragraph (c)(8) of this 
section) by the CDE on its books and records using any reasonable 
method.
    (2) Equity investment. The term equity investment means any stock 
(other than nonqualified preferred stock as defined in section 
351(g)(2)) in an entity that is a corporation for Federal tax purposes 
and any capital interest in an entity that is a partnership for Federal 
tax purposes. See Sec. Sec.  301.7701-1 through 301.7701-3 of this 
chapter for rules governing when a business entity, such as a business 
trust or limited liability company, is classified as a corporation or a 
partnership for Federal tax purposes.
    (3) Equity investments made prior to allocation--(i) In general. 
Except as provided in paragraph (c)(3)(ii) of this section, an equity 
investment in an entity is not eligible to be designated as a qualified 
equity investment if it is made before the entity enters into an 
allocation agreement with the Secretary. An allocation agreement is an 
agreement between the Secretary and a CDE relating to a new markets tax 
credit allocation under section 45D(f)(2).
    (ii) Exceptions. Notwithstanding paragraph (c)(3)(i) of this 
section, an equity investment in an entity is eligible to be designated 
as a qualified equity investment or a non-real estate qualified equity 
investment under paragraph (c)(1)(iii) of this section if--
    (A) Allocation applications submitted by August 29, 2002. (1) The 
equity investment is made on or after April 20, 2001;
    (2) The designation of the equity investment as a qualified equity 
investment is made for a credit allocation received pursuant to an 
allocation application submitted to the Secretary no later than August 
29, 2002; and
    (3) The equity investment otherwise satisfies the requirements of 
section 45D and this section; or
    (B) Other allocation applications. (1) The equity investment is made 
on or after the date the Secretary publishes

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a Notice of Allocation Availability (NOAA) in the Federal Register;
    (2) The designation of the equity investment as a qualified equity 
investment is made for a credit allocation received pursuant to an 
allocation application submitted to the Secretary under that NOAA; and
    (3) The equity investment otherwise satisfies the requirements of 
section 45D and this section.
    (iii) Failure to receive allocation. For purposes of paragraph 
(c)(3)(ii)(A) of this section, if the entity in which the equity 
investment is made does not receive an allocation pursuant to an 
allocation application submitted no later than August 29, 2002, the 
equity investment will not be eligible to be designated as a qualified 
equity investment. For purposes of paragraph (c)(3)(ii)(B) of this 
section, if the entity in which the equity investment is made does not 
receive an allocation under the NOAA described in paragraph 
(c)(3)(ii)(B)(1) of this section, the equity investment will not be 
eligible to be designated as a qualified equity investment.
    (iv) Initial investment date. If an equity investment is designated 
as a qualified equity investment in accordance with paragraph (c)(3)(ii) 
of this section, the investment is treated as initially made on the 
effective date of the allocation agreement between the CDE and the 
Secretary.
    (4) Limitations--(i) In general. The term qualified equity 
investment does not include--
    (A) Any equity investment issued by a CDE more than 5 years after 
the date the CDE enters into an allocation agreement (as defined in 
paragraph (c)(3)(i) of this section) with the Secretary; and
    (B) Any equity investment by a CDE in another CDE, if the CDE making 
the investment has received an allocation under section 45D(f)(2).
    (ii) Allocation limitation. The maximum amount of equity investments 
issued by a CDE that may be designated under paragraph (c)(1)(iii) of 
this section by the CDE may not exceed the portion of the limitation 
amount allocated to the CDE by the Secretary under section 45D(f)(2).
    (5) Substantially all--(i) In general. Except as provided in 
paragraph (c)(5)(v) of this section, the term substantially all means at 
least 85 percent. The substantially-all requirement must be satisfied 
for each annual period in the 7-year credit period using either the 
direct-tracing calculation under paragraph (c)(5)(ii) of this section, 
or the safe harbor calculation under paragraph (c)(5)(iii) of this 
section. For the first annual period, the substantially-all requirement 
is treated as satisfied if either the direct-tracing calculation under 
paragraph (c)(5)(ii) of this section, or the safe-harbor calculation 
under paragraph (c)(5)(iii) of this section, is performed on a single 
testing date and the result of the calculation is at least 85 percent. 
For each annual period other than the first annual period, the 
substantially-all requirement is treated as satisfied if either the 
direct-tracing calculation under paragraph (c)(5)(ii) of this section, 
or the safe harbor calculation under paragraph (c)(5)(iii) of this 
section, is performed every six months and the average of the two 
calculations for the annual period is at least 85 percent. For example, 
the CDE may choose the same two testing dates for all qualified equity 
investments regardless of the date each qualified equity investment was 
initially made under paragraph (b)(2)(i) of this section, provided the 
testing dates are six months apart. The use of the direct-tracing 
calculation under paragraph (c)(5)(ii) of this section (or the safe 
harbor calculation under paragraph (c)(5)(iii) of this section) for an 
annual period does not preclude the use of the safe harbor calculation 
under paragraph (c)(5)(iii) of this section (or the direct-tracing 
calculation under paragraph (c)(5)(ii) of this section) for another 
annual period, provided that a CDE that switches to a direct-tracing 
calculation must substantiate that the taxpayer's investment is directly 
traceable to qualified low-income community investments from the time of 
the CDE's initial investment in a qualified low-income community 
investment. For purposes of this paragraph (c)(5)(i), the 7-year credit 
period means the period of 7 years beginning on the date the qualified 
equity investment is initially made. See paragraph (c)(6) of

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this section for circumstances in which a CDE may treat more than one 
equity investment as a single qualified equity investment.
    (ii) Direct-tracing calculation. The substantially-all requirement 
is satisfied if at least 85 percent of the taxpayer's investment is 
directly traceable to qualified low-income community investments as 
defined in paragraph (d)(1) of this section. The direct-tracing 
calculation is a fraction the numerator of which is the CDE's aggregate 
cost basis determined under section 1012 in all of the qualified low-
income community investments that are directly traceable to the 
taxpayer's cash investment, and the denominator of which is the amount 
of the taxpayer's cash investment under paragraph (b)(4) of this 
section. For purposes of this paragraph (c)(5)(ii), cost basis includes 
the cost basis of any qualified low-income community investment that 
becomes worthless. See paragraph (d)(2) of this section for the 
treatment of amounts received by a CDE in payment of, or for, capital, 
equity or principal with respect to a qualified low-income community 
investment.
    (iii) Safe harbor calculation. The substantially-all requirement is 
satisfied if at least 85 percent of the aggregate gross assets of the 
CDE are invested in qualified low-income community investments as 
defined in paragraph (d)(1) of this section. The safe harbor calculation 
is a fraction the numerator of which is the CDE's aggregate cost basis 
determined under section 1012 in all of its qualified low-income 
community investments, and the denominator of which is the CDE's 
aggregate cost basis determined under section 1012 in all of its assets. 
For purposes of this paragraph (c)(5)(iii), cost basis includes the cost 
basis of any qualified low-income community investment that becomes 
worthless. See paragraph (d)(2) of this section for the treatment of 
amounts received by a CDE in payment of, or for, capital, equity or 
principal with respect to a qualified low-income community investment.
    (iv) Time limit for making investments. The taxpayer's cash 
investment received by a CDE is treated as invested in a qualified low-
income community investment as defined in paragraph (d)(1) of this 
section only to the extent that the cash is so invested within the 12-
month period beginning on the date the cash is paid by the taxpayer 
(directly or through an underwriter) to the CDE.
    (v) Reduced substantially-all percentage. For purposes of the 
substantially-all requirement (including the direct-tracing calculation 
under paragraph (c)(5)(ii) of this section and the safe harbor 
calculation under paragraph (c)(5)(iii) of this section), 85 percent is 
reduced to 75 percent for the seventh year of the 7-year credit period 
(as defined in paragraph (c)(5)(i) of this section).
    (vi) Examples. The following examples illustrate an application of 
this paragraph (c)(5):

    Example 1. X is a partnership and a CDE that has received a $1 
million new markets tax credit allocation from the Secretary. On 
September 1, 2004, X uses a line of credit from a bank to fund a $1 
million loan to Y. The loan is a qualified low-income community 
investment under paragraph (d)(1) of this section. On September 5, 2004, 
A pays $1 million to acquire a capital interest in X. X uses the 
proceeds of A's equity investment to pay off the $1 million line of 
credit that was used to fund the loan to Y. X's aggregate gross assets 
consist of the $1 million loan to Y and $100,000 in other assets. A's 
equity investment in X does not satisfy the substantially-all 
requirement under paragraph (c)(5)(i) of this section using the direct-
tracing calculation under paragraph (c)(5)(ii) of this section because 
the cash from A's equity investment is not used to make X's loan to Y. 
However, A's equity investment in X satisfies the substantially-all 
requirement using the safe harbor calculation under paragraph 
(c)(5)(iii) of this section because at least 85 percent of X's aggregate 
gross assets are invested in qualified low-income community investments.
    Example 2. X is a partnership and a CDE that has received a new 
markets tax credit allocation from the Secretary. On August 1, 2004, A 
pays $100,000 for a capital interest in X. On August 5, 2004, X uses the 
proceeds of A's equity investment to make an equity investment in Y. X 
controls Y within the meaning of paragraph (d)(6)(ii)(B) of this 
section. For the annual period ending July 31, 2005, Y is a qualified 
active low-income community business (as defined in paragraph (d)(4) of 
this section). Thus, for that period, A's equity investment satisfies 
the substantially-all requirement under paragraph (c)(5)(i) of this 
section using the direct-tracing calculation under paragraph (c)(5)(ii) 
of this section. For the annual period ending

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July 31, 2006, Y no longer is a qualified active low-income community 
business. Thus, for that period, A's equity investment does not satisfy 
the substantially-all requirement using the direct-tracing calculation. 
However, during the entire annual period ending July 31, 2006, X's 
remaining assets are invested in qualified low-income community 
investments with an aggregate cost basis of $900,000. Consequently, for 
the annual period ending July 31, 2006, at least 85 percent of X's 
aggregate gross assets are invested in qualified low-income community 
investments. Thus, for the annual period ending July 31, 2006, A's 
equity investment satisfies the substantially-all requirement using the 
safe harbor calculation under paragraph (c)(5)(iii) of this section.
    Example 3. X is a partnership and a CDE that has received a new 
markets tax credit allocation from the Secretary. On August 1, 2004, A 
and B each pay $100,000 for a capital interest in X. X does not treat 
A's and B's equity investments as one qualified equity investment under 
paragraph (c)(6) of this section. On September 1, 2004, X uses the 
proceeds of A's equity investment to make an equity investment in Y and 
X uses the proceeds of B's equity investment to make an equity 
investment in Z. X has no assets other than its investments in Y and Z. 
X controls Y and Z within the meaning of paragraph (d)(6)(ii)(B) of this 
section. For the annual period ending July 31, 2005, Y and Z are 
qualified active low-income community businesses (as defined in 
paragraph (d)(4) of this section). Thus, for the annual period ending 
July 31, 2005, A's and B's equity investments satisfy the substantially-
all requirement under paragraph (c)(5)(i) of this section using either 
the direct-tracing calculation under paragraph (c)(5)(ii) of this 
section or the safe harbor calculation under paragraph (c)(5)(iii) of 
this section. For the annual period ending July 31, 2006, Y, but not Z, 
is a qualified active low-income community business. Thus, for the 
annual period ending July 31, 2006--
    (1) X does not satisfy the substantially-all requirement using the 
safe harbor calculation under paragraph (c)(5)(iii) of this section;
    (2) A's equity investment satisfies the substantially-all 
requirement using the direct-tracing calculation because A's equity 
investment is directly traceable to Y; and
    (3) B's equity investment does not satisfy the substantially-all 
requirement because B's equity investment is traceable to Z.
    Example 4. X is a partnership and a CDE that has received a new 
markets tax credit allocation from the Secretary. On November 1, 2004, A 
pays $100,000 for a capital interest in X. On December 1, 2004, B pays 
$100,000 for a capital interest in X. On December 31, 2004, X uses 
$85,000 from A's equity investment and $85,000 from B's equity 
investment to make a $170,000 equity investment in Y, a qualified active 
low-income community business (as defined in paragraph (d)(4) of this 
section). X has no assets other than its investment in Y. X determines 
whether A's and B's equity investments satisfy the substantially-all 
requirement under paragraph (c)(5)(i) of this section on December 31, 
2004. The calculation for A's and B's equity investments is 85 percent 
using either the direct-tracing calculation under paragraph (c)(5)(ii) 
of this section or the safe harbor calculation under paragraph 
(c)(5)(iii) of this section. Therefore, for the annual periods ending 
October 31, 2005, and November 30, 2005, A's and B's equity investments, 
respectively, satisfy the substantially-all requirement under paragraph 
(c)(5)(i) of this section. For the subsequent annual period, X performs 
its calculations on December 31, 2005, and June 30, 2006. The average of 
the two calculations on December 31, 2005, and June 30, 2006, is 85 
percent using either the direct-tracing calculation under paragraph 
(c)(5)(ii) of this section or the safe harbor calculation under 
paragraph (c)(5)(iii) of this section. Therefore, for the annual periods 
ending October 31, 2006, and November 30, 2006, A's and B's equity 
investments, respectively, satisfy the substantially-all requirement 
under paragraph (c)(5)(i) of this section.

    (6) Aggregation of equity investments. A CDE may treat any qualified 
equity investments issued on the same day as one qualified equity 
investment. If a CDE aggregates equity investments under this paragraph 
(c)(6), the rules in this section shall be construed in a manner 
consistent with that treatment.
    (7) Subsequent purchasers. A qualified equity investment includes 
any equity investment that would (but for paragraph (c)(1)(i) of this 
section) be a qualified equity investment in the hands of the taxpayer 
if the investment was a qualified equity investment in the hands of a 
prior holder.
    (8) Non-real estate qualified equity investment. If a qualified 
equity investment is designated as a non-real estate qualified equity 
investment under paragraph (c)(1)(iii) of this section, then the 
qualified equity investment may only satisfy the substantially-all 
requirement under paragraph (c)(5) of this section if the CDE makes 
qualified low-income community investments that are directly traceable 
(including investments made through one or more CDEs) to non-real estate 
qualified active low-income community businesses

[[Page 282]]

(as defined in paragraph (d)(10) of this section). The proceeds of a 
non-real estate qualified equity investment cannot be used for 
transactions involving a qualified active low-income community business 
that is not a non-real estate qualified active low-income community 
business.
    (d) Qualified low-income community investments--(1) In general. The 
term qualified low-income community investment means any of the 
following:
    (i) Investment in a qualified active low-income community business 
or a non-real estate qualified active low-income community business. Any 
capital or equity investment in, or loan to, any qualified active low-
income community business (as defined in paragraph (d)(4) of this 
section) or any non-real estate qualified active low-income community 
business (as defined in paragraph (d)(10) of this section).
    (ii) Purchase of certain loans from CDEs--(A) In general. The 
purchase by a CDE (the ultimate CDE) from another CDE (whether or not 
that CDE has received an allocation from the Secretary under section 
45D(f)(2)) of any loan made by such entity that is a qualified low-
income community investment. A loan purchased by the ultimate CDE from 
another CDE is a qualified low-income community investment if it 
qualifies as a qualified low-income community investment either--
    (1) At the time the loan was made; or
    (2) At the time the ultimate CDE purchases the loan.
    (B) Certain loans made before CDE certification. For purposes of 
paragraph (d)(1)(ii)(A) of this section, a loan by an entity is treated 
as made by a CDE, notwithstanding that the entity was not a CDE at the 
time it made the loan, if the entity is a CDE at the time it sells the 
loan.
    (C) Intermediary CDEs. For purposes of paragraph (d)(1)(ii)(A) of 
this section, the purchase of a loan by the ultimate CDE from a CDE that 
did not make the loan (the second CDE) is treated as a purchase of the 
loan by the ultimate CDE from the CDE that made the loan (the 
originating CDE) if--
    (1) The second CDE purchased the loan from the originating CDE (or 
from another CDE); and
    (2) Each entity that sold the loan was a CDE at the time it sold the 
loan.
    (D) Examples. The following examples illustrate an application of 
this paragraph (d)(1)(ii):

    Example 1. X is a partnership and a CDE that has received a new 
markets tax credit allocation from the Secretary. Y, a corporation, made 
a $500,000 loan to Z in 1999. In January of 2004, Y is certified as a 
CDE. On September 1, 2004, X purchases the loan from Y. At the time X 
purchases the loan, Z is a qualified active low-income community 
business under paragraph (d)(4)(i) of this section. Accordingly, the 
loan purchased by X from Y is a qualified low-income community 
investment under paragraphs (d)(1)(ii)(A) and (B) of this section.
    Example 2. The facts are the same as in Example 1 except that on 
February 1, 2004, Y sells the loan to W and on September 1, 2004, W 
sells the loan to X. W is a CDE. Under paragraph (d)(1)(ii)(C) of this 
section, X's purchase of the loan from W is treated as the purchase of 
the loan from Y. Accordingly, the loan purchased by X from W is a 
qualified low-income community investment under paragraphs (d)(1)(ii)(A) 
and (C) of this section.
    Example 3. The facts are the same as in Example 2 except that W is 
not a CDE. Because W was not a CDE at the time it sold the loan to X, 
the purchase of the loan by X from W is not a qualified low-income 
community investment under paragraphs (d)(1)(ii)(A) and (C) of this 
section.

    (iii) Financial counseling and other services. Financial counseling 
and other services (as defined in paragraph (d)(7) of this section) 
provided to any qualified active low-income community business, or to 
any residents of a low-income community (as defined in section 45D(e)).
    (iv) Investments in other CDEs--(A) In general. Any equity 
investment in, or loan to, any CDE (the second CDE) by a CDE (the 
primary CDE), but only to the extent that the second CDE uses the 
proceeds of the investment or loan--
    (1) In a manner--
    (i) That is described in paragraph (d)(1)(i) or (iii) of this 
section; and
    (ii) That would constitute a qualified low-income community 
investment if it were made directly by the primary CDE;
    (2) To make an equity investment in, or loan to, a third CDE that 
uses such proceeds in a manner described in paragraph (d)(1)(iv)(A)(1) 
of this section; or

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    (3) To make an equity investment in, or loan to, a third CDE that 
uses such proceeds to make an equity investment in, or loan to, a fourth 
CDE that uses such proceeds in a manner described in paragraph 
(d)(1)(iv)(A)(1) of this section.
    (B) Examples. The following examples illustrate an application of 
paragraph (d)(1)(iv)(A) of this section:

    Example 1. X is a partnership and a CDE that has received a new 
markets tax credit allocation from the Secretary. On September 1, 2004, 
X uses $975,000 to make an equity investment in Y. Y is a corporation 
and a CDE. On October 1, 2004, Y uses $950,000 from X's equity 
investment to make a loan to Z. Z is a qualified active low-income 
community business under paragraph (d)(4)(i) of this section. Of X's 
equity investment in Y, $950,000 is a qualified low-income community 
investment under paragraph (d)(1)(iv)(A)(1) of this section.
    Example 2. W is a partnership and a CDE that has received a new 
markets tax credit allocation from the Secretary. On September 1, 2004, 
W uses $975,000 to make an equity investment in X. On October 1, 2004, X 
uses $950,000 from W's equity investment to make an equity investment in 
Y. X and Y are corporations and CDEs. On October 5, 2004, Y uses 
$925,000 from X's equity investment to make a loan to Z. Z is a 
qualified active low-income community business under paragraph (d)(4)(i) 
of this section. Of W's equity investment in X, $925,000 is a qualified 
low-income community investment under paragraph (d)(1)(iv)(A)(2) of this 
section because X uses proceeds of W's equity investment to make an 
equity investment in Y, which uses $925,000 of the proceeds in a manner 
described in paragraph (d)(1)(iv)(A)(1) of this section.
    Example 3. U is a partnership and a CDE that has received a new 
markets tax credit allocation from the Secretary. On September 1, 2004, 
U uses $975,000 to make an equity investment in V. On October 1, 2004, V 
uses $950,000 from U's equity investment to make an equity investment in 
W. On October 5, 2004, W uses $925,000 from V's equity investment to 
make an equity investment in X. On November 1, 2004, X uses $900,000 
from W's equity investment to make an equity investment in Y. V, W, X, 
and Y are corporations and CDEs. On November 5, 2004, Y uses $875,000 
from X's equity investment to make a loan to Z. Z is a qualified active 
low-income community business under paragraph (d)(4)(i) of this section. 
U's equity investment in V is not a qualified low-income community 
investment because X does not use proceeds of W's equity investment in a 
manner described in paragraph (d)(1)(iv)(A)(1) of this section.

    (2) Payments of, or for, capital, equity or principal--(i) In 
general. Except as otherwise provided in this paragraph (d)(2), amounts 
received by a CDE in payment of, or for, capital, equity or principal 
with respect to a qualified low-income community investment must be 
reinvested by the CDE in a qualified low-income community investment no 
later than 12 months from the date of receipt to be treated as 
continuously invested in a qualified low-income community investment. If 
the amounts received by the CDE are equal to or greater than the cost 
basis of the original qualified low-income community investment (or 
applicable portion thereof), and the CDE reinvests, in accordance with 
this paragraph (d)(2)(i), an amount at least equal to such original cost 
basis, then an amount equal to such original cost basis will be treated 
as continuously invested in a qualified low-income community investment. 
In addition, if the amounts received by the CDE are equal to or greater 
than the cost basis of the original qualified low-income community 
investment (or applicable portion thereof), and the CDE reinvests, in 
accordance with this paragraph (d)(2)(i), an amount less than such 
original cost basis, then only the amount so reinvested will be treated 
as continuously invested in a qualified low-income community investment. 
If the amounts received by the CDE are less than the cost basis of the 
original qualified low-income community investment (or applicable 
portion thereof), and the CDE reinvests an amount in accordance with 
this paragraph (d)(2)(i), then the amount treated as continuously 
invested in a qualified low-income community investment will equal the 
excess (if any) of such original cost basis over the amounts received by 
the CDE that are not so reinvested. Amounts received by a CDE in payment 
of, or for, capital, equity or principal with respect to a qualified 
low-income community investment during the seventh year of the 7-year 
credit period (as defined in paragraph (c)(5)(i) of this section) do not 
have to be reinvested by the CDE in a qualified low-income community 
investment in order to be treated as continuously invested in a 
qualified low-income community investment.

[[Page 284]]

    (ii) Subsequent reinvestments. In applying paragraph (d)(2)(i) of 
this section to subsequent reinvestments, the original cost basis is 
reduced by the amount (if any) by which the original cost basis exceeds 
the amount determined to be continuously invested in a qualified low-
income community investment.
    (iii) Special rule for loans. Periodic amounts received during a 
calendar year as repayment of principal on a loan that is a qualified 
low-income community investment are treated as continuously invested in 
a qualified low-income community investment if the amounts are 
reinvested in another qualified low-income community investment by the 
end of the following calendar year.
    (iv) Example. The application of paragraphs (d)(2)(i) and (ii) of 
this section is illustrated by the following example:

    Example. On April 1, 2003, A, B, and C each pay $100,000 to acquire 
a capital interest in X, a partnership. X is a CDE that has received a 
new markets tax credit allocation from the Secretary. X treats the 3 
partnership interests as one qualified equity investment under paragraph 
(c)(6) of this section. In August 2003, X uses the $300,000 to make a 
qualified low-income community investment under paragraph (d)(1) of this 
section. In August 2005, the qualified low-income community investment 
is redeemed for $250,000. In February 2006, X reinvests $230,000 of the 
$250,000 in a second qualified low-income community investment and uses 
the remaining $20,000 for operating expenses. Under paragraph (d)(2)(i) 
of this section, $280,000 of the proceeds of the qualified equity 
investment is treated as continuously invested in a qualified low-income 
community investment. In December 2008, X sells the second qualified 
low-income community investment and receives $400,000. In March 2009, X 
reinvests $320,000 of the $400,000 in a third qualified low-income 
community investment. Under paragraphs (d)(2)(i) and (ii) of this 
section, $280,000 of the proceeds of the qualified equity investment is 
treated as continuously invested in a qualified low-income community 
investment ($40,000 is treated as invested in another qualified low-
income community investment in March 2009).

    (3) Special rule for reserves. Reserves (not in excess of 5 percent 
of the taxpayer's cash investment under paragraph (b)(4) of this 
section) maintained by the CDE for loan losses or for additional 
investments in existing qualified low-income community investments are 
treated as invested in a qualified low-income community investment under 
paragraph (d)(1) of this section. Reserves include fees paid to third 
parties to protect against loss of all or a portion of the principal of, 
or interest on, a loan that is a qualified low-income community 
investment.
    (4) Qualified active low-income community business--(i) In general. 
The term qualified active low-income community business means, with 
respect to any taxable year, a corporation (including a nonprofit 
corporation) or a partnership engaged in the active conduct of a 
qualified business (as defined in paragraph (d)(5) of this section), if 
the requirements of paragraphs (d)(4)(i)(A), (B), (C), (D), and (E) of 
this section are met (or in the case of an entity serving targeted 
populations, if the requirements of paragraphs (d)(4)(i)(D), (E), and 
(d)(9)(i) or (ii) of this section are met). Solely for purposes of this 
section, a nonprofit corporation will be deemed to be engaged in the 
active conduct of a trade or business if it is engaged in an activity 
that furthers its purpose as a nonprofit corporation.
    (A) Gross-income requirement. At least 50 percent of the total gross 
income of such entity is derived from the active conduct of a qualified 
business (as defined in paragraph (d)(5) of this section) within any 
low-income community (as defined in section 45D(e)). An entity is deemed 
to satisfy this paragraph (d)(4)(i)(A) if the entity meets the 
requirements of either paragraph (d)(4)(i)(B) or (C) of this section, if 
``50 percent'' is applied instead of 40 percent. In addition, an entity 
may satisfy this paragraph (d)(4)(i)(A) based on all the facts and 
circumstances. See paragraph (d)(4)(iv) of this section for certain 
circumstances in which an entity will be treated as engaged in the 
active conduct of a trade or business. See paragraph (d)(9) of this 
section for rules relating to targeted populations.
    (B) Use of tangible property--(1) In general. At least 40 percent of 
the use of the tangible property of such entity (whether owned or 
leased) is within any low-income community. This percentage is 
determined based on a fraction the numerator of which is the average 
value of the tangible property owned or leased by the entity and used by 
the entity during the taxable year

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in a low-income community and the denominator of which is the average 
value of the tangible property owned or leased by the entity and used by 
the entity during the taxable year. Property owned by the entity is 
valued at its cost basis as determined under section 1012. Property 
leased by the entity is valued at a reasonable amount established by the 
entity. See paragraph (d)(9) of this section for rules relating to 
targeted populations.
    (2) Example. The application of paragraph (d)(4)(i)(B)(1) of this 
section is illustrated by the following example:

    Example. X is a corporation engaged in the business of moving and 
hauling scrap metal. X operates its business from a building and an 
adjoining parking lot that X owns. The building and the parking lot are 
located in a low-income community (as defined in section 45D(e)). X's 
cost basis under section 1012 for the building and parking lot is 
$200,000. During the taxable year, X operates its business 10 hours a 
day, 6 days a week. X owns and uses 40 trucks in its business, which, on 
average, are used 6 hours a day outside a low-income community and 4 
hours a day inside a low-income community (including time in the parking 
lot). The cost basis under section 1012 of each truck is $25,000. During 
non-business hours, the trucks are parked in the lot. Only X's 10-hour 
business days are used in calculating the use of tangible property 
percentage under paragraph (d)(4)(i)(B)(1) of this section. Thus, the 
numerator of the tangible property calculation is $600,000 (\4/10\ of 
$1,000,000 (the $25,000 cost basis of each truck times 40 trucks) plus 
$200,000 (the cost basis of the building and parking lot)) and the 
denominator is $1,200,000 (the total cost basis of the trucks, building, 
and parking lot), resulting in 50 percent of the use of X's tangible 
property being within a low-income community. Consequently, X satisfies 
the 40 percent use of tangible property test under paragraph 
(d)(4)(i)(B)(1) of this section.

    (C) Services performed. At least 40 percent of the services 
performed for such entity by its employees are performed in a low-income 
community. This percentage is determined based on a fraction the 
numerator of which is the total amount paid by the entity for employee 
services performed in a low-income community during the taxable year and 
the denominator of which is the total amount paid by the entity for 
employee services during the taxable year. If the entity has no 
employees, the entity is deemed to satisfy this paragraph (d)(4)(i)(C), 
and paragraph (d)(4)(i)(A) of this section, if the entity meets the 
requirement of paragraph (d)(4)(i)(B) of this section if ``85 percent'' 
is applied instead of 40 percent. See paragraph (d)(9) of this section 
for rules relating to targeted populations.
    (D) Collectibles. Less than 5 percent of the average of the 
aggregate unadjusted bases of the property of such entity is 
attributable to collectibles (as defined in section 408(m)(2)) other 
than collectibles that are held primarily for sale to customers in the 
ordinary course of business.
    (E) Nonqualified financial property--(1) In general. Less than 5 
percent of the average of the aggregate unadjusted bases of the property 
of such entity is attributable to nonqualified financial property. For 
purposes of the preceding sentence, the term nonqualified financial 
property means debt, stock, partnership interests, options, futures 
contracts, forward contracts, warrants, notional principal contracts, 
annuities, and other similar property except that such term does not 
include--
    (i) Reasonable amounts of working capital held in cash, cash 
equivalents, or debt instruments with a term of 18 months or less 
(because the definition of nonqualified financial property includes debt 
instruments with a term in excess of 18 months, banks, credit unions, 
and other financial institutions are generally excluded from the 
definition of a qualified active low-income community business); or
    (ii) Debt instruments described in section 1221(a)(4).
    (2) Construction of real property. For purposes of paragraph 
(d)(4)(i)(E)(1)(i) of this section, the proceeds of a capital or equity 
investment or loan by a CDE that will be expended for construction of 
real property within 12 months after the date the investment or loan is 
made are treated as a reasonable amount of working capital.
    (ii) Proprietorships. Any business carried on by an individual as a 
proprietor is a qualified active low-income community business if the 
business would meet the requirements of paragraph (d)(4)(i) of this 
section if the business were incorporated.
    (iii) Portions of business--(A) In general. A CDE may treat any 
trade or

[[Page 286]]

business (or portion thereof) as a qualified active low-income community 
business if the trade or business (or portion thereof) would meet the 
requirements of paragraph (d)(4)(i) of this section if the trade or 
business (or portion thereof) were separately incorporated and a 
complete and separate set of books and records is maintained for that 
trade or business (or portion thereof). However, the CDE's capital or 
equity investment or loan is not a qualified low-income community 
investment under paragraph (d)(1)(i) of this section to the extent the 
proceeds of the investment or loan are not used for the trade or 
business (or portion thereof) that is treated as a qualified active low-
income community business under this paragraph (d)(4)(iii)(A).
    (B) Examples. The following examples illustrate an application of 
paragraph (d)(4)(iii) of this section:

    Example 1. X is a partnership and a CDE that receives a new markets 
tax credit allocation from the Secretary. A pays $1 million for a 
capital interest in X. Z is a corporation that operates a supermarket 
that is not in a low-income community (as defined in section 45D(e)). X 
uses the proceeds of A's equity investment to make a loan to Z that Z 
will use to construct a new supermarket in a low-income community. Z 
will maintain a complete and separate set of books and records for the 
new supermarket. The proceeds of X's loan to Z will be used exclusively 
for the new supermarket. Assume that Z's new supermarket in the low-
income community would meet the requirements to be a qualified active 
low-income community business under paragraph (d)(4)(i) of this section 
if it were separately incorporated. Pursuant to paragraph (d)(4)(iii)(A) 
of this section, X treats Z's new supermarket as the qualified active 
low-income community business. Accordingly, X's loan to Z is a qualified 
low-income community investment under paragraph (d)(1)(i) of this 
section.
    Example 2. X is a partnership and a CDE that receives a new markets 
tax credit allocation from the Secretary. A pays $1 million for a 
capital interest in X. Z is a corporation that operates a liquor store 
in a low-income community (as defined in section 45D(e)). A liquor store 
is not a qualified business under paragraph (d)(5)(iii)(B) of this 
section. X uses the proceeds of A's equity investment to make a loan to 
Z that Z will use to construct a restaurant next to the liquor store. Z 
will maintain a complete and separate set of books and records for the 
new restaurant. The proceeds of X's loan to Z will be used exclusively 
for the new restaurant. Assume that Z's restaurant would meet the 
requirements to be a qualified active low-income community business 
under paragraph (d)(4)(i) of this section if it were separately 
incorporated. Pursuant to paragraph (d)(4)(iii) of this section, X 
treats Z's restaurant as the qualified active low-income community 
business. Accordingly, X's loan to Z is a qualified low-income community 
investment under paragraph (d)(1)(i) of this section.
    Example 3. X is a partnership and a CDE that receives a new markets 
tax credit allocation from the Secretary. A pays $1 million for a 
capital interest in X. Z is a corporation that operates an insurance 
company in a low-income community (as defined in section 45D(e)). Five 
percent or more of the average of the aggregate unadjusted bases of Z's 
property is attributable to nonqualified financial property under 
paragraph (d)(4)(i)(E) of this section. Z's insurance operations include 
different operating units including a claims processing unit. X uses the 
proceeds of A's equity investment to make a loan to Z for use in Z's 
claims processing operations. Z will maintain a complete and separate 
set of books and records for the claims processing unit. The proceeds of 
X's loan to Z will be used exclusively for the claims processing unit. 
Assume that Z's claims processing unit would meet the requirements to be 
a qualified active low-income community business under paragraph 
(d)(4)(i) of this section if it were separately incorporated. Pursuant 
to paragraph (d)(4)(iii) of this section, X treats Z's claims processing 
unit as the qualified active low-income community business. Accordingly, 
X's loan to Z is a qualified low-income community investment under 
paragraph (d)(1)(i) of this section.

    (iv) Active conduct of a trade or business--(A) Special rule. For 
purposes of paragraph (d)(4)(i) of this section, an entity will be 
treated as engaged in the active conduct of a trade or business if, at 
the time the CDE makes a capital or equity investment in, or loan to, 
the entity, the CDE reasonably expects that the entity will generate 
revenues (or, in the case of a nonprofit corporation, engage in an 
activity that furthers its purpose as a nonprofit corporation) within 3 
years after the date the investment or loan is made. This paragraph 
(d)(4)(iv) applies only for purposes of determining whether an entity is 
engaged in the active conduct of a trade or business and does not apply 
for purposes of determining whether the gross-income requirement under 
paragraph (d)(4)(i)(A), (d)(9)(i)(B)(1)(i),

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or (d)(9)(ii)(C)(1)(i) of this section is satisfied.
    (B) Example. The application of paragraph (d)(4)(iv)(A) of this 
section is illustrated by the following example:

    Example. X is a partnership and a CDE that receives a new markets 
tax credit allocation from the Secretary on July 1, 2004. X makes a ten-
year loan to Y. Y is a newly formed entity that will own and operate a 
shopping center to be constructed in a low-income community. Y has no 
revenues but X reasonably expects that Y will generate revenues 
beginning in December 2005. Under paragraph (d)(4)(iv)(A) of this 
section, Y is treated as engaged in the active conduct of a trade or 
business for purposes of paragraph (d)(4)(i) of this section.

    (5) Qualified business--(i) In general. Except as otherwise provided 
in this paragraph (d)(5), the term qualified business means any trade or 
business. There is no requirement that employees of a qualified business 
be residents of a low-income community.
    (ii) Rental of real property. The rental to others of real property 
located in any low-income community (as defined in section 45D(e)) is a 
qualified business if and only if the property is not residential rental 
property (as defined in section 168(e)(2)(A)) and there are substantial 
improvements located on the real property. However, a CDE's investment 
in or loan to a business engaged in the rental of real property is not a 
qualified low-income community investment under paragraph (d)(1)(i) of 
this section to the extent a lessee of the real property is described in 
paragraph (d)(5)(iii)(B) of this section.
    (iii) Exclusions--(A) Trades or businesses involving intangibles. 
The term qualified business does not include any trade or business 
consisting predominantly of the development or holding of intangibles 
for sale or license.
    (B) Certain other trades or businesses. The term qualified business 
does not include any trade or business consisting of the operation of 
any private or commercial golf course, country club, massage parlor, hot 
tub facility, suntan facility, racetrack or other facility used for 
gambling, or any store the principal business of which is the sale of 
alcoholic beverages for consumption off premises.
    (C) Farming. The term qualified business does not include any trade 
or business the principal activity of which is farming (within the 
meaning of section 2032A(e)(5)(A) or (B)) if, as of the close of the 
taxable year of the taxpayer conducting such trade or business, the sum 
of the aggregate unadjusted bases (or, if greater, the fair market 
value) of the assets owned by the taxpayer that are used in such a trade 
or business, and the aggregate value of the assets leased by the 
taxpayer that are used in such a trade or business, exceeds $500,000. 
For purposes of this paragraph (d)(5)(iii)(C), two or more trades or 
businesses will be treated as a single trade or business under rules 
similar to the rules of section 52(a) and (b).
    (6) Qualifications--(i) In general. Except as provided in paragraph 
(d)(6)(ii) of this section, an entity is treated as a qualified active 
low-income community business for the duration of the CDE's investment 
in the entity if the CDE reasonably expects, at the time the CDE makes 
the capital or equity investment in, or loan to, the entity, that the 
entity will satisfy the requirements to be a qualified active low-income 
community business under paragraph (d)(4)(i) of this section throughout 
the entire period of the investment or loan.
    (ii) Control--(A) In general. If a CDE controls or obtains control 
of an entity at any time during the 7-year credit period (as defined in 
paragraph (c)(5)(i) of this section), the entity will be treated as a 
qualified active low-income community business only if the entity 
satisfies the requirements of paragraph (d)(4)(i) of this section 
throughout the entire period the CDE controls the entity.
    (B) Definition of control. Control means, with respect to an entity, 
direct or indirect ownership (based on value) or control (based on 
voting or management rights) of more than 50 percent of the entity. For 
purposes of the preceding sentence, the term management rights means the 
power to influence the management policies or investment decisions of 
the entity.
    (C) Disregard of control. For purposes of paragraph (d)(6)(ii)(A) of 
this section, the acquisition of control of an entity by a CDE is 
disregarded during

[[Page 288]]

the 12-month period following such acquisition of control (the 12-month 
period) if--
    (1) The CDE's capital or equity investment in, or loan to, the 
entity met the requirements of paragraph (d)(6)(i) of this section when 
initially made;
    (2) The CDE's acquisition of control of the entity is due to 
financial difficulties of the entity that were unforeseen at the time 
the investment or loan described in paragraph (d)(6)(ii)(C)(1) of this 
section was made; and
    (3) If the acquisition of control occurs before the seventh year of 
the 7-year credit period (as defined in paragraph (c)(5)(i) of this 
section), either--
    (i) The entity satisfies the requirements of paragraph (d)(4) of 
this section by the end of the 12-month period; or
    (ii) The CDE sells or causes to be redeemed the entire amount of the 
investment or loan described in paragraph (d)(6)(ii)(C)(1) of this 
section and, by the end of the 12-month period, reinvests the amount 
received in respect of the sale or redemption in a qualified low-income 
community investment under paragraph (d)(1) of this section. For this 
purpose, the amount treated as continuously invested in a qualified low-
income community investment is determined under paragraphs (d)(2)(i) and 
(ii) of this section.
    (7) Financial counseling and other services. The term financial 
counseling and other services means advice provided by the CDE relating 
to the organization or operation of a trade or business.
    (8) Special rule for certain loans--(i) In general. For purposes of 
paragraphs (d)(1)(i), (ii), and (iv) of this section, a loan is treated 
as made by a CDE to the extent the CDE purchases the loan from the 
originator (whether or not the originator is a CDE) within 30 days after 
the date the originator makes the loan if, at the time the loan is made, 
there is a legally enforceable written agreement between the originator 
and the CDE which--
    (A) Requires the CDE to approve the making of the loan either 
directly or by imposing specific written loan underwriting criteria; and
    (B) Requires the CDE to purchase the loan within 30 days after the 
date the loan is made.
    (ii) Example. The application of paragraph (d)(8)(i) of this section 
is illustrated by the following example:

    Example. (i) X is a partnership and a CDE that has received a new 
markets tax credit allocation from the Secretary. On October 1, 2004, Y 
enters into a legally enforceable written agreement with W. Y and W are 
corporations but only Y is a CDE. The agreement between Y and W provides 
that Y will purchase loans (or portions thereof) from W within 30 days 
after the date the loan is made by W, and that Y will approve the making 
of the loans.
    (ii) On November 1, 2004, W makes an $825,000 loan to Z pursuant to 
the agreement between Y and W. Z is a qualified active low-income 
community business under paragraph (d)(4) of this section. On November 
15, 2004, Y purchases the loan from W for $840,000. On December 31, 
2004, X purchases the loan from Y for $850,000.
    (iii) Under paragraph (d)(8)(i) of this section, the loan to Z is 
treated as made by Y. Y's loan to Z is a qualified low-income community 
investment under paragraph (d)(1)(i) of this section. Accordingly, under 
paragraph (d)(1)(ii)(A) of this section, X's purchase of the loan from Y 
is a qualified low-income community investment in the amount of 
$850,000.

    (9) Targeted populations. For purposes of section 45D(e)(2), 
targeted populations that will be treated as a low-income community are 
individuals, or an identifiable group of individuals, including an 
Indian tribe, who are low-income persons as defined in paragraph 
(d)(9)(i) of this section or who are individuals who otherwise lack 
adequate access to loans or equity investments as defined in paragraph 
(d)(9)(ii) of this section.
    (i) Low-income persons--(A) Definition--(1) In general. For purposes 
of section 45D(e)(2) and this paragraph (d)(9), an individual shall be 
considered to be low-income if the individual's family income, adjusted 
for family size, is not more than--
    (i) For metropolitan areas, 80 percent of the area median family 
income; and
    (ii) For non-metropolitan areas, the greater of 80 percent of the 
area median family income, or 80 percent of the statewide non-
metropolitan area median family income.

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    (2) Area median family income. For purposes of paragraph 
(d)(9)(i)(A)(1) of this section, area median family income is determined 
in a manner consistent with the determinations of median family income 
under section 8 of the Housing Act of 1937, as amended. Taxpayers must 
use the annual estimates of median family income released by the 
Department of Housing and Urban Development (HUD) and may rely on those 
figures until 45 days after HUD releases a new list of income limits, or 
until HUD's effective date for the new list, whichever is later.
    (3) Individual's family income. For purposes of paragraph 
(d)(9)(i)(A)(1) of this section, an individual's family income is 
determined using any one of the following three methods for measuring 
family income:
    (i) Household income as measured by the U.S. Census Bureau,
    (ii) Adjusted gross income under section 62 as reported on Internal 
Revenue Service Form 1040. Adjusted gross income must include the 
adjusted gross income of any member of the individual's family (as 
defined in section 267(c)(4)) if the family member resides with the 
individual regardless of whether the family member files a separate 
return,
    (iii) Household income determined under section 8 of the Housing Act 
of 1937, as amended.
    (B) Qualified active low-income community business requirements for 
low-income targeted populations--(1) In general. An entity will not be 
treated as a qualified active low-income community business for low-
income targeted populations unless--
    (i) Except as provided in paragraph (d)(9)(i)(D)(2) of this section, 
at least 50 percent of the entity's total gross income for any taxable 
year is derived from sales, rentals, services, or other transactions 
with individuals who are low-income persons for purposes of section 
45D(e)(2) and this paragraph (d)(9);
    (ii) At least 40 percent of the entity's employees are individuals 
who are low-income persons for purposes of section 45D(e)(2) and this 
paragraph (d)(9); or
    (iii) At least 50 percent of the entity is owned by individuals who 
are low-income persons for purposes of section 45D(e)(2) and this 
paragraph (d)(9).
    (2) Employee. The determination of whether an employee is a low-
income person must be made at the time the employee is hired. If the 
employee is a low-income person at the time of hire, that employee is 
considered a low-income person for purposes of section 45D(e)(2) and 
this paragraph (d)(9) throughout the time of employment, without regard 
to any increase in the employee's income after the time of hire.
    (3) Owner. The determination of whether an owner is a low-income 
person must be made at the time the qualified low-income community 
investment is made, or at the time the ownership interest is acquired by 
the owner, whichever is later. If an owner is a low-income person at the 
time the qualified low-income community investment is made or at the 
time the ownership interest is acquired by the owner, whichever is 
later, that owner is considered a low-income person for purposes of 
section 45D(e)(2) and this paragraph (d)(9) throughout the time the 
ownership interest is held by that owner.
    (4) Derived from. For purposes of paragraph (d)(9)(i)(B)(1)(i) of 
this section, the term derived from includes gross income derived from:
    (i) Payments made directly by low-income persons to the entity; and
    (ii) Money and the fair market value of property or services 
provided to the entity primarily for the benefit of low-income persons, 
but only if the persons providing the money, property, or services do 
not receive a direct benefit from the entity (for this purpose, a 
contribution that benefits the general public is not a direct benefit).
    (5) Fair market value of sales, rentals, services, or other 
transactions. For purposes of paragraph (d)(9)(i)(B)(1)(i) of this 
section, an entity with gross income that is derived from sales, 
rentals, services, or other transactions with both non low-income 
persons and low-income persons may treat the gross income derived from 
the sales, rentals, services, or other transactions with low-income 
persons as including the full fair market value even if the low-income 
persons do not pay fair market value.

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    (C) 120-percent-income restriction--(1) In general--(i) In no case 
will an entity be treated as a qualified active low-income community 
business under paragraph (d)(9)(i) of this section if the entity is 
located in a population census tract for which the median family income 
exceeds 120 percent of, in the case of a tract not located within a 
metropolitan area, the statewide median family income, or in the case of 
a tract located within a metropolitan area, the greater of statewide 
median family income or metropolitan area median family income (120-
percent-income restriction).
    (ii) The 120-percent-income restriction shall not apply to an entity 
located within a population census tract with a population of less than 
2,000 if such tract is not located in a metropolitan area.
    (iii) The 120-percent-income restriction shall not apply to an 
entity located within a population census tract with a population of 
less than 2,000 if such tract is located in a metropolitan area and more 
than 75 percent of the tract is zoned for commercial or industrial use. 
For this purpose, the 75 percent calculation should be made using the 
area of the population census tract. For purposes of this paragraph 
(d)(9)(i)(C)(1)(iii), property for which commercial or industrial use is 
a permissible zoning use will be treated as zoned for commercial or 
industrial use.
    (2) Population census tract location--(i) For purposes of the 120-
percent-income restriction, an entity will be considered to be located 
in a population census tract for which the median family income exceeds 
120 percent of the applicable median family income under paragraph 
(d)(9)(i)(C)(1)(i) of this section (non-qualifying population census 
tract) if at least 50 percent of the total gross income of the entity is 
derived from the active conduct of a qualified business (as defined in 
paragraph (d)(5) of this section) within one or more non-qualifying 
population census tracts (non-qualifying gross income amount); at least 
40 percent of the use of the tangible property of the entity (whether 
owned or leased) is within one or more non-qualifying population census 
tracts (non-qualifying tangible property usage); and at least 40 percent 
of the services performed for the entity by its employees are performed 
in one or more non-qualifying population census tracts (non-qualifying 
services performance).
    (ii) The entity is considered to have the non-qualifying gross 
income amount if the entity has non-qualifying tangible property usage 
or non-qualifying services performance of at least 50 percent instead of 
40 percent.
    (iii) If the entity has no employees, the entity is considered to 
have the non-qualifying gross income amount and non-qualifying services 
performance if at least 85 percent of the use of the tangible property 
of the entity (whether owned or leased) is within one or more non-
qualifying population census tracts.
    (D) Rental of real property for low-income targeted populations--(1) 
In general. An entity that rents to others real property for low-income 
targeted populations and that otherwise satisfies the requirements to be 
a qualified business under paragraph (d)(5) of this section will be 
treated as located in a low-income community for purposes of paragraph 
(d)(5)(ii) of this section if at least 50 percent of the entity's total 
gross income is derived from rentals to individuals who are low-income 
persons for purposes of section 45D(e)(2) and this paragraph (d)(9) or 
rentals to a qualified active low-income community business that meets 
the requirements for low-income targeted populations under paragraphs 
(d)(9)(i)(B)(1)(i) or (ii) and (d)(9)(i)(B)(2) of this section.
    (2) Special rule for entities whose sole business is the rental to 
others of real property. If an entity's sole business is the rental to 
others of real property under paragraph (d)(9)(i)(D)(1) of this section, 
then the gross income requirement in paragraph (d)(9)(i)(B)(1)(i) of 
this section will be considered satisfied if the entity is treated as 
being located in a low-income community under paragraph (d)(9)(i)(D)(1) 
of this section.
    (ii) Individuals who otherwise lack adequate access to loans or 
equity investments--(A) In general. Paragraph (d)(9)(ii) of this section 
may be applied only with regard to qualified low-income community 
investments made under the increase in the new markets

[[Page 291]]

tax credit limitation pursuant to section 1400N(m)(2). Therefore, only 
CDEs with a significant mission of recovery and redevelopment of the 
Gulf Opportunity Zone (GO Zone) that receive an allocation from the 
increase described in section 1400N(m)(2) may make qualified low-income 
community investments from that allocation pursuant to the rules in 
paragraph (d)(9)(ii) of this section.
    (B) GO Zone Targeted Population. For purposes of the targeted 
populations rules under section 45D(e)(2), an individual otherwise lacks 
adequate access to loans or equity investments only if the individual 
was displaced from his or her principal residence as a result of 
Hurricane Katrina or the individual lost his or her principal source of 
employment as a result of Hurricane Katrina (GO Zone Targeted 
Population). In order to meet this definition, the individual's 
principal residence or principal source of employment, as applicable, 
must have been located in a population census tract within the GO Zone 
that contains one or more areas designated by the Federal Emergency 
Management Agency (FEMA) as flooded, having sustained extensive damage, 
or having sustained catastrophic damage as a result of Hurricane 
Katrina.
    (C) Qualified active low-income community business requirements for 
the GO Zone Targeted Population--(1) In general. An entity will not be 
treated as a qualified active low-income community business for the GO 
Zone Targeted Population unless--
    (i) At least 50 percent of the entity's total gross income for any 
taxable year is derived from sales, rentals, services, or other 
transactions with the GO Zone Targeted Population, low-income persons as 
defined in paragraph (d)(9)(i) of this section, or some combination 
thereof;
    (ii) At least 40 percent of the entity's employees consist of the GO 
Zone Targeted Population, low-income persons as defined in paragraph 
(d)(9)(i) of this section, or some combination thereof; or
    (iii) At least 50 percent of the entity is owned by the GO Zone 
Targeted Population, low-income persons as defined in paragraph 
(d)(9)(i) of this section, or some combination thereof.
    (2) Location--(i) In general. In order to be a qualified active low-
income community business under paragraph (d)(9)(ii)(C) of this section, 
the entity must be located in a population census tract within the GO 
Zone that contains one or more areas designated by FEMA as flooded, 
having sustained extensive damage, or having sustained catastrophic 
damage as a result of Hurricane Katrina (qualifying population census 
tract).
    (ii) Determination--For purposes of the preceding paragraph, an 
entity will be considered to be located in a qualifying population 
census tract if at least 50 percent of the total gross income of the 
entity is derived from the active conduct of a qualified business (as 
defined in paragraph (d)(5) of this section) within one or more 
qualifying population census tracts (gross income requirement); at least 
40 percent of the use of the tangible property of the entity (whether 
owned or leased) is within one or more qualifying population census 
tracts (use of tangible property requirement); and at least 40 percent 
of the services performed for the entity by its employees are performed 
in one or more qualifying population census tracts (services performed 
requirement). The entity is deemed to satisfy the gross income 
requirement if the entity satisfies the use of tangible property 
requirement or the services performed requirement on the basis of at 
least 50 percent instead of 40 percent. If the entity has no employees, 
the entity is deemed to satisfy the services performed requirement and 
the gross income requirement if at least 85 percent of the use of the 
tangible property of the entity (whether owned or leased) is within one 
or more qualifying population census tracts.
    (D) 200-percent-income restriction--(1) In general--(i) In no case 
will an entity be treated as a qualified active low-income community 
business under paragraph (d)(9)(ii) of this section if the entity is 
located in a population census tract for which the median family income 
exceeds 200 percent of, in the case of a tract not located within a 
metropolitan area, the statewide median family income, or, in the case 
of a

[[Page 292]]

tract located within a metropolitan area, the greater of statewide 
median family income or metropolitan area median family income (200-
percent-income restriction).
    (ii) The 200-percent-income restriction shall not apply to an entity 
located within a population census tract with a population of less than 
2,000 if such tract is not located in a metropolitan area.
    (iii) The 200-percent-income restriction shall not apply to an 
entity located within a population census tract with a population of 
less than 2,000 if such tract is located in a metropolitan area and more 
than 75 percent of the tract is zoned for commercial or industrial use. 
For this purpose, the 75 percent calculation should be made using the 
area of the population census tract. For purposes of this paragraph 
(d)(9)(ii)(D)(1)(iii), property for which commercial or industrial use 
is a permissible zoning use will be treated as zoned for commercial or 
industrial use.
    (2) Population census tract location--(i) For purposes of the 200-
percent-income restriction, an entity will be considered to be located 
in a population census tract for which the median family income exceeds 
200 percent of the applicable median family income under paragraph 
(d)(9)(ii)(D)(1)(i) of this section (non-qualifying population census 
tract) if--at least 50 percent of the total gross income of the entity 
is derived from the active conduct of a qualified business (as defined 
in paragraph (d)(5) of this section) within one or more non-qualifying 
population census tracts (non-qualifying gross income amount); at least 
40 percent of the use of the tangible property of the entity (whether 
owned or leased) is within one or more non-qualifying population census 
tracts (non-qualifying tangible property usage); and at least 40 percent 
of the services performed for the entity by its employees are performed 
in one or more non-qualifying population census tracts (non-qualifying 
services performance).
    (ii) The entity is considered to have the non-qualifying gross 
income amount if the entity has non-qualifying tangible property usage 
or non-qualifying services performance of at least 50 percent instead of 
40 percent.
    (iii) If the entity has no employees, the entity is considered to 
have the non-qualifying gross income amount and non-qualifying services 
performance if at least 85 percent of the use of the tangible property 
of the entity (whether owned or leased) is within one or more non-
qualifying population census tracts.
    (E) Rental of real property for the GO Zone Targeted Population. The 
rental to others of real property for the GO Zone Targeted Population 
that otherwise satisfies the requirements to be a qualified business 
under paragraph (d)(5) of this section will be treated as located in a 
low-income community for purposes of paragraph (d)(5)(ii) of this 
section if at least 50 percent of the entity's total gross income is 
derived from rentals to the GO Zone Targeted Population, rentals to low-
income persons as defined in paragraph (d)(9)(i) of this section, or 
rentals to a qualified active low-income community business that meets 
the requirements for the GO Zone Targeted Population under paragraph 
(d)(9)(ii)(C)(1)(i) or (ii) of this section.
    (10) Non-real estate qualified active low-income community 
business--(i) Definition. The term non-real estate qualified active low-
income community business means any qualified active low-income 
community business (as defined in paragraph (d)(4) of this section) 
whose predominant business activity does not include the development 
(including construction of new facilities and rehabilitation/enhancement 
of existing facilities), management, or leasing of real estate. For 
purposes of the preceding sentence, predominant business activity means 
a business activity that generates more than 50 percent of the business' 
gross income. The purpose of the capital or equity investment in, or 
loan to, the non-real estate qualified active low-income community 
business must not be connected to the development (including 
construction of new facilities and rehabilitation/enhancement of 
existing facilities), management, or leasing of real estate.

[[Page 293]]

    (ii) Payments of, or for, capital, equity or principal with respect 
to a non-real estate qualified active low-income community business--(A) 
In general. For purposes of paragraph (d)(2)(i) of this section, a 
portion of the amounts received by a CDE in payment of, or for, capital, 
equity, or principal with respect to a non-real estate qualified active 
low-income community business after year one of the 7-year credit period 
(as defined by paragraph (c)(5)(i) of this section) may be reinvested by 
the CDE in a qualifying entity (as defined in paragraph (d)(10)(ii)(D)). 
Any portion that the CDE chooses to reinvest in a qualifying entity must 
be reinvested by the CDE no later than 30 days from the date of receipt 
to be treated as continuously invested in a qualified low-income 
community investment for purposes of paragraph (d)(2)(i) of this 
section. If the amount reinvested in a qualifying entity exceeds the 
maximum aggregate portion of the non-real estate qualified equity 
investment, then the excess will not be treated as invested in a 
qualified low-income community investment. The maximum aggregate portion 
of the non-real estate qualified equity investment that may be 
reinvested into a qualifying entity, which will be treated as 
continuously invested in a qualified low-income community investment, 
may not exceed the following percentages of the non-real estate 
qualified equity investment in the following years:
    (1) 15 percent in Year 2 of the 7-year credit period.
    (2) 30 percent in Year 3 of the 7-year credit period.
    (3) 50 percent in Year 4 of the 7-year credit period.
    (4) 85 percent in Year 5 and Year 6 of the 7-year credit period.
    (B) Seventh year of the 7-year credit period. Amounts received by a 
CDE in payment of, or for, capital, equity, or principal with respect to 
a non-real estate qualified active low-income community business (as 
defined in paragraph (d)(10)(i) of this section) during the seventh year 
of the 7-year credit period do not have to be reinvested by the CDE in a 
qualified low-income community investment to be treated as continuously 
invested in a qualified low-income community investment.
    (C) Amounts received from qualifying entity. Except for the seventh 
year of the 7-year credit period under paragraph (d)(10)(ii)(B) of this 
section, amounts received from a qualifying entity must be reinvested by 
the CDE no later than 30 days from the date of receipt to be treated as 
continuously invested in a qualified low-income community investment.
    (D) Definition of qualifying entity. For purposes of paragraphs 
(d)(10)(ii) and (d)(10)(iii) of this section, a qualifying entity is--
    (1) A certified community development financial institution 
(certified CDFI) that is a CDE under section 45D(c)(2)(B) (as defined by 
12 CFR 1805.201), which is unrelated to the CDE making the investment in 
the certified CDFI within the meaning of section 267(b) or section 
707(b)(1); or
    (2) An entity designated by the Secretary by publication in the 
Internal Revenue Bulletin (see Sec.  601.601(d)(2)(ii)(b) of this 
chapter).
    (e) Recapture--(1) In general. If, at any time during the 7-year 
period beginning on the date of the original issue of a qualified equity 
investment in a CDE, there is a recapture event under paragraph (e)(2) 
of this section with respect to such investment, then the tax imposed by 
Chapter 1 of the Internal Revenue Code for the taxable year in which the 
recapture event occurs is increased by the credit recapture amount under 
section 45D(g)(2). A recapture event under paragraph (e)(2) of this 
section requires recapture of credits allowed to the taxpayer who 
purchased the equity investment from the CDE at its original issue and 
to all subsequent holders of that investment.
    (2) Recapture event. There is a recapture event with respect to an 
equity investment in a CDE if--
    (i) The entity ceases to be a CDE;
    (ii) The proceeds of the investment cease to be used in a manner 
that satisfies the substantially-all requirement of paragraph (c)(1)(ii) 
of this section; or
    (iii) The investment is redeemed or otherwise cashed out by the CDE.
    (3) Redemption--(i) Equity investment in a C corporation. For 
purposes of paragraph (e)(2)(iii) of this section, an equity investment 
in a CDE that is treated as a C corporation for Federal tax

[[Page 294]]

purposes is redeemed when section 302(a) applies to amounts received by 
the equity holder. An equity investment is treated as cashed out when 
section 301(c)(2) or section 301(c)(3) applies to amounts received by 
the equity holder. An equity investment is not treated as cashed out 
when only section 301(c)(1) applies to amounts received by the equity 
holder.
    (ii) Equity investment in an S corporation. For purposes of 
paragraph (e)(2)(iii) of this section, an equity investment in a CDE 
that is an S corporation is redeemed when section 302(a) applies to 
amounts received by the equity holder. An equity investment in an S 
corporation is treated as cashed out when a distribution to a 
shareholder described in section 1368(a) exceeds the accumulated 
adjustments account determined under Sec.  1.1368-2 and any accumulated 
earnings and profits of the S corporation.
    (iii) Capital interest in a partnership. In the case of an equity 
investment that is a capital interest in a CDE that is a partnership for 
Federal tax purposes, a pro rata cash distribution by the CDE to its 
partners based on each partner's capital interest in the CDE during the 
taxable year will not be treated as a redemption for purposes of 
paragraph (e)(2)(iii) of this section if the distribution does not 
exceed the CDE's operating income for the taxable year. In addition, a 
non-pro rata de minimis cash distribution by a CDE to a partner or 
partners during the taxable year will not be treated as a redemption. A 
non-pro rata de minimis cash distribution may not exceed the lesser of 5 
percent of the CDE's operating income for that taxable year or 10 
percent of the partner's capital interest in the CDE. For purposes of 
this paragraph (e)(3)(iii), with respect to any taxable year, operating 
income is the sum of:
    (A) The CDE's taxable income as determined under section 703, except 
that--
    (1) The items described in section 703(a)(1) shall be aggregated 
with the non-separately stated tax items of the partnership; and
    (2) Any gain resulting from the sale of a capital asset under 
section 1221(a) or section 1231 property shall not be included in 
taxable income;
    (B) Deductions under section 165, but only to the extent the losses 
were realized from qualified low-income community investments under 
paragraph (d)(1) of this section;
    (C) Deductions under sections 167 and 168, including the additional 
first-year depreciation under section 168(k);
    (D) Start-up expenditures amortized under section 195; and
    (E) Organizational expenses amortized under section 709.
    (4) Bankruptcy. Bankruptcy of a CDE is not a recapture event.
    (5) Waiver of requirement or extension of time--(i) In general. The 
Commissioner may waive a requirement or extend a deadline if such waiver 
or extension does not materially frustrate the purposes of section 45D 
and this section.
    (ii) Manner for requesting a waiver or extension. A CDE that 
believes it has good cause for a waiver or an extension may request 
relief from the Commissioner in a ruling request. The request should set 
forth all the relevant facts and include a detailed explanation 
describing the event or events relating to the request for a waiver or 
an extension. For further information on the application procedure for a 
ruling, see Rev. Proc. 2005-1 (2005-1 I.R.B. 1) or its successor revenue 
procedure (see Sec.  601.601(d)(2) of this chapter).
    (iii) Terms and conditions. The granting of a waiver or an extension 
to a CDE under this section may require adjustments of the CDE's 
requirements under section 45D and this section as may be appropriate.
    (6) Cure period. If a qualified equity investment fails the 
substantially-all requirement under paragraph (c)(5)(i) of this section, 
the failure is not a recapture event under paragraph (e)(2)(ii) of this 
section if the CDE corrects the failure within 6 months after the date 
the CDE becomes aware (or reasonably should have become aware) of the 
failure. Only one correction is permitted for each qualified equity 
investment during the 7-year credit period under this paragraph (e)(6).
    (7) Example. The application of this paragraph (e) is illustrated by 
the following example:


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    Example. In 2003, A and B acquire separate qualified equity 
investments in X, a partnership. X is a CDE that has received a new 
markets tax credit allocation from the Secretary. X uses the proceeds of 
A's qualified equity investment to make a qualified low-income community 
investment in Y, and X uses the proceeds of B's qualified equity 
investment to make a qualified low-income community investment in Z. Y 
and Z are not CDEs. X controls both Y and Z within the meaning of 
paragraph (d)(6)(ii)(B) of this section. In 2003, Y and Z are qualified 
active low-income community businesses. In 2007, Y, but not Z, is a 
qualified active low-income community business and X does not satisfy 
the substantially-all requirement using the safe harbor calculation 
under paragraph (c)(5)(iii) of this section. A's equity investment 
satisfies the substantially-all requirement of paragraph (c)(1)(ii) of 
this section using the direct-tracing calculation of paragraph 
(c)(5)(ii) of this section because A's equity investment is traceable to 
Y. However, B's equity investment fails the substantially-all 
requirement using the direct-tracing calculation because B's equity 
investment is traceable to Z. Therefore, under paragraph (e)(2)(ii) of 
this section, there is a recapture event for B's equity investment (but 
not A's equity investment).

    (f) Basis reduction--(1) In general. A taxpayer's basis in a 
qualified equity investment is reduced by the amount of any new markets 
tax credit determined under paragraph (b)(1) of this section with 
respect to the investment. A basis reduction occurs on each credit 
allowance date under paragraph (b)(2) of this section. This paragraph 
(f) does not apply for purposes of sections 1202, 1400B, and 1400F.
    (2) Adjustment in basis of interest in partnership or S corporation. 
The adjusted basis of either a partner's interest in a partnership, or 
stock in an S corporation, must be appropriately adjusted to take into 
account adjustments made under paragraph (f)(1) of this section in the 
basis of a qualified equity investment held by the partnership or S 
corporation (as the case may be).
    (g) Other rules--(1) Anti-abuse. If a principal purpose of a 
transaction or a series of transactions is to achieve a result that is 
inconsistent with the purposes of section 45D and this section, the 
Commissioner may treat the transaction or series of transactions as 
causing a recapture event under paragraph (e)(2) of this section.
    (2) Reporting requirements--(i) Notification by CDE to taxpayer--(A) 
Allowance of new markets tax credit. A CDE must provide notice to any 
taxpayer who acquires a qualified equity investment in the CDE at its 
original issue that the equity investment is a qualified equity 
investment entitling the taxpayer to claim the new markets tax credit. 
The notice must be provided by the CDE to the taxpayer no later than 60 
days after the date the taxpayer makes the investment in the CDE. The 
notice must contain the amount paid to the CDE for the qualified equity 
investment at its original issue and the taxpayer identification number 
of the CDE.
    (B) Recapture event. If, at any time during the 7-year period 
beginning on the date of the original issue of a qualified equity 
investment in a CDE, there is a recapture event under paragraph (e)(2) 
of this section with respect to such investment, the CDE must provide 
notice to each holder, including all prior holders, of the investment 
that a recapture event has occurred. The notice must be provided by the 
CDE no later than 60 days after the date the CDE becomes aware of the 
recapture event.
    (ii) CDE reporting requirements to Secretary. Each CDE must comply 
with such reporting requirements to the Secretary as the Secretary may 
prescribe.
    (iii) Manner of claiming new markets tax credit. A taxpayer may 
claim the new markets tax credit for each applicable taxable year by 
completing Form 8874, ``New Markets Credit,'' and by filing Form 8874 
with the taxpayer's Federal income tax return.
    (iv) Reporting recapture tax. If there is a recapture event with 
respect to a taxpayer's equity investment in a CDE, the taxpayer must 
include the credit recapture amount under section 45D(g)(2) on the line 
for recapture taxes on the taxpayer's Federal income tax return for the 
taxable year in which the recapture event under paragraph (e)(2) of this 
section occurs (or on the line for total tax, if there is no such line 
for recapture taxes) and write NMCR (new markets credit recapture) next 
to the entry space.

[[Page 296]]

    (3) Other Federal tax benefits--(i) In general. Except as provided 
in paragraph (g)(3)(ii) of this section, the availability of Federal tax 
benefits does not limit the availability of the new markets tax credit. 
Federal tax benefits that do not limit the availability of the new 
markets tax credit include, for example:
    (A) The rehabilitation credit under section 47;
    (B) All deductions under sections 167 and 168, including the 
additional first-year depreciation under section 168(k), and the expense 
deduction for certain depreciable property under section 179; and
    (C) All tax benefits relating to certain designated areas such as 
empowerment zones and enterprise communities under sections 1391 through 
1397D, the District of Columbia Enterprise Zone under sections 1400 
through 1400B, renewal communities under sections 1400E through 1400J, 
and the New York Liberty Zone under section 1400L.
    (ii) Low-income housing credit. If a CDE makes a capital or equity 
investment or a loan with respect to a qualified low-income building 
under section 42, the investment or loan is not a qualified low-income 
community investment under paragraph (d)(1) of this section to the 
extent the building's eligible basis under section 42(d) is financed by 
the proceeds of the investment or loan.
    (4) Bankruptcy of CDE. The bankruptcy of a CDE does not preclude a 
taxpayer from continuing to claim the new markets tax credit on the 
remaining credit allowance dates under paragraph (b)(2) of this section.
    (h) Effective/applicability dates--(1) In general. Except as 
provided in paragraphs (h)(2), (h)(3), and (h)(4) of this section, this 
section applies on or after December 22, 2004, and may be applied by 
taxpayers before December 22, 2004. The provisions that apply before 
December 22, 2004, are contained in Sec.  1.45D-1T (see 26 CFR part 1 
revised as of April 1, 2003, and April 1, 2004).
    (2) Exception. Paragraph (d)(5)(ii) of this section as it relates to 
the restriction on lessees described in paragraph (d)(5)(iii)(B) of this 
section applies to qualified low-income community investments made on or 
after June 22, 2005.
    (3) Targeted populations. The rules in paragraph (d)(9) of this 
section and the last sentence in paragraph (d)(4)(iv)(A) of this section 
apply to taxable years ending on or after December 5, 2011. A taxpayer 
may apply the rules in paragraph (d)(9) of this section to taxable years 
ending before December 5, 2011 for designations made by the Secretary 
after October 22, 2004.
    (4) Investments in non-real estate businesses. Paragraphs (c)(8) and 
(d)(10) of this section apply to equity investments in CDEs made on or 
after September 28, 2012.

[T.D. 9171, 69 FR 77627, Dec. 28, 2004; 70 FR 4012, Jan. 28, 2005, as 
amended by T.D. 9560, 76 FR 75778, Dec. 5, 2011; T.D. 9600, 77 FR 59546, 
Sept. 28, 2012]



Sec.  1.45G-0  Table of contents for the railroad track maintenance
credit rules.

    This section lists the table of contents for Sec.  1.45G-1.

            Sec.  1.45G-1 Railroad track maintenance credit.

    (a) In general.
    (b) Definitions.
    (1) Class II railroad and Class III railroad.
    (2) Eligible railroad track.
    (3) Eligible taxpayer.
    (4) Qualifying railroad structure.
    (5) Qualified railroad track maintenance expenditures.
    (6) Rail facilities.
    (7) Railroad-related property.
    (8) Railroad-related services.
    (9) Railroad track.
    (10) Form 8900.
    (11) Examples.
    (c) Determination of amount of railroad track maintenance credit for 
the taxable year.
    (1) General amount.
    (2) Limitation on the credit.
    (i) Eligible taxpayer is a Class II railroad or Class III railroad.
    (ii) Eligible taxpayer is not a Class II railroad or Class III 
railroad.
    (iii) No carryover of amount that exceeds limitation.
    (3) Determination of amount of QRTME paid or incurred.
    (i) In general.
    (ii) Effect of reimbursements received from persons other than a 
Class II or Class III railroad.
    (4) Examples.
    (d) Assignment of track miles.
    (1) In general.

[[Page 297]]

    (2) Assignment eligibility.
    (3) Effective date of assignment.
    (4) Assignment information statement.
    (i) In general.
    (ii) Assignor.
    (iii) Assignee.
    (iv) Special rule for returns filed prior to November 9, 2007.
    (5) Special rules.
    (i) Effect of subsequent dispositions of eligible railroad track 
during the assignment year.
    (ii) Effect of multiple assignments of eligible railroad track miles 
during the same taxable year.
    (6) Examples.
    (e) Adjustments to basis.
    (1) In general.
    (2) Basis adjustment made to railroad track.
    (3) Examples.
    (f) Controlled groups.
    (1) In general.
    (2) Definitions.
    (i) Trade or business.
    (ii) Group and controlled group.
    (iii) Group credit.
    (iv) Consolidated group.
    (v) Credit year.
    (3) Computation of the group credit.
    (4) Allocation of the group credit.
    (5) Special rules for consolidated groups.
    (i) In general.
    (ii) Special rule for allocation of group credit among consolidated 
group members.
    (6) Tax accounting periods used.
    (i) In general.
    (ii) Special rule when timing of QRTME is manipulated.
    (7) Membership during taxable year in more than one group.
    (8) Intra-group transactions.
    (i) In general.
    (ii) Payment for QRTME.
    (g) Effective/applicability date.
    (1) In general.
    (2) Taxable years ending before September 7, 2006.
    (3) Special rules for returns filed prior to November 9, 2007.
    (4) Taxable years beginning after December 31, 2011.
    (5) Taxable years beginning before January 1, 2012.

[T.D. 9365, 72 FR 63815, Nov. 13, 2007, as amended by T.D. 9717, 80 FR 
18098, Apr. 3, 2015]



Sec.  1.45G-1  Railroad track maintenance credit.

    (a) In general. For purposes of section 38, the railroad track 
maintenance credit (RTMC) for qualified railroad track maintenance 
expenditures (QRTME) paid or incurred by an eligible taxpayer during the 
taxable year is determined under this section. A taxpayer claiming the 
RTMC must do so by filing Form 8900, ``Qualified Railroad Track 
Maintenance Credit,'' with its timely filed (including extensions) 
Federal income tax return for the taxable year the RTMC is claimed. 
Paragraph (b) of this section provides definitions of terms. Paragraph 
(c) of this section provides rules for computing the RTMC, including 
rules regarding limitations on the amount of the credit. Paragraph (d) 
of this section provides rules for assigning miles of railroad track. 
Paragraph (e) of this section contains rules for adjusting basis for the 
amount of the RTMC claimed by an eligible taxpayer. Paragraph (f) of 
this section contains rules for computing the amount of the RTMC in the 
case of a controlled group, and for the allocation of the group credit 
among members of the controlled group.
    (b) Definitions. For purposes of section 45G and this section, the 
following definitions apply:
    (1) Class II railroad and Class III railroad have the respective 
meanings given to these terms by the Surface Transportation Board (STB) 
without regard to the controlled group rules under section 45G(e)(2).
    (2) Eligible railroad track is railroad track (as defined in 
paragraph (b)(9) of this section) located within the United States that 
is owned or leased by a Class II railroad or Class III railroad at the 
close of its taxable year. For purposes of section 45G and this section, 
a Class II railroad or Class III railroad owns railroad track if the 
railroad track is subject to the allowance for depreciation under 
section 167 by the Class II railroad or Class III railroad.
    (3) Eligible taxpayer is--
    (i) A Class II railroad or Class III railroad during the taxable 
year;
    (ii) Any person that transports property using the rail facilities 
(as defined in paragraph (b)(6) of this section) of a Class II railroad 
or Class III railroad during the taxable year, but only is an eligible 
taxpayer with respect to the miles of eligible railroad track assigned 
to the person for that taxable year by that Class II railroad or Class 
III railroad under paragraph (d) of this section; or

[[Page 298]]

    (iii) Any person that furnishes railroad-related property (as 
defined in paragraph (b)(7) of this section) or railroad-related 
services (as defined in paragraph (b)(8) of this section), to a Class II 
railroad or Class III railroad during the taxable year, but only is an 
eligible taxpayer with respect to the miles of eligible railroad track 
assigned to the person for that taxable year by that Class II railroad 
or Class III railroad under paragraph (d) of this section.
    (4) Qualifying railroad structure is property located within the 
United States that is described in the following STB property accounts 
in 49 CFR Part 1201, Subpart A:
    (i) Property Account 3, Grading.
    (ii) Property Account 4, Other right-of-way expenditures.
    (iii) Property Account 5, Tunnels and subways.
    (iv) Property Account 6, Bridges, trestles, and culverts.
    (v) Property Account 7, Elevated structures.
    (vi) Property Account 8, Ties.
    (vii) Property Account 9, Rails and other track material.
    (viii) Property Account 11, Ballast.
    (ix) Property Account 13, Fences, snowsheds, and signs.
    (x) Property Account 27, Signals and interlockers.
    (xi) Property Account 39, Public improvements; construction.
    (5) Qualified railroad track maintenance expenditures (QRTME) are 
expenditures for maintaining, repairing, and improving qualifying 
railroad structure (as defined in paragraph (b)(4) of this section) that 
is owned or leased as of January 1, 2005, by a Class II railroad or 
Class III railroad. These expenditures may or may not be chargeable to a 
capital account.
    (6) Rail facilities of a Class II railroad or Class III railroad are 
railroad yards, tracks, bridges, tunnels, wharves, docks, stations, and 
other related assets that are used in the transport of freight by a 
railroad and that are owned or leased by the Class II railroad or Class 
III railroad.
    (7) Railroad-related property is property that is provided directly 
to, and is unique to, a railroad and that, in the hands of a Class II 
railroad or Class III railroad, is described in--
    (i) The following STB property accounts in 49 CFR Part 1201, Subpart 
A:
    (A) Property Account 3, Grading;
    (B) Property Account 5, Tunnels and subways;
    (C) Property Account 22, Storage warehouses; and
    (ii) Asset classes 40.1 through 40.54 in the guidance issued by the 
Internal Revenue Service under section 168(i)(1) (for further guidance, 
for example, see Rev. Proc. 87-56 (1987-2 CB 674), and Sec.  
601.601(d)(2)(ii)(b) of this chapter), except that any office building, 
any passenger train car, and any miscellaneous structure if such 
structure is not provided directly to, and is not unique to, a railroad 
are excluded from the definition of railroad-related property.
    (8) Railroad-related services are services that are provided 
directly to, and are unique to, a railroad and that relate to railroad 
shipping, loading and unloading of railroad freight, or repairs of rail 
facilities (as defined in paragraph (b)(6) of this section) or railroad-
related property (as defined in paragraph (b)(7) of this section). 
Examples of railroad-related services are the transport of freight by 
rail; the loading and unloading of freight transported by rail; railroad 
bridge services; railroad track construction; providing railroad track 
material or equipment; locomotive leasing or rental; maintenance of 
railroad's right-of-way (including vegetation control); piggyback 
trailer ramping; rail deramping services; and freight train cars repair 
services. Examples of services that are not railroad-related services 
are general business services, such as, accounting and bookkeeping, 
marketing, legal services; janitorial services; office building rental; 
banking services (including financing of railroad-related property); and 
purchasing of, or services performed on, property not described in 
paragraph (b)(7) of this section.
    (9) Except as provided in paragraph (e)(2) of this section, railroad 
track is property described in STB property accounts 8 (ties), 9 (rails 
and other track material), and 11 (ballast) in 49 CFR part 1201, Subpart 
A. Double track is treated as multiple lines of railroad track, rather 
than as a single line of

[[Page 299]]

railroad track. Thus, one mile of single track is one mile, but one mile 
of double track is two miles.
    (10) Form 8900. If Form 8900 is revised or renumbered, any reference 
in this section to that form shall be treated as a reference to the 
revised or renumbered form.
    (11) Examples. The application of this paragraph (b) is illustrated 
by the following examples. In all examples, the taxpayers use a calendar 
taxable year, and are not members of a controlled group.

    Example 1. A is a manufacturer that in 2006, transports its products 
by rail using the railroad tracks owned by B, a Class II railroad that 
owns 500 miles of railroad track within the United States on December 
31, 2006. B properly assigns for purposes of section 45G 100 miles of 
eligible railroad track to A in 2006. A is an eligible taxpayer for 2006 
with respect to the 100 miles of eligible railroad track.
    Example 2. C is a bank that loans money to several Class III 
railroads. In 2006, C loans money to D, a Class III railroad, who in 
turn uses the loan proceeds to purchase track material. Because 
providing loans is not a service that is unique to a railroad, C is not 
providing railroad-related services and, thus, C is not an eligible 
taxpayer, even if D assigns miles of eligible railroad track to C for 
purposes of section 45G.
    Example 3. E leases locomotives directly to Class I, Class II, and 
Class III railroads. In 2006, E leases locomotives to F, a Class II 
railroad that owns 200 miles of railroad track within the United States 
on December 31, 2006. F properly assigns for purposes of section 45G 200 
miles of eligible railroad track to E. Because locomotives are property 
that is unique to a railroad, and E leases these locomotives directly to 
F in 2006, E is an eligible taxpayer for 2006 with respect to the 200 
miles of eligible railroad track assigned to E by F.
    Example 4. The facts are the same as in Example 3, except that E 
leases passenger trains, not locomotives, to F. Because passenger trains 
are not railroad-related property for purposes of section 45G, E is not 
an eligible taxpayer even if F assigns miles of eligible railroad track 
to E for purposes of section 45G.

    (c) Determination of amount of railroad track maintenance credit for 
the taxable year--(1) General amount. Except as provided in paragraph 
(c)(2) of this section, for purposes of section 38, the RTMC determined 
under section 45G(a) for the taxable year is equal to 50 percent of the 
QRTME paid or incurred (as determined under paragraph (c)(3) of this 
section) by an eligible taxpayer during the taxable year.
    (2) Limitation on the credit--(i) Eligible taxpayer is a Class II 
railroad or Class III railroad. If an eligible taxpayer is a Class II 
railroad or Class III railroad, the RTMC determined under paragraph 
(c)(1) of this section for the Class II railroad or Class III railroad 
for any taxable year must not exceed $3,500 multiplied by the sum of--
    (A) The number of miles of eligible railroad track owned or leased 
by the Class II railroad or Class III railroad, reduced by the number of 
miles of eligible railroad track assigned under paragraph (d) of this 
section by the Class II railroad or Class III railroad to another 
eligible taxpayer for that taxable year; and
    (B) The number of miles of eligible railroad track owned or leased 
by another Class II railroad or Class III railroad that are assigned 
under paragraph (d) of this section to the Class II railroad or Class 
III railroad for the taxable year.
    (ii) Eligible taxpayer is not a Class II railroad or Class III 
railroad. If an eligible taxpayer is not a Class II railroad or Class 
III railroad, the RTMC determined under paragraph (c)(1) of this section 
for the eligible taxpayer for any taxable year must not exceed $3,500 
multiplied by the number of miles of eligible railroad track assigned 
under paragraph (d) of this section by a Class II railroad or Class III 
railroad to the eligible taxpayer for the taxable year.
    (iii) No carryover of amount that exceeds limitation. Amounts that 
exceed the limitation under paragraph (c)(2)(i) of this section or 
paragraph (c)(2)(ii) of this section, may never be carried over to 
another taxable year.
    (3) Determination of amount of QRTME paid or incurred--(i) In 
general. The term paid or incurred means, in the case of a taxpayer 
using an accrual method of accounting, a liability incurred (within the 
meaning of Sec.  1.446-1(c)(1)(ii)). A liability may not be taken into 
account under section 45G and this section prior to the taxable year 
during which the liability is incurred. Any amount that an eligible 
taxpayer (assignee) pays a Class II railroad or Class III railroad 
(assignor) in exchange for

[[Page 300]]

an assignment of one or more miles of eligible railroad track under 
paragraph (d) of this section, is treated, for purposes of this section, 
as QRTME paid or incurred by the assignee, and not by the assignor, at 
the time and to the extent the assignor pays or incurs QRTME.
    (ii) Effect of reimbursements received from persons other than a 
Class II or Class III railroad. The amount of QRTME treated as paid or 
incurred during the taxable year by an eligible taxpayer under 
paragraphs (b)(3)(ii) and (iii) of this section shall be reduced by any 
amount to which the eligible taxpayer is entitled to be reimbursed, 
directly or indirectly, from persons other than a Class II or Class III 
railroad.
    (4) Examples. The application of this paragraph (c) is illustrated 
by the following examples. In all examples, the taxpayers use an accrual 
method of accounting and a calendar taxable year, and are not members of 
a controlled group.

    Example 1. Computation of RTMC; section 45G credit limitation is not 
exceeded. (i) G is a Class II railroad that owns or has leased to it 
1,000 miles of railroad track within the United States on December 31, 
2006. H is a manufacturer that in 2006, transports its products by rail 
using the rail facilities of G. In 2006, for purposes of section 45G, G 
assigns 100 miles of eligible railroad track to H and does not make any 
other assignments of railroad track miles. H did not receive any other 
assignments of railroad track miles in 2006. During 2006, G incurred 
QRTME in the amount of $2.5 million and H incurred QRTME in the amount 
of $200,000.
    (ii) For 2006, G determines the tentative amount of RTMC under 
paragraph (c)(1) of this section to be $1,250,000 (50% multiplied by 
$2,500,000 QRTME incurred by G during 2006). G further determines G's 
credit limitation under paragraph (c)(2)(i) of this section for 2006 to 
be $3,150,000 ($3,500 multiplied by 900 miles of eligible railroad track 
(1,000 miles owned by, or leased to, G on December 31, 2006, less 100 
miles assigned by G to H in 2006)). Because G's tentative amount of RTMC 
does not exceed G's credit limitation amount for 2006, G may claim a 
RTMC for 2006 in the amount of $1,250,000.
    (iii) For 2006, H determines the tentative amount of RTMC under 
paragraph (c)(1) of this section to be $100,000 (50% multiplied by 
$200,000 QRTME incurred by H during 2006). H further determines H's 
credit limitation under paragraph (c)(2)(ii) of this section for 2006 to 
be $350,000 ($3,500 multiplied by 100 miles of eligible railroad track 
assigned by G to H in 2006). Because H's tentative amount of RTMC does 
not exceed H's credit limitation amount for 2006, H may claim a RTMC in 
the amount of $100,000.
    Example 2. Computation of RTMC; section 45G credit limitation is 
exceeded. (i) The facts are the same as in Example 1, except that G 
assigned for purposes of section 45G only 50 miles of railroad track to 
H in 2006 and, during 2006, H incurred QRTME in the amount of $400,000.
    (ii) For 2006, G determines the tentative amount of RTMC under 
paragraph (c)(1) of this section to be $1,250,000 (50% multiplied by 
$2,500,000 QRTME incurred by G during 2006). G further determines G's 
credit limitation under paragraph (c)(2)(i) of this section for 2006 to 
be $3,325,000 ($3,500 multiplied by 950 miles of eligible railroad track 
(1,000 miles owned by, or leased to, G on December 31, 2006, less 50 
miles assigned by G to H in 2006)). Because G's tentative amount of RTMC 
does not exceed G's credit limitation amount for 2006, G may claim a 
RTMC in the amount of $1,250,000.
    (iii) For 2006, H determines the tentative amount of RTMC under 
paragraph (c)(1) of this section to be $200,000 (50% multiplied by 
$400,000 QRTME incurred by H during 2006). H further determines H's 
credit limitation under paragraph (c)(2)(ii) of this section for 2006 to 
be $175,000 ($3,500 multiplied by 50 miles of eligible railroad track 
assigned by G to H in 2006). Because H's tentative amount of RTMC 
exceeds H's credit limitation amount for 2006, H may claim a RTMC in the 
amount of $175,000 (the credit limitation amount). Under paragraph 
(c)(2)(iii) of this section, there is no carryover of the $25,000 (the 
tentative amount of $200,000 less the credit limitation amount of 
$175,000) that exceeds the limitation.
    Example 3. Railroad track miles assigned for payment. (i) J is a 
Class II railroad that owns or has leased to it 1,000 miles of railroad 
track within the United States on December 31, 2006. K is a corporation 
that sells ties, ballast, and other track material to Class I, Class II, 
and Class III railroads. During 2006, K sold these items to J and J 
incurred QRTME in the amount of $1 million. Also, on December 6, 2006, J 
assigned for purposes of section 45G 150 miles of eligible railroad 
track to K and K paid J $800,000 for that assignment. K did not pay or 
incur any other QRTME during 2006.
    (ii) For 2006, in accordance with paragraph (c)(3)(ii) of this 
section, J is treated as having incurred QRTME in the amount of $200,000 
($1 million QRTME actually incurred by J less the $800,000 paid by K to 
J for the assignment of the railroad track miles in 2006). For 2006, J 
determines the tentative amount of RTMC under paragraph (c)(1) of this 
section to be $100,000 (50% multiplied by

[[Page 301]]

$200,000 QRTME treated as incurred by J during 2006). J further 
determines J's credit limitation amount under paragraph (c)(2)(i) of 
this section for 2006 to be $2,975,000 ($3,500 multiplied by 850 miles 
of eligible railroad track (1,000 miles owned by, or leased to, J on 
December 31, 2006, less 150 miles assigned by J to K in 2006)). Because 
J's tentative amount of RTMC does not exceed J's credit limitation 
amount for 2006, J may claim a RTMC in the amount of $100,000.
    (iii) For 2006, K is an eligible taxpayer because, during 2006, K 
provided railroad-related property to J and received an assignment of 
eligible railroad track miles from J. Under paragraph (c)(3)(ii) of this 
section, K is treated as having incurred QRTME in the amount of $800,000 
(the amount paid by K to J for the assignment of the railroad track 
miles in 2006). For 2006, K determines the tentative amount of RTMC 
under paragraph (c)(1) of this section to be $400,000 (50% multiplied by 
$800,000 QRTME treated as incurred by K during 2006). K further 
determines K's credit limitation amount under paragraph (c)(2)(ii) of 
this section for 2006 to be $525,000 ($3,500 multiplied by 150 miles of 
eligible railroad track assigned by J in 2006). Because K's tentative 
amount of RTMC does not exceed K's credit limitation amount for 2006, K 
may claim a RTMC in the amount of $400,000.
    (iv) The results in this Example 3 would be the same if K sold the 
ties, ballast, and other track material with a fair market value of $1 
million to J for $200,000 in exchange for the assignment by J of 150 
miles of eligible railroad track to K.
    Example 4. Reimbursement of QRTME. (i) L is a Class III railroad 
that owns or has leased to it 500 miles of railroad track within the 
United States on December 31, 2006. M is a manufacturer that in 2006 
transports its products by rail using the rail facilities of L. During 
2006, L did not incur any QRTME. Also, in 2006, L assigned for purposes 
of section 45G 200 miles of eligible railroad track to M and agreed to 
reduce L's freight shipping rates to M by $250,000 in exchange for M 
upgrading these railroad track miles. Consequently, during 2006, M 
incurred QRTME of $500,000 to upgrade these 200 miles of railroad track 
and L reduced L's freight shipping rates for M by $250,000.
    (ii) For 2006, M is an eligible taxpayer because, during 2006, M 
transported property using the rail facilities of L and received an 
assignment of eligible railroad track miles from L. The amount of QRTME 
paid or incurred by M during 2006 is $500,000 and is not reduced by the 
reimbursement of $250,000 by L to M because, under paragraph (c)(3)(ii) 
of this section, QRTME is not reduced by reimbursements from Class II or 
Class III railroads. For 2006, M determines the tentative amount of RTMC 
under paragraph (c)(1) of this section to be $250,000 (50% multiplied by 
$500,000 QRTME incurred by M during 2006). M further determines M's 
credit limitation amount under paragraph (c)(2)(ii) of this section for 
2006 to be $700,000 ($3,500 multiplied by 200 miles of eligible railroad 
track assigned by L to M in 2006). Because M's tentative amount of RTMC 
does not exceed M's credit limitation amount for 2006, M may claim a 
RTMC in the amount of $250,000.

    (d) Assignment of track miles--(1) In general. An assignment of any 
mile of eligible railroad track under this paragraph (d) is a 
designation by a Class II railroad or Class III railroad that is made 
solely for purposes of section 45G and this section of a specific number 
of miles of eligible railroad track as being assigned to another 
eligible taxpayer for a taxable year. A designation must be in writing 
and must include the name and taxpayer identification number of the 
assignee, and the information required under the rules of paragraph 
(d)(4)(iii)(B) of this section. A designation requires no transfer of 
legal title or other indicia of ownership of the eligible railroad 
track, and need not specify the location of any assigned mile of 
eligible railroad track. Further, an assigned mile of eligible railroad 
track need not correspond to any specific mile of eligible railroad 
track with respect to which the eligible taxpayer actually pays or 
incurs the QRTME.
    (2) Assignment eligibility. Only a Class II railroad or Class III 
railroad may assign a mile of eligible railroad track. If a Class II 
railroad or Class III railroad assigns a mile of eligible railroad track 
to an eligible taxpayer, the assignee is not permitted to reassign any 
mile of eligible railroad track to another eligible taxpayer. The 
maximum number of miles of eligible railroad track that may be assigned 
by a Class II railroad or Class III railroad for any taxable year is its 
total miles of eligible railroad track less the miles of eligible 
railroad track that the Class II railroad or Class III railroad retains 
for itself in determining its RTMC for the taxable year.
    (3) Effective date of assignment. If a Class II railroad or Class 
III railroad assigns a mile of eligible railroad track, the assignment 
is treated as being made by the Class II railroad or Class III railroad 
at the close of its taxable year in which the assignment was

[[Page 302]]

made. With respect to the assignee, the assignment of a mile of eligible 
railroad track is taken into account for the taxable year of the 
assignee that includes the date the assignment is treated as being made 
by the assignor Class II railroad or Class III railroad under this 
paragraph (d)(3).
    (4) Assignment information statement--(i) In general. A taxpayer 
must file Form 8900, ``Qualified Railroad Track Maintenance Credit,'' 
with its timely filed (including extensions) Federal income tax return 
for the taxable year for which the taxpayer assigns any mile of eligible 
railroad track, even if the taxpayer is not itself claiming the RTMC for 
that taxable year.
    (ii) Assignor. Except as provided in paragraph (d)(4)(iv) of this 
section, a Class II railroad or Class III railroad (assignor) that 
assigns one or more miles of eligible railroad track during a taxable 
year to one or more eligible taxpayers must attach to the assignor's 
Form 8900 for that taxable year an information statement providing--
    (A) The name and taxpayer identification number of each assignee;
    (B) The total number of miles of the assignor's eligible railroad 
track;
    (C) The number of miles of eligible railroad track assigned by the 
assignor to each assignee for the taxable year; and
    (D) The total number of miles of eligible railroad track assigned by 
the assignor to all assignees for the taxable year.
    (iii) Assignee. Except as provided in paragraph (d)(4)(iv) of this 
section, an eligible taxpayer (assignee) that has received an assignment 
of miles of eligible railroad track during its taxable year from a Class 
II railroad or Class III railroad, and that claims the RTMC for that 
taxable year, must attach to the assignee's Form 8900 for that taxable 
year a statement--
    (A) Providing the total number of miles of eligible railroad track 
assigned to the assignee for the assignee's taxable year; and
    (B) Attesting that the assignee has in writing, and has retained as 
part of the assignee's records for purposes of Sec.  1.6001-1(a), the 
following information from each assignor:
    (1) The name and taxpayer identification number of each assignor.
    (2) The date of each assignment made by each assignor (as determined 
under paragraph (d)(3) of this section) to the assignee;
    (3) The number of miles of eligible railroad track assigned by each 
assignor to the assignee for the assignee's taxable year.
    (iv) Special rules for returns filed prior to November 9, 2007. If 
an eligible taxpayer's Federal income tax return for a taxable year 
beginning after December 31, 2004, and ending before November 9, 2007, 
was filed before December 13, 2007, and the eligible taxpayer is not 
filing an amended Federal income tax return for that taxable year 
pursuant to paragraph (g)(2) of this section before the eligible 
taxpayer's next filed original Federal income tax return, and the 
eligible taxpayer wants to apply paragraph (g)(2) of this section but 
did not include with that return the information specified in paragraph 
(d)(4)(ii) or (iii) of this section, as applicable, the eligible 
taxpayer must attach a statement containing the information specified in 
paragraph (d)(4)(ii) or (iii) of this section, as applicable, to 
either--
    (A) The eligible taxpayer's next filed original Federal income tax 
return; or
    (B) The eligible taxpayer's amended Federal income tax return that 
is filed pursuant to paragraph (g)(2) of this section, provided that 
amended Federal income tax return is filed by the eligible taxpayer 
before its next filed original Federal income tax return.
    (5) Special rules--(i) Effect of subsequent dispositions of eligible 
railroad track during the assignment year. If a Class II railroad or 
Class III railroad assigns one or more miles of eligible railroad track 
that it owned or leased as of the actual date of the assignment, but 
does not own or lease any eligible railroad track at the close of the 
taxable year in which the assignment is made by the Class II railroad or 
Class III railroad, the assignment is not valid for that taxable year 
for purposes of section 45G and this section.
    (ii) Effect of multiple assignments of eligible railroad track miles 
during the same taxable year. If a Class II railroad or Class III 
railroad assigns more miles of eligible railroad track than it owned or

[[Page 303]]

leased as of the close of the taxable year in which the assignment is 
made by the Class II railroad or Class III railroad, the assignment is 
valid for purposes of section 45G and this section only with respect to 
the name of the assignee and the number of miles listed by the assignor 
Class II railroad or Class III railroad on the statement required under 
paragraph (d)(4)(ii) of this section and only to the extent of the 
maximum miles of eligible railroad track that may be assigned by the 
assignor Class II railroad or Class III railroad as determined under 
paragraph (d)(2) of this section. If the total number of miles on this 
statement exceeds the maximum miles of eligible railroad track that may 
be assigned by the assignor Class II railroad or Class III railroad (as 
determined under paragraph (d)(2) of this section), the total number of 
miles on the statement shall be reduced by the excess amount of miles. 
This reduction is allocated among each assignee listed on the statement 
in proportion to the total number of miles listed on the statement for 
that assignee.
    (6) Examples. The application of this paragraph (d) is illustrated 
by the following examples. In none of the examples are the taxpayers 
members of a controlled group:

    Example 1. Assignor and assignee have the same taxable year. (i) N, 
a calendar year taxpayer, is a Class II railroad that owns 500 miles of 
railroad track within the United States on December 31, 2006. O, a 
calendar year taxpayer, is not a railroad, but is a taxpayer that 
provides railroad-related property to N during 2006. On November 7, 
2006, N assigns for purposes of section 45G 300 miles of eligible 
railroad track to O. O receives no other assignment of eligible railroad 
track in 2006. O pays or incurs QRTME in the amount of $100,000 in 
November 2006, and $50,000 in February 2007. N and O each file Form 8900 
with their timely filed Federal income tax returns for 2006 and attach 
the statement required by paragraph (d)(4)(ii) and (iii), respectively, 
of this section reporting the assignment of the 300 miles of eligible 
railroad track to O.
    (ii) The assignment of the 300 miles of eligible railroad track made 
by N to O on November 7, 2006, is treated as made on December 31, 2006 
(at the close of the N's taxable year). Consequently, the assignment is 
taken into account by O for O's taxable year ending on December 31, 
2006. For 2006, O is an eligible taxpayer because, during 2006, O 
provides railroad-related property to N and receives an assignment of 
300 eligible railroad track miles from N. For 2006, O determines the 
tentative amount of RTMC under paragraph (c)(1) of this section to be 
$50,000 (50% multiplied by $100,000 QRTME paid or incurred by O during 
2006). O further determines the credit limitation amount under paragraph 
(c)(2)(i) of this section for 2006 to be $1,050,000 ($3,500 multiplied 
by 300 miles of eligible railroad track assigned by N to O on December 
31, 2006). Because O's tentative amount of RTMC does not exceed O's 
credit limitation amount for 2006, O may claim a RMTC for 2006 in the 
amount of $50,000.
    Example 2. Assignor and assignee have different taxable years. (i) 
The facts are the same as in Example 1, except that O's taxable year 
ends on March 31.
    (ii) The assignment of the 300 miles of eligible railroad track made 
by N to O on November 7, 2006, is treated as made on December 31, 2006. 
As a result, the assignment is taken into account by O for O's taxable 
year ending on March 31, 2007. Thus, for the taxable year ending on 
March 31, 2007, O determines the tentative amount of RMTC under 
paragraph (c)(1) of this section to be $75,000 (50% multiplied by 
$150,000 QRTME incurred by O during its taxable year ending March 31, 
2007). Because O's tentative amount of RTMC does not exceed O's credit 
limitation amount for the taxable year ending March 31, 2007, O may 
claim a RMTC for the taxable year ending March 31, 2007, in the amount 
of $75,000.
    Example 3. Assignment location differs from QRTME location. (i) P, a 
calendar-year taxpayer, is a Class III railroad that owns or has leased 
to it 200 miles of railroad track within the United States on December 
31, 2006. P owns 50 miles of this railroad track and leases 150 miles of 
this railroad track from Q, a Class I railroad. On February 8, 2006, P 
assigns for purposes of section 45G 50 miles of eligible railroad track 
to R. R is not a railroad, but is a taxpayer that ships products using 
the 50 miles of eligible railroad track owned by P, and R paid $100,000 
in 2006 to P to enable P to upgrade these 50 miles of eligible railroad 
track. In March 2006, P also assigns for purposes of section 45G 150 
miles of eligible railroad track to S. S is not a railroad, but is a 
taxpayer that provides railroad-related property to P, and S paid 
$400,000 to P to enable P to upgrade P's 200 miles of eligible railroad 
track. For 2006, P pays or incurs QRTME in the amount of $500,000 to 
upgrade the 150 miles of eligible railroad track that it leases from Q 
and pays or incurs no QRTME on the 50 miles of eligible railroad track 
that it owns. For 2006, P receives no other assignment of eligible 
railroad track miles and did not retain any eligible railroad track 
miles for itself. Also, R and S do not pay or incur any other amounts 
that would qualify as QRTME during 2006. P,

[[Page 304]]

R, and S each file Form 8900 with their timely filed Federal income tax 
returns for 2006 and attach the statement required by paragraph (d)(4) 
(ii) or (iii) of this section, whichever applies, reporting the 
assignment of eligible railroad track by P to R or S in 2006.
    (ii) For 2006, in accordance with paragraph (c)(3)(ii) of this 
section, P is treated as having incurred QRTME in the amount of $0 
($500,000 QRTME actually incurred by P less the $100,000 paid by R to P 
for the assignment of the 50 miles of eligible railroad track and the 
$400,000 paid by S to P for the assignment of the 150 miles of eligible 
railroad track). Further, P assigned all of its eligible railroad track 
miles to R and S for 2006. Accordingly, for 2006, P may not claim any 
RTMC.
    (iii) For 2006, R is an eligible taxpayer because, during 2006, R 
ships property using the rail facilities of P and receives an assignment 
of 50 eligible railroad track miles from P. In accordance with paragraph 
(c)(3)(ii) of this section, R is treated as having incurred QRTME in the 
amount of $100,000 (the amount paid by R to P for the assignment of the 
eligible railroad track miles in 2006) even though no work was performed 
on the 50 miles of eligible railroad track that was assigned by P to R. 
For 2006, R determines the tentative amount of RTMC under paragraph 
(c)(1) of this section to be $50,000 (50% multiplied by $100,000 QRTME 
treated as incurred by R during 2006). R further determines the credit 
limitation amount under paragraph (c)(2)(ii) of this section to be 
$175,000 ($3,500 multiplied by 50 miles of eligible railroad track 
assigned by P to R in 2006). Because R's tentative amount of RTMC does 
not exceed R's credit limitation amount for 2006, R may claim a RTMC for 
2006 in the amount of $50,000.
    (iv) For 2006, S is an eligible taxpayer because, during 2006, S 
provides railroad-related property to P and receives an assignment of 
150 eligible railroad track miles from P. In accordance with paragraph 
(c)(3)(ii) of this section, S is treated as having incurred QRTME in the 
amount of $400,000 (amount paid by S to P for the assignment of the 
eligible railroad track miles in 2006). For 2006, S determines the 
tentative amount of RTMC under paragraph (c)(1) of this section to be 
$200,000 (50% multiplied by $400,000 QRTME treated as incurred by S 
during 2006). S further determines the credit limitation amount under 
paragraph (c)(2)(ii) of this section to be $525,000 ($3,500 multiplied 
by 150 miles of eligible railroad track assigned by P to S in 2006). 
Because S's tentative amount of RTMC does not exceed S's credit 
limitation amount for 2006, S may claim a RTMC for 2006 in the amount of 
$200,000.
    Example 4. Multiple assignments of track miles. (i) T, a calendar-
year taxpayer, is a Class III railroad that owns or has leased to it 200 
miles of railroad track within the United States on December 31, 2006. T 
owns 75 miles of this railroad track and leases 125 miles of this 
railroad track from U, a Class I railroad. V and W are not railroads, 
but are both taxpayers that provide railroad-related services to T 
during 2006. On January 15, 2006, T assigns for purposes of section 45G 
200 miles of eligible railroad track to V. V agrees to incur, in 2006, 
$1.4 million of QRTME to upgrade a portion of/segment of these 200 miles 
of eligible railroad track. Due to unexpected financial difficulties, V 
only incurs $250,000 of QRTME during 2006 and on May 15, 2006, T learns 
that V is unable to incur the remainder of the QRTME. On June 15, 2006, 
T assigns for purposes of section 45G the 200 miles of railroad track to 
W. In 2006, W incurs $1,100,000 of QRTME to upgrade a portion of/segment 
of the railroad track. For 2006, T receives no other assignment of 
eligible railroad track miles and did not retain any eligible railroad 
track miles for itself. V and W do not receive any other assignments of 
miles of eligible railroad track miles from a Class II railroad or Class 
III railroad during 2006. T and W each file Form 8900 with their timely 
filed Federal income tax returns for 2006, and attach the statement 
required by paragraph (d)(4) (ii) and (iii), respectively, of this 
section, reporting the assignment of 200 miles of eligible railroad 
track to W.
    (ii) Because T did not retain any miles of eligible railroad track 
for itself for 2006, the maximum miles of eligible railroad track that 
may be assigned by T for 2006 is 200 miles pursuant to paragraph (d)(2) 
of this section. On the statement required by paragraph (d)(4)(ii) of 
this section, T assigned a total of 200 miles of eligible railroad track 
to W. Consequently, because T did not list V as an assignee on T's 
statement required by paragraph (d)(4)(ii) of this section, V did not 
receive an assignment of eligible railroad track miles from T during 
2006 and V is not an eligible taxpayer for 2006. Thus, for 2006, V may 
not claim any RTMC even though V incurred QRTME in the amount of 
$250,000.
    (iii) For 2006, W is an eligible taxpayer because, during 2006, W 
provides railroad-related services to T and receives an assignment of 
200 eligible railroad track miles from T. W determines the tentative 
amount of RTMC under paragraph (c)(1) of this section to be $550,000 
(50% multiplied by $1,100,000 QRTME incurred by W during 2006). W 
further determines the credit limitation amount under paragraph 
(c)(2)(ii) of this section to be $700,000 ($3,500 multiplied by the 200 
miles of eligible railroad track assigned by T to W in 2006). Because 
W's tentative amount of RTMC does not exceed W's credit limitation 
amount for 2006, W may claim a RTMC for 2006 in the amount of $550,000.
    Example 5. Multiple assignments of track miles. (i) Same facts as in 
Example 4, except T, to its Form 8900 for 2006, attaches the

[[Page 305]]

statement required by paragraph (d)(4)(ii) of this section assigning 200 
miles of eligible railroad track to W and 200 miles of eligible railroad 
track to V.
    (ii) Because T did not retain any miles of eligible railroad track 
for itself for 2006, the maximum miles of eligible railroad track that 
may be assigned by T for 2006 is 200 miles pursuant to paragraph (d)(2) 
of this section. However, on the statement required by paragraph 
(d)(4)(ii) of this section, T assigned a total of 400 miles of eligible 
railroad track (200 miles to W and 200 miles to V). Consequently, the 
400 miles of eligible railroad track on this statement must be reduced 
to the 200 maximum miles of eligible railroad track available for 
assignment for 2006. Because the statement reports 200 miles of eligible 
railroad track assigned to each W and V, the reduction of 200 miles (400 
total miles of eligible railroad track on the statement less 200 maximum 
miles of eligible railroad track available for assignment) is allocated 
pro-rata between W and V and, therefore, 100 miles each to W and V. 
Thus, pursuant to paragraph (d)(5)(ii) of this section, the number of 
miles of eligible railroad track assigned by T to W and V for 2006 is 
100 miles each.
    (iii) For 2006, V is an eligible taxpayer because, during 2006, V 
provides railroad-related services to T and receives an assignment of 
100 eligible railroad track miles from T. V determines the tentative 
amount of RTMC under paragraph (c)(1) of this section to be $125,000 
(50% multiplied by $250,000 QRTME incurred by V during 2006). V further 
determines the credit limitation amount under paragraph (c)(2)(ii) of 
this section to be $350,000 ($3,500 multiplied by the 100 miles of 
eligible railroad track assigned by T to V in 2006). Because V's 
tentative amount of RTMC does not exceed W's credit limitation amount 
for 2006, V may claim a RTMC for 2006 in the amount of $125,000.
    (iv) For 2006, W is an eligible taxpayer because, during 2006, W 
provides railroad-related services to T and receives an assignment of 
100 eligible railroad track miles from T. W determines the tentative 
amount of RTMC under paragraph (c)(1) of this section to be $550,000 
(50% multiplied by $1,100,000 QRTME incurred by W during 2006). W 
further determines the credit limitation amount under paragraph 
(c)(2)(ii) of this section to be $350,000 ($3,500 multiplied by the 100 
miles of eligible railroad track assigned by T to W in 2006). Because 
W's tentative amount of RTMC exceeds W's credit limitation amount for 
2006, W may claim a RTMC for 2006 in the amount of $350,000 (the credit 
limitation). There is no carryover of the amount of $200,000 (the 
tentative amount of $550,000 less the credit limitation amount of 
$350,000).

    (e) Adjustments to basis--(1) In general. All or some of the QRTME 
paid or incurred by an eligible taxpayer during the taxable year may be 
required to be capitalized under section 263(a) as a tangible asset or 
as an intangible asset. See, for example, Sec.  1.263(a)-4(d)(8), which 
requires capitalization of amounts paid or incurred by a taxpayer to 
produce or improve real property owned by another (except to the extent 
the taxpayer is selling services at fair market value to produce or 
improve the real property) if the real property can reasonably be 
expected to produce significant economic benefits for the taxpayer. The 
basis of the tangible asset or intangible asset includes the capitalized 
amount of the QRTME.
    (2) Basis adjustment made to railroad track. An eligible taxpayer 
must reduce the adjusted basis of any railroad track with respect to 
which the eligible taxpayer claims the RTMC. For purposes of section 
45G(e)(3) and this paragraph (e)(2), the adjusted basis of any railroad 
track with respect to which the eligible taxpayer claims the RTMC is 
limited to the amount of QRTME, if any, that is required to be 
capitalized into the qualifying railroad structure or an intangible 
asset. The adjusted basis of the railroad track is reduced by the amount 
of the RTMC allowable (as determined under paragraph (c) of this 
section) by the eligible taxpayer for the taxable year, but not below 
zero. This reduction is taken into account at the time the QRTME is paid 
or incurred by an eligible taxpayer and before the depreciation 
deduction with respect to such railroad track is determined for the 
taxable year for which the RTMC is allowable. If all or some of the 
QRTME paid or incurred by an eligible taxpayer during the taxable year 
is capitalized under section 263(a) to more than one asset, whether 
tangible or intangible (for example, railroad track and bridges), the 
reduction to the basis of these assets under this paragraph (e)(2) is 
allocated among each of the assets subject to the reduction in 
proportion to the unadjusted basis of each asset at the time the QRTME 
is paid or incurred during that taxable year.

[[Page 306]]

    (3) Examples. The application of this paragraph (e) is illustrated 
by the following examples. In each example, all taxpayers use a calendar 
taxable year, and no taxpayers are members of a controlled group.

    Example 1. (i) X is a Class II railroad that owns 500 miles of 
railroad track within the United States on December 31, 2006. During 
2006, X incurs $1 million of QRTME for maintaining this railroad track. 
X uses the track maintenance allowance method for track structure 
expenditures (for further guidance, see Rev. Proc. 2002-65 (2002-2 CB 
700) and Sec.  601.601(d)(2)(ii)(b) of this chapter). Assume all of the 
$1 million QRTME is track structure expenditures and none of it was 
expended for new track structure.
    (ii) For 2006, X determines the tentative amount of RTMC under 
paragraph (c)(1) of this section to be $500,000 (50% multiplied by $1 
million QRTME incurred by X during 2006). X further determines the 
credit limitation amount under paragraph (c)(2)(i) of this section for 
2006 to be $1,750,000 ($3,500 multiplied by 500 miles of eligible 
railroad track). Because X's tentative amount of RTMC does not exceed 
X's credit limitation amount for 2006, X may claim a RTMC for 2006 in 
the amount of $500,000.
    (iii) Of the $1 million QRTME incurred by X during 2006, X 
determines under the track maintenance allowance method that $750,000 is 
the track maintenance allowance under section 162 and $250,000 is the 
capitalized amount for the track structure. In accordance with paragraph 
(e)(2) of this section, X reduces the capitalized amount of $250,000 by 
the RTMC of $500,000 claimed by X for 2006, but not below zero. Thus, 
the capitalized amount of $250,000 is reduced to zero. X also deducts 
under section 162 a track maintenance allowance of $750,000 on its 2006 
Federal income tax return.
    Example 2. (i) Y is a Class II railroad that owns or has leased to 
it 500 miles of eligible railroad track within the United States on 
December 31, 2006. Z is not a railroad, but is a taxpayer that, in 2006, 
transports its products using the rail facilities of Y. In 2006, Y 
assigns for purposes of section 45G 300 miles of eligible railroad track 
to Z. Z does not receive any other assignments of eligible railroad 
track miles in 2006. During 2006, Z incurs QRTME in the amount of $1 
million, and Y does not incur any QRTME. Y and Z each file Form 8900 
with their timely filed Federal income tax returns for 2006 and attach 
the statement required by paragraph (d)(4)(ii) and (iii), respectively, 
of this section reporting the assignment of the 300 miles of eligible 
railroad track to Z.
    (ii) For 2006, Z determines the tentative amount of RTMC under 
paragraph (c)(1) of this section to be $500,000 (50% multiplied by $1 
million QRTME incurred by Z during 2006). Z further determines the 
credit limitation amount under paragraph (c)(2)(ii) of this section for 
2006 to be $1,050,000 ($3,500 multiplied by 300 miles of eligible 
railroad track assigned by Y to Z in 2006). Because Z's tentative amount 
of RTMC does not exceed Z's credit limitation amount for 2006, Z may 
claim a RTMC for 2006 in the amount of $500,000.
    (iii) For 2006, Z also must determine the portion of the $1 million 
QRTME that Z incurs that is required to be capitalized under section 
263(a), and the portion that is a section 162 expense. Because Z is not 
a Class II railroad or Class III railroad, Z cannot use the track 
maintenance allowance method. Assume that all of the QRTME constitutes 
an intangible asset under Sec.  1.263(a)-4(d)(8) and, therefore, is 
required to be capitalized by Z under section 263(a) as an intangible 
asset. In accordance with paragraph (e)(2) of this section, Z reduces 
the capitalized amount of $1 million by the RTMC of $500,000 claimed by 
Z for 2006. Thus, the capitalized amount of $1 million for the 
intangible asset is reduced to $500,000. Further, pursuant to Sec.  
1.167(a)-3(b)(1)(iv), Z may treat this intangible asset with an adjusted 
basis of $500,000 as having a useful life of 25 years for purposes of 
the depreciation allowance under section 167(a).

    (f) Controlled groups--(1) In general. Pursuant to section 
45G(e)(2), if an eligible taxpayer is a member of a controlled group of 
corporations, rules similar to the rules in Sec.  1.41-6T apply for 
determining the amount of the RTMC under section 45G(a) and this 
section. To determine the amount of RTMC (if any) allowable to a trade 
or business that at the end of its taxable year is a member of a 
controlled group, a taxpayer must--
    (i) Compute the group credit in the manner described in paragraph 
(f)(3) of this section; and
    (ii) Allocate the group credit among the members of the group in the 
manner described in paragraph (f)(4) of this section.
    (2) Definitions. For purposes of section 45G(e)(2) and paragraph (f) 
of this section--
    (i) A trade or business is a sole proprietorship, a partnership, a 
trust, an estate, or a corporation that is carrying on a trade or 
business (within the meaning of section 162). Any corporation that is a 
member of a commonly controlled group shall be deemed to be carrying on 
a trade or business if any

[[Page 307]]

other member of that group is carrying on any trade or business;
    (ii) Group and controlled group means a controlled group of 
corporations, as defined in section 41(f)(5), or a group of trades or 
businesses under common control. For rules for determining whether 
trades or businesses are under common control, see Sec.  1.52-1(b) 
through (g);
    (iii) Group credit means the RTMC (if any) allowable to a controlled 
group;
    (iv) Consolidated group has the meaning set forth in Sec.  1.1502-
1(h); and
    (v) Credit year means the taxable year for which the member is 
computing the RTMC.
    (3) Computation of the group credit. All members of a controlled 
group are treated as a single taxpayer for purposes of computing the 
RTMC. The group credit is computed by applying all of the section 45G 
computational rules (including the rules set forth in this section) on 
an aggregate basis.
    (4) Allocation of the group credit. The group credit is allocated to 
each member of the controlled group on a proportionate basis to its 
share of the aggregate of the QRTMEs taken into account for the taxable 
year by such controlled group for purposes of the credit.
    (5) Special rules for consolidated groups--(i) In general. For 
purposes of applying paragraph (f)(4) of this section, members of a 
consolidated group who are members of a controlled group are treated as 
a single member of the controlled group.
    (ii) Special rule for allocation of group credit among consolidated 
group members. The portion of the group credit that is allocated to a 
consolidated group is allocated to each member of the consolidated group 
on a proportionate basis to its share of the aggregate of the QRTMEs 
taken into account for the taxable year by such consolidated group for 
purposes of the credit.
    (6) Tax accounting periods used--(i) In general. The credit 
allowable to a member of a controlled group is that member's share of 
the group credit computed as of the end of that member's taxable year. 
In computing the group credit for a group whose members have different 
taxable years, a member generally should treat the taxable year of 
another member that ends with or within the credit year of the computing 
member as the credit year of that other member. For example, Q, R, and S 
are members of a controlled group of corporations. Both Q and R are 
calendar year taxpayers. S files a return using a fiscal year ending 
June 30. For purposes of computing the group credit at the end of Q's 
and R's taxable year on December 31, S's fiscal year ending June 30, 
which ends within Q's and R's taxable year, is treated as S's credit 
year.
    (ii) Special rule when timing of QRTME is manipulated. If the timing 
of QRTME by members using different tax accounting periods is 
manipulated to generate a credit in excess of the amount that would be 
allowable if all members of the group used the same tax accounting 
period, then the appropriate Internal Revenue Service official in the 
operating division that has examination jurisdiction of the return may 
require each member of the group to calculate the credit in the current 
taxable year and all future years as if all members of the group had the 
same taxable year and base period as the computing member.
    (7) Membership during taxable year in more than one group. A trade 
or business may be a member of only one group for a taxable year. If, 
without application of this paragraph (f)(7), a business would be a 
member of more than one group at the end of its taxable year, the 
business shall be treated as a member of the group in which it was 
included for its preceding taxable year. If the business was not 
included for its preceding taxable year in any group in which it could 
be included as of the end of its taxable year, the business shall 
designate in its timely filed (including extensions) federal income tax 
return for the taxable year the group in which it is being included. If 
the business does not so designate, then the appropriate Internal 
Revenue Service official in the operating division that has examination 
jurisdiction of the return will determine the group in which the 
business is to be included. If the Federal income tax return for a 
taxable year beginning after December 31, 2004, and ending before 
November 9, 2007, was filed before December 13, 2007, and the business 
wants to apply paragraph

[[Page 308]]

(g)(2) of this section but did not designate its group membership in 
that return, the business must designate its group membership for that 
year either--
    (i) In its next filed original Federal income tax return; or
    (ii) In its amended Federal income tax return that is filed pursuant 
to paragraph (g)(2) of this section, provided that amended Federal 
income tax return is filed by the business before its next filed 
original Federal income tax return.
    (8) Intra-group transactions--(i) In general. Because all members of 
a group under common control are treated as a single taxpayer for 
purposes of determining the RTMC, transfers between members of the group 
are generally disregarded.
    (ii) Payment for QRTME. Amounts paid or incurred by the owner (or 
lessor) of eligible railroad track to another member of the group for 
QRTME shall be taken into account as QRTME by the owner (or lessor) of 
the eligible railroad track for purposes of section 45G only to the 
extent of the lesser of--
    (A) The amount paid or incurred to the other member; or
    (B) The amount that would have been considered paid or incurred by 
the other member for the QRTME, if the QRTME was not reimbursed by the 
owner (or lessor) of the eligible railroad track.
    (g) Effective/applicability date--(1) In general. Except as provided 
in paragraphs (g)(2) and (g)(3) of this section, this section applies to 
taxable years ending on or after September 7, 2006.
    (2) Taxable years ending before September 7, 2006. A taxpayer may 
apply this section to taxable years beginning after December 31, 2004, 
and ending before September 7, 2006, provided that the taxpayer applies 
all provisions in this section to the taxable year.
    (3) Special rules for returns filed prior to November 9, 2007. If a 
taxpayer's Federal income tax return for a taxable year beginning after 
December 31, 2004, and ending before November 9, 2007, was filed before 
December 13, 2007, and the taxpayer is not filing an amended Federal 
income tax return for that taxable year pursuant to paragraph (g)(2) of 
this section before the taxpayer's next filed original Federal income 
tax return, see paragraphs (d)(4)(iv) and (f)(7) of this section for the 
statements that must be attached to the taxpayer's next filed original 
Federal income tax return.
    (4) Taxable years beginning after December 31, 2011. Paragraphs 
(f)(4) and (5) and (g)(4) and (5) of this section apply to taxable years 
beginning on or after April 2, 2018. For taxable years ending before 
April 2, 2018, see Sec.  1.45G-1T as contained in 26 CFR part 1, as 
revised April 1, 2017.
    (5) Taxable years beginning before January 1, 2012. See Sec.  1.45-1 
as contained in 26 CFR part 1, revised April 1, 2014.

[T.D. 9365, 72 FR 63816, Nov. 13, 2007, as amended by T.D. 9717, 80 FR 
18098, Apr. 3, 2015; 80 FR 23238, Apr. 27, 2015; T.D. 9832, 83 FR 13185, 
Mar. 28, 2018]



Sec.  1.45Q-0  Table of Contents

    This section lists the captions contained in Sec. Sec.  1.45Q-1 
through 1.45Q-5.

Sec.  1.45Q-1 Credit for Carbon Oxide Sequestration.

    (a) In general.
    (b) Credit amount for carbon capture equipment originally placed in 
service before February 9, 2018.
    (1) In general.
    (2) Inflation adjustment.
    (c) Credit amount for carbon capture equipment originally placed in 
service on or after February 9, 2018.
    (d) Applicable dollar amount.
    (1) Applicable dollar amount for any taxable year beginning in a 
calendar year after 2016 and before 2027 for qualified carbon oxide not 
used as a tertiary injectant or utilized.
    (2) Applicable dollar amount for any taxable year beginning in a 
calendar year after 2026 for qualified carbon oxide not used as a 
tertiary injectant or utilized.
    (3) Applicable dollar amount for any taxable year beginning in a 
calendar year after 2016 and before 2027 for qualified carbon oxide used 
as a tertiary injectant or utilized.
    (4) Applicable dollar amount for any taxable year beginning in a 
calendar year after 2026 for qualified carbon oxide used as a tertiary 
injectant or utilized.
    (e) Election to apply the $10 and $20 credit amounts in lieu of the 
applicable dollar amounts.
    (f) Application of section 45Q for certain carbon capture equipment 
placed in service before February 9, 2018.
    (g) Installation of additional carbon capture equipment.

[[Page 309]]

    (1) Allocation of section 45Q credits for facilities installing 
additional carbon capture equipment.
    (2) Additional carbon capture equipment.
    (3) New carbon capture equipment.
    (4) Examples.
    (i) Example 1.
    (ii) Example 2.
    (iii) Example 3.
    (h) Eligibility for the section 45Q credit.
    (1) Person to whom the section 45Q credit is attributable.
    (i) Equipment placed in service before February 9, 2018.
    (ii) Equipment placed in service on or after February 9, 2018.
    (iii) Reporting.
    (2) Contractually ensuring capture and disposal, injection, or 
utilization of qualified carbon oxide.
    (i) Binding written contract.
    (ii) Multiple binding written contracts permitted.
    (iii) Contract provisions.
    (iv) Pre-existing contracts.
    (v) Reporting of contract information.
    (vi) Relationship with election to allow section 45Q credit.
    (3) Election to allow the section 45Q credit to another taxpayer.
    (i) Example.
    (ii) Time and manner of making election.
    (iii) Annual election.
    (iv) Required information.
    (v) Requirements for section 45Q credit claimant.
    (vi) Failure to satisfy reporting requirements.
    (i) Applicability date.

Sec.  1.45Q-2 Definitions for Purposes of Sec. Sec.  1.45Q-1 through 
          1.45Q-5.

    (a) Qualified carbon oxide.
    (b) Recycled carbon oxide.
    (c) Carbon capture equipment.
    (1) Use of carbon capture equipment.
    (2) Carbon capture equipment components.
    (3) Single process train.
    (d) Industrial facility.
    (1) Exclusion.
    (2) Industrial source.
    (3) Manufacturing process.
    (4) Examples.
    (i) Example 1.
    (ii) Example 2.
    (e) Electricity generating facility.
    (f) Direct air capture facility.
    (g) Qualified facility.
    (1) Emissions and capture requirements.
    (2) Examples.
    (i) Example 1.
    (ii) Example 2.
    (iii) Example 3.
    (iv) Example 4.
    (v) Example 5.
    (3) Annualization of first-year and last-year qualified carbon oxide 
emission and/or capture amounts.
    (i) In general.
    (ii) Calculation.
    (iii) Consequences.
    (4) Election for applicable facilities.
    (i) Applicable facility.
    (ii) Time and manner of making election.
    (iii) Retroactive credit revocations.
    (5) Retrofitted qualified facility or carbon capture equipment (80/
20 Rule).
    (h) Qualified enhanced oil or natural gas recovery project.
    (1) Application of Sec. Sec.  1.43-2 and 1.43-3.
    (2) Required certification.
    (3) Natural gas.
    (4) Timely filing of petroleum engineer's certification.
    (5) Carbon oxide injected in oil reservoir.
    (6) Tertiary injectant.
    (i) Section 45Q credit.
    (j) Form 8933.
    (k) Applicability date.

Sec.  1.45Q-3 Secure Geological Storage.

    (a) In general.
    (b) Requirements for secure geological storage.
    (c) Documentation.
    (d) Certification.
    (e) Failure to submit complete documentation or certification.
    (f) Applicability date.

Sec.  1.45Q-4 Utilization of Qualified Carbon Oxide.

    (a) In general.
    (b) Amount utilized.
    (1) In general.
    (2) Limitation.
    (c) Lifecycle greenhouse gas emissions and lifecycle analysis (LCA).
    (1) In general.
    (2) LCA verification.
    (3) Standards of adequate lifecycle analysis.
    (4) Third-party independent review of LCA.
    (5) Submission of the LCA.
    (6) LCA review.
    (d) Commercial market.
    (e) Applicability date.

Sec.  1.45Q-5 Recapture of Credit.

    (a) Recapture event.
    (b) Ceases to be disposed of in secure geological storage or used as 
a tertiary injectant.
    (c) Leaked amount of qualified carbon oxide.
    (d) Qualified carbon oxide subject to recapture.
    (e) Recapture amount.
    (f) Recapture period.
    (g) Application of recapture.
    (1) In general.
    (2) Calculation.
    (3) Multiple units.
    (4) Multiple taxpayers.
    (i) In general.
    (ii) Partnerships.

[[Page 310]]

    (A) General rule.
    (B) Terminated partnerships.
    (5) Reporting.
    (6) Examples.
    (i) Example 1.
    (ii) Example 2.
    (iii) Example 3.
    (iv) Example 4.
    (v) Example 5.
    (vi) Example 6.
    (h) Recapture in the event of deliberate removal from storage.
    (1) In general.
    (2) Recycled qualified carbon oxide.
    (i) Limited exceptions.
    (j) Applicability date.

[T.D. 9944, 86 FR 4760, Jan. 15, 2021]



Sec.  1.45Q-1  Credit for Carbon Oxide Sequestration.

    (a) In general. For purposes of section 38 of the Internal Revenue 
Code (Code), the carbon oxide sequestration credit is determined under 
section 45Q of the Code and this section (section 45Q credit). 
Generally, the amount of the section 45Q credit and the party that is 
eligible to claim the credit depend on whether the taxpayer captures 
qualified carbon oxide using carbon capture equipment originally placed 
in service at a qualified facility before February 9, 2018, or on or 
after February 9, 2018, and whether the taxpayer disposes of the 
qualified carbon oxide in secure geological storage without using it as 
a tertiary injectant in a qualified enhanced oil or natural gas recovery 
project (disposal), uses it as a tertiary injectant in a qualified 
enhanced oil or natural gas recovery project and disposes of it in 
secure geological storage (injection), or utilizes it in a manner 
described in section 45Q(f)(5) and Sec.  1.45Q-4 (utilization). The 
section 45Q credit applies only with respect to qualified carbon oxide 
the capture and disposal, injection, or utilization of which is within 
the United States (within the meaning of section 638(1) of the Code) or 
a possession of the United States (within the meaning of section 
638(2)).
    (b) Credit amount for carbon capture equipment originally placed in 
service before February 9, 2018--(1) In general. For carbon capture 
equipment originally placed in service at a qualified facility before 
February 9, 2018, the amount of credit determined under section 45Q(a) 
and this section is the sum of--
    (i) $20 per metric ton of qualified carbon oxide that is--
    (A) Captured by the taxpayer at the qualified facility and disposed 
of by the taxpayer in secure geological storage, and
    (B) Not used by the taxpayer as a tertiary injectant in a qualified 
enhanced oil or natural gas recovery project or utilized by the taxpayer 
in a manner described in section 45Q(f)(5) and Sec.  1.45Q-4, and
    (ii) $10 per metric ton of qualified carbon oxide that is--
    (A) Captured by the taxpayer at the qualified facility and used by 
the taxpayer as a tertiary injectant in a qualified enhanced oil or 
natural gas recovery project, and disposed of by the taxpayer in secure 
geological storage, or
    (B) Captured by the taxpayer at the qualified facility and utilized 
by the taxpayer in a manner described in section 45Q(f)(5) and Sec.  
1.45Q-4.
    (2) Inflation adjustment. In the case of any taxable year beginning 
in a calendar year after 2009, there is substituted for each dollar 
amount contained in paragraphs (b)(1)(i) and (ii) of this section an 
amount equal to the product of--
    (i) Such dollar amount, multiplied by
    (ii) The inflation adjustment factor for such calendar year 
determined under section 43(b)(3)(B) for such calendar year, determined 
by substituting ``2008'' for ``1990.''
    (c) Credit amount for carbon capture equipment originally placed in 
service on or after February 9, 2018. For carbon capture equipment 
originally placed in service at a qualified facility on or after 
February 9, 2018, the amount of credit determined under section 
45Q(a)(3) and (4) and this section is the sum of--
    (1) The applicable dollar amount (as determined under paragraph 
(d)(1) and (2) of this section) per metric ton of qualified carbon oxide 
that is captured during the 12-year period beginning on the date the 
equipment was originally placed in service, and is--
    (i) Disposed of by the taxpayer in secure geological storage, and
    (ii) Not used by the taxpayer as a tertiary injectant in a qualified 
enhanced oil or natural gas recovery project or utilized by the taxpayer 
in a manner

[[Page 311]]

described in section 45Q(f)(5) and Sec.  1.45Q-4; and
    (2) The applicable dollar amount (as determined under paragraph 
(d)(3) and (4) of this section) per metric ton of qualified carbon oxide 
that is captured during the 12-year period beginning on the date the 
equipment was originally placed in service and is--
    (i) Used by the taxpayer as a tertiary injectant in a qualified 
enhanced oil or natural gas recovery project and disposed of by the 
taxpayer in secure geological storage, or
    (ii) Utilized by the taxpayer in a manner described in section 
45Q(f)(5) and Sec.  1.45Q-4.
    (d) Applicable dollar amount. In general, the applicable dollar 
amount depends on whether section 45Q(a)(3) and paragraph (c)(1) of this 
section applies or section 45Q(a)(4) and paragraph (c)(2) of this 
section applies, and the calendar year in which the taxable year begins.
    (1) Applicable dollar amount for any taxable year beginning in a 
calendar year after 2016 and before 2027 for qualified carbon oxide not 
used as a tertiary injectant or utilized. For purposes of section 
45Q(a)(3) and paragraph (c)(1) of this section, the applicable dollar 
amount for each taxable year beginning in a calendar year after 2016 and 
before 2027 is:

                       Table 1 to Paragraph (d)(1)
------------------------------------------------------------------------
                                                              Applicable
                            Year                                dollar
                                                                amount
------------------------------------------------------------------------
2017.......................................................       $22.66
2018.......................................................        25.70
2019.......................................................        28.74
2020.......................................................        31.77
2021.......................................................        34.81
2022.......................................................        37.85
2023.......................................................        40.89
2024.......................................................        43.92
2025.......................................................        46.96
2026.......................................................        50.00
------------------------------------------------------------------------

    (2) Applicable dollar amount for any taxable year beginning in a 
calendar year after 2026 for qualified carbon oxide not used as a 
tertiary injectant or utilized. For purposes of section 45Q(a)(3) and 
paragraph (c)(1) of this section, the applicable dollar amount for any 
taxable year beginning in any calendar year after 2026 is an amount 
equal to the product of $50 and the inflation adjustment factor for the 
calendar year determined under section 43(b)(3)(B) for the calendar 
year, determined by substituting ``2025'' for ``1990.''
    (3) Applicable dollar amount for any taxable year beginning in a 
calendar year after 2016 and before 2027 for qualified carbon oxide used 
as a tertiary injectant or utilized. For purposes of section 45Q(a)(4) 
and paragraph (c)(2) of this section, the applicable dollar amount for 
each taxable year beginning in a calendar year after 2016 and before 
2027 is:

                       Table 2 to Paragraph (d)(3)
------------------------------------------------------------------------
                                                              Applicable
                            Year                                dollar
                                                                amount
------------------------------------------------------------------------
2017.......................................................       $12.83
2018.......................................................        15.29
2019.......................................................        17.76
2020.......................................................        20.22
2021.......................................................        22.68
2022.......................................................        25.15
2023.......................................................        27.61
2024.......................................................        30.07
2025.......................................................        32.54
2026.......................................................        35.00
------------------------------------------------------------------------

    (4) Applicable dollar amount for any taxable year beginning in a 
calendar year after 2026 for qualified carbon oxide used as a tertiary 
injectant or utilized. For purposes of section 45Q(a)(4) and paragraph 
(c)(2) of this section, the applicable dollar amount for any taxable 
year beginning in any calendar year after 2026, is an amount equal to 
the product of $35 and the inflation adjustment factor for such calendar 
year determined under section 43(b)(3)(B) for such calendar year, 
determined by substituting ``2025'' for ``1990.''
    (e) Election to apply the $10 and $20 credit amounts in lieu of the 
applicable dollar amounts. For purposes of determining the carbon oxide 
sequestration credit under this section, a taxpayer may elect to have 
the dollar amounts applicable under section 45Q(a)(1) or (2) and 
paragraph (b) of this section apply in lieu of the dollar amounts 
applicable under section 45Q(a)(3) or (4) and paragraph (d) of this 
section for each metric ton of qualified carbon oxide which is captured 
by the taxpayer using carbon capture equipment which is originally 
placed in service at a qualified facility on or after February 9, 2018. 
The election must be made on a Form 8933

[[Page 312]]

(as defined in Sec.  1.45Q-2(j)), and applies to all metric tons of 
qualified carbon oxide captured by the taxpayer using carbon capture 
equipment which is originally placed in service at the qualified 
facility throughout the full 12-year credit period.
    (f) Application of section 45Q for certain carbon capture equipment 
placed in service before February 9, 2018. In the case of any carbon 
capture equipment placed in service before February 9, 2018, the credits 
under section 45Q(a)(1) and (2) and paragraph (b)(1)(i) and (ii) of this 
section apply with respect to qualified carbon oxide captured using such 
equipment before the end of the calendar year in which the Secretary of 
the Treasury or his delegate, in consultation with the Administrator of 
the Environmental Protection Agency (EPA), certifies that, during the 
period beginning after October 3, 2008, a total of 75,000,000 metric 
tons of qualified carbon oxide have been taken into account in 
accordance with section 45Q(a), as in effect on February 8, 2018, and 
section 45Q(a)(1) and (2). In general, a taxpayer may not claim credits 
under section 45Q(a)(1) and (2) in taxable years after the year in which 
the 75,000,000 metric ton limit is certified with respect to carbon 
capture equipment placed in service before February 9, 2018. However, 
see Sec.  1.45Q-2(g)(4) regarding the election for applicable facilities 
to treat certain carbon capture equipment as having been placed in 
service on February 9, 2018 (section 45Q(f)(6) election).
    (g) Installation of additional carbon capture equipment. In general, 
the credit amounts for property placed in service before February 9, 
2018, apply to a qualified facility at which carbon capture equipment 
was placed in service before February 9, 2018, subject to the 
limitations under paragraph (f) of this section. The same qualified 
facility may place additional carbon capture equipment in service on or 
after February 9, 2018. The additional carbon capture equipment is 
eligible to qualify for the section 45Q credit amounts for equipment 
placed in service on or after February 9, 2018.
    (1) Allocation of section 45Q credits for facilities installing 
additional carbon capture equipment. In the case of a qualified facility 
placed in service before February 9, 2018, for which additional carbon 
capture equipment is placed in service on or after February 9, 2018, the 
amount of qualified carbon oxide which is captured by the taxpayer is 
equal to--
    (i) For purposes of section 45Q(a)(1)(A) and (2)(A), and paragraphs 
(b)(1)(i) and (ii) of this section, the lesser of the total amount of 
qualified carbon oxide captured at such facility for the taxable year, 
or the total amount of the carbon dioxide capture capacity of the carbon 
capture equipment in service at such facility on February 8, 2018, and
    (ii) For purposes of section 45Q(a)(3)(A) and (4)(A), and paragraphs 
(c)(1) and (2) of this section, an amount (not less than zero) equal to 
the excess of the total amount of qualified carbon oxide captured at 
such facility for the taxable year, over the total amount of the carbon 
dioxide capture capacity of the carbon capture equipment in service at 
such facility on February 8, 2018.
    (2) Additional carbon capture equipment. A physical modification or 
equipment addition that results in an increase in the carbon dioxide 
capture capacity of existing carbon capture equipment constitutes the 
installation of additional carbon capture equipment. Increasing the 
amount of carbon dioxide captured without physically modifying existing 
carbon capture equipment or adding new equipment, for example, by merely 
operating the existing carbon capture equipment above the carbon dioxide 
capture capacity, does not constitute the installation of additional 
carbon capture equipment. For purposes of this section, the term carbon 
dioxide capture capacity means capture design capacity. Section 45Q 
credits attributable to qualified carbon oxide captured by additional 
carbon capture equipment that is placed in service on or after February 
9, 2018, are not subject to the 75,000,000 metric ton limitation 
described in section 45Q(g) and paragraph (f) of this section.
    (3) New carbon capture equipment. A physical modification or 
equipment addition with a cost that satisfies the 80/20 Rule provided in 
Sec.  1.45Q-2(g)(5) constitutes the installation of new carbon

[[Page 313]]

capture equipment rather than the installation of additional carbon 
capture equipment.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (g):
    (i) Example 1. Taxpayer X owns qualified facility QF. In 2017, X 
placed in service three units of carbon capture equipment--CC1, CC2, and 
CC3--to capture carbon dioxide emitted by QF. Each of CC1, CC2, and CC3 
are capable of capturing 50,000 metric tons of carbon dioxide. In 2017, 
X entered into a binding written contract with Y to provide 80,000 
metric tons of carbon dioxide annually for Y to dispose of in secure 
geological storage. X operates CC1 and CC2 to capture carbon dioxide 
pursuant to the binding written contract with Y, leaving CC3 idle. In 
2020, X enters into a binding written contract with Z to provide 40,000 
metric tons of carbon dioxide annually for Z to dispose of in secure 
geological storage. X operates CC3 to capture carbon dioxide pursuant to 
the binding written contract with Z. CC3 is not additional carbon 
capture equipment under paragraph (g)(2) of this section simply because 
it began operating CC3 in 2020. X merely increased the amount of carbon 
dioxide captured by existing carbon capture equipment. As a result, any 
section 45Q credits attributable to the carbon dioxide captured by CC3 
and disposed of by Z are calculated under section 45Q(a)(1) and 
paragraph (b)(1)(i) of this section, and are subject to the 75,000,000 
metric ton limitation described in section 45Q(g) and paragraph (f) of 
this section.
    (ii) Example 2. Assume the same facts as in Example 1, except that 
in 2019, X physically modified CC3 to enable CC3 to capture 100,000 
metric tons of carbon dioxide. The physical modification to upgrade CC3 
does not satisfy the 80/20 Rule in Sec.  1.45Q-2(g)(5). In 2020 X enters 
into a binding written contract with Z to provide 80,000 metric tons of 
carbon dioxide annually for Z to dispose of in secure geological 
storage. X operates CC3 to capture carbon dioxide pursuant to the 
binding written contract with Z. Because the physical modification to 
upgrade CC3 does not satisfy the 80/20 Rule, the physical modification 
to upgrade CC3 is considered the installation of additional carbon 
capture equipment under paragraph (g)(2) of this section, rather than 
new carbon capture equipment under paragraph (g)(3) of this section. As 
a result, any section 45Q credits attributable to the first 50,000 
metric tons of carbon dioxide captured by CC3 and disposed of by Z are 
calculated under section 45Q(a)(1) and paragraph (b)(1)(i) of this 
section, and are subject to the 75,000,000 metric ton limitation 
described in section 45Q(g) and paragraph (f) of this section. Any 
section 45Q credits attributable to additional carbon dioxide captured 
by CC3 and disposed of by Z in excess of those first 50,000 metric tons 
are calculated under section 45Q(a)(4) and paragraph (c)(2) of this 
section, and are not subject to the 75,000,000 metric ton limitation 
described in section 45Q(g) and paragraph (f) of this section.
    (iii) Example 3. Assume the same facts as in Example 2, except that 
the physical modification to CC3 satisfies the 80/20 Rule in Sec.  
1.45Q-2(g)(5). The physical modification to CC3 is considered the 
installation of new carbon capture equipment under paragraph (g)(3) of 
this section. As a result, any section 45Q credits attributable to 
carbon dioxide captured by CC3 and disposed of by Z are calculated under 
section 45Q(a)(4) and paragraph (c)(2) of this section, and are not 
subject to the 75,000,000 metric ton limitation described in section 
45Q(g) and paragraph (f) of this section.
    (h) Eligibility for the section 45Q credit. The following rules 
determine who may claim the section 45Q credit.
    (1) Person to whom the section 45Q credit is attributable. In 
general, the person to whom the credit is attributable is the person who 
may claim the credit. Except as provided in paragraph (h)(3) of this 
section, the section 45Q credit is attributable to the following 
persons--
    (i) Equipment placed in service before February 9, 2018. In the case 
of qualified carbon oxide captured using carbon capture equipment that 
is originally placed in service at a qualified facility before February 
9, 2018, the section 45Q credit is attributable to the person that 
captures and physically or contractually ensures the disposal, 
injection, or utilization of such qualified carbon oxide.

[[Page 314]]

    (ii) Equipment placed in service on or after February 9, 2018. In 
the case of qualified carbon oxide captured using carbon capture 
equipment that is originally placed in service at a qualified facility 
on or after February 9, 2018, the section 45Q credit is attributable to 
the person that owns the carbon capture equipment and physically or 
contractually ensures the capture and disposal, injection, or 
utilization of such qualified carbon oxide. For each single process 
train of carbon capture equipment (as described in Sec.  1.45Q-2(c)(3)), 
only one taxpayer will be considered the person to whom the credit is 
attributable under this paragraph (h)(1)(ii). That person will be the 
taxpayer who either physically ensures the capture and disposal, 
injection, or utilization of such qualified carbon oxide or contracts 
with others to capture and dispose, inject, or utilize such qualified 
carbon oxide.
    (iii) Reporting. The taxpayer described in this paragraph (h)(1) as 
eligible to claim the section 45Q credit must claim the credit on a Form 
8933, ``Carbon Dioxide Sequestration Credit,'' with the taxpayer's 
Federal income tax return or Form 1065, ``U.S. Return of Partnership 
Income,'' for each taxable year for which the taxpayer is eligible. The 
taxpayer must provide the name and location of the qualified facilities 
at which the qualified carbon oxide was captured. If the taxpayer is 
claiming the section 45Q credit on an amended Federal income tax return, 
an amended Form 1065, or an administrative adjustment request under 
section 6227 (AAR), as applicable, the taxpayer must state AMENDED 
RETURN FOR SECTION 45Q CREDIT at the top of the amended Federal income 
tax return, the amended Form 1065, or the AAR, as applicable. The 
amended Federal income tax return or the amended Form 1065 must be 
filed, in any event, not later than the applicable period of limitations 
on filing an amended Federal income tax return or Form 1065 is being 
filed. A BBA partnership may make a late election by filing an AAR on or 
before October 15, 2021, but in any event, not later than the period of 
limitations on filing an AAR under section 6227(c).
    (2) Contractually ensuring capture and disposal, injection, or 
utilization of qualified carbon oxide. In the case of qualified carbon 
oxide captured using carbon capture equipment which is originally placed 
in service at a qualified facility on or after February 9, 2018, a 
taxpayer is not required to physically carry out the capture and 
disposal, injection, or utilization of qualified carbon oxide to claim 
the section 45Q credit if the taxpayer contractually ensures in a 
binding written contract that the party that physically carries out the 
capture, disposal, injection, or utilization of the qualified carbon 
oxide does so in the manner required under section 45Q, this section and 
Sec. Sec.  1.45Q-2, 1.45Q-3, 1.45Q-4, and 1.45Q-5. A taxpayer may enter 
into a binding written contract with a general contractor that hires 
subcontractors to physically carry out the capture, disposal, injection, 
or utilization of the qualified carbon oxide, but the contract must bind 
the subcontractors to the requirements of this paragraph (h)(2). In the 
case of qualified carbon oxide captured using carbon capture equipment 
which is originally placed in service at a qualified facility before 
February 9, 2018, a taxpayer that contractually ensures the capture of 
the qualified carbon oxide is not eligible for the section 45Q credit. 
However, the taxpayer is not required to physically carry out the 
disposal, injection, or utilization of qualified carbon oxide to claim 
the section 45Q credit if the taxpayer contractually ensures in a 
binding written contract that the party that physically carries out the 
disposal, injection, or utilization of the qualified carbon oxide does 
so in the manner required under section 45Q, this section, and 
Sec. Sec.  1.45Q-2, 1.45Q-3, 1.45Q-4, and 1.45Q-5.
    (i) Binding written contract. A written contract is binding only if 
it is enforceable under State law against both the taxpayer and the 
party that physically carries out the capture, disposal, injection, or 
utilization of the qualified carbon oxide, or a predecessor or successor 
of either, and does not limit damages to a specified amount (for 
example, by use of a liquidated damages provision). For this purpose, a 
contractual provision that limits damages to an amount equal to at least 
five percent of the total contract price will not be treated

[[Page 315]]

as limiting damages to a specified amount. For additional guidance 
regarding the definition of a binding written contract, see Sec.  
1.168(k)-1(b)(4)(ii)(A)-(D).
    (ii) Multiple binding written contracts permitted. A taxpayer may 
enter into multiple binding written contracts with multiple parties for 
the capture, disposal, injection, or utilization of qualified carbon 
oxide. A party that physically carries out the capture, disposal, 
injection, or utilization of qualified carbon oxide may enter into 
multiple binding written contracts with multiple parties that own carbon 
capture equipment or capture or contractually ensure the capture of 
qualified carbon oxide.
    (iii) Contract provisions. Contracts ensuring the capture, disposal, 
injection, or utilization of qualified carbon oxide--
    (A) Must include commercially reasonable terms and provide for 
enforcement of the party's obligation to perform the capture, disposal, 
injection, or utilization of the qualified carbon oxide;
    (B) May, but are not required to, include long-term liability 
provisions, indemnity provisions, penalties for breach of contract, or 
liquidated damages provisions;
    (C) May, but are not required to, include information including how 
many metric tons of qualified carbon oxide the parties agree to dispose 
of, inject, or utilize;
    (D) May, but are not required to, include minimum quantities that 
the parties agree to dispose of, inject, or utilize;
    (E) Must, in the case of qualified carbon oxide that is intended to 
be disposed of in secure geological storage and not used as a tertiary 
injectant in a qualified enhanced oil or natural gas recovery project, 
obligate the disposing party to comply with Sec. Sec.  1.45Q-3(b)(1) and 
(c), and, in the case of a recapture event, promptly inform the 
capturing party of all information that is pertinent to the recapture 
(e.g., location of leak, leaked amount of qualified carbon oxide, dollar 
value of section 45Q credit attributable to leaked qualified carbon 
oxide);
    (F) Must, for qualified carbon oxide that is intended to be used as 
a tertiary injectant in a qualified enhanced oil or natural gas 
recovery, obligate the disposing party to comply with Sec.  1.45Q-
3(b)(2) and (c), and in the case of a recapture event, promptly inform 
the capturing party of all information that is pertinent to recapture of 
the section 45Q credit as listed in Sec.  1.45Q-5; and
    (G) Must, for qualified carbon oxide that is intended to be utilized 
in a manner specified in Sec.  1.45Q-4, obligate the utilizing party to 
comply with Sec.  1.45Q-4.
    (iv) Pre-existing contracts. If a taxpayer entered into a contract 
for the capture, disposal, injection, or utilization of qualified carbon 
oxide prior to January 13, 2021, and that contract does not satisfy all 
of the requirements of this paragraph (h)(2), the taxpayer must amend 
its existing contract or execute a new contract that satisfies all of 
the requirements of this paragraph (h)(2) by July 12, 2021.
    (v) Reporting of contract information. The existence of each 
contract and the parties involved must be reported to the IRS annually. 
Each party to a contract must complete a signed Form 8933 (as defined in 
Sec.  1.45-2(j)) and provide information required by the instructions to 
Form 8933. The party that contracts with the taxpayer claiming the 
credit must also provide that taxpayer with a signed Form 8933 in 
accordance with the instructions to Form 8933. The taxpayer claiming the 
credit must attach and file all other signed Forms 8933 received by each 
other party to the contract to its own signed Form 8933. Failure of the 
taxpayer claiming the credit to satisfy this reporting requirement in a 
taxable year will result in the inability of that taxpayer to claim the 
credit with respect to any qualified carbon oxide that is disposed of, 
injected, or utilized in that taxable year pursuant to that particular 
contract. In addition to any information stated as required on Form 
8933, the report must include the following information--
    (A) The name and taxpayer identification number of the taxpayer to 
whom the credit is attributable;
    (B) The name and taxpayer identification number of each party with 
whom the taxpayer has entered into a

[[Page 316]]

contract to ensure the disposal, injection, or utilization of qualified 
carbon oxide;
    (C) The date each contract to ensure the disposal, injection, or 
utilization of qualified carbon oxide was entered into;
    (D) The number of metric tons of qualified carbon oxide each 
contracting party disposes of, injects, or utilizes on behalf of the 
contracting taxpayer each taxable year for reporting to the IRS; and
    (E) For contracts for the disposal of qualified carbon oxide in 
secure geological storage or the use of qualified carbon oxide as a 
tertiary injectant in enhanced oil or natural gas recovery, the name of 
the operator, the field, unit, and reservoir, location by county and 
state, and identification number assigned to the facility by the EPA's 
electronic Greenhouse Gas Reporting Tool (e-GGRT ID number) for 
submission of the facility's 40 CFR part 98 annual reports.
    (vi) Relationship with election to allow section 45Q credit. A 
taxpayer does not elect to allow all or a portion of the credit to any 
of the contracting parties merely by contracting with that party to 
ensure the disposal, injection, or utilization of qualified carbon 
oxide. Any election to allow all or a portion of the credit to be 
claimed by another party must be made separately pursuant to paragraph 
(h)(3) of this section.
    (3) Election to allow the section 45Q credit to another taxpayer. 
The taxpayer described in paragraph (h)(1) of this section as the person 
to whom the section 45Q credit is attributable (electing taxpayer) may 
elect to allow the person that enters into a contract with the electing 
taxpayer to dispose of the qualified carbon oxide (disposer), utilize 
the qualified carbon oxide (utilizer), or use the qualified carbon oxide 
as a tertiary injectant (injector) to claim the credit (credit claimant) 
(section 45Q(f)(3)(B) election). However, the electing taxpayer may not 
elect or otherwise allow the section 45Q credit to a contractor or 
subcontractor that physically captures carbon oxide on behalf of the 
taxpayer. For purposes of this paragraph (h)(3), the disposer or 
injector that is eligible to be a credit claimant is the party that 
obtains the permit to dispose of the qualified carbon oxide in secure 
geological storage. In the case of an injector that is itself a joint 
venture (not a federal tax partnership), only those taxpayers that hold 
a working interest in the joint venture may be credit claimants. A 
credit claimant may not allow the section 45Q credit to a subcontractor 
that performs the disposal, utilization, or injection for the credit 
claimant. The electing taxpayer may not claim any section 45Q credits 
that are allowable to a credit claimant. An electing taxpayer may elect 
to allow a credit claimant to claim the full amount or a partial amount 
of section 45Q credits arising during the taxable year. An electing 
taxpayer may elect to allow a single credit claimant or multiple credit 
claimants to claim section 45Q credits in the same taxable year. If an 
electing taxpayer elects to allow multiple credit claimants to claim 
section 45Q credits, the maximum amount of section 45Q credits allowable 
to each credit claimant is proportional to the amount of qualified 
carbon oxide disposed of, utilized, or used as a tertiary injectant by 
the credit claimant. A credit claimant may receive allowances of section 
45Q credits from multiple electing taxpayers in the same taxable year. 
In the case of an electing taxpayer with multiple qualified facilities, 
the electing taxpayer must make a separate election for each qualified 
facility.
    (i) Example. Electing Taxpayer, E, captures 1,000,000 metric tons of 
qualified carbon oxide with carbon capture equipment that was placed in 
service in 2020. In 2021, E contracts with two companies, A and B, for 
the disposal of the qualified carbon oxide. E is eligible for a section 
45Q credit at a rate of $22.68 per metric ton, for a total section 45Q 
credit of $22,680,000. E contractually ensures that A will dispose of 
300,000 metric tons of qualified carbon oxide and that B will dispose of 
700,000 metric tons of qualified carbon oxide. E may make a section 
45Q(f)(3)(B) election to allow up to $6,804,000 of section 45Q credit to 
A and up to $15,876,000 of section 45Q credit to B, equal to the value 
of the number of metric tons each

[[Page 317]]

party has contracted to ensure disposal, multiplied by the credit value 
of the metric tons disposed of.
    (ii) Time and manner of making election. The electing taxpayer makes 
a section 45Q(f)(3)(B) election by filing a statement of election 
containing the information described in paragraph (h)(3)(iv) of this 
section with the taxpayer's Federal income tax return or Form 1065 for 
each taxable year in which the credit arises. The section 45Q(f)(3)(B) 
election must be made in accordance with Form 8933 no later than the 
time prescribed by law (including extensions) for filing the Federal 
income tax return or Form 1065 for the year in which the credit arises. 
The election may not be filed with an amended Federal income tax return, 
an amended Form 1065, or an AAR, as applicable, after the prescribed 
date (including extensions) for filing the original Federal income tax 
return or Form 1065 for the year, with the exception of amended Federal 
income tax returns, amended Forms 1065, or AARs, as applicable, for any 
taxable year ending after February 9, 2018, and beginning on or before 
January 13, 2021. The amended Federal income tax return or the amended 
Form 1065 must be filed, in any event, not later than the applicable 
period of limitations on assessment for the taxable year for which the 
amended Federal income tax return or Form 1065 is being filed. A BBA 
partnership may make a late election by filing an AAR on or before 
October 15, 2021, but in any event, not later than the period of 
limitations on filing an AAR under section 6227(c).
    (iii) Annual election. A section 45(Q)(f)(3)(B) election is only 
effective for the taxable year for which it is made. A new section 
45Q(f)(3)(B) election must be made for each taxable year for which an 
electing taxpayer wishes to allow section 45Q credits to a credit 
claimant.
    (iv) Required information. For the section 45Q(f)(3)(B) election to 
be valid under paragraph (h)(3)(ii) of this section, the election 
statement of the electing taxpayer must be made on Form 8933 and must 
indicate that an election is being made under section 45Q(f)(3)(B). The 
electing taxpayer must provide each credit claimant with a copy of the 
electing taxpayer's Form 8933. The electing taxpayer must, in addition 
to any information required on Form 8933 set forth the following 
information--
    (A) The electing taxpayer's name, address, taxpayer identification 
number, location, and e-GGRT ID number(s) (if available) of each 
qualified facility where qualified carbon oxide was captured;
    (B) The full amount of credit attributable to the taxpayer prior to 
the election and the corresponding metric tons of qualified carbon 
oxide;
    (C) The name, address, and taxpayer identification number of each 
credit claimant, and the name and location and e-GGRT ID number(s) (if 
available) of:
    (i) Each secure geological storage site where the qualified carbon 
oxide is disposed of or injected, or
    (ii) Each site where the qualified carbon oxide is utilized;
    (D) The dollar amount of section 45Q credits the taxpayer is 
allowing each credit claimant to claim and the corresponding metric tons 
of qualified carbon oxide; and
    (E) The dollar amount of section 45Q credits retained by the 
electing taxpayer and the corresponding metric tons of qualified carbon 
oxide.
    (v) Requirements for section 45Q credit claimant. For a section 
45Q(f)(3)(B) election to be valid, the section 45Q credit claimant must 
include the following information on Form 8933--
    (A) The name, address, taxpayer identification number of the credit 
claimant;
    (B) The name, address, and taxpayer identification number of each 
taxpayer making an election under section 45Q(f)(3)(B) to allow the 
credit to the credit claimant;
    (C) The name and location and e-GGRT ID number(s) (if available) of 
each qualified facility where qualified carbon oxide was captured;
    (D) The name and location and e-GGRT ID number(s) (if available) of:
    (i) Each secure geological storage site where the qualified carbon 
oxide is disposed of or injected, or
    (ii) Each site where the qualified carbon oxide is utilized.

[[Page 318]]

    (E) The full dollar amount of section 45Q credits attributable to 
each electing taxpayer prior to the election and the corresponding 
metric tons of qualified carbon oxide;
    (F) The dollar amount of section 45Q credits that each electing 
taxpayer is allowing the credit claimant to claim and the corresponding 
metric tons of qualified carbon oxide; and
    (G) A copy of the electing taxpayer's Form 8933. The credit claimant 
must include this Form 8933 with its timely filed Federal income tax 
return or Form 1065 (including extensions). The election may not be 
filed with an amended Federal income tax return, an amended Form 1065, 
or an AAR, as applicable, after the prescribed date (including 
extensions) for filing the original Federal income tax return or Form 
1065 for the year, with the exception of amended Federal income tax 
returns, amended Forms 1065, or AARs, as applicable, for any taxable 
year ending after February 9, 2018, and beginning on or before January 
13, 2021. The amended Federal income tax return or the amended Form 1065 
must be filed, in any event, not later than the applicable period of 
limitations on filing an amended Federal income tax return or Form 1065. 
In the case of a BBA partnership, the BBA partnership may make a late 
election by filing an AAR on or before October 15, 2021, but in any 
event, not later than the period of limitations on filing an AAR under 
section 6227(c).
    (vi) Failure to satisfy reporting requirements. With respect to any 
section 45Q(f)(3)(B) election, the failure of an electing taxpayer or a 
credit claimant to satisfy the requirements in paragraph (h)(3)(iv) or 
(v) in a taxable year will result in the inability to claim the credit 
with respect to any qualified carbon oxide that is disposed of, 
injected, or utilized in that taxable year pursuant to that particular 
election.
    (i) Applicability date. This section applies to taxable years 
beginning on or after January 13, 2021. Taxpayers may choose to apply 
this section for taxable years beginning on or after January 1, 2018, 
provided the taxpayer applies this section and Sec. Sec.  1.45Q-2, 
1.45Q-3, 1.45Q-4, and 1.45Q-5 in their entirety and in a consistent 
manner.

[T.D. 9944, 86 FR 4760, Jan. 15, 2021]



Sec.  1.45Q-2  Definitions for Purposes of Sec. Sec.  1.45Q-1 through 1.45Q-5.

    (a) Qualified carbon oxide. The term qualified carbon oxide means--
    (1) Any carbon dioxide which--
    (i) Is captured from an industrial source by carbon capture 
equipment which is originally placed in service before February 9, 2018,
    (ii) Would otherwise be released into the atmosphere as industrial 
emission of greenhouse gas or lead to such release, and
    (iii) Is measured at the source of capture and verified at the point 
of disposal, injection, or utilization; or
    (2) Any carbon dioxide or other carbon oxide which--
    (i) Is captured from an industrial source by carbon capture 
equipment which is originally placed in service on or after February 9, 
2018,
    (ii) Would otherwise be released into the atmosphere as industrial 
emission of greenhouse gas or lead to such release, and
    (iii) Is measured at the source of capture and verified at the point 
of disposal, injection, or utilization; or
    (3) In the case of a direct air capture facility, any carbon dioxide 
that is captured directly from the ambient air and is measured at the 
source of capture and verified at the point of disposal, injection, or 
utilization.
    (b) Recycled carbon oxide. The term qualified carbon oxide includes 
the initial deposit of captured carbon oxide used as a tertiary 
injectant. Qualified carbon oxide does not include carbon oxide that is 
recaptured, recycled, and re-injected as part of the enhanced oil or 
natural gas recovery process.
    (c) Carbon capture equipment. In general, carbon capture equipment 
includes all components of property that are used to capture or process 
carbon oxide until the carbon oxide is transported for disposal, 
injection, or utilization. Except as described in paragraph (c)(2) of 
this section, carbon capture equipment generally does not include 
components of property used for transporting qualified carbon oxide for 
disposal, injection, or utilization. Carbon

[[Page 319]]

capture equipment that is originally placed in service at a qualified 
facility on or after February 9, 2018, may be owned by a taxpayer other 
than the taxpayer that owns the industrial facility at which the carbon 
capture equipment is placed in service.
    (1) Use of carbon capture equipment. Carbon capture equipment is 
equipment used for the purpose of--
    (i) Separating, purifying, drying, and/or capturing carbon oxide 
that would otherwise be released into the atmosphere from an industrial 
facility;
    (ii) Removing carbon oxide from the atmosphere via direct air 
capture; or
    (iii) Compressing or otherwise increasing the pressure of carbon 
oxide.
    (2) Carbon capture equipment components. Carbon capture equipment 
generally includes components of property necessary to compress, treat, 
process, liquefy, pump or perform some other physical action to capture 
qualified carbon oxide. For purposes of this paragraph (c), carbon 
capture equipment includes a system of gathering and distribution lines 
that collect carbon oxide captured from a qualified facility or multiple 
qualified facilities that constitute a single project (as described in 
section 8.01 of Notice 2020-12, 2020-11 I.R.B. 495 (see Sec.  
601.601(d)(1) and (2)(ii) of this chapter)) for the purpose of 
transporting that carbon oxide away from the qualified facility or 
single project to a pipeline used to transport carbon oxide to or from 
one or more taxpayers and projects.
    (3) Single process train. All components that make up an 
independently functioning process train capable of capturing, 
processing, and preparing carbon oxide for transport will be treated as 
a single unit of carbon capture equipment.
    (d) Industrial facility. An industrial facility is a facility, 
including an electricity generating facility, that produces a carbon 
oxide stream from a fuel combustion source or fuel cell, a manufacturing 
process, or a fugitive carbon oxide emission source that, absent capture 
and disposal, injection, or utilization, would otherwise be released 
into the atmosphere as industrial emission of greenhouse gas or lead to 
such release.
    (1) Exclusion. An industrial facility does not include a facility 
that produces carbon dioxide from carbon dioxide production wells at 
natural carbon dioxide-bearing formations or a naturally occurring 
subsurface spring. For purposes of section 45Q, a carbon dioxide 
production well at natural carbon dioxide-bearing formations or a 
naturally occurring subsurface spring means a well that contains 90 
percent or greater carbon dioxide by volume (90 percent test).
    (2) Exception for wells at natural carbon dioxide-bearing formations 
or a naturally occurring subsurface spring that contain a product other 
than carbon dioxide. A well meeting the 90 percent test will not be 
treated as a carbon dioxide production well at natural carbon dioxide-
bearing formations or a naturally occurring subsurface spring if:
    (i) The deposit contains a product, other than carbon oxide, that is 
commercially viable to extract and sell without taking into account the 
availability of a commercial market for the carbon oxide that is 
extracted or any section 45Q tax credit that might be available;
    (ii) The taxpayer provides an attestation to paragraph (d)(2)(i) of 
this section from an independent registered engineer with experience in 
feasibility studies for extraction of gases from the subsurface;
    (iii) A direct air capture facility (defined in section 
45Q(e)(1)(A)) is not used to capture carbon oxide from the gas stream; 
and
    (iv) Any carbon oxide extracted from the deposit is used as tertiary 
injectant in an enhanced oil or natural gas recovery project or as 
feedstock of a utilization project.
    (2) Industrial source. An industrial source is an emission of carbon 
oxide from an industrial facility.
    (3) Manufacturing process. A manufacturing process is a process 
involving the manufacture of one or more products, other than carbon 
oxide, that are intended to be sold at a profit, or are used for a 
commercial purpose (other than producing carbon oxide). All facts and 
circumstances with respect to the process and products are to be taken 
into account.

[[Page 320]]

    (4) Examples. The following examples illustrate the rules of 
paragraph (d) of this section:
    (i) Example 1. A natural underground reservoir contains a gas that 
is comprised of 50 percent carbon dioxide and 50 percent methane by 
volume. The raw gas is not usable without the application of a 
separation process to create two gases that are primarily carbon dioxide 
and methane. Taxpayer B constructs processing equipment that separates 
the raw gas into carbon oxide and methane. The carbon dioxide is sold to 
a third party for use in a qualified enhanced oil recovery project. Some 
of the methane is used as fuel to power the processing equipment. The 
remainder of the methane is injected into the reservoir. The injection 
will increase the ultimate recovery of carbon dioxide. The injected 
methane can be produced later from the reservoir. At the end of the 
taxable year Taxpayer B has not secured a contract to sell methane and 
does not have any plans to use the methane for a commercial purpose 
other than producing carbon oxide. Because carbon dioxide is the only 
product manufactured that is intended to be sold at a profit or used for 
a commercial purpose, the separation process applied to the gases is not 
a manufacturing process within the meaning of paragraph (d)(3) of this 
section. The carbon dioxide captured by the process is not qualified 
carbon oxide.
    (ii) Example 2. (A) A natural underground reservoir contains a gas 
that is comprised of 95 percent carbon dioxide and 5 percent helium by 
volume. The raw gas is not usable without the application of a 
separation process to create two gases that are primarily carbon dioxide 
and helium. Taxpayer C determines that the extraction of helium is 
economically viable even if there were no commercial market for carbon 
dioxide or any section 45Q credit. An independent registered engineer 
attests to Taxpayer C's determination. Taxpayer C constructs processing 
equipment that separates the raw gas into carbon dioxide and helium. The 
helium is sold to various customers for use in commercial and industrial 
applications. The carbon dioxide is sold to a third party for use in a 
qualified enhanced oil recovery project. Any carbon dioxide which the 
third party cannot accept is returned to the reservoir or vented in 
accordance with applicable permits.
    (B) Because the extraction of helium is economically viable even if 
there were no commercial market for carbon dioxide or any section 45Q 
credit, the reservoir will not be considered a natural carbon dioxide-
bearing formation or a naturally occurring subsurface spring within the 
meaning of paragraph (d)(1) and the separation process applied to the 
gases is a manufacturing process within the meaning of paragraph (d)(3). 
Taxpayer C may claim the section 45Q credit with respect to the carbon 
dioxide sold to the third party and which the third party uses in ad oil 
recovery project during the taxable year. Taxpayer C may not claim the 
section 45Q credit with respect to the carbon dioxide that is returned 
to the reservoir or vented.
    (e) Electricity generating facility. An electricity generating 
facility is a facility described in section 45Q(d)(2)(A) or (B) of the 
Internal Revenue Code (Code) that is subject to depreciation under MACRS 
Asset Class 49.11 (Electric Utility Hydraulic Production Plant), 49.12 
(Electric Utility Nuclear Production Plant), 49.13 (Electric Utility 
Steam Production Plant), or 49.15 (Electric Utility Combustion Turbine 
Production Plant).
    (f) Direct air capture facility. A direct air capture facility means 
any facility that uses carbon capture equipment to capture carbon oxide 
directly from the ambient air. It does not include any facility that 
captures carbon dioxide (1) that is deliberately released from naturally 
occurring subsurface springs or (2) using natural photosynthesis.
    (g) Qualified facility. A qualified facility means any industrial 
facility or direct air capture facility, the construction of which 
begins before January 1, 2026, and either at which construction of 
carbon capture equipment begins before that date, or the original 
planning and design for which includes installation of carbon capture 
equipment, and at which carbon capture equipment is placed in service 
that captures the requisite annual thresholds of carbon oxide described 
in paragraph (g)(1) of

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this section. See Notice 2020-12 (see Sec.  601.601(d)(1) and (2)(ii) of 
this chapter), for guidance on the determination of when construction 
has begun on a qualified facility or on carbon capture equipment. For 
purposes of whether a facility satisfies the requisite annual carbon 
oxide capture thresholds described in paragraph (g)(1) of this section, 
a taxpayer may apply the rules of section 8.01 of Notice 2020-12 (see 
Sec.  601.601(d)(1) and (2)(ii) of this chapter) to treat multiple 
facilities as a single facility.
    (1) Emissions and capture requirements. The carbon capture equipment 
placed in service at the qualified facility must capture--
    (i) In the case of a facility, other than a direct air capture 
facility, which emits not more than 500,000 metric tons of carbon oxide 
i the atmosphere during the taxable year, at least 25,000 metric tons of 
qualified carbon oxide during the taxable year which is utilized in a 
manner consistent with section 45Q(f)(5) and Sec.  1.45Q-4 (section 
45Q(d)(2)(A) facility);
    (ii) In the case of an electricity generating facility which is not 
a section 45Q(d)(2)(A) facility (section 45Q(d)(2)(B) facility), not 
less than 500,000 metric tons of qualified carbon oxide during the 
taxable year; and
    (iii) In the case of a direct air capture facility or other facility 
that is not a section 45Q(d)(2)(A) facility or a section 45Q(d)(2)(B) 
facility, at least 100,000 metric tons of qualified carbon oxide during 
the taxable year.
    (2) Examples. The following examples illustrate the rules of 
paragraph (g) of this section:
    (i) Example 1. During the taxable year, an ethanol plant emits 
200,000 metric tons of carbon dioxide. Carbon capture equipment located 
at the facility captures 35,000 metric tons of carbon dioxide, all of 
which are utilized in a manner consistent with section 45Q(f)(5) and 
Sec.  1.45Q-4. The ethanol plant is a qualified facility under section 
45Q(d)(2)(C) and Sec.  1.45Q-2(g)(1)(i) during the taxable year because 
it met the requirement to capture at least 25,000 metric tons of 
qualified carbon oxide during the taxable year which were utilized in a 
manner consistent with section 45Q(f)(5) and Sec.  1.45Q-4.
    (ii) Example 2. During the taxable year, an electricity generating 
facility emits 600,000 metric tons of carbon dioxide. Carbon capture 
equipment located at the facility captures a total of 450,000 metric 
tons of carbon dioxide. 50,000 metric tons of the captured carbon 
dioxide are utilized in a manner consistent with section 45Q(f)(5) and 
Sec.  1.45Q-4, and 400,000 metric tons of the carbon dioxide are 
disposed of in secure geological storage. The electricity generating 
facility is not a qualified facility under section 45Q(d)(2)(B) during 
the taxable year because it did not capture at least 500,000 metric tons 
of qualified carbon oxide during the taxable year. Further, because the 
electricity generating facility emitted greater than 500,000 metric tons 
of carbon dioxide during the taxable year, but only captured 450,000 
metric tons, it is not a qualified facility under section 45Q(d)(2)(A) 
and Sec.  1.45Q-2(g)(1)(ii).
    (iii) Example 3. During the taxable year, a cement manufacturing 
plant emits 110,000 metric tons of carbon dioxide. Carbon capture 
equipment located at the plant captures 100,000 metric tons of carbon 
dioxide. 10,000 metric tons of the amount captured are utilized in a 
manner consistent with section 45Q(f)(5) and Sec.  1.45Q-4, and 90,000 
metric tons of carbon dioxide, are disposed of in secure geological 
storage. The cement manufacturing plant is a qualified facility during 
the taxable year because the carbon capture equipment located at the 
plant met the requirement under section 45Q(d)(2)(C) and Sec.  1.45Q-
2(g)(1)(i) to capture at least 100,000 metric tons of qualified carbon 
oxide during the taxable year.
    (iv) Example 4. Taxpayer X owns and operates three natural gas 
processing facilities (A, B, and C) that separate carbon dioxide from 
natural gas. A, B, and C are all located within several miles of each 
other. X installed carbon capture equipment by A, B, and C. Carbon 
dioxide captured by A, B, and C is collected via a single system of 
gathering and distribution lines for delivery to a transportation 
pipeline. X contracts with third-party Z for the use of carbon dioxide 
captured by A, B, and C as a tertiary injectant pursuant to a single 
contract. During the taxable year, equipment at A captures 30,000

[[Page 322]]

metric tons of carbon dioxide, equipment at B captures 40,000 metric 
tons of carbon dioxide, and equipment at C captures 50,000 tons of 
carbon dioxide. All other factors listed in the single project rule in 
section 8.01 of Notice 2020-12 support the conclusion that A, B and C 
are a single facility. X may treat A, B, and C as a single facility 
under the rules of section 8.01 of Notice 2020-12 for purposes of 
determining whether the requirement under section 45Q(d)(2)(C) and Sec.  
1.45Q-2(g)(1)(i), to capture at least 100,000 metric tons of qualified 
carbon oxide during the taxable year is satisfied. If X treats A, B, and 
C as a single facility, the minimum capture requirement will be 
satisfied for the taxable year.
    (3) Annualization of first-year and last-year qualified carbon oxide 
emission and/or capture amounts--(i) In general. For both the taxable 
year in which carbon capture equipment is placed in service at a 
qualified facility and the taxable year in which the 12-year period 
described in sections 45Q(a)(3)(A) and (4)(A) and Sec.  1.45Q-1(c)(1) 
and (2) ends, annualization of the amount of qualified carbon oxide 
emitted and captured (or captured directly from the ambient air in the 
case of a direct air capture facility) is permitted to determine if the 
threshold requirements under paragraph (g)(1) of this section are 
satisfied. Such annualization may result in a facility being deemed to 
satisfy the threshold requirements under paragraph (g)(1) of this 
section for the year and may permit a taxpayer to claim section 45Q 
credits even though the amount of qualified carbon oxide emitted or 
captured in the first year or last year of the 12-year period is less 
than the threshold requirements under paragraph (g)(1) of this section.
    (ii) Calculation. Annualization is only available for the taxable 
year in which the carbon capture equipment is placed in service at the 
qualified facility and the taxable year in which the 12-year period 
described in sections 45Q(a)(3)(A) and (4)(A) and Sec.  1.45Q-1(c)(1) 
and (2) ends. Annualized amounts must be calculated by--
    (A) Determining the amount of qualified carbon oxide emitted and 
captured (or captured directly from the ambient air in the case of a 
direct air capture facility) during the taxable year in which the carbon 
capture equipment was placed in service at the qualified facility or the 
taxable year in which the 12-year period described in sections 
45Q(a)(3)(A) and (4)(A) and Sec.  1.45Q-1(c)(1) and (2) ends,
    (B) Dividing the amount of qualified carbon determined under 
paragraph (g)(3)(ii)(A) of this section by the number of days in the 
period either (I) beginning with the date on which the carbon capture 
equipment was placed in service at the qualified facility and ending 
with the last day of the taxable year containing that date, or (II) 
beginning with the first day of the taxable year in which the 12-year 
period described in sections 45Q(a)(3)(A) and (4)(A) and Sec.  1.45Q-
1(c)(1) and (2) ends and ending with the last day of that 12-year 
period; and
    (C) Multiplying by 365.
    (iii) Consequences. If the annualized amounts of qualified carbon 
oxide emitted and captured (or captured directly from the ambient air in 
the case of a direct air capture facility) as calculated under this 
formula meet the threshold requirements under paragraph (g)(1) of this 
section, the threshold requirements under paragraph (g)(1) of this 
section are deemed satisfied for the taxable year in which the carbon 
capture equipment was placed in service at the qualified facility or the 
taxable year in which the 12-year period described in sections 
45Q(a)(3)(A) and (4)(A) and Sec.  1.45Q-1(c)(1) and (2) ends. The 
taxpayer may be eligible for a section 45Q credit for that taxable year 
but must calculate the credit based on actual amounts of qualified 
carbon oxide captured and disposed of, injected, or utilized during the 
taxable year.
    (4) Election for applicable facilities. In the case of an applicable 
facility, for any taxable year during which such facility captures not 
less than 500,000 metric tons of qualified carbon oxide, the taxpayer 
described in section 45Q(f)(3)(A)(ii) and Sec.  1.45Q-1(h)(1)(ii) (that 
is, the person that owns the carbon capture equipment and physically or 
contractually ensures the capture and disposal, injection or utilization 
of such qualified carbon oxide), may elect to have such facility, and 
any carbon

[[Page 323]]

capture equipment placed in service at such facility, deemed as having 
been placed in service on February 9, 2018 (section 45Q(f)(6) election). 
For purposes of whether a facility satisfies the 500,000 metric ton 
qualified carbon oxide capture threshold, a taxpayer may apply the rules 
of section 8.01 of Notice 2020-12 to treat multiple facilities as a 
single facility.
    (i) Applicable facility. An applicable facility means a qualified 
facility described in section 45Q(f)(6)(B) and Sec.  1.45Q-2(g) that was 
placed in service before February 9, 2018, for which no taxpayer claimed 
a section 45Q credit for qualified carbon oxide captured at the facility 
for any taxable year ending before February 9, 2018.
    (ii) Time and manner of making election. The taxpayer described 
Sec.  1.45Q-1(h)(1) makes a section 45Q(f)(6) election by filing a 
statement of election with the taxpayer's income tax return for each 
taxable year in which the credit arises. The section 45Q(f)(6) election 
must be made in accordance with Form 8933 filed with the taxpayer's 
Federal income tax return for each taxable year in which the taxpayer 
makes the section 45Q(f)(6) election. The statement of election must, in 
addition to any information required on Form 8933, set forth the 
electing taxpayer's name, address, taxpayer identification number, 
location, and e-GGRT ID number(s) (if available) of the applicable 
facility.
    (iii) Retroactive credit revocations. A taxpayer may not file an 
amended Federal income tax return, an amended Form 1065, or an AAR, as 
applicable, for any taxable year ending before February 9, 2018, to 
revoke a prior claim of section 45Q credits.
    (5) Retrofitted qualified facility or carbon capture equipment (80/
20 Rule). A qualified facility or carbon capture equipment may qualify 
as originally placed in service even if it contains some used components 
of property, provided the fair market value of the used components of 
property is not more than 20 percent of the qualified facility or carbon 
capture equipment's total value (that is, the cost of the new components 
of property plus the value of the used components of property) (80/20 
Rule). In determining the value of the used components of property as 
compared to the new components, the general principles of Revenue Ruling 
94-31 (see Sec.  601.601(d)(2)(i)(a) and (ii) of this chapter), will 
apply. The relevant unit of retrofitted carbon capture equipment for 
purposes of the 80/20 Rule is an independently functioning process 
train. For purposes of the 80/20 Rule, the cost of a new qualified 
facility or carbon capture equipment includes all properly capitalized 
costs of the new qualified facility or carbon capture equipment. Solely 
for purposes of the 80/20 Rule, properly capitalized costs of a new 
qualified facility or carbon capture equipment may, at the option of the 
taxpayer, include the cost of new equipment for a pipeline (the cost of 
equipment for a new pipeline, not equipment used to repair an existing 
pipeline) owned and used exclusively by that taxpayer to transport 
carbon oxides captured by that taxpayer's qualified facility or carbon 
capture equipment that would otherwise be emitted into the atmosphere.
    (h) Qualified enhanced oil or natural gas recovery project. The term 
qualified enhanced oil or natural gas recovery project has the same 
meaning as a qualified enhanced oil recovery project under section 
43(c)(2) of the Code and Sec.  1.43-2, by substituting crude oil or 
natural gas for crude oil in section 43(c)(2)(A)(i) and Sec. Sec.  1.43-
2 and 1.43-3.
    (1) Application of Sec. Sec.  1.43-2 and 1.43-3. For purposes of 
applying Sec. Sec.  1.43-2 and 1.43-3 with respect to a qualified 
enhanced oil or natural gas recovery project, the term enhanced oil or 
natural gas recovery is substituted for enhanced oil recovery, and the 
term oil or natural gas is substituted for oil.
    (2) Required certification. The qualified enhanced oil or natural 
gas recovery project must be certified under Sec.  1.43-3, even if no 
credit related to enhanced oil or natural gas recovery is claimed for 
the taxable year. For purposes of a natural gas project--
    (i) The petroleum engineer's certification under Sec.  1.43-3(a)(3) 
and the operator's continued certification of a project under Sec.  
1.43-3(b)(3) must include an additional statement that the certification 
is for purposes of the section 45Q carbon oxide sequestration tax 
credit;

[[Page 324]]

    (ii) The petroleum engineer's certification must be attached to a 
Form 8933 and filed not later than the last date prescribed by law 
(including extensions) for filing the operator's or designated owner's 
Federal income tax return or Form 1065 for the first taxable year in 
which qualified carbon oxide is injected into the reservoir; and
    (iii) The operator's continued certification of a project must be 
attached to a Form 8933 and filed not later than the last date 
prescribed by law (including extensions) for filing the operator's or 
designated owner's Federal income tax return or Form 1065 for taxable 
years after the taxable year for which the petroleum engineer's 
certification is filed but not after the taxable year in which injection 
activity ceases and all injection wells are plugged and abandoned.
    (3) Natural gas. Natural gas has the same meaning as under section 
613A(e)(2) of the Code.
    (4) Timely filing of petroleum engineer's certification. For 
purposes of this paragraph (h), if a section 45Q credit is claimed on an 
amended Federal income tax return, an amended Form 1065, or an AAR, as 
applicable, the petroleum engineer's certification for a natural gas 
project will be treated as filed timely if it is attached to a Form 8933 
that is submitted with such amended Federal income tax return, amended 
Form 1065, or AAR. With respect to a section 45Q credit that is claimed 
on a timely filed Federal income tax return or Form 1065 for a taxable 
year ending after December 31, 2017, and beginning on or before January 
13, 2021, for which the petroleum engineer's certification for a natural 
gas project was not submitted, the petroleum engineer's certification 
for a natural gas project will be treated as filed timely if it is 
attached to an amended Form 8933 for such taxable year.
    (5) Carbon oxide injected in oil reservoir. Carbon oxide that is 
injected into an oil reservoir that is not a qualified enhanced oil 
recovery project under section 43(c)(2) due to circumstances such as the 
first injection of a tertiary injectant occurring before 1991, or 
because a petroleum engineer's certification was not timely filed, 
cannot be treated as qualified carbon oxide, disposed of in secure 
geological storage, or utilized in a manner described in section 
45Q(f)(5). This rule will not apply to an oil reservoir if--
    (i) The reservoir has permanently ceased oil production;
    (ii) The operator has obtained an Underground Injection Control 
Class VI permit; and
    (iii) The operator complies with 40 CFR part 98 subpart RR.
    (6) Tertiary Injectant. For purposes of section 45Q, a tertiary 
injectant is qualified carbon oxide that is injected into and stored in 
a qualified enhanced oil or natural gas recovery project and contributes 
to the extraction of crude oil or natural gas. The term tertiary 
injectant has the same meaning as used in section 193(b)(1) of the Code.
    (i) Section 45Q credit. The term section 45Q credit means the carbon 
oxide sequestration credit determined under section 45Q of the Internal 
Revenue Code and Sec.  1.45Q-1.
    (j) Form 8933. The term Form 8933 means Form 8933, Carbon Oxide 
Sequestration Credit, any successor form(s), pursuant to instructions to 
any of the foregoing (see Sec.  601.602 of this chapter), or other 
guidance. This definition of Form 8933 applies to this section and to 
Sec. Sec.  1.45Q-1, 1.45Q-3, 1.45Q-4, and 1.45Q-5.
    (k) Applicability date. This section applies to taxable years 
beginning on or after January 13, 2021. Taxpayers may choose to apply 
this section for taxable years beginning on or after January 1, 2018, 
provided the taxpayer applies this section and Sec. Sec.  1.45Q-1, 
1.45Q-3, 1.45Q-4, and 1.45Q-5 in their entirety and in a consistent 
manner.

[T.D. 9944, 86 FR 4760, Jan. 15, 2021]



Sec.  1.45Q-3  Secure Geological Storage.

    (a) In general. To qualify for the section 45Q credit, a taxpayer 
must either physically or contractually dispose of captured qualified 
carbon oxide in secure geological storage in the manner provided in 
paragraph (b) of this section, or utilize qualified carbon oxide in a 
manner conforming with section 45Q(f)(5) of the Internal Revenue Code 
and Sec.  1.45Q-4. Secure geological storage includes, but is not 
limited to, storage at deep saline formations, oil and gas reservoirs, 
and unminable coal seams.
    (b) Requirements for secure geological storage. For purposes of the 
section 45Q

[[Page 325]]

credit, qualified carbon oxide is considered disposed of by the taxpayer 
in secure geological storage such that the qualified carbon oxide does 
not escape into the atmosphere if the qualified carbon oxide is--
    (1) Injected into a well that
    (i) Complies with applicable Underground Injection Control or other 
regulations, located onshore or offshore under submerged lands within 
the territorial jurisdiction of States or federal waters, and
    (ii) Is not used as a tertiary injectant in a qualified enhanced oil 
or natural gas recovery project, in compliance with applicable 
requirements under 40 CFR part 98 subpart RR; or
    (2) Injected into a well that
    (i) Complies with applicable Underground Injection Control or other 
regulations, is located onshore or offshore under submerged lands within 
the territorial jurisdiction of States or federal waters, and
    (ii) Is used as a tertiary injectant in a qualified enhanced oil or 
natural gas recovery project and stored in compliance with applicable 
requirements under 40 CFR part 98 subpart RR, or the International 
Organization for Standardization (ISO) standards endorsed by the 
American National Standards Institute (ANSI) under CSA/ANSI ISO 
27916:2019, Carbon dioxide capture, transportation and geological 
storage--Carbon dioxide storage using enhanced oil recovery 
(CO2-EOR) (CSA/ANSI ISO 27916:2019).
    (c) Documentation. Documentation must be filed in accordance with 
Form 8933.
    (d) Certification. For qualified enhanced oil or natural gas 
recovery projects in which the taxpayer reported volumes of carbon oxide 
to the Environmental Protection Agency pursuant to 40 CFR part 98 
subpart RR, the taxpayer may self-certify the volume of qualified carbon 
oxide claimed for purposes of section 45Q. For qualified enhanced oil or 
natural gas recovery projects in which the taxpayer determined volumes 
pursuant to CSA/ANSI ISO 27916:2019, a taxpayer may prepare 
documentation as outlined in CSA/ANSI ISO 27916:2019 internally, but all 
such documentation must be provided to a qualified independent engineer 
or geologist, who then must certify that the documentation provided, 
including the mass balance calculations as well as information regarding 
monitoring and containment assurance, is accurate and complete. The 
qualified independent engineer or geologist certifying a project must be 
duly registered or certified in any State. The certification must 
contain an affidavit from the certifying engineer or geologist stating 
that he or she is independent from the taxpayer (and if a section 
45Q(f)(3)(B) election has been made, the affidavit must state that he or 
she is independent from both the electing taxpayer and the credit 
claimant). Certifications must be made annually and under penalties of 
perjury. For any leaked amount of qualified carbon oxide (as defined in 
Sec.  1.45Q-5(c)) that is determined pursuant to CSA/ANSI ISO 
27916:2019, the certification must also include a statement that the 
quantity was determined in accordance with sound engineering principles. 
Taxpayers that capture qualified carbon oxide giving rise to the section 
45Q credit must file Form 8933 with a timely filed Federal income tax 
return or Form 1065, including extensions or for the purpose of this 
rule, amendments to Federal income tax returns, Forms 1065, or on AARs, 
as applicable. Taxpayers that dispose of, inject, or utilize qualified 
carbon oxide must also file Form 8933 with a timely filed Federal income 
tax return or Form 1065, including extensions or for the purpose of this 
rule, amendments to Federal income tax returns, Forms 1065, or on AARs, 
as applicable. If the volume of carbon oxide certified and reported is a 
negative amount, see Sec.  1.45Q-5 for rules regarding recapture.
    (e) Failure to submit complete documentation or certification. No 
section 45Q credit is allowed for any taxable year for which the 
taxpayer (including credit claimants) has failed to timely submit 
complete documentation and certification that is required by this 
regulation or Form 8933. The credit will be allowed only for a taxable 
year for which complete documentation and certification has been timely 
submitted. Certifications for each taxable year must be submitted by the 
due date of the federal income tax return

[[Page 326]]

or Form 1065 on which the section 45Q credit is claimed, including 
extensions. However, if a section 45Q credit is claimed on an amended 
Federal income tax return, an amended Form 1065, or an AAR, as 
applicable, certifications may also be submitted with such amended 
Federal income tax return, amended Form 1065, or AAR. Further, if a 
section 45Q credit was claimed on a timely filed Federal income tax 
return or Form 1065 for a taxable year ending on or after January 1, 
2018, and beginning on or before January 13, 2021, for which 
certifications were not submitted, such certifications may be submitted 
with a timely filed amended Federal income tax return, an amended Form 
1065, or an AAR, as applicable, for such taxable year.
    (f) Applicability date. This section applies to taxable years 
beginning on or after January 13, 2021. Taxpayers may choose to apply 
this section for taxable years beginning on or after January 1, 2018, 
provided the taxpayer applies this section and Sec. Sec.  1.45Q-1, 
1.45Q-2, 1.45Q-4, and 1.45Q-5 in their entirety and in a consistent 
manner.

[T.D. 9944, 86 FR 4760, Jan. 15, 2021]



Sec.  1.45Q-4  Utilization of Qualified Carbon Oxide.

    (a) In general. For purposes of this section, utilization of 
qualified carbon oxide means--
    (1) The fixation of such qualified carbon oxide through 
photosynthesis or chemosynthesis, such as through the growing of algae 
or bacteria,
    (2) The chemical conversion of such qualified carbon oxide to a 
material or chemical compound in which such qualified carbon oxide is 
securely stored, or
    (3) The use of such qualified carbon oxide for any other purpose for 
which a commercial market exists (with the exception of use as a 
tertiary injectant in a qualified enhanced oil or natural gas recovery 
project), as described in paragraph (d) of this section.
    (b) Amount utilized--(1) In general. For purposes of Sec.  1.45Q-
1(b) (ii) and (c)(2)(ii), the amount of qualified carbon oxide utilized 
by the taxpayer is equal to the metric tons of qualified carbon oxide 
which the taxpayer demonstrates, based upon an analysis of lifecycle 
greenhouse gas emissions (LCA), were--
    (i) Captured and permanently isolated from the atmosphere through 
use of a process described in paragraph (a) of this section, or
    (ii) Displaced from being emitted into the atmosphere through use of 
a process described in paragraph (a) of this section.
    (2) Limitation. The amount determined under paragraph (b)(1) of this 
section cannot exceed the amount of qualified carbon oxide measured at 
the source of capture.
    (c) Lifecycle greenhouse gas emissions and lifecycle analysis 
(LCA)--(1) In general. For purposes of paragraph (b) of this section, 
the term lifecycle greenhouse gas emissions means the aggregate quantity 
of greenhouse gas emissions (including direct emissions and significant 
indirect emissions such as significant emissions from land use changes) 
related to the full product lifecycle, including all stages of product 
and feedstock production and distribution, from feedstock generation or 
extraction through the distribution and delivery and use of the finished 
product to the ultimate consumer, where the mass values for all 
greenhouse gases are adjusted to account for their relative global 
warming potential according to Table A-1 of 40 CFR part 98 subpart A. 
Such emissions are expressed in carbon dioxide equivalent 
(CO2-e).
    (2) LCA verification. The taxpayer verifies the amount of qualified 
carbon oxide utilized through an LCA. The LCA must demonstrate that the 
proposed process results in a net reduction of carbon dioxide 
equivalents when compared to a comparison system. The results of the LCA 
must be documented in a written LCA report.
    (3) Standards of adequate lifecycle analysis. The LCA report must be 
prepared in conformity with and contain documentation that conforms with 
International Organization for Standardization (ISO) 14040:2006, 
Environmental management--Life cycle assessment--Principles and 
framework and ISO 14044:2006, Environmental management--Life cycle 
assessment--Requirements and

[[Page 327]]

guidelines. The LCA may consist of direct and indirect data in 
conformity with ISO 14040:2006 and 14044:2006.
    (4) Third-party independent review of LCA. The LCA report must be 
performed or verified by an independent third party. The LCA report must 
provide a statement documenting the qualifications of the independent 
third party, including proof of appropriate U.S. or foreign professional 
license, an affidavit from the third party stating that it is 
independent from the taxpayer (if a section 45Q(f)(3)(B) election has 
been made, the affidavit must state that the third party is independent 
from both the electing taxpayer and the credit claimant), and the 
statement must be made under penalties of perjury. If an independent 
third-party review is conducted, then it must include an assessment of 
the model and supporting data.
    (5) Submission of the LCA. The taxpayer must submit the LCA report 
and third-party independent statement required by paragraph (c) of this 
section to the IRS and the Department of Energy. The taxpayer must also 
submit the model if the LCA is not verified by an independent third-
party review.
    (6) LCA review. The LCA report will be subject to a technical review 
by the DOE. The IRS will determine whether to approve the LCA and will 
notify the taxpayer. The taxpayer must receive approval of its LCA prior 
to claiming the section 45Q credits for such taxable year on any federal 
income tax return. In addition to receiving approval of its LCA, the 
taxpayer must satisfy all other requirements of section 45Q and 
Sec. Sec.  1.45Q-1, 1.45Q-2, and this section in order to be eligible to 
claim section 45Q credits.
    (d) Commercial market. A commercial market means a market in which a 
product, process, or service that utilizes carbon oxide is sold or 
transacted on commercial terms. A taxpayer must submit a statement 
attached to its Form 8933 substantiating that a commercial market exists 
for its particular product, process, or service.
    (e) Applicability date. This section applies to taxable years 
beginning on or after January 13, 2021. Taxpayers may choose to apply 
this section for taxable years beginning on or after January 1, 2018, 
provided the taxpayer applies this section and Sec. Sec.  1.45Q-1, 
1.45Q-2, 1.45Q-3, and 1.45Q-5 in their entirety and in a consistent 
manner.

[T.D. 9944, 86 FR 4760, Jan. 15, 2021]



Sec.  1.45Q-5  Recapture of Credit.

    (a) Recapture event. A recapture event occurs when qualified carbon 
oxide for which a section 45Q credit has been previously claimed ceases 
to be disposed of in secure geological storage (as described in Sec.  
1.45Q-3(b)), or used as a tertiary injectant during the recapture 
period. Recapture events are determined separately for each project 
involving the disposal or use of qualified carbon oxide as a tertiary 
injectant. A recapture event does not occur if some portion of qualified 
carbon oxide disposed of in the current year does not remain in secure 
storage at the end of the year. The amount of such carbon oxide that is 
securely stored in the current year is determined according to the 
applicable requirements of 40 CFR part 98 subpart RR or CSA/ANSI ISO 
27916:2019.
    (b) Ceases to be disposed of in secure geological storage or used as 
a tertiary injectant. Qualified carbon oxide for which a section 45Q 
credit has been previously claimed ceases to be disposed of in secure 
geological storage (as described in Sec.  1.45Q-3(b)), or used as a 
tertiary injectant, if the leaked amount of qualified carbon oxide in 
the taxable year exceeds the amount of qualified carbon oxide securely 
stored in that same taxable year.
    (c) Leaked amount of qualified carbon oxide. When a taxpayer that 
claimed a section 45Q credit with respect to qualified carbon oxide 
stored at a secure storage site, operator of the secure storage site, or 
regulatory agency with jurisdiction over the site determines that the 
qualified carbon oxide that was disposed of in secure geological storage 
has leaked to the atmosphere, the taxpayer or the party with whom the 
taxpayer contracted to ensure the secure geological storage of the 
qualified carbon oxide must quantify the metric tons of qualified carbon 
oxide that has leaked to the atmosphere pursuant to the requirements of 
40 CFR part 98 subpart RR or CSA/

[[Page 328]]

ANSI ISO 27916:2019. The quantity determined pursuant to CSA/ANSI ISO 
27916:2019 must be certified by a qualified independent engineer or 
geologist, including a statement that the quantity was determined in 
accordance with sound engineering principles in the same manner as 
required in Sec.  1.45Q-3. The IRS will consider all available facts and 
circumstances, and may consult with the relevant regulatory agency with 
jurisdiction over such site, in verifying the amount of qualified carbon 
oxide that has leaked to the atmosphere. The verified amount is the 
leaked amount of qualified carbon oxide.
    (d) Qualified carbon oxide subject to recapture. The quantity of 
recaptured qualified carbon oxide (in metric tons) subject to recapture 
is the amount by which the leaked amount of qualified carbon oxide 
exceeds the amount of qualified carbon oxide securely stored in the 
taxable year. The leaked amount of qualified carbon oxide shall be 
subtracted from the amount of qualified carbon oxide that is securely 
stored in the taxable year. If the leaked amount does not exceed the 
amount of qualified carbon oxide that is securely stored in the taxable 
year, then the taxpayer is entitled to a credit equal to the amount of 
qualified carbon oxide securely stored less the leaked amount in the 
taxable year, multiplied by the appropriate statutory credit rate.
    (e) Recapture amount. The recapture amount is equal to the product 
of the quantity of recaptured qualified carbon oxide (in metric tons) 
subject to recapture and the appropriate statutory credit rate.
    (f) Recapture period. The recapture period begins on the date of 
first injection of qualified carbon oxide for disposal in secure 
geological storage or use as a tertiary injectant for which a section 
45Q credit was claimed. The recapture period ends on the earlier of 
three years after the last taxable year in which the taxpayer claimed a 
section 45Q credit or was eligible to claim a credit that it elected to 
carry forward or the date monitoring ends under the requirements of the 
standards described in Sec.  1.45Q-3(b)(1) or (2).
    (g) Application of recapture--(1) In general. Any recapture amount 
must be taken into account in the taxable year in which it is identified 
and reported. If the leaked amount of qualified carbon oxide does not 
exceed the amount of qualified carbon oxide securely stored in the 
taxable year reported, there is no recapture amount and no further 
adjustments to prior taxable years are needed. If the leaked amount of 
qualified carbon oxide does exceed the amount of qualified carbon oxide 
securely stored in the taxable year reported, then the taxpayer must add 
the recapture amount to the amount of tax due in the taxable year in 
which the recapture event occurs.
    (2) Calculation. Recapture amounts are calculated on a last-in-
first-out basis (LIFO), such that the leaked amount of qualified carbon 
oxide that exceeds the amount of qualified carbon oxide securely stored 
in the current taxable year will be deemed attributable first to the 
prior taxable year, then to taxable year before that, and then up to a 
maximum of the third preceding year.
    (3) Multiple units. In the event of a recapture event in which the 
leaked amount of qualified carbon oxide had been captured from multiple 
units of carbon capture equipment that were not under common ownership, 
the recapture amount must be allocated on a pro rata basis among the 
multiple units of carbon capture equipment. All taxpayers that claimed a 
section 45Q credit with respect to one or more of such units of carbon 
capture equipment are responsible for adding the recapture amount to 
their amount of tax due in the taxable year in which the recapture event 
occurs.
    (4) Multiple taxpayers--(i) In general. In the event of a recapture 
event involving a leaked amount of qualified carbon oxide that is deemed 
attributable to qualified carbon oxide for which multiple taxpayers 
claimed section 45Q credits (for example, if ownership of the carbon 
capture equipment was transferred, or if a taxpayer made an election 
under section 45Q(f)(3)(B) to allow one or more credit claimants to 
claim a portion of the section 45Q credit), the recapture amount must be 
allocated on a pro rata basis among the taxpayers that claimed the 
section 45Q credits.

[[Page 329]]

    (ii) Partnerships--(A) General rule. For purposes of paragraph 
(g)(4)(i) of this section, if a partnership is one of the multiple 
taxpayers that claimed section 45Q credit amounts, the partnership and 
not its partners will be the taxpayer to which the pro rata recapture 
amount must be allocated. The partnership must allocate its pro rata 
recapture amount among its partners under Sec.  1.704-1(b)(4)(ii).
    (B) Terminated partnerships. If a partnership described in paragraph 
(g)(4)(ii)(A) of this section terminates under section 708(b)(1) prior 
to a recapture event, the partners of that terminated partnership at the 
time the section 45Q credit was claimed will be the taxpayers to which 
the pro rata recapture amount must be allocated.
    (5) Reporting. If a recapture event occurs during a project's 
recapture period, any taxpayer that claimed a section 45Q credit for 
that project must report the following information on a Form 8933 filed 
with that taxpayer's Federal income tax return or Form 1065 for the 
taxable year for which the recapture event occurred--
    (A) The recapture amount (as defined in Sec.  1.45Q-5(e));
    (B) The leaked amount of qualified carbon oxide (in metric tons) (as 
defined in Sec.  1.45Q-5(c));
    (C) The statutory credit rate(s) at which the section 45Q credits 
were previously calculated; and
    (D) A statement that describes how the taxpayer became aware of the 
recapture event, how the leaked amount was determined, and the identity 
and involvement of any regulatory agencies.
    (6) Examples. The following examples illustrate the principles of 
this paragraph (g):
    (i) Example 1. (A) A owns direct air capture Facility X. No other 
taxpayer has owned Facility X, and A has never allowed another taxpayer 
to claim any section 45Q credits with respect to qualified carbon oxide 
captured by Facility X. Facility X captured 100,000 metric tons of 
carbon dioxide in each of 2021, 2022, and 2023. All captured carbon 
dioxide was sold to B for use a tertiary injectant in a qualified 
enhanced oil recovery project. B provided contractual assurance that the 
carbon dioxide would be disposed of in secure geological storage. A 
claimed section 45Q credit amounts of $2,268,000 in 2021, $2,515,000 in 
2022, and $2,761,000 in 2023 using the statutory rates in Sec.  1.45Q-
1(d)(3). In 2024, A captured and sold another 100,000 metric tons of 
carbon dioxide to B, which B used as a tertiary injectant in a qualified 
enhanced oil recovery project. In late 2024, B determined that 10,000 
metric tons of qualified carbon dioxide injected during 2021 had leaked 
from the containment area of the reservoir and were released into the 
atmosphere.
    (B) Because the leakage determined in 2024 (10,000 metric tons) did 
not exceed the presumed amount stored in 2024 (100,000 metric tons), a 
recapture event did not occur in 2024. B's actual storage in 2024 is 
90,000 metric tons of qualified carbon oxide. A's section 45Q credit for 
2024 is $2,706,300 (net 90,000 metric tons of qualified carbon oxide 
captured, disposed of in secure geological storage, and used as a 
tertiary injectant multiplied by the statutory credit rate for 2024 of 
$30.07).
    (ii) Example 2. (A) Assume same facts as in Example 1. Additionally, 
in 2025, B determines that 190,000 metric tons of qualified carbon 
dioxide injected in 2021 and 2022 had leaked and were released into the 
atmosphere. No injection of carbon dioxide takes place in 2025.
    (B) Because the leakage determined in 2025 (190,000 metric tons) 
exceeds the amount stored in 2025 (0 metric tons), a recapture event 
occurred in 2025. A's credit for 2025 is $0 because the net amount of 
carbon dioxide captured, disposed of in secure geological storage, and 
used as a tertiary injectant in 2025 was 0 metric tons. The 2025 
recapture amount is calculated by multiplying the 190,000 metric tons of 
recaptured qualified carbon oxide by the appropriate statutory credit 
rate using the LIFO method. The first 90,000 metric tons of recaptured 
qualified carbon oxide is deemed attributable to 2024, and is recaptured 
at the 2024 statutory rate of $30.07 per metric ton. The remaining 
100,000 metric tons of recaptured qualified carbon oxide are deemed 
attributable to 2023. The credits attributable to 2023 are recaptured at 
the 2023 statutory rate of $27.61 per

[[Page 330]]

metric ton. Thus, the total recapture amount is $5,467,300, and is added 
to A's tax due for 2025.
    (iii) Example 3. (A) Assume the same facts as in Example 2, except 
that A sells Facility X to C on January 1, 2024. C sells 100,000 metric 
tons of carbon dioxide captured by Facility X to B for use as a tertiary 
injectant in a qualified enhanced oil recovery project. C claims a 
section 45Q credit in 2024 of $2,706,300 (net 90,000 metric tons of 
qualified carbon oxide captured, disposed of in secure geological 
storage, and used as a tertiary injectant multiplied by the statutory 
credit rate for 2024 of $30.07).
    (B) The total recapture amount in 2025 is the same $5,467,300 as in 
Example 2, but is allocated between A and C. The first 90,000 metric 
tons of recaptured qualified carbon oxide are deemed attributable to 
2024. The credits that are attributable to 2024 are recaptured at the 
2024 statutory rate of $30.07 per ton (for a recapture amount of 
$2,706,300). Because C claimed that amount of section 45Q credit in 
2024, a recapture amount of $2,706,300 is added to C's tax due for 2025. 
The remaining 100,000 metric tons of recaptured qualified carbon oxide 
are deemed attributable to 2023. The credits that are attributable to 
2023 are recaptured at the 2023 statutory rate of $27.61 per ton (for a 
recapture amount of $2,761,000). Because A claimed that amount of 
section 45Q credit in 2023, a recapture amount of $2,761,000 is added to 
A's tax due for 2025.
    (iv) Example 4. (A) Assume the same facts as in Example 2, except 
that in 2023, A made a section 45Q(f)(3)(B) election to allow B to claim 
one-half of the section 45Q credit for 2023. A and B each claimed 
$1,380,500 of section 45Q credit in 2023 (50,000 metric tons each 
multiplied by the 2023 statutory rate of $27.61).
    (B) The total recapture amount in 2025 is the same $5,467,300 as in 
Example 2, but is allocated among A and B. The first 90,000 metric tons 
of recaptured qualified carbon oxide is deemed attributable to 2024. The 
section 45Q credit amounts attributable to 2024 are recaptured at the 
2024 statutory rate of $30.07 per ton (for a recapture amount of 
$2,706,300). Because A claimed that amount of section 45Q credit in 
2024, $2,706,300 is added to A's tax due for 2025. The remaining 100,000 
metric tons of recaptured qualified carbon oxide is deemed attributable 
to 2023. The section 45Q credit amounts attributable to 2023 are 
recaptured at the 2023 statutory rate of $27.61 per ton (for a recapture 
amount of $2,761,000). Because A and B each claimed half of that amount 
($1,380,500) of section 45Q credit in 2023, $1,380,500 is added to both 
A's and B's tax due for 2025. Thus, a recapture amount of $4,086,800 is 
added to A's tax due for 2025, and a recapture amount of $1,380,500 is 
added to B's tax due for 2025.
    (v) Example 5. (A) Assume the same facts as in Example 2, except 
that the 100,000 metric tons of carbon dioxide sold to B in 2021, 2022, 
2023, and 2024 for use as a tertiary injectant in a qualified enhanced 
oil recovery project were captured equally (50,000 metric tons per year) 
from qualified facilities owned by J and K. Neither J nor K made a 
section 45Q(f)(3)(B) election to allow B to claim the credit.
    (B) Because the leakage determined in 2024 (10,000 metric tons) did 
not exceed the presumed amount stored in 2024 (100,000 metric tons) a 
recapture event did not occur in 2024. The total amount of section 45Q 
credit for 2024 is $2,706,300 (net 90,000 metric tons of qualified 
carbon oxide captured, disposed of in secure geological storage, and 
used as a tertiary injectant multiplied by the statutory credit rate for 
2024 of $30.07). J and K may each claim half of this amount of section 
45Q credit ($1,353,150) in 2024.
    (C) The total recapture amount in 2025 is the same $5,467,300 as in 
Example 2, but is allocated between J and K. The section 45Q credit 
amounts relating to the first 90,000 metric tons of recaptured qualified 
carbon oxide are deemed attributable to 2024 and are recaptured at the 
2024 statutory rate of $30.07 per ton (for a recapture amount of 
$2,706,300). Because J and K each claimed half of that amount 
($1,353,150) of section 45Q credit in 2024, $1,353,150 is added to both 
J's and K's tax due for 2025. The section 45Q credit amounts relating to 
the remaining 100,000 metric tons of recaptured qualified carbon oxide 
are deemed attributable to 2023

[[Page 331]]

and are recaptured at the 2023 statutory rate of $27.61 per ton (for a 
recapture amount of $2,761,000). Because J and K each claimed half of 
that amount ($1,380,500) of section 45Q credit in 2023, an additional 
$1,380,500 is added to both J's and Ks tax due for 2025. Thus, a total 
recapture amount of $2,733,650 is added to both J's and K's tax due for 
2025.
    (vi) Example 6. (A) M owns Industrial Facility Z. No other taxpayer 
has ever owned Z, and M has never allowed another taxpayer to claim any 
section 45Q credits with respect to qualified carbon oxide captured from 
Z. M captured 1,000,000 metric tons of carbon dioxide annually in each 
of 2017, 2018, 2019, 2020, 2021, 2022, 2023, 2024, and 2025. All 
captured carbon dioxide was sold to N for use a tertiary injectant in a 
qualified enhanced oil recovery project. N provided contractual 
assurance that the carbon dioxide would be sequestered in secure 
geological storage. M claimed section 45Q credit amounts of $12,830,000 
in 2017, $15,209,000 in 2018, $17,760,000 in 2019, $20,220,000 in 2020, 
$22,680,000 in 2021, $25,150,000 in 2022, $27,610,000 in 2023, 
$30,070,000 in 2024, and $32,540,000 in 2025 using the statutory rates 
in Sec.  1.45Q-1(d)(3). No injection of carbon oxides takes place in 
2026. In 2026, N determined that 6,200,000 metric tons of qualified 
carbon dioxide previously injected had leaked from the containment area 
of the reservoir and were released into the atmosphere.
    (B) Because the leakage determined in 2025 (6,200,000 metric tons) 
exceed the amount stored in 2026 (0 metric tons) a recapture event 
occurred in 2026. A's credit for 2026 is $0 because the net amount of 
carbon dioxide captured and used as a tertiary injectant in 2026 was 0 
metric tons. The 2026 recapture amount is calculated by multiplying the 
6,200,000 metric tons of recaptured qualified carbon oxide by the 
appropriate statutory credit rate using the LIFO method. The first 
1,000,000 metric tons of recaptured qualified carbon oxide is deemed 
attributable to 2025, and is recaptured at the 2025 statutory rate of 
$32.54 per metric ton. The next 1,000,000 metric tons of recaptured 
qualified carbon oxide is deemed attributable to 2024, and is recaptured 
at the 2024 statutory rate of $30.07 per metric ton. The next 1,000,000 
metric tons of recaptured qualified carbon oxide is deemed attributable 
to 2023, and is recaptured at the 2023 statutory rate of $27.16 per 
metric ton. The remaining 3,200,000 metric tons are not subject to 
recapture because of the three-year lookback limit in Sec.  1.45Q-
1(g)(2). Thus, the total recapture amount is $89,770,000, and is added 
to A's tax due for 2026.
    (h) Recapture in the event of deliberate removal from storage--(1) 
In general. If qualified carbon oxide for which a credit has been 
claimed is deliberately removed from a secure geological storage site, 
then a recapture event would occur in the year in which the qualified 
carbon oxide is removed from the storage site pursuant to Sec.  1.45Q-
5(a).
    (2) Recycled qualified carbon oxide. If qualified carbon oxide for 
which a credit has been claimed is recaptured, recycled, and reinjected 
as part of the enhanced oil and natural gas recovery project, that 
qualified carbon oxide will be considered recycled carbon oxide under 
section 45Q(c)(2). If recycled carbon oxide is reinjected into the same 
qualified enhanced oil or natural gas recovery project it was originally 
injected into, it will not be considered deliberately removed from a 
secure geological storage site for purposes of paragraph (h)(1) of this 
section. If recycled carbon oxide is reinjected into a different 
qualified enhanced oil or natural gas recovery project from the one it 
was initially injected into, or used for any other purpose, that 
qualified carbon oxide will be considered deliberately removed from a 
secure geological storage site for purposes of paragraph (h)(1) of this 
section.
    (i) Limited exceptions. A recapture event is not triggered in the 
event of a loss of containment of qualified carbon oxide resulting from 
actions not related to the selection, operation, or maintenance of the 
storage facility, such as volcanic activity or terrorist attack.
    (j) Applicability date. This section applies to taxable years 
beginning on or after January 13, 2021. Taxpayers may choose to apply 
this section for taxable years beginning on or after January 1, 2018, 
provided the taxpayer applies this section and Sec. Sec.  1.45Q-1, 
1.45Q-2, 1.45Q-3,

[[Page 332]]

and 1.45Q-4 in their entirety and in a consistent manner.

[T.D. 9944, 86 FR 4760, Jan. 15, 2021]



Sec.  1.45R-0  Table of contents.

    This section lists the table of contents for Sec. Sec.  1.45R-1 
through 1.45R-5.

                       Sec.  1.45R-1 Definitions.

    (a) Definitions.
    (1) Average premium.
    (2) Composite billing.
    (3) Credit period.
    (4) Eligible small employer.
    (5) Employee.
    (6) Employer-computed composite rate.
    (7) Exchange.
    (8) Family member.
    (9) Full-time equivalent employee (FTE).
    (10) List billing.
    (11) Net premium payments.
    (12) Nonelective contribution.
    (13) Payroll taxes.
    (14) Qualified health plan QHP.
    (15) Qualifying arrangement.
    (16) Seasonal worker.
    (17) SHOP dependent coverage.
    (18) Small Business Health Options Program (SHOP).
    (19) State.
    (20) Tax-exempt eligible small employer.
    (21) Tier.
    (22) Tobacco surcharge.
    (23) United States.
    (24) Wages.
    (25) Wellness program.
    (b) Effective/applicability date.

                Sec.  1.45R-2 Eligibility for the credit.

    (a) Eligible small employer.
    (b) Application of section 414 employer aggregation rules.
    (c) Employees taken into account.
    (d) Determining the hours of service performed by employees.
    (1) In general.
    (2) Permissible methods.
    (3) Examples.
    (e) FTE calculation.
    (1) In general.
    (2) Example.
    (f) Determining the employer's average annual wages.
    (1) In general.
    (2) Example.
    (g) Effective/applicability date.

                  Sec.  1.45R-3 Calculating the credit.

    (a) In general.
    (b) Average premium limitation.
    (1) In general.
    (2) Examples.
    (c) Credit phaseout.
    (1) In general.
    (2) $25,000 dollar amount adjusted for inflation.
    (3) Examples
    (d) State credits and subsidies for health insurance.
    (1) Payments to employer.
    (2) Payments to issuer.
    (3) Credits may not exceed net premium payment.
    (4) Examples.
    (e) Payroll tax limitation for tax-exempt eligible small employers.
    (1) In general.
    (2) Example.
    (f) Two-consecutive-taxable year credit period limitation.
    (g) Premium payments by the employer for a taxable year.
    (1) In general.
    (2) Excluded amounts.
    (h) Rules applicable to trusts, estates, regulated investment 
companies, real estate investment trusts and cooperative organizations.
    (i) Transition rule for 2014.
    (1) In general.
    (2) Example.
    (j) Effective/applicability date.

            Sec.  1.45R-4 Uniform percentage of premium paid.

    (a) In general.
    (b) Employers offering one QHP.
    (1) Employers offering one QHP, self-only coverage, composite 
billing.
    (2) Employers offering one QHP, other tiers of coverage, composite 
billing.
    (3) Employers offering one QHP, self-only coverage, list billing.
    (4) Employers offering one QHP, other tiers of coverage, list 
billing.
    (5) Employers offering SHOP dependent coverage.
    (c) Employers offering more than one QHP.
    (1) QHP-by-QHP method.
    (2) Reference QHP method.
    (d) Tobacco surcharges and wellness program discounts.
    (i) Tobacco surcharges.
    (ii) Wellness programs.
    (e) Special rules regarding employer compliance with applicable 
State and local law.
    (f) Examples.
    (g) Effective/applicability date.

                   Sec.  1.45R-5 Claiming the credit.

    (a) Claiming the credit.
    (b) Estimated tax payments and alternative minimum tax (AMT) 
liability.
    (c) Reduction of section 162 deduction.
    (d) Effective/applicability date.

[T.D. 9672, 79 FR 36646, June 30, 2014]

[[Page 333]]



Sec.  1.45R-1  Definitions.

    (a) Definitions. The definitions in this section apply to this 
section and Sec. Sec.  1.45R-2, 1.45R-3, 1.45R-4, and 1.45R-5.
    (1) Average premium. The term average premium means an average 
premium for the small group market in the rating area in which the 
employee enrolls for coverage. The average premium for the small group 
market in a rating area is determined by the Secretary of Health and 
Human Services.
    (2) Composite billing. The term composite billing means a system of 
billing under which a health insurer charges a uniform premium for each 
of the employer's employees or charges a single aggregate premium for 
the group of covered employees that the employer then divides by the 
number of covered employees to determine the uniform premium.
    (3) Credit period--(i) In general. The term credit period means, 
with respect to any eligible small employer (or any predecessor 
employer), the two-consecutive-taxable-year period beginning with the 
first taxable year beginning after 2013, for which the eligible small 
employer files an income tax return with an attached Form 8941, ``Credit 
for Small Employer Health Insurance Premiums'' (or files a Form 990-T, 
``Exempt Organization Business Income Tax Return,'' with an attached 
Form 8941 in the case of a tax-exempt eligible employer). For a 
transition rule for 2014, see Sec.  1.45R-3(i).
    (ii) Examples. The following examples illustrate the provisions of 
paragraph (a)(3)(i) of this section:

    Example 1. (i) Facts. In 2014, an eligible small employer (Employer) 
that uses a calendar year as its taxable year begins to offer insurance 
through a SHOP Exchange. Employer has 4 employees and otherwise 
qualifies for the credit, but none of the employees enroll in the 
coverage offered by Employer through the SHOP Exchange. In mid-2015, the 
4 employees enroll for coverage through the SHOP Exchange but Employer 
does not file Form 8941 or claim the credit. In 2016, Employer has 20 
employees and all are enrolled in coverage offered through the SHOP 
Exchange. Employer files Form 8941 with Employer's 2016 tax return to 
claim the credit.
    (ii) Conclusion. Employer's taxable year 2016 is the first year of 
the credit period. Accordingly, Employer's two-year credit period is 
2016 and 2017.
    Example 2. (i) Facts. Same facts as Example 1, but Employer files 
Form 8941 with Employer's 2015 tax return.
    (ii) Conclusion. Employer's taxable year 2015 is the first year of 
the credit period. Accordingly, Employer's two-year credit period is 
2015 and 2016 (and does not include 2017). Employer is entitled to a 
credit based on a partial year of SHOP Exchange coverage for Employer's 
taxable year 2015.

    (4) Eligible small employer. (i) The term eligible small employer 
means an employer that meets the requirements set forth in Sec.  1.45R-
2.
    (ii) For the definition of tax-exempt eligible small employer, see 
paragraph (a)(19) of this section.
    (iii) A farmers' cooperative described under section 521 that is 
subject to tax pursuant to section 1381, and otherwise meets the 
requirements of this paragraph (a)(4) and Sec.  1.45R-2, is an eligible 
small employer.
    (5) Employee--(i) In general. Except as otherwise specifically 
provided in this paragraph (a)(5), the term employee means an individual 
who is an employee of the eligible small employer under the common law 
standard. See Sec.  31.3121(d)-1(c).
    (ii) Leased employees. For purposes of this paragraph (a)(5), the 
term employee also includes a leased employee (as defined in section 
414(n)).
    (iii) Certain individuals excluded. The term employee does not 
include independent contractors (including sole proprietors), partners 
in a partnership, shareholders owning more than two percent of an S 
corporation, and any owners of more than five percent of other 
businesses. The term employee also does not include family members of 
these owners and partners, including the employee-spouse of a 
shareholder owning more than two percent of the stock of an S 
corporation, the employee-spouse of an owner of more than five percent 
of a business, the employee-spouse of a partner owning more than a five 
percent interest in a partnership, and the employee-spouse of a sole 
proprietor, or any other member of the household of these owners and 
partners who qualifies as a dependent under section 152(d)(2)(H).

[[Page 334]]

    (iv) Seasonal workers. The term employee does not include seasonal 
workers unless the seasonal worker provides services to the employer on 
more than 120 days during the taxable year.
    (v) Ministers. Whether a minister is an employee is determined under 
the common law standard for determining worker status. If, under the 
common law standard, a minister is not an employee, the minister is not 
an employee for purposes of this paragraph (a)(5) and is not taken into 
account in determining an employer's FTEs, and premiums paid for the 
minister's health insurance coverage are not taken into account in 
computing the credit. If, under the common law standard, a minister is 
an employee, the minister is an employee for purposes of this paragraph 
(a)(5), and is taken into account in determining an employer's FTEs, and 
premiums paid by the employer for the minister's health insurance 
coverage can be taken into account in computing the credit. Because the 
performance of services by a minister in the exercise of his or her 
ministry is not treated as employment for purposes of the Federal 
Insurance Contributions Act (FICA), compensation paid to the minister is 
not wages as defined under section 3121(a), and is not counted as wages 
for purposes of computing an employer's average annual wages.
    (vi) Former employees. Premiums paid on behalf of a former employee 
with no hours of service may be treated as paid on behalf of an employee 
for purposes of calculating the credit (see Sec.  1.45R-3) provided 
that, if so treated, the former employee is also treated as an employee 
for purposes of the uniform percentage requirement (see Sec.  1.45R-4). 
For the treatment of terminated employees for purposes of determining 
employer eligibility for the credit, see Sec.  1.45R-2(c).
    (6) Employer-computed composite rate. The term employer-computed 
composite rate refers to a rate for a tier of coverage (such as 
employee-only, dependent or family) of a QHP that is the average rate 
determined by adding the premiums for that tier of coverage for all 
employees eligible to participate in the QHP (whether or not they 
actually receive coverage under the plan or under that tier of coverage) 
and dividing by the total number of such eligible employees. The 
employer-computed composite rate may be used in list billing to convert 
individual premiums for a tier of coverage into an employer-computed 
composite rate for that tier of coverage. See Sec.  1.45R-4(b)(3).
    (7) Exchange. The term Exchange means an exchange as defined in 45 
CFR 155.20.
    (8) Family member. The term family member is defined with respect to 
a taxpayer as a child (or descendant of a child); a sibling or step-
sibling; a parent (or ancestor of a parent); a step-parent; a niece or 
nephew; an aunt or uncle; or a son-in-law, daughter-in-law, father-in-
law, mother-in-law, brother-in-law or sister-in-law. A spouse of any of 
these family members is also considered a family member.
    (9) Full-time equivalent employee (FTE). The number of full-time 
equivalent employees (FTEs) is determined by dividing the total number 
of hours of service for which wages were paid by the employer to 
employees during the taxable year by 2,080. See Sec.  1.45R-2(d) and (e) 
for permissible methods of calculating hours of service and the method 
for calculating the number of an employer's FTEs.
    (10) List billing. The term list billing refers to a system of 
billing under which a health insurer lists a separate premium for each 
employee based on the age of the employee or other factors.
    (11) Net premium payments. The term net premium payments means, in 
the case of an employer receiving a State tax credit or State subsidy 
for providing health insurance to its employees, the excess of the 
employer's actual premium payments over the State tax credit or State 
subsidy received by the employer. In the case of a State payment 
directly to an insurance company (or another entity licensed under State 
law to engage in the business of insurance), the employer's net premium 
payments are the employer's actual premium payments. If a State-
administered program (such as Medicaid or another program that makes 
payments

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directly to a health care provider or insurance company on behalf of 
individuals and their families who meet certain eligibility guidelines) 
makes payments that are not contingent on the maintenance of an 
employer-provided group health plan, those payments are not taken into 
account in determining the employer's net premium payments.
    (12) Nonelective contribution. The term nonelective contribution 
means an employer contribution other than a contribution pursuant to a 
salary reduction arrangement under section 125.
    (13) Payroll taxes. For purposes of section 45R, the term payroll 
taxes means amounts required to be withheld as tax from the employees of 
a tax-exempt eligible small employer under section 3402, amounts 
required to be withheld from such employees under section 3101(b), and 
amounts of tax imposed on the tax-exempt eligible small employer under 
section 3111(b).
    (14) Qualified health plan or QHP. The term qualified health plan or 
the term QHP means a qualified health plan as defined in Affordable Care 
Act section 1301(a) (see 42 U.S.C. 18021(a)), but does not include a 
catastrophic plan described in Affordable Care Act section 1302(e) (see 
42 U.S.C. 18022(e)).
    (15) Qualifying arrangement. The term qualifying arrangement means 
an arrangement that requires an eligible small employer to make a 
nonelective contribution on behalf of each employee who enrolls in a QHP 
offered to employees by the employer through a SHOP Exchange in an 
amount equal to a uniform percentage (not less than 50 percent) of the 
premium cost of the QHP.
    (16) Seasonal worker. The term seasonal worker means a worker who 
performs labor or services on a seasonal basis as defined by the 
Secretary of Labor, including (but not limited to) workers covered by 29 
CFR 500.20(s)(1), and retail workers employed exclusively during holiday 
seasons. Employers may apply a reasonable, good faith interpretation of 
the term seasonal worker and a reasonable good faith interpretation of 
29 CFR 500.20(s)(1) (including as applied by analogy to workers and 
employment positions not otherwise covered under 29 CFR 500.20(s)(1)).
    (17) SHOP dependent coverage. The term SHOP dependent coverage 
refers to coverage offered through SHOP separately to any individual who 
is or may become eligible for coverage under the terms of a group health 
plan offered through SHOP because of a relationship to a participant-
employee, whether or not a dependent of the participant-employee under 
section 152 of the Internal Revenue Code. The term SHOP dependent 
coverage does not include coverage such as family coverage, which 
includes coverage of the participant-employee.
    (18) Small Business Health Options Program (SHOP). The term Small 
Business Health Options Program (SHOP) means an Exchange established 
pursuant to section 1311 of the Affordable Care Act and defined in 45 
CFR 155.20.
    (19) State. The term State means a State as defined in section 
7701(a)(10), including the District of Columbia.
    (20) Tax-exempt eligible small employer. The term tax-exempt 
eligible small employer means an eligible small employer that is exempt 
from federal income tax under section 501(a) as an organization 
described in section 501(c).
    (21) Tier. The term tier refers to a category of coverage under a 
benefits package that varies only by the number of individuals covered. 
For example, employee-only coverage, dependent coverage, and family 
coverage would constitute three separate tiers of coverage.
    (22) Tobacco surcharge. The term tobacco surcharge means any 
allowable differential that is charged for insurance in the SHOP 
Exchange that is attributable to tobacco use as the term tobacco use is 
defined in 45 CFR 147.102(a)(1)(iv).
    (23) United States. The term United States means United States as 
defined in section 7701(a)(9).
    (24) Wages. The term wages for purposes of section 45R means wages 
as defined under section 3121(a) for purposes of the Federal Insurance 
Contributions Act (FICA), determined without regard to the social 
security wage base limitation under section 3121(a)(1).
    (25) Wellness program. The term wellness program for purposes of 
section

[[Page 336]]

45R means a program of health promotion or disease prevention subject to 
the requirements of Sec.  54.9802-1(f).
    (b) Effective/applicability date. This section is applicable for 
periods after 2013. For rules relating to certain plan years beginning 
in 2014, see Sec.  1.45R-3(i).

[T.D. 9672, 79 FR 36646, June 30, 2014]



Sec.  1.45R-2  Eligibility for the credit.

    (a) Eligible small employer. To be eligible for the credit under 
section 45R, an employer must be an eligible small employer. In order to 
be an eligible small employer, with respect to any taxable year, an 
employer must have no more than 25 full-time equivalent employees 
(FTEs), must have in effect a qualifying arrangement, and the average 
annual wages of the employer's FTEs must not exceed an amount equal to 
twice the dollar amount in effect under Sec.  1.45R-3(c)(2). For 
purposes of eligibility for the credit for taxable years beginning in or 
after 2014, a qualifying arrangement is an arrangement that requires an 
employer to make a nonelective contribution on behalf of each employee 
who enrolls in a qualified health plan (QHP) offered to employees 
through a small business health options program (SHOP) Exchange in an 
amount equal to a uniform percentage (not less than 50 percent) of the 
premium cost of the QHP. Notwithstanding the foregoing, an employer that 
is an agency or instrumentality of the federal government, or of a 
State, local or Indian tribal government, is not an eligible small 
employer if it is not an organization described in section 501(c) that 
is exempt from tax under section 501(a). An employer does not fail to be 
an eligible small employer merely because its employees are not 
performing services in a trade or business of the employer. An employer 
located outside the United States (including an employer located in a 
U.S. territory) must have income effectively connected with the conduct 
of a trade or business in the United States, and otherwise meet the 
requirements of this section, to be an eligible small employer. For 
eligibility standards for SHOP related to foreign employers, see 45 CFR 
155.710. Paragraphs (b) through (f) of this section provide the rules 
for determining whether the requirements to be an eligible small 
employer are met, including rules related to identifying and counting 
the number of the employer's FTEs, counting the employees' hours of 
service, and determining the employer's average annual FTE wages for the 
taxable year. For rules on determining whether the uniform percentage 
requirement is met, see Sec.  1.45R-4.
    (b) Application of section 414 employer aggregation rules. All 
employers treated as a single employer under section 414(b), (c), (m) or 
(o) are treated as a single employer for purposes of this section. Thus, 
all employees of a controlled group under section 414(b), (c) or (o), or 
an affiliated service group under section 414(m), are taken into account 
in determining whether any member of the controlled group or affiliated 
service group is an eligible small employer. Similarly, all wages paid 
to, and premiums paid for, employees by the members of the controlled 
group or affiliated service group are taken into account when 
determining the amount of the credit for a group treated as a single 
employer under these rules.
    (c) Employees taken into account. To be eligible for the credit, an 
employer must have employees as defined in Sec.  1.45R-1(a)(5) during 
the taxable year. All such employees of the eligible small employer are 
taken into account for purposes of determining the employer's FTEs and 
average annual FTE wages. Employees include employees who terminate 
employment during the year for which the credit is being claimed, 
employees covered under a collective bargaining agreement, and employees 
who do not enroll in a QHP offered by the employer through a SHOP 
Exchange.
    (d) Determining the hours of service performed by employees--(1) In 
general. An employee's hours of service for a year include each hour for 
which an employee is paid, or entitled to payment, for the performance 
of duties for the employer during the employer's taxable year. It also 
includes each hour for which an employee is paid, or entitled to 
payment, by the employer on account of a period of time during which no 
duties are performed due to vacation, holiday, illness, incapacity

[[Page 337]]

(including disability), layoff, jury duty, military duty or leave of 
absence (except that no more than 160 hours of service are required to 
be counted for an employee on account of any single continuous period 
during which the employee performs no duties).
    (2) Permissible methods. In calculating the total number of hours of 
service that must be taken into account for an employee during the 
taxable year, eligible small employers need not use the same method for 
all employees, and may apply different methods for different 
classifications of employees if the classifications are reasonable and 
consistently applied. Eligible small employers may change the method for 
calculating employees' hours of service for each taxable year. An 
eligible small employer may use any of the following three methods.
    (i) Actual hours worked. An employer may use the actual hours of 
service provided by employees including hours worked and any other hours 
for which payment is made or due (as described in paragraph (d)(1) of 
this section).
    (ii) Days-worked equivalency. An employer may use a days-worked 
equivalency whereby the employee is credited with 8 hours of service for 
each day for which the employee would be required to be credited with at 
least one hour of service under paragraph (d)(1) of this section.
    (iii) Weeks-worked equivalency. An employer may use a weeks-worked 
equivalency whereby the employee is credited with 40 hours of service 
for each week for which the employee would be required to be credited 
with at least one hour of service under paragraph (d)(1) of this 
section.
    (3) Examples. The following examples illustrate the rules of 
paragraph (d) of this section:

    Example 1. Counting hours of service by hours actually worked or for 
which payment is made or due. (i) Facts. An eligible small employer 
(Employer) has payroll records that indicate that Employee A worked 
2,000 hours and that Employer paid Employee A for an additional 80 hours 
on account of vacation, holiday and illness. Employer uses the actual 
hours worked method described in paragraph (d)(2)(i) of this section.
    (ii) Conclusion. Under this method of counting hours, Employee A 
must be credited with 2,080 hours of service (2,000 hours worked and 80 
hours for which payment was made or due).
    Example 2. Counting hours of service under days-worked equivalency. 
(i) Facts. Employee B worked from 8:00 am to 12:00 pm every day for 200 
days. Employer uses the days-worked equivalency method described in 
paragraph (d)(2)(ii) of this section.
    (ii) Conclusion. Under this method of counting hours, Employee B 
must be credited with 1,600 hours of service (8 hours for each day 
Employee B would otherwise be credited with at least 1 hour of service x 
200 days).
    Example 3. Counting hours of service under weeks-worked equivalency. 
(i) Facts. Employee C worked 49 weeks, took 2 weeks of vacation with 
pay, and took 1 week of leave without pay. Employer uses the weeks-
worked equivalency method described in paragraph (d)(2)(iii) of this 
section.
    (ii) Conclusion. Under this method of counting hours, Employee C 
must be credited with 2,040 hours of service (40 hours for each week 
during which Employee C would otherwise be credited with at least 1 hour 
of service x 51 weeks).
    Example 4. Excluded employees. (i) Facts. Employee D worked 3 
consecutive weeks at 32 hours per week during the holiday season. 
Employee D did not work during the remainder of the year. Employee E 
worked limited hours after school from time to time through the year for 
a total of 350 hours. Employee E does not work through the summer. 
Employer uses the actual hours worked method described in paragraph 
(d)(2)(i) of this section.
    (ii) Conclusion. Employee D is a seasonal employee who worked for 
120 days or less for Employer during the year. Employee D's hours are 
not counted when determining the hours of service of Employer's 
employees. Employee E works throughout most of the year and is not a 
seasonal employee. Employer counts Employee E's 350 hours of service 
during the year.

    (e) FTE Calculation--(1) In general. The number of an employer's 
FTEs is determined by dividing the total hours of service, determined in 
accordance with paragraph (d) of this section, credited during the year 
to employees taken into account under paragraph (c) of this section (but 
not more than 2,080 hours for any employee) by 2,080. The result, if not 
a whole number, is then rounded to the next lowest whole number. If, 
however, after dividing the total hours of service by 2,080, the 
resulting number is less than one, the employer rounds up to one FTE.
    (2) Example. The following example illustrates the provisions of 
paragraph (e) of this section:


[[Page 338]]


    Example. Determining the number of FTEs. (i) Facts. A sole 
proprietor pays 5 employees wages for 2,080 hours each, pays 3 employees 
wages for 1,040 hours each, and pays 1 employee wages for 2,300 hours. 
One of the employees working 2,080 hours is the sole proprietor's 
nephew. The sole proprietor's FTEs would be calculated as follows: 8,320 
hours of service for the 4 employees paid for 2,080 hours each (4 x 
2,080); the sole proprietor's nephew is excluded from the FTE 
calculation; 3,120 hours of service for the 3 employees paid for 1,040 
hours each (3 x 1,040); and 2,080 hours of service for the 1 employee 
paid for 2,300 hours (lesser of 2,300 and 2,080). The sum of the 
included hours of service equals 13,520 hours of service.
    (ii) Conclusion. The sole proprietor's FTEs equal 6 (13,520 divided 
by 2,080 = 6.5, rounded to the next lowest whole number).

    (f) Determining the employer's average annual FTE wages--(1) In 
general. All wages paid to employees (including overtime pay) are taken 
into account in computing an eligible small employer's average annual 
FTE wages. The average annual wages paid by an employer for a taxable 
year is determined by dividing the total wages paid by the eligible 
small employer during the employer's taxable year to employees taken 
into account under paragraph (c) of this section by the number of the 
employer's FTEs for the year. The result is then rounded down to the 
nearest $1,000 (if not otherwise a multiple of $1,000). For purposes of 
determining the employer's average annual wages for the taxable year, 
only wages that are paid for hours of service determined under paragraph 
(d) of this section are taken into account.
    (2) Example. The following example illustrates the provision of 
paragraphs (e) and (f) of this section:

    Example. (i) Facts. An employer has 26 FTEs with average annual 
wages of $23,000. Only 22 of the employer's employees enroll for 
coverage offered by the employer through a SHOP Exchange.
    (ii) Conclusion. The hours of service and wages of all employees are 
taken into consideration in determining whether the employer is an 
eligible small employer for purposes of the credit. Because the employer 
does not have fewer than 25 FTEs for the taxable year, the employer is 
not an eligible small employer for purposes of this section, even if 
fewer than 25 employees (or FTEs) enroll for coverage through the SHOP 
Exchange.

    (g) Effective/applicability date. This section is applicable for 
periods after 2013. For transition rules relating to certain plan years 
beginning in 2014, see Sec.  1.45R-3(i).

[T.D. 9672, 79 FR 36646, June 30, 2014]



Sec.  1.45R-3  Calculating the credit.

    (a) In general. The tax credit available to an eligible small 
employer equals 50 percent of the eligible small employer's premium 
payments made on behalf of its employees under a qualifying arrangement, 
or in the case of a tax-exempt eligible small employer, 35 percent of 
the employer's premium payments made on behalf of its employees under a 
qualifying arrangement. The employer's tax credit is subject to the 
following adjustments and limitations:
    (1) The average premium limitation for the small group market in the 
rating area in which the employee enrolls for coverage, described in 
paragraph (b) of this section;
    (2) The credit phaseout described in paragraph (c) of this section;
    (3) The net premium payment limitation in the case of State credits 
or subsidies described in paragraph (d) of this section;
    (4) The payroll tax limitation for a tax-exempt eligible small 
employer described in paragraph (e) of this section;
    (5) The two-consecutive-taxable year-credit period limitation, 
described in paragraph (f) of this section;
    (6) The rules with respect to the premium payments taken into 
account, described in paragraph (g) of this section;
    (7) The rules with respect to credits applicable to trusts, estates, 
regulated investment companies, real estate investment trusts and 
cooperatives described in paragraph (h) of this section; and
    (8) The transition relief for 2014 described in paragraph (i) of 
this section.
    (b) Average premium limitation--(1) In general. The amount of an 
eligible small employer's premium payments that is taken into account in 
calculating the credit is limited to the premium payments the employer 
would have made under the same arrangement if the average premium for 
the small group market in the rating area

[[Page 339]]

in which the employee enrolls for coverage were substituted for the 
actual premium.
    (2) Examples. The following examples illustrate the provisions of 
paragraph (b)(1) of this section:

    Example 1. Comparing premium payments to average premium for small 
group market. (i) Facts. An eligible small employer (Employer) offers a 
health insurance plan with employee-only and SHOP dependent coverage 
through a small business options program (SHOP) Exchange. Employer has 9 
full-time equivalent employees (FTEs) with average annual wages of 
$23,000 per FTE. All 9 employees are employees as defined under Sec.  
1.45R-1(a)(5). Six employees are enrolled in employee-only coverage and 
5 of these 6 employees have also enrolled either one child or one spouse 
in SHOP dependent coverage. Employer pays 50% of the premiums for all 
employees enrolled in employee-only coverage and 50% of the premiums for 
all employees who enrolled family members in SHOP dependent coverage 
(and the employee is responsible for the remainder in each case). The 
premiums are $4,000 a year for employee-only coverage and $3,000 a year 
for each individual enrolled in SHOP dependent coverage. The average 
premium for the small group market in Employer's rating area is $5,000 
for employee-only coverage and $4,000 for each individual enrolled in 
SHOP dependent coverage. Employer's premium payments for each FTE 
($2,000 for employee-only coverage and $1,500 for SHOP dependent 
coverage) do not exceed 50 percent of the average premium for the small 
group market in Employer's rating area ($2,500 for employee-only 
coverage and $2,000 for each individual enrolled in SHOP dependent 
coverage).
    (ii) Conclusion. The amount of premiums paid by Employer for 
purposes of computing the credit equals $19,500 ((6 x $2,000) plus (5 x 
$1,500)).
    Example 2. Premium payments exceeding average premium for small 
group market. (i) Facts. Same facts as Example 1, except that the 
premiums are $6,000 for employee-only coverage and $5,000 for each 
dependent enrolled in coverage. Employer's premium payments for each 
employee ($3,000 for employee-only coverage and $2,500 for SHOP 
dependent coverage) exceed 50% of the average premium for the small 
group market in Employer's rating area ($2,500 for self-only coverage 
and $2,000 for family coverage).
    (ii) Conclusion. The amount of premiums paid by Employer for 
purposes of computing the credit equals $25,000 ((6 x $2,500) plus (5 x 
$2,000)).

    (c) Credit phaseout--(1) In general. The tax credit is subject to a 
reduction (but not reduced below zero) if the employer's FTEs exceed 10 
or average annual FTE wages exceed $25,000. If the number of FTEs 
exceeds 10, the reduction is determined by multiplying the otherwise 
applicable credit amount by a fraction, the numerator of which is the 
number of FTEs in excess of 10 and the denominator of which is 15. If 
average annual FTE wages exceed $25,000, the reduction is determined by 
multiplying the otherwise applicable credit amount by a fraction, the 
numerator of which is the amount by which average annual FTE wages 
exceed $25,000 and the denominator of which is $25,000. In both cases, 
the result of the calculation is subtracted from the otherwise 
applicable credit to determine the credit to which the employer is 
entitled. For an employer with both more than 10 FTEs and average annual 
FTE wages exceeding $25,000, the total reduction is the sum of the two 
reductions.
    (2) $25,000 dollar amount adjusted for inflation. For taxable years 
beginning in a calendar year after 2013, each reference to ``$25,000'' 
in paragraph (c)(1) of this section is replaced with a dollar amount 
equal to $25,000 multiplied by the cost-of-living adjustment under 
section 1(f)(3) for the calendar year, determined by substituting 
``calendar year 2012'' for ``calendar year 1992'' in section 1(f)(3)(B).
    (3) Examples. The following examples illustrate the provisions of 
paragraph (c) this section. For purposes of these examples, no employer 
is a tax-exempt organization and no other adjustments or limitations on 
the credit apply other than those adjustments and limitations explicitly 
set forth in the example.

    Example 1. Calculating the maximum credit for an eligible small 
employer without an applicable credit phaseout. (i) Facts. An eligible 
small employer (Employer) has 9 FTEs with average annual wages of 
$23,000. Employer pays $72,000 in health insurance premiums for those 
employees (which does not exceed the total average premium for the small 
group market in the rating area), and otherwise meets the requirements 
for the credit.
    (ii) Conclusion. Employer's credit equals $36,000 (50% x $72,000).
    Example 2. Calculating the credit phaseout if the number of FTEs 
exceeds 10 or average annual wages exceed $25,000, as adjusted for 
inflation. (i) Facts. An eligible small employer (Employer) has 12 FTEs 
and average annual FTE wages of $30,000 in a year when the

[[Page 340]]

amount in paragraph (c)(1) of this section, as adjusted for inflation, 
is $25,000. Employer pays $96,000 in health insurance premiums for its 
employees (which does not exceed the average premium for the small group 
market in the rating area) and otherwise meets the requirements for the 
credit.
    (ii) Conclusion. The initial amount of the credit is determined 
before any reduction (50% x $96,000) = $48,000. The credit reduction for 
FTEs in excess of 10 is $6,400 ($48,000 x 2/15). The credit reduction 
for average annual FTE wages in excess of $25,000 is $9,600 ($48,000 x 
$5,000/$25,000), resulting in a total credit reduction of $16,000 
($6,400 + $9,600). Employer's total tax credit equals $32,000 ($48,000-
$16,000).

    (d) State credits and subsidies for health insurance--(1) Payments 
to employer. If the employer is entitled to a State tax credit or a 
premium subsidy that is paid directly to the employer, the premium 
payment made by the employer is not reduced by the credit or subsidy for 
purposes of determining whether the employer has satisfied the 
requirement to pay an amount equal to a uniform percentage (not less 
than 50 percent) of the premium cost. Also, except as described in 
paragraph (d)(3) of this section, the maximum amount of the credit is 
not reduced by reason of a State tax credit or subsidy or by reason of 
payments by a State directly to an employer.
    (2) Payments to issuer. If a State makes payments directly to an 
insurance company (or another entity licensed under State law to engage 
in the business of insurance) to pay a portion of the premium for 
coverage of an employee enrolled for coverage through a SHOP Exchange, 
the State is treated as making these payments on behalf of the employer 
for purposes of determining whether the employer has satisfied the 
requirement to pay an amount equal to a uniform percentage (not less 
than 50 percent) of the premium cost of coverage. Also, except as 
described below in paragraph (d)(3) of this section, these premium 
payments by the State are treated as an employer contribution under this 
section for purposes of calculating the credit.
    (3) Credits may not exceed net premium payment. Regardless of the 
application of paragraphs (d)(1) and (2) of this section, in no event 
may the amount of the credit exceed the amount of the employer's net 
premium payments as defined in Sec.  1.45R-1(a)(11).
    (4) Examples. The following examples illustrate the provisions of 
paragraphs (d)(1) through (3) of this section. For purposes of these 
examples, each employer is an eligible small employer that is not a tax-
exempt organization and the eligible small employer's taxable year and 
plan year begin during or after 2014. No other adjustments or 
limitations on the credit apply other than those adjustments and 
limitations explicitly set forth in the example.

    Example 1. State premium subsidy paid directly to employer. (i) 
Facts. The State in which an eligible small employer (Employer) operates 
provides a health insurance premium subsidy of up to 40% of the health 
insurance premiums for each eligible employee. The State pays the 
subsidy directly to Employer. Employer has one employee, Employee D. 
Employee D's health insurance premiums are $100 per month and are paid 
as follows: $80 by Employer and $20 by Employee D through salary 
reductions to a cafeteria plan. The State pays Employer $40 per month as 
a subsidy for Employer's payment of insurance premiums on behalf of 
Employee D. Employer is otherwise an eligible small employer that meets 
the requirements for the credit.
    (ii) Conclusion. For purposes of calculating the credit, the amount 
of premiums paid by the employer is $80 per month (the premium payment 
by the Employer without regard to the subsidy from the State). The 
maximum credit is $40 ($80 x 50%).
    Example 2. State premium subsidy paid directly to insurance company. 
(i) Facts. The State in which Employer operates provides a health 
insurance premium subsidy of up to 30% for each eligible employee. 
Employer has one employee, Employee E. Employee E is enrolled in 
employee-only coverage through a qualified health plan (QHP) offered by 
Employer through a SHOP Exchange. Employee E's health insurance premiums 
are $100 per month and are paid as follows: $50 by Employer; $30 by the 
State and $20 by the employee. The State pays the $30 per month directly 
to the insurance company and the insurance company bills Employer for 
the employer and employee's share, which equal $70 per month. Employer 
is otherwise an eligible small employer that meets the requirements for 
the credit.
    (ii) Conclusion. For purposes of calculating the amount of the 
credit, the amount of premiums paid by Employer is $80 per month (the 
sum of Employer's payment and the State's payment). The maximum credit 
is $40 ($80 x 50%).

[[Page 341]]

    Example 3. Credit limited by employer's net premium payment. (i) 
Facts. The State in which Employer operates provides a health insurance 
premium subsidy of up to 50% for each eligible employee. Employer has 
one employee, Employee F. Employee F is enrolled in employee-only 
coverage under the QHP offered to Employee F by Employer through a SHOP 
Exchange. Employee F's health insurance premiums are $100 per month and 
are paid as follows: $20 by Employer; $50 by the State and $30 by 
Employee F. The State pays the $50 per month directly to the insurance 
company and the insurance company bills Employer for the employer's and 
employee's shares, which total $50 per month. The amount of premiums 
paid by Employer (the sum of Employer's payment and the State's payment) 
is $70 per month, which is more than 50% of the $100 monthly premium 
payment. The amount of the premium for calculating the credit is also 
$70 per month.
    (ii) Conclusion. The maximum credit without adjustments or 
limitations is $35 ($70 x 50%). Employer's net premium payment is $20 
(the amount actually paid by Employer excluding the State subsidy). 
Because the credit may not exceed Employer's net premium payment, the 
credit is $20 (the lesser of $35 or $20).

    (e) Payroll tax limitation for tax-exempt eligible small employers--
(1) In general. For a tax-exempt eligible employer, the amount of the 
credit claimed cannot exceed the total amount of payroll taxes (as 
defined in Sec.  1.45R-1(a)(13)) of the employer during the calendar 
year in which the taxable year begins.
    (2) Example. The following example illustrates the provisions of 
paragraph (e)(1) of this section. For purposes of this example, the 
eligible small employer's taxable year and plan year begin during or 
after 2014. No other adjustments or limitations on the credit apply 
other than those adjustments and limitations explicitly set forth in the 
example.

    Example. Calculating the maximum credit for a tax-exempt eligible 
small employer. (i) Facts. Employer is a tax-exempt eligible small 
employer that has 10 FTEs with average annual wages of $21,000. Employer 
pays $80,000 in health insurance premiums for its employees (which does 
not exceed the average premium for the small group market in the rating 
area) and otherwise meets the requirements for the credit. The total 
amount of Employer's payroll taxes equals $30,000.
    (ii) Conclusion. The initial amount of the credit is determined 
before any reduction: (35% x $80,000) = $28,000, and Employer's payroll 
taxes are $30,000. The total tax credit equals $28,000 (the lesser of 
$28,000 and $30,000).

    (f) Two-consecutive-taxable-year credit period limitation. The 
credit is available to an eligible small employer, including a tax-
exempt eligible small employer, only during that employer's credit 
period. For a transition rule for 2014, see paragraph (i) of this 
section. To prevent the avoidance of the two-year limit on the credit 
period through the use of successor entities, a successor entity and a 
predecessor entity are treated as the same employer. For this purpose, 
the rules for identifying successor entities under Sec.  31.3121(a)(1)-
1(b) apply. Accordingly, for example, if an eligible small employer 
claims the credit for the 2014 and 2015 taxable years, that eligible 
small employer's credit period will have expired so that any successor 
employer to that eligible small employer will not be able to claim the 
credit for any subsequent taxable years.
    (g) Premium payments by the employer for a taxable year--(1) In 
general. Only premiums paid by an eligible small employer or tax-exempt 
eligible small employer on behalf of each employee enrolled in a QHP or 
payments paid to the issuer in accordance with paragraph (d)(2) of this 
section are counted in calculating the credit. If an eligible small 
employer pays only a portion of the premiums for the coverage provided 
to employees (with employees paying the rest), only the portion paid by 
the employer is taken into account. Premiums paid on behalf of seasonal 
workers may be counted in determining the amount of the credit (even 
though seasonal worker wages and hours of service are not included in 
the FTE calculation and average annual FTE wage calculation unless the 
seasonal worker works for the employer on more than 120 days during the 
taxable year). Subject to the average premium limitation, premiums paid 
on behalf of an employee with respect to any individuals who are or may 
become eligible for coverage under the terms of the plan because of a 
relationship to the employee (including through family coverage or SHOP 
dependent coverage) may also be taken into account

[[Page 342]]

in determining the amount of the credit. (However, premiums paid for 
SHOP dependent coverage are not taken into account in determining 
whether the uniform percentage requirement is met, see Sec.  1.45R-
4(b)(5).)
    (2) Excluded amounts--(i) Salary reduction amounts. Any premium paid 
pursuant to a salary reduction arrangement under a section 125 cafeteria 
plan is not treated as paid by the employer for purposes of section 45R 
and these regulations. For this purpose, premiums paid with employer-
provided flex credits that employees may elect to receive as cash or 
other taxable benefits are treated as paid pursuant to a salary 
reduction arrangement under a section 125 cafeteria plan.
    (ii) HSAs, HRAs, and FSAs. Employer contributions to, or amounts 
made available under, health savings accounts, reimbursement 
arrangements, and health flexible spending arrangements are not taken 
into account in determining the premium payments by the employer for a 
taxable year.
    (h) Rules applicable to trusts, estates, regulated investment 
companies, real estate investment trusts and cooperative organizations. 
Rules similar to the rules of section 52(d) and (e) and the regulations 
thereunder apply in calculating and apportioning the credit with respect 
to a trust, estate, a regulated investment company or real estate 
investment trusts or cooperative organization.
    (i) Transition rule for 2014--(1) In general. This paragraph (i) 
applies if as of August 26, 2013, an eligible small employer offers 
coverage for a health plan year that begins on a date other than the 
first day of its taxable year. In such a case, if the eligible small 
employer has a health plan year beginning after January 1, 2014 but 
before January 1, 2015 (2014 health plan year) that begins after the 
start of its first taxable year beginning on or after January 1, 2014 
(2014 taxable year), and the employer offers one or more QHPs to its 
employees through a SHOP Exchange as of the first day of its 2014 health 
plan year, then the eligible small employer is treated as offering 
coverage through a SHOP Exchange for its entire 2014 taxable year for 
purposes of section 45R if the health care coverage provided from the 
first day of the 2014 taxable year through the day immediately preceding 
the first day of the 2014 health plan year would have qualified for a 
credit under section 45R using the rules applicable to taxable years 
beginning before January 1, 2014. If the eligible small employer claims 
the section 45R credit in the 2014 taxable year, the 2014 taxable year 
begins the first year of the credit period.
    (2) Example. The following example illustrates the rule of this 
paragraph (i) of this section. For purposes of this example, it is 
assumed that the eligible small employer is not a tax-exempt 
organization and that no other adjustments or limitations on the credit 
apply other than those adjustments and limitations explicitly set forth 
in the example.

    Example. (i) Facts. An eligible small employer (Employer) has a 2014 
taxable year that begins January 1, 2014 and ends on December 31, 2014. 
As of August 26, 2013, Employer had a 2014 health plan year that begins 
July 1, 2014 and ends June 30, 2015. Employer offers a QHP through a 
SHOP Exchange the coverage under which begins July 1, 2014. Employer 
also provides other coverage from January 1, 2014 through June 30, 2014 
that would have qualified for a credit under section 45R based on the 
rules applicable to taxable years beginning before 2014.
    (ii) Conclusion. Employer may claim the credit at the 50% rate under 
section 45R for the entire 2014 taxable year using the rules under this 
paragraph (i) of this section. Accordingly, in calculating the credit, 
Employer may count premiums paid for the coverage from January 1, 2014 
through June 30, 2014, as well as premiums paid for the coverage from 
July 1, 2014 through December 31, 2014. If Employer claims the credit 
for the 2014 taxable year, that taxable year is the first year of the 
credit period.

    (j) Effective/applicability date. This section is applicable for 
periods after 2013. For transition rules relating to certain plan years 
beginning in 2014, see paragraph (i) of this section.

[T.D. 9672, 79 FR 36646, June 30, 2014]



Sec.  1.45R-4  Uniform percentage of premium paid.

    (a) In general. An eligible small employer must pay a uniform 
percentage (not less than 50 percent) of the premium for each employee 
enrolled in a qualified health plan (QHP) offered to employees by the 
employer through a

[[Page 343]]

small business health options program (SHOP) Exchange.
    (b) Employers offering one QHP. An employer that offers a single QHP 
through a SHOP Exchange must satisfy the requirements of this paragraph 
(b).
    (1) Employers offering one QHP, employee-only coverage, composite 
billing. For an eligible small employer offering employee-only coverage 
and using composite billing, the employer satisfies the requirements of 
this paragraph if it pays the same amount toward the premium for each 
employee receiving employee-only coverage under the QHP, and that amount 
is equal to at least 50 percent of the premium for employee-only 
coverage.
    (2) Employers offering one QHP, other tiers of coverage, composite 
billing. For an eligible small employer offering one QHP providing at 
least one tier of coverage with a higher premium than employee-only 
coverage and using composite billing, the employer satisfies the 
requirements of this paragraph (b)(2) if it either--
    (i) Pays an amount for each employee enrolled in that more expensive 
tier of coverage that is the same for all employees and that is no less 
than the amount that the employer would have contributed toward 
employee-only coverage for that employee, or
    (ii) Meets the requirements of paragraph (b)(1) of this section for 
each tier of coverage that if offers.
    (3) Employers offering one QHP, employee-only coverage, list 
billing. For an eligible small employer offering one QHP providing only 
employee-only coverage and using list billing, the employer satisfies 
the requirements of this paragraph (b)(3) if either--
    (i) The employer pays toward the premium an amount equal to a 
uniform percentage (not less than 50 percent) of the premium charged for 
each employee, or
    (ii) The employer converts the individual premiums for employee-only 
coverage into an employer-computed composite rate for self-only 
coverage, and, if an employee contribution is required, each employee 
who receives coverage under the QHP pays a uniform amount toward the 
employee-only premium that is no more than 50 percent of the employer-
computed composite rate for employee-only coverage.
    (4) Employers offering one QHP, other tiers of coverage, list 
billing. For an eligible small employer offering one QHP providing at 
least one tier of coverage with a higher premium than employee-only 
coverage and using list billing, the employer satisfies the requirements 
of this paragraph (b)(4) if it either--
    (i) Pays toward the premium for each employee covered under each 
tier of coverage an amount equal to or exceeding the amount that the 
employer would have contributed with respect to that employee for 
employee-only coverage, calculated either based upon the actual premium 
that would have been charged by the insurer for that employee for 
employee-only coverage or based upon the employer-computed composite 
rate for employee-only coverage, or
    (ii) Meets the requirements of paragraph (b)(3) of this section for 
each tier of coverage that it offers substituting the employer-computed 
composite rate for each tier of coverage for the employer-computed 
composite rate for employee-only coverage.
    (5) Employers offering SHOP dependent coverage. If SHOP dependent 
coverage is offered through the SHOP Exchange, the employer does not 
fail to satisfy the uniform percentage requirement by contributing a 
different amount toward that SHOP dependent coverage, even if that 
contribution is zero. For treatment of premiums paid on behalf of an 
employee's dependents, see Sec.  1.45R-3(g)(1).
    (c) Employers offering more than one QHP. If an eligible small 
employer offers more than one QHP, the employer must satisfy the 
requirements of this paragraph (c). The employer may satisfy the 
requirements of this paragraph (c) in either of the following two ways:
    (1) QHP-by-QHP method. The employer makes payments toward the 
premium with respect to each QHP for which the employer is claiming the 
credit that satisfy the uniform percentage requirement under paragraph 
(b) of this section on a QHP-by-QHP basis (so that the amounts or 
percentages of premium paid by the employer for each

[[Page 344]]

QHP need not be identical, but the payments with respect to each QHP 
must satisfy paragraph (b) of this section); or
    (2) Reference QHP method. The employer designates a reference QHP 
and makes employer contributions in accordance with the following 
requirements--
    (i) The employer determines a level of employer contributions for 
each employee such that, if all eligible employees enrolled in the 
reference QHP, the contributions would satisfy the uniform percentage 
requirement under paragraph (b) of this section, and
    (ii) The employer allows each employee to apply an amount of 
employer contribution determined necessary to meet the uniform 
percentage requirement under paragraph (b) of this section either toward 
the reference QHP or toward the cost of coverage under any of the other 
available QHPs.
    (d) Tobacco surcharges and wellness program discounts or rebates--
(i) Tobacco surcharges. The tobacco surcharge and amounts paid by the 
employer to cover the surcharge are not included in premiums for 
purposes of calculating the uniform percentage requirement, nor are 
payments of the surcharge treated as premium payments for purposes of 
calculating the credit. The uniform percentage requirement is also 
applied without regard to employee payment of the tobacco surcharges in 
cases in which all or part of the employee tobacco surcharges are not 
paid by the employer.
    (ii) Wellness programs. If a plan of an employer provides a wellness 
program, for purposes of meeting the uniform percentage requirement any 
additional amount of the employer contribution attributable to an 
employee's participation in the wellness program over the employer 
contribution with respect to an employee that does not participate in 
the wellness program is not taken into account in calculating the 
uniform percentage requirement, whether the difference is due to a 
discount for participation or a surcharge for nonparticipation. The 
employer contribution for employees that do not participate in the 
wellness program must be at least 50 percent of the premium (including 
any premium surcharge for nonparticipation). However, for purposes of 
computing the credit, the employer contributions are taken into account, 
including those contributions attributable to an employee's 
participation in a wellness program.
    (e) Special rules regarding employer compliance with applicable 
State or local law. An employer will be treated as satisfying the 
uniform percentage requirement if the failure to otherwise satisfy the 
uniform percentage requirement is attributable solely to additional 
employer contributions made to certain employees to comply with an 
applicable State or local law.
    (f) Examples. The following examples illustrate the provisions of 
paragraphs (a) through (e) of this section:

    Example 1. (i) Facts. An eligible small employer (Employer) offers a 
QHP on a SHOP Exchange, Plan A, which uses composite billing. The 
premiums for Plan A are $5,000 per year for employee-only coverage, and 
$10,000 for family coverage. Employees can elect employee-only or family 
coverage under Plan A. Employer pays $3,000 (60% of the premium) toward 
employee-only coverage under Plan A and $6,000 (60% of the premium) 
toward family coverage under Plan A.
    (ii) Conclusion. Employer's contributions of 60% of the premium for 
each tier of coverage satisfy the uniform percentage requirement.
    Example 2. (i) Facts. Same facts as Example 1, except that Employer 
pays $3,000 (60% of the premium) for each employee electing employee-
only coverage under Plan A and pays $3,000 (30% of the premium) for each 
employee electing family coverage under Plan A.
    (ii) Conclusion. Employer's contributions of 60% of the premium 
toward employee-only coverage and the same dollar amount toward the 
premium for family coverage satisfy the uniform percentage requirement, 
even though the percentage is not the same.
    Example 3. (i) Facts. Employer offers two QHPs, Plan A and Plan B, 
both of which use composite billing. The premiums for Plan A are $5,000 
per year for employee-only coverage and $10,000 for family coverage. The 
premiums for Plan B are $7,000 per year for employee-only coverage and 
$13,000 for family coverage. Employees can elect employee-only or family 
coverage under either Plan A or Plan B. Employer pays $3,000 (60% of the 
premium) for each employee electing employee-only coverage under Plan A, 
$3,000 (30% of the premium) for each employee electing family coverage 
under Plan A, $3,500 (50% of the premium) for each employee electing 
employee-only coverage under Plan B, and $3,500 (27% of the premium) for 
each

[[Page 345]]

employee electing family coverage under Plan B.
    (ii) Conclusion. Employer's contributions of 60% (or $3,000) of the 
premiums for employee-only coverage and the same dollar amounts toward 
the premium for family coverage under Plan A, and of 50% (or $3,500) of 
the premium for employee-only of coverage and the same dollar amount 
toward the premium for family coverage under Plan B, satisfy the uniform 
percentage requirement on a QHP-by-QHP basis; therefore the employer's 
contributions to both plans satisfy the uniform percentage requirement.
    Example 4. (i) Facts. Same facts as Example 3, except that Employer 
designates Plan A as the reference QHP. Employer pays $2,500 (50% of the 
premium) for each employee electing employee-only coverage under Plan A 
and pays $2,500 of the premium for each employee electing family 
coverage under Plan A or either employee-only or family coverage under 
Plan B.
    (ii) Conclusion. Employer's contribution of 50% (or $2,500) toward 
the premium of each employee enrolled under Plan A or Plan B satisfies 
the uniform percentage requirement.
    Example 5. (i) Facts. Employer receives a list billing premium quote 
with respect to Plan X, a QHP offered by Employer on a SHOP Exchange for 
health insurance coverage for each of Employer's four employees. For 
Employee L, age 20, the employee-only premium is $3,000 per year, and 
the family premium is $8,000. For Employees M, N and O, each age 40, the 
employee-only premium is $5,000 per year and the family premium is 
$10,000. The total employee-only premium for the four employees is 
$18,000 ($3,000 + (3 x 5,000)). Employer calculates an employer-computed 
composite employee-only rate of $4,500 ($18,000/4). Employer offers to 
make contributions such that each employee would need to pay $2,000 of 
the premium for employee-only coverage. Under this arrangement, Employer 
would contribute $1,000 toward employee-only coverage for L and $3,000 
toward employee-only coverage for M, N, and O. In the event an employee 
elects family coverage, Employer would make the same contribution 
($1,000 for L or $3,000 for M, N, or O) toward the family premium.
    (ii) Conclusion. Employer satisfies the uniform percentage 
requirement because it offers and makes contributions based on an 
employer-calculated composite employee-only rate such that, to receive 
employee-only coverage, each employee must pay a uniform amount which is 
not more than 50% of the composite rate, and it allows employees to use 
the same employer contributions toward family coverage.
    Example 6. (i) Facts. Same facts as Example 5, except that Employer 
calculates an employer-computed composite family rate of $9,500 (($8,000 
+ 3 x 10,000)/4) and requires each employee to pay $4,000 of the premium 
for family coverage.
    (ii) Conclusion. Employer satisfies the uniform percentage 
requirement because it offers and makes contributions based on a 
calculated employee-only and family rate such that, to receive either 
employee-only or family coverage, each employee must pay a uniform 
amount which is not more than 50% of the composite rate for coverage of 
that tier.
    Example 7. (i) Facts. Same facts as Example 5, except that Employer 
also receives a list billing premium quote from Plan Y with respect to a 
second QHP offered by Employer on a SHOP Exchange for each of Employer's 
4 employees. Plan Y's quote for Employee L, age 20, is $4,000 per year 
for employee-only coverage or $12,000 per year for family coverage. For 
Employees M, N and O, each age 40, the premium is $7,000 per year for 
employee-only coverage or $15,000 per year for family coverage. The 
total employee-only premium under Plan Y is $25,000 ($4,000 + (3 x 
7,000)). The employer-computed composite employee-only rate is $6,250 
($25,000/4). Employer designates Plan X as the reference plan. Employer 
offers to make contributions based on the employer-calculated composite 
premium for the reference QHP (Plan X) such that each employee has to 
contribute $2,000 to receive employee-only coverage through Plan X. 
Under this arrangement, Employer would contribute $1,000 toward 
employee-only coverage for L and $3,000 toward employee-only coverage 
for M, N, and O. In the event an employee elects family coverage through 
Plan X or either employee-only or family coverage through Plan Y, 
Employer would make the same contributions ($1,000 for L or $3,000 for 
M, N, or O) toward that coverage.
    (ii) Conclusion. Employer satisfies the uniform percentage 
requirement because it offers and makes contributions based on the 
employer-calculated composite employee-only premium for the Plan X 
reference QHP such that, in order to receive employee-only coverage, 
each employee must pay a uniform amount which is not more than 50% of 
the employee-only composite premium of the reference QHP; it allows 
employees to use the same employer contributions toward family coverage 
in the reference QHP or coverage through another QHPs.
    Example 8. (i) Facts. Employer offers employee-only and SHOP 
dependent coverage through a QHP to its three employees using list 
billing. All three employees enroll in the employee-only coverage, and 
one employee elects to enroll two dependents in SHOP dependent coverage. 
Employer contributes 100% of the employee-only premium costs, but only 
contributes 25% of the premium costs toward SHOP dependent coverage.
    (ii) Conclusion. Employer's contribution of 100% toward the premium 
costs of employee-

[[Page 346]]

only coverage satisfies the uniform percentage requirement, even though 
Employer is only contributing 25% toward SHOP dependent coverage.
    Example 9. (i) Facts. Employer has five employees. Employer is 
located in a State that requires employers to pay 50% of employees' 
premium costs, but also requires that an employee's contribution not 
exceed a certain percentage of the employee's monthly gross earnings 
from that employer. Employer offers to pay 50% of the premium costs for 
all its employees, and to comply with the State law, Employer 
contributes more than 50% of the premium costs for two of its employees.
    (ii) Conclusion. Employer satisfies the uniform percentage 
requirement because its failure to otherwise satisfy the uniform 
percentage requirement is attributable solely to compliance with the 
applicable State or local law.
    Example 10. (i) Facts. Employer has three employees who all enroll 
in employee-only coverage. Employer is located in a State that has a 
tobacco surcharge on the premiums of employees who use tobacco. One of 
Employer's employees smokes. Employer contributes 50% of the employee-
only premium costs, but does not cover any of the tobacco surcharge for 
the employee who smokes.
    (ii) Conclusion. Employer's contribution of 50% toward the premium 
costs of employee-only coverage satisfies the uniform percentage 
requirement. Tobacco surcharges are not factored into premiums when 
calculating the uniform percentage requirement.
    Example 11. (i) Facts. Employer has five employees who all enroll in 
employee-only coverage. Employer offers a wellness program that reduces 
the employee share of the premium for employees who participate in the 
wellness program. Employer contributes 50% of the premium costs of 
employee-only coverage for employees who do not participate in the 
wellness program and 55% of the premium costs of employee-only coverage 
for employees who participate in the wellness program. Three of the five 
employees participate in the wellness program.
    (ii) Conclusion. Employer's contribution of 50% toward the premium 
costs of employee-only coverage for the two employees who do not 
participate in the wellness program and 55% toward the premium costs of 
employee-only coverage for three employees who participate in the 
wellness program satisfies the uniform percentage requirement because 
the additional 5% contribution due to the employees' participation in 
the wellness program is not taken into account. However, the additional 
5% contributions are taken into account for purposes of calculating the 
credit.

    (g) Effective/applicability date. This section is applicable for 
periods after 2013. For transition rules relating to certain plan years 
starting in 2014, see Sec.  1.45R-3(i).

[T.D. 9672, 79 FR 36646, June 30, 2014]



Sec.  1.45R-5  Claiming the credit.

    (a) Claiming the credit. The credit is a general business credit. It 
is claimed on an eligible small employer's annual income tax return and 
offsets an employer's actual tax liability for the year. The credit is 
claimed by attaching Form 8941, ``Credit for Small Employer Health 
Insurance Premiums,'' to the eligible small employer's income tax return 
or, in the case of a tax-exempt eligible small employer, by attaching 
Form 8941 to the employer's Form 990-T, ``Exempt Organization Business 
Income Tax Return.'' To claim the credit, a tax-exempt eligible small 
employer must file a form 990-T with an attached Form 8941, even if a 
Form 990-T would not otherwise be required to be filed.
    (b) Estimated tax payments and alternative minimum tax (AMT) 
liability. An eligible small employer may reflect the credit in 
determining estimated tax payments for the year in which the credit 
applies in accordance with the estimated tax rules as set forth in 
sections 6654 and 6655 and the applicable regulations. An eligible small 
employer may also use the credit to offset the employer's alternative 
minimum tax (AMT) liability for the year, if any, subject to certain 
limitations based on the amount of the employer's regular tax liability, 
AMT liability and other allowable credits. See section 38(c)(1), as 
modified by section 38(c)(4)(B)(vi). However, an eligible small 
employer, including a tax-exempt eligible small employer, may not reduce 
its deposits and payments of employment tax (that is, income tax 
required to be withheld under section 3402, social security and Medicare 
tax under sections 3101 and 3111, and federal unemployment tax under 
section 3301) during the year in anticipation of the credit.
    (c) Reduction of section 162 deduction. No deduction under section 
162 is allowed for the eligible small employer for that portion of the 
health insurance premiums that is equal to the amount of the credit 
under Sec.  1.45R-2.

[[Page 347]]

    (d) Effective/applicability date. This section is applicable for 
periods after 2013. For rules relating to certain plan years beginning 
in 2014, see Sec.  1.45R-3(i).

[T.D. 9672, 79 FR 36646, June 30, 2014]



Sec.  1.46-1  Determination of amount.

    (a) Effective dates--(1) In general. This section is effective for 
taxable years beginning after December 31, 1975. However, transitional 
rules under paragraph (g) of this section are effective for certain 
earlier taxable years.
    (2) Acts covered. This section reflects changes made by the 
following Acts of Congress:

                             Act and Section

Tax Reduction Act of 1975, section 301.
Tax Reform Act of 1976, sections 802, 1701, 1703.
Revenue Act of 1978, sections 311, 312, 315.
Energy Tax Act of 1978, section 301.
Economic Recovery Tax Act of 1981, section 212.
Technical Corrections Act of 1982, section 102(f).
Tax Reform Act of 1986, section 251.

    (3) Prior regulations. For taxable years beginning before January 1, 
1976, see 26 CFR 1.46-1 (Rev. as of April 1, 1979). Those regulations do 
not reflect changes made by Pub. L. 89-384, Pub. L. 89-389, and Pub. L. 
91-172.
    (b) General rule. The amount of investment credit (credit) allowed 
by section 38 for the taxable year is the portion of credit available 
under section 46(a)(1) that does not exceed the limitation based on tax 
under section 46(a)(3).
    (c) Credit available. The credit available for the taxable year is 
the sum of--
    (1) Unused credit carried over from prior taxable years under 
section 46(b) (carryovers).
    (2) Amount of credit determined under section 46(a)(2) for the 
taxable year (credit earned), and
    (3) Unused credit carried back from succeeding taxable years under 
section 46(b) (carrybacks).
    (d) Credit earned. The credit earned for the taxable year is the sum 
of the following percentages of qualified investment (as determined 
under section 46 (c) and (d))--
    (1) The regular percentage (as determined under section 46),
    (2) For energy property, the energy percentage (as determined under 
section 46), and
    (3) For the portion of the basis of a qualified rehabilitated 
building (as defined in Sec.  1.48-12(b)) that is attributable to 
qualified rehabilitation expenditures (as defined in Sec.  1.48-12(c)), 
the rehabilitation percentage (as determined under section 46(b)(4)).
    (e) Designation of credits. The credit available for the taxable 
year is designated as follows:
    (1) The credit attributable to the regular percentage is the 
``regular credit''.
    (2) The credit attributable to the ESOP percentage is the ``ESOP 
credit''.
    (3) The credit attributable to the energy percentage for energy 
property other than solar or wind is the ``nonrefundable energy 
credit''.
    (4) The credit attributable to the energy percentage for solar or 
wind energy property is the ``refundable energy credit''.
    (5) The credit attributable to the rehabilitation percentage for 
qualified rehabilitation expenditures is the rehabilitation investment 
credit.
    (f) Special rules for certain energy property. Energy property is 
defined in section 48(l). Under section 46(a)(2)(D), energy property 
that is section 38 property solely by reason of section 48(l)(1) 
qualifies only for the energy credit. Other energy property qualifies 
for both the regular credit (and, if applicable, the ESOP credit) and 
the energy credit. For limitation on the energy percentage for property 
financed by industrial development bonds, see section 48(l)(11).
    (g) Transitional rule for regular and ESOP credit--(1) In general. 
Although section 46(a)(2) was amended by section 301(a)(1) of the Energy 
Tax Act of 1977 to eliminate the transitional rules under section 
46(a)(2)(D), those rules still apply in certain instances. Section 
46(a)(2)(D) was added by section 301(a) of the Tax Reduction Act of 1975 
and amended by section 802(a) of the Tax Reform Act of 1976.
    (2) Regular credit. Under section 46(a)(2)(D), the regular credit is 
10 percent and applies for the following property:

[[Page 348]]

    (i) Property to which section 46 (d) does not apply, the 
construction, reconstruction, or erection of which is completed by the 
taxpayer after January 21, 1975, but only to the extent of basis 
attributable to construction, reconstruction, or erection after that 
date.
    (ii) Property to which section 46(d) does not apply, acquired by the 
taxpayer after January 21, 1975.
    (iii) Qualified progress expenditures (as defined in section 46(d)) 
made after January 21, 1975.
    (3) ESOP credit. See section 48(m) for transitional rules limiting 
the period for which the ESOP percentage under section 46(a)(2)(E) 
applies. For prior statutes, see section 46(a)(2) (B) and (D), as added 
by section 301 of the Tax Reduction Act of 1975 and amended by section 
802 of the Tax Reform Act of 1976.
    (4) Cross reference. (i) The principles of Sec.  1.48-2 (b) and (c) 
apply in determining the portion of basis attributable to construction, 
reconstruction, or erection after January 21, 1975, and in determining 
the time when property is acquired.
    (ii) Section 311 of the Revenue Act of 1978 made the 10 percent 
regular credit permanent.
    (5) Seven percent credit. To the extent that, under paragraph (g)(1) 
of this section, the 10 percent does not apply, the regular credit, in 
general, is 7 percent. For a special limitation on qualified investment 
for public utility property (other than energy property), see section 
46(c)(3)(A).
    (6) Qualified progress expenditures. For progress expenditure 
property that is constructed, reconstructed, or erected by the taxpayer 
within the meaning of Sec.  1.48-2(b), the ten-percent credit applies in 
the year the property is placed in service to the portion of the 
qualified investment that remains after reduction for qualified progress 
expenditures under section 46(c)(4), but only to the extent that the 
remaining qualified investment is attributable to construction, 
reconstruction, or erection after January 21, 1975. For progress 
expenditure property that is acquired by the taxpayer (within the 
meaning of Sec.  1.48-2(b)) after January 21, 1975, and placed in 
service after that date, the ten-percent credit applies in the year the 
property is placed in service to the entire portion of qualified 
investment that remains after reduction for qualified progress 
expenditures.
    (h) Tax liability limitation--(1) In general. Section 46(a)(3) 
provides a tax liability limitation on the amount of credit allowed by 
section 38 (other than the refundable energy credit) for any taxable 
year. See section 46(a)(10)(C)(i). Tax liability is defined in paragraph 
(j) of this section. The excess of available credit over the applicable 
tax liability limitation for the year is an unused credit which may be 
carried forward or carried back under section 46(b).
    (2) Regular and ESOP tax liability limitation. In general, the tax 
liability limitation for the regular and ESOP credits is the portion of 
tax liability that does not exceed $25,000 plus a percentage of the 
excess, as determined under section 46(a)(3)(B).
    (3) Nonrefundable energy credit tax liability limitation. (i) For 
nonrefundable energy credit carrybacks to a taxable year ending before 
October 1, 1978, the tax liability limitation is the portion of tax 
liability that does not exceed $25,000 plus a percentage of the excess, 
as determined under section 46(a)(3)(B).
    (ii) For a taxable year ending after September 30, 1978, the tax 
liability limitation for available nonrefundable energy credit is 100 
percent of the year's tax liability.
    (4) Alternative limitations. Alternative limitations apply for 
certain utilities, railroads, and airlines in determining the regular 
tax liability limitation and, for nonrefundable energy credit carrybacks 
to taxable years ending before October 1, 1978, the nonrefundable energy 
credit tax liability limitation. These alternative limitations do not 
apply in determining the energy tax liability limitation for a taxable 
year ending after October 1, 1978. The provisions listed below set forth 
the alternative limitations:

------------------------------------------------------------------------
     Code section                Type                Years applicable
------------------------------------------------------------------------
46(a)(6) \1\           Utilities                 Taxable years ending in
                                                  1975-1978
46(a)(7) \2\           Utilities                 Taxable year ending in
                                                  1979
46(a)(8)               Railroads and Airlines    Taxable year ending in
                                                  1979 or 1980

[[Page 349]]

 
46(a)(8) \3\           Railroads                 Taxable years ending in
                                                  1977 or 1978
46(a)(9) \3\           Airlines                  Taxable years ending in
                                                  1977 or 1978
------------------------------------------------------------------------
\1\ Section 46(a)(6) was added by section 301(b)(2) of the Tax Reduction
  Act of 1975 and redesignated as section 46(a)(7) by section 302(a)(1)
  of the Tax Reform Act of 1976.
\2\ Section 46(a)(7) was amended by section 312(b)(1) of the Revenue Act
  of 1978.
\3\ These provisions were repealed by section 312(b)(2) of the Revenue
  Act of 1978.

    (i) [Reserved]
    (j) Tax liability--(1) In general. ``Tax liability'' for purposes of 
the regular and ESOP credit and carrybacks of nonrefundable energy 
credit to a taxable year ending before October 1, 1978, means the 
liability for tax as defined in section 46(a)(4). For ordering of 
regular, ESOP, and nonrefundable energy credits, see paragraph (m) of 
this section. In addition to taxes excluded under section 46(a)(4), tax 
liability does not include tax resulting from recapture of credit under 
section 47 and the alternative minimum tax imposed by section 55. See 
sections 47(c) and 55(c)(1).
    (2) Certain nonrefundable energy credit. For a taxable year ending 
after September 30, 1978, ``tax liability'' for purposes of the 
nonrefundable energy credit is liability for tax, as defined in section 
46(a)(4) and paragraph (j)(1) of this section, reduced by the regular 
and ESOP credit allowed for the taxable year. Thus, carrybacks of 
regular or ESOP credit to a taxable year may displace nonrefundable 
energy carryovers or credit earned taken into account in that year. 
However, carrybacks of regular, ESOP, or nonrefundable energy credit do 
not affect refundable energy credit which is treated as an overpayment 
of tax under section 6401(b). See paragraph (k) of this section.
    (k) Special rule for refundable energy credit. The amount of the 
refundable energy credit is determined under the rules of section 46 
(other than section 46(a)(3)). However, to permit the refund, the 
refundable energy credit for purposes of the Internal Revenue Code 
(other than section 38, part IVB, and chapter 63 of the Code) is treated 
as allowed by section 39 and not by section 38. The refundable credit is 
not applied against tax liability for purposes of determining the tax 
liability limitation for other investment credits. Rather, it is treated 
as an overpayment of tax under section 6401(b).
    (l) FIFO rule. If the credit available for a taxable year is not 
allowed in full because of the tax liability limitation, special rules 
determine the order in which credits are applied. Under the first-in-
first-out rule of section 46(a)(1) (FIFO), carryovers are applied 
against the tax liability limitation first. To the extent the tax 
liability limitation exceeds carryovers, credit earned, and carrybacks 
are then applied.
    (m) Special ordering rule--(1) In general. Under section 
46(a)(10)(A), the FIFO rule applies separately--
    (i) First, with respect to regular and ESOP credits, and
    (ii) Second, with respect to nonrefundable energy credit.
    (2) Regular and ESOP credit. Under Sec.  1.46-8(c)(9)(ii), regular 
and ESOP credits available are applied in the following order:
    (i) Regular carryovers;
    (ii) ESOP carryovers;
    (iii) Regular credit earned;
    (iv) ESOP credit earned;
    (v) Regular carrybacks; and
    (vi) ESOP carrybacks.
    (3) Example. For an example of the order of application of regular 
and ESOP credits, see Sec.  1.46-8(c)(9)(iii).
    (n) Examples. The following examples illustrate paragraphs (a) 
through (m) of this section.

    Example 1. (a) Corporation M's regular credit available for its 
taxable year ending December 31, 1979 is as follows:

Regular carryovers...........................................     $5,000
Regular credit earned........................................     10,000
Regular carrybacks...........................................     15,000
                                                              ----------
   Credit available..........................................     30,000
 

    (b) M's ``tax liability'' for 1979 is $30,000. M's tax liability 
limitation for 1979 for the regular credit is $28,000, consisting of 
$25,000 plus 60 percent of the $5,000 of ``tax liability'' in excess of 
$25,000.
    (c) The regular carryovers and credit earned are allowed in full. 
However, only $13,000 of the regular carryback is allowed for 1979. The 
remaining $2,000 must be carried to the next year to which it may be 
carried under section 46(b).
    Example 2. (a) For its taxable year ending December 31, 1980, 
corporation N has $30,000 regular credit earned and $9,000 nonrefundable 
energy credit earned. N has no carryovers to 1980 and no ``tax 
liability'' for pre-1980 years.

[[Page 350]]

    (b) N's ``tax liability'' for 1980 for the regular credit is 
$35,000. N's tax liability limitation for 1980 for the regular credit is 
$32,000, consisting of $25,000 plus 70 percent of the $10,000 of ``tax 
liability'' in excess of $25,000.
    (c) The entire regular credit is allowed in 1980.
    (d) N's ``tax liability'' for 1980 for the nonrefundable energy 
credit is $5,000, consisting of $35,000 less $30,000 regular credit 
allowed for 1980. N's tax liability limitation for 1980 for the 
nonrefundable energy credit is 100 percent of $5,000.
    (e) $5,000 of the nonrefundable energy credit is allowed for 1980. 
The remaining $4,000 energy credit is an unused nonrefundable energy 
credit which must be carried to the next year to which it may be carried 
under section 46(b).
    Example 3. (a) Assume the same facts as in Example 2 except that in 
its taxable year ending December 31, 1981, N earns a regular credit of 
which it may carry back $2,000 to 1980.
    (b) The $30,000 regular credit earned and $2,000 of the regular 
carryback is allowed for 1980. N's ``tax liability'' for 1980 for the 
nonrefundable energy credit is reduced to $3,000, consisting of $35,000 
less $32,000 regular credit allowed for 1980. The nonrefundable energy 
credit allowed for 1980 is reduced to $3,000. The remaining $6,000 is an 
unused nonrefundable energy credit which must be carried to the next 
year to which it may be carried under section 46(b).
    Example 4. (a) For its taxable year ending December 31, 1980, 
corporation P's regular credit earned is $20,000. P also has a $9,000 
refundable energy credit for 1980. There are no carryovers or carrybacks 
to 1980.
    (b) P's ``tax liability'' for 1980 for the regular credit is $25,000 
which is also the tax liability limitation for the regular credit.
    (c) The entire $20,000 regular credit is allowed for 1980. The 
entire $9,000 refundable energy credit is treated as an overpayment of 
tax under section 6401(b), even though ``tax liability'' remains.
    Example 5. Assume the same facts as in Example 4, except that in the 
following year P earns a regular credit, $5,000 of which it may carry 
back to 1980. The $5,000 carryback is allowed in full in 1980.
    Example 6. (i) Corporation X, a calendar year taxpayer, constructs a 
ship on which it begins construction on January 1, 1973, and which, when 
placed in service on December 31, 1980, has a basis of $450,000. Of that 
amount, $100,000 is attributable to construction before January 22, 
1975. X makes an election under section 46(d) (qualified progress 
expenditures) for taxable years after 1975.
    (ii) For 1976, 1977, 1978, and 1979, qualified progress expenditures 
total $200,000. The ten-percent credit applies to those expenditures.
    (iii) For 1980, qualified investment for the ship is $450,000. Under 
section 46(c)(4), X must reduce this amount by $200,000, the amount of 
qualified progress expenditures taken into account. The ten-percent 
credit applies to the portion of the remaining qualified investment 
attributable to construction after January 21, 1975 ($150,000). The 
seven-percent credit applies to the portion of qualified investment 
attributable to construction before January 22, 1975 ($100,000).
    Example 7. (i) Corporation Y agrees to build a ship for Corporation 
X, which uses the calendar year. In 1973, Y begins construction of the 
ship which X acquires and places in service on December 31, 1980. X 
makes an election under section 46(d) for taxable years after 1974. The 
contract price is $400,000.
    (ii) For 1975, 1976, 1977, 1978, and 1979, qualified progress 
expenditures total $250,000. The ten-percent credit applies to those 
expenditures.
    (iii) For 1980, qualified investment for the ship is $400,000, which 
is the contract price. X must reduce qualified investment by $250,000, 
the amount of qualified progress expenditures. The ten-percent credit 
applies to the $150,000 of qualified investment that remains after 
reduction for qualified progress expenditures.

    (o) Married individuals. If a separate return is filed by a husband 
or wife, the tax liability limitation is computed by substituting a 
$12,500 amount for the $25,000 amount that applies under section 
46(a)(3). However, this reduction of the $25,000 amount to $12,500 
applies only if the taxpayer's spouse is entitled to a credit under 
section 38 for the taxable year of such spouse which ends with, or 
within, the taxpayer's taxable year. The taxpayer's spouse is entitled 
to a credit under section 38 either because of investment made in 
qualified property for such taxable year of the spouse (whether directly 
made by such spouse or whether apportioned to such spouse, for example, 
from an electing small business corporation, as defined in section 
1371(b)), or because of an investment credit carryback or carryover to 
such taxable year. The determination of whether an individual is married 
shall be made under the principles of section 143 and the regulations 
thereunder.
    (p) Apportionment of $25,000 amount among component members of a 
controlled group--(1) In general. In determining the tax liability 
limitation under section 46(a)(3) for corporations that are component 
members of a controlled group on December 31, only one $25,000

[[Page 351]]

amount is available to those component members for their taxable years 
that include that December 31. See subparagraph (2) of this paragraph 
for apportionment of such amount among such component members. See 
subparagraph (3) of this paragraph for definition of ``component 
member''.
    (2) Manner of apportionment. (i) In the case of corporations which 
are component members of a controlled group on a particular December 31, 
the $25,000 amount may be apportioned among such members for their 
taxable years that include such December 31 in any manner the component 
members may select, provided that each such member less than 100 percent 
of whose stock is owned, in the aggregate, by the other component 
members of the group on such December 31 consents to an apportionment 
plan. The consent of a component member to an apportionment plan with 
respect to a particular December 31 shall be made by means of a 
statement, signed by a person duly authorized to act on behalf of the 
consenting member, stating that such member consents to the 
apportionment plan with respect to such December 31. The statement shall 
set forth the name, address, employer identification number, and taxable 
year of each component member of the group on such December 31, the 
amount apportioned to each such member under the plan, and the location 
of the Service Center where the statement is to be filed. The consent of 
more than one component member may be incorporated in a single 
statement. The statement shall be timely filed with the Service Center 
where the component member having the taxable year first ending on or 
after such December 31 files its return for such taxable year and shall 
be irrevocable after such filing. If two or more component members have 
the same such taxable year, a statement of consent may be filed by any 
one of such members. However, if the due date (including any extensions 
of time) of the return of such member is on or before December 15, 1971, 
the required statement shall be considered as timely filed if filed on 
or before March 15, 1972. Each component member of the group on such 
December 31 shall keep as a part of its records a copy of the statement 
containing all the required consents.
    (ii) An apportionment plan adopted by a controlled group with 
respect to a particular December 31 shall be valid only for the taxable 
year of each member of the group which includes such December 31. Thus, 
a controlled group must file a separate consent to an apportionment plan 
with respect to each taxable year which includes a December 31 as to 
which an apportionment plan is desired.
    (iii) If the apportionment plan is not timely filed, the $25,000 
amount specified in section 46(a)(3) shall be reduced for each component 
member of the controlled group, for its taxable year which includes a 
December 31, to an amount equal to $25,000 divided by the number of 
component members of such group on such December 31.
    (iv) If a component member of the controlled group makes its income 
tax return on the basis of a 52-53-week taxable year, the principles of 
section 441(f)(2)(A)(ii) and Sec.  1.441-2 apply in determining the last 
day of such taxable year.
    (3) Definitions of controlled group of corporations and component 
member of controlled group. For the purpose of this paragraph, the terms 
``controlled group of corporations'' and ``component member'' of a 
controlled group of corporations shall have the same meaning assigned to 
those terms in section 1563 (a) and (b). For purposes of applying Sec.  
1.1563-1(b)(2)(ii)(c), an electing small business corporation shall be 
treated as an excluded member whether or not it is subject to the tax 
imposed by section 1378.
    (4) Members of a controlled group filing a consolidated return. If 
some component members of a controlled group join in filing a 
consolidated return pursuant to Sec.  1.1502-3(a)(3), and other 
component members do not join, then, unless a consent is timely filed 
apportioning the $25,000 amount among the group filing the consolidated 
return and the other component members of the controlled group, each 
component member of the controlled group (including each component 
member which joins in filing the consolidated return)

[[Page 352]]

shall be treated as a separate corporation for purposes of equally 
apportioning the $25,000 amount under subparagraph (2)(iii) of this 
paragraph. In that case, the tax liability limitation for the group 
filing the consolidated return is computed by substituting for the 
$25,000 amount under section 46(a)(3) the total amount apportioned to 
each component member that joins in filing the consolidated return. If 
the affiliated group filing the consolidated return and the other 
component members of the controlled group adopt an apportionment plan, 
the affiliated group shall be treated as a single member for the purpose 
of applying subparagraph (2)(i) of this paragraph. Thus, for example, 
only one consent executed by the common parent to the apportionment plan 
is required for the group filing the consolidated return. If any 
component member of the controlled group which joins in the filing of 
the consolidated return is an organization to which section 593 applies 
or a cooperative organization described in section 1381(a), see 
paragraph (a)(3)(ii) of Sec.  1.1502-3.
    (5) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. At all times during 1976 Smith, an individual, owns all 
the stock of corporations X, Y, and Z. Corporation X files an income tax 
return on a calendar year basis. Corporation Y files an income tax 
return on the basis of a fiscal year ending June 30. Corporation Z files 
an income tax return on the basis of a fiscal year ending September 30. 
On December 31, 1976, X, Y, and Z are component members of the same 
controlled group. X, Y, and Z all consent to an apportionment plan in 
which the $25,000 amount is apportioned entirely to Y for its taxable 
year ending June 30, 1977 (Y's taxable year which includes December 31, 
1976). Such consent is timely filed. For purposes of computing the 
credit under section 38, Y's tax liability limitation for its taxable 
year ending June 30, 1977, is so much of Y's tax liability as does not 
exceed $25,000, plus 50 percent of Y's tax liability in excess of 
$25,000. X's and Z's limitations for their taxable years ending December 
31, 1976, and September 30, 1977, respectively, are equal to 50 percent 
of X's tax liability for 50 percent of Z's tax liability. On the other 
hand, if an apportionment plan is not timely filed, X's limitation would 
be so much of X's tax liability as does not exceed $8,333.33, plus 50 
percent of X's liability in excess of $8,333.33, and Y's and Z's 
limitations would be computed similarly.
    Example 2. At all times during 1976, Jones, an individual, owns all 
the outstanding stock of corporations P, Q, and R. Corporations Q and R 
both file returns for taxable years ending December 31, 1976. P files a 
consolidated return as a common parent for its fiscal year ending June 
30, 1977, with its two wholly-owned subsidiaries N and O. On December 
31, 1976, N, O, P. Q, and R are component members of the same controlled 
group. No consent to an apportionment plan is filed. Therefore, each 
member is apportioned $5,000 of the $25,000 amount ($25,000 divided 
equally among the five members). The tax liability limitation for the 
group filing the consolidated return (P, N, and O) for the year ending 
June 30, 1977 (the consolidated taxable year within which December 31, 
1976, falls) is computed by using $15,000 instead of the $25,000 amount. 
The $15,000 is arrived at by adding together the $5,000 amounts 
apportioned to P, N, and O.

    (q) Rehabilitation percentage--(1) General rule--(i) In general. Due 
to amendments made by the Tax Reform Act of 1986, different rules apply 
depending on when the property attributable to the qualified 
rehabilitated expenditures (as defined in Sec.  1.48-12(c)) is placed in 
service. Paragraph (q)(1)(ii) of this section contains the general rule 
relating to property placed in service after December 31, 1986. 
Paragraph (q)(1)(iii) of this section contains rules relating to 
property placed in service before January 1, 1987. Paragraph (q)(1)(iv) 
of this section contains rules relating to property placed in service 
after December 31, 1986, that qualifies for a transition rule.
    (ii) Property placed in service after December 31, 1986. Except as 
otherwise provided in paragraph (q)(1)(iv) of this section, in the case 
of section 38 property described in section 48(a)(1)(E) placed in 
service after December 31, 1986, the term ``rehabilitation percentage'' 
means--
    (A) 10 percent in the case of qualified rehabilitation expenditures 
with respect to a qualified rehabilitated building other than a 
certified historic structure, and
    (B) 20 percent in the case of qualified rehabilitation expenditures 
with respect to a certified historic structure.
    (iii) Property placed in service before January 1, 1987. For 
qualified rehabilitation expenditures (as defined in

[[Page 353]]

Sec.  1.48-12(c)) with respect to property placed in service before 
January 1, 1987, section 46(b)(4)(A) as in effect prior to the enactment 
of the Tax Reform Act of 1986 provided for a three-tier rehabilitation 
percentage. The applicable rehabilitation percentage for such 
expenditures depends on whether the qualified rehabilitated building is 
a ``30-year building,'' a ``40-year building,'' or a certified historic 
structure (as defined in section 48(g)(3) and Sec.  1.48-12(d)(1)). The 
rehabilitation percentage for such qualified rehabilitation expenditures 
incurred with respect to a qualified rehabilitated building is 15 
percent to the extent that the building is a 30-year building (i.e., at 
least 30 years, but less than 40 years, has elapsed between the date the 
physical work on the rehabilitation began and the date the building was 
first placed in service), 20 percent to the extent that the building is 
a 40-year building (i.e., at least 40 years has so elapsed), and 25 
percent for certified historic structures, regardless of age. See 
paragraph (q)(2)(ii) of this section for rules concerning buildings to 
which additions have been added.
    (iv) Property placed in service after December 31, 1986, that 
qualifies under the transition rules. In the case of section 38 property 
described in section 48(a)(1)(E) placed in service after December 31, 
1986, and to which the amendments made by section 251 of the Tax Reform 
Act of 1986 do not apply because the transition rules in section 251(d) 
of that Act and Sec.  1.48-12(a)(2)(iv)(B) or (C) apply, the 
rehabilitation percentage for a ``30-year building'' (within the meaning 
of paragraph (q)(1)(iii) of this section) shall be 10 percent, the 
rehabilitation percentage for a ``40-year building'' (within the meaning 
of paragraph (q)(1)(iii) of this section) shall be 13 percent, and the 
rehabilitation percentage for a certified historic structure shall be 25 
percent.
    (2) Special rules--(i) Moved buildings. With respect to paragraph 
(q)(1)(ii) of this section, Sec.  1.48-12(b)(5) provides that a building 
(other than a certified historic structure) is not a qualified 
rehabilitated building unless it has been at the location where it is 
being rehabilitated since January 1, 1936. In addition, for purposes of 
paragraph (q)(1) (iii) and (iv) of this section, a building is not a 
``30-year building'' unless it has been at the location where it is 
being rehabilitated for the thirty-year period immediately preceding the 
beginning of the rehabilitation process, and is not a ``40-year 
building'' unless it has been at the location where it is being 
rehabilitated for the forty-year period immediately preceding the 
beginning of the rehabilitation process.
    (ii) Building to which additions have been added--(A) Property 
placed in service after December 31, 1986. For purposes of paragraph 
(q)(1)(ii) of this section, if part of a building meets the definition 
of a qualified rehabilitated building, and part of the building does not 
meet the definition of a qualified rehabilitated building because such 
part is an addition that was placed in service after December 31, 1935, 
the qualified rehabilitation expenditures made to the building must be 
allocated to the pre-1936 portion of the building and the post-1935 
portion of the building using the principles in Sec.  1.48-
12(c)(10)(ii). Qualified rehabilitation expenditures attributable to the 
post-1935 addition shall not qualify for the 10 percent rehabilitation 
percentage.
    (B) Property placed in service before January 1, 1987, and property 
qualifying for a transitional rule. For purposes of paragraphs (q)(1) 
(iii) and (iv) of this section, if part of a building meets the 
definition of a ``40-year building'' and part of the building is an 
addition that was placed in service less than forty years before 
physical work on the rehabilitation began but more than thirty years 
before such date, then the qualified rehabilitation expenditures made to 
the building shall be allocated between the forty year old portion of 
the building and the thirty year old portion of the building, and a 20 
percent rehabilitation percentage shall be applied to the forty year old 
portion of the building and a 15 percent rehabilitation percentage shall 
be applied to the thirty year old portion. This allocation shall be made 
using the principles in Sec.  1.48-12(c)(10)(ii). If an allocation 
cannot be made between the expenditures to the forty year old portion of 
the building and the thirty year old portion of the building, then the 
building will be considered to be a 30-year

[[Page 354]]

building. Furthermore, for purposes of this paragraph (q), a building 
(other than a certified historic structure) is not a qualified 
rehabilitated building to the extent of that portion of the building 
that is less than 30 years old. If rehabilitation expenditures are 
incurred with respect to an addition to a qualified rehabilitated 
building, but the addition is not considered to be part of the qualified 
rehabilitated building because the addition does not meet the age 
requirement in section 48(g)(1)(B) (as in effect prior to its amendment 
by the Tax Reform Act of 1986) and Sec.  1.48-12(b)(4)(i)(B), then no 
rehabilitation percentage will be applied to the expenditures 
attributable to the rehabilitation of the addition. Thus, for purposes 
of paragraphs (q)(1) (iii) and (iv) of this section, it may be necessary 
to allocate rehabilitation expenditures incurred with respect to a 
building between the original portion of the building and the addition.
    (iii) Mixed-use buildings. If qualified rehabilitation expenditures 
are incurred for property that is excluded from section 38 property 
described in section 48(a)(1)(E) (because, for example, they are made 
with respect to a portion of the building used for lodging within the 
meaning of section 48(a)(3) and Sec.  1.48-1(h)), an allocation of the 
expenditures must be made between the expenditures that result in an 
addition to basis that is section 38 property and the expenditures that 
result in an addition to basis that is excluded from the definition of 
section 38 property since the rehabilitation percentage is applicable 
only to section 38 property. These allocations should be made using the 
principles contained in Sec.  1.48-12(c)(10)(ii).
    (3) Regular and energy percentages not to apply. The regular 
percentage and the energy percentage shall not apply to that portion of 
the basis of any building that is attributable to qualified 
rehabilitation expenditures (as defined in Sec.  1.48-12(c)).
    (4) Effective date. The rehabilitation percentage is applicable only 
to qualified rehabilitation expenditures (as defined in Sec.  1.48-
12(c)). For rules relating to applicability of the regular percentage to 
qualified rehabilitation expenditures (as defined in Sec.  1.48-11(c)), 
see Sec.  1.48-11.

[T.D. 6731, 29 FR 6064, May 8, 1964]

    Editorial Note: For Federal Register citations affecting Sec.  1.46-
1, see the List of CFR Sections Affected, which appears in the Finding 
Aids section of the printed volume and at www.govinfo.gov.



Sec.  1.46-2  Carryback and carryover of unused credit.

    (a) Effective date. This section is effective for taxable years 
beginning after December 31, 1975. For taxable years beginning before 
January 1, 1976, see 26 CFR 1.46-2 (Rev. as of April 1, 1979).
    (b) In general. Under section 46(b)(1), unused credit may be carried 
back and carried over. Carrybacks and carryovers of unused credit are 
taken into account in determining the amount of credit available and the 
credit allowed for the taxable years to which they may be carried. In 
general, the application of the rules of this section to regular and 
ESOP credits are separate from their application to nonrefundable energy 
credits. For example, the limitations on carrybacks and carryovers of 
unused nonrefundable energy credit under section 46(b) (2) and (3), 
respectively, differ in amount from the limitations on the regular and 
ESOP credits because the tax liability limitations for those credits 
differ. See Sec.  1.46-1(h). For a further example, see the special 
ordering rule in Sec.  1.46-1(m). Section 46(b) does not apply to the 
refundable energy credit.
    (c) Unused credit. If carryovers and credit earned (as defined in 
Sec.  1.46-1(c)(1)) exceed the applicable tax liability limitation, the 
excess attributable to credit earned is an unused credit. The taxable 
year in which an unused credit arises is referred to as the ``unused 
credit year''.
    (d) Taxable years to which unused credit may be carried. An unused 
credit is a carryback to each of the 3 taxable years preceding the 
unused credit year and a carryover to each of the 7 taxable years 
succeeding the unused credit year. An unused credit must be carried 
first to the earliest of those 10 taxable years. An unused credit then 
must be carried to each of the other 9 taxable years (in order of time) 
to the extent

[[Page 355]]

that the unused credit was not absorbed during a prior taxable year 
because of the limitations under section 46(b) (2) and (3).
    (e) Special rule for pre-1971 years--(1) In general. For unused 
credit years ending before January 1, 1971, unused credit is allowed a 
10-year carryover rather than the 7-year carryover. The principles of 
paragraph (d) of this section apply to this 10-year carryover.
    (2) Cross reference. For limitations on the taxable years to which 
unused credit from pre-1971 credit years may be carried, see paragraph 
(g) of this section.
    (f) Limitations on carrybacks. Under the FIFO rule to section 
46(a)(1), carryovers and credit earned are applied against the tax 
liability limitation before carrybacks. Thus, carrybacks to a taxable 
year may not exceed the amount by which the applicable tax liability 
limitation for that year exceeds the sum of carryovers to and credit 
earned for that year. Carrybacks from an unused credit year are applied 
against tax liability before carrybacks from a later unused credit year. 
To the extent an unused credit cannot be carried back to a particular 
preceding taxable year, the unused credit must be carried to the next 
succeeding taxable year to which it may be carried.
    (g) Limitations on carryovers--(1) General rule. Carryovers to a 
taxable year may not exceed the applicable tax liability limitation for 
that year. Carryovers from an unused credit year are applied before 
carryovers from a later unused credit year.
    (2) Exception. A 10-year carryover from a pre-1971 unused credit 
year may, under certain circumstances, be postponed to prevent a later-
earned 7-year carryover from expiring. This exception does not extend 
the 10-year carryover period for pre-1971 unused credit. See section 
46(b)(1)(D).
    (h) Examples. The following examples illustrate paragraphs (a) 
through (g) of this section.

    Example 1. (a) Corporation M is organized on January 1, 1977 and 
files its income tax return on a calendar year basis. Assume the facts 
set forth in columns (1) and (2) of the following table. The 
determination of the regular credit allowed for each of the taxable 
years indicated is set forth in the remaining portions of the table.

----------------------------------------------------------------------------------------------------------------
                                    (1)        (2)        (3)         (4)         (5)         (6)         (7)
                                --------------------------------------------------------------------------------
                                                                      Tax
                                                                   liability
                                                                   limitation    Credit    Remaining    Unused
                                   Credit      Tax                 (remaining   allowed       tax       credit
                                 available  liability   Percent    from col.   (lower of   liability   ((1)-(5))
                                                                     (6) on      (1) or   limitation  or (amount
                                                                   preceding      (4))     ((4)-(5))   absorbed)
                                                                     line)
----------------------------------------------------------------------------------------------------------------
1977:
  A. Credit earned.............    $20,000    $45,000         50    $35,000      $20,000     $15,000          0
  B. Carryback from 1978.......    *15,000  .........  .........    [15,000]      15,000
1978:
  A. Credit earned.............     80,000     55,000         50     40,000       40,000           0    $20,000
    Carryback to 1977..........  .........  .........  .........  ...........  .........  ..........   (*15,000)
    Carryover to 1979..........  .........  .........  .........  ...........  .........  ..........    (*5,000)
1979:
  A. Carryover from 1978.......     *5,000     50,000         60     40,000        6,000      35,000
  B. Credit earned.............     50,000  .........  .........    [35,000]      35,000           0     15,000
    Carryover to 1980..........  .........  .........  .........  ...........  .........  ..........   (*15,000)
1980:
  A. Carryover from 1979.......    *15,000     55,000         70     46,000       15,000      31,000
  B. Credit earned.............     25,000  .........  .........    [31,000]      25,000       6,000          0
----------------------------------------------------------------------------------------------------------------
*For line ``A'' each year: Lesser of (1) tax liability or (2) $25,000 + (percentage in col. (3) x [col. (2) -
  $25,000]). See, Sec.   1.46-1(h). For other lines: Amount in col. (6) on preceding line.

    Example 2. (a) Assume the same facts as in Example 1 except for 1979 
M earns a $35,000 nonrefundable energy credit. The following table shows 
the determinations for each year.

[[Page 356]]



--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                           (1)                 (2)                (3)         (4)         (5)         (6)         (7)
                                                       -------------------------------------------------------------------------------------------------
                                                                          Tax liability                       Tax
                                                                  ----------------------------             liability
                                                                                                          limitation*    Credit    Remaining    Unused
                                                          Credit                                           (remaining   allowed       tax       credit
                                                        available     (a)        (b) Energy     Percent    from col.   (lower of   liability   ((1)-(5))
                                                                    Regular   ((2)(a)-(5)(R))                (6) on      (1) or   limitation  or (amount
                                                                                                           preceding      (4))     ((4)-(5))   absorbed)
                                                                                                             line)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1977:
  Regular:
    A. Credit earned..................................    $20,000    $45,000  ...............         50    $35,000     $20,000R     $15,000          0
    B. Carryback from 1978............................    *15,000  .........  ...............  .........    [15,000]     15,000R           0
1978:
  Regular:
    A. Credit earned..................................     60,000     55,000  ...............         50     40,000      40,000R           0    $20,000
      Carryback to 1977...............................  .........  .........  ...............  .........  ...........  .........  ..........   (*15,000)
      Carryover to 1979...............................  .........  .........  ...............  .........  ...........  .........  ..........    (*5,000)
  Energy:
    A. Carryback from 1979............................    *15,000  .........       $15,000           100     15,000      15,000E           0
1979:
  Regular:
    A. Carryover from 1978............................     *5,000     50,000  ...............         60     40,000       5,000R      35,000
    B. Credit earned..................................     50,000  .........  ...............  .........    [35,000]     35,000R           0     15,000
      Carryover to 1980...............................  .........  .........  ...............  .........  ...........  .........  ..........   (*15,000)
  Energy:
    A. Credit earned..................................     35,000  .........        10,000           100     10,000      10,000E           0     25,000
      Carryback to 1978...............................  .........  .........  ...............  .........  ...........  .........  ..........   (*15,000)
      Carryover to 1980...............................  .........  .........  ...............  .........  ...........  .........  ..........   (*10,000)
1980:
  Regular:
    A. Carryover from 1979............................    *15,000     55,000  ...............         70     46,000      15,000R      31,000
    B. Credit earned..................................     25,000  .........  ...............  .........    [31,000]     25,000R       6,000          0
  Energy:
    A. Carryover from 1979............................    *10,000  .........        15,000           100     15,000      10,000E       5,000
--------------------------------------------------------------------------------------------------------------------------------------------------------
*See footnote to the chart in Example 1.

    (b) Although, in general, a nonrefundable energy credit may be 
carried back to taxable years ending before October 1, 1978, in this 
example the unused nonrefundable energy credit from 1979 may not be 
absorbed in 1977. The 1977 tax liability limitation for the 
nonrefundable energy credit is the same as it is for the regular credit, 
reduced by regular credit previously allowed for 1977. See Sec. Sec.  
1.46-1(h)(3) and 1.46-1(m).
    Example 3. (a) Assume the same facts as in Example 2 except M has 
regular credit of $37,000 for 1981 and M's tax liability for 1981 is 
$32,500. The determinations for 1980 and 1981 are set forth in the 
following table.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                              (1)               (2)               (3)         (4)         (5)         (6)         (7)
                                                          ----------------------------------------------------------------------------------------------
                                                                           Tax liability                      Tax
                                                                     -------------------------             liability
                                                                                                          limitation*    Credit    Remaining    Unused
                                                             Credit                                        (remaining   allowed       tax       credit
                                                           available     (a)      (b) Energy    Percent    from col.   (lower of   liability   ((1)-(5))
                                                                       Regular   ((2)-(5)(R))                (6) on      (1) or   limitation  or (amount
                                                                                                           preceding      (4))     ((4)-(5))   absorbed)
                                                                                                             line)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1979 (restated):
  Energy:
    To be carried over...................................  .........  .........  ............  .........  ...........  .........  ..........    $10,000
      Carryover to 1980..................................  .........  .........  ............  .........  ...........  .........  ..........    (*9,000)
      Carryover to 1981..................................  .........  .........  ............  .........  ...........  .........  ..........    (*1,000)
1980 (restated):
  Regular:
    A. Carryover from 1979...............................    $15,000    $55,000  ............         70    $46,000     $15,000R     $31,000
    B. Credit earned.....................................    *25,000  .........  ............  .........    [31,000]     25,000R       6,000          0
    C. Carryback from 1981...............................     *6,000  .........  ............  .........     [6,000]      6,000R           0

[[Page 357]]

 
  Energy:
    A. Carryover from 1979...............................     *9,000  .........       $9,000         100      9,000       9,000E
1981: Regular:
    A. Credit earned.....................................     37,000     32,500  ............         80     31,000      31,000R           0      6,000
      Carryback to 1980..................................  .........  .........  ............  .........  ...........  .........  ..........    (*6,000)
  Energy:
    A. Carryover from 1979...............................     *1,000  .........        1,500         100      1,500       1,000E         500          0
--------------------------------------------------------------------------------------------------------------------------------------------------------
*See footnote to chart under Example 1.

    (b) Allowance of the regular carryback in 1980 from 1981 requires 
that the computations for 1980 be restated. The energy tax liability 
limitation for 1980 is reduced from $15,000 (as determined in Example 2) 
to $9,000. Thus, $1,000 of the $10,000 energy credit allowed for 1980 is 
displaced by the regular carryback. That amount may not be carried back 
because there is no remaining energy tax liability limitation for the 
prior 3 years (see table in Example 2). It may be carried over to 1981 
and allowed in full in that year.

    (i) [Reserved]
    (j) Electing small business corporation. A shareholder of an 
electing small business corporation (as defined in section 1371(b)) may 
not take into account unused credit of the corporation attributable to 
unused credit years for which the corporation was not an electing small 
business corporation. However, a taxable year for which the corporation 
is an electing small business corporation is counted as a taxable year 
for determining the taxable years to which that unused credit may be 
carried.
    (k) Periods of less than 12 months. A fractional part of a year that 
is considered a taxable year under sections 441(b) and 7701(a)(23) is 
treated as a preceding or succeeding taxable year for determining under 
section 46(b) the taxable years to which an unused credit may be 
carried.
    (l) Corporate acquisitions. For carryover of unused credits in the 
case of certain corporate acquisitions, see section 381(c)(23).

(Secs. 7805 (68A Stat. 917, 26 U.S.C. 7805) and 38(b) (76 Stat. 962, 26 
U.S.C. 38))

[T.D. 7751, 46 FR 1679, Jan. 7, 1981]



Sec.  1.46-3  Qualified investment.

    (a) In general. (1) With respect to any taxable year, the qualified 
investment of the taxpayer is the aggregate (expressed in dollars) of 
(i) the applicable percentage of the basis of each new section 38 
property placed in service by the taxpayer during such taxable year, 
plus (ii) the applicable percentage of the cost of each used section 38 
property placed in service by the taxpayer during such taxable year. 
With respect to any section 38 property, qualified investment means the 
applicable percentage of the basis (or cost) of such property. Section 
38 property placed in service by the taxpayer during the taxable year 
includes the taxpayer's share of the basis (or cost) of section 38 
property placed in service by a partnership in the taxable year of such 
partnership ending with or within the taxpayer's taxable year. In the 
case of a shareholder of an electing small business corporation (as 
defined in section 1371(b)), or a beneficiary of an estate or trust, see 
Sec. Sec.  1.48-5 and 1.48-6, respectively, for apportionment of the 
basis (or cost) of section 38 property placed in service by such 
corporation, estate, or trust. For the definitions of new section 38 
property and used section 38 property, see Sec. Sec.  1.48-2 and 1.48-3, 
respectively. See Sec.  1.46-5 for special rules for progress 
expenditure property.
    (2) The basis (or cost) of section 38 property placed in service 
during a taxable year shall not be taken into account in determining 
qualified investment for such year if such property is disposed of or 
otherwise ceases to be section 38 property during such year,

[[Page 358]]

except where Sec.  1.47-3 applies. Thus, if individual A places in 
service during a taxable year section 38 property and later in the same 
year sells such property, the basis (or cost) of such property shall not 
be taken into account in determining A's qualified investment. On the 
other hand, if A places in service section 38 property during a taxable 
year and dies later in the same year, the basis (or cost) of such 
property would be taken into account in computing qualified investment. 
Similarly, if section 38 property is destroyed by fire in the same year 
in which it is placed in service and paragraph (h) of this section 
applies to reduce the basis (or cost) of replacement property, the basis 
(or cost) of the destroyed property would be taken into account in 
computing qualified investment. In order to determine whether section 38 
property is disposed of or otherwise ceases to be section 38 property 
see Sec.  1.47-2.
    (3) Qualified investment is reduced in the case of property which is 
``public utility property'' (see paragraph (h) of this section), and in 
the case of property of organizations to which section 593 applies, 
regulated investment companies or real estate investment trusts subject 
to taxation under subchapter M, chapter 1 of the Code, and cooperative 
organizations described in section 1381(a) (see Sec.  1.46-4).
    (b) Applicable percentage. The applicable percentage to be applied 
to the basis (or cost) of property is 33\1/3\ percent if the estimated 
useful life of the property is 3 years or more but less than 5 years; 
66\2/3\ percent if the estimated useful life is 5 years or more but less 
than 7 years; or 100 percent if the estimated useful life is 7 years or 
more. In the case of property which is not described in section 50, the 
preceding sentence shall be applied by substituting ``4 years'' for ``3 
years'', ``6 years'' for ``5 years'', and ``8 years'' for ``7 years''. 
The provisions of this paragraph may be illustrated by the following 
example:

    Example. Corporation Y acquires and places in service during 1972 
the following new and used section 38 properties:

------------------------------------------------------------------------
                                                   Estimated
                                                     useful    Basis (or
                     Property                         life       cost)
                                                    (years)
------------------------------------------------------------------------
A (new)..........................................          4     $60,000
B (new)..........................................         10      90,000
C (new)..........................................          6     150,000
D (used).........................................          3      30,000
------------------------------------------------------------------------

    Corporation Y's qualified investment for 1972 is $220,000 determined 
in the following manner:

------------------------------------------------------------------------
                                    Basis (or    Applicable   Qualified
             Property                 cost)      percentage   investment
------------------------------------------------------------------------
A................................      $60,000      33\1/3\      $20,000
B................................       90,000          100       90,000
C................................      150,000      66\2/3\      100,000
D................................       30,000      33\1/3\       10,000
                                  --------------------------------------
  Total....................................................      220,000
------------------------------------------------------------------------

    (c) Basis or cost. (1) The basis of any new section 38 property 
shall be determined in accordance with the general rules for determining 
the basis of property. Thus, the basis of property would generally be 
its cost (see section 1012), unreduced by the adjustment to basis 
provided by section 48(g)(1) with respect to property placed in service 
before January 1, 1964, and any other adjustment to basis, such as that 
for depreciation, and would include all items properly included by the 
taxpayer in the depreciable basis of the property, such as installation 
and freight costs. However, for purposes of determining qualified 
investment, the basis of new section 38 property constructed, 
reconstructed, or erected by the taxpayer shall not include any 
depreciation sustained with respect to any other property used in the 
construction, reconstruction, or erection of such new section 38 
property. (See paragraph (b)(4) of Sec.  1.48-1.) If new section 38 
property is acquired in exchange for cash and other property in a 
transaction described in section 1031 in which no gain or loss is 
recognized, the basis of the newly acquired property for purposes of 
determining qualified investment would be equal to the adjusted basis of 
the other property plus the cash paid. See Sec.  1.48-4 for the basis of 
property to a lessee where the lessor has elected to treat such lessee 
as a purchaser.
    (2) The cost of any used section 38 property shall be determined in 
accordance with paragraph (b) of Sec.  1.48-3. However, the aggregate 
cost of used section 38 property which may be

[[Page 359]]

taken into account in any taxable year in computing qualified investment 
cannot exceed $50,000 (see paragraph (c) of Sec.  1.48-3).
    (3) For reduction in the basis (or cost) of certain property which 
replaces other property which was destroyed or damaged by fire, storm, 
shipwreck, or other casualty, or which was stolen, see paragraph (h) of 
this section.
    (d) Placed in service. (1) For purposes of the credit allowed by 
section 38, property shall be considered placed in service in the 
earlier of the following taxable years:
    (i) The taxable year in which, under the taxpayer's depreciation 
practice, the period for depreciation with respect to such property 
begins; or
    (ii) The taxable year in which the property is placed in a condition 
or state of readiness and availability for a specifically assigned 
function, whether in a trade or business, in the production of income, 
in a tax-exempt activity, or in a personal activity.

Thus, if property meets the conditions of subdivision (ii) of this 
subparagraph in a taxable year, it shall be considered placed in service 
in such year notwithstanding that the period for depreciation with 
respect to such property begins in a succeeding taxable year because, 
for example, under the taxpayer's depreciation practice such property is 
accounted for in a multiple asset account and depreciation is computed 
under an ``averaging convention'' (see Sec.  1.167(a)-10), or 
depreciation with respect to such property is computed under the 
completed contract method, the unit of production method, or the 
retirement method.
    (2) In the case of property acquired by a taxpayer for use in his 
trade or business (or in the production of income), the following are 
examples of cases where property shall be considered in a condition or 
state of readiness and availability for a specifically assigned 
function:
    (i) Parts are acquired and set aside during the taxable year for use 
as replacements for a particular machine (or machines) in order to avoid 
operational time loss.
    (ii) Operational farm equipment is acquired during the taxable year 
and it is not practicable to use such equipment for its specifically 
assigned function in the taxpayer's business of farming until the 
following year.
    (iii) Equipment is acquired for a specifically assigned function and 
is operational but is undergoing testing to eliminate any defects.
    (iv) Reforestation expenditures (as defined in Sec.  1.194-3(c)) are 
incurred during the taxable year in connection with qualified timber 
property (as defined in Sec.  1.194-3(a)).

However, fruit-bearing trees and vines shall not be considered in a 
condition or state of readiness and availability for a specifically 
assigned function until they have reached an income-producing stage. 
Moreover, materials and parts acquired to be used in the construction of 
an item of equipment shall not be considered in a condition or state of 
readiness and availability for a specifically assigned function.
    (3) Notwithstanding subparagraph (1) of this paragraph, property 
with respect to which an election is made under Sec.  1.48-4 to treat 
the lessee as having purchased such property shall be considered placed 
in service by the lessor in the taxable year in which possession is 
transferred to such lessee.
    (4)(i) The credit allowed by section 38 with respect to any property 
shall be allowed only for the first taxable year in which such property 
is placed in service by the taxpayer. The determination of whether 
property is section 38 property in the hands of the taxpayer shall be 
made with respect to such first taxable year. Thus, if a taxpayer places 
property in service in a taxable year and such property does not qualify 
as section 38 property (or only a portion of such property qualifies as 
section 38 property) in such year, no credit (or a credit only as to the 
portion which qualifies in such year) shall be allowed to the taxpayer 
with respect to such property notwithstanding that such property (or a 
greater portion of such property) qualifies as section 38 property in a 
subsequent taxable year. For example, if a taxpayer places property in 
service in 1963 and uses the property entirely for personal purposes in 
such year, but in 1964 begins using the property in a trade or business, 
no credit is allowable

[[Page 360]]

to the taxpayer under section 38 with respect to such property. See 
Sec.  1.48-1 for the definition of section 38 property.
    (ii) Notwithstanding subdivision (i) of this subparagraph, if, for 
the first taxable year in which property is placed in service by the 
taxpayer, the property qualifies as section 38 property but the basis of 
the property does not reflect its full cost for the reason that the 
total amount to be paid or incurred by the taxpayer for the property is 
indeterminate, a credit shall be allowed to the taxpayer for such first 
taxable year with respect to so much of the cost as is reflected in the 
basis of the property as of the close of such year, and an additional 
credit shall be allowed to the taxpayer for any subsequent taxable year 
with respect to the additional cost paid or incurred during such year 
and reflected in the basis of the property as of the close of such year. 
The estimated useful life used in computing each additional credit with 
respect to the property shall be the same as the estimated useful life 
used in computing the credit for the first taxable year in which the 
property was placed in service by the taxpayer. Assume, for example, 
that in 1964 X Corporation, a utility company which makes its return on 
the basis of a calendar year, enters into an agreement with Y 
Corporation, a builder, to construct certain utility facilities for a 
housing development built by Y. Assume further that part of the funds 
for the construction of the utility facilities is advanced by Y under a 
contract providing that X will repay the advances over a 10-year period 
in accordance with an agreed formula, after which no further amounts 
will be repayable by X even though the full amount advanced by Y has not 
been repaid. Assuming that the utility facilities are placed in service 
in 1964 and qualify as section 38 property, X is allowed a credit for 
1964 with respect to its basis in the utility facilities at the close of 
1964. For each succeeding taxable year X is allowed an additional credit 
with respect to the increase in the basis of the utility facilities 
resulting from the repayments to Y during such year.
    (e) Estimated useful life--(1)(i) In general. With respect to assets 
placed in service by the taxpayer during any taxable year, for the 
purpose of computing qualified investment the estimated useful lives 
assigned to all assets which fall within a particular guideline class 
(within the meaning of Revenue Procedure 62-21) may be determined, at 
the taxpayer's option, under either subparagraph (2) or (3) of this 
paragraph. Thus, the taxpayer may assign estimated useful lives to all 
the assets falling in one guideline class in accordance with 
subparagraph (2) of this paragraph, and may assign estimated useful 
lives to all the assets falling within another guideline class in 
accordance with subparagraph (3) of this paragraph. See subparagraphs 
(4) and (5) of this paragraph for determination of estimated useful 
lives of assets not subject to subparagraph (2) or (3) of this 
paragraph.
    (ii) Except as provided in subparagraph (7), this paragraph shall 
not apply to property described in section 50.
    (2) Class life system. The taxpayer may assign to each asset falling 
within a guideline class, which is placed in service during the taxable 
year, the class life of the taxpayer for the guideline class for such 
year as determined under section 4, part II of Revenue Procedure 62-21. 
The preceding sentence may be applied to the assets falling within a 
guideline class irrespective of whether the taxpayer uses single asset 
accounts or multiple asset accounts in computing depreciation with 
respect to such assets and irrespective of whether the taxpayer chooses 
to have his depreciation allowance with respect to such assets examined 
under the rules provided in Revenue Procedure 62-21.
    (3) Individual useful life system. (i) The taxpayer may assign an 
individual estimated useful life to each asset falling within a 
guideline class which is placed in service during the taxable year. With 
respect to the assets falling within the guideline class which are 
placed in single asset accounts for purposes of computing depreciation, 
the estimated useful life used for each asset for that purpose shall be 
used in determining qualified investment. With respect to the assets 
falling within the guideline class which are placed in multiple asset 
accounts (including a guideline

[[Page 361]]

class account described in Revenue Procedure 62-21) for which a group, 
classified, or composite rate is used in computing depreciation (or in 
single asset accounts for which an average life rate is used), the 
determination of estimated useful life for each asset in the account 
shall be made individually on the best estimate obtainable on the basis 
of all the facts and circumstances. The individual estimated useful 
lives used for all the assets placed in a multiple asset account, when 
viewed together, must be consistent with the group, classified, or 
composite life used for the account for purposes of computing 
depreciation.
    (ii) In determining the individual estimated useful lives of assets 
similar in kind contained in a multiple asset account (or in single 
asset accounts for which an average life rate is used), the taxpayer may 
(a) assign to each of such assets the average useful life of such assets 
used for purposes of computing depreciation, or (b) assign separate 
lives to such assets based on the estimated range of years taken into 
consideration in establishing the average useful life. Thus, for 
example, if a taxpayer places nine similar trucks with an average 
estimated useful life of 7 years, based on an estimated range of 6 to 8 
years (two trucks with a useful life of 6 years, five trucks with a 
useful life of 7 years, and two trucks with a useful life of 8 years), 
in a multiple asset account for which a group rate is used in computing 
depreciation, he may either assign a useful life of 6 years to two of 
the trucks, 7 years to five of the trucks, and 8 years to two of the 
trucks, or he may assign the average useful life of the trucks (7 years) 
to each of the nine trucks. Likewise, if a taxpayer places 100 similar 
telephone poles with an average useful life of 28 years, based on an 
estimated range of 3 to 40 years (two with a useful life of less than 4 
years, three with a useful life of 4 to 6 years, four with a useful life 
of 6 to 8 years, and 91 with a useful life of more than 8 years), in a 
multiple asset account for which a group rate is used in computing 
depreciation, he may either assign useful lives corresponding to the 
estimated range of years of the poles (i.e., a useful life of less than 
4 years to two of the poles, etc.), or he may assign the average useful 
life of the poles (28 years) to each of the poles.
    (iii) [Reserved]
    (iv) For purposes of subdivision (ii) of this subparagraph, assets 
(other than ``mass assets'') shall not be considered as ``similar in 
kind'' in respect of other assets unless all such assets are 
substantially of the same value, nor shall used section 38 property be 
considered as ``similar in kind'' to new section 38 property.
    (4) Useful life of property subject to amortization--(i) In general. 
In the case of property with respect to which amortization in lieu of 
depreciation is allowable, the term over which amortization deductions 
are taken shall be considered as the estimated useful life of such 
property.
    (ii) Qualified timber property. In the case of qualified timber 
property (within the meaning of section 194(c)(1)), the normal growing 
period of such property shall be considered its estimated useful life.
    (5) Useful life of property subject to certain methods of 
depreciation. If a taxpayer is using a method of depreciation, such as 
the unit of production or retirement method, which does not measure the 
useful life of the property in terms of years, he must estimate such 
useful life in years in order to compute his qualified investment.
    (6) Record requirements. The taxpayer shall maintain sufficient 
records to determine whether section 47 (relating to certain 
dispositions, etc., of section 38 property) applies with respect to any 
asset.
    (7) Section 50 property. (i) The provisions of this subparagraph and 
subparagraphs (4) and (6) of this paragraph shall apply to property 
which is described in section 50.
    (ii) The estimated useful life of property for purposes of computing 
qualified investment shall be the useful life used or to be used by the 
taxpayer in computing the allowance for depreciation with respect to 
such property under section 167 for the taxable year in which the 
property is placed in service. Thus, if property is placed in service by 
a taxpayer in a taxable year but the period for depreciation with 
respect to such property does not begin until a

[[Page 362]]

succeeding taxable year (see paragraph (d)(1) of this section), the 
estimated useful life for purposes of computing qualified investment 
must be the estimated useful life that the taxpayer uses in computing 
the allowance for depreciation. See subdivision (iv) of this 
subparagraph for rules for determining the estimated useful life of 
property with respect to which the allowance for depreciation under 
section 167 is computed under the unit of production method, the income-
forecast method, or any other method which does not measure the useful 
life of the property in terms of years.
    (iii)(a) The estimated useful life of any section 38 property to 
which an election under section 167(m) applies shall be the asset 
depreciation period selected for such property under Sec.  1.167(a)-
11(b)(4), whether or not such property constitutes mass assets (as 
defined in Sec.  1.47-1(e)(4)).
    (b) The estimated useful life of any section 38 property to which an 
election under section 167(m) does not apply and which is placed in a 
multiple asset account for which a group, classified, or composite rate 
is used in computing depreciation (or in single asset accounts for which 
an average life rate is used) shall be determined individually for each 
asset on the best estimate obtainable on the basis of all the facts and 
circumstances. The individual estimated useful life for each asset 
placed in a multiple asset account (including a mass asset account) must 
be the same as the useful life of such asset used in determining the 
group, classified, or composite life for the account for purposes of 
computing depreciation. The individual estimated useful lives of assets 
similar in kind may be determined in accordance with subdivisions (ii) 
and (iv) of subparagraph (3) of this paragraph. In the case of mass 
assets, subdivision (iii) of subparagraph (3) of this paragraph shall 
apply.
    (f) Partnerships--(1) In general. In the case of a partnership, each 
partner shall take into account separately, for his taxable year with or 
within which the partnership taxable year ends, his share of the basis 
of partnership new section 38 property and his share of the cost of 
partnership used section 38 property placed in service by the 
partnership during such partnership taxable year. Each partner shall be 
treated as the taxpayer with respect to his share of the basis of 
partnership new section 38 property and his share of the cost of 
partnership used section 38 property. The estimated useful life to each 
partner of such property shall be deemed to be the estimated useful life 
of the property in the hands of the partnership. Partnership section 38 
property shall not, by reason of each partner taking his share of the 
basis or cost into account, lose its character as either new section 38 
property or used section 38 property, as the case may be. For 
computation of each partner's qualified investment for the energy credit 
for a qualified intercity bus, see Sec.  1.48-9(q)(9)(iv).
    (2) Determination of partner's share. (i) Each partner's share of 
the basis (or cost) of any section 38 property shall be determined in 
accordance with the ratio in which the partners divide the general 
profits of the partnership (that is, the taxable income of the 
partnership as described in section 702(a)(9)) regardless of whether the 
partnership has a profit or a loss for its taxable year during which the 
section 38 property is placed in service. However, if the ratio in which 
the partners divide the general profits of the partnership changes 
during the taxable year of the partnership, the ratio effective for the 
date on which the property is placed in service shall apply.
    (ii) Notwithstanding subdivision (i) of this subparagraph, if all 
related items of income, gain, loss, and deduction with respect to any 
item of partnership section 38 property are specially allocated in the 
same manner and if such special allocation is recognized under section 
704 (a) and (b) and paragraph (b) of Sec.  1.704-1, then each partner's 
share of the basis of such item of new section 38 property or the cost 
of such item of used section 38 property shall be determined by 
reference to such special allocation effective for the date on which the 
property is placed in service.
    (iii) Notwithstanding subdivisions (i) and (ii) of this 
subparagraph, if with respect to a partnership's taxable year the 
conditions set forth in (a) through (c) of this subdivision are 
satisfied with

[[Page 363]]

respect to a partner, then such partner shall not take into account the 
basis (or cost) of any section 38 property placed in service by the 
partnership during such taxable year. The conditions referred to in the 
preceding sentence are:
    (a) Such partner's interest in the general profits of the 
partnership during the taxable year is 5 percent or less;
    (b) Under the partnership agreement, such partner will retire from 
the partnership during the taxable year or within 7 years after the end 
of such year; and
    (c) The partnership agreement provides that the basis (or cost) of 
section 38 property placed in service by the partnership during the 
taxable year shall not be taken into account by a partner described in 
(a) and (b) of this subdivision.

Any basis (or cost) of section 38 property which is not taken into 
account by a partner because of the provisions of this subdivision shall 
be taken into account by the other partners in accordance with 
subdivision (i) of this subparagraph.
    (3) Examples. This paragraph may be illustrated by the following 
examples:

    Example 1. Partnership ABCD acquires and places in service on 
January 1, 1962, an item of new section 38 property, and acquires and 
places in service on September 1, 1962, another item of new section 38 
property. The ABCD partnership and each of its partners reports income 
on the basis of the calendar year. Partners A, B, C, and D share 
partnership profits equally. Each partner's share of the basis of each 
new partnership section 38 property is 25 percent.
    Example 2. Assume the same facts as in Example 1 and the following 
additional facts: A dies on June 30, 1962, and B purchases A's interest 
as of such date. Each partner's share of the profits from January 1 to 
June 30 is 25 percent. From July 1 to December 31, B's share of the 
profits is 50 percent, and C and D's share of the profits is 25 percent 
each. For A's last taxable year (January 1 to June 30, 1962), A shall 
take into account 25 percent of the basis of the section 38 property 
placed in service on January 1. B shall take into account 25 percent of 
the basis of the section 38 property placed in service on January 1 and 
50 percent of the basis of the section 38 property placed in service on 
September 1, C and D shall each take into account 25 percent of the 
basis of each new section 38 property placed in service by the 
partnership in 1962.
    Example 3. Partnership MR is engaged in the business of renting soda 
fountain equipment and icemakers to restaurants. The partnership makes 
no elections under Sec.  1.48-4 to treat its lessees as having purchased 
such property. Under the terms of the partnership agreement, the income, 
gain or loss on disposition, depreciation, and other deductions 
attributable to the icemakers are specially allocated 70 percent to 
partner M and 30 percent to partner R. In all other respects M and R 
share profits and losses equally. If the special allocation with respect 
to the icemakers is recognized under section 704 (a) and (b) and 
paragraph (b) of Sec.  1.704-1, the basis (or cost) of the icemakers 
which qualify as partnership section 38 property shall be taken into 
account 70 percent by M and 30 percent by R. The basis (or cost) of 
partnership section 38 property not subject to the special allocation 
shall be taken into account equally by M and R.
    Example 4. Assume the same facts as in Example 3 and the following 
additional facts: During November 1962, the partnership, which reports 
its income on the basis of a fiscal year ending May 31, acquires and 
places in service two items which qualify as new section 38 property, an 
icemaker and a soda fountain. The icemaker has an estimated useful life 
of 8 years to the partnership and a basis of $1,000. The soda fountain 
has an estimated useful life of 6 years to the partnership and a basis 
of $600. Partner M also owns and operates a business as a sole 
proprietorship and reports income on the calendar year basis. During 
1963, M acquires and places in service in his sole proprietorship a 
machine which qualifies as new section 38 property. This machine has an 
estimated useful life of 4 years and a basis of $300. M owns no interest 
in any other partnerships, electing small business corporations, 
estates, or trusts. M's total qualified investment for 1963 is $1,000, 
computed as follows:

----------------------------------------------------------------------------------------------------------------
                                     Estimated                     M's share of     Applicable       Qualified
            Property                useful life        Basis           basis        percentage      investment
----------------------------------------------------------------------------------------------------------------
         Partnership MR
Icemaker........................               8          $1,000            $700             100            $700
Soda fountain...................               6             600             300         66\2/3\             200
       Sole proprietorship
Machine.........................               4             300  ..............         33\1/3\             100
                                 -------------------------------------------------------------------------------
    Total.......................................................................................           1,000
----------------------------------------------------------------------------------------------------------------


[[Page 364]]

    (g) Public utility property--(1) In general--(i) Scope of paragraph. 
This paragraph only applies to property described in section 50. For 
rules relating to public utility property not described in section 50, 
see 26 CFR part 1, Sec.  1.46-3(g) (as revised April 1, 1977). This 
paragraph does not reflect amendments to section 46(c) made after 
enactment of the Revenue Act of 1971.
    (ii) Amount of qualified investment. A taxpayer's qualified 
investment in section 38 property that is public utility property is \4/
7\ of the amount otherwise determined under this section.
    (2) Meaning and uses of certain terms. For purposes of this 
paragraph--
    (i) Public utility property. ``Public utility property'' is property 
used by a taxpayer predominantly in a trade or business that is a public 
utility activity and property that is nonregulated communication 
property.
    (ii) Public utility activity. A ``public utility activity'' is any 
activity in which the goods or services described in section 46(c)(3)(B) 
(i), (ii), or (iii) are furnished or sold at regulated rates. If 
property is used by a taxpayer both in a public utility activity and in 
another activity, the characterization of such property is based on the 
predominant use of such property during the taxable year in which it is 
placed in service.
    (iii) Regulated rates. A taxpayer's rates are ``regulated'' if they 
are established or approved on a rate-of-return basis. Rates regulated 
on a rate-of-return basis are an authorization to collect revenues that 
cover the taxpayer's cost of providing goods or services, including a 
fair return on the taxpayer's investment in providing such goods or 
services, where the taxpayer's costs and investment are determined by 
use of a uniform system of accounts prescribed by the regulatory body. A 
taxpayer's rates are not ``regulated'' if they are established or 
approved on the basis of maintaining competition within an industry, 
insuring adequate service to customers of an industry, or charging 
``reasonable'' rates within an industry since the taxpayer is not 
authorized to collect revenues based on the taxpayer's cost of providing 
goods or services. Rates are considered to have been ``established or 
approved'' if a schedule of rates is filed with a regulatory body that 
has the power to approve such rates, even though the regulatory body 
takes no action on the filed schedule or generally leaves undisturbed 
rates filed by the taxpayer.
    (iv) Nonregulated communication property. ``Nonregulated 
communication property'' is property that is clearly the same type of 
property (and is used by the taxpayer predominantly for the same type of 
communication purposes) as communication property, but it is used by the 
taxpayer predominantly in a trade or business that is not a public 
utility activity. For purposes of this paragraph (g)(2)(iv), of this 
section, communication property is property ordinarily used for 
communication purposes by persons who provide regulated telephone or 
microwave communication services described in section 46(c)(3)(B)(iii). 
The determination of whether property is clearly of this same type and 
is used predominantly for these same communication purposes as 
communication property is made on the basis of the facts and 
circumstances of each particular case, including the current state of 
technology in the communications industry and the range and type of 
services permitted or required to be provided by the regulated telephone 
and microwave communication industry. As of 1978, wires or cables used 
predominantly to distribute to subscribers the signals of one or more 
television broadcast stations or cablecast stations (such as in a CATV 
system) are not used for the same type of communication purposes as 
communication property. Communication property includes microwave 
transmission equipment, private communication equipment (other than land 
mobile radio equipment for which the operator must obtain a license from 
the Federal Communications Commission), private switchboard (PBX) 
equipment, communications terminal equipment connected to telephone 
networks, data transmission equipment, and communications satellites. 
Communication property does not include (as of 1978) computer terminals 
or facsimile reproduction equipment that is connected to telephone lines 
to transmit data. It also does not include office furniture stands for 
communication property,

[[Page 365]]

tools, repair vehicles, and similar property, even if such property is 
exclusively used in providing regulated telephone or microwave 
communication services.
    (3) Leased property. Public utility property includes property which 
is leased to others by a taxpayer where the leasing of such property is 
part of the lessor's public utility activity. Thus, such leased property 
is public utility property even though the lessee uses such property in 
an activity which is not a public utility activity, and whether or not 
the lessor of such property makes a valid election under Sec.  1.48-4 to 
treat the lessee as having purchased such property for purposes of the 
credit allowed by section 38. Property leased by a lessor, where the 
leasing is not part of a public utility activity, to a lessee who uses 
such property predominantly in a public utility activity is public 
utility property for purposes of computing the lessor's or lessee's 
qualified investment with respect to such property.
    (4) Property used in both the production or transmission of gas and 
the local distribution of gas. (i) With respect to properties of a 
taxpayer engaged in both the production or transmission of gas and the 
local distribution of gas, section 38 property shall be considered as 
used predominantly in the trade or business of the furnishing or sale of 
gas through a local distribution system if expenditures for such 
property are chargeable to any of the following accounts under either 
the uniform system of accounts prescribed for natural gas companies 
(class A and class B) by the Federal Power Commission, effective January 
1, 1961, or the uniform system of accounts for class A and B gas 
utilities adopted in 1958 by the National Association of Railroad and 
Utility Commissioners (or would be chargeable to any of the following 
accounts if the taxpayer used either of such systems):
    (a) Accounts 360 through 363, inclusive (Local Storage Plant), or
    (b) Accounts 374 through 387, inclusive (Distribution Plant).
    (ii) If expenditures for section 38 property are chargeable (or 
would be chargeable) to any of the following accounts under either of 
the systems named in subdivision (i) of this subparagraph, the 
determination of whether or not such property is used predominantly in 
the trade or business of the furnishing or sale of gas through a local 
distribution system shall be made under all the facts and circumstances 
relating to the actual use of such property in the year such property is 
placed in service:
    (a) Accounts 304 through 320, inclusive (Manufactured Gas Production 
Plant), or
    (b) Accounts 389 through 399, inclusive (General Plant).


For example, if an office machine is used 55 percent of the time for 
billing customers of the taxpayer's local distribution system in the 
year in which it is placed in service, such office machine shall be 
considered as used predominantly in the trade or business of the 
furnishing or sale of gas through a local distribution system.
    (5) Certain submarine cable property. In the case of any interest in 
a submarine cable circuit which is property described in section 50 used 
to furnish telegraph service between the United States and a point 
outside the United States of a taxpayer engaged in furnishing 
international telegraph service (if the rates for such furnishing have 
been established or approved by a governmental unit, agency, 
instrumentality, commission, or similar body described in subparagraph 
(2) of this paragraph), the qualified investment shall not exceed the 
qualified investment attributable to so much of the interest of the 
taxpayer in the circuit as does not exceed 50 percent of all interests 
in the circuit.
    (h) Certain replacement property. (1)(i) If section 38 property is 
placed in service by the taxpayer to replace property (whether or not 
section 38 property) similar or related in service or use, which was 
destroyed or damaged before August 16, 1971, by fire, storm, shipwreck, 
or other casualty, or was stolen before such date, then for purposes of 
paragraph (a) of this section the basis (or cost) of the replacement 
section 38 property otherwise determined under paragraph (c) of this 
section shall be reduced by an amount equal to the lesser of--

[[Page 366]]

    (a) The amount of money, or the fair market value of other property, 
received as compensation, by insurance or otherwise, for the property 
which was destroyed, damaged, or stolen, or
    (b) The adjusted basis of such destroyed, damaged, or stolen 
property (immediately before such destruction, damage, or theft).
    (ii) For purposes of subdivision (i) of this subparagraph--
    (a) Section 38 property placed in service after the due date 
(including extensions of time thereof) for filing the taxpayer's income 
tax return for the taxable year in which the other property was 
destroyed, damaged, or stolen shall not be considered as replacement 
section 38 property, and
    (b) If the property which is destroyed, damaged, or stolen, is 
leased property, no other leased property shall be considered as 
replacement property with respect to the property destroyed, damaged, or 
stolen, in any case in which the lessor makes or made an election under 
section 48(d) (relating to election with respect to certain leased 
property) with respect to either the property destroyed, damaged, or 
stolen, the other leased property, or both.
    (2) Subparagraph (1) of this paragraph shall not apply to 
replacement property if the reduction, under such subparagraph (1), in 
the basis (or cost) of such replacement property is less than the excess 
of--
    (i) The qualified investment with respect to the destroyed, damaged, 
or stolen property, over
    (ii) The recomputed qualified investment with respect to such 
property (determined under the principles of paragraph (a) of Sec.  
1.47-1).
    (3) This paragraph may be illustrated by the following examples:

    Example 1. (i) A acquired and placed in service on January 1, 1962, 
machine No. 1, which qualified as section 38 property, with a basis of 
$30,000 and an estimated useful life of 6 years. The amount of qualified 
investment with respect to such machine was $20,000. On January 2, 1963, 
machine No. 1 is completely destroyed by fire. On January 1, 1963, the 
adjusted basis of such machine in A's hands is $24,500. On November 1, 
1963, A receives $23,000 in insurance proceeds as compensation for the 
destroyed machine, and on December 15, 1963, A acquires and places in 
service machine No. 2, which qualifies as section 38 property, with a 
basis of $41,000 and an estimated useful life of 6 years to replace 
machine No. 1.
    (ii) Under subparagraph (1) of this paragraph, the $41,000 basis of 
machine No. 2 is reduced, for purposes of paragraph (a) of this section, 
by $23,000 (that is, the $23,000 insurance proceeds since such amount is 
less than the $24,500 adjusted basis of machine No. 1 immediately before 
it was destroyed) to $18,000 since such reduction (that is, $23,000) is 
greater than the $20,000 reduction in qualified investment which would 
be made if paragraph (a) of Sec.  1.47-1 were to apply to machine No. 1 
($20,000 qualified investment less zero recomputed qualified 
investment).
    Example 2. (i) The facts are the same as in Example 1 except that on 
November 1, 1963, A receives only $19,000 in insurance proceeds as 
compensation for the destroyed machine.
    (ii) The $41,000 basis of machine No. 2 is not reduced, for purposes 
of paragraph (a) of this section, under this paragraph since the $19,000 
reduction which would have been made under this paragraph had it applied 
(that is, the $19,000 insurance proceeds since such amount is less than 
the $24,500 adjusted basis of machine No. 1 immediately before it was 
destroyed) is less than the $20,000 reduction in qualified investment 
which is made since paragraph (a) of Sec.  1.47-1 applies to machine No. 
1 ($20,000 qualified investment less zero recomputed qualified 
investment).

(Secs. 194 (94 Stat. 1989; 26 U.S.C. 194) and 7805 (68A Stat. 917, 26 
U.S.C. 7805) of the Internal Revenue Code of 1954; secs. 38(b) (76 Stat. 
963, 26 U.S.C. 38(b)), 48(l)(16) (94 Stat. 264, 26 U.S.C. 48(l)(16)), 
and 7805 (68A Stat. 917, 26 U.S.C. 7805)

[T.D. 6731, 29 FR 6068, May 8, 1964, as amended by T.D. 6931, 32 FR 
14026, Oct. 10, 1967; T.D. 7203, 37 FR 17125, Aug. 25, 1972; T.D. 7602, 
44 FR 17667, Mar. 23, 1979; T.D. 7927, 48 FR 55849, Dec. 16, 1983; T.D. 
7982, 49 FR 39541, Oct. 9, 1984; T.D. 8183, 53 FR 6618, Mar. 2, 1988; 
T.D. 8474, 58 FR 25557, Apr. 27, 1993]



Sec.  1.46-4  Limitations with respect to certain persons.

    (a) Mutual savings institutions. In the case of an organization to 
which section 593 applies (that is, a mutual savings bank, a cooperative 
bank, or a domestic building and loan association)--
    (1) The qualified investment with respect to each section 38 
property shall be 50 percent of the amount otherwise determined under 
Sec.  1.46-3, and
    (2) The $25,000 amount specified in section 46(a)(2), relating to 
limitation based on amount of tax, shall be reduced by 50 percent of 
such amount.


[[Page 367]]



For example, if a domestic building and loan association places in 
service on January 1, 1963, new section 38 property with a basis of 
$30,000 and an estimated useful life of 6 years, its qualified 
investment for 1963 with respect to such property computed under Sec.  
1.46-3 is $20,000 (66\2/3\ percent of $30,000). However, under this 
paragraph such amount is reduced to $10,000 (50 percent of $20,000). If 
an organization to which section 593 applies is a member of an 
affiliated group (as defined in section 46(a)(5)), the $25,000 amount 
specified in section 46(a)(2) shall be reduced in accordance with the 
provisions of paragraph (f) of Sec.  1.46-1 before such amount is 
further reduced under this paragraph.
    (b) Regulated investment companies and real estate investment 
trusts. (1) In the case of a regulated investment company or a real 
estate investment trust subject to taxation under subchapter M, chapter 
1 of the Code--
    (i) The qualified investment with respect to each section 38 
property otherwise determined under Sec.  1.46-3, and
    (ii) The $25,000 amount specified in section 46(a)(2), relating to 
limitation based on amount of tax,

shall be reduced to such person's ratable share of each such amount. If 
a regulated investment company or a real estate investment trust is a 
member of an affiliated group (as defined in section 46(a)(5)), the 
$25,000 amount specified in section 46(a)(2) shall be reduced in 
accordance with the provisions of paragraph (f) of Sec.  1.46-1 before 
such amount is further reduced under this paragraph.
    (2) A person's ratable share of the amount described in subparagraph 
(1)(i) and the amount described in subparagraph (1)(ii) of this 
paragraph shall be the ratio which--
    (i) Taxable income for the taxable year, bears to
    (ii) Taxable income for the taxable year plus the amount of the 
deduction for dividends paid taken into account under section 
852(b)(2)(D) in computing investment company taxable income, or under 
section 857(b)(2)(B) (section 857(b)(2)(C), as then in effect, for 
taxable years ending before October 5, 1976) in computing real estate 
investment trust taxable income, as the case may be.

For purposes of the preceding sentence, taxable income means, in the 
case of a regulated investment company its investment company taxable 
income (within the meaning of section 852(b)(2)), and in the case of a 
real estate investment trust its real estate investment trust taxable 
income (within the meaning of section 857(b)(2)). In the case of a 
taxable year ending after October 4, 1976, real estate investment trust 
taxable income, for purposes of section 46(e) and this paragraph, is 
determined by excluding any net capital gain, and by computing the 
deduction for dividends paid without regard to capital gains dividends 
(as defined in section 857(b)(3)(C)). The amount of the deduction for 
dividends paid includes the amount of deficiency dividends (other than 
capital gains deficiency dividends) taken into account in computing 
investment company taxable income or real estate investment trust 
taxable income for the taxable year. See section 860(f) for the 
definition of deficiency dividends. For purposes of this paragraph only, 
in computing taxable income for a taxable year beginning before January 
1, 1964, a regulated investment company or a real estate investment 
trust may compute depreciation deductions with respect to section 38 
property placed in service before January 1, 1964, without regard to the 
reduction in basis of such property required under Sec.  1.48-7.
    (3) This paragraph may be illustrated by the following example:

    Example. (i) Corporation X, a regulated investment company subject 
to taxation under section 852 of the Code which makes its return on the 
basis of the calendar year, places in service on January 1, 1964, 
section 38 property with a basis of $30,000 and an estimated useful life 
of 6 years. Corporation X's investment company taxable income under 
section 852(b)(2) is $10,000 after taking into account a deduction for 
dividends paid of $90,000.
    (ii) Under this paragraph, corporation X's qualified investment for 
the taxable year 1964 with respect to such property is $2,000, computed 
as follows: (a) $20,000 (qualified investment under Sec.  1.46-3), 
multiplied by (b) $10,000 (taxable income), divided by (c) $100,000 
(taxable income plus the deduction for dividends paid). For 1964, the 
$25,000 amount specified in section 46(a)(2) is reduced to $2,500.


[[Page 368]]


    (c) Cooperatives. (1) In the case of a cooperative organization 
described in section 1381(a)--
    (i) The qualified investment with respect to each section 38 
property otherwise determined under Sec.  1.46-3, and
    (ii) The $25,000 amount specified in section 46(a)(2), relating to 
limitation based on amount of tax,


shall be reduced to such cooperative's ratable share of each such 
amount. If a cooperative organization described in section 1381(a) is a 
member of an affiliated group (as defined in section 46(a)(5)), the 
$25,000 amount specified in section 46(a)(2) shall be reduced in 
accordance with the provisions of paragraph (f) of Sec.  1.46-1 before 
such amount is further reduced under this paragraph.
    (2) A cooperative's ratable share of the amount described in 
subparagraph (1)(i) and the amount described in subparagraph (1)(ii) of 
this paragraph shall be the ratio which--
    (i) Taxable income for the taxable year, bears to
    (ii) Taxable income for the taxable year plus the sum of (a) the 
amount of the deductions allowed under section 1382(b), (b) the amount 
of the deductions allowed under section 1382(c), and (c) amounts similar 
to the amounts described in (a) and (b) of this subdivision the tax 
treatment of which is determined without regard to subchapter T, chapter 
1 of the Code and the regulations thereunder.

Amounts similar to deductions allowed under section 1382 (b) or (c) are, 
for example, in the case of a taxable year of a cooperative organization 
beginning before January 1, 1963, the amount of patronage dividends 
which are excluded or deducted and any nonpatronage distributions which 
are deducted under section 522(b)(1). In the case of a taxable year of a 
cooperative organization beginning after December 31, 1962, such amounts 
are the amount of patronage dividends and nonpatronage distributions 
which are excluded or deducted without regard to section 1382 (b) or (c) 
because they are paid with respect to patronage occurring before 1963. 
For purposes of this paragraph only, in computing taxable income for a 
taxable year beginning before January 1, 1964, a cooperative may compute 
depreciation deductions with respect to section 38 property placed in 
service before January 1, 1964, without regard to the reduction in basis 
of such property required under Sec.  1.48-7.
    (3) This paragraph may be illustrated by the following example:

    Example. (i) Cooperative X, an organization described in section 
1381(a) which makes its return on the basis of the calendar year, places 
in service on January 1, 1964, section 38 property with a basis of 
$30,000 and an estimated useful life of 6 years. Cooperative X's taxable 
income is $10,000 after taking into account deductions of $20,000 
allowed under section 1382(b), deductions of $60,000 allowed under 
section 1382(c), and deductions of $10,000 allowed under section 
522(b)(1)(B).
    (ii) Under this paragraph, cooperative X's qualified investment for 
the taxable year 1964 with respect to such property is $2,000, computed 
as follows: (a) $20,000 (qualified investment under Sec.  1.46-3), 
multiplied by (b) $10,000 (taxable income), divided by (c) $100,000 
(taxable income plus the sum of the deductions allowed under sections 
1382(b), 1382(c), and 522(b)(1)(B)). For 1964, the $25,000 amount 
specified in section 46(a)(2) is reduced to $2,500.

    (d) Noncorporate lessors. (1) In the case of a lease entered into 
after September 22, 1971, a credit is allowed under section 38 to a 
noncorporate lessor of property with respect to the leased property only 
if--
    (i) Such property has been manufactured or produced by the lessor in 
the ordinary course of his business, or
    (ii) The term of the lease (taking into account any options to 
renew) is less than 50 percent of the estimated useful life of the 
property (determined under Sec.  1.46-3(e)), and for the period 
consisting of the first 12 months after the date on which the property 
is transferred to the lessee the sum of the deductions with respect to 
such property which are allowable to the lessor solely by reason of 
section 162 (other than rents and reimbursed amounts with respect to 
such property) exceeds 15 percent of the rental income produced by such 
property.

In the case of property of which a partnership is the lessor, the credit 
otherwise allowable under section 38 with respect to such property to 
any partner which is a corporation shall be allowed notwithstanding the 
first sentence of this subparagraph. For purposes of this

[[Page 369]]

subparagraph, an electing small business corporation (as defined in 
section 1371) shall be treated as a person which is not a corporation. 
This paragraph shall not apply to property used by the taxpayer in his 
trade or business (other than the leasing of property) for a period of 
at least 24 months preceding the day on which any lease of such property 
is entered into.
    (2) For purposes of subparagraph (1)(ii) of this paragraph, if at 
the time the lessor files his income tax return for the taxable year in 
which the property is placed in service, the lessor is unable to show 
that the more-than-15-percent test has been satisfied, then no credit 
may be claimed by the lessor on such return with respect to such 
property unless (i) taking into account the lessor's obligations under 
the lease it is reasonable to believe that the more-than-15-percent test 
will be satisfied, and (ii) the lessor files a statement with his return 
from which it may be determined that he expects to satisfy the more-
than-15-percent test. If the more-than-15-percent test is not satisfied 
with respect to the property, the taxpayer must file an amended return 
for the year in which the property is placed in service.
    (3)(i) The more-than-15-percent test described in subparagraph 
(1)(ii) of this paragraph is based on the relationship of the expenses 
of the lessor relating to or attributable to the property to the gross 
income from rents of the taxpayer produced by the property. The test is 
applied with respect to such expenses and gross income as are properly 
attributable to the period consisting of the first 12 months after the 
date on which the property is transferred to the lessee. When more than 
one property is subject to a single lease and, pursuant to subparagraph 
(4) of this paragraph, the arrangement is considered to be a separate 
lease of each property, the test is applied separately to each such 
lease by making an apportionment of the payments received and expenses 
incurred with respect to each such property, considering all relevant 
factors. Such apportionment is made in accordance with any reasonable 
method selected and consistently applied by the taxpayer. For example, 
under subparagraph (4) of this paragraph, where a taxpayer leases an 
airplane which he owns to an airline along with a baggage truck, he is 
treated as having made two separate leases, one covering the airplane 
and one covering the baggage truck. Thus, the test will be applied by 
apportioning the related income and expenses between the two leases. 
Similarly, where a taxpayer leases a factory building erected by him 
containing section 38 property (machinery and equipment), the test will 
be applied to the taxpayer as though he had leased (to the lessee) the 
building and the section 38 property separately. Thus, the rental income 
and expenses are apportioned between the building and the section 38 
property.
    (ii) Only those deductions allowable solely by reason of section 162 
are taken into account in applying the more-than-15-percent test. Hence, 
depreciation allowable by reason of section 167 (including amortization 
allowable in lieu of depreciation); interest allowable by reason of 
section 163; taxes allowable by reason of section 164; and depletion 
allowable by reason of section 611 are examples of deductions which are 
not taken into account in applying the test. Moreover, rents and 
reimbursed amounts paid or payable by the lessor are not taken into 
account notwithstanding that a deduction in respect of such rents or 
reimbursed amounts is allowable solely by reason of section 162. For 
purposes of this paragraph, a reimbursed amount is any expense for which 
the lessee or some other party is obligated to reimburse the lessor. 
Section 162 expenses paid or payable by any person other than the lessor 
are not taken into account unless the lessor is obligated to reimburse 
the person paying the expense. Further, if the lessee is obligated to 
pay to the lessor a charge for services which is separately stated or 
determinable, the expenses incurred by the lessor with respect to those 
services are not taken into account.
    (iii) For purposes of the more-than-15-percent test, the gross 
income from rents of the lessor produced by the property is the total 
amount which is payable to the lessor by reason of the lease agreement 
other than reimbursements of section 162 expenses and

[[Page 370]]

charges for services which are separately stated or determinable. The 
fact that such amount depends, in whole or in part, on the sales or 
profits of the lessee or the performance of significant services by the 
lessor shall not affect the characterization of such amounts as gross 
income from rents for purposes of this paragraph. Gross income from 
rents also includes any taxes imposed on the lessor by local law but 
which are paid directly by the lessee on behalf of the lessor.
    (4) For purposes of determining under this paragraph whether 
property is subject to a lease, the provisions of Sec.  1.57-3(d)(1) 
(relating to definition of a lease) shall apply. If a noncorporate 
lessor enters into two or more successive leases with respect to the 
same or substantially similar items of section 38 property, the terms of 
such leases shall be aggregated and such leases shall be considered one 
lease for the purpose of determining whether the term of such leases is 
less than 50 percent of the estimated useful life of the property 
subject to such leases. Thus, for example, if an individual owns an 
airplane with an estimated useful life of 7 years and enters into three 
successive 3-year leases of such airplane, such leases will be 
considered to be one lease for a term of nine years for the purpose of 
determining whether the term of the lease is less than 3\1/2\ years (50 
percent of the 7-year estimated useful life).
    (5) The requirements of this paragraph shall not apply with respect 
to any property which is treated as section 38 property by reason of 
section 48(a)(1)(E).

(Sec. 860(e) (92 Stat. 2849, 26 U.S.C. 860(e)); sec. 860(g) (92 Stat. 
2850, 26 U.S.C. 860(g)); and sec. 7805 (68A Stat. 917, 26 U.S.C. 7805))

[T.D. 6731, 29 FR 6071, May 8, 1964, as amended by T.D. 6958, 33 FR 
9170, June 21, 1968; T.D. 7203, 37 FR 17126, Aug. 25, 1972; T.D. 7767, 
46 FR 11262, Feb. 6, 1981; T.D. 7936, 49 FR 2105, Jan. 18, 1984; T.D. 
8031, 50 FR 26697, June 28, 1985]



Sec.  1.46-5  Qualified progress expenditures.

    (a) Effective date. This section applies to taxable years ending 
after December 31, 1974. This section reflects amendments to the 
Internal Revenue Code made only by the Tax Reduction Act of 1975, the 
Tax Reform Act of 1976, and the Revenue Act of 1978.
    (b) General rule. Under section 46(d), a taxpayer may elect to take 
the investment credit for qualified progress expenditures (as defined in 
paragraph (g) of this section). In general, qualified progress 
expenditures are amounts paid (paid or incurred in the case of self-
constructed property) for construction of progress expenditure property. 
The taxpayer must reasonably estimate that the property will take at 
least 2 years to construct and that the useful life of the property will 
be 7 years or more. Qualified progress expenditures may not be taken 
into account if made before the later of January 22, 1975, or the first 
taxable year to which an election under section 46(d) applies. In 
general, qualified progress expenditures are not allowed for the year 
property is placed in service, nor for the first year or any subsequent 
year recapture is required under section 47(a)(3). There is a percentage 
limitation on qualified progress expenditures for taxable years 
beginning before January 1, 1980. For a special rule relating to 
transfers of progress expenditure property, see paragraph (r) of this 
section.
    (c) Reduction of qualified investment. Under section 46(c)(4), a 
taxpayer must reduce qualified investment for the year property is 
placed in service by qualified progress expenditures taken into account 
by that person or a predecessor. A ``predecessor'' of a taxpayer is a 
person whose election under section 46(d) carries over to the taxpayer 
under paragraph (o)(3) of this section.
    (d) Progress expenditure property. Progress expenditure property is 
property constructed by or for the taxpayer, with a normal construction 
period of 2 years or more. The taxpayer must reasonably believe that the 
property will be new section 38 property with a useful life of 7 years 
or more when placed in service. Whether property is progress expenditure 
property is determined on the basis of facts know at the close of the 
taxable year of the taxpayer in which construction begins (or, if later, 
at the close of the first taxable year to which an election under 
section 46(d) applies). For purposes of this paragraph (d), property is

[[Page 371]]

constructed by or for the taxpayer only if it is built or manufactured 
from materials and component parts. Accordingly, progress expenditure 
property does not include property such as orchards, vineyards, 
livestock, or motion picture films or videotapes.
    (e) Normal construction period--(1) In general. (i) The normal 
construction period is the period the taxpayer reasonably expects will 
be required to construct the property. The period begins on the date 
physical work on construction of the property commences and ends on the 
date the property is available to be placed in service. The normal 
construction period does not include, however, construction before 
January 22, 1975, nor construction before the first day of the first 
taxable year for which an election under section 46(d) is in effect. 
Physical work on construction of property does not include preliminary 
activities such as planning, designing, preparing blueprints, exploring, 
or securing financing.
    (ii) The determination of the time when physical work on 
construction commences is based on the facts and circumstances of each 
case. Physical work on construction of property may include the physical 
work done by a subcontractor on a component specifically designated as 
part of the property. Also, the commencement of physical work on 
construction may occur at a site different from the main site of 
construction of the property. For example, if a shipyard orders a 
turbine before it begins work on building a ship, the normal 
construction period of the ship is measured from the time the 
subcontractor commences physical work on construction of the turbine (if 
it is normal for such work to precede the work of the main contractor).
    (iii) Generally, physical work on construction does not include 
physical activity that is not necessary to complete construction of the 
property, nor does it include physical work on construction of a 
building or other property that will not be new section 38 property when 
placed in service. Physical work on construction also does not include 
research and development activities in a laboratory or experimental 
setting.
    (iv) The normal construction period of property ends on the date it 
is expected the property will be available to be placed in service. 
Property is considered available to be placed in service when 
construction is completed and the property is available for delivery to 
the site of its assigned function. It is not necessary that property be 
in a state of readiness for a specifically assigned function. Nor is it 
necessary that it actually be delivered to the site of its assigned 
function.
    (2) Estimates. Taxpayers should refer to normal industry practice in 
estimating the normal construction period of particular items. A 
different period may be used if special circumstances exist making it 
impractical to make the estimate on the basis of normal industry 
practice. The estimate must be based on information available at the 
close of the taxable year in which physical work on construction of the 
property begins, or, if later, at the close of the first taxable year 
for which an election under section 46(d) is in effect for the taxpayer. 
If the estimate is reasonable when made, the actual time it takes to 
complete the work is, in general, irrelevant in determining whether 
property is progress expenditure property. However, if there is a 
significant error in estimating the normal construction period, it may 
be evidence that the estimate was unreasonable when made. For taxable 
years ending after April 1, 1988, a taxpayer not relying or normal 
industry practice to estimate the normal construction period of 
particular property must attach to the tax return for the taxable year 
in which physical work on construction of the property begins (or, if 
later, the first taxable year for which an election under section 46(d) 
is in effect) a statement of the basis relied upon in estimating the 
normal construction period of the property.
    (3) Integrated unit. (i) In determining whether property has a 
normal construction period of 2 years or more, property that will be 
placed in service separately is to be considered separately. For 
example, if two ships are contracted for at the same time, each ship is 
considered separately under this paragraph. However, for property that

[[Page 372]]

will be placed in service as an integrated unit, the taxpayer must 
determine the normal construction period of the integrated unit. If the 
normal construction period of the integrated unit is 2 years or more, 
the normal construction period of each item of new section 38 property 
that is a part of the integrated unit is considered to be 2 years or 
more. Thus, the normal construction period of an integrated unit may be 
2 years or more even if no part of the unit has a normal construction 
period of 2 years or more.
    (ii) Property is part of an integrated unit only if the operation of 
that item is essential to the performance of the function to which the 
unit is assigned. Property essential to the performance of the function 
to which the unit is assigned includes property the use of which is 
significantly connected to that function and which effects the safe, 
proper, or efficient performance of the unit. Generally, property must 
be placed in service at the same time to be considered part of the same 
integrated unit. Properties are not an integrated unit, however, solely 
because they are to be placed in service at the same time.
    (iii) The normal construction period for an integrated unit begins 
on the date the normal construction period of the first item of new 
section 38 property that is part of the unit begins. It is not necessary 
that physical work commence at the main construction site of the 
integrated unit.

The period ends on the date the last item of new section 38 property 
that is part of that unit is available to be placed in service. Property 
that is not new section 38 property, such as a building, is not 
considered part of an integrated unit for purposes of determining the 
normal construction period of that unit. For example, if a manufacturing 
plant has a normal construction period of two years or more but the 
equipment (i.e., new section 38 property) to be installed in the plant 
has a normal construction period of less than two years, the plant and 
the equipment do not constitute an integrated unit with a construction 
period of two years or more and the equipment is not progress 
expenditure property.
    (4) Examples. The following examples illustrate this paragraph (e).

    Example 1. On July 1, 1974, corporation X begins physical work on 
construction of a machine with an estimated useful life when placed in 
service of more than 7 years. For its taxable year ending June 30, 1975, 
X makes an election under section 46(d). For purposes of determining on 
June 30, 1975, whether the machine is ``progress expenditure property'', 
the normal construction period is treated as having begun on January 22, 
1975. Thus, the machine will be considered to be progress expenditure 
property on June 30, 1975, only if the estimated time required to 
complete construction after June 30 is at least 18 months and 22 days 
(i.e., 2 years less the period January 22, 1975, through June 30, 1975).
    Example 2. (i) Corporation X constructs a pipeline in two sections 
and simultaneously begins physical work on construction of each section 
on January 1, 1976. One section extends from city M to city N. The other 
extends from city N to city O. Oil will be transferred to storage tanks 
at both city N and city O. Corporation X also begins construction on 
January 1, 1976, of a pumping station necessary to the operation of the 
pipeline from city M to city N. Construction of a pumping station 
necessary to the operation of the pipeline from city N to city O begins 
on June 30, 1977. For 1976, corporation X makes an election under 
section 46(d).
    (ii) The section of pipeline from city M to city N and the 
associated pumping station will be available to be placed in service on 
January 1, 1977. Construction of the section of the pipeline from city N 
to city O will be completed on June 30, 1977. However, that section of 
the pipeline will not be available to be placed in service until 
completion of the associated pumping station on January 1, 1978.
    (iii) The section of pipeline from city M to city N and the section 
from city N to city O must be considered separately in determining the 
normal construction period of the property. Each section will be placed 
in service separately. However, each section of the pipeline and the 
associated pumping station may be considered an integrated unit. The 
pumping stations are essential to the operation of each section of 
pipeline. Each section of pipeline and the associated pumping station 
are placed in service at the same time.
    (iv) The section of pipeline from city M to city N and the 
associated pumping station are not progress expenditure property, 
because the normal construction period of that unit is only 1 year 
(January 1, 1976 to January 1, 1977).
    (v) The section of pipeline from city N to city O and the associated 
pumping station are progress expenditure property, because

[[Page 373]]

the normal construction of that integrated unit is 2 years (January 1, 
1976 to January 1, 1978). It is immaterial that neither the construction 
period of that section of pipeline (January 1, 1976 to June 30, 1977) 
nor the construction period of the associated pumping station (June 30, 
1977 to January 1, 1978) is 2 years.
    (vi) Assume the pumping station associated with the pipeline from 
city N to city O includes backup pumping equipment that will be used 
only if the primary pumping equipment fails. The backup equipment is 
part of the integrated unit because it serves to effect the safe or 
efficient performance of the unit.

    (f) New section 38 property with a 7-year useful life--(1) In 
general. The taxpayer must determine if property will be new section 38 
property with a useful life of 7 years or more when placed in service. 
The determination must be made at the close of the taxable year in which 
construction begins or, if later, at the close of the first taxable year 
to which an election under section 46(d) applies for the taxpayer.
    (2) Determination based on reasonably expected use. The 
determination of whether property will be ``new section 38 property'' 
(within the meaning of Sec. Sec.  1.48-1 and 1.48-2 when placed in 
service must be based on the reasonably expected use of the property by 
the taxpayer. There is a presumption that property will be new section 
38 property if it would be new section 38 property if placed in service 
by the taxpayer when the determination is made. For example, in 
determining if property is an integral part of manufacturing under 
section 48(a)(1)(B)(i), it will be presumed that property will be new 
section 38 property if the taxpayer is engaged in manufacturing when the 
determination is made. Also, significant steps taken to establish a 
trade or business will be evidence the taxpayer will be engaged in that 
trade or business when the property is placed in service.
    (3) Estimated useful life. The determination of whether property 
will have an estimated useful life of 7 years or more when placed in 
service must be made by applying the principles of Sec.  1.46-3(e). If 
the estimated useful life is less than 7 years when the property is 
actually placed in service, the credit previously allowed under section 
46(d) must be recomputed under section 47(a)(3)(B).
    (g) Definition of qualified progress expenditures--(1) In general. A 
taxpayer's qualified progress expenditures are the sum of qualified 
progress expenditures for self-constructed property (determined under 
paragraph (h) of this section), plus qualified progress expenditures for 
non-self-constructed property (determined under paragraph (j) of this 
section). Only amounts includible under Sec.  1.46-3(c) in the basis of 
new section 38 property may be considered as qualified progress 
expenditures.
    (2) Excluded amounts. Qualified progress expenditures do not 
include:
    (i) In the case of non-self-constructed property, amounts incurred 
(whether or not paid)--
    (A) Before the normal construction period begins, or
    (B) Before the later of January 22, 1975, or the first day of the 
first taxable year for which an election under section 46(d) applies for 
the taxpayer;
    (ii) In the case of self-constructed property, amounts chargeable to 
capital account--
    (A) Before the normal construction period begins, or
    (B) Before the later of January 22, 1975, or the first day of the 
first taxable year for which an election under section 46(d) applies for 
the taxpayer,

(See, however, section 46(d)(4)(A) and paragraph (h)(3)(i) of this 
section, relating to the time when amounts for component parts and 
materials are properly chargeable to capital account);
    (iii) Expenditures with respect to particular property in the 
earlier of--
    (A) The taxable year in which the property is placed in service, or
    (B) The taxable year in which the taxpayer must recapture investment 
credit under section 47(a)(3) for the property or any subsequent year;
    (iv) Expenditures for construction, reconstruction, or erection of 
property that is not section 38 property; or
    (v) Amounts treated as an expense and deducted in the year paid or 
accrued.
    (h) Qualified progress expenditures for self-constructed property--
(1) In general. Qualified progress expenditures for self-constructed 
property (as defined in

[[Page 374]]

paragraph (k) of this section) are amounts properly chargeable to 
capital account in connection with that property. In general, amounts 
paid or incurred are chargeable to capital account if under the 
taxpayer's method of accounting they are properly includible in 
computing basis under Sec.  1.46-3. Qualified progress expenditures for 
self-constructed property include both direct costs (e.g., labor, 
material, parts) and indirect costs (e.g., overhead, insurance) 
associated with construction of property to the extent those costs are 
properly chargeable to capital account.
    (2) Property partially non-self constructed. If an item of property 
is self-constructed because more than half of the construction 
expenditures are made directly by the taxpayer, then any expenditures 
(whether or not made directly by the taxpayer) for construction of that 
item of property are not subject to the limitations of section 
46(d)(3)(B) and paragraph (j) of this section (relating to actual 
payment and progress in construction).
    (3) Time when amounts paid or incurred are properly chargeable to 
capital account. (i) In general, expenditures for component parts and 
materials to be used in construction of self-constructed property are 
not properly chargeable to capital account until consumed or physically 
attached in the construction process. Component parts and materials that 
have been neither consumed nor physically attached in the construction 
process, but which have been irrevocably allocated to construction of 
that property are properly chargeable to capital account. Component 
parts and materials designed specifically for the self-constructed 
property may be considered irrevocably allocated to construction of that 
property at the time of manufacture of the component parts and 
materials. Component parts and materials not designed specifically for 
the property may be considered irrevocably allocated to construction at 
the time of delivery to the construction site if they would be 
economically impractical to remove. For example, pumps delivered to 
sites of construction of a tundra pipeline may be treated as irrevocably 
allocated to that pipeline on the date of delivery, even if they would 
be usable, but for their location on the tundra, in connection with 
other property. Component parts and materials are not to be considered 
irrevocably allocated to use in self-constructed property until physical 
work on construction of that property has begun (as determined under 
paragraph (e)(1)(ii) of this section). Mere bookkeeping notations are 
not sufficient evidence that the necessary allocation has been made.
    (ii) A taxpayer's procedure for determining the time when an 
expenditure is properly chargeable to capital account for self-
constructed property is a method of accounting. Under section 446(e), 
the method of accounting, once adopted, may not be changed without 
consent of the Secretary.
    (4) Records requirement. The taxpayer shall maintain detailed 
records which permit specific identification of the amounts properly 
chargeable by the taxpayer during each taxable year to capital account 
for each item of self-constructed property.
    (i) [Reserved]
    (j) Qualified progress expenditures for non-self-constructed 
property--(1) In general. Qualified progress expenditures for non-self-
constructed property (as defined in paragraph (l) of this section) are 
amounts actually paid by the taxpayer to another person for construction 
of the property, but only to the extent progress is made in 
construction. For example, such expenditures may include payments to the 
manufacturer of an item of progress expenditure property, payments to a 
contractor building progress expenditure property, or payments for 
engineering designs or blueprints that are drawn up during the normal 
construction period.
    (2) Property partially self-constructed. If an item of property is 
non-self-constructed, but a taxpayer uses its own employees to construct 
a portion of the property, expenditures for construction of that portion 
are made directly by the taxpayer (see Sec.  1.46-5(h)(1)). Subject to 
the limitations of paragraph (g) of this section, those expenditures are 
qualified progress expenditures for non-self-constructed property if 
they satisfy the requirements of paragraphs (j) (4), (5), and (6) of 
this section. Wages

[[Page 375]]

actually paid to the taxpayer's employees are presumed to correspond to 
progress in construction. Other amounts, including expenditures for 
materials, parts, and overhead, must be actually paid, not borrowed from 
the payee, and attributable to progress made in construction by the 
taxpayer.
    (3) Property constructed by more than one person. The percentage of 
completion limitation (as prescribed in paragraph (j)(6) of this 
section), including the presumption of ratable progress in construction, 
applies to an item of progress expenditure property as a whole. However, 
if several manufacturers or contractors do work in connection with the 
same property, the progress that each person makes toward completion of 
construction of the property must be determined separately. Section 
46(d)(3)(B) is then applied separately to amounts paid to each 
manufacturer or contractor based on each person's progress in 
construction. For example, assume the taxpayer contracts with three 
persons to build an item of equipment. The taxpayer contracts with A to 
build the frame, B to build the motor, and C to assemble the frame and 
motor. Assume each contract represents 33\1/3\ percent of the 
construction costs of the property. If, within the taxable year in which 
construction begins, A and B each complete 50 percent of the 
construction of the frame and motor, respectively, amounts paid to A 
during that taxable year not in excess of 16\2/3\ percent of the overall 
cost of the property, and amounts paid to B during that taxable year not 
in excess of 16\2/3\ percent of the overall cost of the property, are 
qualified progress expenditures. Section 46(d)(3)(B) does not apply, 
however, to persons, such as lower-tier subcontractors, that do not have 
a direct contractual relationship with the taxpayer. If, in the above 
example, A engages a subcontractor to construct part of the frame, 
section 46(d)(3)(B) is applied only to amounts paid by the taxpayer to 
A, B, and C, but the portion of construction completed by A during a 
taxable year includes the portion completed by A's subcontractor.
    (4) Requirement of actual payment. Qualified progress expenditures 
for non-self-constructed property must be actually paid and not merely 
incurred. Amounts paid during the taxable year to another person for 
construction of non-self-constructed property may be in the form of 
money or property (e.g., materials). However, property given as payment 
may be considered only to the extent it will be includible under Sec.  
1.46-3(c) in the basis of the non-self-constructed property when it is 
placed in service.
    (5) Certain borrowing disregarded. Qualified progress expenditures 
for non-self-constructed property do not include any amount paid to 
another person (the ``payee'') for construction if the amount is paid 
out of funds borrowed directly or indirectly from the payee. Amounts 
borrowed directly or indirectly from the payee by any person that is 
related to the taxpayer (within the meaning of section 267) or that is a 
member of the same controlled group of corporations (as defined in 
section 1563(a)) will be considered borrowed indirectly from the payee. 
Similarly, amounts borrowed under any financing arrangement that has the 
effect of making the payee a surety will be considered amounts borrowed 
indirectly by the taxpayer from the payee.
    (6) Percentage of completion limitation. (i) Under section 
46(d)(3)(B)(ii), payments made in any taxable year may be considered 
qualified progress expenditures for non-self-constructed property only 
to the extent they are attributable to progress made in construction 
(percentage of completion limitation). Progress will generally be 
measured in terms of the manufacturer's incurred cost, as a fraction of 
the anticipated cost (as adjusted from year to year). Architectural or 
engineering estimates will be evidence of progress made in construction. 
Cost accounting records also will be evidence of progress. Progress will 
be presumed to occur not more rapidly than ratably over the normal 
construction period. However, the taxpayer may rebut the presumption by 
clear and convincing evidence of a greater percentage of completion.
    (ii) If, after the first year of construction, there is a change in 
either the total cost to the taxpayer or the total cost of construction 
by another person,

[[Page 376]]

the taxpayer must recompute the percentage of completion limitation on 
the basis of revised cost. However, the recomputation will affect only 
amounts allowed as qualified progress expenditures in the taxable year 
in which the change occurs and in subsequent taxable years. The 
recomputation remains subject to the presumption of pro rata completion.
    (iii) If, for any taxable year, the amount paid to another person 
for construction of an item of property under section 46(d)(3)(B)(i) 
exceeds the percentage of completion limitation in section 
46(d)(3)(B)(ii), the excess is treated as an amount paid to the other 
person for construction for the succeeding taxable year. If for any 
taxable year the percentage of completion limitation for an item of 
property exceeds the amount paid to another during the taxable year for 
construction, the excess is added to the percentage of completion 
limitation for that property for the succeeding taxable year.
    (iv) The taxpayer must maintain detailed records which permit 
specific identification of the amounts paid to each person for 
construction of each item of property and the percentage of construction 
completed by each person for each taxable year.
    (7) Example. The following example illustrates paragraph (j)(6) of 
this section.

    Example. (i) Corporation X agrees to build an airplane for 
corporation Y, a calendar year taxpayer. The airplane is non-self-
constructed progress expenditure property. Physical work on construction 
begins on January 1, 1980. The normal construction period for the 
airplane is five years and the airplane is delivered and placed in 
service on December 31, 1984.
    (ii) The cost of construction to corporation X is $500,000. The 
contract price is $550,000. Corporation Y makes a $110,000 payment in 
each of the years 1980 and 1981, an $85,000 payment in 1982, a $135,000 
payment in 1983, and a $110,000 payment in 1984.
    (iii) For 1980, corporation Y makes an election under section 46(d). 
Progress is presumed to occur ratably over the 5-year construction 
period, which is 20 percent in each year. Twenty percent of the contract 
price is $110,000. The percentage of completion limitation for each 
year, thus, is $110,000.
    (iv) For each of the years 1980 and 1981, the $110,000 payments may 
be treated as qualified progress expenditures. The payments equal the 
percentage of completion limitation.
    (v) For 1982, the $85,000 payment may be treated as a qualified 
progress expenditure, because it is less than the percentage of 
completion limitation. The excess of the percentage of completion 
limitation ($110,000) over the 1982 payment ($85,000) is added to the 
percentage of completion limitation for 1983. One hundred and ten 
thousand dollars minus $85,000 equals $25,000. Twenty-five thousand 
dollars plus $110,000 equals $135,000, which is the percentage of 
completion limitation for 1983.
    (vi) For 1983, the entire $135,000 payment may be treated as a 
qualified progress expenditure. The payment equals the percentage of 
completion limitation for 1983.
    (vii) For 1984, no qualified progress expenditures may be taken into 
account, because the airplane is placed in service in that year.
    (viii) See example 2 of paragraph (r)(4) of this section for the 
result if Y sells its contract rights to the property on December 31, 
1982.

    (k) Definition of self-constructed property--(1) In general. 
Property is self-constructed property if it is reasonable to believe 
that more than half of the construction expenditures for the property 
will be made directly by the taxpayer. Construction expenditures made 
directly by the taxpayer include direct costs such as wages and 
materials and indirect costs such as overhead attributable to 
construction of the property. Expenditures for direct and indirect costs 
of construction will be treated as construction expenditures made 
directly by the taxpayer only to the extent that the expenditures 
directly benefit the construction of the property by employees of the 
taxpayer. Thus, wages paid to taxpayers's employees and expenditures for 
basic construction materials, such as sheet metal, lumber, glass, and 
nails, which are used by employees of the taxpayer to construct progress 
expenditure property, will be considered made directly by the taxpayer. 
Construction expenditures made by the taxpayer to a contractor or 
manufacturer, in general, will not be considered made directly by the 
taxpayer. Thus, the cost of component parts, such as boilers and 
turbines, which are purchased and merely installed or assembled by the 
taxpayer, will not be considered expenditures made directly by the 
taxpayer for construction. (See paragraph (h)(3) of this section to 
determine when such cost is

[[Page 377]]

properly chargeable to capital account.)
    (2) Time when determination made. The determination of whether 
property is self-constructed is to be made at the close of the taxable 
year in which physical work on construction of the property begins, or, 
if later, the close of the first taxable year to which an election under 
this section applies. Once it is reasonably estimated that more than 
half of construction expenditures will be made directly by the taxpayer, 
the fact the taxpayer actually makes half, or less than half, of the 
expenditures directly will not affect classification of the property as 
self-constructed property. Similarly, once a determination has been 
made, classification of property as self-constructed property is not 
affected by a change in circumstances in a later taxable year. However, 
a significant error unrelated to a change in circumstances may be 
evidence that the estimate was unreasonable when made.
    (3) Determination based on certain expenditures. For purposes of 
determining whether more than half of the expenditures for construction 
of an item of property will be made directly by the taxpayer, the 
taxpayer may take into account only expenditures properly includable by 
the taxpayer in the basis of the property under the provisions of Sec.  
1.46-3(c). Thus, property is self-constructed property only if more than 
half of the estimated basis of the property to be used for purposes of 
determining the credit allowed by section 38 is attributable to 
expenditures made directly by the taxpayer.
    (l) Definition of non-self-constructed property. Non-self-
constructed property is property that is not self-constructed property. 
Thus, property is non-self-constructed property if it is reasonable to 
believe that only half, or less than half, of the expenditures for 
construction will be made directly by the taxpayer.
    (m) Alternative limitations for public utility, railroad, or airline 
property. The alternative limitations on qualified investment under 
section 46(a) (7) and (8) for public utility, railroad, or airline 
property (whichever applies) apply in determining the credit for 
qualified progress expenditures. The determination of whether progress 
expenditure property will be public utility, railroad, or airline 
property (whichever applies) when placed in service must be made at the 
close of the taxable year in which physical work on construction begins 
or, if later, at the close of the first taxable year for which an 
election under section 46(d) is in effect. If, at that time, the 
taxpayer is in a trade or business as a public utility, railroad, or 
airline (as described in section 46(c)(3)(B) and 46(a)(8) (D) and (E), 
respectively), it is evidence the property will be public utility, 
railroad, or airline property when placed in service.
    (n) Leased property. A lessor of progress expenditure property may 
not elect under section 48(d) to treat a lessee (or a person who will be 
a lessee) as having made qualified progress expenditures.
    (o) Election--(1) In general. The election under section 46(d)(6) to 
increase qualified investment by qualified progress expenditures may be 
made for any taxable year ending after December 31, 1974. Except as 
provided in paragraph (o)(2) of this section, the election is effective 
for the first taxable year for which it is made and for all taxable 
years thereafter unless it is revoked with the consent of the 
Commissioner. Except as provided in paragraphs (o) (2) and (3) of this 
section, the election applies to all qualified progress expenditures 
made by the taypayer during the taxable year for construction of any 
progress expenditure property. Thus, the taxpayer may not make the 
election for one item of progress expenditure property and not for other 
items. If progress expenditure property is being constructed by or for a 
partnership, S corporation (as defined in section 1361(a)), trust, or 
estate, an election under section 46(d)(6) must be made separately by 
each partner or shareholder, or each beneficiary if the beneficiary, in 
determining his tax liability, would be allowed investment credit under 
section 38 for property subject to the election. The election may not be 
made by a partnership or S corporation, and may be made by a trust or 
estate only if the trust or estate, in determining its tax liability, 
would be allowed investment credit under section 38 for property subject 
to

[[Page 378]]

the election. The election of any partner, shareholder, beneficiary, 
trust, or estate will be effective for that person, even if a related 
partner, shareholder, beneficiary, trust, or estate does not make the 
election. An election made by a partner, shareholder, beneficiary, 
trust, or estate applies to all progress expenditure property of that 
person. For example, an election made by corporation X, which is a 
partner in the XYZ partnership, applies to progress expenditure property 
the corporation holds in its own capacity and also to its interest in 
progress expenditure property of the partnership.
    (2) Time and manner of making election. An election under section 
46(d)(6) must be made on Form 3468 and filed with the original income 
tax return for the first taxable year ending after December 31, 1974 to 
which the election will apply. An election made before March 2, 1988, by 
filing a written statement (whether or not attached to the income tax 
return) will be considered valid. The election may not be made on an 
amended return filed after the time prescribed for filing the original 
return (including extensions) for that taxable year. However, an 
election under this section may be made or revoked by filing a statement 
with an amended return filed on or before May 31, 1988, if the due date 
for filing a return for the first taxable year to which the election 
applies is before May 31, 1988.
    (3) Carryover of election in certain transactions. In general, and 
election under section 46(d)(6) does not carry over to the transferee of 
progress expenditure property (or an interest therein). However, if 
under section 47(b) the property does not cease to be progress 
expenditure property because of the transfer, the election will carry 
over to the transferee. If so, the election will apply only to the 
property transferred. For rules relating to the determination of 
qualified progress expenditures of the transferee, see paragraph (r) of 
this section.
    (p) Partnerships, S corporations, trusts, or estates--(1) In 
general. Each partner, shareholder, trust, estate, or beneficiary of a 
trust or estate that makes an election under section 46(d) shall take 
into account its share of qualified progress expenditures (determined 
under paragraph (p)(2) of this section) made by the partnership, S 
corporation, trust, or estate. In determining qualified investment for 
the year in which the property is placed in service, the basis of the 
property is apportioned as provided in Sec. Sec.  1.46-3(f), 1.48-6, or 
1.48-5 (whichever applies). Each partner, shareholder, trust, estate, or 
beneficiary that made the election must reduce qualified investment 
under section 46(c)(4) for the year the property is placed in service by 
qualified progress expenditures taken into account by that person.
    (2) Determination of share of qualified progress expenditures. The 
share of qualified progress expenditures of each partner, shareholder, 
trust, estate, or beneficiary that makes an election under section 46(d) 
must be determined in accordance with the same ratio used under 
Sec. Sec.  1.46-3(f)(2), 1.48-5(a)(1), or 1.48-6(a)(1) (whichever 
applies) to determine its share of basis (or cost). The last sentence of 
Sec.  1.46-3(f)(2)(i) must be applied by referring to the date on which 
qualified progress expenditures are paid or chargeable to capital amount 
(whichever is applicable).
    (3) Examples. The following examples illustrate this paragraph (p).

    Example 1. (i) Corporation X contracts to build a ship for 
partnership AB that qualifies as progress expenditure property. The 
contract price is $100,000. Physical work on construction of the ship 
begins on January 1, 1980. The ship is placed in service on December 31, 
1983.
    (ii) The AB partnership reports income on the calendar year basis. 
Partners A and B share profits equally. For A's taxable year ending 
December 31, 1980, A makes an election under section 46(d) B does not 
make the election.
    (iii) For each of the years 1980, 1981, 1982, and 1983, the AB 
partnership makes $25,000 payments to corporation X. The payments made 
in 1980, 1981, and 1982 are qualified progress expenditures. The 1983 
payment is not a qualified progress expenditure, because the ship is 
placed in service in that year.
    (iv) For each of the years 1980, 1981, and 1982, A may take into 
account qualified progress expenditures of $12,500 because A had a 50 
percent partnership interest in each of those years.
    (v) For 1983, qualified investment for the ship is $100,000. A and 
B's share are $50,000 each, because each had a 50 percent partnership 
interest in 1983. However, A must reduce its $50,000 share for 1983 by 
$37,500, the

[[Page 379]]

amount of qualified progress expenditures taken into account by A. B's 
share is not reduced, because B did not take into account qualified 
progess expenditures.
    Example 2. (i) The facts are the same as in example 1 except that on 
June 30, 1983, the partnership agreement is amended to admit a new 
partner, C. The partners agree to share profits equally. There is no 
special allocation in effect under section 704 with respect to the ship.
    (ii) For each of the years 1980, 1981, and 1982, A may take into 
account qualified progress expenditures of $12,500 because A has a 50 
percent partnership interest in those years.
    (iii) For 1983, A, B, and C's share of qualified investment is 
$33,333 each, because each had a 33\1/3\ percent partnership interest in 
that year. A must reduce its share to zero, because it took $37,500 into 
account as qualified progress expenditures. In addition, the excess of 
the $37,500 over the $33,333 applied as a reduction is subject to 
recapture under section 47(a)(3)(B). B and C's shares are not reduced, 
because neither taxpayer took into account qualified progress 
expenditures.

    (q) Limitation on qualified progress expenditures for taxable years 
beginning before 1980--(1) In general. (i) Under section 46(d)(7), 
qualified progress expenditures for any taxable year beginning before 
January 1, 1980, are limited. The taxpayer must apply the limitation 
under section 46(d)(7) on an item by item basis. In general, the 
taxpayer may take into account the applicable percentage (as determined 
under the table in section 46(d)(7)(A)) of qualified progress 
expenditures for each of those years. In addition, the taxpayer may take 
into account for each of those years 20 percent of qualified investment 
for each of the preceding taxable years determined without applying the 
limitations of section 46(d)(7).
    (ii) The applicable percentage under section 46(d)(7)(A) may be 
applied only for one taxable year that ends within a calendar year in 
determining qualified investment for an item of progress expenditure 
property. For example, calendar year partners of a calendar year 
partnership may increase qualified investment for 1976 by 20 percent of 
qualified progress expenditures made in 1975 for an item of property. If 
the partnership incorporates in 1976 and the taxable year of the 
corporation begins on July 1, 1976, and ends on June 30, 1977, qualified 
investment of the corporation for its taxable year beginning on July 1, 
1976, cannot be increased by 20 percent of the 1975 expenditure.
    (2) Example. The following example illustrates this paragraph (q).

    Example. (i) Corporation X contracts with A on January 1, 1976, to 
build an electric generator that qualifies as non-self-constructed 
progress expenditure property. A will build the generator at a cost of 
$125,000. Corporation X agrees to pay A $150,000. Corporation X reports 
income on the calendar year basis. Corporation X makes an election under 
section 46(d) for 1976. Physical work on construction begins on January 
1, 1976. Corporation X makes payments of $30,000 to A for construction 
of the generator in each of the years 1976, 1977, 1978, 1979, and 1980. 
A incurs a cost of $25,000 in each of those years for construction of 
the property. The property is placed in service in 1980.
    (ii) For 1976, X may increase qualified investment by $12,000, 40 
percent of the payment made in 1976.
    (iii) For 1977, corporation X may increase qualified investment by 
$24,000. Eighteen thousand dollars of that amount is 60 percent of the 
1977 payment. The remaining $6,000 is 20 percent of the $30,000 payment 
made in 1976.
    (iv) For 1978, corporation X may increase qualified investment by 
$36,000. Twenty-four thousand dollars of that amount is 80 percent of 
the 1978 payment. The remaining $12,000 is 20 percent of the $30,000 
payment made in 1976, plus 20 percent of the $30,000 payment made in 
1977.
    (v) For 1979, corporation X may increase qualified investment by 
$48,000. Thirty thousand dollars of that amount is 100 percent of the 
1979 payment. The remaining $18,000 of that amount is 20 percent of the 
$30,000 payments made in each of the years 1976, 1977, and 1978.
    (vi) Qualified investment for corporation X for 1980 is $30,000. The 
$30,000 is the basis (or cost) of the generator ($150,000), reduced by 
qualified progress expenditures allowed with respect to that property 
($120,000).

    (r) Special rules for transferred property--(1) In general. A 
transferee of progress expenditure property (or an interest therein) may 
take into account qualified progress expenditures for the property only 
if--
    (i) The property is progress expenditure property in the hands of 
the transferee, and
    (ii) The transferee makes an election under section 46(d) or the 
election made by the transferor (or its predecessor) carries over to the 
transferee under paragraph (o)(3) of this section.

[[Page 380]]

    (2) Status as progress expenditure property. (i) If the transfer 
requires recapture under section 47(a)(3) and Sec.  1.47-1(g) (or would 
require recapture if the transferor had made an election under section 
46(d)), then--
    (A) For purposes of determining if the property is progress 
expenditure property in the hands of the transferee, the normal 
construction period for the property begins on the date of the transfer, 
or, if later, on the first day of the first taxable year for which the 
transferee makes an election under section 46(d), and
    (B) For purposes of determining whether the property is self-
constructed or non-self-constructed in the hands of the transferee, the 
amount paid or incurred for the transfer of the property will not be 
considered a construction expenditure made directly by the transferee.
    (ii) If the transfer does not require recapture under section 
47(a)(3) and Sec.  1.47-1(g), and the election carries over to the 
taxpayer under paragraph (o)(3) of this section, the property does not 
lose its status as progress expenditure property because of the 
transfer.
    (3) Amount of qualified progress expenditures for transferee. (i) If 
the transfer does not require recapture under section 47(a)(3) and Sec.  
147-1(g), and the election carries over to the taxpayer under paragraph 
(o)(3) of this section, the transferee must determine its qualified 
progress expenditures--
    (A) By using the same normal construction period used by the 
transferor,
    (B) By treating the property as having the same status as self-
constructed or non-self-constructed as the property had in the hands of 
the transferor, and
    (C) In the case of non-self-constructed property, by taking into 
account any excess described in section 46(d)(4)(C)(i) (relating to the 
excess of payments over the percentage-of-completion limitation) or 
section 46(d)(4)(C)(ii) (relating to the excess of the percentage-of-
completion limitation over the amount of payments) that the transferor 
would have taken into account with respect to that property.
    (ii) If the transfer requires recapture under section 47(a)(3) and 
Sec.  1.47-1(g) (or would require recapture if the transferor had made 
an election under section 46(d)), the amount paid or incurred for the 
transfer will be considered a payment for construction of that property 
to the extent that--
    (A) It is properly includible in the basis of the property under 
Sec.  1.46-3(c),
    (B) The taxpayer can show the amount is attributable to construction 
costs paid or chargeable to capital account by the transferor or other 
person after physical work on construction of the property began, and
    (C) It does not exceed the amount by which the transferor has 
increased qualified investment for qualified progress expenditures 
incurred with respect to the property (or would have increased qualified 
investment but for the ``lesser of'' limitation of section 46(d)(3)(B) 
or the absence of an election under section 46(d)), plus any amount that 
would have been treated as a qualified progress expenditure by the 
transferor had the property not been transferred.

Once the status of the property as self-constructed or non-self-
constructed property in the hands of the transferee has been determined, 
all rules under this section for determining the amount of qualified 
progress expenditures for that type of property apply. For example, if 
the property is non-self-constructed in the hands of the transferee, 
amounts merely incurred (but not paid) for the transfer are not taken 
into account as qualified progress expenditures. Actual payment is 
necessary (see paragraph (j)(3) of this section). In applying section 
46(d)(3)(B)(ii), the amount paid or incurred for the transfer (to the 
extent that it qualifies as a payment for construction under the first 
sentence of this paragraph (r)(3)(ii)) is considered to be part of the 
overall cost to the transferee of construction by another person, and 
the portion of construction which is completed during the taxable year 
is determined by taking into account construction that was completed 
before the constructed property was acquired by the transferee. If the 
transferee makes an election under section 46(d) and this section for 
the taxable year in which the transfer occurs, then

[[Page 381]]

for purposes of applying the presumption in section 46(d)(4)(D) that 
construction is deemed to occur not more rapidly than ratably over the 
normal construction period, the transferee's normal construction period 
is considered to have begun on the date on which physical work on 
construction of the acquired property began.
    (4) Examples. The following examples illustrate this paragraph (r).

    Example 1. Corporation X begins physical work on construction of 
progress expenditure property for corporation Y on January 1, 1976. Y 
accurately estimates a 3-year normal construction period and elects 
under section 46(d) on its return for its taxable year ending December 
31, 1976. On January 1, 1978, Y sells the contract rights for 
construction of the property to corporation Z, which uses a fiscal year 
ending June 30. Qualified progress expenditures allowed to Y in 1976 and 
1977 are subject to recapture under section 47(a)(3). Because Z's normal 
construction period for the property is less than 2 years (January 1, 
1978 to January 1, 1979), the property is not progress expenditure 
property in Z's hands. Z may not elect progress expenditure treatment 
for the property.
    Example 2. (i) Assume the same facts as in the example in paragraph 
(j)(7) of this section, except, on December 31, 1982, Y sells its 
contract rights to the property for $340,000 to corporation Z, which 
also uses the calendar year. Z pays Y the full $340,000 on that date. 
The property is still to be placed in service on December 31, 1984, and 
will not be available for placing in service at an earlier date. Z makes 
payments to X of $135,000 on December 31, 1983, and $110,000 on December 
31, 1984.
    (ii) The investment credit allowed Y in 1980 and 1981 for qualified 
progress expenditures is subject to recapture under section 47(a)(3) and 
Y may not treat its $85,000 payment in 1982 as a qualified progress 
expenditure.
    (iii) For purposes of determining if the airplane is qualified 
progress expenditure property with respect to Z, the normal construction 
period for the property for Z begins on December 31, 1982, the date of 
transfer. Since the remaining construction period is two years, the 
property is progress expenditure property if it otherwise qualifies in 
Z's hands.
    (iv) Only $305,000 of the $340,000 payment to Y can qualify as a 
qualified progress expenditure, because only that amount is attributable 
to construction costs paid by Y and does not exceed the sum of the 
amount by which Y increased qualified investment in 1980 and 1981 for 
qualified progress expenditures ($220,000) and the amount that Y would 
have treated as a qualified progress expenditure in 1982 ($85,000).
    (v) Assume that Z cannot establish that progress in construction has 
been completed more rapidly than ratably. If Z makes an election under 
section 46(d) for 1982, then for purposes of applying the percentage of 
completion limitation, Z's normal construction period is considered to 
begin on January 1, 1980. Progress is presumed to occur ratably over the 
5-year construction period, which is 20 percent in each year.
    (vi) For 1982, Z may treat the full $305,000 as a qualified progress 
expenditure because it is less than the percentage of completion 
limitation, $330,000 ($110,000 a year for 1980, 1981, and 1982).
    (vii) For 1983, Z may treat the entire $135,000 payment as a 
qualified progress expenditure, since it does not exceed the percentage 
of completion limitation for that year, $135,000 ($110,000 plus the 
$25,000 excess from 1982).
    (viii) For Z's taxable year ending December 31, 1984, no qualified 
progress expenditures may be taken into account because the property is 
placed in service during that year.

[T.D. 8183, 53 FR 6618, Mar. 2, 1988; 53 FR 11162, Apr. 5, 1988]



Sec.  1.46-6  Limitation in case of certain regulated companies.

    (a) In general--(1) Scope of section. This section does not reflect 
amendments made to section 46 after enactment of the Revenue Act of 
1971, other than the redesignation of section 46(e) as section 46(f) by 
the Tax Reduction Act of 1975.
    (2) Disallowance of credit. Under section 46(f), a credit otherwise 
allowable under section 38 (``credit'') will be disallowed in certain 
cases with respect to ``section 46(f) property'' as defined in paragraph 
(b)(1) of this section. Paragraph (f) of this section describes 
circumstances under which a determination put into effect by a 
regulatory body will result in the disallowance of the credit. Such a 
determination will result in a disallowance only if section 46(f) (1) or 
(2) applies to such property and such determination affects the 
taxpayer's cost of service or rate base in a manner inconsistent with 
section 46(f) (1) or (2) (whichever is applicable).
    (3) General rules. The provisions of section 46(f) (1) and (2) are 
limitations on the treatment of the credit for ratemaking purposes and 
for purposes of the taxpayer's regulated books of account only. Under 
the provisions of section 46(f)(1), the credit may not be

[[Page 382]]

flowed through to income (i.e., used to reduce taxpayer's cost of 
service) but in certain circumstances may be used to reduce rate base 
(provided that such reduction is restored not less rapidly than 
ratably). If an election is made under section 46(f)(2), the credit may 
be flowed through to income (but not more rapidly than ratably) and 
there may not be any reduction in rate base. If an election is made 
under section 46(f)(3), none of the limitations of section 46(f) (1) or 
(2) apply to certain section 46(f) property of the taxpayer. Thus, under 
the provisions of section 46(f)(3), no credit is disallowed if the 
credit is treated in any manner for ratemaking purposes, including any 
manner of treatment permitted under the limitations of section 46(f) (1) 
or (2).
    (4) Elections. For rules relating to the manner of making, on or 
before March 9, 1972, the three elections listed in section 46(f) (1), 
(2), and (3), see 26 CFR 12.3. For rules relating to the application of 
such elections, see paragraph (h) of this section.
    (5) Cross references. For rules with respect to the treatment of 
corporate reorganizations, asset acquisitions, and taxpayers subject to 
the jurisdiction of more than one regulatory body, etc., see paragraph 
(j) of this section.
    (6) Nonapplication of prior law. Under section 105 (e) of the 
Revenue Act of 1971, section 203 (e) of the Revenue Act of 1964, 78 
Stat. 35, does not apply to section 46(f) property.
    (b) Definitions. For purposes of this section, the following 
definitions apply:
    (1) Section 46(f) property. ``Section 46(f) property'' is property 
described in section 50 that is--
    (i) Public utility property within the meaning of section 
46(c)(3)(B) (other than nonregulated communication property described in 
Sec.  1.46-3(g)(2)(iv)) or
    (ii) Property used predominantly in the trade or business of the 
furnishing or sale of steam through a local distribution system or of 
the transportation of gas or steam by pipeline, if the rates for the 
trade or business are regulated within the meaning of Sec.  1.46-
3(g)(2)(iii).

For purposes of determining whether property is used predominantly in 
the trade or business of transportation of gas by pipeline (or of 
transportation of gas by pipeline and of furnishing or sale of gas 
through a local distribution system), the rules prescribed in Sec.  
1.46-3(g)(4) apply except that accounts 365 through 371 inclusive 
(Transmission Plant) are added to the accounts listed in Sec.  1.46-
3(g)(4)(i).
    (2) Cost of service. (i)(A) For purposes of this section, ``cost of 
service'' is the amount required by a taxpayer to provide regulated 
goods or services. Cost of service includes operating expenses 
(including salaries, cost of materials, etc.) maintenance expenses, 
depreciation expenses, tax expenses, and interest expenses. For purposes 
of this section, any effect on a taxpayer's permitted return on 
investment that results from a reduction in the taxpayer's rate base 
does not constitute a reduction in cost of service, even though, as a 
technical ratemaking term, ``cost of service'' ordinarily includes a 
permitted return on investment. In addition, taking into account a 
deduction for the additional interest that the taxpayer would pay or 
accrue if the credit were unavailable in determining Federal income tax 
expense (``synchronization of interest'') does not constitute a 
reduction in cost of service for purposes of section 46(f)(2). This 
adjustment to Federal income tax expense may be taken into account in 
determining cost of service for the regulated accounting period or 
periods that include the taxable year to which the adjustment relates or 
for any subsequent regulated accounting period.
    (B) See paragraph (b)(3)(ii)(B) of this section for rules relating 
to the amount of additional interest that the taxpayer would pay or 
accrue if the credit were unavailable.
    (ii) In determining whether, or to what extent, a credit has been 
used to reduce cost of service, reference shall be made to any 
accounting treatment that affects cost of service. Examples of such 
treatment include reducing by all or a portion of the credit the amount 
of Federal income tax expense taken into account for ratemaking purposes 
and reducing the depreciable

[[Page 383]]

bases of property by all or a portion of the credit for ratemaking 
purposes.
    (3) Rate base. (i) For purposes of this section, ``rate base'' is 
the monetary amount that is multiplied by a rate of return to determine 
the permitted return on investment.
    (ii)(A) In determining whether, or to what extent, a credit has been 
used to reduce rate base, reference shall be made to any accounting 
treatment that affects rate base. In addition, in those cases in which 
the rate of return is based on the taxpayer's cost of capital, reference 
shall be made to any accounting treatment that reduces the permitted 
return on investment by treating the credit less favorably than the 
capital that would have been provided if the credit were unavailable. 
Thus, the credit may not be assigned a ``cost of capital'' rate that is 
less than the overall cost of capital rate, determined on the basis of a 
weighted average, for the capital that would have been provided if the 
credit were unavailable.
    (B) For purposes of determining the cost of capital rate assigned to 
the credit and the amount of additional interest that the taxpayer would 
pay or accrue, the composition of the capital that would have been 
provided if the credit were unavailable may be determined--
    (1) On the basis of all the relevant facts and circumstances; or
    (2) By assuming for both such purposes that such capital would be 
provided solely by common shareholders, preferred shareholders, and 
long-term creditors in the same proportions and at the same rates of 
return as the capital actually provided to the taxpayer by such 
shareholders and creditors.

For purposes of this section, capital provided by long-term creditors 
does not include deferred taxes as described in section 167(e)(3)(G) or 
168(e)(3)(B)(ii).
    (C) If a taxpayer's overall rate of return is based on a deemed or 
hypothetical capital structure, paragraph (b)(3)(ii)(B) of this section 
shall be applied by treating the deemed or hypothetical capital as if it 
were the capital actually provided to the taxpayer and determining the 
composition of the capital that would have been provided if the credit 
were unavailable in a manner consistent with such treatment.
    (iii) Whether, or to what extent, a credit has been used to reduce 
rate base for any period to which pre-June 23, 1986 rates apply will be 
determined under 26 CFR 1.46-6(b) (3) and (4) (revised as of April 1, 
1985) if such a determination avoids disallowance of a credit that would 
be disallowed under paragraph (b)(3)(ii) or (4)(ii) of this section. For 
this purpose, a period of which pre-June 23, 1986 rates apply is any 
period for which the effect of the credit on rate base for ratemaking 
purposes is established under a determination put into effect (within 
the meaning of paragraph (f) of this section) before June 23, 1986.
    (4) Indirect reductions to cost of service or rate base. (i) Cost of 
service or rate base is also considered to have been reduced by reason 
of all or a portion of a credit if such reduction is made in an indirect 
manner.
    (ii) One type of such indirect reduction is any ratemaking decision 
in which the credit is treated as operating income (subject to 
ratemaking regulation) or is treated less favorably than the capital 
that would have been provided if the credit were unavailable. For 
example, if the credit is accounted for as nonoperating income on a 
company's regulated books of account but a ratemaking decision has the 
effect of treating the credit as operating income in determining rate of 
return to common shareholders, then cost of service has been indirectly 
reduced by reason of the credit.
    (iii) A second type of indirect reduction is any ratemaking decision 
intended to achieve an effect similar to a direct reduction to cost of 
service or rate base. In determining whether a ratemaking decision is 
intended to achieve this effect, consideration is given to all the 
relevant facts and circumstances of each case, including, but not 
limited to--
    (A) The record of the proceeding,
    (B) The regulatory body's orders or opinions (including any 
dissenting views), and
    (C) The anticipated effect of the ratemaking decision on the 
company's revenues in comparison to a direct reduction to cost of 
service or rate base by

[[Page 384]]

reason of the investment tax credits available to the regulated company.
    (iv) This paragraph (b)(4)(iv) describes a situation that is not an 
indirect reduction to cost of service or rate base by reason of all or a 
portion of a credit. The ratemaking treatment of credits may affect the 
financial condition of a company, including the company's ability to 
attract new capital, the cost of that capital, the company's future 
financial requirements, the market price of the company's securities, 
and the degree of risk attributable to investment in those securities. 
The financial condition may be reflected in certain customary financial 
indicators such as the comparative capital structure of the company, 
coverage ratios, price/earnings ratios, and price/book ratios. Under the 
facts and circumstances test of paragraph (b)(4)(iii) of this section, 
the consideration of a company's financial condition by a regulatory 
body is not an indirect reduction to cost of service or rate base, even 
though such condition, as affected by the ratemaking treatment of the 
company's investment tax credits, is considered in the development of a 
reasonable rate of return on common shareholders' investment.
    (c) General rule--(1) In general. Section 46(f)(1) applies to all of 
the taxpayer's section 46(f) property except property to which an 
election under section 46(f) (2) or (3) applies. Under section 46(f)(1), 
the credit for the taxpayer's section 46(f) property will be disallowed 
if--
    (i) The taxpayer's cost of service for ratemaking purposes is 
reduced by reason of any portion of such credit, or
    (ii) The taxpayer's rate base is reduced by reason of any portion of 
the credit and such reduction in rate base is not restored or is 
restored less rapidly than ratably within the meaning of paragraph (g) 
of this section.
    (2) Insufficient natural domestic supply. The provisions of 
paragraph (c)(1)(ii) of this section shall not apply to permit any 
reduction in taxpayer's rate base with respect to its ``short supply 
property'' if it made an election under the last sentence of section 
46(f)(1) on or before March 9, 1972.
    (3) Short supply property. For purposes of this section, section 
46(f) property is ``short supply property'' if--
    (i) The property is described in paragraph (b)(1)(ii) of this 
section,
    (ii) The regulatory body described in section 46(c)(3)(B) that has 
jurisdiction for ratemaking purposes with respect to such trade or 
business is an agency or instrumentality of the United States, and
    (iii) This regulatory body makes a short supply determination and 
the determination is in effect on the date such property is placed in 
service.
    (4) Short supply determination. A short supply determination is made 
or revoked on the date of its publication in the Federal Register. It is 
a determination that the natural domestic supply of gas or steam is 
insufficient to meet the present and future requirements of the domestic 
economy.
    (5) Dates short supply determination in effect. (i) A short supply 
determination is considered to be in effect with respect to section 
46(f) property placed in service at any time before the determination is 
revoked. However, a short supply determination made after June 20, 1979 
is not considered to be in effect with respect to section 46(f) property 
placed in service before such determination was made.
    (d) Special rule for ratable flow-through. If an election was made 
under section 46(f)(2) on or before March 9, 1972, section 46(f)(2) 
applies to all of the taxpayer's section 46(f) property except property 
to which an election under section 46(f)(3) applies. Under section 
46(f)(2), the credit for the taxpayer's section 46(f) property will be 
disallowed if--
    (1) The taxpayer's cost of service, for ratemaking purposes or in 
its regulated books of account, is reduced by more than a ratable 
portion of such credit within the meaning of paragraph (g) of this 
section or
    (2) The taxpayer's rate base is reduced by reason of any portion of 
such credit.
    (e) Flow-through property. If a taxpayer made an election under 
section 46(f)(3) on or before March 9, 1972, section 46(f) (1) and (2) 
do not apply to the taxpayer's section 46(f) property to which section 
167(l)(2)(C) applies. In the

[[Page 385]]

case of an election under section 46(f)(3), a credit will not be 
disallowed, notwithstanding a determination by a regulatory body having 
jurisdiction over such taxpayer that reduces the taxpayer's cost of 
service or rate base by reason of such credit. In general, section 
167(l)(2)(C) applies to property with respect to which a taxpayer may 
use a flow-through method of accounting (within the meaning of section 
167(l)(3)(H)) to take into account the allowance for depreciation under 
section 167(a). Section 167(l)(2)(C) applies to property even though the 
taxpayer does not use a flow-through method of accounting with respect 
to the property. Section 167(l)(2)(C) does not apply to property if the 
taxpayer can not use a flow-through method of accounting with respect to 
the property. For example, section 167(l)(2)(C) does not apply to 
property with respect to which an election under section 167(l)(4)(A) 
applies. Thus, such property does not qualify for an election under 
section 46(f)(3).
    (f) Limitations--(1) In general. This paragraph provides rules 
relating to limitations on the disallowance of credits under section 
46(f)(4). Key terms are defined in paragraphs (f) (7), (8), and (9) of 
this section.
    (2) Disallowance postponed. There is no disallowance of a credit 
before the first final inconsistent determination is put into effect for 
the taxpayer's section 46(f) property.
    (3) Time of disallowance. A credit is disallowed--
    (i) When the first final inconsistent determination is put into 
effect and
    (ii) When any inconsistent determination (whether or not final) is 
put into effect after the first final inconsistent determination is put 
into effect.
    (4) Credits disallowed. A credit is disallowed for section 46(f) 
property placed in service (within the meaning of Sec.  1.46-3(d)) by 
the taxpayer--
    (i) Before the date any inconsistent determination described in 
paragraph (f)(2) of this section is put into effect and
    (ii) On or after such date and before the date a subsequent 
consistent determination (whether or not final) is put into effect.
    (5) Barred years. No amount of credit for a taxable year is 
disallowed under paragraph (f)(3) of this section if, for such year, 
assessment of a deficiency is barred by any law or rule of law.
    (6) Notification and other requirements. The taxpayer shall notify 
the district director of a disallowance of a credit under paragraph 
(f)(3) of this section within 30 days of the date that the applicable 
determination is put into effect. In the case of such a disallowance, 
the taxpayer shall recompute its tax liability for any affected taxable 
year, and such recomputation shall be made in the form of an amended 
return where necessary.
    (7) Determinations. For purposes of this paragraph, the term 
``determination'' refers to a determination made with respect to section 
46(f) property (other than property to which an election under section 
46(f)(3) applies) by a regulatory body described in section 46(c)(3)(B) 
that determines the effect of the credit--
    (i) For purposes of section 46(f)(1), on the taxpayer's cost of 
service or rate base for ratemaking purposes or
    (ii) In the case of a taxpayer that made an election under section 
46(f)(2), on the taxpayer's cost of service, for ratemaking purposes or 
in its regulated books of account, or on the taxpayer's rate base for 
ratemaking purposes.

A regulatory body does not have to take affirmative action to make a 
determination. Thus, a regulatory body's failure to take action on a 
rate schedule filed by a taxpayer is a determination if the rates can be 
put into effect without further action by the regulatory body.
    (8) Types of determinations. For purposes of this paragraph--
    (i) The term ``inconsistent'' refers to a determination that is 
inconsistent with section 46(f) (1) or (2) (as the case may be). Thus, 
for example, a determination to reduce the taxpayer's cost of service by 
more than a ratable portion of the credit would be a determination that 
is inconsistent with section 46(f)(2). As a further example, such a 
determination would also be inconsistent if section 46(f)(1) applied 
because no reduction in cost of service is permitted under section 
46(f)(1).

[[Page 386]]

    (ii) The term ``consistent'' refers to a determination that is 
consistent with section 46(f) (1) or (2) (as the case may be).
    (iii) The term ``final determination'' means a determination with 
respect to which all rights to appeal or to request a review, a 
rehearing, or a redetermination have been exhausted or have lapsed.
    (iv) The term ``first final inconsistent determination'' means the 
first final determination put into effect after December 10, 1971, that 
is inconsistent with section 46(f) (1) or (2) (as the case may be).
    (9) Put into effect. A determination is put into effect on the 
latter of--
    (i) The date it is issued (or, if a first final inconsistent 
determination, the date it becomes final) or
    (ii) The date it becomes operative.
    (10) Examples. The provisions of this paragraph may be illustrated 
by the following examples:

    Example 1. Corporation X, a calendar-year taxpayer engaged in a 
public utility activity is subject to the jurisdiction of regulatory 
body A. On September 15, 1971, X purchases section 46(f) property and 
places it in service on that date. For 1971, X takes the credit 
allowable by section 38 with respect to such property. X does not make 
any election permitted by section 46(f). On October 9, 1972, A makes a 
determination that X must account for the credit allowable under section 
38 in a manner inconsistent with section 46(f)(1). The determination, 
which was the first determination by A after December 10, 1971, becomes 
final on January 1, 1973, and holds that X must retroactively adjust the 
manner in which it accounted for the credit allowable under section 38 
starting with the taxable year that began on January 1, 1972. Since, 
under the provisions of paragraph (f)(8) of this section, the 
determination by A is put into effect on January 1, 1973 (the date it 
becomes final), the credit is retroactively disallowed with respect to 
any of X's section 46(f) property placed in service before January 1, 
1973, on any date which occurs during a taxable year with respect to 
which an assessment of a deficiency has not been barred by any law or 
rule of law. In addition, the credit is disallowed with respect to X's 
section 46(f) property placed in service on or after January 1, 1973, 
and before the date that a subsequent determination by A, which as to X 
is consistent with section 46(f)(1), is put into effect. Thus, X must 
amend its income tax return for 1971 to reflect the retroactive 
disallowance of the credit otherwise allowable under section 38 with 
respect to the section 46(f) property placed in service on September 15, 
1971.
    Example 2. The facts are the same as in example 1, except that the 
first inconsistent determination by A becomes final on April 5, 1972, 
and requires X to account for the credit for all taxable years beginning 
on or after January 1, 1973, in a manner inconsistent with section 
46(f)(1). Under the provisions of paragraph (f)(8) of this section, the 
determination was put into effect on January 1, 1973 (the date it became 
operative). The result is the same as in example 1.
    Example 3. The facts are the same as in example 1, except that on 
June 1, 1975, A issues a determination that X shall retroactively 
account for the credit allowable by section 38 in a manner consistent 
with the provisions of section 46(f)(1) for taxable years beginning on 
or after January 1, 1971. The determination becomes final on January 5, 
1976, in the same form as originally issued. The result is the same as 
in example 1 with respect to property X places in service before June 1, 
1975. The credit is allowed with respect to property X places in service 
on or after June 1, 1975 (the date that the consistent determination is 
put into effect).

    (g) Ratable methods--(1) In general. Under this paragraph (g), rules 
are prescribed for purposes of determining whether or not, under section 
46(f)(1), a reduction in the taxpayer's rate base with respect to the 
credit is restored less rapidly than ratably and whether or not under 
section 46(f)(2) the taxpayer's cost of service for ratemaking purposes 
is reduced by more than a ratable portion of such credit.
    (2) Regulated depreciation expense. What is ``ratable'' is 
determined by considering the period of time actually used in computing 
the taxpayer's regulated depreciation expense for the property for which 
a credit is allowed. ``Regulated depreciation expense'' is the 
depreciation expense for the property used by a regulatory body for 
purposes of establishing the taxpayer's cost of service for ratemaking 
purposes. Such period of time shall be expressed in units of years (or 
shorter periods), units of production, or machine hours and shall be 
determined in accordance with the individual useful life system or 
composite (or other group asset) account system actually used in 
computing the taxpayer's regulated depreciation expense. A method of 
restoring, or reducing, is ratable if the amount to be restored to rate 
base, or to reduce cost of service (as the case

[[Page 387]]

may be), is allocated ratably in proportion to the number of such units. 
Thus, for example, assume that the regulated depreciation expense is 
computed under the straight line method by applying a composite annual 
percentage rate to ``original cost'' (as defined for purposes of 
computing regulated depreciation expense). If, with respect to an item 
of section 46(f) property, the amount to be restored annually to rate 
base is computed by applying a composite annual percentage rate to the 
amount by which the rate base was reduced, then the restoration is 
ratable. Similarly, if cost of service is reduced annually by an amount 
computed by applying a composite annual percentage rate to the amount of 
the credit, cost of service is reduced by a ratable portion. If such 
composite annual percenage rate were revised for purposes of computing 
regulated depreciation expense beginning with a particular accounting 
period, the computation of ratable restoration or ratable portion (as 
the case may be) must also be revised beginning with such period. A 
composite annual percentage rate is determined solely by reference to 
the period of time actually used by the taxpayer in computing its 
regulated depreciation expense without reduction for salvage or other 
items such as over and under accruals. A composite annual percentage 
rate determined by taking into account salvage value or other items 
shall be considered to be ratable in the case of a determination 
(whether or not final) issued before March 22, 1979, and any rate order 
(whether or not final) that is entered into before June 20, 1979, in 
response to a rate case filed before April 23, 1979. For this purpose, 
the term ``rate order'' does not include an order by a regulatory body 
that perfunctorily adopts rates as filed if such rates are suspended or 
subject to rebate.
    (h) Elections--(1) Applicability of elections. (i) Any election 
under section 46(f) applies to all of the taxpayer's property eligible 
for the election, whether or not the taxpayer is regulated by more than 
one regulatory body.
    (ii) Section 46(f)(1) applies to all of the taxpayer's section 46(f) 
property in the absence of an election under either section 46(f) (2) or 
(3). If an election is made under section 46(f)(2), section 46(f)(1) 
does not apply to any of the taxpayer's section 46(f) property.
    (iii) An election made under the last sentence of section 46(f)(1) 
applies to that portion of the taxpayer's section 46(f) property to 
which section 46(f)(1) applies and which is short supply property within 
the meaning of paragraph (c)(2) of this section.
    (iv) If a taxpayer makes an election under section 46(f)(2) and 
makes no election under section 46(f)(3), the election under section 
46(f)(2) applies to all of the taxpayer's section 46(f) property.
    (v) If a taxpayer makes an election under section 46(f)(3), such 
election applies to all of the taxpayer's section 46(f) property to 
which section 167(l)(2)(C) applies. Section 46(f) (1) or (2) (as the 
case may be) applies to that portion of the taxpayer's section 46(f) 
property that is not property to which section 167(f)(2)(C) applies. 
Thus, for example, if a taxpayer makes an election under section 
46(f)(2) and also makes an election under section 46(f)(3), section 
46(f)(3) applies to all of the taxpayer's section 46(f) property to 
which section 167(l)(2)(C) applies, and section 46(f)(2) applies to the 
remainder of the taxpayer's section 46(f) property.
    (2) Method of making elections. See 26 CFR 12.3 for rules relating 
to the method of making the elections described in section 46(f) (1), 
(2), or (3).
    (i) [Reserved]
    (j) Reorganizations, asset acquisitions, multiple regulation, etc.--
(1) Taxpayers not entirely subject to jurisdiction of one regulatory 
body. (i) If a taxpayer is required by a regulatory body having 
jurisdiction over less than all of its property to account for the 
credit under a determination that is inconsistent with section 46(f) (1) 
or (2) (as the case may be), such credit shall be disallowed only with 
respect to property subject to the jurisdiction of such regulatory body.
    (ii) For purposes of this paragraph (j), a regulatory body is 
considered to have jurisdiction over property of a taxpayer if the 
property is included in the rate base for which the regulatory body 
determines an allowable rate of return for ratemaking purposes or if 
expenses

[[Page 388]]

with respect to the property are included in cost of service as 
determined by the regulatory body for ratemaking purposes. For example, 
if regulatory body A, having jurisdiction over 60 percent of an item of 
corporation X's section 46(f) property, makes a determination which is 
inconsistent with section 46(f), and if regulatory body B, having 
jurisdiction over the remaining 40 percent of such item of property, 
makes a consistent determination (or if the remaining 40 percent is not 
subject to the jurisdiction of any regulatory body), then 60 percent of 
the credit for such item will be disallowed. For a further example, if 
regulatory body A, having jurisdiction over 60 percent of X's section 
46(f) property, has jurisdiction over 100 percent of a particular 
generator, 100 percent of the credit for such generator will be 
disallowed.
    (iii) For rules which provide that the 3 elections under section 
46(f) may not be made with respect to less than all of the taxpayer's 
property eligible for the election, see paragraph (h)(1)(i) of this 
section.
    (2) [Reserved]
    (k) Treatment of accumulated deferred investment tax credits upon 
the deregulation of public utility property--(1) Scope--(i) In general. 
This paragraph (k) provides rules for the application of former sections 
46(f)(1) and 46(f)(2) of the Internal Revenue Code to a taxpayer with 
respect to public utility property that ceases, whether by disposition, 
deregulation, or otherwise, to be public utility property with respect 
to the taxpayer and that is not described in paragraph (k)(1)(ii) of 
this section (deregulated public utility property).
    (ii) Exception. This paragraph (k) does not apply to property that 
ceases to be public utility property with respect to the taxpayer on 
account of an ordinary retirement within the meaning of Sec.  1.167(a)-
11(d)(3)(ii).
    (2) Ratable amount--(i) Restoration of rate base reduction. A 
reduction in the taxpayer's rate base on account of the credit with 
respect to public utility property that becomes deregulated public 
utility property is restored ratably during the period after the 
property becomes deregulated public utility property if the amount of 
the reduction remaining to be restored does not, at any time during the 
period, exceed the restoration percentage of the recoverable stranded 
cost of the property at such time. For this purpose--
    (A) The stranded cost of the property is the cost of the property 
reduced by the amount of such cost that the taxpayer has recovered 
through regulated depreciation expense during the period before the 
property becomes deregulated public utility property;
    (B) The recoverable stranded cost of the property at any time is the 
stranded cost of the property that the taxpayer will be permitted to 
recover through rates after such time; and
    (C) The restoration percentage for the property is determined by 
dividing the reduction in rate base remaining to be restored with 
respect to the property immediately before the property becomes 
deregulated public utility property by the stranded cost of the 
property.
    (ii) Cost of service reduction. Reductions in the taxpayer's cost of 
service on account of the credit with respect to public utility property 
that becomes deregulated public utility property are ratable during the 
period after the property becomes deregulated public utility property if 
the cumulative amount of the reduction during such period does not, at 
any time during the period, exceed the flowthrough percentage of the 
cumulative stranded cost recovery for the property at such time. For 
this purpose--
    (A) The stranded cost of the property is the cost of the property 
reduced by the amount of such cost that the taxpayer has recovered 
through regulated depreciation expense during the period before the 
property becomes deregulated public utility property;
    (B) The cumulative stranded cost recovery for the property at any 
time is the stranded cost of the property that the taxpayer has been 
permitted to recover through rates on or before such time; and
    (C) The flowthrough percentage for the property is determined by 
dividing the amount of credit with respect to the property remaining to 
be used to reduce cost of service immediately before the property 
becomes deregulated

[[Page 389]]

public utility property by the stranded cost of the property.
    (3) Cross reference. See Sec.  1.168(i)-(3) for rules relating to 
the treatment of balances of excess deferred income taxes when public 
utility property becomes deregulated public utility property.
    (4) Effective/applicability dates--(i) In general. Except as 
provided in paragraph (k)(4)(ii) of this section, this paragraph (k) 
applies to public utility property that becomes deregulated public 
utility property with respect to a taxpayer after December 21, 2005.
    (ii) Property that becomes public utility property of the 
transferee. This paragraph (k) does not apply to property that becomes 
deregulated public utility property with respect to a taxpayer an 
account of a transfer on or before March 20, 2008 if after the transfer 
the property is public utility property of the transferee.
    (iii) Application of regulation project (REG-104385-01). A reduction 
in the taxpayer's cost of service will be treated as ratable if it is 
consistent with the proposed rules in regulation project (REG-104385-01) 
(68 FR 10190) March 4, 2003, and occurs during the period beginning on 
March 5, 2003, and ending on the earlier of--
    (A) The last date on which the utility's rates are determined under 
the rate order in effect on December 21, 2005; or
    (B) December 21, 2007.

[T.D. 7602, 44 FR 17668, Mar. 23, 1979, as amended by T.D. 8089, 51 FR 
18777, May 22, 1986; T.D. 9387, 73 FR 14936, Mar. 20, 2008; 73 FR 18708, 
Apr. 7, 2008]



Sec.  1.46-7  Statutory provisions; plan requirements for taxpayers 
electing additional investment credit, etc.

    As amended by sections 802(b)(7), and 803 (c), (d), and (e) of the 
Tax Reform Act of 1976 (90 Stat. 1520), section 301 (d), (e), and (f) of 
the Tax Reduction Act of 1975 (89 Stat. 38) provides as follows:

    Sec. 301. Increase in investment credit * * *
    (d) Plan requirements for taxpayers electing additional credit. In 
order to meet the requirements of this subsection--
    (1) Except as expressly provided in subsections (e) and (f), a 
corporation (hereinafter in this subsection referred to as the 
``employer'') must establish an employee stock ownership plan (described 
in paragraph (2)) which is funded by transfers of employer securities in 
accordance with the provisions of paragraph (6) and which meets all 
other requirements of this subsection.
    (2) The plan referred to in paragraph (1) must be a defined 
contribution plan established in writing which--
    (A) Is a stock bonus plan, a stock bonus and a money purchase 
pension plan, or a profit-sharing plan,
    (B) Is designed to invest primarily in employer securities, and
    (C) Meets such other requirements (similar to requirements 
applicable to employee stock ownership plans as defined in section 
4975(e)(7) of the Internal Revenue Code of 1954) as the Secretary of the 
Treasury or his delegate may prescribe.
    (3) The plan must provide for the allocation of all employer 
securities transferred to it or purchased by it (because of the 
requirements of section 46(a)(2)(B) of the Internal Revenue Code of 
1954) to the account of each participant (who was a participant at any 
time during the plan year, whether or not he is a participant at the 
close of the plan year) as of the close of each year in an amount which 
bears substantially the same proportion to the amount of all such 
securities allocated to all participants in the plan for that plan year 
as the amount of compensation paid to such participant (disregarding any 
compensation in excess of the first $100,000 per year) bears to the 
compensation paid to all such participants during that year 
(disregarding any compensation in excess of the first $100,000 with 
respect to any participant). Notwithstanding the first sentence of this 
paragraph, the allocation to participants' accounts may be extended over 
whatever period may be necessary to comply with the requirements of 
section 415 of the Internal Revenue Code of 1954. For purposes of this 
paragraph, the amount of compensation paid to a participant for a year 
is the amount of such participant's compensation within the meaning of 
section 415(c)(3) of such Code for such year.
    (4) The plan must provide that each participant has a nonforfeitable 
right to any stock allocated to his account under paragraph (3), and 
that no stock allocated to a participant's account may be distributed 
from that account before the end of the eighty-fourth month beginning 
after the month in which the stock is allocated to the account except in 
the case of separation from the service, death, or disability.
    (5) The plan must provide that each participant is entitled to 
direct the plan as to the manner in which any employer securities 
allocated to the account of the participant are to be voted.
    (6) On making a claim for credit, adjustment, or refund under 
section 38 of the Internal Revenue Code of 1954, the employer

[[Page 390]]

states in such claim that it agrees, as a condition of receiving any 
such credit, adjustment, or refund--
    (A) In the case of a taxable year beginning before January 1, 1977, 
to transfer employer securities forthwith to the plan having an 
aggregate value at the time of the claim of 1 percent of the amount of 
the qualified investment (as determined under section 46 (c) and (d) of 
such Code) of the taxpayer for the taxable year, and
    (B) In the case of a taxable year beginning after December 31, 
1976--
    (i) To transfer employer securities to the plan having an aggregate 
value at the time of the claim of 1 percent of the amount of the 
qualified investment (as determined under section 46 (c) and (d) of such 
Code) of the employer for the taxable year,
    (ii) Except as provided in clause (iii), to effect the transfer not 
later than 30 days after the time (including extensions) for filing its 
income tax return for a taxable year, and
    (iii) In the case of an employer whose credit (as determined under 
section 46(a)(2)(B) of such Code) for a taxable year beginning after 
December 31, 1976, exceeds the limitations of paragraph (3) of section 
46(a) of such Code--
    (I) To effect that portion of the transfer allocable to investment 
credit carrybacks of such excess credit at the time required under 
clause (ii) for the unused credit year (within the meaning of section 
46(b) of such Code), and
    (II) To effect that portion of the transfer allocable to investment 
credit carryovers of such excess credit at the time required under 
clause (ii) for the taxable year to which such portion is carried over.

For purposes of meeting the requirements of this paragraph, a transfer 
of cash shall be treated as a transfer of employer securities if the 
cash is, under the plan, used to purchase employer securities.
    (7) Notwithstanding any other provision of law to the contrary, if 
the plan does not meet the requirements of section 401 of the Internal 
Revenue Code of 1954--
    (A) Stock transferred under paragraph (6) or subsection (e)(3) and 
allocated to the account of any participant under paragraph (3) and 
dividends thereon shall not be considered income of the participant or 
his beneficiary under the Internal Revenue Code of 1954 until actually 
distributed or made available to the participant or his beneficiary and, 
at such time, shall be taxable under section 72 of such Code (treating 
the participant or his beneficiary as having a basis of zero in the 
contract),
    (B) No amount shall be allocated to any participant in excess of the 
amount which might be allocated if the plan met the requirements of 
section 401 of such Code, and
    (C) The plan must meet the requirements of sections 410 and 415 of 
such Code.
    (8)(A) Except as provided in subparagraph (B)(iii), if the amount of 
the credit determined under section 46(a)(2)(B) of the Internal Revenue 
Code of 1954 is recaptured or redetermined in accordance with the 
provisions of such Code, the amounts transferred to the plan under this 
subsection and subsection (e) and allocated under the plan shall remain 
in the plan or in participant accounts, as the case may be, and continue 
to be allocated in accordance with the plan.
    (B) If the amount of the credit determined under section 46(a)(2)(B) 
of the Internal Revenue Code of 1954 is recaptured in accordance with 
the provisions of such Code--
    (i) The employer may reduce the amount required to be transferred to 
the plan under paragraph (6) of this subsection, or under paragraph (3) 
of subsection (e), for the current taxable year or any succeeding 
taxable years by the portion of the amount so recaptured which is 
attributable to the contribution to such plan,
    (ii) Notwithstanding the provisions of paragraph (12), the employer 
may deduct such portion, subject to the limitations of section 404 of 
such Code (relating to deductions for contributions to an employees' 
trust or plan), or
    (iii) If the requirements of subsection (f)(1) are met, the employer 
may withdraw from the plan an amount not in excess of such portion.
    (C) If the amount of the credit claimed by an employer for a prior 
taxable year under section 38 of the Internal Revenue Code of 1954 is 
reduced because of a redetermination which becomes final during the 
taxable year, and the employer transferred amounts to a plan which were 
taken into account for purposes of this subsection for that prior 
taxable year, then--
    (i) The employer may reduce the amount it is required to transfer to 
the plan under paragraph (6) of this subsection, or under paragraph (3) 
of subsection, (e), for the taxable year or any succeeding taxable year 
by the portion of the amount of such reduction in the credit or increase 
in tax which is attributable to the contribution to such plan, or
    (ii) Notwithstanding the provisions of paragraph (12), the employer 
may deduct such portion subject to the limitations of section 404 of 
such Code.
    (9) For purposes of this subsection, the term--
    (A) ``Employer securities'' means common stock issued by the 
employer or a corporation which is a member of a controlled group of 
corporations which includes the employer (within the meaning of section 
1563 (a) of the Internal Revenue Code of 1954, determined without regard 
to section 1563 (a)(4) and (e)(3)(C) of such Code) with voting power and 
dividend rights no less favorable than the voting power and dividend 
rights of other

[[Page 391]]

common stock issued by the employer or such controlling corporation, or 
securities issued by the employer or such controlling corporation, 
convertible into such stock, and
    (B) ``Value'' means the average of closing prices of the employer's 
securities, as reported by a national exchange on which securities are 
listed, for the 20 consecutive trading days immediately preceding the 
date of transfer or allocation of such securities or, in the case of 
securities not listed on a national exchange, the fair market value as 
determined in good faith and in accordance with regulations issued by 
the Secretary of the Treasury or his delegate.
    (10) The Secretary of the Treasury or his delegate shall prescribe 
such regulations and require such reports as may be necessary to carry 
out the provisions of this subsection and subsections (e) and (f).
    (11) If the employer fails to meet any requirement imposed under 
this subsection or subsection (e) or (f) or under any obligation 
undertaken to comply with the requirement of this subsection or 
subsection (e) or (f), he is liable to the United States for a civil 
penalty of an amount equal to the amount involved in such failure. The 
preceding sentence shall not apply if the taxpayer corrects such failure 
(as determined by the Secretary of the Treasury or his delegate) within 
90 days after notice thereof. For purposes of this paragraph, the term 
``amount involved'' means an amount determined by the Secretary or his 
delegate, but not in excess of 1 percent of the qualified investment of 
the taxpayer for the taxable year under section 46(a)(2)(B) and not less 
than the product of one-half of one percent of such amount multiplied by 
the number of months (or parts thereof) during which such failure 
continues. The amount of such penalty may be collected by the Secretary 
of the Treasury in the same manner in which a deficiency in the payment 
of Federal income tax may be collected.
    (12) Notwithstanding any provision of the Internal Revenue Code of 
1954 to the contrary, no deductions shall be allowed under section 162, 
212, or 404 of such Code for amounts transferred to an employee stock 
ownership plan and taken into account under this subsection.
    (13)(A) As reimbursement for the expense of establishing the plan, 
the employer may withhold from amounts due the plan for the taxable year 
for which the plan is established, or the plan may pay, so much of the 
amounts paid or incurred in connection with the establishment of the 
plan as does not exceed the sum of 10 percent of the first $100,000 that 
the employer is required to transfer to the plan for that taxable year 
under paragraph (6) (including any amounts transferred under subsection 
(e)(3)) and 5 percent of any amount in excess of the first $100,000 of 
such amount.
    (B) As reimbursement for the expense of administering the plan, the 
employer may withhold from amounts due the plan, or the plan may pay, so 
much of the amounts paid or incurred during the taxable year as expenses 
of administering the plan as does not exceed the smaller of--
    (i) The sum of 10 percent of the first $100,000 and 5 percent of any 
amount in excess of $100,000 of the income from dividends paid to the 
plan with respect to stock of the employer during the plan year ending 
with or within the employer's taxable year, or
    (ii) $100,000.
    (14) The return of a contribution made by an employer to an employee 
stock ownership plan designed to satisfy the requirements of this 
subsection or subsection (e) (or a provision for such a return) does not 
fail to satisfy the requirements of this subsection, subsection (e), 
section 401(a) of the Internal Revenue Code of 1954, or section 
403(c)(1) of the Employee Retirement Income Security Act of 1974 if--
    (A) The contribution is conditioned under the plan upon 
determination by the Secretary of the Treasury that such plan meets the 
applicable requirements of this subsection, subsection (e), or section 
401(a) of such Code.
    (B) The application for such a determination is filed with the 
Secretary not later than 90 days after the date on which the credit 
under section 38 is allowed, and
    (C) The contribution is returned within one year after the date on 
which the Secretary issues notice to the employer that such plan does 
not satisfy the requirements of this subsection, subsection (e), or 
section 401(a) of such Code.
    (e) Plan requirements for taxpayers electing additional one-half 
percent credit--(1) General rule. For purposes of clause (ii) of section 
46(a)(2)(B) of the Internal Revenue Code of 1954, the amount determined 
under this subsection for a taxable year is an amount equal to the sum 
of the matching employee contributions for the taxable year which meet 
the requirements of this subsection.
    (2) Election; basic plan requirements. No amount shall be determined 
under this subsection for the taxable year unless the corporation elects 
to have this subsection apply for that year. A corporation may not elect 
to have the provisions of this subsection apply for a taxable year 
unless the corporation meets the requirements of subsection (d) and the 
requirements of this subsection.
    (3) Employer contribution. On making a claim for credit, adjustment, 
or refund under section 38 of the Internal Revenue Code of 1954, the 
employer shall state in such claim that the employer agrees, as a 
condition of receiving any such credit, adjustment, or refund 
attributable to the provisions of section 46(a)(2)(B)(ii) of such Code, 
to transfer at the

[[Page 392]]

time described in subsection (d)(6)(B) employer securities (as defined 
in subsection (d)(9)(A)) to the plan having an aggregate value at the 
time of the transfer of not more than one-half of one percent of the 
amount of the qualified investment (as determined under subsections (c) 
and (d) of section 46 of such Code) of the taxpayer for the taxable 
year. For purposes of meeting the requirements of this paragraph, a 
transfer of cash shall be treated as a transfer of employer securities 
if the cash is, under the plan, used to purchase employer securities.
    (4) Requirements relating to matching employee contributions. (A) An 
amount contributed by an employee under a plan described in subsection 
(d) for the taxable year may not be treated as a matching employee 
contribution for that taxable year under this subsection unless--
    (i) Each employee who participates in the plan described in 
subsection (d) is entitled to make such a contribution,
    (ii) The contribution is designated by the employee as a 
contribution intended to be used for matching employer amounts 
transferred under paragraph (3) to a plan which meets the requirements 
of this subsection, and
    (iii) The contribution is in the form of an amount paid in cash to 
the employer or plan administrator not later than 24 months after the 
close of the taxable year in which the portion of the credit allowed by 
section 38 of such Code (and determined under clause (ii) of section 46 
(a)(2)(B) of such Code which the contribution is to match) is allowed, 
and is invested forthwith in employer securities (as defined in 
subsection (d)(9)(A)).
    (B) The sum of the amounts of matching employee contributions taken 
into account for purposes of this subsection for any taxable year may 
not exceed the value (at the time of transfer) of the employer 
securities transferred to the plan in accordance with the requirements 
of paragraph (3) for the year for which the employee contributions are 
designated as matching contributions.
    (C) The employer may not make participation in the plan a condition 
of employment and the plan may not require matching employee 
contributions as a condition of participation in the plan.
    (D) Employee contributions under the plan must meet the requirements 
of section 401(a)(4) of such Code (relating to contributions).
    (5) A plan must provide for allocation of all employer securities 
transferred to it or purchased by it under this subsection to the 
account of each participant (who was a participant at any time during 
the plan year, whether or not he is a participant at the close of the 
plan year) as of the close of the plan year in an amount equal to his 
matching employee contributions for the year. Matching employee 
contributions and amounts so allocated shall be deemed to be allocated 
under subsection (d)(3).
    (f) Recapture--(1) General rule. Amounts transferred to a plan under 
subsection (d)(6) or (e)(3) may be withdrawn from the plan by the 
employer if the plan provides that while subject to recapture--
    (A) Amounts so transferred with respect to a taxable year are 
segregated from other plan assets, and
    (B) Separate accounts are maintained for participants on whose 
behalf amounts so transferred have been allocated for a taxable year.
    (2) Coordination with other law. Notwithstanding any other law or 
rule of law, an amount withdrawn by the employer will neither fail to be 
considered to be nonforfeitable nor fail to be for the exclusive benefit 
of participants or their beneficiaries merely because of the withdrawal 
from the plan of--
    (A) Amounts described in paragraph (1), or
    (B) Employer amounts transferred under subsection (e)(3) to the plan 
which are not matched by matching employee contributions or which are in 
excess of the limitations of section 415 of such Code,

nor will the withdrawal of any such amount be considered to violate the 
provisions of section 403(c)(1) of the Employee Retirement Income 
Security Act of 1974.
    [Sec. 301(d) of the Tax Reduction Act of 1975 (89 Stat. 38) as 
amended by sec. 802(b)(7) and sec. 803 (c) and (e) of the Tax Reform Act 
of 1976 (90 Stat. 1520); sec. 301 (e) and (f) of the Tax Reduction Act 
of 1975 as added by sec. 803(d) of the Tax Reform Act of 1976]

(Sec. 301(d)(2)(C) of the Tax Reduction Act of 1975; sec. 7805 of the 
Internal Revenue Code of 1954 (89 Stat. 38, 68A Stat. 917; 26 U.S.C. 
7805)

[T.D. 7857, 47 FR 54793, Dec. 6, 1982]



Sec.  1.46-8  Requirements for taxpayers electing additional one-percent
investment credit (TRASOP's).

    (a) Introduction--(1) In general. A corporation may elect under 
section 46(a)(2)(B) of the Code to obtain an additional investment 
credit for property described in section 46(a)(2)(D). This section 
provides rules for electing to have the provisions of section 
46(a)(2)(B) apply and for implementing an employee stock ownership plan 
under section 301(d) of the Tax Reduction Act of 1975 (``1975 TRA''). 
The plan must meet the formal requirements of paragraph (d), and the 
operational requirements of paragraph (e), of this section. An 
additional credit may be obtained for the periods described in

[[Page 393]]

section 46(a)(2)(D). Unless otherwise indicated, statutory references in 
this section are to the Internal Revenue Code of 1954 as in effect prior 
to the amendments made by the Revenue Act of 1978.
    (2) Reports. The returns required by section 6058(a) must be filed 
on behalf of a plan established under paragraph (c)(7) of this section, 
whether or not the plan is qualified under section 401(a).
    (3) Cross-references. The following table indicates where in this 
section provisions appear relating to each provision of section 301 (d) 
and (f) of the 1975 TRA.

------------------------------------------------------------------------
           Section 301              Section 1.46-8          Subject
------------------------------------------------------------------------
(d)(1)..........................  (c)(7)(i),          Establishing a
                                   (c)(8)(i).          TRASOP, in
                                                       general; funding
                                                       a TRASOP, in
                                                       general.
  (2)(A)........................  (c)(7)(ii)........  Type of plan.
    (B).........................  (d)(3), (e)(10)...  Investment design.
    (C).........................  (d)(1)............  Plan requirements,
                                                       in general.
  (3)...........................  (d)(6)............  Allocation.
                                  (b)(8)............  Compensation,
                                                       definition.
  (4)...........................  (d)(7)............  Nonforfeitability.
                                  (d)(9)............  Distributions.
  (5)...........................  (d)(8)............  Voting rights.
  (6)...........................  (c)...............  Procedures for
                                                       additional
                                                       credit.
  (7)(A)........................  (c)(7)(ii)........  Taxability, non-
                                                       401(a) TRASOP.
    (B).........................  (e)(3)............  Allocations under
                                                       401(a).
    (C).........................  (e)(3)............  Section 410 and
                                                       section 415
                                                       requirements.
  (8)...........................  (e)(9)............  Reductions of
                                                       investment
                                                       credit.
  (9)(A)........................  (b)(4)............  Employer
                                                       securities,
                                                       definition.
                                  (e)(10), (f)......  Employer
                                                       securities,
                                                       requirements.
    (B).........................  (b)(7)............  Value, definition.
  (10)..........................  (a)(2)............  Reporting
                                                       requirements.
  (11)..........................  (h)...............  Failure to comply.
  (12)..........................  (c)(10)...........  Deductibility.
  (13)..........................  (e) (6) and (7)...  Reimbursement for
                                                       expenses.
  (14)..........................  (c)(8)(v) and       Contingent
                                   (d)(7)(i).          contributions.
(f).............................  (d)(7),             Withdrawals of
                                   (e)(8)(vii), (f).   TRASOP
                                                       securities.
------------------------------------------------------------------------

    (b) Definitions. When used in this section, the terms listed below 
have the indicated meanings:
    (1) TRASOP. A ``TRASOP'' is an employee stock ownership plan that 
meets the requirements of section 301(d) of the 1975 TRA. See Sec.  
1.46-7. It is a type of plan described in paragraph (d)(1) of this 
section and may, but need not, be an ESOP under Sec.  54.4975-11 of this 
chapter (Pension Excise Tax Regulations). See Sec.  1.46-8(d)(5) 
concerning use of TRASOP assets as collateral for debts and expenses of 
the plan.
    (2) Additional credit. An ``additional credit'' is the additional 
one-percent investment credit under section 46(a)(2)(B)(i).
    (3) Employer. An ``employer'' is a corporation that establishes a 
TRASOP.
    (4) Employer securities--(i) In general. ``Employer securities'' are 
common stock, and securities convertible into common stock, of the 
employer or of a corporation that is a member of a controlled group of 
corporations including the employer. Employer securities must meet the 
requirements of paragraph (g) of this section. Membership in a 
controlled group for purposes of this section is determined under 
section 414(b) of the Code.
    (ii) Pre-1977 employer securities. In addition, employer securities 
acquired by a TRASOP before January 1, 1977, include common stock, and 
securities convertible into common stock, of a corporation in control of 
the employer within the meaning of section 368(c).
    (iii) Caution. An employer security under this section is not 
necessarily a qualifying employer security as defined in section 
407(d)(5) of the Employee Retirement Income Security Act of 1974 (ERISA) 
or section 4975(e)(8). Moreover, sections 406, 407, and 408 of ERISA in 
certain cases limit the acquisition and disposition of qualifying 
employer securities as defined in section 407(d)(5) of ERISA.
    (5) TRASOP securities. ``TRASOP securities'' are employer securities 
that--
    (i) Are transferred to a TRASOP, or acquired with cash transferred 
to a TRASOP, to obtain an additional credit, and
    (ii) Except as provided under paragraphs (g) (4) and (5) of this 
section, or as required by applicable law, are subject to no other put, 
call, or other option, or buy-sell or similar arrangement while held by 
the plan.
    (6) Publicly traded. The term ``publicly traded'' has the meaning 
specified in Sec.  54.4975-7(b)(1)(iv) of this chapter.
    (7) Value--(i) In general. With respect to the transfer of TRASOP 
securities by a corporation to a TRASOP or the

[[Page 394]]

acquisition of TRASOP securities with cash transferred by a corporation 
to a TRASOP, ``value'' means fair market value determined in good faith 
and based on all relevant factors as of the date of transfer or 
acquisition of the TRASOP securities. If the plan acquires TRASOP 
securities from other than a disqualified person within the meaning of 
section 4975(e)(2), a good faith determination of value includes a 
determination of fair market value based on an appraisal independently 
arrived at by a person who customarily makes such appraisals and who is 
independent of any person from whom the TRASOP securities are acquired.
    (ii) Twenty-day average rule. A special 20-day average valuation 
rule applies to certain publicly traded securities transferred by a 
corporation to a TRASOP. It does not apply to securities acquired with 
cash transferreed by a corporation to a TRASOP. Under the special rule, 
the term ``value'' refers to an average of daily closing prices for a 
security, as reported on any national securities exchange or as quoted 
on any system sponsored by a national securities association, over the 
20 consecutive trading days immediately preceding the applicable last 
day described in paragraph (c)(8)(i) of this section. The average is 
based on the closing prices for each day when the security is in fact 
traded during the 20-day period. However, the special rule does not 
apply unless the security is in fact traded for at least 10 of the 20 
days.
    (iii) 20-day average transitional exception. If a TRASOP security is 
transferred before March 20, 1979, the plan may value the security on 
the basis of the 20 consecutive trading days preceding the date on which 
the security is transferred or the date as of which the security is 
allocated to a participant's account.
    (8) Compensation. ``Compensation'' means ``participant's 
compensation'' under section 415(c)(3) and Sec.  1.415-2(d). However, 
except for purposes of applying section 415, compensation must be 
determined for a plan year, not a limitation year.
    (c) Procedures for additional credit--(1) Applicable year--(i) 
General rule. With respect to a qualified investment, the ``applicable 
year'' of a corporation is generally the taxable year in which the 
investment is made. For purposes of this section, an investment is made 
either in a year when section 38 property is placed in service or in a 
year when qualified progress expenditures are incurred.
    (ii) Carryover option. A corporation may determine the applicable 
years for qualified investments made in any taxable year beginning after 
December 31, 1976, under the following method: The first applicable year 
with respect to the additional credit for a given year's qualified 
investment is the year the qualified investment is made or, if later, 
the first taxable year for which any additional credit is allowable if 
claimed for that qualified investment. If there is an investment credit 
carryover from the first applicable year, each taxable year to which any 
part of the additional credit for that qualified investment is carried 
over is also an applicable year. If the carryover treatment is elected 
for the additional credit attributable to a year's qualified investment, 
all applicable years for the additional credit attributable to that 
investment must be determined under the carryover option.
    (iii) Increased credit. A taxable year in which a corporation's 
additional credit is increased because of a redetermination is also an 
applicable year. See paragraph (c)(9)(iv) of this section.
    (iv) Illustration. To illustrate the application of paragraphs 
(c)(1) (i) and (ii) of this section, assume that a calendar-year 
corporation makes a qualified investment in 1977 and that 1977 is an 
unused credit year described in section 46(b)(1). If the general rule is 
applied, 1977 is an applicable year. However, because 1977 is an unused 
credit year (at least with respect to the additional credit), if the 
corporation does not elect to treat 1977 as an applicable year but 
carries over its entire additional credit for 1977 to 1978 and uses it 
in 1978, then 1978 is an applicable year. If part of the additional 
credit is carried over further to 1979, the year 1979 is also an 
applicable year.
    (v) Change in method. The choice between the general rule and 
carryover

[[Page 395]]

option methods of determining the additional credit attributable to 
applicable years is made with respect to each year's qualified 
investment, and does not bind the corporation with respect to selection 
of methods for the additional credit attributable to other years' 
qualified investment. A failure to comply does not occur merely because 
a corporation elects to apply either method for the additional credit 
attributable to separate years' qualified investment.
    (2) Time and manner of electing. A corporation with a qualified 
investment must elect to be eligible for an additional credit by 
attaching a statement of election--
    (i) To its income tax return, filed on or before the due date 
including extensions of time, for a taxable year not later than its 
first applicable year with respect to a qualified investment, or
    (ii) In the case of a return filed before December 31, 1975, to an 
amended return filed on or before December 31, 1975.
    (3) Statement of election. The statement of election must contain 
the name and taxpayer identification number of the corporation. Also, it 
must declare in the following words, or in words having substantially 
the same meaning, that:
    (i) The corporation elects to have section 46(a)(2)(B)(i) of the 
Internal Revenue Code of 1954 apply; and
    (ii) The corporation agrees to implement (or continue to implement, 
as appropriate) a TRASOP and to claim the additional credit as required 
by Sec.  1.46-8 of the Income Tax Regulations.
    (4) Separate election. A separate election must be made for each 
taxable year's qualified investment to obtain an additional credit for 
that qualified investment. If a corporation does not make a timely 
election to obtain an additional credit for a taxable year, it may not 
subsequently make the election on an amended return or otherwise.
    (5) No partial election. An election to obtain an additional credit 
applies to a corporation's entire qualified investment for a taxable 
year. Thus, a corporation may not elect to obtain a partial additional 
credit for any year's qualified investment. However, the partial 
disallowance of an additional credit will not result in an election 
being treated as a partial election. Also, an election by a member of a 
controlled group of corporations that applies only to the electing 
member's qualified investment is not a partial election. See Sec.  1.46-
8(h)(9) with respect to transitional rules for elections made before 
January 19, 1979.
    (6) No revocation of election. After the time for electing the 
additional credit has expired for a taxable year, a corporation may not 
revoke its election for that year.
    (7) Establishing a TRASOP--(i) In general. A corporation electing to 
obtain an additional credit must establish a TRASOP with accompanying 
trust on or before the last day for making the election regardless of 
when in fact the election is made. A TRASOP is considered to be in 
existence on a particular date if it meets the requirements of Sec.  
1.410(a)-2(c)(1). A new plan need not be established if an existing plan 
qualifies as a TRASOP, or is amended to meet the requirements of this 
section, on or before the last day for making the election. The 
requirements of this section are not satisfied merely by establishing 
and crediting a separate ``TRASOP'' account on the corporation's books.
    (ii) Type of plan. A TRASOP need not meet the requirements of 
section 401(a). However, it must be a stock bonus plan, a combination 
stock bonus plan and money purchase pension plan, or a profit-sharing 
plan under Sec.  1.401-1(b)(1) of this chapter. See section 301(d)(7)(A) 
of the 1975 TRA for the tax consequences relating to a TRASOP that does 
not meet the requirements of section 401(a). See also title I of ERISA 
for additional provisions applicable to a TRASOP as an employee pension 
benefit plan under section 3(2) of ERISA.
    (8) Funding a TRASOP--(i) In general. A corporation electing to 
obtain an additional credit must fund its TRASOP by transferring TRASOP 
securities or cash to it no later than 30 days after the applicable last 
day. That day is the last day for electing the additional credit, 
irrespective of when the election is actually made. However, in the case 
of an investment credit that was carried over and claimed in a 
subsequent applicable year by reason of

[[Page 396]]

paragraph (c)(1)(ii) of this section, that day is the last day 
(including extensions) for filing its income tax return for the 
subsequent applicable year. TRASOP securities may be transferred to a 
plan at any time during the applicable year, but not before the first 
day of an applicable year. If TRASOP securities are transferred to the 
plan within the permissible time period after the close of the 
applicable year, they are treated as transferred during that applicable 
year first until all TRASOP securities required by this paragraph (c) 
for that applicable year are transferred to, and taken into account 
under, the TRASOP. Thus, for example, assume that on a return filed on 
September 17, 1979 (with extensions, the last day for filing a return 
for 1978), a calendar-year corporation claims an additional credit of 
$5,000 for 1978, an applicable year under the TRASOP. No contributions 
were made in 1978 on account of the 1978 credit, but TRASOP securities 
with a value of $6,000 were contributed in 1979. The corporation also 
expects to be able to claim an additional credit of $10,000 for 1979. 
TRASOP securities transferred between January 1, 1979, and October 17, 
1979, must be taken into account under the plan for 1978 before they are 
taken into account for 1979. Accordingly, securities having a value of 
$5,000 are applied against the obligation for 1978, and $1,000 of the 
contribution is retained to be applied to the eventual obligation for 
1979.
    (ii) Cash transfers. A corporation may transfer cash to the TRASOP 
instead of TRASOP securities only if the TRASOP uses the cash to acquire 
TRASOP securities no later than 30 days after the time for funding the 
TRASOP.
    (iii) Valuation. The value of the TRASOP securities for an 
applicable year must equal one percent of the corporation's qualified 
investment for that year. However, if paragraph (c)(1)(ii) of this 
section is followed by a corporation, the value of TRASOP securities for 
an applicable year must equal the amount of additional credit claimed 
for that year.
    (iv) Cash reserve. The value of TRASOP securities acquired with cash 
transferred by a corporation may be reduced by two items. The first item 
is an amount not more than the value of fractional shares allocable to 
participants entitled to receive an immediate distribution at the time 
of the transfer. The second item is start-up expenses and administrative 
expenses to the extent permitted under section 301(d)(13) of the 1975 
TRA and paragraphs (e) (6) and (7) of this section.
    (v) Conditional funding. The funding of a TRASOP may be conditional 
if the TRASOP satisfies the provisions of section 301(d)(14) of the 1975 
TRA. For purposes of section 301(d)(14), an investment credit is 
considered to be allowed on the date the election for the applicable 
year is made under paragraph (c)(2) of this section.
    (vi) Certain benefit offset mechanisms. A TRASOP will be deemed to 
be not funded to the extent that TRASOP securities are used to offset 
benefits under a defined benefit plan.
    (9) Claiming additional credit--(i) In general. Section 46(a)(3) 
subjects the amount of investment credit earned with respect to a 
taxpayer's qualified investment for a taxable year to a limitation based 
on the corporation's tax liability.
    (ii) Unused credit year. Section 46(a)(1) provides a first-in-first-
out rule for the investment credit in a taxable year. Section 46(b)(1) 
provides for the carryback and carryover of unused credits. If less than 
all of a taxpayer's credit earned for a taxable year is allowable, the 
10-percent credit determined under section 46(a)(2)(A) earned for a 
particular year is allowed first. Any portion of the additional credit 
for a taxable year that is not allowable may be carried back or carried 
over to the extent permitted by section 46(b)(1). However, an additional 
credit which is allowed for a taxable year is not reduced by a carryback 
to that year of an unused credit from a succeeding taxable year.
    (iii) Example. Paragraph (c)(9)(ii) of this section is illustrated 
by the following example:

    Example. A calendar-year corporation begins operation and 
establishes a TRASOP in 1975. The facts and treatment relating to the 
corporation's qualified investments and investment tax credits for 1975 
and 1976 are as follows:

[[Page 397]]



------------------------------------------------------------------------
                                                     1975        1976
------------------------------------------------------------------------
Facts:
  1. Qualified investment.......................    $500,000    $500,000
  2. Credits earned:
    a. 10% credit...............................      50,000      50,000
    b. Additional credit........................       5,000       5,000
    c. Carryover of additional credit from prior  ..........       3,000
     year, line 5...............................
  3. Sec. 46(a)(3) limitation                         52,000      47,000
Treatment of credits:
  4. Credits allowed:
    a. Carryover of additional credit...........  ..........       3,000
    b. Current 10% credit.......................      50,000      44,000
    c. Current additional credit................       2,000           0
  5. Unused credits:
    a. 10% credit...............................           0       6,000
    b. Additional credit........................       3,000       5,000
------------------------------------------------------------------------


Thus, in 1975 the section 46(a)(3) limitation ($52,000) is applied first 
to allow all of the 10-percent investment credit ($50,000). Accordingly 
only $2,000 of the additional credit earned is allowed in 1975 and 
$3,000 of the additional credit is carried forward to 1976. In 1976, 
section 46(a)(1) requires that this $3,000 of additional credit is 
allowed first, and then only $44,000 of the 10-percent credit earned in 
1976 is allowed since the section 46(a)(3) limitation for that year is 
$47,000. The unused credits from 1976 cannot be carried back since 1975, 
the only prior year, is an unused credit year.

    (iv) Redeterminations increasing credit. If a corporation's 
allowable additional credit is increased because of a redetermination, 
the increase is treated as if it were an unused credit carryover for 
purposes of paragraphs (c)(1)(ii) and (c)(8)(i) of this section. For 
purposes of this subdivision (iv), the date of the increase is 
determined under paragraph (e)(9)(iii) of this section as if it were the 
date of a reduction. Thus, for example, assume that a calendar-year 
corporation claims an additional credit of $100,000 in 1978 because of a 
qualified investment in that year. In 1980, the additional credit 
attributable to 1978 qualified investment is redetermined to be 
$110,000. With respect to the 1978 qualified investment, 1980 is also an 
applicable year to the extent of $10,000. The increased credit is 
reflected on the employer's return for 1980. The corporation must fund 
the TRASOP with this $10,000 under paragraph (c)(8) of this section.
    (v) Redeterminations increasing tax liability. If a corporation's 
tax liability for a year is increased such that an additional credit 
carried forward and claimed in a later year is allowable in the earlier 
year, the claim of the additional credit will be considered timely if it 
was otherwise timely under this section. Thus, for example, assume that 
a calendar-year corporation makes qualified investment of $5,000,000 in 
1978 but, based on its income tax liability, is unable to use any of the 
credit until 1979, when the entire $50,000 additional credit can be 
used. The corporation adopts the TRASOP, elects the full $50,000 credit 
and funds in a timely manner for tax year 1979. However, as a result of 
a 1981 redetermination of the 1978 tax liability, the corporation is 
able to use $30,000 of the additional credit in 1978 and the remaining 
$20,000 in 1979. The allowable credit for 1978 is increased by $30,000 
and the increase is treated as an unused credit carryover, for which the 
year of redetermination, 1981, is the applicable year. Assuming that no 
other credits are available, the 1979 credit is reduced from $50,000 to 
$20,000, and this reduction is taken into account in the redetermination 
year by offsetting the reduction against amounts due the plan or by 
deducting the amount of the reduction. The adoption of the TRASOP for 
1979, rather than 1978, is considered timely.
    (10) Deductions at expiration of carryover period. Under paragraph 
(c)(1)(i) of this section, a corporation that uses no additional credit 
in the year of a qualifed investment may nonetheless treat the year in 
which the qualified investment is made as the first applicable year. If 
the carryover period under section 46(b)(1)(B) expires before the 
corporation uses the entire additional credit with respect to the 
qualified investment, contributions attributable to the unused credit 
are deductible, subject to the limitations of section 404(a), as if made 
in the taxable year when the carryover period expires. The amount 
deductible is the dollar amount of the unused credit irrespective of the 
current value of the securities contributed with respect to the credit.
    (d) Formal plan requirements--(1) In general. To be a TRASOP, a plan 
must meet the formal requirements of this paragraph (d).

[[Page 398]]

    (2) Plan year. To be a TRASOP, a plan must specify a plan year that 
begins with or within the corporation's taxable year.
    (3) Designed to invest primarily in employer securities. To be a 
TRASOP, a plan must state that it is designed to invest primarily in 
employer securities. A TRASOP intended to qualify as an ESOP under Sec.  
54.4975-11 must state that it is designed to invest primarily in 
employer securities. See paragraph (e)(10) of this section concerning 
the requirement that a plan invest in employer securities on an ongoing 
basis.
    (4) Separate accounting. To be a TRASOP, a plan must state that 
TRASOP securities are to be accounted for separately from any other 
contributions to the plan.
    (5) Debts and expenses of the TRASOP. To be a TRASOP, a plan must 
state that TRASOP securities cannot be used to satisfy a loan made to 
the TRASOP or be used as collateral for a loan made to a TRASOP. 
However, if the plan so provides, to the extent permitted under section 
301(d)(13) of the 1975 TRA and paragraphs (e) (6) and (7) of this 
section, certain amounts may be used for the TRASOP's start-up expenses 
and administrative expenses.
    (6) Allocation of TRASOP securities--(i) General rules. To be a 
TRASOP, a plan must provide for the allocation of TRASOP securities 
under section 301(d)(3) of the 1975 TRA and this subparagraph (6).
    (ii) Timing. TRASOP securities are allocated as of the last day of 
the plan year beginning with or within the appropriate applicable year.
    (iii) Participants. Each employee who is a participant at any time 
during the plan year for which allocation is made must receive an 
allocation as of the end of that year even though not then employed by 
the employer. However, to receive allocations, employees must satisfy 
the minimum participation requirements of the plan (for example, 1,000 
hours of service).
    (iv) Compensation considered. Under section 301(d)(3) of the 1975 
TRA, allocations must be based on the proportion that each participant's 
compensation bears to all participants' compensation. Compensation in 
excess of $100,000 must be disregarded in making these allocations. A 
plan may have a lower stated ceiling on compensation (from $0 to 
$100,000) and if the plan has such a lower ceiling, compensation in 
excess of this ceiling must likewise be disregarded. Also, allocations 
must be based on a participant's compensation while actually employed, 
not just while actually participating, in the plan year.
    (v) Section 415 priority rule; transitional rule. For purposes of 
section 415, this subdivision (v) applies only to limitation years 
beginning after November 30, 1982. If a TRASOP security is not allocated 
to a participant's account for a plan year because of section 415 and 
section 301(d)(3) of the 1975 TRA, no other amount may be allocated for 
that participant under any defined contribution plan of the same 
employer after the actual allocation date for that TRASOP plan year, 
until all unallocated TRASOP securities have been allocated as provided 
in paragraphs (d)(6) (vi) and (vii) of this section. This subdivision 
(v) applies to a TRASOP when, under section 415(f)(1)(B), the TRASOP is 
treated along with an employer's other defined contribution plans as one 
plan for purposes of section 415.
    (vi) Unallocated amounts. Under section 301(d)(3) of the 1975 TRA, 
TRASOP securities unallocated for a plan year to participants' accounts 
because of section 415 must be allocated proportionately to the accounts 
of other participants until the addition to the account of each 
participant reaches the limits of section 415.
    (vii) Suspense account. If, after these allocations, TRASOP 
securities remain unallocated, they must be held in an unallocated 
suspense account under the TRASOP. Any income produced by these 
securities must also be held in the account. A plan with such an account 
will not fail to qualify under section 401(a) merely because of the 
account. In each successive TRASOP plan year (whether or not an 
applicable year), the unallocated assets are released from this account 
for allocation on a first-in-first-out basis. They are then allocated to 
the participants' accounts proportionately under paragraph (d)(6) (i) 
through (vi) of this section for each later year until no

[[Page 399]]

TRASOP securities remain unallocated. Value for this allocation is 
determined under paragraph (b)(7) of this section as of the date of 
transfer from the suspense account or, if the special 20-day average 
rule applies, the value is determined on the basis of the 20 consecutive 
trading days immediately preceding the date of transfer from the 
suspense account.
    (viii) Escrow account. A TRASOP may provide for the establishment of 
an escrow account instead of a suspense account. The escrow account must 
satisfy paragraph (d)(6)(vii) of this section. The beneficiary of the 
escrow account is to be the TRASOP. The corporation may establish the 
escrow account and contribute stock or cash to it. In such a case, the 
escrow agent must transfer assets to the plan each year equal to the 
amount to be allocated proportionately under paragraph (d)(6)(i)-(vi) of 
this section. Assets held in an escrow account are plan assets.
    (ix) Treatment of certain plan terminations. To be a TRASOP, a plan 
must provide that, if a plan terminates because the corporation ceases 
to exist, unallocated amounts described in paragraph (d)(6)(vi) of this 
section must be allocated to the extent possible under section 415 for 
the year of termination. The remaining unallocated amounts must then be 
withdrawn. These unallocated amounts are treated as recaptured under all 
the rules of paragraph (e)(9)(vii) of this section except its last 
sentence. See paragraph (d)(9)(i) of this section concerning 
distributions of allocated TRASOP securities.
    (x) No integration. No TRASOP may be integrated, directly or 
indirectly, with contributions or benefits under title II of the Social 
Security Act or any other state or federal law.
    (xi) Fractional securities. Participants' accounts are to be 
allocated fractional securities or fractional rights to securities.
    (xii) Accounting for amounts withheld by employer or paid by plan as 
start-up or administrative expenses. An employer may withhold certain 
start-up and administrative expenses from TRASOP securities due the 
plan. Also, a plan may reduce amounts to be allocated to the extent that 
certain plan assets are used to reimburse the employer, for example for 
salaries of employees providing services to the plan, or to pay fees 
directly to independent contractors for expenses. These expenses do not 
reduce the amount of additional credit claimed and are not allowable as 
expenses in computing taxable income. Additional rules concerning these 
expenses are in paragraphs (e) (6) and (7) of this section.
    (7) Nonforfeitability. To be a TRASOP, a plan must state that each 
participant has a nonforfeitable right to allocated TRASOP securities. 
For purposes of this section, forfeitures described in section 411(a)(3) 
are not permitted. However, amounts shall not fail to be considered to 
be nonforfeitable if the plan provides for their return to the 
corporation--
    (i) In the case of conditional contributions, under section 
301(d)(14) of the 1975 TRA and paragraph (c)(8)(v) of this section, and
    (ii) In the case of investment credit recapture or an event deemed 
to be a recapture, under section 301(f) of the 1975 TRA and paragraph 
(f) of this section.
    (8) Voting rights--(i) Provision for passthrough. To be a TRASOP, a 
plan must state that each participant is entitled to direct a designated 
fiduciary how to exercise any voting rights on TRASOP securities 
allocated to the account of the participant. The plan need not permit 
participants to direct the voting of unallocated TRASOP or other 
securities held by the trust. It may authorize the designated fiduciary 
to exercise voting rights for unallocated securities.
    (ii) Notification by the employer. To be a TRASOP, the plan must 
obligate the corporation to furnish the designated fiduciary and 
participants with notices and information statements when voting rights 
are to be exercised. The time and manner for furnishing participants 
with a notice or information statement must comply with both applicable 
law and the corporation's charter and bylaws as generally applicable to 
security holders. In general, the content of the statement must be the 
same for plan participants as for other security holders.

[[Page 400]]

    (iii) Fractional securities. To be a TRASOP, the plan must allow the 
participants to vote any allocated fractional securities or fractional 
rights to securities. This requirement is met if the designated 
fiduciary votes the combined fractional securities or rights to the 
extent possible to reflect the direction of the voting participants.
    (iv) Unexercised voting rights. To be a TRASOP, the plan may not 
permit the designated fiduciary to exercise voting rights which a 
participant fails to exercise. However, the plan may permit the 
solicitation and exercise of participants' voting rights by management 
and others under a proxy provision applicable to all security holders.
    (9) Distributions--(i) In general. To be a TRASOP, a plan must 
permit the distribution of allocated TRASOP securities only as provided 
under section 301(d)(4) of the 1975 TRA. Also, under Sec.  1.401-
1(b)(1)(i) of this chapter, to the extent that a TRASOP is a money 
purchase pension plan, it can only provide for a distribution in the 
case of separation from service, death, or disability. No TRASOP may 
provide for the distribution of TRASOP securities upon plan termination 
within the 84-month holding period. For purposes of section 301(d)(4) of 
the 1975 TRA, the 84-month holding period begins on the date as of which 
TRASOP securities are allocated.
    (ii) Certain fractional securities. A stock bonus TRASOP may 
distribute cash instead of fractional securities.
    (e) Operational plan requirements--(1) General rule. To be a TRASOP, 
a plan in operation must meet the requirements of this paragraph (e). 
However, the provisions under paragraph (e)(8) of this section apply 
only to TRASOPs qualified under section 401(a).
    (2) Compliance with plan provisions. To be a TRASOP, a plan must 
operate in compliance with its provisions. Failure to operate in 
compliance with plan provisions constitutes an operational failure to 
comply. See paragraph (h)(5)(iii) of this section.
    (3) Compliance with certain Code provisions. To be a TRASOP, a plan 
must meet the requirements of section 301(d)(7) of the 1975 TRA. Thus, 
whether or not it is qualified under section 401(a), a TRASOP must meet 
the requirements of section 401(a) with respect to allocations, section 
410 with respect to participation, and section 415 with respect to 
limitations on contributions and benefits. However, these requirements 
are modified by paragraph (d)(6) of this section, relating to 
allocations and section 415.
    (4) Employee contributions. Under a TRASOP, the participants' 
receipt of benefits attributable to TRASOP securities contributed for 
the additional credit (but not the extra additional credit) must not 
depend on contributions by participants. If a corporation has a plan in 
existence which requires employee contributions, a portion of the plan 
may be a TRASOP if employee contributions are not required with respect 
to that portion of the plan.
    (5) Controlled group of corporations, etc. Whether or not a TRASOP 
is qualified under section 401(a), all employees who by reason of 
section 414 (b) and (c) are treated as employees of an electing 
corporation are treated as employed by the corporation in determining 
whether the plan satisfies the requirements of sections 301(d)(7) (B) 
and (C) of the 1975 TRA. A member of a controlled group under paragraph 
(b)(4)(i) of this section with a qualified investment but with no actual 
employees may obtain an additional credit even though the only 
participants in the corporation's TRASOP are actually employed by 
another member of the controlled group.
    (6) Start-up expenses--(i) In general. For purposes of this section, 
the term ``start-up expense'' means any ordinary and necessary amount of 
a nonrecurring nature paid or incurred by the corporation or by the plan 
in connection with the establishment of a TRASOP under paragraph (c)(7) 
of this section. Thus, for example, start-up expenses may include 
expenses relating to: the drafting or amending of plan documents to 
establish a TRASOP under section 301(d) or (e) of the 1975 TRA, the 
seeking of agency approval for these documents and related transactions, 
the obtaining of shareholder approval for establishing a TRASOP, and the 
registering of securities for initial funding of a TRASOP.
    (ii) Treatment of start-up expenses. Start-up expenses may be 
withheld by the employer from amounts that would

[[Page 401]]

otherwise be due the plan under paragraph (c)(8) of this section, to the 
extent that these amounts are known by the employer when funding first 
occurs for an applicable year. To the extent that these amounts are not 
withheld by the employer, the plan may pay remaining amounts from plan 
assets within a reasonable time after the amounts are known by the plan.
    (iii) Ceiling on start-up expenses. Reimbursement for start-up 
expenses is limited to a ceiling. This ceiling is the sum of 10 percent 
of the first $100,000 that an employer is first required to transfer 
under paragraph (c)(8) of this section for an applicable year and 5 
percent of that amount in excess of $100,000. If this first year is an 
unused credit year from which there is a carryover, amounts required to 
be transferred in subsequent years for claiming carryovers from this 
first year are considered in determining this ceiling. Thus, for 
example, assume that a calendar-year corporation first earns an 
additional credit in 1977 of $9,000 and that $3,000 of this amount is 
claimed on the income tax return for 1977, for 1978 and for 1979. The 
corporation's ceiling on start-up expenses is $300 when its 1977 return 
is filed. The total ceiling increases to $600 when its 1978 return is 
filed and to $900 when its 1979 return is filed, with the claiming of an 
additional $3,000 credit for each of the three years.
    (iv) Special rule for taxable years ending before January 1, 1977. 
Special treatment is available for expenses paid or incurred before 
January 1, 1977, that were not taken into account in the manner provided 
by section 301(d)(13) of the 1975 TRA. These expenses may be withdrawn 
under paragraph (e)(9)(vii) of this section in the same manner as 
reductions in the corporation's additional credit caused by a recapture. 
This withdrawal may only be made during the first taxable year ending 
after March 20, 1979. It is subject to the ceiling of section 301(d)(13) 
of the 1975 TRA. Expenses previously deducted by a corporation must be 
reduced on a timely-filed amended return by the amount of this 
withdrawal.
    (7) Administrative expenses--(i) In general. For purposes of this 
section, the term ``administrative expense'' means any amount, other 
than a start-up expense, paid or incurred by the corporation or by the 
plan that is ordinary and necessary in maintaining the TRASOP. Thus, for 
example, administrative expenses may include expenses relating to: 
compensating plan fiduciaries and administrators, leasing office space 
and equipment, reproducing and mailing information to participants and 
beneficiaries, and filing reports, returns, and amendments relating to a 
TRASOP. Paragraph (e)(6) (ii) and (iv), relating to treatment of start-
up expenses and to a special rule for taxable years ending before 
January 1, 1977, also applies to administrative expenses.
    (ii) Ceiling on administrative expenses. Reimbursement for 
administrative expenses under paragraph (e)(6)(ii) of this section is 
limited to the smaller of two amounts for each plan year. The first 
amount is $100,000. The second amount is the sum of 10 percent of the 
first $100,000 of dividend income paid with respect to TRASOP securities 
held by the plan during the plan year ending with or within the 
corporation's taxable year and 5 percent of any such dividend income in 
excess of $100,000.
    (8) TRASOP qualification under section 401(a)--(i) Permanence. A 
TRASOP is not required to be a qualified plan under section 401(a). 
However, to meet the requirements of section 401(a), a TRASOP must be a 
permanent plan, as described in Sec.  1.401-1(b)(2) of this chapter. 
Under section 401(a)(21), a plan will not fail to be considered 
permanent merely because the amount of employer contributions under the 
plan is determined solely by reference to the amount of additional 
credit allowable under this section. Thus, for example, it will not fail 
to be considered permanent merely because employer contributions are not 
made for a year for which an additional credit is not available by 
reason of no qualified investment for which an additional credit can be 
obtained. Section 401(a)(21) applies only to the extent the TRASOP is 
funded with TRASOP securities and cash in lieu of TRASOP securities.
    (ii) Partial discontinuance of contributions. A plan that meets the 
requirements of section 401(a) may receive contributions of TRASOP 
securities as

[[Page 402]]

well as other contributions. If the other contributions continue on a 
permanent basis, the plan's qualification under section 401(a) will not 
be adversely affected merely because TRASOP securities cease to be 
contributed to it. The discontinuance of TRASOP contributions does not 
alter the requirement that past TRASOP contributions remain invested in 
employer securities. See paragraph (e)(10) of this section.
    (iii) Income distribution. Income paid with respect to employer 
securities acquired by a TRASOP may be distributed at any time after 
receipt by the plan to participants on whose behalf such securities have 
been allocated without adversely affecting the qualified status of the 
plan under section 401(a). (See the last sentence of section 803(h), Tax 
Reform Act of 1976.) However, under a TRASOP that is a stock bonus or 
profit-sharing plan, income held by the plan for a 2-year period or 
longer must be distributed under rules generally applicable to stock 
bonus and profit-sharing plans qualified under section 401(a). Income 
distributed by a TRASOP is not subject to the partial exclusion of 
dividends provided in section 116, whether or not the income is held by 
the plan for two or more years.
    (9) Reductions in investment credit--(i) General rule. Certain 
reductions in a corporation's investment credit result from either a 
recapture under section 47 of the corporation's investment credit or a 
redetermination of the allowable credit. If these reductions are taken 
into account under a TRASOP, the plan may only use one or more of the 
methods described in paragraphs (e)(9), (v), (vi), and (vii) of this 
section for taking into account these reductions. Thus, for example, 
more than one method is permitted upon a recapture with respect to a 
qualified investment made in a particular year. However, the method 
described in paragraphs (e)(9)(vii) of this section applies only to a 
recapture and not to a redetermination.
    (ii) Ratable reduction. A reduction is allocated ratably between the 
10-percent credit and the additional credit. Thus, for example, if a 
calendar-year corporation claims a $33,000 investment credit for 1976, 
including $3,000 additional credit, and $11,000 of the total credit is 
recaptured in 1978, the $3,000 additional credit is reduced by $1,000. 
This subdivision (ii) does not apply to a reduction solely of the 
additional credit as could occur, for example, in the case of a 
redetermination caused by a mathematical error in computing the 
additional credit or in the case of a recapture caused by a bad faith 
failure to comply under paragraph (h) of this section.
    (iii) Date of reduction. A reduction in investment credit occurs 
under this paragraph (e)(9) on the earliest of these dates: (A) The date 
an income tax return (or an amended return) is filed reflecting the 
reduction; (B) the date a judicial determination affecting the amount of 
the reduction becomes final; and (C) the date specified in a closing 
agreement made under section 7121 that is approved by the Commissioner. 
For purposes of this subdivision (iii), a judicial determination becomes 
final at the time prescribed in Sec.  1.547-2(b)(1) (ii) or (iii), 
relating to personal holding company tax.
    (iv) Year for taking reduction into account. A reduction in 
investment credit must be taken into account in the earliest year or 
years possible under the applicable method beginning no later than the 
year in which the date of the reduction falls.
    (v) Decrease future contributions. The reduction may be taken into 
account as a decrease in the value of TRASOP securities to be 
transferred to the plan. The amount of the decrease is equal to the 
dollar amount of the reduction.
    (vi) Deduct under section 404. On the date of the reduction, the 
amount of the reduction may be treated as an amount paid to the TRASOP 
for purposes of, and as a deduction to the extent allowed under, section 
404.
    (vii) Withdraw TRASOP securities. If an additional credit allowed 
for a taxable year is recaptured, the corporation may withdraw from the 
plan TRASOP securities transferred to, or acquired by, the plan for 
claiming that year's credit. The withdrawal must only be from assets 
segregated under paragraph (f)(2) of this section and must be first from 
assets accounted for in an unallocated suspense account for

[[Page 403]]

the particular year. The amount of assets actually withdrawn bears the 
same proportion to the amount of assets subject to withdrawal as the 
amount of additional credit recaptured bears to the amount of additional 
credit claimed. Thus, for example, if the assets subject to withdrawal 
consist of 300 shares of one class of employer stock and one-third of 
the additional credit is recaptured, 100 shares of the stock are 
withdrawn. However, if the current value of the assets subject to 
withdrawal exceeds the dollar amount of the additional credit claimed, 
assets may be withdrawn only to the extent that their current value does 
not exceed the dollar amount of the recaptured portion of the additional 
credit. Thus, for example, if the 300 segregated shares in the prior 
example have a current value of $9,000 and the dollar value of the 
additional credit claimed is $4,500, when one-third of the additional 
credit is recaptured, only 50 shares, not 100 shares, are withdrawn. 
Current value is determined under paragraph (b)(7) of this section as of 
the withdrawal date or, if the special 20-day average rule is applied, 
it is based on the 20 consecutive trading days immediately preceding the 
withdrawal date. Withdrawals from an individual's account for the year 
with respect to which recapture occurs must bear the same ratio to the 
total amount withdrawn for that year as the individual's TRASOP account 
balance for that year bears to the total TRASOP account balances for 
that year. In the case of a TRASOP security acquired after March 20, 
1979, the corporation may not withdraw it unless the plan meets the 
requirements of paragraph (d)(7)(ii) of this section when the plan 
acquires the TRASOP security.
    (viii) Prior distribution rule. If a TRASOP distributes an amount 
allocated with respect to an investment credit for a taxable year and 
the credit for that year is later recaptured, withdrawals may not reduce 
participants' accounts below the level to which they would have been 
reduced had the prior distribution not occurred. Recaptured amounts 
above this level may only be deducted under paragraph (e)(9)(vi) of this 
section. They may not be used to decrease future contributions under 
paragraph (e)(9)(v).
    (ix) Illustration. The operation of paragraph (e)(9)(viii) of this 
section is illustrated as follows:

    Example. For 1977, a calendar-year corporation claims an additional 
credit of $10,000. The corporation's TRASOP meets the requirements of 
section 301(f) of the 1975 TRA. Each of 10 participants under the plan 
for that year receives an equal allocation of 10 shares valued at 
$1,000. In 1978, one participant terminates employment and receives a 
distribution of 10 shares. In 1979, a recapture reduces the 1977 
additional credit by $2,000. The value of employer securities has not 
changed from the allocation date. If the 10 shares had not been 
distributed, 20 shares would be available for withdrawal, 2 shares from 
each participant's account. Since 9 participants remain from 1977, only 
18 shares are available for withdrawal (2 shares x 9 remaining 
participants). If these 18 shares are withdrawn, the corporation may 
take into account 2 shares by deducting their value to the extent 
permitted under paragraph (e)(9)(vi) of this section.

    (10) Continued investment in employer securities. The requirement 
that a plan be designed to invest primarily in employer securities is a 
continuing obligation. Therefore, a transaction changing the status of a 
corporation as an employer may require the conversion of certain plan 
assets into other securities. See paragraphs (d)(9) and (g)(6) of this 
section. In general, cash or other assets derived from the disposition 
of employer securities must be reinvested in employer securities not 
later than the 90th day following the date of disposition. However, the 
Commissioner may grant an extension of the period for reinvestment in 
employer securities depending on the facts and circumstances of each 
case.
    (f) Section 301(f) withdrawals--(1) In general. No assets may be 
withdrawn by a corporation under section 301(f) of the 1975 TRA unless 
the assets are either TRASOP securities or plan assets into which TRASOP 
securities have been converted (``withdrawal assets''). See paragraph 
(e)(10) concerning restrictions on investment of TRASOP assets in assets 
other than employer securities. Withdrawal assets must meet the 
segregated accounting requirements of this paragraph. The physical 
segregation of assets is not required.

[[Page 404]]

    (2) Segregated accounting. The segregated accounting requirements 
are that--
    (i) Withdrawal assets must be segregated from other plan assets on a 
taxable-year-by-taxable-year basis; and
    (ii) Separate accounts must be maintained on a taxable-year-by-
taxable-year basis for each participant on whose behalf withdrawal 
assets are allocated.
    (3) Aggregate plan year accounting. Withdrawal assets for taxable 
years beginning before October 4, 1976, also meet the segregated 
accounting requirements if they are aggregated and accounted for in one 
separate account apart from withdrawal assets in separate accounts for 
later taxable years.
    (g) Requirements for employer securities--(1) General rules. The 
term ``employer security'' does not include stock rights, warrants and 
options. An employer security that is not common stock must at all times 
be immediately convertible into common stock that is an employer 
security at a conversion price which is no greater than the fair market 
value of that common stock at the time the plan acquires the security.
    (2) Common stock--(i) In general. To be an employer security, common 
stock must meet certain voting power and dividend right requirements. 
For purposes of this paragraph (g), stock held by the TRASOP is not 
treated as outstanding.
    (ii) Dividend right limitations. If dividend rights are subject to a 
limitation, then stock representing at least 50 percent of the fair 
market value of the employer's outstanding common stock at the time the 
common stock is transferred to or purchased by the TRASOP must be 
subject to the same limitation. However, common stock that satisfies 
paragraph (g)(3)(ii) of this section is not subject to this subdivision 
(ii).
    (3) Voting power and dividend rights. To be an employer security, 
common stock must have voting power and dividend rights which, when 
taken together, are ``no less favorable'' than the voting power and 
dividend rights of any other common stock issued by the employer. Common 
stock which meets one of the following tests is ``no less favorable''.
    (i) Ten-percent shareholder test. The stock is part of, or identical 
to, a class of outstanding stock of which at least 50 percent is not 
owned by 10-percent shareholders. For this purpose, a 10-percent 
shareholder is one who owns at least 10 percent of the outstanding 
shares in a class, including shares constructively owned under section 
318.
    (ii) Substantial proportionality test. More than one class of common 
stock is outstanding and an identical percentage of shares from each 
class is transferred to the TRASOP.
    (iii) Voting power test. The stock is part of, or identical to, the 
existing class of stock having the greatest number of votes per unit of 
fair market value. For example, assume there are only two classes of 
common stock, Class A and Class B. Their fair market values per share 
are $1 and $.50, respectively, and the owner of each share of each class 
is entitled to one vote per share. Thus, Class B has two votes per $1 
and Class A has one vote per $1. Accordingly, the Class B stock has the 
greatest number of votes per unit of fair market value.
    (4) Right of first refusal. TRASOP securities may, but need not, be 
subject to a right of first refusal. However, whether or not the plan is 
an ESOP, any such right must meet the requirements of Sec.  54.4975-
7(b)(9) of this chapter.
    (5) Put option. A TRASOP security that is transferred to a TRASOP 
after September 30, 1976, must be subject to a put option if it is not 
publicly traded when distributed or if it is subject to a trading 
limitation when distributed. The provisions of Sec.  54.4975-7(b)(10)-
(12) and Sec.  54.4975-11(a)(3) of this chapter apply to such securities 
whether or not the plan is an ESOP.
    (6) Change of employer security status. In general, a transaction 
changing the status of a corporation as an employer, or as a member of a 
controlled group of corporations including the employer, adversely 
affects the status as employer securities of common stock and securities 
held by a plan (``old employer securities''). However, to the extent 
that the transaction causing the change in status of the old employer 
securities does not result in a recapture under section 47 of any 
investment

[[Page 405]]

credit underlying the transfer to, or acquisition by, the plan of the 
old employer securities, common stock and securities (``new employer 
securities'') substituted for old employer securities are treated as if 
they were the old employer securities if--
    (i) The plan is not terminated,
    (ii) The old employer securities and the new employer securities are 
of equal value at the time of the transaction changing the status of the 
old employer securities, and
    (iii) The new employer securities otherwise meet the requirements of 
this section.
    (h) Failure to comply--(1) General rule--(i) Effect of failure. If a 
corporation elects under paragraphs (c)(2) through (5) of this section 
to obtain an additional credit and fails to comply with respect to that 
credit at any time, it is liable to the United States for a civil 
penalty equal to the amount involved in the failure to comply. If the 
corporation fails to comply with respect to an additional credit during 
the 84-month period described in section 301(d)(4) of the 1975 TRA, the 
credit is also recaptured. A separate failure to comply occurs for each 
taxable year in which a failure continues to exist.
    (ii) Illustration of continuing failure's effect. Assume that in 
1975 an additional credit is allowed and a failure to comply occurs in 
1975 with respect to that credit. Assume also that in 1976 the 1975 
failure continues uncorrected, another additional credit is allowed, and 
a failure to comply occurs with respect to the 1976 credit. Under these 
circumstances, on the last day of 1976 three separate failures to comply 
exist: (A) The 1975 failure with respect to the 1975 credit, (B) the 
1976 failure with respect to the 1975 credit, and (C) the 1976 failure 
with respect to the 1976 credit.
    (2) Assessment and collection. The civil penalty must be assessed 
and collected in the same manner in which a deficiency in the payment of 
federal income tax is assessed and collected.
    (3) Exception. If a failure to comply is corrected within the 
correction period described in paragraph (h)(5) of this section--
    (i) The corporation is not liable for a civil penalty; and
    (ii) If the corporation establishes that at the time of the failure 
a good faith effort to comply was made, its additional credit is not 
disallowed.
    (4) Failure to comply (penalty classifications)--(i) In general. An 
electing corporation fails to comply if a defect described in paragraphs 
(h)(4) (ii) through (iv) of this section occurs with respect to an 
additional credit allowed for a particular taxable year. The 
characterization of the defect in this subparagraph (4) determines the 
amount involved under paragraph (h)(8) of this section for the purpose 
of assessing the civil penalty.
    (ii) Funding defect. A funding defect occurs if a corporation or its 
TRASOP fails to satisfy the requirements of paragraph (c) (8) or (9) of 
this section, relating to funding a TRASOP and claiming an additional 
credit.
    (iii) Special operational defect. A special operational defect 
occurs if a TRASOP fails in operation to satisfy the requirements 
described in paragraphs (d) (5) through (9) of this section, relating to 
debts and expenses of a TRASOP, allocation of TRASOP securities, 
nonforfeitability, voting rights, and distributions, or paragraph (e)(3) 
of this section, relating to compliance with certain Code provisions.
    (iv) De minimis defect. A de minimis defect occurs if a corporation 
or its TRASOP fails to satisfy any requirement of this section other 
than those enumerated either in paragraph (h)(4) (ii) and (iii) of this 
section or in paragraphs (a)(2) and (c) (2) through (5) of this section. 
A failure to comply under this subdivision (iv) may be formal or 
operational in nature.
    (5) Failure to comply (correction rules classifications)--(i) In 
general. If for an electing corporation a defect described in paragraph 
(h)(4) of this section occurs, the procedure for correcting the failure 
to comply depends upon whether the failure is classified as a ``formal'' 
failure or an ``operational'' failure under this subparagraph (5).
    (ii) Formal failure to comply. Formal failures are corrected by 
retroactive amendment. If a formal plan requirement is not met, the plan 
must be retroactively amended by no later than the expiration of the 
correction period under paragraph (h)(6) of this section.

[[Page 406]]

A plan fails to meet a formal plan requirement of paragraph (d) of this 
section if, for example, it does not state, as required by paragraph 
(d)(3) of this section, that it is designed to invest primarily in 
employer securities.
    (iii) Operational failure to comply. Operational failures are 
corrected by undoing the defective transaction and by making the plan 
and the participants whole. If the value of TRASOP securities 
transferred to the TRASOP is less than the amount of the additional 
credit, the corporation must make up any resulting funding deficiency 
within the correction period. This is done, for example, by contributing 
additional TRASOP securities plus an amount equal to the dividends or 
interest that would have been paid between the time that the TRASOP 
securities should have been transferred and the actual time for the 
transfer. The contribution of additional TRASOP securities is based on 
their value under paragraph (b)(7) of this section as of the date by 
which they were required to be transferred to the plan. An electing 
corporation fails to meet an obligation undertaken under this section 
if, for example, it fails to comply with paragraph (c)(8) of this 
section.
    (6) Correction period--(i) In general. For purposes of this 
paragraph (h), the ``correction period'' begins when the failure to 
comply occurs and ends 90 days after receipt by the corporation of a 
notice of deficiency under section 6212 with respect to the civil 
penalty and the investment credit.
    (ii) Extensions of correction period. Extensions of the correction 
period are determined under Sec.  53.4941(e)-1(d)(2) (i), (ii), and (iv) 
of this chapter (Foundation Excise Tax Regulations). For this purpose, a 
failure to comply is treated as an act of self-dealing, the corporation 
is treated as a foundation, and a civil penalty is treated as a tax 
under section 4941(a)(1).
    (7) Good faith. The corporation has the burden of establishing under 
paragraph (h)(3)(ii) of this section that it made a good faith effort to 
comply. For example, if a corporation shows that it has made a good 
faith effort to establish the fair market value of the employer 
securities transferred to the TRASOP, it may be entitled to the 
additional credit even if, on later examination of the return, it is 
determined that more securities should have been transferred. For 
purposes of this paragraph (h)(7), reasonable reliance on Technical 
Information Release 1413 (1975-50 I.R.B. 16), questions and answers 
relating to ESOP's, is a good faith effort to comply.
    (8) Amount involved--(i) In general. The amount involved in a 
failure to comply is an amount described in this subparagraph (8). A 
maximum amount and a minimum amount are determined with respect to an 
additional credit allowed for a particular taxable year.
    (ii) Maximum amount involved. Notwithstanding any other rule in this 
paragraph (h), all amounts involved with respect to an additional credit 
allowed for a particular taxable year may not exceed the amount of that 
credit.
    (iii) Minimum amount involved. The minimum amount is \1/2\ of one 
percent of the additional credit times the number of full months, or 
parts of full months, during which the failure to comply exists. ``Full 
month'' has the meaning assigned in Sec.  1.1250-1(d)(4) (realty 
depreciation recapture).
    (iv) Funding amount involved. The amount involved for a funding 
defect is the greater of the minimum amount involved or the amount 
required to place the plan in the position it would have been in if no 
funding defect had occurred.
    (v) Special operational amount involved. The amount involved for a 
special operational defect is the maximum amount involved.
    (vi) De minimis amount involved. The amount involved for a de 
minimis defect is the minimum amount involved.
    (9) Certain permissible actions--(i) Elections prior to January 19, 
1979. A corporation does not fail to comply (within the meaning of this 
paragraph (h)) merely because it revokes an election made prior to 
January 19, 1979, under the general rule described in paragraph 
(c)(1)(i) of this section and with respect to which no additional credit 
was claimed in the taxable year for which

[[Page 407]]

the election was made. Such a revocation is permitted irrespective of 
whether the carryover option described in paragraph (c)(1)(ii) is 
elected with respect to qualified investment made in a year for which a 
general rule election is revoked.
    (ii) Pro rata use of credit. A corporation does not fail to comply 
merely because, for an applicable year ending prior to January 19, 1979, 
it provides for pro rata use of the regular 10-percent credit and the 1-
percent additional credit to the extent that less than all of a 
taxpayer's credit earned for a taxable year is allowable.
    (iii) Transitional rule. The Commissioner, based on the particular 
facts and circumstances of individual cases, may determine that a good 
faith failure to comply before January 19, 1979, with a final or 
temporary rule adopted under this section on or after that date does not 
require retroactive correction under paragraph (h)(5)(ii) of this 
section.

(Sec. 301(d)(2)(C) of the Tax Reduction Act of 1975; sec. 7805 of the 
Internal Revenue Code of 1954 (89 Stat. 38, 68A Stat. 917; 26 U.S.C. 
7805))

[T.D. 7857, 47 FR 54795, Dec. 6, 1982]



Sec.  1.46-9  Requirements for taxpayers electing an extra one-half
percent additional investment credit.

    (a) Introduction--(1) In general. A corporation that qualifies for 
an additional credit under Sec.  1.46-8 may elect under section 
46(a)(2)(B)(ii) of the Code to obtain an extra one-half percent 
additional investment credit for property described in section 
46(a)(2)(D). Paragraph (c) of this section provides additional 
procedures for electing this extra credit. This section also provides 
rules for implementing an employee stock ownership plan that meets the 
requirements of sections 301 (d) and (e) of the Tax Reduction Act of 
1975 (``1975 TRA''). The plan must meet the additional formal 
requirements of paragraph (d), and the additional operational 
requirements of paragraph (e) of this section. Unless otherwise 
indicated, statutory references in this section are to the Internal 
Revenue Code of 1954, as applicable for the year in which a qualified 
investment is made.
    (2) Applicability of one-percent TRASOP provisions. Subject to the 
exceptions and additional rules of this section, the provisions of Sec.  
1.46-8 apply to an election made, and to a plan implemented, under this 
section. However, this section does not change the requirements of Sec.  
1.46-8 for purposes of obtaining an additional one-percent credit.
    (3) Effective date. This section applies only to taxable years 
beginning after December 31, 1976. See section 803(j)(2)(A) of the Tax 
Reform Act of 1976.
    (b) Definitions--(1) One-percent terms. When used in this section, 
the terms listed below have the same meanings as in Sec.  1.46-8(b):
    (i) TRASOP. See Sec.  1.46-8(b)(1).
    (ii) Employer. See Sec.  1.46-8(b)(3).
    (iii) Employer securities. See Sec.  1.46-8(b)(4).
    (iv) TRASOP securities. See Sec.  1.46-8(b)(5).
    (v) Publicly traded. See Sec.  1.46-8(b)(6).
    (vi) Value. See Sec.  1.46-8(b)(7).
    (vii) Compensation. See Sec.  1.46-8(b)(8).
    (2) Additional credit. An ``additional credit'' or ``extra 
additional credit'' is the extra one-half percent additional investment 
credit under section 46(a)(2)(B)(ii)--
    (i) For purposes of applying this section, and
    (ii) When the context requires, for purposes of applying Sec.  1.46-
8 to this extra credit.
    (3) Matching employee contribution. A ``matching employee 
contribution'' is a contribution that meets the requirements of 
paragraph (f) of this section.
    (4) Basic amount. A ``basic amount'' is a matching employee 
contribution which is equal to the maximum credit multiplied by a 
fraction. The numerator of this fraction is a participant's compensation 
for the plan year. (See Sec.  1.46-9(f)(3)(ii), concerning disregarded 
compensation.) The denominator is the aggregate of all participants' 
compensation for the plan year. The ``maximum credit'' is the estimated 
value of all employer contributions under paragraph (c)(4)(i) of this 
section for the applicable year, determined as if the maximum possible 
matching employee contributions were made.

[[Page 408]]

    (5) Supplemental contribution. A ``supplemental contribution'' is a 
matching employee contribution made in addition to a basic amount.
    (c) Special procedures for extra additional credit--(1) Statement of 
election. A corporation's statement of election described in Sec.  1.46-
8(c)(3) must contain the name and taxpayer identification number of the 
corporation. Also, it must declare in the following words, or in words 
having substantially the same meaning, that:
    (i) The corporation elects to have section 46(a)(2)(B) (i) and (ii) 
of the Internal Revenue Code of 1954 apply; and
    (ii) The corporation agrees to implement (or continue to implement, 
as appropriate) a TRASOP and to claim the additional credit as required 
by Sec.  1.46-8 and Sec.  1.46-9 of the Income Tax Regulations.
    (2) Separate election. A separate election must be made for each 
year's qualified investment to obtain the extra additional credit for 
the qualified investment. If a corporation does not make a timely 
election to obtain an extra additional credit for a taxable year, it may 
not subsequently make the election on an amended return or otherwise.
    (3) No partial election. To reduce administrative costs, a plan may 
establish a ceiling on matching employee contributions. Thus, for 
example, it may provide for the contribution of only a basic amount 
without supplemental contributions under paragraph (f)(2)(iv) of this 
section. Such a ceiling that in effect limits the additional credit to 
less than one-half percent of the qualified investment is not a partial 
election prohibited by Sec.  1.46-8(c)(5).
    (4) Funding a TRASOP--(i) Employer contributions. The carryover 
option under Sec.  1.46-8(c)(1)(ii) is available for both the one-
percent and one-half percent additional credits or for the one-half 
percent additional credit alone. In applying Sec.  1.46-8(c)(8)(iii), 
the value of TRASOP securities, other than those acquired with matching 
employee contributions, for an applicable year must equal one-half 
percent of the corporation's qualified investment for that year or, if 
less, the amount of matching employee contributions received (including 
pledges, where permitted by the plan) by the time the election for that 
year is made. However, if a corporation exercises the carryover option 
in Sec.  1.46-8(c)(1)(ii), the value of these TRASOP securities for an 
applicable year must equal the amount of additional credit claimed for 
that year determined after being reduced, if necessary, to equal 
contributions received (including pledges, if permitted) by the time the 
credit is claimed for that year. The value of these TRASOP securities, 
but not the amount of credit claimed, is further reduced to the extent 
that the employer withholds TRASOP securities to take into account 
start-up and administrative expenses under paragraph (e)(1) of this 
section or an investment tax credit reduction under paragraph (e)(2) of 
this section.
    (ii) Employee contributions. Paragraph (f)(4) of this section, but 
not Sec.  1.46-8(c)(8) (i) through (iii), applies to TRASOP securities 
acquired with matching employee contributions.
    (5) Claiming additional credit. In applying Sec.  1.46-8(c)(9)(ii), 
if less than all of a corporation's credit earned for a taxable year is 
allowed, the extra additional credit under this section for that year is 
allowed last.
    (d) Additional formal plan requirements--(1) Contributions by 
employees--(i) In general. The plan must contain statements relating to 
matching employee contributions as required under paragraph (f) of this 
section.
    (ii) Aggregate floor. A plan may provide for the return of all 
matching employee contributions for a year if the aggregate amount of 
such contributions is not at least equal to an amount stated in the 
plan. See also Sec.  1.46-9(f)(3)(iv).
    (2) Separate accounting. The plan must state that employer 
contributions and matching employee contributions respectively described 
in paragraph (c)(4)(i) and (ii) of this section are accounted for 
separately from each other as well as from other contributions, 
including those described in Sec.  1.46-8(c)(8).
    (3) Allocation of TRASOP securities contributed by employer. The 
plan must provide for the allocation under section 301(e)(5) of the 1975 
TRA and this subparagraph (3) of TRASOP securities

[[Page 409]]

contributed by the employer. These allocations reflect a ratable 
reduction for TRASOP securities withheld by the employer under paragraph 
(c)(4)(i) of this section. TRASOP securities so allocated are deemed to 
be allocated under section 301(d) of the 1975 TRA. In applying Sec.  
1.46-8(d)(6) to this section, only subdivisions (ii), (iv), (ix), (x), 
(xi) and (xii) thereof apply to allocations under this section.
    (4) Effect of section 415. In applying the limitations of section 
415 to limitation years beginning after January 19, 1979, allocations of 
TRASOP securities are considered in the following order: first, 
allocations under Sec.  1.46-8; second, allocations under this section. 
See Sec.  1.46-8(d)(6)(v) concerning the allocation of amounts under any 
other defined contribution plan. No suspense or escrow account may be 
maintained to hold contributions under this section that are unallocated 
because of section 415. Thus, section 415 in effect limits the 
availability of an extra additional credit in a particular year. 
However, if the plan so provides, a potential extra additional credit is 
treated as an investment credit carryover under the carryover option 
described in Sec.  1.46-8(c)(1)(ii) to the extent that it is not used in 
a particular year because of section 415.
    (5) Nonforfeitability. Employer contributions are also not 
considered to be forfeitable under Sec.  1.46-8(d)(7) merely because the 
plan provides for their return to the corporation in an amount equal to 
the excess of employer contributions under this section over matching 
employee contributions or in the case of discriminatory operation under 
paragraph (f)(3) of this section. See paragraph (f)(3)(iv).
    (6) Distributions. Notwithstanding Sec.  1.46-8(d)(9)(i), a plan may 
not distribute from a participant's employer contribution account cash 
or employer securities attributable to unpaid pledges of the 
participant.
    (e) Additional operational plan requirements--(1) Start-up and 
administrative expenses--(i) In general. The expense of establishing 
plan features relating to the extra additional credit is a start-up 
expense. The expense of collecting matching employee contributions is an 
administrative expense.
    (ii) Payment. Under Sec.  1.46-8(e) (6) and (7), an employee may 
withhold or a plan may use, to the extent not withheld, TRASOP 
securities for start-up and administrative expense payments. However, 
withdrawals must be either limited to employer contributions under Sec.  
1.46-8(c)(8) or reasonably apportioned between these employer 
contributions and contributions under paragraph (c)(4)(i) of this 
section. An example of reasonable apportionment is earmarking expenses 
attributable to each of the additional credits and allocating any 
remaining non-earmarked expenses on either a 2:1 or 1:1 ratio between 
the additional credits. Another example is simply apportioning expenses 
between the additional credits on a 2:1 or 1:1 ratio basis without 
earmarking. However, if one-percent and one-half percent start-up 
expenses are attributable to different qualified investments, 
withdrawals for one-half percent expenses are limited to employer 
contributions under paragraph (c)(4)(i) of this section.
    (iii) Ceiling. In determining the ceiling on start-up expenses under 
Sec.  1.46-8(e)(6)(iii), only employer contributions under Sec.  1.46-
8(c)(8) and paragraph (c)(4)(i) of this section are considered. In 
determining the ceiling on administrative expenses under Sec.  1.46-
8(e)(7)(ii), dividends on all TRASOP securities, including those 
acquired with matching employee contributions, are considered.
    (2) Redeterminations and recaptures. A reduction in investment 
credit because of a redetermination or recapture is allocated ratably 
under the principles of Sec.  1.46-8(e)(9)(ii) among the 10-percent 
credit, the one-percent credit, and the one-half percent credit for a 
particular year. However, as illustrated in Sec.  1.46-8(e)(9)(ii), this 
subparagraph (3) does not apply to a redetermination solely of one or 
both of the additional credits.
    (3) Withdrawal asset segregation. The segregated accounting 
provisions of Sec.  1.46-8(f) apply independently to withdrawal assets 
attributable to TRASOP securities under Sec.  1.46-8 and to TRASOP 
securities under this section.
    (f) Matching employee contributions--(1) Designation by employee. 
The plan must state that each employee on whose behalf an allocation is 
made

[[Page 410]]

under Sec.  1.46-8(d)(6) for an applicable year is eligible to designate 
and contribute an amount to the TRASOP for that year as a matching 
employee contribution.
    (2) Form and timing of contribution--(i) Cash. A participant may 
contribute in a manner provide under the plan a designated amount in 
cash directly to the plan or indirectly by the employer's withholding 
from amounts otherwise due the participant. The full amount, or pledge 
in lieu of an amount, for an applicable year must be contributed by the 
applicable last day described in Sec.  1.46-8(c)(8)(i).
    (ii) Optional pledges in lieu of cash. The plan need not permit a 
pledge. However, when permitted by the plan, an irrevocable written 
pledge made in good faith by a participant is treated as a matching 
employee contribution of cash, whether or not the pledge is in fact 
contractually binding. The pledge must be to contribute, by no later 
than a time specified in the TRASOP, a designated amount in cash 
directly to the plan or indirectly by authorizing the employer to 
withhold from compensation otherwise due a participant. The specified 
time may not be later than 24 months after the close of the applicable 
year for which the amount is treated as a matching employee 
contribution.
    (iii) Transitional rule. A plan may provide for the receipt of 
employee pledges at any time before the later of the applicable last day 
or January 15, 1980. If the last day for receipt of pledges for an 
applicable year is January 15, 1980, the one-half percent TRASOP credit 
for the applicable year may be elected on an amended return filed not 
later than that date, and employer contributions for the applicable year 
must be made by that date. A plan may provide that pledges which 
otherwise would have been payable on or before December 31, 1979 may be 
paid on or before January 15, 1980.
    (iv) Basic and supplemental contributions. A plan formula may limit 
a matching employee contribution to a basic amount. It may also permit 
matching employee contributions of supplemental amounts to the extent 
that total basic amount contributions do not equal the amount of the 
additional credit claimed under this section. Employees may make 
supplemental contributions covering unpaid pledges only after the 
employer has disclosed the value of securities and income attributable 
to the unpaid pledge.
    (3) Prohibited discrimination--(i) General rule. Matching employee 
contributions must be based on a formula stated in the plan that does 
not result in prohibited discrimination under section 401(a)(4) either 
in form or in operation. Thus, for example, a flat dollar amount 
required as a matching employee contribution to qualify for employer-
provided benefits under this section may not be too high for lower paid 
employees to contribute under the plan. Further, lower paid employees 
must participate to such an extent that allocations under this section 
do not result in prohibited discrimination
    (ii) Compensation disregarded. Compensation disregarded in 
allocations under Sec.  1.46-8(d)(6)(iv) is disregarded under this 
paragraph and for purposes of determining basic amounts as defined in 
paragraph (b)(4) of this section.
    (iii) Former employees. A TRASOP must give all participants a 
reasonable opportunity to make matching employee contributions. However, 
neither a former employee who is a participant at the end of the plan 
year by reason of Sec.  1.46-8(d)(6)(iii), nor the estate of a deceased 
employee, need have the same options as are available to other 
participants. Thus, for example, a former employee may be limited to 
cash contributions even though other participants are permitted to make 
pledges. Also, if former employees of estates of deceased employees fail 
to make matching employee contributions, they are not considered in 
determining whether or not a TRASOP is discriminatory.
    (iv) Return of contributions. A plan may provide for the return of 
employee and employer contributions for a year to the extent that plan 
operation would otherwise result in prohibited discrimination.
    (4) Investment in employer securities--(i) General rule. Matching 
employee contributions must be invested in TRASOP securities no later 
than 30 days after the time for funding a TRASOP under Sec.  1.46-
8(c)(8)(ii) or, if

[[Page 411]]

later, the time specified under the special rule for pledges.
    (ii) Special rule for pledges. Cash contributed to pay a pledge 
permitted by paragraph (f)(2)(ii) of this section must be invested in 
employer securities so that the cash is not held more than 3 months. The 
3-month period includes the period, if any, that the cash is held by the 
employer.
    (5) Reduction of matching employee contribution--(i) In general. 
Matching employee contributions must be reduced in three cases. First, 
they are reduced to the extent that there are no corresponding employer 
contributions described in paragraph (c)(4)(i) of this section. This 
occurs, for example, when the aggregate of the basic amounts of matching 
employee contributions exceeds the allowable credit. Second, they are 
reduced to the extent that corresponding employer contributions matching 
them under paragraph (c)(4)(i) of this section are withdrawn under 
section 301(f) of the 1975 TRA. Third, they are reduced by the amount of 
any pledge unpaid at the time specified in paragraph (f)(2)(ii) of this 
section.
    (ii) Apportioning reductions. Generally, the account of each 
contributor under this section for an applicable year is reduced by a 
percentage of the account. This percentage equals the total reduction of 
all matching employee contributions for that year divided by the total, 
before the reduction, of all matching employee contributions. However, 
if a reduction is directly attributable to a particular contributor, 
only that contributor's account is reduced. A reduction is directly 
attributable to a particular contributor when, for example, the limits 
of section 415 prohibit a full allocation of employer contributions 
equal to the contributor's matching employee contribution for an 
applicable year or when a contributor fails to pay a pledge. A reduction 
may not yield a negative balance in a participant's account.
    (iii) Disposing of reductions. If a participant's matching employee 
contribution is reduced, the amount of the reduction must either be 
treated as a voluntary contribution or returned to the participant by 
the later of two dates. The first date is 30 days after the time for 
investing in TRASOP securities under paragraph (f)(4) of this section. 
The second date is the 30th day after the date on which the withdrawal 
of employer contributions occurs that causes the reduction. It may be 
treated as a voluntary contribution only if, as stated in the plan, the 
participant so indicates in writing when making the matching employee 
contribution.
    (iv) Supplemental contributions covering unpaid pledges. 
Notwithstanding the timing requirements of paragraph (f)(2) of this 
section, supplemental contributions covering unpaid pledges must be made 
no later than 60 days after accounting for the corresponding reduction 
under paragraph (f)(5)(ii) of this section.
    (v) Effect of reduction on credit. For the purpose of applying 
section 415 to an additional allocation to the account of a participant 
attributable to a supplemental contribution covering an unpaid pledge, 
the contribution is treated as an annual addition to the supplemental 
contributor's account in the applicable year for which the reduction 
occurred. An amount in excess of the contribution may be allocated in 
equal amounts for each year from the applicable year to the year of the 
reduction. The employer's credit is reduced only to the extent that a 
proportionate transfer of assets is not made from the account of the 
participant to whom the reduction is attributable to the accounts of 
supplemental contributors.
    (vi) Example. The rules contained in paragraphs (f) (2) and (5) of 
this section are illustrated by the following example:

    Example. Assume that A is an employee of corporation M, a calendar 
year taxpayer that maintains a TRASOP. A has pledged $100 as a matching 
employee contribution for 1977, the first applicable year of M's TRASOP. 
M has transferred employer securities valued at $100 that have been 
allocated to A's account under the Plan. The TRASOP provides that 
pledges must be paid no later then 24 months after the end of the 
applicable year. Thus, A's $100 pledge must be paid by December 31, 
1979. As of December 31, 1979, the employer securities attributable to 
A's pledge have a value of $90 and have produced undistributed dividend 
income of $13. Thus, the value of the portion of A's account 
attributable to the unpaid pledge is $103. After December 31, 1979, the 
value of this portion of A's account

[[Page 412]]

is disclosed to participants, and employee B chooses to pay off A's 
unpaid pledge, as provided in the plan, by making a $100 supplemental 
contribution. The full amount of the securities and dividend income 
attributable to the unpaid pledge are transferred from A's account to 
that of B as of December 31, 1979. M's credit for 1977 is not reduced. 
The $100 supplemental contribution is an annual addition to B's account 
for purposes of applying section 415 in 1979. Income attributable to the 
pledge in excess of the supplemental contribution, $3 ($103-$100), may 
be allocated and treated as an annual addition by spreading this excess 
amount over the years from the applicable year to the year of the 
reduction (1977, 1978, 1979).

    (g) Failure to comply--(1) General rule. If a corporation elects 
under Sec.  1.46-8(c) (2) through (5) and paragraph (c)(1) of this 
section to obtain an additional credit, Sec.  1.46-8(h) (1), (2), (3), 
(5), (6), and (7) as modified by this paragraph (g) apply.
    (2) Failure to comply (penalty classifications)--(i) In general. A 
corporation fails to comply with an extra additional credit election if 
a defect described in paragraph (g)(2) (ii)-(iv) of this section occurs 
in a taxable year.
    (ii) Funding defect. A funding defect occurs under this section if a 
corporation or its TRASOP fails to satisfy the requirements of Sec.  
1.46-8(c) (8) or (9) or paragraph (c)(4) of this section, as they apply 
directly to the extra additional credit.
    (iii) Special operational defect. A special operational defect 
occurs if a TRASOP fails in operation to satisfy the requirements 
decribed in Sec.  1.46-8(d) (5) through (9) (except (6) (i), (iii), and 
(v) through (viii)) or (e)(3), or paragraphs (d) (5), (6), and (e)(3) of 
this section, as they apply directly to the extra additional credit.
    (iv) De minimis defect. A de minimis defect occurs if a corporation 
or its TRASOP fails to satisfy the requirements, other than those 
enumerated in paragraphs (c) (1) and (2) and (g)(2) (ii) and (iii), of 
this section or of Sec.  1.46-8 other than those excluded under Sec.  
1.46-8(h)(4)(iv).
    (3) Amount involved. The amount involved in a failure to comply 
under this section is based upon the extra additional credit within the 
meaning of section 46(a)(2)(B)(ii).
    (4) Coordination of civil penalties. The civil penalties under Sec.  
1.46-8 and this section are determined separately. In no case may the 
amount involved with respect to a particular failure to comply in one 
year exceed under both sections the full additional credit within the 
meaning of section 46(a)(2)(B) (i) and (ii).

[T.D. 7856, 47 FR 54805, Dec. 6, 1982]



Sec.  1.46-10  [Reserved]



Sec.  1.47-1  Recomputation of credit allowed by section 38.

    (a) General rule--(1) In general. (i) If during the taxable year any 
section 38 property the basis (or cost) of which was taken into account, 
under paragraph (a) of Sec.  1.46-3, in computing the taxpayer's 
qualified investment is disposed of, or otherwise ceases to be section 
38 property or becomes public utility property (as defined in paragraph 
(g) of Sec.  1.46-3) or is a qualifying commuter highway vehicle (as 
defined in paragraph (a) of Sec.  1.46-11) which undergoes a change in 
use (as defined in paragraph (m)(2) of this section) with respect to the 
taxpayer, before the close of the estimated useful life (as determined 
under subparagraph (2)(i) of this paragraph) which was taken into 
account in computing such qualified investment, then the credit earned 
for the credit year (as defined in subdivision (ii)(a) of this 
subparagraph) shall be recomputed under the principles of paragraph (a) 
of Sec.  1.46-1 and paragraph (a) of Sec.  1.46-3 substituting, in lieu 
of the estimated useful life of the property that was taken into account 
originally in computing qualified investment, the actual useful life of 
the property as determined under subparagraph (2)(ii) of this paragraph. 
There shall also be recomputed under the principles of Sec. Sec.  1.46-1 
and 1.46-2 the credit allowed for the credit year and for any other 
taxable year affected by reason of the reduction in credit earned for 
the credit year, giving effect to such reduction in the computation of 
carryovers or carrybacks of unused credit. If the recomputation 
described in the preceding sentence results in the aggregate in a 
decrease (taking into account any recomputations under this paragraph in 
respect of prior recapture years, as defined in subdivision (ii)(b) of 
this subparagraph) in the credits allowed for

[[Page 413]]

the credit year and for any other taxable year affected by the reduction 
in credit earned for the credit year, then the income tax for the 
recapture year shall be increased by the amount of such decrease in 
credits allowed. For treatment of such increase in tax, see paragraph 
(b) of this section. For rules relating to ``disposition'' and 
``cessation'', see Sec.  1.47-2. For rules relating to certain 
exceptions to the application of this section, see Sec.  1.47-3. For 
special rules in the case of an electing small business corporation (as 
defined in section 1371(b)), an estate or trust, or a partnership, see 
respectively, Sec. Sec.  1.47-4, 1.47-5, or 1.47-6. For rules applicable 
to energy property, see paragraph (h) of this section. For special rules 
relating to recomputation of credit allowed by section 38 if progress 
expenditure property (as defined in Sec.  1.46-5(d)) ceases to be 
progress expenditure property with respect to the taxpayer, see 
paragraph (g) of this section.
    (ii) For purposes of this section and Sec. Sec.  1.47-2 through 
1.47-6--
    (a) The term ``credit year'' means the taxable year in which section 
38 property was taken into account in computing a taxpayer's qualified 
investment.
    (b) The term ``recapture year'' means the taxable year in which 
section 38 property the basis (or cost) of which was taken into account 
in computing a taxpayer's qualified investment is disposed of, or 
otherwise ceases to be section 38 property or becomes public utility 
property with respect to the taxpayer, before the close of the estimated 
useful life which was taken into account in computing such qualified 
investment.
    (c) The term ``recapture determination'' means a recomputation made 
under this paragraph.
    (2) Rules for applying subparagraph (1). For purposes of 
subparagraph (1) of this paragraph--
    (i) In determining whether section 38 property is disposed of, or 
otherwise ceases to be section 38 property with respect to the taxpayer, 
before the close of the estimated useful life which was taken into 
account in computing the taxpayer's qualified investment, the term 
``estimated useful life'' means the shortest life of the useful life 
category within which falls the estimated useful life which was assigned 
to such property under paragraph (e) of Sec.  1.46-3. Thus, section 38 
property which is assigned, under paragraph (e) of Sec.  1.46-3, an 
estimated useful life of 6 years shall not be treated, for purposes of 
subparagraph (1) of this paragraph, as having been disposed of before 
the close of its estimated useful life if such property is sold 5 years 
(that is, the shortest life of the 5 years or more but less than 7 years 
useful life category) after the date on which it was placed in service. 
Likewise, section 38 property with an estimated useful life of 15 years 
which is placed in service on January 1, 1972, shall not be treated as 
having been disposed of before the close of its estimated useful life if 
such property is sold at any time after January 1, 1979 (that is, 7 
years or more after the date on which it was placed in service).
    (ii) In determining the recomputed qualified investment with respect 
to property which is disposed of or otherwise ceases to be section 38 
property the term ``actual useful life'' means, except as otherwise 
provided in this section and Sec. Sec.  1.47-2 through 1.47-6, the 
period beginning with the date on which the property was placed in 
service by the taxpayer and ending with the date of such disposition or 
cessation. See paragraph (c) of this section.
    (iii) In determining the recomputed qualified investment with 
respect to property which ceases to be section 38 property with respect 
to the taxpayer after August 15, 1971, or which becomes public utility 
property after such date, such property shall be treated as if it were 
property described in section 50 at the time it was placed in service 
(whether or not it was property described in section 50 at such time). 
Thus, if property was placed in service on October 15, 1968, and was 
assigned an estimated useful life of 4 years, there would be no increase 
in tax under section 47 if the property were disposed of at any time 
after October 14, 1971, that is, 3 years or more after the property was 
placed in service.
    (b) Increase in income tax and reduction of investment credit 
carryover--(1) Increase in tax. Except as provided in subparagraph (2) 
of this paragraph, any

[[Page 414]]

increase in income tax under this section shall be treated as income tax 
imposed on the taxpayer by chapter 1 of the Code for the recapture year 
notwithstanding that without regard to such increase the taxpayer has no 
income tax liability, has a net operating loss for such taxable year, or 
no income tax return was otherwise required for such taxable year.
    (2) Special rule. Any increase in income tax under this section 
shall not be treated as income tax imposed on the taxpayer by chapter 1 
of the Code for purposes of determining the amount of the credits 
allowable to such taxpayer under--
    (i) Section 33 (relating to taxes of foreign countries and 
possessions of United States),
    (ii) Section 34 (relating to dividends received by individuals 
before January 1, 1965),
    (iii) Section 35 (relating to partially tax-exempt interest received 
by individuals),
    (iv) Section 37 (relating to retirement income), and
    (v) Section 38 (relating to investment in certain depreciable 
property).
    (3) Reduction in credit allowed as a result of a net operating loss 
carryback. (i) If a net operating loss carryback from the recapture year 
or from any taxable year subsequent to the recapture year reduces the 
amount allowed as a credit under section 38 for any taxable year up to 
and including the recapture year, then there shall be a new recapture 
determination under paragraph (a) of this section for each recapture 
year affected, taking into account the reduced amount of credit allowed 
after application of the net operating loss carryback.
    (ii) Subdivision (i) of this subparagraph may be illustrated by the 
following examples:

    Example 1. (a) X Corporation, which makes its return on the basis of 
a calendar year, acquired and placed in service on January 1, 1962, an 
item of section 38 property with a basis of $10,000 and an estimated 
useful life of 8 years. The amount of qualified investment with respect 
to such asset was $10,000. For the taxable year 1962, X Corporation's 
credit earned of $700 (7 percent of $10,000) was allowed under section 
38 as a credit against its liability for tax of $700. In 1963 and 1964 X 
Corporation had no liability for tax and placed in service no section 38 
property. On January 3, 1963, such item of section 38 property was sold 
to Y Corporation. Since the actual useful life of such item was only 1 
year, there was a recapture determination under paragraph (a) of this 
section. The income tax imposed by chapter 1 of the Code on X 
Corporation for the taxable year 1963 was increased by the $700 decrease 
in its credit earned for the taxable year 1962 (that is, the $700 
original credit earned minus zero recomputed credit earned).
    (b) For the taxable year 1965, X Corporation has a net operating 
loss which is carried back to the taxable year 1962 and reduces its 
liability for tax, as defined in paragraph (c) of Sec.  1.46-1, for such 
taxable year to $200. As a result of such net operating loss carryback, 
X Corporation's credit allowed under section 38 for the taxable year 
1962 is limited to $200 and the excess of $500 ($700 credit earned minus 
$200 limitation based on amount of tax) is an investment credit 
carryover to the taxable year 1963.
    (c) For 1965, there is a recapture determination under subdivision 
(i) of this subparagraph for the 1963 recapture year. The $700 increase 
in the income tax imposed on X Corporation for the taxable year 1963 is 
redetermined to be $200 (that is, the $200 credit allowed after taking 
into account the 1965 net operating loss minus zero credit which would 
have been allowed taking into account the 1963 recapture determination). 
In addition, X Corporation's $500 investment credit carryover to the 
taxable year 1963 is reduced by $500 ($700 minus $200) to zero and X 
Corporation is entitled to a $500 refund of the tax paid as a result of 
the 1963 determination.
    Example 2. (a) X Corporation, which makes its returns on the basis 
of a calendar year, acquired and placed in service on January 1, 1962, 
an item of section 38 property with a basis of $10,000 and an estimated 
useful life of 8 years. The amount of qualified investment with respect 
to such asset was $10,000. For the taxable year 1962, X Corporation's 
credit earned of $700 (7 percent of $10,000) was allowed under section 
38 as a credit against its liability for tax of $700. In 1963 and in 
1964 X Corporation had no liability for tax and placed in service no 
section 38 property. On January 3, 1965, such item of section 38 
property is sold to Y Corporation. For the taxable year 1965, X 
Corporation has a net operating loss which is carried back to the 
taxable year 1962 and reduces its liability for tax, as defined in 
paragraph (c) of Sec.  1.46-1, for such taxable year to $100.
    (b) As a result of such net operating loss carryback, X 
Corporation's credit allowed under section 38 for the taxable year 1962 
is limited to $100 and the excess of $600 ($700 credit earned minus $100 
limitation based on amount of tax) is an investment credit carryover to 
the taxable year 1963.

[[Page 415]]

    (c) Since the actual useful life of the item of section 38 property 
sold to Y Corporation was only 3 years, there is a recapture 
determination under paragraph (a) of this section. X Corporation's $600 
investment credit carryover to 1963 is reduced by $600 to zero. The 
income tax imposed by chapter 1 of the Code on X Corporation for the 
taxable year 1965 is increased by the $100 reduction in credit allowed 
by section 38 for 1962.

    (4) Statement of recomputation. The taxpayer shall attach to his 
income tax return for the recapture year a separate statement showing in 
detail the computation of the increase in income tax imposed on such 
taxpayer by chapter 1 of the Code and the reduction in any investment 
credit carryovers.
    (c) Date placed in service and date of disposition or cessation--(1) 
General rule. For purposes of this section and Sec. Sec.  1.47-2 through 
1.47-6, in determining the actual useful life of section 38 property--
    (i) Such property shall be treated as placed in service on the first 
day of the month in which such property is placed in service. The month 
in which property is placed in service shall be determined under the 
principles of paragraph (d) of Sec.  1.46-3.
    (ii) If during the taxable year such property ceases to be section 
38 property with respect to the taxpayer--
    (a) As a result of the occurrence of an event on a specific date 
(for example, a sale, transfer, retirement or other disposition), such 
cessation shall be treated as having occurred on the actual date of such 
event.
    (b) For any reason other than the occurrence of an event on a 
specific date (for example, because such property is used predominantly 
in connection with the furnishing of lodging during such taxable year), 
such cessation shall be treated as having occurred on the first day of 
such taxable year.
    (2) Special rule. Notwithstanding subparagraph (1) of this 
paragraph, if a taxpayer uses an averaging convention (see Sec.  
1.167(a)(10)) in computing depreciation with respect to section 38 
property, then, for purposes of this section and Sec. Sec.  1.47-2 
through 1.47-6, he may use the assumed dates of additions and 
retirements in determining the actual useful life of such property 
provided such assumed dates are used consistently for purposes of 
subpart B of part IV of subchapter A of chapter 1 of the Code with 
respect to all section 38 property for which such convention is used for 
purposes of depreciation. This subparagraph shall not apply in any case 
where from all the facts and circumstances it appears that the use of 
such assumed dates results in a substantial distortion of the investment 
credit allowed by section 38. Thus, for example, if the taxpayer 
computes depreciation under a convention under which the average of the 
beginning and ending balances of the asset account for the taxable year 
are taken into account, he may use July 1 as the assumed date of all 
additions and retirements to such account. Similarly, if the taxpayer 
computes depreciation under a convention under which the average of the 
beginning and ending balances of the asset account for each month is 
taken into account, he may use the date determined by reference to the 
weighted average of the monthly averages as the assumed date of all 
additions and retirements to such account.
    (3) Example. This paragraph may be illustrated by the following 
example:

    Example. Assume that section 38 property is placed in service 
(within the meaning of paragraph (d) of Sec.  1.46-3) on December 1, 
1965 (thus, the credit is treated as being earned in 1965) but under the 
taxpayer's depreciation practice the period for depreciation with 
respect to such property begins on January 1, 1966, and that the 
property is actually retired on December 2, 1970. Under the general rule 
of subparagraph (1) of this paragraph, the property is treated as placed 
in service on December 1, 1965, and as ceasing to be section 38 property 
with respect to the taxpayer on December 2, 1970, even though under the 
taxpayer's depreciation practice the period for depreciation with 
respect to such property begins on January 1, 1966, and terminates on 
January 1, 1971. However, under the special rule of subparagraph (2) of 
this paragraph the taxpayer may determine the actual useful life of the 
property by reference to the assumed dates of January 1, 1966, and 
January 1, 1971.

    (d) Examples. Paragraphs (a) through (c) of this section may be 
illustrated by the following examples:

    Example 1. (i) X Corporation, which makes its returns on the basis 
of the calendar year, acquired and placed in service on January 1, 1962, 
three items of section 38 property each with a basis of $12,000 and an 
estimated useful life of 15 years. The amount of qualified

[[Page 416]]

investment with respect to each such asset was $12,000. For the taxable 
year 1962, X Corporation's credit earned of $2,520 was allowed under 
section 38 as a credit against its liability for tax of $4,000. On 
December 2, 1965, one of the items of section 38 property is sold to Y 
Corporation.
    (ii) The actual useful life of the item of property which is sold on 
December 2, 1965, is three years and eleven months. The recomputed 
qualified investment with respect to such item of property is zero 
($12,000 basis multiplied by zero applicable percentage) and X 
Corporation's recomputed credit earned for the taxable year 1962 is 
$1,680 (7 percent of $24,000). The income tax imposed by chapter 1 of 
the Code on X Corporation for the taxable year 1965 is increased by the 
$840 decrease in its credit earned for the taxable year 1962 (that is, 
$2,520 original credit earned minus $1,680 recomputed credit earned).
    Example 2. (i) The facts are the same as in example 1 and in 
addition on December 2, 1966, a second item of section 38 property 
placed in service in the taxable year 1962 is sold to Y Corporation.
    (ii) The actual useful life of the item of property which is sold on 
December 2, 1966, is four years and eleven months. The recomputed 
qualified investment with respect to such item of property is $4,000 
($12,000 basis multiplied by 33\1/3\ percent applicable percentage) and 
X Corporation's recomputed credit earned for the taxable year 1962 is 
$1,120 (7 percent of $16,000). The income tax imposed by chapter 1 of 
the Code on X Corporation for the taxable year 1966 is increased by $560 
(that is, $1,400 ($2,520 original credit earned minus $1,120 recomputed 
credit earned) reduced by the $840 increase in tax for 1965).
    Example 3. (i) The facts are the same as in example 1 except that 
for the taxable year 1962 X Corporation's liability for tax under 
section 46(a)(3) is only $1,520. Therefore, for such taxable year X 
Corporation's credit allowed under section 38 is limited to $1,520 and 
the excess of $1,000 ($2,520 credit earned minus $1,520 limitation based 
on amount of tax) is an unused credit. Of such $1,000 unused credit, 
$100 is allowed as a credit under section 38 for the taxable year 1963, 
$100 is allowed for 1964, and $800 is carried to the taxable year 1965.
    (ii) The actual useful life of the item of property which is sold on 
December 2, 1965, is three years and eleven months. The recomputed 
qualified investment with respect to such item of property is zero 
($12,000 basis multiplied by zero applicable percentage) and X 
Corporation's recomputed credit earned for the taxable year 1962 is 
$1,680 (7 percent of $24,000). If such $1,680 recomputed credit earned 
had been taken into account in place of the $2,520 original credit 
earned, X's credit allowed for 1962 would have been $1,520, and of the 
$160 unused credit from 1962 $100 would have been allowed as a credit 
under section 38 for 1963, and $60 would have been allowed for 1964. X 
Corporation's $800 investment credit carryover to the taxable year 1965 
is reduced by $800 to zero. The income tax imposed by chapter 1 of the 
Code on X Corporation for the taxable year 1965 is increased by $40 
(that is, the aggregate reduction in the credits allowed by section 38 
for 1962, 1963, and 1964).
    Example 4. (i) X Corporation, which makes its returns on the basis 
of the calendar year, acquired and placed in service on November 1, 
1962, an item of section 38 property with a basis of $12,000 and an 
estimated useful life of 10 years. The amount of qualified investment 
with respect to such property was $12,000. For the taxable year 1962, X 
Corporation's credit earned of $840 was allowed under section 38 as a 
credit against its liability for tax of $840. For each of the taxable 
years 1963 and 1964 X Corporation's liability for tax was zero and its 
credit earned was $400; therefore, for each of such years its unused 
credit was $400. For the taxable year 1965 its liability for tax was 
$200 and its credit earned was zero; therefore, $200 of the $400 unused 
credit from 1963 was allowed as credit for 1965 and $600 ($200 from 1963 
and $400 from 1964) is an investment credit carryover to 1966. On 
February 2, 1966, such item of section 38 property is sold to Y 
Corporation.
    (ii) The actual useful life of such item of property is three years 
and three months. The recomputed qualified investment with respect to 
such property is zero ($12,000 basis multipled by zero) and X 
Corporation's recomputed credit earned for the taxable year 1962 is 
zero. If such zero recomputed credit earned had been taken into account 
in place of the $840 original credit earned, the entire $400 unused 
credit from 1963 (including the $200 portion which was originally 
allowed as a credit for 1965) and the $400 unused credit from 1964 would 
have been allowed as investment credit carrybacks against X 
Corporation's liability for tax of $840 for 1962. (See Sec.  1.46-2 for 
rules relating to the carryback of unused credits.)
    (iii) Therefore, the $600 carryover from 1963 and 1964 to 1966 is 
eliminated and the income tax imposed by chapter 1 of the Code on X 
Corporation for the taxable year 1966 is increased by the $240 aggregate 
reduction in the credits allowed by section 38 for the taxable years 
1962 and 1965 (that is, $1,040 credit allowed minus $800 which would 
have been allowed).
    Example 5. (i) X Corporation, which makes its returns on the basis 
of the calendar year, acquired and placed in service on November 1, 
1962, an item of section 38 property with a basis of $10,000 and an 
estimated useful life of 8 years. The amount of qualified investment 
with respect to such asset was $10,000. For the taxable year 1962, X 
Corporation's credit

[[Page 417]]

earned of $700 was allowed as a credit against its liability for tax. 
For each of the taxable years 1963, 1964, and 1965 X had no taxable 
income. On July 3, 1966, the item of section 38 property is sold to Y 
Corporation. For the taxable year 1966 X Corporation has a net operating 
loss of $3,000.
    (ii) The actual useful life of the item of property is three years 
and eight months. The recomputed qualified investment with respect to 
such item of property is zero and X Corporation's recomputed credit 
earned for the taxable year 1962 is zero. Notwithstanding the $3,000 net 
operating loss for the taxable year 1966, the income tax imposed by 
chapter 1 of the Code on X Corporation for such year is $700 (that is, 
the decrease in its credit earned for the taxable year 1962).

    (e) Identification of property--(1) General rule--(i) Record 
requirements. In general, the taxpayer must maintain records from which 
he can establish, with respect to each item of section 38 property, the 
following facts:
    (a) The date the property is disposed of or otherwise ceases to be 
section 38 property,
    (b) The estimated useful life which was assigned to the property 
under paragraph (e) of Sec.  1.46-3,
    (c) The month and the taxable year in which the property was placed 
in service, and
    (d) The basis (or cost), actually or reasonably determined, of the 
property.
    (ii) Recapture determination. For purposes of determining whether 
section 38 property is disposed of, or otherwise ceases to be section 38 
property with respect to the taxpayer, before the close of its estimated 
useful life, and for purposes of determining recomputed qualified 
investment, the taxpayer must establish from his records the facts 
required by subdivision (i) of this subparagraph.
    (iii) Examples. If the taxpayer fails to maintain records from which 
he can establish the facts required by subdivision (i) of this 
subparagraph, then this section shall be applied to the taxpayer in the 
manner indicated in the following examples:

    Example 1. Corporation X, organized on January 1, 1964, files its 
income tax return on the basis of a calendar year. During the years 1964 
and 1965, X places in service several items of machinery to which it 
assigns estimated useful lives of 8 years. X places the items of 
machinery in a composite account for purposes of computing depreciation. 
When X's 1966 return is being audited, X is unable to establish whether 
the items placed in service in 1964 and 1965 were still on hand at the 
end of 1966. Therefore, for purposes of paragraph (a) of this section, X 
is treated as having disposed of, in 1966, all of the items of machinery 
placed in service in 1964 and 1965.
    Example 2. Corporation Y, organized on January 1, 1960, files its 
income tax return on the basis of a calendar year. During each of the 
years 1960 through 1965, Y places in service four items of machinery to 
each of which it assigns an estimated useful life of 8 years for 
depreciation purposes (and for purposes of computing qualified 
investment for relevant years). Y places the items of machinery in a 
composite account for purposes of computing depreciation (and for 
purposes of computing qualified investment for relevant years). When Y's 
1965 return is being audited, Y can establish that it retired during 
1965 only six items of this machinery. However, Y cannot establish the 
date on which these six items were placed in service, nor can Y 
establish that the items placed in service in 1963 or 1964 are still on 
hand as of the end of 1965. No previous recapture has taken place with 
respect to any of the items placed in service in 1963 or 1964. Assuming 
that paragraph (e) (2) and (3) of this section is not applicable, Y is 
treated, for purposes of paragraph (a) of this section, as having 
disposed of, in 1965, the four items placed in service in 1964, the most 
recent year before 1965 in which such property was placed in service, 
and two items from 1963, the next most recent year.
    Example 3. The facts are the same as in example 2 except that when 
Y's 1966 return is being audited, Y can establish from its records that 
all four items placed in service in 1965 are still on hand and that only 
three items were retired in 1966. For purposes of paragraph (a) of this 
section, Y is treated as having disposed of, in 1966, the two remaining 
items of machinery placed in service in 1963, and one of the items 
placed in service in 1962.

    (2) Treatment of ``mass assets''. (i) If, in the case of mass assets 
(as defined in subparagraph (4) of this paragraph), it is impracticable 
for the taxpayer to maintain records from which he can establish with 
respect to each item of section 38 property the facts required by 
subparagraph (1) of this paragraph, and if he adopts other reasonable 
recordkeeping practices, consonant with

[[Page 418]]

good accounting and engineering practices, and consistent with his prior 
recordkeeping practices, then he may substitute data from an appropriate 
mortality dispersion table. An appropriate mortality dispersion table 
must be based on an acceptable sampling of the taxpayer's actual 
experience or other acceptable statistical or engineering techniques. In 
lieu of such mortality dispersion table, the taxpayer may use a standard 
mortality dispersion table prescribed by the Commissioner. If the 
taxpayer uses such standard mortality dispersion table for any taxable 
year, it must be used for all subsequent taxable years unless the 
taxpayer obtains the consent of the Commissioner to change. If mass 
assets are placed in a multiple asset account and if the depreciation 
rate for such account is based on the maximum expected life of the 
longest lived asset in such account, in applying a mortality dispersion 
table (including a standard mortality dispersion table) the average 
expected useful life of the mass assets in such account must be used.
    (ii) Subdivision (i) of this subparagraph shall not apply with 
respect to assets placed in service in a taxable year ending on or after 
June 30, 1967, and beginning before January 1, 1971, or with respect to 
assets placed in service for a taxable year beginning after December 31, 
1970, for which the taxpayer has not made the election provided by 
section 167(m), unless the estimated useful lives which were assigned to 
such assets for purposes of determining qualified investment--
    (a) Were separate lives based on the estimated range of years taken 
into account in establishing the average useful life of assets similar 
in kind under paragraph (e)(3)(ii)(b) of Sec.  1.46-3, and
    (b) Were determined by use of a mortality dispersion table 
(including a standard mortality dispersion table).
    (iii) Any standard mortality dispersion table prescribed by the 
Commissioner shall be based on average useful life categories and with 
respect to each category shall contain five columns, the first four of 
which shall state the percentage of property assumed to have a useful 
life of--

    Column (1): Less than 4 years,
    Column (2): 4 years or more but less than 6 years,
    Column (3): 6 years or more but less than 8 years, and
    Column (4): 8 years or more.


The fifth column shall show the total qualified investment as a 
percentage and shall be used in connection with the determination to be 
made under Sec.  1.46-3(e)(3)(iii). In the case of a table which is to 
apply to property which is described in section 50 or to property which 
is treated as property described in section 50 under paragraph 
(a)(2)(iii) of this section, this subdivision shall be applied by 
substituting ``3 years'' for ``4 years'', ``5 years'' for ``6 years'', 
and ``7 years'' for ``8 years''.
    (iv) Whenever the standard mortality dispersion table is used for a 
taxable year under subdivision (i) of this subparagraph (whether or not 
such table was used in determining qualified investment), the percentage 
of property shown in column (1) of the table shall (for purposes of 
section 47, this section, and Sec. Sec.  1.47-2 through 1.47-6) be 
deemed to have been disposed of on the day before the expiration of the 
4-year period beginning on the date on which it was considered as placed 
in service under Sec.  1.47-1(c); the percentage of property shown in 
column (2) of the table shall be deemed to have been disposed of on the 
day before the expiration of the 6-year period beginning on the date on 
which it was so considered as placed in service; and the percentage of 
property shown in column (3) shall be deemed to have been disposed of on 
the day before the expiration of the 8-year period beginning on the date 
on which it was so considered as placed in service. In applying this 
subdivision for purposes of recomputing qualified investment, the proper 
average useful life category shall be used whether or not such category 
was used in determining qualified investment. In the case of property 
which is described in section 50 or property which is treated as 
property described in section 50 under paragraph (a)(2)(iii) of this 
section (other than property the qualified investment with respect to 
which was determined by use of the standard or an appropriate mortality 
dispersion table), this subdivision shall be applied by substituting 
``3-year period'' for ``4-year period'', ``5-

[[Page 419]]

year period'' for ``6-year period'', and ``7-year period'' for ``8-year 
period''.
    (v) In lieu of using subdivision (iv) of this subparagraph for 
purposes of recomputing qualified investment, a taxpayer may, for the 
first recapture year (as defined in paragraph (a)(1)(ii)(b) of this 
section) to which such subdivision (iv) would otherwise apply with 
respect to any mass asset account, recompute qualified investment on the 
basis of the difference between (a) the proper total qualified 
investment based on the percentage shown in column (5) of the table, and 
(b) the total qualified investment actually claimed by the taxpayer for 
the year in which the property was placed in service.

    Example. Assume that the taxpayer places in service during 1963 mass 
assets costing him $100,000, that he places these assets in a multiple 
asset account for which he properly claims a useful life of 6 years and 
a qualified investment of $66,667 (\2/3\ x $100,000), and that he is 
allowed an investment credit of $4,667.67. When the taxpayer's 1967 
return is being audited he is unable to establish that any of the mass 
assets placed in service in 1963 were still on hand at the end of 1967.
    The taxpayer elects to use the standard mortality dispersion table 
prescribed by the Commissioner to determine the amount of recapture with 
respect to these mass assets. Assume that the table prescribed by the 
Commissioner shows with respect to mass assets with an average useful 
life of 6 years the following:

------------------------------------------------------------------------
Percent of property assumed to have a useful life of--
-------------------------------------------------------
               4 years or    6 years or                  Total qualified
 Less than 4    more, but     more, but    8 years or      investment
  years (1)    less than 6   less than 8    more (4)      (percent) (5)
                years (2)     years (3)
------------------------------------------------------------------------
    15.87         34.13         34.13         15.87           50.00
------------------------------------------------------------------------

    (a) Under these circumstances 15.87 percent of the mass assets 
placed in service in 1963 are deemed to have been disposed of during 
1967. With respect to these assets, the amount of qualified investment 
for 1963 was $10,580 ($15,870 x \2/3\) and the amount of credit earned 
was $740.60 (7 percent of $10,580), whereas the recomputed qualified 
investment is zero and the recomputed credit earned is zero. Thus, the 
tax imposed by chapter 1 of the Code for 1967 is increased by $740.60.
    (b) No recapture determination is required for 1968 since no assets 
are deemed to have been disposed of in that year. During 1969, 34.13 
percent of the mass assets placed in service in 1963 are deemed to have 
been disposed of. With respect to these assets, the amount of qualified 
investment for 1963 was $22,753.34 ($34,130 x \2/3\) and the amount of 
credit earned was $1,592.73 (7 percent of $22,753.34), whereas the 
recomputed qualified investment is $11,376.67 ($34,130 x \1/3\) and the 
recomputed credit earned is $796.37 (7 percent of $11,376.67). Thus, the 
tax imposed by chapter 1 of the Code for 1969 is increased by $796.36 
($1,592.73 minus $796.37).
    (c) If the taxpayer chooses to recompute qualified investment by 
using the method provided in subdivision (v) of this subparagraph, the 
increase in tax for 1967 (the first recapture year) would be $1,167.67, 
i.e., the original credit earned, $4,667.67, minus the recomputed credit 
earned, $3,500 (50 percent, the percentage shown in column (5), of 
$100,000 multiplied by 7 percent). As long as the same average useful 
life category reflects the taxpayer's experience for subsequent years, 
no recapture determination will be required for any future year, except 
as provided by subparagraph (3)(iv) of this paragraph.

    (vi) Subdivision (i) of this subparagraph shall not apply with 
respect to section 38 property to which an election under section 167(m) 
applies unless the taxpayer assigns actual retirements of such section 
38 property for all taxable years to the same vintage account for 
purposes of section 47 and for purposes of computing the allowance for 
depreciation under section 167. The assignment of actual retirements of 
section 38 property for a taxable year to particular vintage accounts 
may be made on the basis of an appropriate mortality dispersion table 
(based on an acceptable sampling of the taxpayer's actual experience or 
other statistical or engineering techniques) or on the basis of a 
standard mortality dispersion table prescribed by the Commissioner. If 
the taxpayer assigns actual retirements for any taxable year to 
particular vintage accounts on the basis of such standard mortality 
dispersion table, actual retirements for all subsequent taxable years 
must be assigned to particular vintage accounts on the basis of such 
table. Actual retirements of section 38 property for a taxable year 
shall be assigned to particular vintage accounts by--
    (a) Determining the expected retirements for such taxable year from 
each vintage account containing such section 38 property, and

[[Page 420]]

    (b) Ratably allocating such actual retirements to each vintage 
account containing such section 38 property.


However, the unadjusted basis of retired assets assigned to any 
particular vintage account shall not exceed the unadjusted basis of the 
property contained in such account.
    (3) Special rules. (i) Taxpayers who properly determine estimated 
useful lives under Sec.  1.46-3(e)(3) (ii)(b) or (iii) may treat such 
assets as having been disposed of or having ceased to be section 38 
assets in the order of the estimated useful lives that were assigned to 
such assets. Thus, the asset that is first disposed of or first ceases 
to be section 38 property may be treated as the asset to which there was 
assigned the shortest estimated useful life; the next asset disposed of 
or ceasing to be section 38 property may be treated as the asset to 
which there was assigned the second shortest life, etc.
    (ii) In the case of taxpayers who use the rule of subdivision (i) of 
this subparagraph with respect to mass assets for which the estimated 
useful life was determined under Sec.  1.46-3(e)(3)(iii), if the 
dispersion shown by the mortality dispersion table effective for a 
taxable year subsequent to the credit year is the same as the dispersion 
shown by the mortality table that was effective for the credit year (for 
example, if the same average useful life on the standard mortality 
dispersion table reflects the taxpayer's experience for both such 
years), no recapture determination is required for such subsequent 
taxable year.
    (iii) Notwithstanding subdivision (i) of this subparagraph, 
taxpayers who, for purposes of determining qualified investment, do not 
use a mortality dispersion table with respect to certain section 38 
assets similar in kind but who consistently assign under paragraph 
(e)(3)(ii)(b) of Sec.  1.46-3 to such assets separate lives based on the 
estimated range of years taken into consideration in establishing the 
average useful life of such assets, may select the order in which such 
assets shall be considered as having been disposed of, regardless of the 
taxable years in which such assets were placed in service. If a taxpayer 
uses the method provided in this subdivision to determine that any asset 
is considered as having been disposed of, then, in addition to complying 
with the record requirements of subparagraph (1)(i) of this paragraph, 
such taxpayer must maintain records from which he can establish to the 
satisfaction of the district director that such asset has not previously 
been considered as having been disposed of. In addition, if, for any 
taxable year, a taxpayer uses the method provided in this subdivision 
for any asset, he must use for such year and for each subsequent taxable 
year (unless he obtains the district director's consent to change) with 
respect to all assets similar in kind to such asset--
    (a) The method of determining estimated useful lives described in 
paragraph (e)(3)(ii)(b) of Sec.  1.46-3, and
    (b) The method he has selected under this subdivision for 
determining the order in which such assets are considered as having been 
disposed of.

A request by a taxpayer to obtain the district director's consent to 
change a system or method described in this subdivision with respect to 
assets similar in kind must be submitted to the district director on or 
before the last day of the taxable year with respect to which the change 
is sought.
    (iv) Notwithstanding subdivisions (i), (ii), and (iii) of this 
subparagraph, there shall be taken into account separately any abnormal 
retirement of section 38 property of substantial value for which the 
estimated useful life was determined under Sec.  1.46-3(e)(3) (ii)(b) or 
(iii). For definition of abnormal retirement, see paragraph (b) of Sec.  
1.167(a)-8.
    (4) [Reserved]
    (5) Example. This paragraph may be illustrated by the following 
example:

    Example. (i) Taxpayer A uses numerous small returnable containers in 
his business. It is impracticable for A to keep individual detailed 
records with respect to such containers which are mass assets. In 1965, 
A places in service 10 million containers purchased for $1 million, and 
reasonably determines that each of such containers has a basis of 10 
cents. A places such containers in a multiple asset account to which is 
assigned a 5-year average useful life for purposes of computing 
depreciation. A has conducted an appropriate mortality study which shows 
that the containers have the following estimated useful lives:

[[Page 421]]



------------------------------------------------------------------------
                                                                Useful
                      Percent of assets                          life
                                                                (years)
------------------------------------------------------------------------
10..........................................................           3
20..........................................................           6
40..........................................................           5
20..........................................................           6
10..........................................................           7
------------------------------------------------------------------------


A assigns separate lives to such assets based on the estimated range of 
years taken into account in establishing the average useful life of such 
containers. The qualified investment with respect to such containers is 
$400,000 computed as follows:

------------------------------------------------------------------------
                                                  Applicable   Qualified
             Useful life                 Basis    percentage  investment
------------------------------------------------------------------------
4...................................    $200,000     33\1/3\     $66,666
5...................................     400,000     33\1/3\     133,334
6...................................     200,000     66\2/3\     133,334
7...................................     100,000     66\2/3\      66,666
                                     -----------------------------------
                                      ..........  ..........     400,000
------------------------------------------------------------------------

A's credit earned for 1965 of $28,000 (7 percent times $400,000) is 
allowed as a credit under section 38 against A's liability for tax of $2 
million. (For purposes of this example the computations of investment 
credit and recapture with respect to containers placed in service in 
years other than 1965 are omitted.) The mortality studies effective for 
1966 and 1967 show that none of the containers placed in service in 1965 
was retired.
    (ii) A's mortality study effective with respect to 1968 shows that 
the containers are being retired as follows:

------------------------------------------------------------------------
                                                                Useful
                      Percent of assets                          life
                                                                (years)
------------------------------------------------------------------------
30..........................................................           3
20..........................................................           4
30..........................................................           5
10..........................................................           6
10..........................................................           7
------------------------------------------------------------------------

Thus, the 1968 study shows that 30 percent of the 10 million containers 
placed in service in 1965 were retired in 1968. Under the rule of 
subparagraph (3)(i) of this paragraph, the 3 million containers are 
treated as consisting of the 1 million containers to which was assigned 
a 3-year useful life and the 2 million containers to which was assigned 
a 4-year useful life. Taking into account only the fact that 30 percent 
of the containers placed in service in 1965 had an actual life of less 
than 4 years, A's recomputed qualified investment for 1965 is $333,333 
and his recomputed credit earned is $23,333. A's income tax for 1968 is 
increased by $4,667 ($28,000 original credit earned minus $23,333 
recomputed credit earned).
    (iii) The mortality study effective for 1969 shows the same results 
as the mortality study effective for 1968. Thus, it shows that 2 million 
containers were retired in 1969 (an actual life of 4 years). Under the 
rule of subparagraph (3)(i) of this paragraph such 2 million containers 
are treated as having been among 4 million containers to which were 
assigned a 5-year useful life. Therefore, no recapture determination is 
required for 1969.
    (iv) The mortality study effective for 1970 shows the same results 
as the mortality study effective for 1968. Thus, it shows that 3 million 
containers were retired in 1970 (an actual life of 5 years). Under the 
rule of subparagraph (3)(i) of this paragraph, the 3 million are treated 
as having been assigned useful lives as follows: 2 million as having 
been assigned a useful life of 5 years, and 1 million as having been 
assigned a useful life of 6 years. Taking into account only the fact 
that 10 percent of the containers placed in service in 1965 had an 
actual life of 5 years rather than the 6 years estimated useful life 
assigned to them, A's recomputed qualified investment is $300,000 and 
A's credit earned for 1965 is $21,000. Thus, taking into account the 
1968 recapture determination A's income tax for 1970 is increased by 
$2,333.

    (f) Public utility property--(1) Recomputed qualified investment. In 
recomputing qualified investment with respect to section 38 property 
which becomes public utility property (as defined in paragraph (g) of 
Sec.  1.46-3)--
    (i) If such property becomes public utility property less than 3 
years from the date on which it was placed in service, then such 
property shall be treated as public utility property for its entire 
useful life.
    (ii) If such property becomes public utility property 3 years or 
more but less than 5 years from the date on which it was placed in 
service, then such property shall be treated as section 38 property 
which is not public utility property for the first 3 years of its 
estimated useful life and as public utility property for the remaining 
period of its estimated useful life.
    (iii) If such property becomes public utility property 5 years or 
more but less than 7 years from the date on which it was placed in 
service, then such property shall be treated as section 38 property 
which is not public utility property for the first 5 years of its 
estimated useful life and as public utility property for the remaining 
period of its estimated useful life.

If property becomes public utility property before August 16, 1971, this 
subparagraph shall be applied by substituting ``4 years'' for ``3 
years'', ``6

[[Page 422]]

years'' for ``5 years'', and ``8 years'' for ``7 years''.
    (2) Examples. Subparagraph (1) of this paragraph may be illustrated 
by the following examples:

    Example 1. (i) X Corporation, which makes its returns on the basis 
of the calendar year, acquired and placed in service on January 1, 1969, 
an item of section 38 property with a basis of $12,000 and an estimated 
useful life of 8 years. The amount of qualified investment with respect 
to such property was $12,000. For the taxable year 1969, X Corporation's 
credit earned was $840 (7 percent of $12,000) and for such taxable year 
X Corporation was allowed under section 38 a credit of $840 against its 
liability for tax. During the taxable year 1972 such property becomes 
public utility property (as defined in paragraph (g) of Sec.  1.46-3) 
with respect to X Corporation.
    (ii) Such item of section 38 property is treated as section 38 
property which is not public utility property for the first 3 years of 
its 8-year estimated useful life and is treated as public utility 
property for the remaining 5 years. The recomputed qualified investment 
with respect to such item of section 38 property is $7,428, computed as 
follows:

$12,000 basis x 33\1/3\ percent applicable percentage.........    $4,000
$12,000 basis x \3/7\ x 66\2/3\ percent applicable percentage.     3,428
                                                               ---------
    Total recomputed qualified investment.....................     7,428
 


X Corporation's recomputed credit earned for the taxable year 1969 is 
$520 (7 percent of $7,428). The income tax imposed by chapter 1 of the 
Code on X Corporation for the taxable year 1972 is increased by the $320 
decrease in its credit earned for the taxable year 1969 (that is, $840 
original credit earned minus $520 recomputed credit earned).
    Example 2. (i) The facts are the same as in example 1 and in 
addition the item of section 38 property which became public utility 
property in 1972 is sold to Y Corporation on January 2, 1975.
    (ii) The actual useful life of such item of property is 6 years. For 
the first 3 years of its 8-year estimated useful life such item is 
treated as section 38 property which is not public utility property and 
for the remaining 3 years is treated as public utility property. The 
recomputed qualified investment with respect to such item of property is 
$5,714, computed as follows:

$12,000 basis x 33\1/3\ percent applicable percentage.........    $4,000
$12,000 basis x \3/7\ x 33\1/3\ percent applicable percentage.     1,714
                                                               ---------
    Total recomputed qualified investment.....................     5,714
 


X Corporation's recomputed credit earned for the taxable year 1969 is 
$400 (7 percent of $5,714). The income tax imposed by chapter 1 of the 
Code on X Corporation for the taxable year 1975 is increased by $120 
(that is, $440 ($840 original credit earned minus $400 recomputed credit 
earned) minus $320 increase in tax for 1969).

    (g) Special rules for progress expenditure property. Under section 
47(a)(3), a recapture determination is required if property ceases to be 
progress expenditure property (as defined in Sec.  1.46-5(d)). Property 
ceases to be progress expenditure property if it is sold or otherwise 
disposed of before it is placed in service. For example, cancellation of 
the contract for progress expenditure property or abandonment of the 
project by the taxpayer will be considered a ``disposition'' within the 
meaning of Sec.  1.47-2. A cessation occurs if progress expenditure 
property ceases to be property that will be section 38 property with a 
useful life of 7 years or more when placed in service. In general, a 
sale and leaseback is treated as a cessation. However, see paragraph 
(g)(2) of Sec.  1.47-3 for special rules for certain sale and leaseback 
transactions. Recapture determinations for progress expenditure property 
are to be made in a way similar to that provided under Sec. Sec.  1.47-1 
through 1.47-6. Reduction of qualified investment must begin with the 
most recent credit year (i.e., the most recent taxable year the property 
is taken into account in computing qualified investment under Sec.  
1.46-3 or 1.46-5).
    (h) Special rules for energy property--(1) In general. A recapture 
determination is required for the investment credit attributable to the 
energy percentage (energy credit) if property is (i) disposed of or (ii) 
otherwise ceases to be energy property (as defined in section 48(l)) 
with regard to the taxpayer before the close of the estimated useful 
life (as determined under paragraph (a)(2)(i) of this section) which was 
taken into account in computing qualified investment.
    (2) Dispositions. The term ``disposition'' is described in Sec.  
1.47-2(a)(1). A transfer of energy property that is a ``disposition'' 
requiring a recapture determination for the investment credit 
attributable to the regular percentage (regular credit) and the ESOP 
percentage (ESOP credit) will also be a ``disposition'' requiring a 
recapture determination for the energy credit.

[[Page 423]]

    (3) Cessation. (i) The term ``cessation'' is described in Sec.  
1.47-2(a)(2). For energy property, a cessation occurs during a taxable 
year if, by reason of a change in use or otherwise, the property would 
not have qualified for an energy credit if placed in service during that 
year. A change in use will not require a recapture determination for the 
regular or ESOP credit unless, by reason of the change, the property 
would not have qualified for the regular or ESOP credit if placed in 
service during that year.
    (ii) A qualified intercity bus described in Sec.  1.48-9(q) must 
meet the predominant use test (of Sec.  1.48-9(q)(7)) for the remainder 
of the taxable year from the date it is placed in service and for each 
taxable year thereafter. A cessation occurs in any taxable year in which 
the bus is no longer a qualifying bus under Sec.  1.48-9(q)(6). A 
qualified intercity bus does not cease to be energy property for a 
taxable year subsequent to the one in which it was placed in service by 
reason of a decrease in operating capacity (see Sec.  1.48-9(q)(9)) for 
that year compared to any prior taxable year.
    (4) Recordkeeping requirement. For recordkeeping requirements with 
respect to dispositions or cessations, the rules of paragraph (e)(1) of 
this section apply. For example, the taxpayer must maintain records for 
each recycling facility indicating the percentage of virgin materials 
used each year. See, Sec.  1.48-9(g)(5)(ii).
    (5) Examples. The following examples illustrate this paragraph (h).

    Example 1. (a) In 1980, corporation X, a calendar year taxpayer, 
acquires and places in service a computer that will perform solely 
energy conserving functions in connection with an existing industrial 
process. Assume the computer has a 10 year useful life and qualifies for 
both the regular and energy credits. In 1981, a change is made in the 
industrial process (within the meaning of Sec.  1.48-9(l)(2)). However, 
for 1981 the computer continues to perform solely energy conserving 
functions. In 1982, the computer ceases to perform energy conserving 
functions and begins to perform a production related function.
    (b) For 1981, a recapture determination is not required. For 1982, 
the entire energy credit must be recaptured, although none of the 
regular credit is recaptured. If in 1989 the computer first ceased to 
perform an energy conserving function, no part of the energy credit 
would be recaptured.
    Example 2. Assume the same facts and conclusion as in example 1. 
Assume further that X sells the computer in 1985. A recapture 
determination is required for the regular credit.
    Example 3. In 1981, corporation Y, a calendar year taxpayer, 
acquires and places in service recycling equipment. Assume the equipment 
has a 7-year useful life and qualifies for both the regular credit and 
energy credit. During the course of 1982, more than 10 percent of the 
material recycled is virgin material. The energy credit is recaptured in 
its entirety, although none of the regular credit is recaptured. See 
Sec.  1.48-9(g)(5)(B)(ii).
    Example 4. In 1980, corporation Z, a calendar year taxpayer, 
acquires and places in service a boiler the primary fuel for which is an 
alternate substance. The boiler has a 7-year useful life. Assume the 
boiler is a structural component of a building within the meaning of 
Sec.  1.48-1(e)(2). Assume further that the boiler is not a part of a 
qualified rehabilitated building (as defined in section 48(g)(1)) or a 
single purpose agricultural or horticultural structure (as defined in 
section 48(p)). Z is allowed only an energy credit since the boiler is a 
structural component of a building. In 1984, Z modifies the boiler to 
use oil as the primary fuel. A recapture determination is required for 
the energy credit. See Sec.  1.48-9(c)(3).

    (i)-(l) [Reserved]
    (m) Commuter highway vehicles--(1) Recomputed qualified investment. 
(i) If a qualifying commuter highway vehicle (as defined in Sec.  1.46-
11(a) undergoes a change in use but does not cease to be section 38 
property, qualified investment for that vehicle is recomputed as if the 
vehicle was section 38 property which is not a qualifying commuter 
highway vehicle for its entire useful life.
    (ii) The following example illustrates this paragraph (m)(1).

    Example. X Corporation, a calendar year taxpayer, acquired and 
placed in service on January 1, 1982, a qualifying commuter highway 
vehicle with a basis of $10,000 and which qualified as three year 
recovery property under section 168(c)(2)(A)(i). The amount of qualified 
investment for the vehicle under section 46(c) (1) and (6) is $10,000. 
For the taxable year 1982, X Corporation's credit earned was $1,000 (10 
percent of $10,000) and X Corporation was allowed under section 38 a 
$1,000 credit against its 1982 tax liability. During the taxable year 
1984, the vehicle undergoes a change in use but does not cease to be 
section 38 property. The vehicle is treated

[[Page 424]]

as section 38 property which is not a qualifying commuter highway 
vehicle for its entire useful life. The recomputed qualified investment 
for the vehicle is $6,000 (60 percent of $10,000) and X Corporation's 
recomputed credit earned is $600 (10 percent of $6,000). The income tax 
imposed by chapter 1 of the Code on X Corporation for 1984 is increased 
by the $400 decrease in its credit earned for 1982 ($1,000-$600).

    (2) Change in use--(i) A qualifying commuter highway vehicle 
undergoes a change in use if the vehicle does not meet the commuter use 
requirement (as defined in Sec.  1.46-11(d)) for each computation 
period.
    (ii) Each of the following is a computation period:
    (A) The period beginning on the date the vehicle was placed in 
service and ending on the last day of the taxpayer's taxable year in 
which the vehicle was placed in service;
    (B) Each of the taxpayer's taxable years beginning after the date 
the vehicle was placed in service and ending before the end of the first 
36 months after the vehicle was placed in service; and
    (C) The period ending at the end of the first 36 months after the 
vehicle was placed in service and beginning on the first day of the 
taxpayer's taxable year in which the end of those first 36 months falls.
    (iii) The following example illustrates this paragraph (m)(2).

    Example. (a) Z Corporation, a calendar year taxpayer, acquired and 
placed in service a qualifying commuter highway vehicle on January 15, 
1979. Z Corporation used the vehicle as set forth in the following 
table:

------------------------------------------------------------------------
                                           Total     Commuter
          Taxable year ending              miles       miles      Ratio
------------------------------------------------------------------------
1979...................................     10,000       9,000       .90
1980...................................     10,000       8,000       .80
1981...................................     10,000       8,000       .80
1982 (1-14)............................      1,000         100       .10
------------------------------------------------------------------------

    (b) The first computation period begins on the date the vehicle is 
placed in service, in this example 1-15-79, and ends 12-31-79. In that 
computation period, the ratio of commuter miles to total miles is .90 
(9,000 miles / 10,000 miles). Therefore, the vehicle meets the commuter 
use requirement for that period and has not undergone a change in use. 
Similar calculations for the computation periods 1-1-80 to 12-31-80 and 
1-1-81 to 12-31-81 produce the same result.
    (c) As of the computation period beginning 1-1-82 and ending 1-14-
82, the ratio of commuter use to total mileage is .10 (100 miles / 1,000 
miles). Since that ratio is less than .80, the vehicle does not meet the 
commuter use requirement for the period and the vehicle has undergone a 
change in use.

(Secs. 38(b) (76 Stat. 963, 26 U.S.C. 38(b)), 48(l)(16) (94 Stat. 264, 
26 U.S.C. 48(l)(16)), and 7805 (68A Stat. 917, 26 U.S.C. 7805))

[T.D. 6931, 32 FR 14027, Oct. 10, 1967, as amended by T.D. 7203, 37 FR 
17127, Aug. 25, 1972; T.D. 7765, 46 FR 7291, Jan. 23, 1981; T.D. 7982, 
49 FR 39541, Oct. 9, 1984; T.D. 8035, 50 FR 29370, July 19, 1985; T.D. 
8183, 53 FR 6625, Mar. 2, 1988; T.D. 8474, 58 FR 25557, Apr. 27, 1993]



Sec.  1.47-2  ``Disposition'' and ``cessation''.

    (a) General rule--(1) ``Disposition''. For purposes of this section 
and Sec.  1.47-1 and Sec. Sec.  1.47-3 through 1.47-6, the term 
``disposition'' includes a sale in a sale-and-leaseback transaction, a 
transfer upon the foreclosure of a security interest and a gift, but 
such term does not include a mere transfer of title to a creditor upon 
creation of a security interest. See paragraph (g) of Sec.  1.47-3 for 
treatment of certain sale-and-leaseback transactions.
    (2) ``Cessation''. (i) A determination of whether section 38 
property ceases to be section 38 property with respect to the taxpayer 
must be made for each taxable year subsequent to the credit year. Thus, 
in each such taxable year the taxpayer must determine, as if such 
property were placed in service in such taxable year, whether such 
property would qualify as section 38 property (within the meaning of 
Sec.  1.48-1) in the hands of the taxpayer for such taxable year.
    (ii) Section 38 property does not cease to be section 38 property 
with respect to the taxpayer in any taxable year subsequent to the 
credit year merely because under the taxpayer's depreciation practice no 
deduction for depreciation with respect to such property is allowable to 
the taxpayer for the taxable year, provided that the property continues 
to be used in the taxpayer's trade or business (or in the production of 
income) and otherwise qualifies as section 38 property with respect to 
the taxpayer.
    (iii) This subparagraph may be illustrated by the following 
examples:

    Example 1. A, an individual who makes his returns on the basis of 
the calendar year, on January 1, 1962, acquired and placed in service in 
his trade or business an item of section

[[Page 425]]

38 property with an estimated useful life of eight years. On January 1, 
1965, A removes the item of section 38 property from use in his trade or 
business by converting such item to personal use. Therefore no deduction 
for depreciation with respect to such item of property is allowable to A 
for the taxable year 1965. On January 1, 1965, such item of property 
ceases to be section 38 property with respect to A.
    Example 2. On January 1, 1965, A placed in service an item of 
section 38 property with a basis of $10,000 and an estimated useful life 
of 4 years. A depreciates such item, which has a salvage value of $2,000 
(after taking into account section 167(f)), on the declining balance 
method at a rate of 50 percent (that is, twice the straight line rate of 
25 percent). With respect to such item, A is allowed deductions for 
depreciation of $5,000 for 1965, $2,500 for 1966, and $500 for 1967. A 
is not allowed a deduction for depreciation for 1968 although he 
continues to use such item in his trade or business. Such item does not 
cease to be section 38 property with respect to A in 1968.

    (b) Leased property--(1) In general. For purposes of paragraph (a) 
of Sec.  1.47-1, generally the mere leasing of section 38 property by a 
lessor who took the basis of such property into account in computing his 
qualified investment for the credit year shall not be considered to be a 
disposition. However, in a case where a lease is treated as a sale for 
income tax purposes such transaction is considered to be a disposition. 
Leased section 38 property ceases to be section 38 property with respect 
to the lessor if, in any taxable year subsequent to the credit year, 
such property would not qualify as section 38 property (as defined in 
Sec.  1.48-1) in the hands of the lessor, the lessee, or any sublessee. 
Thus, if, in a taxable year subsequent to the credit year, a lessee uses 
the property predominantly outside the United States, such property 
shall be considered to have ceased to be section 38 property with 
respect to the lessor.
    (2) Where lessor elects to treat lessee as purchaser. For purposes 
of paragraph (a) of Sec.  1.47-1, if, under Sec.  1.48-4, the lessor of 
new section 38 property made a valid election to treat the lessee as 
having purchased such property for purposes of the credit allowed by 
section 38, the following rules apply in determining whether such 
property is disposed of, or otherwise ceases to be section 38 property 
with respect to the lessee:
    (i) Generally, a mere disposition by the lessor of property subject 
to a lease shall not be considered to be a disposition by the lessee.
    (ii) If the lessor makes a disposition of property subject to a 
lease to a person who may not, under Sec.  1.48-4, make a valid election 
to treat the lessee as having purchased such property for purposes of 
the credit allowed by section 38 (such as a person described in 
paragraph (a)(5) of Sec.  1.48-4), such property shall be considered to 
have ceased to be section 38 property with respect to the lessee on the 
date of such disposition.
    (iii) If a lease is terminated and the property is transferred by 
the lessee to the lessor or to any other person, such transfer shall be 
considered to be a disposition by the lessee.
    (iv) If the lessee actually purchases such property in the credit 
year or in a taxable year subsequent to the credit year, such purchase 
shall not be considered to be a disposition.
    (v) The property ceases to be section 38 property with respect to 
the lessee if in any taxable year subsequent to the credit year such 
property would not qualify as section 38 property (as defined in Sec.  
1.48-1) in the hands of the lessor, the lessee, or any sublessee. Thus, 
for example, if, in a taxable year subsequent to the credit year, a 
sublessee uses the property predominantly outside the United States, the 
property ceases to be section 38 property with respect to the lessee.
    (c) Reduction in basis of section 38 property--(1) General rule. If, 
in the credit year or in any taxable year subsequent to the credit year, 
the basis (or cost) of section 38 property is reduced, for example, as a 
result of a refund of part of the cost of the property, then such 
section 38 property shall be treated as having ceased to be section 38 
property with respect to the taxpayer to the extent of the amount of 
such reduction in basis (or cost) on the date the refund which results 
in such reduction in basis (or cost) is received or accrued, except that 
for purposes of Sec.  1.47-1(a) the actual useful life of the property 
treated as having ceased to be section 38 property shall be considered 
to be less than 3 years.

[[Page 426]]

    (2) Example. Subparagraph (1) of this paragraph may be illustrated 
by the following example:

    Example. (i) On January 1, 1962, A, a cash basis taxpayer, acquired 
from X Cooperative an item of section 38 property with a basis of $100 
and an estimated useful life of 10 years which he placed in service on 
such date. The amount of qualified investment with respect to such asset 
was $100. For the taxable year 1962 A was allowed under section 38 a 
credit of $7 against his liability for tax. On June 1, 1963, A receives 
a $10 patronage dividend from X Cooperative with respect to such asset. 
Under paragraph (c)(2)(i) of Sec.  1.1385-1, the basis of the asset in 
A's hands is reduced by $10.
    (ii) Under subparagraph (1) of this paragraph, on June 1, 1963, the 
item of section 38 property ceases to be section 38 property with 
respect to A to the extent of $10 of the original $100 basis.

    (d) Retirements. A retirement of section 38 property, including a 
normal retirement (as defined in paragraph (b) of Sec.  1.167(a)-8, 
relating to definition of normal and abnormal retirements), whether from 
a single asset account or a multiple asset account, and an abandonment, 
are dispositions for purposes of paragraph (a) of Sec.  1.47-1.
    (e) Conversion of section 38 property to personal use. (1) If, for 
any taxable year subsequent to the credit year--
    (i) A deduction for depreciation is allowable to the taxpayer with 
respect to only a part of section 38 property because such property is 
partially devoted to personal use, and
    (ii) The part of the property (expressed as a percentage of its 
total basis (or cost)) with respect to which a deduction for 
depreciation is allowable for such taxable year is less than the part of 
the property with respect to which a deduction for depreciation was 
allowable in the credit year,

then such property shall be considered as having ceased to be section 38 
property with respect to the taxpayer to such extent. Further, property 
ceases to be section 38 property with respect to the taxpayer to the 
extent that a deduction for depreciation thereon is disallowed under 
section 274 (relating to disallowance of certain entertainment, etc., 
expenses).
    (2) Examples. Subparagraph (1) of this paragraph may be illustrated 
by the following examples:

    Example 1. (i) A, a calendar-year taxpayer, acquired and placed in 
service on January 1, 1962, an automobile with a basis of $2,400 and an 
estimated useful life of four years. In the taxable year 1962 the 
automobile was used by A 80 percent of the time in his trade or business 
and was used 20 percent of the time for personal purposes. Thus, for the 
taxable year 1962 only 80 percent of the basis of the automobile 
qualified as section 38 property since a deduction for depreciation was 
allowable to A only with respect to 80 percent of the basis of the 
automobile. In the taxable year 1963 the automobile is used by A only 60 
percent of the time in his trade or business. Thus, for the taxable year 
1963 a deduction for depreciation is allowable to A only with respect to 
60 percent of the basis of the automobile.
    (ii) Under subparagraph (1) of this paragraph, on January 1, 1963, 
the automobile ceases to be section 38 property with respect to A to the 
extent of 20 percent (80 percent minus 60 percent) of the $2,400 basis 
of the automobile.
    Example 2. (i) The facts are the same as in example 1 and in 
addition for the taxable year 1964 a deduction for depreciation is 
allowable to A only with respect to 40 percent of the basis of the 
property.
    (ii) Under subparagraph (1) of this paragraph, on January 1, 1964, 
the automobile ceases to be section 38 property with respect to A to the 
extent of 20 percent (60 percent minus 40 percent) of the $2,400 basis 
of the automobile.

[T.D. 6931, 32 FR 14032, Oct. 10, 1967, as amended by T.D. 7203, 37 FR 
17128, Aug. 25, 1972]



Sec.  1.47-3  Exceptions to the application of Sec.  1.47-1.

    (a) In general. Notwithstanding the provisions of Sec.  1.47-2, 
relating to ``disposition'' and ``cessation,'' paragraph (a) of Sec.  
1.47-1 shall not apply if paragraph (b) of this section (relating to 
transfers by reason of death), paragraph (c) of this section (relating 
to property destroyed by casualty), paragraph (d) of this section 
(relating to reselection of used section 38 property), paragraph (e) of 
this section (relating to transactions to which section 381(a) applies), 
paragraph (f) of this section (relating to mere change in form of 
conducting a trade or business), paragraph (g) of this section (relating 
to sale-and-leaseback transactions), or paragraph (h) of this section 
(relating to certain property replaced after Apr. 18, 1969) applies with 
respect to such disposition or cessation.

[[Page 427]]

    (b) Transfers by reason of death--(1) General rule. Notwithstanding 
the provisions of Sec.  1.47-2, relating to ``disposition'' and 
``cessation'', paragraph (a) of Sec.  1.47-1 shall not apply to a 
transfer of section 38 property by reason of the death of the taxpayer. 
Thus, for example, with respect to section 38 property held in joint 
tenancy, paragraph (a) of Sec.  1.47-1 shall not apply to the transfer 
of the deceased taxpayer's interest to the surviving joint tenant. If, 
under Sec.  1.48-4, the lessor of new section 38 property made a valid 
election to treat the lessee as having purchased such property for 
purposes of the credit allowed by section 38, paragraph (a) of Sec.  
1.47-1 does not apply if, by reason of the death of the lessee, there is 
a termination of the lease and transfer of the leased property to the 
lessor, or there is an assignment of the lease and transfer of the 
leased property to another person. Moreover, paragraph (a) of Sec.  
1.47-1 does not apply to the transfer of a partner's interest in a 
partnership, a beneficiary's interest in an estate or trust, or shares 
of stock of a shareholder of an electing small business corporation (as 
defined in section 1371(b)) by reason of the death of such partner, 
beneficiary, or shareholder. Paragraph (a) of Sec.  1.47-1 shall not 
apply to property prior to his death even if the value of such gift is 
included in his gross estate for estate tax purposes (such as, a gift in 
contemplation of death under section 2035). The effect of this 
subparagraph is that any section 38 property held by a taxpayer at the 
time of his death is deemed to have been held by him for its entire 
estimated useful life.
    (2) Examples. Subparagraph (1) of this paragraph may be illustrated 
by the following examples:

    Example 1. (i) A, an individual, acquired and placed in service on 
January 1, 1962, an item of section 38 property with a basis of $10,000 
and an estimated useful life of eight years. On April 28, 1963, A dies 
and, as a result of A's death, his interest in such item of section 38 
property is transferred to a testamentary trust pursuant to A's will, 
and on February 1, 1967, the trust is terminated and the item of section 
38 property is transferred to the beneficiaries of the trust.
    (ii) Under subparagraph (1) of this paragraph, paragraph (a) of 
Sec.  1.47-1 does not apply to the transfer, as a result of A's death, 
of his interest in such item of section 38 property to the testamentary 
trust. Moreover, paragraph (a) of Sec.  1.47-1 does not apply to the 
February 1, 1967, transfer of such item of section 38 property by the 
trust to its beneficiaries.
    Example 2. (i) X Corporation, an electing small business corporation 
(as defined in section 1371(b)) which makes its returns on the basis of 
a calendar year, acquired and placed in service during 1962 an item of 
section 38 property. On December 31, 1962, X Corporation had 10 shares 
of stock outstanding which were owned as follows: A owned eight shares 
and B owned two shares. On December 31, 1962, 80 percent of the basis of 
the item of section 38 property was apportioned to A and 20 percent to 
B. On June 1, 1964, A dies and, as a result of A's death, his eight 
shares of stock in X Corporation are transferred to his wife. On July 
10, 1965, X Corporation sells the item of section 38 property to Y 
Corporation.
    (ii) Under subparagraph (1) of this paragraph, paragraph (a) of 
Sec.  1.47-1 does not apply to the transfer, as a result of A's death, 
of his eight shares of stock in X Corporation to his wife. Moreover, 
with respect to the July 10, 1965, sale paragraph (a) of Sec.  1.47-1 
applies only to the 20 percent of the basis of the item of section 38 
property which was apportioned to B.

    (c) Property destroyed by casualty--(1) Dispositions after April 18, 
1969. Notwithstanding the provisions of Sec.  1.47-2, relating to 
``disposition'' and ``cessation'', paragraph (a) of Sec.  1.47-1 shall 
not apply to property which, after April 18, 1969, and before August 16, 
1971, is disposed of or otherwise ceases to be section 38 property with 
respect to the taxpayer on account of its destruction or damage by fire, 
storm, shipwreck, or other casualty, or by reason of its theft.
    (2) Dispositions before April 19, 1969. (i) In the case of property 
which, before April 19, 1969, is disposed of or otherwise ceases to be 
section 38 property with respect to the taxpayer on account of its 
destruction or damage by fire, storm, shipwreck or other casualty, or by 
reason of its theft, paragraph (a) of Sec.  1.47-1 shall apply except to 
the extent provided in subdivisions (ii) and (iii) of this subparagraph.
    (ii) Paragraph (a) of Sec.  1.47-1 shall not apply if--
    (a) Section 38 property is placed in service by the taxpayer to 
replace (within the meaning of paragraph (h) of Sec.  1.46-3) the 
destroyed, damaged, or stolen property, and

[[Page 428]]

    (b) The basis (or cost) of the section 38 property which is placed 
in service by the taxpayer to replace the destroyed, damaged, or stolen 
property is reduced under paragraph (h) of Sec.  1.46-3.
    (iii) If property which would be section 38 property but for section 
49 is placed in service by the taxpayer to replace the destroyed, 
damaged, or stolen property, then the provisions of paragraph (h) of 
this section (other than the requirement that the replacement take place 
within 6 months after the disposition) shall apply.
    (3) Examples. The provisions of subparagraph (2)(ii) of this 
paragraph may be illustrated by the following examples:

    Example 1. (i) A acquired and placed in service on January 1, 1962, 
machine No. 1 which qualified as section 38 property with a basis of 
$30,000 and an estimated useful life of 6 years. The amount of qualified 
investment with respect to such machine was $20,000. For the taxable 
year 1962 A's credit earned of $1,400 was allowed under section 38 as a 
credit against its liability for tax. On January 1, 1963, machine No. 1 
is completely destroyed by fire. On January 1, 1963, the adjusted basis 
of machine No. 1 in A's hands is $24,500. A receives $23,000 in 
insurance proceeds as compensation for the destroyed machine, and on 
February 15, 1964, A acquires and places in service machine No. 2, which 
qualifies as section 38 property, with a basis of $41,000 and an 
estimated useful life of 6 years to replace machine No. 1.
    (ii) Under subparagraph (1) of this paragraph, paragraph (a) of 
Sec.  1.47-1 does not apply with respect to machine No. 1 since machine 
No. 2 is placed in service to replace machine No. 1 and the $41,000 
basis of machine No. 2 is reduced, under paragraph (h) of Sec.  1.46-3, 
by $23,000. (See example 1 of paragraph (h)(3) of Sec.  1.46-3.)
    Example 2. (i) The facts are the same as in example 1 except that A 
receives only $19,000 in insurance proceeds as compensation for the 
destroyed machine.
    (ii) Although machine No. 2 is placed in service to replace machine 
No. 1, subparagraph (1) of this paragraph does not apply with respect to 
machine No. 1 since the basis of machine No. 2 is not reduced under 
paragraph (h) of Sec.  1.46-3. Paragraph (a) of Sec.  1.47-1 applies 
with respect to the January 1, 1963, destruction of machine No. 1. The 
actual useful life of machine No. 1 is 1 year. The recomputed qualified 
investment with respect to such machine is zero ($30,000 basis 
multiplied by zero applicable percentage) and A's recomputed credit 
earned for the taxable year 1962 is zero. The income tax imposed by 
chapter 1 of the Code on A for the taxable year 1963 is increased by 
$1,400.

    (d) Reselection of used section 38 property--(1) Reselection. If--
    (i) Used section 38 property (as defined in Sec.  1.48-3) the cost 
of which was taken into account in computing the taxpayer's qualified 
investment is disposed of, or otherwise ceases to be section 38 property 
with respect to the taxpayer, before the close of the estimated useful 
life which was taken into account in computing such qualified 
investment, and
    (ii) For the taxable year in which the property described in 
subdivision (i) of this subparagraph was placed in service, the sum of 
(a) the cost of used section 38 property placed in service by the 
taxpayer, and (b) the cost of used section 38 property apportioned to 
such taxpayer exceeded $50,000,

then such taxpayer may treat the cost of any used section 38 property 
(regardless of its estimated useful life) which was not originally 
selected, under paragraph (c)(4) of Sec.  1.48-3, to be taken into 
account in computing qualified investment for such taxable year (or 
previously reselected under this subparagraph) as having been selected 
(in accordance with the principles of paragraph (c)(4)(ii) of Sec.  
1.48-3) in place of the cost of the used section 38 property described 
in subdivision (i) of this subparagraph. Hereinafter such reselected 
property is referred to as ``newly selected used section 38 property''. 
For purposes of this subparagraph, the cost of used section 38 property 
apportioned to a taxpayer means the sum of the cost of used section 38 
property apportioned to him by a trust, estate, or electing small 
business corporation (as defined in section 1371(b)), and his share of 
the cost of partnership used section 38 property, with respect to the 
taxable year of such trust, estate, corporation or partnership ending 
with or within such taxpayer's taxable year. In the case of a taxpayer 
to whom paragraph (c)(2) of Sec.  1.48-3 applied for the taxable year in 
which the property described in subdivision (i) of this subparagraph was 
placed in service, a $25,000 amount shall be substituted for the $50,000 
amount referred to in subdivision (ii)(b) of this subparagraph,

[[Page 429]]

and in the case of a member of an affiliated group (as defined in 
subparagraph (6) of Sec.  1.48-3(e)) the amount apportioned to such 
member under paragraph (e) of Sec.  1.48-3 shall be substituted for such 
$50,000 amount.
    (2) Application of paragraph (a) of Sec.  1.47-1. (i) If a taxpayer 
treats, under subparagraph (1) of this paragraph, the cost of any used 
section 38 property which was not originally selected as having been 
selected in place of the cost of used section 38 property described in 
subparagraph (1)(i) of this paragraph, then, not withstanding the 
provisions of Sec.  1.47-2 (relating to ``disposition'' and 
``cessation''), paragraph (a) of Sec.  1.47-1 shall not apply to the 
property described in subparagraph (1)(i) of this paragraph to the 
extent of the cost of the newly selected used section 38 property.
    (ii) If the cost of the used section 38 property described in 
subparagraph (1)(i) of this paragraph exceeds the cost of the newly 
selected used section 38 property, then the property described in 
subparagraph (1)(i) of this paragraph shall cease to be section 38 
property with respect to the taxpayer to the extent of such excess.
    (iii) If the newly selected used section 38 property is disposed of, 
or otherwise ceases to be section 38 property with respect to the 
taxpayer, before the close of the estimated useful life of the property 
described in subparagraph (1)(i) of this paragraph, then, unless he 
reselects other used section 38 property, paragraph (a) of Sec.  1.47-1 
shall apply with respect to such newly selected used section 38 
property. For purposes of recomputing qualified investment with respect 
to such newly selected used section 38 property the actual useful life 
shall be deemed to be the period beginning with the date on which the 
property described in subparagraph (1)(i) of this paragraph was placed 
in service by the taxpayer and ending with the date of the disposition 
or cessation with respect to such newly selected used section 38 
property. See paragraph (c) of Sec.  1.47-1, relating to date placed in 
service and date of disposition or cessation.
    (3) Information requirement. (i) If in any taxable year this 
paragraph applies to a taxpayer, such taxpayer shall attach to his 
income tax return for such taxable year a statement containing the 
information required by subdivision (ii) of this subparagraph.
    (ii) The statement referred to in subdivision (i) of this 
subparagraph shall contain the following information:
    (a) The taxpayer's name, address and taxpayer account number; and
    (b) With respect to the originally selected used section 38 property 
and the newly selected used section 38 property, the month and year 
placed in service, cost, and estimated useful life.
    (4) Examples. This paragraph may be illustrated by the following 
examples:

    Example 1. (i) X Corporation purchased and placed in service on 
January 1, 1962, machines No. 1 and No. 2, which qualified as used 
section 38 property, each with a cost of $50,000 and an estimated useful 
life of eight years. The aggregate cost of used section 38 property 
taken into account by X Corporation in computing its qualified 
investment for the taxable year 1962 could not exceed $50,000; 
therefore, under paragraph (c)(4) of Sec.  1.48-3, X selected the 
$50,000 cost of machine No. 1 to be taken into account in computing its 
qualified investment for the taxable year 1962. The qualified investment 
with respect to machine No. 1 was $50,000. For the taxable year 1962 X's 
credit earned of $3,500 was allowed under section 38 as a credit against 
its liability for tax. On January 2, 1965, X Corporation sells machine 
No. 1 to Y Corporation.
    (ii) Under subparagraph (1) of this paragraph, X Corporation treats 
the $50,000 cost of machine No. 2 as having been selected to be taken 
into account in computing its qualified investment for the taxable year 
1962 in place of the $50,000 cost of machine No. 1. Therefore, under 
subparagraph (2)(i) of this paragraph, paragraph (a) of Sec.  1.47-1 
does not apply to the January 2, 1965, disposition of machine No. 1.
    Example 2. (i) The facts are the same as in example 1 and in 
addition X Corporation, on December 2, 1966, sells machine No. 2 to Z 
Corporation.
    (ii) Under subparagraph (2)(iii) of this paragraph, paragraph (a) of 
Sec.  1.47-1 applies with respect to the December 2, 1966, disposition 
of machine No. 2. The actual useful life of machine No. 2 is four years 
and eleven months (that is, the period beginning on January 1, 1962, and 
ending on December 2, 1966). The recomputed qualified investment with 
respect to machine No. 2 is $16,667 ($50,000 cost multiplied by 33\1/3\ 
percent applicable percentage) and X Corporation's recomputed credit 
earned for the taxable year 1962 is $1,167. The income tax imposed by 
chapter 1 of the Code on X Corporation for

[[Page 430]]

the taxable year 1966 is increased by the $2,333 decrease in its credit 
earned for the taxable year 1962 (that is, $3,500 original credit earned 
minus $1,167 recomputed credit earned).
    Example 3. (i) The facts are the same as in example 1 except that 
machine No. 2 had a cost of $30,000.
    (ii) Under subparagraph (1) of this paragraph, X Corporation treats 
the $30,000 cost of machine No. 2 as having been selected to be taken 
into account in computing its qualified investment for the taxable year 
1962 in place of the $50,000 cost of machine No. 1. Therefore, under 
subparagraph (2)(i) of this paragraph, paragraph (a) of Sec.  1.47-1 
does not apply to the January 2, 1965, disposition of machine No. 1 to 
the extent of $30,000 of the $50,000 cost of machine No. 1. However, 
under subparagraph (2)(ii) of this paragraph, paragraph (a) of Sec.  
1.47-1 applies to the January 2, 1965, disposition of machine No. 1 to 
the extent of $20,000 (that is, $50,000 cost of machine No. 1 minus 
$30,000 cost of machine No. 2). The actual useful life of such $20,000 
portion of machine No. 1 is three years (that is, the period beginning 
on January 1, 1962, and ending on January 2, 1965). The recomputed 
qualified investment with respect to the $20,000 portion of the cost of 
machine No. 1 is zero ($20,000 portion of the cost multiplied by zero 
applicable percentage) and X Corporation's recomputed credit earned for 
the taxable year 1962 is $2,100 (7 percent of $30,000). The income tax 
imposed by chapter 1 of the Code on X Corporation for the taxable year 
1965 is increased by the $1,400 decrease in its credit earned for the 
taxable year 1962 (that is, $3,500 original credit earned minus $2,100 
recomputed credit earned).

    (e) Transactions to which section 381(a) applies--(1) General rule. 
Notwithstanding the provisions of Sec.  1.47-2, relating to 
``disposition'' and ``cessation'', paragraph (a) of Sec.  1.47-1 shall 
not apply to a disposition of section 38 property in a transaction to 
which section 381(a) (relating to carryovers in certain corporate 
acquisitions) applies. If the section 38 property described in the 
preceding sentence is disposed of, or otherwise ceases to be section 38 
property with respect to the acquiring corporation, before the close of 
the estimated useful life which was taken into account in computing the 
transferor corporation's qualified investment, then paragraph (a) of 
Sec.  1.47-1 shall apply to the acquiring corporation with respect to 
such section 38 property. For purposes of recomputing qualified 
investment with respect to such property its actual useful life shall be 
the period beginning with the date on which it was placed in service by 
the transferor corporation and ending with the date of the disposition 
by, or cessation with respect to, the acquiring corporation.
    (2) Examples. This paragraph may be illustrated by the following 
examples:

    Example 1. (i) X Corporation, a wholly owned subsidiary of Y 
Corporation, acquired and placed in service on January 1, 1962, an item 
of section 38 property with a basis of $12,000 and an estimated useful 
life of eight years. Both X and Y make their returns on the basis of a 
calendar year. The qualified investment with respect to such item was 
$12,000. For the taxable year 1962 X Corporation's credit earned of $840 
was allowed under section 38 as a credit against its liability for tax. 
On January 15, 1967, X Corporation is liquidated under section 332 and 
all of its properties, including the item of section 38 property, are 
transferred to Y Corporation. The bases of the properties in the hands 
of Y Corporation are determined under section 334(b)(1).
    (ii) Under subparagraph (1) of this paragraph, paragraph (a) of 
Sec.  1.47-1 does not apply to the January 15, 1967, transfer to Y 
Corporation.
    Example 2. (i) The facts are the same as in example 1 and in 
addition on February 2, 1968, Y Corporation sells the item of section 38 
property to Z Corporation.
    (ii) Under subparagraph (1) of this paragraph, paragraph (a) of 
Sec.  1.47-1 does not apply to the January 15, 1967, transfer to Y 
Corporation. However, paragraph (a) of Sec.  1.47 applies to the 
February 2, 1968, sale of the property by Y Corporation. The actual 
useful life of the property is six years and one month (that is, the 
period beginning on January 1, 1962, and ending on February 2, 1968).

    (f) Mere change in form of conducting a trade or business--(1) 
General rule. (i) Notwithstanding the provisions of Sec.  1.47-2, 
relating to ``disposition'' and ``cessation'', paragraph (a) of Sec.  
1.47-1 shall not apply to section 38 property which is disposed of, or 
otherwise ceases to be section 38 property with respect to the taxpayer, 
before the close of the estimated useful life which was taken into 
account in computing the taxpayer's qualified investment by reason of a 
mere change in the form of conducting the trade or business in which 
such section 38 property is used provided that the conditions set forth 
in subdivision (ii) of this subparagraph are satisfied.

[[Page 431]]

    (ii) The conditions referred to in subdivision (i) of this 
subparagraph are as follows:
    (a) The section 38 property described in subdivision (i) of this 
subparagraph is retained as section 38 property in the same trade or 
business,
    (b) The transferor (or in a case where the transferor is a 
partnership, estate, trust, or electing small business corporation, the 
partner, beneficiary, or shareholder) of such section 38 property 
retains a substantial interest in such trade or business,
    (c) Substantially all the assets (whether or not section 38 
property) necessary to operate such trade or business are transferred to 
the transferee to whom such section 38 property is transferred, and
    (d) The basis of such section 38 property in the hands of the 
transferee is determined in whole or in part by reference to the basis 
of such section 38 property in the hands of the transferor. This 
subparagraph shall not apply to the transfer of section 38 property if 
paragraph (e) of this section, relating to transactions to which section 
381 applies, applies with respect to such transfer.
    (2) Substantial interest. For purposes of this paragraph, a 
transferor (or in a case where the transferor is a partnership, estate, 
trust, or electing small business corporation, the partner, beneficiary, 
or shareholder) shall be considered as having retained a substantial 
interest in the trade or business only if, after the change in form, his 
interest in such trade or business--
    (i) Is substantial in relation to the total interest of all persons, 
or
    (ii) Is equal to or greater than his interest prior to the change in 
form.

Thus, where a taxpayer owns a 5-percent interest in a partnership, and, 
after the incorporation of that partnership, the taxpayer retains at 
least a 5-percent interest in the corporation, the taxpayer will be 
considered as having retained a substantial interest in the trade or 
business as of the date of the change in form.
    (3) Property held for the production of income. Subparagraph (1)(i) 
of this paragraph applies to section 38 property held for the production 
of income (within the meaning of section 167(a)(2)) as well as to 
section 38 property used in a trade or business.
    (4) Leased property. In a case where a lessor of new section 38 
property made a valid election, under Sec.  1.48-4, to treat the lessee 
as having purchased such property for purposes of the credit allowed by 
section 38, in determining whether subparagraph (1)(i) of this paragraph 
applies to an assignment of the lease and transfer of possession of such 
property, the condition contained in subparagraph (1)(ii)(d) of this 
paragraph is not applicable.
    (5) Disposition or cessation. (i) If section 38 property described 
in subparagraph (1)(i) of this paragraph is disposed of by the 
transferee, or otherwise ceases to be section 38 property with respect 
to the transferee, before the close of the estimated useful life which 
was taken into account in computing the qualified investment of the 
transferor (or in a case where the transferor is a partnership, estate, 
trust, or electing small business corporation, the qualified investment 
of the partners, beneficiaries, or shareholders) then under paragraph 
(a) of Sec.  1.47-1 such property ceases to be section 38 property with 
respect to the transferor (or such partners, beneficiaries, or 
shareholders), and a recapture determination shall be made with respect 
to such property. For purposes of recomputing qualified investment with 
respect to such property, the actual useful life shall be the period 
beginning with the date on which it was placed in service by the 
transferor and ending with the date of the disposition by, or cessation 
with respect to, the transferee.
    (ii) If in any taxable year the transferor (or in a case where the 
transferor is a partnership, estate, trust, or electing small business 
corporation, the partner, beneficiary, or shareholder) of the section 38 
property described in subparagraph (1)(i) of this paragraph does not 
retain a substantial interest in the trade or business directly or 
indirectly (through ownership in other entities provided that such other 
entities' bases in such interest are determined in whole or in part by 
reference to the basis of such interest in the hands of the transferor) 
then, under paragraph (a) of Sec.  1.47-1, such property ceases to be 
section 38 property with

[[Page 432]]

respect to the transferor and he (or the partner, beneficiary, or 
shareholder) shall make a recapture determination. For purposes of 
recomputing qualified investment with respect to property described in 
this subdivision, its actual useful life shall be the period beginning 
with the date on which it was placed in service by the transferor and 
ending with the first date on which the transferor (or the partner, 
beneficiary, or shareholder) does not retain a substantial interest in 
the trade or business. Any taxpayer who seeks to establish his interest 
in a trade or business under the rule of this subdivision shall maintain 
adequate records to demonstrate his indirect interest in such trade or 
business after any such transfer or transfers.
    (iii) In making a recapture determination under this subparagraph 
there shall be taken into account any prior recapture determinations 
with respect to the transferor in connection with the same property.
    (iv) Notwithstanding subparagraph (1) of this paragraph and 
subdivision (ii) of this subparagraph in the case of a mere change in 
the form of a trade or business, if the interest of a taxpayer in the 
trade or business is reduced but such taxpayer has retained a 
substantial interest in such trade or business, paragraph (a)(2) of 
Sec.  1.47-4 (relating to electing small business corporations), 
paragraph (a)(2) of Sec.  1.47-5 (relating to estates or trusts) or 
paragraph (a)(2) of Sec.  1.47-6 (relating to partnerships) shall apply, 
as the case may be.
    (6) Examples. This paragraph may be illustrated by the following 
examples in each of which it is assumed that the transfer satisfies the 
conditions of subparagraphs (1)(ii) (a), (c), and (d) of this paragraph.

    Example 1. (i) On January 1, 1962, A, an individual, acquired and 
placed in service in his sole proprietorship an item of section 38 
property with a basis of $12,000 and an estimated useful life of eight 
years. The qualified investment with respect to such item was $12,000. 
For the taxable year 1962 A's credit earned of $840 was allowed under 
section 38 as a credit against his liability for tax. On March 15, 1963, 
A transfers all of the assets used in his sole proprietorship to X 
Corporation, a newly formed corporation, in exchange for 45 percent of 
the stock of X Corporation.
    (ii) Under subparagraph (1)(i) of this paragraph, paragraph (a) of 
Sec.  1.47-1 does not apply to the March 15, 1963, transfer to X 
Corporation.
    Example 2. (i) The facts are the same as in example 1 and in 
addition on February 2, 1964, X Corporation sells the item of section 38 
property to Y Corporation.
    (ii) Under subparagraph (1)(i) of this paragraph, paragraph (a) of 
Sec.  1.47-1 does not apply to the March 15, 1963, transfer to X 
Corporation. However, under subparagraph (5)(i) of this paragraph, 
paragraph (a) of Sec.  1.47-1 applies to the February 2, 1964, sale of 
the item of section 38 property by X Corporation to Y Corporation. The 
actual useful life of the property is two years and one month (that is, 
the period beginning on January 1, 1962, and ending on February 2, 
1964). The recomputed qualified investment with respect to such property 
is zero ($12,000 basis multiplied by zero applicable percentage) and A's 
recomputed credit earned for the taxable year 1962 is zero. The income 
tax imposed by chapter 1 of the Code on A for 1964 is increased by the 
$840 decrease in his credit earned for the taxable year 1962 (that is, 
$840 credit earned minus zero recomputed credit earned).
    Example 3. (i) On January 1, 1962, partnership ABC, which makes its 
returns on the basis of a calendar year, acquired and placed in service 
on item of section 38 property with a basis of $20,000 and an estimated 
useful life of eight years. Partnership ABC has 10 partners who make 
their returns on the basis of a calendar year and share partnership 
profits equally. Each partner's share of the basis of such item of 
section 38 property is 10 percent, that is, $2,000. On March 15, 1963, 
partnership ABC transfers all of the assets used in its trade or 
business to the X Corporation, a newly formed corporation, in exchange 
for all of the stock of X Corporation and immediately thereafter 
transfers 10 percent of such stock to each of the 10 partners.
    (ii) Under subparagraph (1)(i) of this paragraph, paragraph (a) of 
Sec.  1.47-1 does not apply to the March 15, 1963 transfer by the ABC 
Partnership to X Corporation.
    Example 4. (i) The facts are the same as in example 3 except that 
partnership ABC transfers 10 percent of the stock in X Corporation to 
each of 8 partners, 20 percent to partner A, and cash to partner B.
    (ii) Under subparagraph (1)(i) of this paragraph, with respect to 
all of the partners (including partner A) except partner B, paragraph 
(a) of Sec.  1.47-1 does not apply to the March 15, 1963, transfer by 
the ABC Partnership to X Corporation. Paragraph (a) of Sec.  1.47-1 
applies with respect to partner B's $2,000 share of the item of section 
38 property. See paragraph (a)(1) of Sec.  1.47-6.
    Example 5. (i) X Corporation operates a manufacturing business and a 
separate personal service business. On January 1, 1962, X acquired and 
placed in service a truck, which

[[Page 433]]

qualified as section 38 property, in its manufacturing business. The 
truck had a basis of $10,000 and an estimated useful life of 8 years. On 
February 10, 1965, X transfers all the assets used in its manufacturing 
business to Partnership XY in exchange for a 50-percent interest in such 
partnership.
    (ii) Under subparagraph (1)(i) of this paragraph, paragraph (a) of 
Sec.  1.47-1 does not apply to the February 10, 1965, transfer to 
Partnership XY.

    (g) Sale-and-leaseback transactions--(1) In general. Notwithstanding 
the provisions of Sec.  1.47-2, relating to ``disposition'' and 
``cessation'', paragraph (a) of Sec.  1.47-1 shall not apply where 
section 38 property is disposed of and as part of the same transaction 
is leased back to the vendor even though gain or loss is recognized to 
the vendor-lessee and the property ceases to be subject to depreciation 
in his hands. If paragraph (a) of Sec.  1.47-1 applies with respect to 
such property subsequent to the transaction, the actual useful life 
shall begin with the date on which such property was first placed in 
service by the vendor-lessee as owner.
    (2) Special rule for progress expenditure property. The sale and 
leaseback (or agreement or contract to leaseback) of progress 
expenditure property (including any contract rights to the property), in 
general, will be treated as a cessation described in section 47(a)(3)(A) 
with respect to the seller-lessee. However, a sale and leaseback (or 
agreement or contract to leaseback) will not be treated as a cessation 
to the extent qualified investment passed through to the lessee under 
section 48(d) in the year the property is placed in service equals or 
exceeds qualified progress expenditures for the property taken into 
account by the lessee. If a sale-leaseback transaction is treated as a 
cessation, qualified investment must be reduced and the credit 
recomputed, beginning with the most recent credit year (i.e., the most 
recent year property is taken into account in computing qualified 
investment under Sec.  1.46-3 or 1.46-5). The amount of the reduction is 
the amount, if any, by which qualified progress expenditures taken into 
account by the lessee in all prior years exceeds qualified investment 
passed through to the lessee under section 48(d). This paragraph (g)(2) 
does not apply to any progress expenditure property that has been placed 
in service by a vendor-lessee (as described in paragraph (g)(1) of this 
section) prior to a sale-leaseback of that property in a transaction 
described in paragraph (g)(1) of this section.
    (h) Certain property replaced after April 18, 1969--(1) In general. 
(i) If section 38 property is disposed of and property which is, for 
purposes of section 1033 and the regulations thereunder, similar or 
related in service or use to the property disposed of and which would be 
section 38 property but for the application of section 49 is placed in 
service to replace the property disposed of, the increase in income tax 
and adjustment of investment credit carryovers and carrybacks resulting 
from the recomputation under paragraph (a) of Sec.  1.47-1 shall be 
reduced (but not below zero) by the credit that would be allowed for the 
qualified investment of the replacement property (determined as if such 
property were section 38 property). The preceding sentence shall not 
apply unless the replacement takes place within 6 months after the 
disposition. If property otherwise qualifies as replacement property, it 
is immaterial that it is placed in service (for example, to undergo 
testing) before the replaced property is disposed of. The assignment by 
the taxpayer in his return of an estimated useful life to the 
replacement property in computing its qualified investment will be 
considered a representation by the taxpayer that he expects to retain 
the replacement property for its entire estimated useful life. If such 
property is disposed of before the end of such life, then the 
circumstances surrounding the replacement will be examined to determine 
whether the taxpayer's representation was in good faith and, if 
appropriate, the qualified investment of the replacement property will 
be recomputed for the year of replacement using the actual useful life 
of such property.
    (ii) The provisions of subdivision (i) of this subparagraph may be 
illustrated by the following example:

    Example. On January 1, 1967, A, a calendar year taxpayer, acquired 
and placed in service a new machine with a basis of $100 and an 
estimated useful life of 8 years. A's qualified investment was $100 and 
his credit earned was $7, which was allowed as a credit against

[[Page 434]]

tax for 1967. On January 15, 1971. A disposed of the machine and 
replaced it with a similar new machine costing $75 and having an 
estimated useful life of 8 years. The new machine would be section 38 
property but for section 49. Since the actual useful life of the 
original machine was at least 4 but less than 6 years, the recomputed 
qualified investment of the machine is $33.33 (33\1/3\ percent of $100) 
and under paragraph (a) of Sec.  1.47-1 the amount of recapture tax 
would be $4.67 ($7, the original credit earned, minus $2.33, the 
recomputed credit earned). However, under the provisions of this 
paragraph, the recapture tax is reduced (but not below zero) by the 
credit that would be allowed for the replacement property (determined as 
if such property were section 38 property). Under these facts the 
recapture tax is zero ($4.67, the recapture tax with respect to the 
original machine, minus $5.25, the credit that would be allowed on the 
new machine).

    (2) Leased property. Property disposed of may be replaced with 
property leased from another, provided (i) an election with respect to 
the newly leased property could be made under section 48(d) but for 
section 49, and (ii) the lessee obtains the lessor's written statement 
that he will not claim such property as replacement property under this 
paragraph. The statement of the lessor shall contain the information 
specified in subdivisions (i) through (vii) of Sec.  1.48-4(f)(1) and 
the statement (or a copy thereof) shall be retained in the records of 
the lessor and the lessee for a period of at least 3 years after the 
property is transferred to the lessee.

[T.D. 6931, 32 FR 14033, Oct. 10, 1967, as amended by T.D. 7126, 36 FR 
11192, June 10, 1971; T.D. 7203; 37 FR 17128, Aug. 25, 1972; T.D. 8183, 
53 FR 6625, Mar. 2, 1988]



Sec.  1.47-4  Electing small business corporation.

    (a) In general--(1) Disposition or cessation in hands of 
corporation. If an electing small business corporation (as defined in 
section 1371(b)) or a former electing small business corporation 
disposes of any section 38 property (or if any section 38 property 
otherwise ceases to be section 38 property in the hands of the 
corporation) before the close of the estimated useful life which was 
taken into account in computing qualified investment with respect to 
such property, a recapture determination shall be made with respect to 
each shareholder who is treated, under Sec.  1.48-5, as a taxpayer with 
respect to such property. Each such recapture determination shall be 
made with respect to the pro rata share of the basis (or cost) of such 
property taken into account by such shareholder in computing his 
qualified investment. For purposes of each such recapture determination 
the actual useful life of such property shall be the period beginning 
with the date on which it was placed in service by the electing small 
business corporation and ending with the date of the disposition or 
cessation. In making a recapture determination under this subparagraph 
there shall be taken into account any prior recapture determinations 
made with respect to the shareholder in connection with the same 
property. For definition of ``recapture determination'' see paragraph 
(a)(1) of Sec.  1.47-1.
    (2) Disposition of shareholder's interest. (i) If--
    (a) The basis (or cost) of section 38 property is apportioned, under 
Sec.  1.48-5, to a shareholder of an electing small business corporation 
who takes such basis (or cost) into account in computing his qualified 
investment, and
    (b) After the end of the shareholder's taxable year in which such 
apportionment was taken into account and before the close of the 
estimated useful life of the property, such shareholder's proportionate 
stock interest in such corporation is reduced (for example, by a sale or 
redemption, or by the issuance of additional shares) below the 
percentage specified in subdivision (ii) of this subparagraph,

then, on the date of such reduction such section 38 property ceases to 
be section 38 property with respect to such shareholder to the extent of 
the actual reduction in such shareholder's proportionate stock interest. 
(For example, if $100 of the basis of section 38 property was 
apportioned to a shareholder and if his proportionate stock interest is 
reduced from 60 percent to 30 percent (that is, 50 percent of his 
original interest), then such property shall be treated as having ceased 
to be section 38 property to the extent of $50.) Accordingly, a 
recapture determination shall be made with respect to such shareholder. 
For purposes of such

[[Page 435]]

recapture determination the actual useful life of such property shall be 
the period beginning with the date on which it was placed in service by 
the electing small business corporation and ending with the date on 
which it is treated as having ceased to be section 38 property with 
respect to the shareholder. In making a recapture determination under 
this subparagraph there shall be taken into account any prior recapture 
determination made with respect to the shareholder in connection with 
the same property.
    (ii) The percentage referred to in subdivision (i)(b) of this 
subparagraph is 66\2/3\ percent of the shareholder's proportionate stock 
interest in the corporation on the date of the apportionment under Sec.  
1.48-5. However, once property has been treated under this subparagraph 
as having ceased to be section 38 property to any extent the percentage 
referred to shall be 33\1/3\ percent of the shareholder's proportionate 
stock interest in the corporation on the date of the apportionment under 
Sec.  1.48-5.
    (iii) In determining a shareholder's proportionate stock interest in 
a former electing small business corporation for purposes of this 
subparagraph, the shareholder shall be considered to own stock in such 
corporation which he owns directly or indirectly (through ownership in 
other entities provided such other entities' bases in such stock are 
determined in whole or in part by reference to the basis of such stock 
in the hands of the transferor). For example, if A, who owns all of the 
100 shares of the outstanding stock of corporation X, a corporation 
which was formerly an electing small business corporation, transfers on 
November 1, 1966, 70 shares of X stock to corporation Y in exchange for 
90 percent of the stock of Y in a transaction to which section 351 
applies, then, for purposes of subdivision (i) of this subparagraph, A 
shall be considered to own 93 percent of the stock of X, 30 percent 
directly and 63 percent indirectly (i.e., 90 percent of 70). Any 
taxpayer who seeks to establish his interest in the stock of a former 
electing small business corporation under the rule of this subdivision 
shall maintain adequate records to demonstrate his indirect interest in 
the corporation after any such transfer or transfers.
    (b) Election of a small business corporation under section 1372--(1) 
General rule. If a corporation makes a valid election under section 1372 
to be an electing small business corporation (as defined in section 
1371(b)), then on the last day of the taxable year immediately preceding 
the first taxable year for which such election is effective, any section 
38 property the basis (or cost) of which was taken into account in 
computing the corporation's qualified investment in taxable years prior 
to the first taxable year for which the election is effective (and which 
has not been disposed of or otherwise ceased to be section 38 property 
with respect to the corporation prior to such last day) shall be 
considered as having ceased to be section 38 property with respect to 
such corporation and Sec.  1.47-1 shall apply. However, if the 
corporation and each of the persons who are shareholders of the 
corporation on the first day of the first taxable year for which the 
election under section 1372 is to be effective, or on the date of such 
election, whichever is later, execute the agreement specified in 
subparagraph (2) of this paragraph, Sec.  1.47-1 shall not apply to any 
such section 38 property by reason of the election by the corporation 
under section 1372.
    (2) Agreement of shareholders and corporation. (i) The agreement 
referred to in subparagraph (1) of this paragraph shall be signed by the 
shareholders and the corporation, and shall recite that, in the event 
the section 38 property described in subparagraph (1) of this paragraph 
is later disposed of by, or ceases to be section 38 property with 
respect to, the corporation during a taxable year of the corporation for 
which the election under section 1372 is effective, each such signer 
agrees (a) to notify the district director of such disposition or 
cessation, and (b) to be jointly and severally liable to pay to the 
district director an amount equal to the increase in tax provided by 
section 47. The amount of such increase shall be determined as if such 
property had ceased to be section 38 property as of the last day of the 
taxable year immediately preceding the first taxable

[[Page 436]]

year for which the election under section 1372 is effective, except that 
the actual useful life (within the meaning of paragraph (a) of Sec.  
1.47-1) of the property shall be considered to have ended on the date of 
the actual disposition by, or cessation in the hands of, the electing 
small business corporation.
    (ii) The agreement shall set forth the name, address, and taxpayer 
account number of each party and the internal revenue district in which 
each such party files his or its income tax return for the taxable year 
which includes the last day of the corporation's taxable year 
immediately preceding the first taxable year for which the election 
under section 1372 is effective. The agreement may be signed on behalf 
of the corporation by any person who is duly authorized. The agreement 
shall be filed with the district director with whom the corporation 
files its income tax return for its taxable year immediately preceding 
the first taxable year for which the election under section 1372 is 
effective and shall be filed on or before the due date (including 
extensions of time) of such return. However, if the due date (including 
extensions of time) of such income tax return is on or before September 
1, 1967, the agreement may be filed on or before December 31, 1967. For 
purposes of the two preceding sentences, the district director may, if 
good cause is shown, permit the agreement to be filed on a later date.
    (c) Examples. This section may be illustrated by the following 
examples in each of which it is assumed that X Corporation, an electing 
small business corporation which makes its returns on the basis of the 
calendar year, acquired and placed in service on June 1, 1962, three 
items of section 38 property. The basis and estimated useful life of 
each item of section 38 property are as follows:

------------------------------------------------------------------------
                                                               Estimated
                                                                useful
                    Asset No.                        Basis       life
                                                                (Years)
------------------------------------------------------------------------
1...............................................     $30,000           4
2...............................................      30,000           6
3...............................................      30,000           8
------------------------------------------------------------------------

On December 31, 1962, X Corporation had 20 shares of stock outstanding 
which were owned equally by A and B who make their returns on the basis 
of a calendar year. Under Sec.  1.48-5, the total bases of section 38 
properties was apportioned to the shareholders of X Corporation as 
follows:

------------------------------------------------------------------------
                                             Useful life category
                                     -----------------------------------
                                        4 to 6      6 to 8    8 years or
                                         years       years       more
------------------------------------------------------------------------
    Total bases.....................     $30,000     $30,000     $30,000
                                     -----------------------------------
Shareholder A (10/20)...............      15,000      15,000      15,000
Shareholder B (10/20)...............      15,000      15,000      15,000
------------------------------------------------------------------------

Assuming that during 1962 shareholders A and B did not place in service 
any section 38 property and that they did not own any interests in other 
electing small business corporations, partnerships, estates, or trusts, 
the qualified investment of each shareholder is $30,000, computed as 
follows:

------------------------------------------------------------------------
                                                  Applicable   Qualified
                      Basis                       percentage  investment
------------------------------------------------------------------------
$15,000.........................................     33\1/3\      $5,000
$15,000.........................................     66\2/3\      10,000
$15,000.........................................         100      15,000
                                                             -----------
                                                  ..........      30,000
------------------------------------------------------------------------

For the taxable year 1962, each shareholder's credit earned of $2,100 (7 
percent of $30,000) was allowed under section 38 as a credit against his 
liability for tax.

    Example 1. (i) On December 2, 1965, X Corporation sells asset No. 3 
to Y Corporation.
    (ii) The actual useful life of asset No. 3 is three years and six 
months. The recomputed qualified investment with respect to each 
shareholder's share of the basis of asset No. 3 is zero ($15,000 share 
of basis multiplied by zero applicable percentage) and for the taxable 
year 1962 each shareholder's recomputed credit earned is $1,050 (7 
percent of $15,000). The income tax imposed by chapter 1 of the Code on 
each of the shareholders for the taxable year 1965 is increased by the 
$1,050 decrease in his credit earned for the taxable year 1962 (that is, 
$2,100 original credit earned minus $1,050 recomputed credit earned).
    Example 2. (i) On December 3, 1964, shareholder A sells 5 of his 10 
shares of stock in X Corporation to C, and on December 3, 1965, A sells 
his remaining 5 shares of stock to D. In addition, on January 2, 1966, X 
Corporation sells asset No. 3 to Y Corporation.
    (ii) Under paragraph (a)(2) of this section, on December 3, 1964, 50 
percent of the share of the basis of each of the three items of section 
38 property ceases to be section 38 property with respect to shareholder 
A since immediately after the December 3, 1964, sale A's proportionate 
stock interest in X Corporation is reduced to 50 percent of the 
proportionate stock interest in X Corporation

[[Page 437]]

which he held on December 31, 1962. The actual useful life of the share 
of the bases of the section 38 properties which cease to be section 38 
property with respect to A is two years and six months (that is, the 
period beginning with June 1, 1962, and ending with December 3, 1964). 
A's recomputed qualified investment with respect to such properties is 
$15,000, computed as follows:

------------------------------------------------------------------------
                                                              Recomputed
                     Basis                       Applicable   qualified
                                                 percentage   investment
------------------------------------------------------------------------
$7,500........................................      33\1/3\       $2,500
$7,500........................................      66\2/3\        5,000
$7,500........................................          100        7,500
                                                            ------------
                                                ...........       15,000
------------------------------------------------------------------------


For the taxable year 1962 shareholder A's recomputed credit earned is 
$1,050 (7 percent of $15,000). The income tax imposed by chapter 1 of 
the Code on shareholder A for the taxable year 1964 is increased by the 
$1,050 decrease in his credit earned for the taxable year 1962 (that is, 
$2,100 original credit earned minus $1,050 recomputed credit earned).
    (iii) Under paragraph (a)(2) of this section, on December 3, 1965, 
the remaining 50 percent of the share of the basis of each of the three 
items of section 38 property ceases to be section 38 property with 
respect to shareholder A since immediately after the December 3, 1965, 
sale A's proportionate stock interest in X Corporation is reduced to 
zero. The actual useful life of the share of the bases of the section 38 
properties which cease to be section 38 property with respect to A is 
three years and six months (that is, the period beginning with June 1, 
1962, and ending with December 3, 1965). A's recomputed qualified 
investment with respect to such properties is zero. For the taxable year 
1962 shareholder A's recomputed credit earned is zero. The income tax 
imposed by chapter 1 of the Code on shareholder A for the taxable year 
1965 is increased by $1,050 (that is, $2,100 ($2,100 original credit 
earned minus zero recomputed credit earned) reduced by the $1,050 
increase in tax for 1964).
    (iv) The actual useful life of asset No. 3 which was sold on January 
2, 1966, is three years and seven months. The recomputed qualified 
investment with respect to B's share of the basis of asset No. 3 is zero 
($15,000 share of basis multiplied by zero applicable percentage) and 
for the taxable year 1962, B's recomputed credit earned is $1,050 (7 
percent of $15,000). The income tax imposed by chapter 1 of the Code on 
shareholder B for the taxable year 1966 is increased by the $1,050 
decrease in his credit earned for the taxable year 1962 ($2,100 original 
credit earned minus $1,050 recomputed credit earned). The sale of asset 
No. 3 on January 2, 1966, by X Corporation has no effect on A.

    (d) Termination or revocation of an election under section 1372. 
Section 38 property shall not be considered to be disposed of or to have 
ceased to be section 38 property solely by reason of a termination or 
revocation of a corporation's election under section 1372.

[T.D. 6931, 32 FR 14035, Oct. 10, 1967]



Sec.  1.47-5  Estates and trusts.

    (a) In general--(1) Disposition or cessation in hands of estate or 
trust. If an estate or trust disposes of any section 38 property (or if 
any section 38 property otherwise ceases to be section 38 property in 
the hands of the estate or trust) before the close of the estimated 
useful life which was taken into account in computing qualified 
investment with respect to such property, a recapture determination 
shall be made with respect to the estate or trust, and each beneficiary 
who is treated, under Sec.  1.48-6, as a taxpayer with respect to such 
property. Each such recapture determination shall be made with respect 
to the share of the basis (or cost) of such property taken into account 
by such estate or trust and such beneficiary in computing its or his 
each such recapture determination the actual useful life of such 
property shall be the period beginning with the date on which it was 
placed in service by the estate or trust and ending with the date of the 
disposition or cessation. In making a recapture determination under this 
subparagraph with respect to a taxpayer there shall be taken into 
account any prior recapture determinations made with respect to such 
taxpayer in connection with the same property. For definition of 
``recapture determination'' see paragraph (a)(1) of Sec.  1.47-1.
    (2) Disposition of interest. (i) If--
    (a) The basis (or cost) of section 38 property is apportioned, under 
Sec.  1.48-6, to an estate or trust which, or to a beneficiary of an 
estate or trust who, takes such basis (or cost) into account in 
computing his qualified investment, and
    (b) After the date on which such section 38 property was placed in 
service by the estate or trust and before the

[[Page 438]]

close of the estimated useful life of the property, such estate's, 
trust's, or such beneficiary's proportionate interest in the income of 
the estate or trust is reduced (for example, by a sale, or by the terms 
of the estate or trust instrument) below the percentage specified in 
subdivision (ii) of this subparagraph, then, on the date of such 
reduction, such section 38 property ceases to be section 38 property 
with respect to such estate, trust, or beneficiary to the extent of the 
actual reduction in such estate's, trust's, or beneficiary's 
proportionate interest in the income of the estate or trust. (For 
example, if $100 of the basis of section 38 property was apportioned to 
a beneficiary and if his proportionate interest in the income of the 
estate or trust is reduced from 60 percent to 30 percent (that is, 50 
percent of his original interest), then such property shall be treated 
as having ceased to be section 38 property to the extent of $50). 
Accordingly, a recapture determination shall be made with respect to 
such estate, trust, or beneficiary. For purposes of such recapture 
determination the actual useful life of such property shall be the 
period beginning with the date on which it was placed in service by the 
estate or trust and ending with the date on which it is treated as 
having ceased to be section 38 property with respect to the estate, 
trust, or beneficiary. In making a recapture determination under this 
subparagraph there shall be taken into account any prior recapture 
determination made with respect to the estate, trust, or beneficiary in 
connection with the same property.
    (ii) The percentage referred to in subdivision (i)(b) of this 
subparagraph is 66\2/3\ percent of the estate's, trust's, or 
beneficiary's proportionate interest in the income of the estate or 
trust for the taxable year of the apportionment under Sec.  1.48-6. 
However, once property has been treated under this subparagraph as 
having ceased to be section 38 property to any extent the percentage 
referred to shall be 33\1/3\ percent of the estate's, trust's, or 
beneficiary's proportionate interest in the income of the estate or 
trust for the taxable year of the apportionment under Sec.  1.48-6.
    (iii) In determining a beneficiary's proportionate interest in the 
income of an estate or trust for purposes of this subparagraph, the 
beneficiary shall be considered to own any interest in such an estate or 
trust which he owns directly or indirectly (through ownership in other 
entities provided such other entities' bases in such interest are 
determined in whole or in part by reference to the basis of such 
interest in the hands of the beneficiary). For example, if A, whose 
proportionate interest in the income of trust X is 30 percent, transfers 
all of such interest to corporation Y in exchange for all of the stock 
of Y in a transaction to which section 351 applies, then, for purposes 
of subdivision (i) of this subparagraph, A shall be considered to own a 
30-percent interest in trust X. Any taxpayer who seeks to establish his 
interest in an estate or trust under the rule of this subdivision shall 
maintain adequate records to demonstrate his indirect interest in the 
estate or trust after any such transfer or transfers.
    (b) Examples. Paragraph (a) of this section may be illustrated by 
the following examples in each of which it is assumed that XYZ Trust, 
which makes its returns on the basis of the calendar year, acquired and 
placed in service on June 1, 1962, three items of section 38 property. 
The basis and estimated useful life of each item of section 38 property 
are as follows:

------------------------------------------------------------------------
                                                               Estimated
                                                                useful
                    Asset No.                        Basis       life
                                                                (Years)
------------------------------------------------------------------------
1...............................................     $30,000           4
2...............................................      30,000           6
3...............................................      30,000           8
------------------------------------------------------------------------

For the taxable year 1962 the income of XYZ Trust is $20,000, which is 
allocable equally to XYZ Trust and beneficiary A. Beneficiary A makes 
his returns on the basis of a calendar year. Under Sec.  1.48-6, the 
total bases of the section 38 properties was apportioned to XYZ Trust 
and beneficiary A as follows:

[[Page 439]]


----------------------------------------------------------------------------------------------------------------
                                                                                     Useful life category
                                                                             -----------------------------------
                                                                                4 to 6      6 to 8    8 years or
                                                                                 years       years       more
----------------------------------------------------------------------------------------------------------------
    Total bases.................................................  ..........     $30,000     $30,000     $30,000
                                                                             -----------------------------------
                                                                   ($10,000)      15,000      15,000      15,000
                                                                 ------------
XYZ Trust.......................................................   ($20,000)
Beneficiary A...................................................   ($10,000)      15,000      15,000      15,000
                                                                 ------------
                                                                   ($20,000)
----------------------------------------------------------------------------------------------------------------

Assuming that during 1962 beneficiary A did not place in service any 
section 38 property and that he did not own any interests in other 
estates, trusts, electing small business corporations, or partnerships, 
the qualified investment of XYZ Trust and of beneficiary A is $30,000 
each, computed as follows:

------------------------------------------------------------------------
                                                  Applicable   Qualified
                      Basis                       percentage  investment
------------------------------------------------------------------------
$15,000.........................................     33\1/3\      $5,000
$15,000.........................................     66\2/3\      10,000
$15,000.........................................         100      15,000
                                                 -----------------------
                                                  ..........      30,000
------------------------------------------------------------------------

For the taxable year 1962, XYZ Trust and beneficiary A each had a credit 
earned of $2,100 (7 percent of $30,000). Each such credit earned was 
allowed under section 38 as a credit against the liability for tax.

    Example 1. (i) On December 2, 1965, XYZ Trust sells asset No. 3 to X 
Corporation.
    (ii) The actual useful life of asset No. 3 is three years and six 
months. The recomputed qualified investment with respect to XYZ Trust's 
and beneficiary A's share of the basis of asset No. 3 is zero ($15,000 
share of basis multiplied by zero applicable percentage) and for the 
taxable year 1962, XYZ Trust's and beneficiary A's recomputed credit 
earned is $1,050 (7 percent of $15,000). The income tax imposed by 
chapter 1 of the Code on XYZ Trust and on beneficiary A for the taxable 
year 1965 is increased by the $1,050 decrease in his credit earned for 
the taxable year 1962 (that is, $2,100 original credit earned minus 
$1,050 recomputed credit earned).
    Example 2. (i) On December 3, 1964, beneficiary A sells 50 percent 
of his interest in the income of XYZ Trust to B, and on December 3, 
1965, A sells his remaining 50 percent interest to C. In addition, on 
January 2, 1966, XYZ Trust sells asset No. 3 to Y Corporation.
    (ii) Under paragraph (a)(2) of this section, on December 3, 1964, 50 
percent of the basis of each of the three items of section 38 property 
ceases to be section 38 property with respect to beneficiary A since 
immediately after the December 3, 1964, sale A's proportionate interest 
in the income of XYZ Trust is reduced to 50 percent of his proportionate 
interest in the income of XYZ Trust for the taxable year 1962. The 
actual useful life of the share of the bases of the section 38 
properties which cease to be section 38 property with respect to A is 
two years and six months (that is, the period beginning with June 1, 
1962, and ending with December 3, 1964). Beneficiary A's recomputed 
qualified investment with respect to such properties is $15,000, 
computed as follows:

------------------------------------------------------------------------
                                                  Applicable   Qualified
                      Basis                       percentage  investment
------------------------------------------------------------------------
$7,500..........................................     33\1/3\      $2,500
$7,500..........................................     66\2/3\       5,000
$7,500..........................................         100       7,500
                                                 -----------------------
                                                  ..........      15,000
------------------------------------------------------------------------


For the taxable year 1962 beneficiary A's recomputed credit earned is 
$1,050 (7 percent of $15,000). The income tax imposed by chapter 1 of 
the Code on beneficiary A for the taxable year 1964 is increased by the 
$1,050 decrease in his credit earned for the taxable year 1962 (that is, 
$2,100 original credit earned minus $1,050 recomputed credit earned).
    (iii) Under paragraph (a)(2) of this section, on December 3, 1965, 
the remaining 50 percent of the share of the basis of each of the three 
items of section 38 property ceases to be section 38 property with 
respect to beneficiary A since immediately after the December 3, 1965, 
sale A's proportionate interest in the income of XYZ Trust is reduced to 
zero. The actual useful life of the share of the basis of the section 38 
properties which cease to be section 38 property with respect to A is 
three years and six months (that is, the period beginning with June 1, 
1962, and ending with December 3, 1965). A's recomputed qualified 
investment with respect to such properties is zero. For the taxable year 
1962 beneficiary A's recomputed credit earned is zero. The income tax 
imposed by chapter 1 of the Code on beneficiary A for the taxable year 
1965 is increased by $1,050 (that is, $2,100 ($2,100 original credit 
earned minus zero recomputed credit earned) reduced by the $1,050 
increase in tax for 1964).
    (iv) The actual useful life of asset No. 3 which was sold on January 
2, 1966, is three

[[Page 440]]

years and seven months. The recomputed qualified investment with respect 
to XYZ Trust's share of the basis of asset No. 3 is zero ($15,000 share 
of basis multiplied by zero applicable percentage) and for the taxable 
year 1962, XYZ Trust's recomputed credit earned is $1,050 (7 percent of 
$15,000). The income tax imposed by chapter 1 of the Code on XYZ Trust 
for the taxable year 1966 is increased by the $1,050 decrease in its 
credit earned for the taxable year 1962 ($2,100 original credit earned 
minus $1,050 recomputed credit earned). The sale of asset No. 3 on 
January 2, 1966, has no effect on A.

[T.D. 6931, 32 FR 14037, Oct. 10, 1967]



Sec.  1.47-6  Partnerships.

    (a) In general--(1) Disposition or cessation in hands of 
partnership. If a partnership disposes of any partnership section 38 
property (or if any partnership section 38 property otherwise ceases to 
be section 38 property in the hands of the partnership) before the close 
of the estimated useful life which was taken into account in computing 
qualified investment with respect to such property, a recapture 
determination shall be made with respect to each partner who is treated, 
under paragraph (f) of Sec.  1.46-3, as a taxpayer with respect to such 
property. Each such recapture determination shall be made with respect 
to the share of the basis (or cost) of such property taken into account 
by such partner in computing his qualified investment. For purposes of 
each such recapture determination the actual useful life of such 
property shall be the period beginning with the date on which it was 
placed in service by the partnership and ending with the date of the 
disposition or cessation. In making a recapture determination under this 
subparagraph there shall be taken into account any prior recapture 
determinations made with respect to the partner in connection with the 
same property. For definition of ``recapture determination'' see 
paragraph (a)(1) of Sec.  1.47-1.
    (2) Disposition of partner's interest. (i) If--
    (a) The basis (or cost) of partnership section 38 property is taken 
into account by a partner in computing his qualified investment, and
    (b) After the date on which such partnership section 38 property was 
placed in service by the partnership and before the close of the 
estimated useful life of the property, such partner's proportionate 
interest in the general profits of the partnership (or in the particular 
item of property) is reduced (for example, by a sale, by a change in the 
partnership agreement, or by the admission of a new partner) below the 
percentage specified in subdivision (ii) of this subparagraph, then, on 
the date of such reduction such partnership section 38 property ceases 
to be section 38 property with respect to such partner to the extent of 
the actual reduction in such partner's proportionate interest in the 
general profits of the partnership (or in the particular item of 
property). (For example, if $100 of the basis of section 38 property was 
taken into account by a partner and if his proportionate interest in the 
general profits of the partnership is reduced from 60 percent to 30 
percent (that is, 50 percent of his original interest), then such 
property shall be treated as having ceased to be section 38 property to 
the extent of $50.) Accordingly, a recapture determination shall be made 
with respect to such partner. For purposes of such recapture 
determination the actual useful life of such property shall be the 
period beginning with the date on which it was placed in service by the 
partnership and ending with the date on which it is treated as having 
ceased to be section 38 property with respect to the partner. In making 
a recapture determination under this subparagraph there shall be taken 
into account any prior recapture determination made with respect to the 
partner in connection with the same property.
    (ii) The percentage referred to in subdivision (i)(b) of this 
subparagraph is 66\2/3\ percent of the partner's proportionate interest 
in the general profits of the partnership (or in the particular item of 
property) for the year in which such property was placed in service. 
However, once property has been treated under this subparagraph as 
having ceased to be section 38 property to any extent the percentage 
referred to shall be 33\1/3\ percent of the partner's proportionate 
interest in the general profits of the partnership (or in the particular 
item of property) for the year in which such property was placed in 
service.

[[Page 441]]

    (iii) In determining a partner's proportionate interest in the 
general profits of a partnership for purposes of this subparagraph, the 
partner shall be considered to own any interest in such a partnership 
which he owns directly or indirectly (through ownership in other 
entities provided the other entities' bases in such interest are 
determined in whole or in part by reference to the basis of such 
interest in the hands of the partner). For example, if A, whose 
proportionate interest in the general profits of partnership X is 20 
percent, transfers all of such interest to corporation Y in exchange for 
all of the stock of Y in a transaction to which section 351 applies, 
then, for purposes of subdivision (i) of this subparagraph, A shall be 
considered to own a 20-percent interest in partnership X. Any taxpayer 
who seeks to establish his interest in a partnership under the rule of 
this subdivision shall maintain adequate records to demonstrate his 
indirect interest in the partnership after any such transfer or 
transfers.
    (b) Examples. Paragraph (a) of this section may be illustrated by 
the following examples in each of which it is assumed that ABC 
Partnership, which makes its returns on the basis of the calendar year, 
acquired and placed in service on June 1, 1962, three items of section 
38 property. The basis and estimated useful life of each item of section 
38 property are as follows:

------------------------------------------------------------------------
                                                               Estimated
                    Asset No.                        Basis      useful
                                                              life Years
------------------------------------------------------------------------
1...............................................     $30,000           4
2...............................................      30,000           6
3...............................................      30,000           8
------------------------------------------------------------------------

Partners A and B, who make their returns on the basis of a calendar 
year, share the profits and losses of ABC Partnership equally. Under 
paragraph (f)(2) of Sec.  1.46-3, each partner's share of the basis of 
the partnership section 38 property is as follows:

------------------------------------------------------------------------
                                                       Partners share of
                                 Estimated                   basis
           Asset No.               useful     Basis  -------------------
                                    life                A 50      B 50
                                  (years)              percent   percent
------------------------------------------------------------------------
1..............................          4   $30,000   $15,000   $15,000
2..............................          6    30,000    15,000    15,000
3..............................          8    30,000    15,000    15,000
------------------------------------------------------------------------

Assuming that during 1962 partners A and B did not place in service any 
section 38 property and that they did not own any interests in other 
partnerships, electing small business corporations, estates, or trusts, 
the qualified investment of each partner is $30,000, computed as 
follows:

------------------------------------------------------------------------
                                       Share of   Applicable   Qualified
        Partnership asset No.            basis    percentage  investment
------------------------------------------------------------------------
1...................................     $15,000     33\1/3\      $5,000
2...................................      15,000     66\2/3\      10,000
3...................................      15,000         100      15,000
                                     -----------------------------------
                                      ..........  ..........      30,000
------------------------------------------------------------------------

For the taxable year 1962, each partner's credit earned of $2,100 (7 
percent of $30,000) was allowed under section 38 as a credit against his 
liability for tax.

    Example 1. (i) On December 2, 1965, ABC Partnership sells asset No. 
3 to X Corporation.
    (ii) The actual useful life of asset No. 3 is three years and six 
months. The recomputed qualified investment with respect to each 
partner's share of the basis of asset No. 3 is zero ($15,000 shares of 
basis multiplied by zero applicable percentage) and for the taxable year 
1962, each partner's recomputed credit earned is $1,050 (7 percent of 
$15,000). The income tax imposed by chapter 1 of the Code on each of the 
partners for the taxable year 1965 is increased by the $1,050 decrease 
in his credit earned for the taxable year 1962 (that is, $2,100 original 
credit earned minus $1,050 recomputed credit earned).
    Example 2. (i) On December 3, 1964, partner A sells one-half of his 
50 percent interest in ABC Partnership to C, and on December 3, 1965, A 
sells the remaining one- half of his interest to D. In addition, on 
January 2, 1966, ABC Partnership sells asset No. 3 to X Corporation.
    (ii) Under paragraph (a)(2) of this section, on December 3, 1964, 50 
percent of the basis of each of the three items of section 38 property 
ceases to be section 38 property with respect to partner A since 
immediately after the December 3, 1964, sale A's proportionate interest 
in the general profits of ABC Partnership is reduced to 50 percent of 
his proportionate interest in the general profits of ABC Partnership for 
1962. The actual useful life of the share of the basis of each of the 
section 38 properties which cease to be section 38 property with respect 
to A is two years and six months (that is, the period beginning with 
June 1, 1962, and ending with December 3, 1964). Partner A's recomputed 
qualified investment with respect to such properties is $15,000, 
computed as follows:

------------------------------------------------------------------------
                                       Share of   Applicable   Qualified
        Partnership asset No.            basis    percentage  investment
------------------------------------------------------------------------
1...................................      $7,500     33\1/3\      $2,500
2...................................       7,500     66\2/3\       5,000
3...................................       7,500         100       7,500
                                     -----------------------------------

[[Page 442]]

 
                                      ..........  ..........      15,000
------------------------------------------------------------------------


For the taxable year 1962 partner A's recomputed credit earned is $1,050 
(7 percent of $15,000). The income tax imposed by chapter 1 of the Code 
on partner A for the taxable year 1964 is increased by the $1,050 
decrease in his credit earned for the taxable year 1962 (that is, $2,100 
original credit earned minus $1,050 recomputed credit earned).
    (iii) Under paragraph (a)(2) of this section, on December 3, 1965, 
the remaining 50 percent of the share of the basis of each of the three 
items of section 38 property ceases to be section 38 property with 
respect to partner A since immediately after the December 3, 1965, sale 
A's proportionate interest in the general profits of ABC Partnership is 
reduced to zero. The actual useful life of the share of the bases of the 
section 38 properties which cease to be section 38 property with respect 
to A is three years and six months (that is, the period beginning with 
June 1, 1962, and ending with December 3, 1965). A's recomputed 
qualified investment with respect to such properties is zero. For the 
taxable year 1962 partner A's recomputed credit earned is zero. The 
income tax imposed by chapter 1 of the Code on partner A for the taxable 
year 1965 is increased by $1,050 (that is, $2,100 ($2,100 original 
credit earned minus zero recomputed credit earned) reduced by the $1,050 
increase in tax for 1964).
    (iv) The actual useful life of asset No. 3 which was sold on January 
2, 1966, is three years and seven months. The recomputed qualified 
investment with respect to partner B's share of the basis of asset No. 3 
is zero ($15,000 share of basis multiplied by zero applicable 
percentage) and for the taxable year 1962, partner B's recomputed credit 
earned is $1,050 (7 percent of $15,000). The income tax imposed by 
chapter 1 of the Code on partner B for the taxable year 1966 is 
increased by the $1,050 decrease in his credit earned for the taxable 
year 1962 ($2,100 original credit earned minus $1,050 recomputed credit 
earned). The sale of asset No. 3 on January 2, 1966, has no effect on A.

[T.D. 6931, 32 FR 14039, Oct. 10, 1967]



Sec.  1.47-7  Rehabilitation credit allocated over a 5-year period.

    (a) In general. For purposes of section 46, for any taxable year 
during the 5-year period beginning in the taxable year in which a 
qualified rehabilitated building, as defined in section 47(c)(1) and 
Sec.  1.48-12(b), is placed in service, the rehabilitation credit for 
the taxable year is an amount equal to the ratable share for the taxable 
year, provided the requirements of section 47 are satisfied. Except as 
provided by section 13402(c)(2) of Public Law 115-97, 131 Stat. 2054 
(2017), this section applies with respect to qualified rehabilitation 
expenditures, as defined in section 47(c)(2) and Sec.  1.48-12(c), paid 
or incurred after December 31, 2017.
    (b) Ratable share. For purposes of paragraph (a) of this section, 
the term ratable share means, for any taxable year during the 5-year 
period described in such paragraph, the amount equal to 20 percent of 
the rehabilitation credit determined with respect to the qualified 
rehabilitated building, allocated ratably to each year during such 
period.
    (c) Rehabilitation credit determined. The term rehabilitation credit 
determined means the amount equal to 20 percent of the qualified 
rehabilitation expenditures, as defined in section 47(c)(2) and Sec.  
1.48-12(c), taken into account under section 47(b)(1) for the taxable 
year in which the qualified rehabilitated building is placed in service. 
However, if the taxpayer claims the additional first year depreciation 
for the qualified rehabilitation expenditures pursuant to Sec.  
1.168(k)-2(g)(9), the term rehabilitation credit determined means the 
amount equal to 20 percent of the remaining rehabilitated basis, as 
defined in Sec.  1.168(k)-2(g)(9)(i)(B), of the qualified rehabilitated 
building for the taxable year in which such building is placed in 
service.
    (d) Coordination with section 50. For purposes of section 50 and 
Sec.  1.50-1, the amount of the rehabilitation credit determined is the 
amount defined in paragraph (c) of this section.
    (e) Examples. The provisions of paragraphs (a) through (d) of this 
section are illustrated by the following examples. Assume that the 
additional first year depreciation deduction provided by section 168(k) 
is not allowed or allowable for the qualified rehabilitation 
expenditures.
    (1) Example 1: Rehabilitation Credit Determined and Ratable Share. 
Between February 1, 2021 and October 1, 2021, X, a calendar year C 
corporation, incurred qualified rehabilitation expenditures of $200,000 
with respect to a qualified rehabilitated building. X placed the 
building in service on October 15, 2021.

[[Page 443]]

X's rehabilitation credit determined in 2021 under paragraph (c) of this 
section is $40,000 ($200,000 x 0.20). For purposes of section 46, for 
each taxable year during the 5-year period beginning in 2021, the 
ratable share allocated under paragraph (b) of this section for the year 
is $8,000 ($40,000 x 0.20).
    (2) Example 2: Coordination with section 50(c). The facts are the 
same as in paragraph (e)(1) of this section (Example 1). For purposes of 
determining the amount of X's basis adjustment in 2021 under section 
50(c), the amount of the rehabilitation credit determined under 
paragraph (c) of this section is $40,000.
    (3) Example 3: Coordination with section 50(a). The facts are the 
same as in paragraph (e)(1) of this section (Example 1). In 2021 and 
2022, X claimed the full amount of the ratable share allowed under 
section 46, or $8,000 per taxable year. X's total allowable ratable 
share for 2023 through 2025 is $24,000 ($8,000 allowable per taxable 
year). On November 1, 2023, X disposes of the qualified rehabilitated 
building. Under section 50(a)(1)(B)(iii), because the period of time 
between when the qualified rehabilitated building was placed in service 
is more than two, but less than 3 full years, the applicable recapture 
percentage is 60%. Based on these facts, X has an increase in tax of 
$9,600 under section 50(a) ($16,000 of credit claimed in 2021 and 2022 x 
0.60) and has $3,200 of credits remaining in each of 2023 through 2025, 
after forgoing $4,800 in credits in each of the years 2023 through 2025 
($8,000 x 0.60).
    (4) Example 4: Coordination with section 50(d)(5) and Sec.  1.50-1; 
C corporation lessee. X, a calendar year C corporation, leases 
nonresidential real property from Y. The property is a qualified 
rehabilitated building that is placed in service on October 15, 2021. 
Under paragraph (c) of this section, the amount of the rehabilitation 
credit determined is $100,000. Y elects under Sec.  1.48-4 to treat X as 
having acquired the property. The shortest recovery period that could be 
available to the property under section 168 is 39 years. Because Y has 
elected to treat X as having acquired the property, Y does not reduce 
its basis in the property under section 50(c). Instead, pursuant to 
section 50(d)(5) and Sec.  1.50-1, X, the lessee of the property, must 
include ratably in gross income over 39 years an amount equal to the 
rehabilitation credit determined with respect to such property.
    (5) Example 5: Coordination with section 50(d)(5) and Sec.  1.50-1; 
partnership lessee. A and B, calendar year taxpayers, form a 
partnership, the AB partnership, that leases nonresidential real 
property from Y. The property is a qualified rehabilitated building that 
is placed in service on October 15, 2021. Under paragraph (c) of this 
section, the amount of the rehabilitation credit determined is $200,000. 
Y elects under Sec.  1.48-4 to treat the AB partnership as having 
acquired the property. The shortest recovery period that could be 
available to the property under section 168 is 39 years. Because Y has 
elected to treat the AB partnership as having acquired the property, Y 
does not reduce its basis in the building under section 50(c). Instead, 
A and B, the ultimate credit claimants, as defined in Sec.  1.50-
1(b)(3)(ii), must include the amount of the rehabilitation credit 
determined under paragraph (c) of this section with respect to A and B 
ratably in gross income over 39 years, the shortest recovery period 
available with respect to such property.
    (f) Applicability date. This section applies to taxable years 
beginning on or after September 18, 2020. Taxpayers may choose to apply 
this section for taxable years beginning before September 18, 2020, 
provided the taxpayer applies this section in its entirety and in a 
consistent manner.

[T.D. 9915, 85 FR 58267, Sept. 18, 2020]



Sec.  1.48-1  Definition of section 38 property.

    (a) In general. Property which qualifies for the credit allowed by 
section 38 is known as ``section 38 property''. Except as otherwise 
provided in this section, the term ``section 38 property'' means 
property (1) with respect to which depreciation (or amortization in lieu 
of depreciation) is allowable to the taxpayer, (2) which has an 
estimated useful life of 3 years or more (determined as of the time such 
property is placed in service), and (3) which is (i) tangible personal 
property, (ii) other tangible property (not including a

[[Page 444]]

building and its structural components) but only if such other property 
is used as an integral part of manufacturing, production, or extraction, 
or an integral part of furnishing transportation, communications, 
electrical energy, gas, water, or sewage disposal services by a person 
engaged in a trade or business of furnishing any such service, or is a 
research or storage facility used in connection with any of the 
foregoing activities, (iii) an elevator or escalator which satisfies the 
conditions of section 48(a)(1)(C), or (iv) in the case of a qualified 
rehabilitated building, that portion of the basis which is attributable 
to qualified rehabilitation expenditures. The determination of whether 
property qualifies as section 38 property in the hands of the taxpayer 
for purposes of the credit allowed by section 38 must be made with 
respect to the first taxable year in which such property is placed in 
service by the taxpayer. See paragraph (d) of Sec.  1.46-3. For the 
meaning of ``estimated useful life'', see paragraph (e) of Sec.  1.46-3. 
In the case of property which is not described in section 50, this 
paragraph shall be applied by substituting ``4 years'' for ``3 years''.
    (b) Depreciation allowable. (1) Property (with the exception of 
property described in section 48(a)(1)(F) and paragraph (p) of this 
section) is not section 38 property unless a deduction for depreciation 
(or amortization in lieu of depreciation) with respect to such property 
is allowable to the taxpayer for the taxable year. A deduction for 
depreciation is allowable if the property is of a character subject to 
the allowance for depreciation under section 167 and the basis (or cost) 
of the property is recovered through a method of depreciation, 
including, for example, the unit of production method and the retirement 
method as well as methods of depreciation which measure the life of the 
property in terms of years. If property is placed in service (within the 
meaning of paragraph (d) of Sec.  1.46-3) in a trade or business (or in 
the production of income), but under the taxpayer's depreciation 
practice the period for depreciation with respect to such property 
begins in a taxable year subsequent to the taxable year in which such 
property is placed in service, then a deduction for depreciation shall 
be treated as allowable with respect to such property in the earlier 
taxable year (or years). Thus, for example, if a machine is placed in 
service in a trade or business in 1963, but the period for depreciation 
with respect to such machine begins in 1964, because the taxpayer uses 
an averaging convention (see Sec.  1.167(a)-10) in computing 
depreciation, then, for purposes of determining whether the machine 
qualifies as section 38 property, a deduction for depreciation shall be 
treated as allowable in 1963.
    (2) If, for the taxable year in which property is placed in service, 
a deduction for depreciation is allowable to the taxpayer only with 
respect to a part of such property, then only the proportionate part of 
the property with respect to which such deduction is allowable qualifies 
as section 38 property for the purpose of determining the amount of 
credit allowable under section 38. Thus, for example, if property is 
used 80 percent of the time in a trade or business and is used 20 
percent of the time for personal purposes, only 80 percent of the basis 
(or cost) of such property qualifies as section 38 property. Further, 
property does not qualify to the extent that a deduction for 
depreciation thereon is disallowed under section 274 (relating to 
disallowance of certain entertainment, etc., expenses).
    (3) If the cost of property is not recovered through a method of 
depreciation but through a deduction of the full cost in one taxable 
year, for purposes of subparagraph (1) of this paragraph a deduction for 
depreciation with respect to such property is not allowable to the 
taxpayer. However, if an adjustment with respect to the income tax 
return for such taxable year requires the cost of such property to be 
recovered through a method of depreciation, a deduction for depreciation 
will be considered as allowable to the taxpayer.
    (4) If depreciation sustained on property is not an allowable 
deduction for the taxable year but is added to the basis of property 
being constructed, reconstructed, or erected by the taxpayer, for 
purposes of subparagraph (1) of this paragraph a deduction for 
depreciation shall be treated as allowable

[[Page 445]]

for the taxable year with respect to the property on which depreciation 
is sustained. Thus, if $1,000 of depreciation sustained with respect to 
property No. 1, which is placed in service in 1964 by taxpayer A, is not 
allowable to A as a deduction for 1964 but is added to the basis of 
property being constructed by A (property no. 2), for purposes of 
subparagraph (1) of this paragraph a deduction for depreciation shall be 
treated as allowable to A for 1964 with respect to property no. 1. 
However, the $1,000 amount is not included in the basis of property no. 
2 for purposes of determining A's qualified investment with respect to 
property no. 2. See paragraph (c)(1) of Sec.  1.46-3.
    (c) Definition of tangible personal property. If property is 
tangible personal property it may qualify as section 38 property 
irrespective of whether it is used as an integral part of an activity 
(or constitutes a research or storage facility used in connection with 
such activity) specified in paragraph (a) of this section. Local law 
shall not be controlling for purposes of determining whether property is 
or is not ``tangible'' or ``personal''. Thus, the fact that under local 
law property is held to be personal property or tangible property shall 
not be controlling. Conversely, property may be personal property for 
purposes of the investment credit even though under local law the 
property is considered to be a fixture and therefore real property. For 
purposes of this section, the term ``tangible personal property'' means 
any tangible property except land and improvements thereto, such as 
buildings or other inherently permanent structures (including items 
which are structural components of such buildings or structures). Thus, 
buildings, swimming pools, paved parking areas, wharves and docks, 
bridges, and fences are not tangible personal property. Tangible 
personal property includes all property (other than structural 
components) which is contained in or attached to a building. Thus, such 
property as production machinery, printing presses, transportation and 
office equipment, refrigerators, grocery counters, testing equipment, 
display racks and shelves, and neon and other signs, which is contained 
in or attached to a building constitutes tangible personal property for 
purposes of the credit allowed by section 38. Further, all property 
which is in the nature of machinery (other than structural components of 
a building or other inherently permanent structure) shall be considered 
tangible personal property even though located outside a building. Thus, 
for example, a gasoline pump, hydraulic car lift, or automatic vending 
machine, although annexed to the ground, shall be considered tangible 
personal property.
    (d) Other tangible property--(1) In general. In addition to tangible 
personal property, any other tangible property (but not including a 
building and its structural components) used as an integral part of 
manufacturing, production, or extraction, or as an integral part of 
furnishing transportation, communications, electrical energy, gas, 
water, or sewage disposal services by a person engaged in a trade or 
business of furnishing any such service, or which constitutes a research 
or storage facility used in connection with any of the foregoing 
activities, may qualify as section 38 property.
    (2) Manufacturing, production, and extraction. For purposes of the 
credit allowed by section 38, the terms ``manufacturing'', 
``production'', and ``extraction'' include the construction, 
reconstruction, or making of property out of scrap, salvage, or junk 
material, as well as from new or raw material, by processing, 
manipulating, refining, or changing the form of an article, or by 
combining or assembling two or more articles, and include the 
cultivation of the soil, the raising of livestock, and the mining of 
minerals. Thus, section 38 property would include, for example, property 
used as an integral part of the extracting, processing, or refining of 
metallic and nonmetallic minerals, including oil, gas, rock, marble, or 
slate; the construction of roads, bridges, or housing; the processing of 
meat, fish or other foodstuffs; the cultivation of orchards, gardens, or 
nurseries; the operation of sawmills, the production of lumber, lumber 
products or other building materials; the fabrication or treatment of 
textiles, paper, leather goods, or glass; and the rebuilding, as 
distinguished from the mere repairing, of machinery.

[[Page 446]]

    (3) Transportation and communications businesses. Examples of 
transportation businesses include railroads, airlines, bus companies, 
shipping or trucking companies, and oil pipeline companies. Examples of 
communications businesses include telephone or telegraph companies and 
radio or television broadcasting companies.
    (4) Integral part. In order to qualify for the credit, property 
(other than tangible personal property and research or storage 
facilities used in connection with any of the activities specified in 
subparagraph (1) of this paragraph) must be used as an integral part of 
one or more of the activities specified in subparagraph (1) of this 
paragraph. Property such as pavements, parking areas, inherently 
permanent advertising displays or inherently permanent outdoor lighting 
facilities, or swimming pools, although used in the operation of a 
business, ordinarily is not used as an integral part of any of such 
specified activities. Property is used as an integral part of one of the 
specified activities if it is used directly in the activity and is 
essential to the completeness of the activity. Thus, for example, in 
determining whether property is used as an integral part of 
manufacturing, all properties used by the taxpayer in acquiring or 
transporting raw materials or supplies to the point where the actual 
processing commences (such as docks, railroad tracks and bridges), or in 
processing raw materials into the taxpayer's final product, would be 
considered as property used as an integral part of manufacturing. 
Specific examples of property which normally would be used as an 
integral part of one of the specified activities are blast furnaces, oil 
and gas pipelines, railroad tracks and signals, telephone poles, 
broadcasting towers, oil derricks, and fences used to confine livestock. 
Property shall be considered used as an integral part of one of the 
specified activities if so used either by the owner of the property or 
by the lessee of the property.
    (5) Research or storage facilities. (i) If property (other than a 
building and its structural components) constitutes a research or 
storage facility and if it is used in connection with an activity 
specified in subparagraph (1) of this paragraph, such property may 
qualify as section 38 property even though it is not used as an integral 
part of such activity. Examples of research facilities include wind 
tunnels and test stands. Examples of storage facilities include oil and 
gas storage tanks and grain storage bins. Although a research or storage 
facility must be used in connection with, for example, a manufacturing 
process, the taxpayer-owner of such facility need not be engaged in the 
manufacturing process.
    (ii) In the case of property described in section 50, property will 
constitute a storage facility only if the facility is used principally 
for the bulk storage of fungible commodities. Bulk storage means the 
storage of a commodity in a large mass prior to its consumption or 
utilization. Thus, if a facility is used to store oranges that have been 
sorted and boxed, it is not used for bulk storage.
    (e) Definition of building and structural components. (1) Generally, 
buildings and structural components thereof do not qualify as section 38 
property. See, however, section 48(a)(1)(E) and (g), and Sec.  1.48-11 
(relating to investment credit for qualified rehabilitated building). 
The term ``building'' generally means any structure or edifice enclosing 
a space within its walls, and usually covered by a roof, the purpose of 
which is, for example, to provide shelter or housing, or to provide 
working, office, parking, display, or sales space. The term includes, 
for example, structures such as apartment houses, factory and office 
buildings, warehouses, barns, garages, railway or bus stations, and 
stores. Such term includes any such structure constructed by, or for, a 
lessee even if such structure must be removed, or ownership of such 
structure reverts to the lessor, at the termination of the lease. Such 
term does not include (i) a structure which is essentially an item of 
machinery or equipment, or (ii) a structure which houses property used 
as an integral part of an activity specified in section 48(a)(1)(B)(i) 
if the use of the structure is so closely related to the use of such 
property that the structure clearly can be expected to be replaced when 
the property it initially houses is replaced. Factors which indicate 
that a structure is closely related

[[Page 447]]

to the use of the property it houses include the fact that the structure 
is specifically designed to provide for the stress and other demands of 
such property and the fact that the structure could not be economically 
used for other purposes. Thus, the term ``building'' does not include 
such structures as oil and gas storage tanks, grain storage bins, silos, 
fractionating towers, blast furnaces, basic oxygen furnaces, coke ovens, 
brick kilns, and coal tipples.
    (2) The term ``structural components'' includes such parts of a 
building as walls, partitions, floors, and ceilings, as well as any 
permanent coverings therefor such as paneling or tiling; windows and 
doors; all components (whether in, on, or adjacent to the building) of a 
central air conditioning or heating system, including motors, 
compressors, pipes and ducts; plumbing and plumbing fixtures, such as 
sinks and bathtubs; electric wiring and lighting fixtures; chimneys; 
stairs, escalators, and elevators, including all components thereof; 
sprinkler systems; fire escapes; and other components relating to the 
operation or maintenance of a building. However, the term ``structural 
components'' does not include machinery the sole justification for the 
installation of which is the fact that such machinery is required to 
meet temperature or humidity requirements which are essential for the 
operation of other machinery or the processing of materials or 
foodstuffs. Machinery may meet the ``sole justification'' test provided 
by the preceding sentence even though it incidentally provides for the 
comfort of employees, or serves, to an insubstantial degree, areas where 
such temperature or humidity requirements are not essential. For 
example, an air conditioning and humidification system installed in a 
textile plant in order to maintain the temperature or humidity within a 
narrow optimum range which is critical in processing particular types of 
yarn or cloth is not included within the term ``structural components''. 
For special rules with respect to an elevator or escalator, the 
construction, reconstruction, or erection of which is completed by the 
taxpayer after June 30, 1963, or which is acquired after June 30, 1963, 
and the original use of which commences with the taxpayer and commences 
after such date, see section 48(a)(1)(C) and paragraph (m) of this 
section.
    (f) Intangible property. Intangible property, such as patents, 
copyrights, and subscription lists, does not qualify as section 38 
property. The cost of intangible property, in the case of a patent or 
copyright, includes all costs of purchasing or producing the item 
patented or copyrighted. Thus, in the case of a motion picture or 
television film or tape, the cost of the intangible property includes 
manuscript and screenplay costs, the cost of wardrobe and set design, 
the salaries of cameramen, actors, directors, etc., and all other costs 
properly includible in the basis of such film or tape. In the case of a 
book, the cost of the intangible property includes all costs of 
producing the original copyrighted manuscript, including the cost of 
illustration, research, and clerical and stenographic help. However, if 
tangible depreciable property is used in the production of such 
intangible property, see paragraph (b)(4) of this section.
    (g) Property used outside the United States--(1) General rule. (i) 
Except as provided in subparagraph (2) of this paragraph, the term 
``section 38 property'' does not include property which is used 
predominantly outside the United States (as defined in section 
7701(a)(9)) during the taxable year. The determination of whether 
property is used predominantly outside the United States during the 
taxable year shall be made by comparing the period of time in such year 
during which the property is physically located outside the United 
States with the period of time in such year during which the property is 
physically located within the United States. If the property is 
physically located outside the United States during more than 50 percent 
of the taxable year, such property shall be considered used 
predominantly outside the United States during that year. If property is 
placed in service after the first day of the taxable year, the 
determination of whether such property is physically located outside the 
United States during more than 50 percent of the taxable year shall be 
made with respect to the

[[Page 448]]

period beginning on the date on which the property is placed in service 
and ending on the last day of such taxable year.
    (ii) Since the determination of whether a credit is allowable to the 
taxpayer with respect to any property may be made only with respect to 
the taxable year in which the property is placed in service by the 
taxpayer, property used predominantly outside the United States during 
the taxable year in which it is placed in service cannot qualify as 
section 38 property with respect to such taxpayer, regardless of the 
fact that the property is permanently returned to the United States in a 
later year. Furthermore, if property is used predominantly in the United 
States in the year in which it is placed in service by the taxpayer, and 
a credit under section 38 is allowed with respect to such property, but 
such property is thereafter in any one year used predominantly outside 
the United States, such property ceases to be section 38 property with 
respect to the taxpayer and is subject to the application of section 47.
    (iii) This subparagraph applies whether property is used 
predominantly outside the United States by the owner of the property, or 
by the lessee of the property. If property is leased and if the lessor 
makes a valid election under Sec.  1.48-4 to treat the lessee as having 
purchased such property for purposes of the credit allowed by section 
38, the determination of whether such property is physically located 
outside the United States during more than 50 percent of the taxable 
year shall be made with respect to the taxable year of the lessee; 
however, if the lessor does not make such an election, such 
determination shall be made with respect to the taxable year of the 
lessor.
    (2) Exceptions. The provisions of subparagraph (1) of this paragraph 
do not apply to--
    (i) Any aircraft which is registered by the Administrator of the 
Federal Aviation Agency, and which (a) is operated, whether on a 
scheduled or nonscheduled basis, to and from the United States, or (b) 
is placed in service by the taxpayer during a taxable year ending after 
March 9, 1967, and is operated under contract with the United States: 
Provided, That use of the aircraft under the contract constitutes its 
principal use outside the United States during the taxable year. The 
term ``to and from the United States'' is not intended to exclude an 
aircraft which makes flights from one point in a foreign country to 
another such point, as long as such aircraft returns to the United 
States with some degree of frequency;
    (ii) Rolling stock, of a domestic railroad corporation subject to 
part I of the Interstate Commerce Act, which is used within and without 
the United States. For purposes of this subparagraph, the term ``rolling 
stock'' means locomotives, freight and passenger train cars, floating 
equipment, and miscellaneous transportation equipment on wheels, the 
expenditures for which are chargeable (or, in the case of leased 
property, would be chargeable) to the equipment investment accounts in 
the uniform system of accounts for railroad companies prescribed by the 
Interstate Commerce Commission;
    (iii) Any vessel documented under the laws of the United States 
which is operated in the foreign or domestic commerce of the United 
States. A vessel is documented under the laws of the United States if it 
is registered, enrolled, or licensed under the laws of the United States 
by the Commandant, U.S. Coast Guard. Vessels operated in the foreign or 
domestic commerce of the United States include those documented for use 
in foreign trade, coastwise trade, or fisheries;
    (iv) Any motor vehicle of a United States person (as defined in 
section 7701(a)(30)) which is operated to and from the United States 
with some degree of frequency;
    (v) Any container of a United States person which is used in the 
transportation of property to and from the United States;
    (vi) Any property (other than a vessel or an aircraft) of a U.S. 
person which is used for the purpose of exploring for, developing, 
removing, or transporting resources from the outer Continental Shelf 
(within the meaning of section 2 of the Outer Continental Shelf Lands 
Act, as amended and supplemented; 43 U.S.C. 1331). Thus for example, 
offshore

[[Page 449]]

drilling equipment may be section 38 property;
    (vii) Any property placed in service after December 31, 1965 which 
(a) is owned by a domestic corporation (other than a corporation 
entitled to the benefits of section 931 or 934(b)) or by a United States 
citizen (other than a citizen entitled to the benefits of section 931, 
932, 933, or 934(c)), and (b) is used predominantly in a possession of 
the United States during the taxable year by such a corporation or such 
a citizen, or by a corporation created or organized in, or under the law 
of, a possession of the United States. Thus, property placed in service 
after December 31, 1965, which is owned by a domestic corporation not 
entitled to the benefits of section 931 or 934(b), which is leased to a 
corporation organized under the laws of a U.S. possession, and which is 
used by such lessee predominantly in a possession of the United States 
may qualify as section 38 property. However, property which is owned by 
a corporation not entitled to the benefits of section 931 or 934(b) but 
which is leased to a domestic corporation entitled to such benefits 
would not qualify as section 38 property. The determination of whether 
property is used predominantly in a possession of the United States 
during the taxable year shall be made under principles similar to those 
described in subparagraph (1) of this paragraph. For example, if a 
machine is placed in service in a possession of the United States on 
July 1, 1966, by a calendar year taxpayer and if it is physically 
located in such a possession during more than 50 percent of the period 
beginning on July 1, 1966 and ending on December 31, 1966, then such 
machine shall be considered used predominantly in a possession of the 
United States during the taxable year 1966;
    (viii) Any communications satellite (as defined in section 103(3) of 
the Communications Satellite Act of 1962, 47 U.S.C., sec. 702(3)), or 
any interest therein, of a U.S. person;
    (ix) Any cable which is property described in section 50, or any 
interest therein, of a domestic corporation engaged in furnishing 
telephone service to which section 46(c)(3)(B)(iii) applies (or of a 
wholly owned domestic subsidiary of such corporation), if such cable is 
part of a submarine cable system which constitutes part of a 
communications link exclusively between the United States and one or 
more foreign countries; and
    (x) Any property described in section 50 (other than a vessel or an 
aircraft) of a U.S. person which is used in international or territorial 
waters for the purpose of exploring for, developing, removing, or 
transporting resources from ocean waters or deposits under such waters.
    (h) Property used for lodging--(1) In general. (i) Except as 
provided in subparagraph (2) of this paragraph, the term ``section 38 
property'' does not include property which is used predominantly to 
furnish lodging or is used predominantly in connection with the 
furnishing of lodging during the taxable year. Property used in the 
living quarters of a lodging facility, including beds and other 
furniture, refrigerators, ranges, and other equipment, shall be 
considered as used predominantly to furnish lodging. The term ``lodging 
facility'' includes an apartment house, hotel, motel, dormitory, or any 
other facility (or part of a facility) where sleeping accommodations are 
provided and let, except that such term does not include a facility used 
primarily as a means of transportation (such as an aircraft, vessel, or 
a railroad car) or used primarily to provide medical or convalescent 
services, even though sleeping accommodations are provided.
    (ii) Property which is used predominantly in the operation of a 
lodging facility or in serving tenants shall be considered used in 
connection with the furnishing of lodging, whether furnished by the 
owner of the lodging facility or another person. Thus, for example, 
lobby furniture, office equipment, and laundry and swimming pool 
facilities used in the operation of an apartment house or in serving 
tenants would be considered used predominantly in connection with the 
furnishing of lodging. However, property which is used in furnishing, to 
the management of a lodging facility or its tenants, electrical energy, 
water, sewage disposal services, gas, telephone service, or other 
similar services shall

[[Page 450]]

not be treated as property used in connection with the furnishing of 
lodging. Thus, such items as gas and electric meters, telephone poles 
and lines, telephone station and switchboard equipment, and water and 
gas mains, furnished by a public utility would not be considered as 
property used in connection with the furnishing of lodging.
    (iii) Notwithstanding any other provision of this paragraph (h), in 
the case of a qualified rehabilitated building (within the meaning of 
section 48(g)(1) and Sec.  1.48-12(b)), expenditures for property 
resulting in basis described in section 48(a)(1)(E) shall not be treated 
as section 38 property to the extent that such property is attributable 
to a portion of the building that is used for lodging or in connection 
with lodging. For example, if expenditures are incurred to rehabilitate 
a five story qualified rehabilitated building, three floors of which are 
used for apartments and two floors of which are used as commercial 
office space, the portion of the basis of the building attributable to 
qualified rehabilitated expenditures attributable to the commercial part 
of the building shall not be considered to be expenditures for property, 
or in connection with property, used predominantly for lodging. 
Allocation of expenditures between the two portions of the building are 
to be made using the principles contained in Sec.  1.48-12(C)(10)(ii).
    (2) Exceptions--(i) Nonlodging commercial facility. A nonlodging 
commercial facility which is available to persons not using the lodging 
facility on the same basis as it is available to the tenants of the 
lodging facility shall not be treated as property which is used 
predominantly to furnish lodging or predominantly in connection with the 
furnishing of lodging. Examples of non-lodging commercial facilities 
include restaurants, drug stores, grocery stores, and vending machines 
located in a lodging facility.
    (ii) Property used by a hotel or motel. Property used by a hotel, 
motel, inn, or other similar establishment, in connection with the trade 
or business of furnishing lodging shall not be considered as property 
which is used predominantly to furnish lodging or predominantly in 
connection with the furnishing of lodging, provided that the predominant 
portion of the living accommodations in the hotel, motel, etc., is used 
by transients during the taxable year. For purposes of the preceding 
sentence, the term ``predominant portion'' means ``more than one-half''. 
Thus, if more than one-half of the living quarters of a hotel, motel, 
inn, or other similar establishment is used during the taxable year to 
accommodate tenants on a transient basis, none of the property used by 
such hotel, motel, etc., in the trade or business of furnishing lodging 
shall be considered as property which is used predominantly to furnish 
lodging or predominantly in connection with the furnishing of lodging. 
Accommodations shall be considered used on a transient basis if the 
rental period is normally less than 30 days.
    (iii) Coin-operated machines. In the case of property which is 
described in section 50, coin-operated vending machines and coin-
operated washing machines and dryers shall not be considered as property 
which is used predominantly to furnish lodging or predominantly in 
connection with the furnishing of lodging.
    (iv) Certified historic structures. For purposes of this paragraph 
(h), regardless of the actual use of a certified historic structure, 
that portion of the basis of such certified historic structure which is 
attributable to qualified rehabilitation expenditures (as defined in 
Sec.  1.48-12(c)) shall not be considered as property which is either 
used predominantly to furnish lodging or predominantly in connection 
with the furnishing of lodging. Accordingly, such portion of the basis 
may qualify as section 38 property. (For the definition of ``certified 
historic structure,'' see section 48(g)(3) and Sec.  1.48-12(d).)
    (i) [Reserved]
    (j) Property used by certain tax-exempt organizations. The term 
``section 38 property'' does not include property used by an 
organization (other than a cooperative described in section 521) which 
is exempt from the tax imposed by chapter 1 of the Code unless such 
property is used predominantly in an unrelated trade or business the 
income of which is subject to tax under section 511. If such property is 
debt-financed

[[Page 451]]

property as defined in section 514(b), the basis or cost of such 
property for purposes of computing qualified investment under section 
46(c) shall include only that percentage of the basis or cost which is 
the same percentage as is used under section 514(a), for the year the 
property is placed in service, in computing the amount of gross income 
to be taken into account during such taxable year with respect to such 
property. The term ``property used by an organization'' means (1) 
property owned by the organization (whether or not leased to another 
person), and (2) property leased to the organization. Thus, for example, 
a data processing or copying machine which is leased to an organization 
exempt from tax would be considered as property used by such 
organization. Property (unless used predominantly in an unrelated trade 
or business) leased by another person to an organization exempt from tax 
or leased by such an organization to another person is not section 38 
property to either the lessor or the lessee, and in either case the 
lessor may not elect under Sec.  1.48-4 to treat the lessee of such 
property as having purchased such property for purposes of the credit 
allowed by section 38. This paragraph shall not apply to property leased 
on a casual or short-term basis to an organization exempt from tax.
    (k) Property used by governmental units. The term ``section 38 
property'' does not include property used by the United States, any 
State (including the District of Columbia) or political subdivision 
thereof, any international organization (as defined in section 
7701(a)(18)) other than the International Telecommunications Satellite 
Consortium or any successor organization, or any agency or 
instrumentality of the United States, of any State or political 
subdivision thereof, or of any such international organization. The term 
``property used by the United States, etc.'' means (1) property owned by 
any such governmental unit (whether or not leased to another person), 
and (2) property leased to any such governmental unit. Thus, for 
example, a data processing or copying machine which is leased to any 
such governmental unit would be considered as property used by such 
governmental unit. Property leased by another person to any such 
governmental unit or leased by such governmental unit to another person 
is not section 38 property to either the lessor or the lessee, and in 
either case the lessor may not elect under Sec.  1.48-4 to treat the 
lessee of such property as having purchased such property for purposes 
of the credit allowed by section 38. This paragraph shall not apply to 
property leased on a casual or short-term basis to any such governmental 
unit.
    (l) [Reserved]
    (m) Elevators and escalators--(1) In general. Under section 
48(a)(1)(C), an elevator or escalator qualifies as section 38 property 
if--
    (i) The construction, reconstruction, or erection of the elevator or 
escalator is completed by the taxpayer after June 30, 1963, or
    (ii) The elevator or escalator is acquired after June 30, 1963, and 
the original use of such elevator or escalator commences with the 
taxpayer and commences after such date.

In the case of construction, reconstruction, or erection of an elevator 
or escalator commenced before January 1, 1962, and completed after June 
30, 1963, there shall be taken into account in determining the qualified 
investment under section 46(c) only that portion of the basis which is 
properly attributable to construction, reconstruction, or erection after 
December 31, 1961. Further, if the construction, reconstruction, or 
erection of such property is commenced after December 31, 1961, and is 
completed after June 30, 1963, the entire basis of the elevator or 
escalator shall be taken into account in determining qualified 
investment under section 46(c). Also, if an elevator or escalator is 
reconstructed by the taxpayer after June 30, 1963, the basis 
attributable to such reconstruction may be taken into account in 
determining the qualified investment under section 46(c), irrespective 
of the fact that the original construction or erection of such elevator 
or escalator may have occurred before January 1, 1962. Paragraph (b) of 
Sec.  1.48-2 shall be applied in determining the date of acquisition, 
original use, and basis attributable to construction, reconstruction, or 
erection.

[[Page 452]]

    (2) Definition of elevators and escalators. For purposes of this 
section the term ``elevator'' means a cage or platform and its hoisting 
machinery for conveying persons or freight to or from different levels 
and functionally related equipment which is essential to its operation. 
The term includes, for example, guide rails and cables, motors and 
controllers, control panels and landing buttons, and elevator gates and 
doors, which are essential to the operation of the elevator. The term 
``elevator'' does not, however, include a structure which is considered 
a building for purposes of the investment credit. The term ``escalator'' 
means a moving staircase and functionally related equipment which is 
essential to its operation. For purposes of determining qualified 
investment under section 46(c) and Sec.  1.46-3, the basis of an 
elevator or escalator does not include the cost of any structural 
alterations to the building, such as the cost of constructing a shaft or 
of making alterations to the floor, walls, or ceiling, even though such 
alterations may be necessary in order to install or modernize the 
elevator or escalator.
    (3) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. If an elevator with a total basis of $100,000 is 
completed after June 30, 1963, and the portion attributable to 
construction by the taxpayer after December 31, 1961, is determined by 
engineering estimates or by cost accounting records to be $30,000, only 
the $30,000 portion may be taken into account as an investment in new 
section 38 property in computing qualified investment.
    Example 2. If construction of an elevator with a total basis of 
$90,000 is commenced by the taxpayer after December 31, 1961, and is 
completed after June 30, 1963, the entire basis of $90,000 may be taken 
into account as an investment in new section 38 property.
    Example 3. The facts are the same as in example 2 except that 
construction of the elevator was completed before June 30, 1963. The 
elevator is not considered to be section 38 property.
    Example 4. In 1964, a taxpayer reconditions an elevator, which had 
been constructed and placed in service in 1962 and which had an adjusted 
basis in 1964 of $75,000. The cost of reconditioning amounts to an 
additional $50,000. The basis of the elevator which may be taken into 
account in computing qualified investment in section 38 property is 
$50,000, irrespective of whether the taxpayer contracts to have it 
reconditioned or reconditions it himself, and irrespective of whether 
the materials used in the process are new in use.

    (n) Amortized property. Any property with respect to which an 
election under 167(k), 169, 184, 187, or 188 applies shall not be 
treated as section 38 property. In the case of any property to which 
section 169 applies, the preceding sentence shall apply only to so much 
of the adjusted basis of the property as (after the application of 
section 169(f)) constitutes the amortizable basis for purposes of 
section 169. This paragraph shall not apply to property with respect to 
which an election under section 167(k), 184, 187, or 188 applies unless 
such property is described in section 50.
    (o) [Reserved]
    (p) Qualified timber property. (1) Qualified timber property (within 
the meaning of section 194(c)(1)) shall be treated as section 38 
property to the extent of the portion of the basis of such property 
which is the amortizable basis (as defined in Sec.  1.194-3(b)) acquired 
during the taxable year and taken into account under section 194 (after 
applying the limitation of section 194(b)(1)). Such amortizable basis 
shall qualify as section 38 property whether or not an election is made 
under section 194. However, any portion of such amortizable basis which 
is attributable to property which otherwise qualifies as section 38 
property shall not be treated as section 38 property under section 
48(a)(1)(F) and this paragraph. For example, amortizable basis 
attributable to depreciation on equipment would not qualify as section 
38 property under this paragraph if such equipment qualifies as section 
38 property under sections 48(a)(1) (A) or (B). In determining the 
portion of amortizable basis which qualifies as section 38 property 
under this paragraph, the reduction in amortizable basis to account for 
depreciation sustained with respect to property used in the 
reforestation process (which otherwise qualifies as section 38 property) 
shall be applied before the $10,000 limitation on eligible costs under 
section 194(b)(1). For example, if in a taxable year a taxpayer incurs 
qualifying reforestation costs resulting

[[Page 453]]

in $12,000 of amortizable basis with respect to property for which an 
election is in effect, and $2,000 of these costs are attributable to 
depreciation of the taxpayer's equipment, such $12,000 would first be 
reduced by the $2,000 of depreciation, and the $10,000 limitation under 
section 194(b)(1) would be applied following such reduction.
    (2) If a taxpayer makes an election to amortize reforestation 
expenditures under section 194, and allocates the $10,000 limitation 
among more than one property under Sec.  1.194-2(b)(2), then such 
allocation shall apply for purposes of determining the amortizable basis 
that qualifies as section 38 property under paragraph (p)(1) of this 
section. If no election is made under section 194, the taxpayer may 
select the manner in which the $10,000 limitation is to be allocated 
among the qualified timber properties.

(Sec. 38(b), 76 Stat. 963; 26 U.S.C. 38; secs. 194 (94 Stat. 1989; 26 
U.S.C. 194) and 7805 (68A Stat. 917, 26 U.S.C. 7805) of the Internal 
Revenue Code of 1954)

[T.D. 6731, 29 FR 6073, May 8, 1964]

    Editorial Note: For Federal Register citations affecting Sec.  1.48-
1, see the List of CFR Sections Affected, which appears in the Finding 
Aids section of the printed volume and at www.govinfo.gov.



Sec.  1.48-2  New section 38 property.

    (a) In general. Section 48(b) defines ``new section 38 property'' as 
section 38 property--
    (1) The construction, reconstruction, or erection of which is 
completed by the taxpayer after December 31, 1961, or
    (2) Which is acquired by the taxpayer after December 31, 1961, 
provided that the original use of such property commences with the 
taxpayer and commences after such date.

In the case of construction, reconstruction, or erection of such 
property commenced before January 1, 1962, and completed after December 
31, 1961, there shall be taken into account as the basis of new section 
38 property in determining qualified investment only that portion of the 
basis which is properly attributable to contruction, reconstruction, or 
erection after December 31, 1961. See Sec.  1.48-1 for the definition of 
section 38 property.
    (b) Special rules for determining date of acquisition, original use, 
and basis attributable to construction, reconstruction, or erection. For 
purposes of paragraph (a) of this section, the principles set forth in 
paragraphs (a) (1) and (2) of Sec.  1.167(c)-1 shall be applied. Thus, 
for example, the following rules are applicable:
    (1) Property is considered as constructed, reconstructed, or erected 
by the taxpayer if the work is done for him in accordance with his 
specifications.
    (2) The portion of the basis of property attributable to 
construction, reconstruction, or erection after December 31, 1961, 
consists of all costs of construction, reconstruction, or erection 
allocable to the period after December 31, 1961, including the cost or 
other basis of materials entering into such work (but not including, in 
the case of reconstruction of property, the adjusted basis of the 
reconstructed property as of the time such reconstruction is commenced).
    (3) It is not necessary that materials entering into construction, 
reconstruction, or erection be acquired after December 31, 1961, or that 
they be new in use.
    (4) If construction or erection by the taxpayer began after December 
31, 1961, the entire cost or other basis of such construction or 
erection may be taken into account as the basis of new section 38 
property.
    (5) Construction, reconstruction, or erection by the taxpayer begins 
when physical work is started on such construction, reconstruction, or 
erection.
    (6) Property shall be deemed to be acquired when reduced to physical 
possession, or control.
    (7) The term ``original use'' means the first use to which the 
property is put, whether or not such use corresponds to the use of such 
property by the taxpayer. For example, a reconditioned or rebuilt 
machine acquired by the taxpayer will not be treated as being put to 
original use by the taxpayer. The question of whether property is 
reconditioned or rebuilt property is a question of fact. Property will 
not be treated as reconditioned or rebuilt merely because it contains 
some used parts.

[[Page 454]]


If the cost of reconstruction may properly either be capitalized and 
recovered through depreciation or charged against the depreciation 
reserve, such cost may be taken into account as the basis of new section 
38 property even though it is charged against the depreciation reserve.
    (c) Examples. This section may be illustrated by the following 
examples:

    Example 1. If a machine with a total cost of $100,000 is completed 
after December 31, 1961, and the portion attributable to construction by 
the taxpayer after December 31, 1961, is determined by engineering 
estimates or by cost accounting records to be $30,000, the $30,000 
amount shall be taken into account by the taxpayer in computing 
qualified investment in new section 38 property.
    Example 2. In 1965, a taxpayer reconditions a machine, which he 
constructed and placed in service in 1962 and which has an adjusted 
basis in 1965 of $10,000. The cost of reconditioning amounts to an 
additional $20,000. The basis of the machine which shall be taken into 
account in computing qualified investment in new section 38 property for 
1965 is $20,000, whether he contracts to have it reconditioned or 
reconditions it himself, and irrespective of whether the materials used 
for reconditioning are new in use.
    Example 3. In 1961, a taxpayer pays the entire purchase price of 
$10,000 for section 38 property to be delivered in 1962. In 1962 he 
takes possession of the property and commences the original use of the 
asset in that year. The $10,000 amount shall be taken into account in 
computing qualified investment in new section 38 property for 1962.
    Example 4. A taxpayer, instead of reconditioning his old machine, 
buys a ``factory reconditioned'' or ``rebuilt'' machine in 1962 to 
replace it. The reconditioned or rebuilt machine is not new section 38 
property since such taxpayer is not the first user of the machine. See, 
however, Sec.  1.48-3 (relating to used section 38 property).
    Example 5. In 1962, a taxpayer buys from X for $20,000 an item of 
section 38 property which has been previously used by X. The taxpayer in 
1962 makes an expenditure on the property of $5,000 of the type that 
must be capitalized. Regardless of whether the $5,000 is added to the 
basis of such property or is capitalized in a separate account, such 
amount shall be taken into account by the taxpayer in computing 
qualified investment in new section 38 property for 1962. No part of the 
$20,000 purchase price may be taken into account for such purpose. See, 
however, Sec.  1.48-3 (relating to used section 38 property).

    (d) Special rule for qualified rehabilitated buildings. 
Notwithstanding the rules in paragraphs (a) through (c) of this section, 
that portion of the basis of a qualified rehabilitated building 
attributable to qualified rehabilitation expenditures is treated as new 
section 38 property. See section 48(a)(1)(E) and (g), and Sec.  1.48-11.

[T.D. 6731, 29 FR 6076, May 8, 1964, as amended by T.D. 8031, 50 FR 
26698, June 28, 1985]



Sec.  1.48-3  Used section 38 property.

    (a) In general. (1) Section 48(c) provides that ``used section 38 
property'' means section 38 property acquired by purchase after December 
31, 1961, which is not ``new section 38 property.'' See Sec. Sec.  1.48-
1 and 1.48-2, respectively, for definitions of section 38 property and 
new section 38 property. In determining whether property is acquired by 
purchase, the provisions of paragraph (c)(1) of Sec.  1.179-3 shall 
apply, except that (i) ``1961'' shall be substituted for ``1957'', and 
(ii) the definition of ``component member'' of a controlled group of 
corporations in paragraph (d)(4) of this section shall be substituted 
for the definition of such term in paragraph (e) of Sec.  1.179-3.
    (2)(i) Property shall not qualify as used section 38 property if, 
after its acquisition by the taxpayer, it is used by (a) a person who 
used such property before such acquisition, or (b) a person who bears a 
relationship described in section 179(d)(2) (A) or (B) to a person who 
used such property before such acquisition. Thus, for example, if 
property is used by a person and is later sold by him under a sale and 
lease-back arrangement, such property in the hands of the purchaser-
lessor is not used section 38 property because the property, after its 
acquisition, is being used by the same person who used it before its 
acquisition. Similarly, where a lessee has been leasing property and 
subsequently purchases it (whether or not the lease contains an option 
to purchase), such property is not used section 38 property with respect 
to the purchaser because the property is being used by the same person 
who used it before its acquisition. In addition, if property owned by a 
lessor is sold subject to the lease, or is sold upon the termination of 
the lease, the property will not qualify as used section 38 property 
with respect to the purchaser if, after the purchase, the property is 
used

[[Page 455]]

by a person who used the property as a lessee before the purchase.
    (ii) For purposes of applying subdivision (i) of this subparagraph, 
property shall not be considered as used by a person before its 
acquisition if such property was used only on a casual basis by such 
person.
    (iii) In determining whether a person bears a relationship described 
in section 179(d)(2) (A) or (B) to a person who used property before its 
acquisition by the taxpayer, the provisions of paragraphs (c)(1) (i) and 
(ii) of Sec.  1.179-3 shall apply, except that the definition of 
``component member'' of a controlled group of corporations in paragraph 
(d)(4) of this section shall be substituted for the definition of such 
term in paragraph (e) of Sec.  1.179-3.
    (3) The provisions of this paragraph may be illustrated by the 
following examples:

    Example 1. Corporation P acquires properties 1 and 2 in 1960 and 
uses them in its trade or business until 1962. In 1962, corporation P 
sells such properties to corporation Y, which leases back property 1 to 
corporation P and leases property 2 to corporation S, a wholly owned 
subsidiary of corporation P. Property 1 is not used section 38 property 
in the hands of corporation Y because, after its acquisition by 
corporation Y, it is used by a person (corporation P) who used it prior 
to such acquisition. Property 2 is not used section 38 property because, 
after its acquisition by corporation Y, it is used by a person 
(corporation S) who is related, within the meaning of section 
179(d)(2)(B), to a person (corporation P) who used it before such 
acquisition.
    Example 2. In 1962, corporation L leases property from corporation 
M. In 1964, corporation L acquires the property that it previously had 
been leasing. The property acquired by corporation L is not used section 
38 property because such property is used after such acquisition by the 
same person (corporation L) who used the property before its acquisition 
(corporation L).
    Example 3. Corporation X buys property in 1962 and leases such 
property to corporation Y. Corporation X in 1965 sells the property to A 
subject to the lease. The property acquired by A is not used section 38 
property if such property continues to be used by corporation Y, because 
corporation Y used the property before its acquisition by A.
    Example 4. A owns a bulldozer which he rents out to a number of 
different users, including B. In 1962, B used the bulldozer from 
February 16 to March 12 and again on October 15 and 16. B purchases the 
bulldozer from A on December 1, 1962. The prior use of the property by B 
does not disqualify such property as used section 38 property to B, 
because he used such property only on a casual basis prior to its 
purchase.

    (b) Cost. (1) The cost of used section 38 property is equal to the 
basis of such property, but does not include so much of such basis as is 
determined by reference to the adjusted basis of other property (whether 
or not section 38 property) held at any time by the taxpayer acquiring 
such used section 38 property.
    (2) If property (whether or not section 38 property) is disposed of 
by the taxpayer (other than by reason of its destruction or damage by 
fire, storm, shipwreck, or other casualty, or its theft) and used 
section 38 property similar or related in service or use is acquired as 
a replacement therefor in a transaction in which the basis of the 
replacement property is not determined by reference to the adjusted 
basis of the property replaced, then the cost of the used section 38 
property so acquired shall be its basis reduced by the adjusted basis of 
the property replaced. The preceding sentence shall apply only if the 
taxpayer acquires (or enters into a contract to acquire) the replacement 
property within a period of 60 days before or after the date of the 
disposition.
    (3) Notwithstanding subparagraphs (1) and (2) of this paragraph, the 
cost of used section 38 property shall not be reduced with respect to 
the adjusted basis of any property disposed of if, by reason of section 
47, such disposition resulted in an increase of tax or a reduction of 
investment credit carrybacks or carryovers described in section 46(b).
    (4) The provisions of this paragraph may be illustrated by the 
following examples:

    Example 1. In 1972, A acquires machine 2 (an item of used section 38 
property which has a sales price of $5,600) by trading in machine 1 (an 
item of section 38 property acquired in 1962), and by paying an 
additional $4,000 cash. The adjusted basis of machine 1 is $1,600. Under 
the provisions of sections 1012 and 1031(d), the basis of machine 2 is 
$5,600 ($1,600 adjusted basis of machine 1 plus cash expended of 
$4,000). The cost of machine 2 which may be taken into account in 
computing qualified investment for 1972 is $4,000

[[Page 456]]

(basis of $5,600 less $1,600 adjusted basis of machine 1).
    Example 2. The facts are the same as in example 1 except that 
machine 2 has a sales price of $6,000. The trade-in allowance on machine 
1 is $2,000. The result is the same as in example 1, that is, the basis 
of machine 2 is $5,600 ($1,600 plus $4,000); therefore, the cost of 
machine 2 which may be taken into account in computing qualified 
investment for 1972 is $4,000 (basis of $5,600 less $1,600 adjusted 
basis of machine 1).
    Example 3. On September 18, 1962, B sells truck 1, which he acquired 
in 1961 and which has an adjusted basis in his hands of $1,200. On 
October 15, 1962, he purchases for $2,000 truck 2 (an item of used 
section 38 property) as a replacement therefor. The cost of truck 2 
which may be taken into account in computing qualified investment is 
$800 ($2,000 less $1,200).
    Example 4. In 1962, C acquires property 1, an item of new section 38 
property with a basis of $12,000 and a useful life of eight years or 
more. He is allowed a credit under section 38 of $840 (7 percent of 
$12,000) with respect to such property. In 1968, C acquires property 2 
(an item of used section 38 property) by trading in property 1 and by 
paying an additional amount in cash. Section 47(a) applies to the 
disposition of property 1 and C's tax liability for 1968 is increased by 
$280. Since the application of section 47(a) results in an increase in 
tax, for purposes of computing qualified investment the cost of property 
2 is not reduced by any part of the adjusted basis of the property 
traded in.

    (c) Dollar limitation--(1) In general. Section 48(c)(2) provides 
that the aggregate cost of used section 38 property which may be taken 
into account for any taxable year in computing qualified investment 
under section 46(c)(1)(B) shall not exceed $50,000. If the total cost of 
used section 38 property exceeds $50,000, there must be selected, in the 
manner provided in subparagraph (4) of this paragraph, the particular 
items of used section 38 property the cost of which is to be taken into 
account in computing qualified investment. The cost of used section 38 
property that may be taken into account by a person in applying the 
$50,000 limitation for any taxable year includes not only the cost of 
used section 38 property placed in service by such person during such 
taxable year, but also the cost of used section 38 property apportioned 
to such person. For purposes of this section, the cost of used section 
38 property apportioned to any person means the cost of such property 
apportioned to him by a trust, estate, or electing small business 
corporation (as defined in section 1371(b)), and his share of the cost 
of partnership used section 38 property, with respect to the taxable 
year of such trust, estate, corporation or partnership ending with or 
within such person's taxable year. Thus, if an individual places in 
service during his taxable year used section 38 property with a cost of 
$25,000, if the cost of used section 38 property apportioned to him by 
an electing small business corporation for such year is $30,000, and if 
his share for such year of the cost of used section 38 property placed 
in service by a partnership is $20,000, he may select from the used 
section 38 property with a total cost of $75,000 the particular used 
section 38 property the cost of which he wishes to take into account. No 
part of the excess of $25,000 ($75,000 cost minus $50,000 annual 
limitation) may be taken into account in any other taxable year. For 
determining the amount of the cost to be apportioned by an electing 
small business corporation, see paragraph (a)(2) of Sec.  1.48-5; in the 
case of estates and trusts, see paragraph (a)(2) of Sec.  1.48-6. See 
paragraph (e) of this section for application of $50,000 limitation in 
the case of affiliated groups.
    (2) Married individuals filing separate returns. In the case of a 
husband or wife who files a separate return, the aggregate cost of used 
section 38 property which may be taken into account for the taxable year 
to which such return relates cannot exceed $25,000. The preceding 
sentence shall not apply, however, unless the taxpayer's spouse places 
in service (or is apportioned the cost of) used section 38 property for 
the taxable year of such spouse which ends with or within the taxpayer's 
taxable year. Thus, if a husband and wife who file separate returns on a 
calendar year basis both place in service used section 38 property 
during the taxable year, the maximum cost of used section 38 property 
which may be taken into account by each is $25,000. However, in such 
case, if only one spouse places in service (or is apportioned the cost 
of) used section 38 property during the taxable year, such spouse may 
take into account a maximum of $50,000 for

[[Page 457]]

such year. The determination of whether an individual is married shall 
be made under the principles of section 143 and the regulations 
thereunder.
    (3) Partnerships. In the case of a partnership, the aggregate cost 
of used section 38 property placed in service by the partnership (or 
apportioned to the partnership) which may be taken into account by the 
partners with respect to any taxable year of the partnership may not 
exceed $50,000. If such aggregate cost exceeds $50,000, the partnership 
must make a selection in the manner provided in subparagraph (4) of this 
paragraph. The $50,000 limitation applies to each partner, as well as to 
the partnership.
    (4) Selection of $50,000 cost. (i) If the sum of (a) the cost of 
used section 38 property placed in service during the taxable year by 
any person, (b) such person's share of the cost of partnership used 
section 38 property placed in service during the taxable year of a 
partnership ending with or within such person's taxable year, and (c) 
the cost of used section 38 property apportioned to such person for such 
taxable year by an electing small business corporation, estate, or 
trust, exceeds $50,000, such person must make a selection for such 
taxable year in the manner provided in subdivision (ii) of this 
subparagraph.
    (ii) For purposes of computing qualified investment (or, in the case 
of a partnership, electing small business corporation, estate, or trust, 
for purposes of selecting used section 38 property the cost of which may 
be taken into account by the partners, shareholders, or estate or trust 
and its beneficiaries) any person to whom subdivision (i) of this 
subparagraph applies must select a total cost of $50,000 from (a) the 
cost of specific used section 38 property placed in service by such 
person, (b) such person's share of the cost of specific used section 38 
property placed in service by a partnership and (c) the cost of used 
section 38 property apportioned to such person by an electing small 
business corporation, estate, or trust. When a particular property is 
selected, the entire cost (or entire share of cost of a particular 
property in the case of partnership property) of such property must be 
taken into account unless, as a result of the selection of such 
particular property, the $50,000 limitation is exceeded. Likewise, in 
the case of an apportionment from an electing small business 
corporation, estate, or trust, when the cost in a particular useful life 
category is selected, the entire cost in such category must be taken 
into account unless, as a result of the selection of such cost, the 
$50,000 limitation is exceeded. Thus, if a person places in service 
during the taxable year three items of used section 38 property, each 
with a cost of $20,000, he must select the entire cost of two of the 
items and only $10,000 of the cost of the third item; he may not select 
a portion of the cost of each of the three items. The selection by any 
person shall be made by taking the cost of used section 38 property into 
account in computing qualified investment (or in selecting the used 
section 38 property the cost of which may be taken into account by the 
partners, etc.), and if such property was placed in service by such 
person, he must maintain records which permit specific identification of 
any item of used section 38 property selected.
    (5) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. H, who operates a sole proprietorship, purchases and 
places in service in 1963 used section 38 property with a cost of 
$60,000. His spouse, W, is a shareholder in an electing small business 
corporation which purchases and places in service during its fiscal year 
ending June 30, 1963, used section 38 property with a cost of $50,000. 
Both spouses file separate returns on a calendar year basis. W, as a 60 
percent shareholder on the last day of the taxable year of the 
corporation, is apportioned $30,000 (60 percent of $50,000) of the cost 
of the used section 38 property placed in service by the corporation. 
The cost of used section 38 property that may be taken into account by H 
on his separate return is $25,000. The cost of used section 38 property 
that may be taken into account by W on her separate return is $25,000. 
On the other hand, if the corporation had made no investment in used 
section 38 property, H could take $50,000 of the $60,000 cost into 
account.
    Example 2. Partners X, Y, and Z share the profits and losses of 
partnership XYZ in the ratio of 50 percent, 30 percent, and 20 percent, 
respectively. The partnership and each partner make returns on the basis 
of the calendar year. Each partner also operates a sole proprietorship. 
In 1963, the partnership and

[[Page 458]]

the partners purchase and place in service the following used section 38 
property:

------------------------------------------------------------------------
                                                   Estimated
                                                    useful
                    Property                         life        Cost
                                                    (years)
------------------------------------------------------------------------
                 Partnership XYZ
Property No. 1..................................           9     $10,000
Property No. 2..................................           7      50,000
Property No. 3..................................           7      50,000
Property No. 4..................................           5      30,000
                    Partner X
Property No. 5..................................           6      30,000
                    Partner Y
Property No. 6..................................          10      60,000
                    Partner Z
Property No. 7..................................           4      36,000
------------------------------------------------------------------------

    (i) Selection by partnership. In accordance with subparagraph 
(4)(ii) of this paragraph, the partnership selects property No. 1 and 
$40,000 of the cost of property No. 2 to be taken into account. 
Therefore, each partner's share of cost of the property selected by the 
partnership is as follows:

----------------------------------------------------------------------------------------------------------------
                                                  Estimated                       Partner's share of cost
                  Property No.                   useful life    Selected  --------------------------------------
                                                   (years)        cost       X (50%)      Y (30%)      Z (20%)
----------------------------------------------------------------------------------------------------------------
1..............................................            9      $10,000       $5,000       $3,000       $2,000
2..............................................            7       40,000       20,000       12,000        8,000
                                                ----------------------------------------------------------------
    Total......................................  ...........       50,000       25,000       15,000       10,000
----------------------------------------------------------------------------------------------------------------

    (ii) Selection by partners. In accordance with subparagraph (4)(ii) 
of this paragraph, the partners make the following selections: Partner X 
selects property No. 5 ($30,000), his share of the cost of property No. 
1 ($5,000), and $15,000 of his share of the cost of property No. 2. 
Partner Y selects $50,000 of the cost of property No. 6, and no part of 
his share of the cost of partnership property. Partner Z, having an 
aggregate cost of used section 38 property of only $46,000 (partnership 
property of $10,000 and individually owned property of $36,000), takes 
into account the entire $46,000.
    (iii) Qualified investment of partner X. X's total qualified 
investment in used section 38 property for 1963 is $35,000, computed as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                               Estimated
                        Property No.                          useful life    Selected    Applicable   Qualified
                                                                (years)        cost      percentage   investment
----------------------------------------------------------------------------------------------------------------
1...........................................................            9       $5,000          100       $5,000
2...........................................................            7       15,000      66\2/3\       10,000
5...........................................................            6       30,000      66\2/3\       20,000
                                                             ---------------------------------------------------
  Total.....................................................  ...........       50,000  ...........       35,000
----------------------------------------------------------------------------------------------------------------

    (iv) Qualified investment of partner Y. Y's total qualified 
investment in used section 38 property for 1963 is $50,000 (100 percent 
of $50,000) since he selected $50,000 of the cost of property No. 6 
which has a useful life of 8 years or more.
    (v) Qualified investment of partner Z. Z's total qualified 
investment in used section 38 property for 1963 is $19,333, computed as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                               Estimated
                        Property No.                          useful life    Selected    Applicable   Qualified
                                                                (years)        cost      percentage   investment
----------------------------------------------------------------------------------------------------------------
1...........................................................            9       $2,000          100       $2,000
2...........................................................            7        8,000      66\2/3\        5,333
7...........................................................            4       36,000      33\1/3\       12,000
                                                             ---------------------------------------------------
  Total.....................................................  ...........       46,000  ...........       19,333
----------------------------------------------------------------------------------------------------------------


    (d) Dollar limitation for component members of a controlled group--
(1) In general. (i) Section 48(c)(2)(C) provides that the $50,000 
limitation on the cost of used section 38 property which may be taken 
into account for any taxable year shall, in the case of component

[[Page 459]]

members of a controlled group (as defined in subparagraph (4) of this 
paragraph) on a particular December 31, be reduced for each such member 
by apportioning the $50,000 amount among such component members for 
their taxable years that include such December 31 in accordance with 
their respective amounts of used section 38 property which may be taken 
into account, that is, in accordance with the total cost of used section 
38 property placed in service by each such member during its taxable 
year (without regard to the $50,000 limitation or the applicable 
percentages to be applied in computing qualified investment).
    (ii) Except as otherwise provided in this paragraph, the $50,000 
amount shall be apportioned among those corporations which are component 
members of the controlled group on a December 31. For the taxable year 
of each such member which includes such December 31, the cost of used 
section 38 property taken into account in computing qualified investment 
under section 46(c)(1)(B) shall not exceed the amount which bears the 
same ratio to $50,000 as the cost of used section 38 property placed in 
service by such member for such taxable year bears to the total cost of 
used section 38 property placed in service by all component members of 
the controlled group for their taxable years which include such December 
31.
    (iii) If a component member of the group makes its income tax return 
on the basis of a 52-53-week taxable year, the principles of section 
441(f)(2)(A)(ii) and Sec.  1.441-2 apply in determining the last day of 
such a taxable year.
    (2) Statement by the ``filing member''. For purposes of this 
paragraph, the term ``filing member'' with respect to a particular 
December 31 means the member (or members) of a controlled group which 
has, among those members of the group which are apportioned part of the 
$50,000 amount for their taxable years which include such December 31, 
the taxable year including such December 31 which ends on the earliest 
date. The filing member of the group shall attach to its income tax 
return a statement containing the name, address, and employer 
identification number of each component member of the controlled group 
on such December 31 and a schedule showing the computation of the 
apportionment of the $50,000 amount among the component members of the 
group. Each such other member shall retain as part of its records a copy 
of the statement containing the apportionment schedule. Except as 
otherwise provided in subparagraph (3)(ii) of this paragraph, each 
member which is apportioned part of the $50,000 amount shall take such 
apportioned amount into account in filing its return for its taxable 
year which includes such December 31.
    (3) Estimate of used section 38 property to be placed in service. 
(i) For purposes of subparagraphs (1) and (2) of this paragraph, if on 
the date (including extensions of time) for filing the income tax return 
of the filing member of the group with respect to a particular December 
31, the total cost of used section 38 property actually placed in 
service by any component member of the group during such member's 
taxable year that includes such December 31 is not known, then such 
member shall estimate such cost. The estimate shall be made on the basis 
of the facts and circumstances known as of the time of the estimate. Any 
such estimate shall also be used in determining the total cost of used 
section 38 property placed in service by all component members for their 
taxable years including such December 31.
    (ii) If an estimate is used by any component member of a controlled 
group pursuant to subdivision (i) of this subparagraph, each member may 
later file an original or amended return in which the apportionment of 
the $50,000 amount is based upon the cost of used section 38 property 
actually placed in service by all component members of the group during 
their taxable year which include such December 31. Such amended 
apportionment shall be made only if each component member of the group 
whose limitation would be changed files an original or amended return 
which reflects the amended apportionment based upon the cost of the used 
section 38 property actually placed in service by component members of 
the group. In such case, the new statement reflecting the

[[Page 460]]

amended apportionment shall be attached to the amended return of the 
filing member of the group, and a copy of such statement shall be 
retained by each such member pursuant to the requirements of 
subparagraph (2) of this paragraph.
    (4) Definitions of controlled group of corporations and component 
member of controlled group. For purposes of this section, the terms 
``controlled group of corporations'' and ``component member'' of a 
controlled group of corporations shall have the same meaning assigned to 
those terms in section 1563 (a) and (b), except that the phrase ``more 
than 50 percent'' shall be substituted for the phrase ``at least 80 
percent'' each place it appears in section 1563(a)(1). For purposes of 
applying Sec.  1.1563-1(b)(2)(ii)(c), an electing small business 
corporation shall be treated as an excluded member whether or not it is 
subject to the tax imposed by section 1378.
    (5) Members of controlled group filing a consolidated return. For 
the purpose of apportioning the $50,000 amount in the case of component 
members of a controlled group which join in filing a consolidated 
return, all such members shall be treated as though they were a single 
component member of the controlled group. Thus, in determining the 
limitation on the cost of used section 38 property which may be taken 
into account by the group filing the consolidated return, the 
apportionment provided in subparagraph (1)(ii) of this paragraph shall 
be made by using the aggregate cost of such property placed in service 
by all members of the group filing the consolidated return. If all 
component members of the controlled group join in filing a consolidated 
return, the group may select the items to be taken into account to the 
extent of an aggregate cost of $50,000; if some component members of the 
controlled group do not join in filing the consolidated return, then the 
members of the group which join in filing the consolidated return may 
select the items to be taken into account to the extent of the amount 
apportioned to such members under subparagraph (1)(ii) of this 
paragraph.
    (6) Examples. This paragraph may be illustrated by the following 
examples:

    Example 1. (i) On December 31, 1970, corporations M, N, and O are 
component members of the same controlled group. The taxable years of M, 
N, and O end, respectively, on January 31, March 31, and April 30. 
During the respective taxable years of each corporation which include 
December 31, 1970, M places in service no used section 38 property, and 
N and O place in service used section 38 property with respective costs 
of $100,000 and $150,000. N is the ``filing member'' of the group since 
N, among the members (N and O) which are apportioned part of the $50,000 
amount for their taxable years which include such December 31, has the 
taxable year ending on the earliest date.
    (ii) The cost of used section 38 property taken into account by N 
for its taxable year ending March 31, 1971, may not exceed $20,000, that 
is, an amount which bears the same ratio to $50,000 as the cost of used 
section 38 property placed in service by N for its taxable year 
($100,000) bears to the total cost of used section 38 property placed in 
service by all component members of the controlled group (M, N, and O) 
for their taxable years which include December 31, 1970 ($250,000). 
Similarly, the cost of used section 38 property taken into account by O 
for its taxable year ending April 30, 1971, may not exceed $30,000.
    Example 2. (i) On December 31, 1971, corporations S and T are 
component members of the same controlled group. The taxable years of 
corporations S and T end, respectively, on January 31 and June 30. On 
April 15, 1972, S files an income tax return for its taxable year ending 
January 31, 1972, during which year it places in service used section 38 
property costing $100,000. T estimates that it will place in service 
used section 38 property costing $150,000 during its taxable year ending 
June 30, 1972.
    (ii) S, the ``filing member'' of the group, must file an 
apportionment schedule under which it may take into account as the cost 
of used section 38 property an amount not in excess of $20,000 
($100,000/$250,000 x $50,000). If T actually places in service during 
its taxable year used section 38 property costing more or less than 
$150,000, its income tax return for its taxable year ending June 30, 
1972, may reflect the amended apportionment of the $50,000 limitation 
based upon the cost of used section 38 property actually placed in 
service by the group, provided that S attaches a new apportionment 
schedule to an amended return to reflect the amended apportionment. For 
example, if T places in service used section 38 property costing 
$200,000, the cost of used section 38 property taken into account by S 
and T for their respective taxable years could not exceed $16,667 
($100,000/$300,000 x $50,000) and $33,333

[[Page 461]]

($200,000/$300,000 x $50,000), respectively, under an amended 
apportionment.

(Secs. 38(b) and 7805 of the Internal Revenue Code of 1954 (76 Stat. 
962, U.S.C. 38(b); 68A Stat. 917; 26 U.S.C. 7805)

[T.D. 6731, 29 FR 6076, May 8, 1964, as amended by T.D. 7181, 37 FR 
8064, Apr. 25, 1972; T.D. 7820, 47 FR 25139, June 10, 1982; T.D. 8996, 
67 FR 35012, May 17, 2002]



Sec.  1.48-4  Election of lessor of new section 38 property to treat
lessee as purchaser.

    (a) In general--(1) Lessee treated as purchaser. Under section 
48(d), a lessor of property may elect to treat the lessee of such 
property as having purchased such property (or, in the case of short-
term lease property described in subparagraph (2) of this paragraph, a 
portion of such property) for purposes of the credit allowed by section 
38 if the following conditions are satisfied:
    (i) The property must be ``section 38 property'' in the hands of the 
lessor; that is, it must be property with respect to which depreciation 
(or amortization in lieu of depreciation) is allowable to the lessor, it 
must have a useful life of 3 years (4 years in the case of property 
which is not described in section 50) or more in his hands, and in every 
other respect it must meet the requirements of Sec.  1.48-1. Thus, for 
example, property leased by a municipality to a taxpayer for use in what 
is commonly known as an ``industrial park'' is not eligible for the 
election since, under paragraph (k) of Sec.  1.48-1, property used by a 
governmental unit is not section 38 property. In addition, property used 
by the lessee predominantly outside the United States is not eligible 
for the election since, under paragraph (g) of Sec.  1.48-1, such 
property is not section 38 property. For purposes of this subdivision, 
if the lessor is an estate or trust, depreciation (or amortization in 
lieu of depreciation) will be considered allowable to the estate or 
trust even if it is apportioned to the beneficiaries or other persons.
    (ii) The property must be ``new section 38 property'' (within the 
meaning of Sec.  1.48-2) in the hands of the lessor, and the original 
use of such property must commence with the lessor. See paragraph (b) of 
this section for the application of the rules relating to ``original 
use'' in the case of leased property.
    (iii) The property would constitute ``new section 38 property'' to 
the lessee if such lessee had actually purchased the property. Thus, the 
election is not available if the lessee is not the original user of the 
property. See paragraph (b) of this section for the application of the 
rules relating to ``original use'' in the case of leased property. See 
paragraph (d) of this section for the determination of the estimated 
useful life of leased property in the hands of the lessee.
    (iv) A statement of election to treat the lessee as a purchaser has 
been filed in the manner and within the time provided in paragraph (f) 
or (g) of this section.
    (v) The lessor is not a person referred to in section 46(d)(1), that 
is, a mutual savings bank, cooperative bank, or domestic building and 
loan association to which section 593 applies; a regulated investment 
company or real estate investment trust subject to taxation under 
subchapter M, chapter 1 of the Code; or a cooperative organization 
described in section 1381(a).

The election may be made on a property-by-property basis or a general 
election may be made with respect to each taxable year of a particular 
lessee. If the conditions of this subparagraph have been met, the lessee 
shall be treated as though he were the actual owner of all or a portion 
of the property for purposes of the credit allowed by section 38. Thus, 
the lessee shall be entitled to a credit allowed by section 38 with 
respect to such property for the taxable year in which he places such 
property in service, and the lessor shall not be entitled to a credit 
allowed by section 38 with respect to such property unless the property 
is short-term lease property (as defined in subparagraph (2) of this 
paragraph). Moreover, if the leased property is disposed of, or if it 
otherwise ceases to be section 38 property, the property will be subject 
to the provisions of section 47 (relating to early dispositions, etc.).
    (2) Short-term lease property. For purposes of this section, the 
term ``short-term lease property'' means property which--
    (i) Is new section 38 property;

[[Page 462]]

    (ii) Has a class life (determined under section 167(m)) in excess of 
14 years;
    (iii) Is leased under a lease entered into after November 8, 1971, 
for a period which is less than 80 percent of the class life of such 
property; and
    (iv) Is not leased subject to a net lease within the meaning of 
section 57(c)(1)(B) and the regulations thereunder.

The class life of property shall be determined under section 167(m) and 
the regulations prescribed in connection with that section, except that 
such class life shall be determined without regard to any variance from 
the class life permitted under such section. If a class life has not 
been prescribed for property under section 167(m) on the date such 
property is leased, the class life of the property shall be the 
estimated useful life used to compute the allowance for depreciation 
with respect to such property under section 167. For purposes of 
subdivision (iii) of this subparagraph, the period for which a lease is 
entered into shall be determined without regard to any option on the 
part of the lessee to extend or renew such lease, and without regard to 
any option on the part of the lessee to cancel the lease after a 
specified period if under the terms of such lease, such a cancellation 
would result in the imposition of a substantial penalty upon the lessee. 
Generally, a penalty equal to 25 percent of the total remaining rental 
payments due under the lease will be regarded as substantial.
    (b) Original use. For purposes of this section only, the lessor and 
the lessee may both be considered as the original users of an item of 
leased property. The determination of whether the lessor qualifies as 
the original user of leased property shall be made under paragraph 
(b)(7) of Sec.  1.48-2. The determination of whether the lessee 
qualifies as the original user of leased property shall be made, under 
paragraph (b)(7) of Sec.  1.48-2, as if the lessee actually purchased 
the property. Thus, the lessee would not be considered the original user 
of the property if it has been previously used by the lessor or another 
person, or if it is reconstructed, rebuilt, or reconditioned property. 
However, the lessee would be considered the original user if he is the 
first person to use the property for its intended function. Thus, the 
fact that the lessor may have, for example, tested, stored, or attempted 
to lease the property to other persons will not preclude the lessee from 
being considered the original user.
    (c) Qualified investment--(1) In general. If a valid election is 
made under this section, the amount of qualified investment under 
section 46(c) with respect to the leased property shall be determined 
under this paragraph and paragraphs (d) and (e) of this section.
    (2) Nonshort-term lease property. In the case of property which is 
not short-term lease property, the lessee is treated as having acquired 
the entire property for an amount equal to--
    (i) The fair market value of such property on the date possession is 
transferred to the lessee, or
    (ii) If the property is leased by a component member of a controlled 
group to another component member of the same controlled group (within 
the meaning of paragraph (f)(4) of Sec.  1.46-1) on the date possession 
of the property is transferred to the lessee, the basis of the property 
in the hands of the lessor.
    (3) Short-term lease property. (i) In the case of short-term lease 
property, the lessee is treated as having acquired a portion of such 
property. The amount for which the lessee is treated as having acquired 
such portion is an amount equal to a fraction, the numerator of which is 
the term of the lease and the denominator of which is the class life of 
the property leased, of the amount for which the lessee would be treated 
as having acquired the property under subparagraph (2) of this paragraph 
if the property were not short-term lease property.
    (ii) In the case of short-term lease property, the qualified 
investment of the lessor is an amount equal to his qualified investment 
in such property determined under section 46(c) multiplied by a 
fraction, the numerator of which is the class life of the property 
leased minus the term of the lease and the denominator of which is the 
class life of such property.
    (4) Example. The provisions of this paragraph may be illustrated by 
the following example:


[[Page 463]]


    Example. (a) On December 1, 1971, X corporation completed 
construction of an item of new section 38 property with a basis of 
$10,000. Under section 167(m), the property has a class life of 16 
years. On December 1, 1971, X leases the property to individual A for 4 
years and A immediately places the property in service. The lease is not 
a net lease within the meaning of section 57(c)(1)(B). On the date of 
the lease, the fair market value of the property is $12,000. The 
property would qualify as new section 38 property in A's hands if it had 
been purchased by A. Under this section, the property is short-term 
lease property. X makes the election under this section to treat A as 
having acquired a portion of the property.
    (b) A is treated as having acquired from X a portion of the property 
for $3,000 (the fair market value of the property, $12,000, multiplied 
by a fraction, \4/16\ , the numerator of which is the term of the lease 
and the denominator of which is the class life of the leased property). 
Since under paragraph (d) of this section the useful life of such 
property in the hands of A is the same as the useful life of such 
property in the hands of X, and such useful life is at least 7 years, 
A's qualified investment with respect to the property is $3,000.
    (c) The qualified investment of X is $7,500 (the qualified 
investment of X under section 46(c), $10,000, multiplied by a fraction, 
\12/16\, the numerator of which is the class life of the leased 
property, 16, minus the term of the lease, 4, and the denominator of 
which is the class life of the property).

    (d) Estimated useful life of leased property. The estimated useful 
life to the lessee of property subject to the election shall be deemed 
to be the estimated useful life in the hands of the lessor for purposes 
of computing depreciation, regardless of the term of the lease. The 
lessor shall determine the estimated useful life of each leased property 
on an individual basis even though multiple asset accounts are used. 
However, in the case of assets similar in kind contained in a multiple 
asset account, the lessor shall assign to each of such assets the 
average useful life of such assets used in computing depreciation. Thus, 
for example, if during a taxable year a lessor leases 10 similar trucks 
with an average estimated useful life for depreciation purposes of 6 
years, based on an estimated range of 5 to 7 years, he must assign a 
useful life of 6 years to each of the 10 trucks.
    (e) Lessor itself a lessee--(1) In general. If the lessee of 
property is treated, under this section, as having purchased all or a 
portion of such property and if such lessee leases such property to a 
sublessee, the qualified investment with respect to such property in the 
hands of the sublessee shall be determined under paragraphs (c) and (d) 
of this section as if the original lessor had leased the property 
directly to the sublessee for the term of the sublessee's lease on the 
date possession of the property is transferred to the sublessee. For 
this purpose, property which is short-term lease property in the hands 
of the lessee shall be treated as short-term lease property in the hands 
of the sublessee regardless of whether such property is leased to the 
sublessee subject to a net lease (within the meaning of section 
57(c)(1)(B)). In the case of property which is short-term lease property 
in the hands of the sublessee, the amount for which the lessee is 
treated as having acquired such property under paragraph (c) of this 
section shall be reduced by an amount equal to such amount multiplied by 
a fraction, the numerator of which is the term of the lease of the 
sublessee and the denominator of which is the term of the lease of the 
lessee.
    (2) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example. (a) On December 1, 1971, corporation X completes 
construction of a machine at a cost of $10,000. The machine has a class 
life under section 167(m) of 20 years. On December 1, 1971, X leases the 
machine to corporation Y for 12 years, and Y immediately subleases the 
machine to individual A for 8 years. X and Y are component members of 
the same controlled group. The lease between X and Y is not a net lease 
within the meaning of section 57(c)(1)(B). The fair market value of the 
property on December 1, 1971, is $16,000. Both X and Y make valid 
elections under this section.
    (b) The property is short-term lease property and this paragraph 
applies.
    (c) The qualified investment of A is $6,400. Such amount is 
determined by multiplying $16,000, the amount for which A would be 
treated under paragraph (c)(2) of this section as having acquired the 
property if it were not short-term lease property, by \8/20\.
    (d) The qualified investment of Y is $2,000. Such amount is 
determined by multiplying $10,000, the amount for which Y would be 
treated under paragraph (c)(2) of this section as having acquired the 
property if it were not short-term lease property, by \12/20\, and by

[[Page 464]]

reducing the amount so determined ($6,000) by \8/12\ of such amount 
($4,000) to $2,000.
    (e) The qualified investment of X is $4,000. Such amount is 
determined by multiplying the amount of X's qualified investment 
determined under section 46(c) without regard to this section ($10,000) 
by \8/20\.

    (f) Property-by-property election--(1) Manner of making election. 
The election of a lessor with respect to a particular property (or 
properties) shall be made by filing a statement with the lessee, signed 
by the lessor and including the written consent of the lessee, 
containing the following information:
    (i) The name, address, and taxpayer account number of the lessor and 
the lessee;
    (ii) The district director's office with which the income tax 
returns of the lessor and the lessee are filed;
    (iii) A description of each property with respect to which the 
election is being made;
    (iv) The date on which possession of the property (or properties) is 
transferred to the lessee;
    (v) The estimated useful life category of the property (or 
properties) in the hands of the lessor, that is, 3 years or more but 
less than 5 years, 5 years or more but less than 7 years, or 7 years or 
more;
    (vi) The amount for which the lessee (or sublessee) is treated as 
having acquired the leased property under paragraph (c)(2) or (3) of 
this section; and
    (vii) If the lessor is itself a lessee, the name, address, and 
taxpayer account number of the original lessor, and the district 
director's office with which the income tax return of such original 
lessor is filed.
    (2) Time for making election. The statement referred to in 
subparagraph (1) of this paragraph shall be filed with the lessee on or 
before the due date (including any extensions of time) of the lessee's 
return for the lessee's taxable year during which possession of the 
property is transferred to the lessee, except that if such taxable year 
ends after March 31, 1971, and before December 11, 1971, the statement 
shall be filed with the lessee on or before the due date (including any 
extensions of time) of the lessee's return for such taxable year, or on 
or before October 24, 1972, whichever is later.
    (3) Election is irrevocable. An election under this paragraph shall 
be irrevocable as of the time the statement referred to in subparagraph 
(1) of this paragraph is filed with the lessee.
    (g) General election--(1) In general. In lieu of making elections on 
a property-by-property basis in the manner and time prescribed in 
paragraph (f) of this section, a lessor may, with respect to a 
particular taxable year of a particular lessee, make a general election 
to treat such lessee as having purchased all properties possession of 
which is transferred under lease by the lessor to the lessee during such 
taxable year of the lessee.
    (2) Manner and time for making general election. The general 
election of a lessor with respect to a taxable year of a lessee shall be 
made by filing a statement with the lessee, signed by the lessor and 
including the written consent of the lessee, on or before the due date 
(including any extensions of time) of the lessee's return for such 
taxable year, except that if such taxable year ends after March 31, 
1971, and before December 11, 1971, the statement shall be filed with 
the lessee on or before the due date (including any extensions of time) 
of the lessee's return for such taxable year, or on or before October 
24, 1972, whichever is later. Such statement of general election shall 
contain:
    (i) The name, address, and taxpayer account number of the lessor and 
the lessee;
    (ii) The taxable year of the lessee with respect to which such 
general election is made;
    (iii) The district director's office with which the income tax 
returns of the lessor and the lessee are filed;
    (iv) If the lessor is itself a lessee, the name, address, and 
taxpayer account number of the original lessor, and the district 
director's office with which the income tax return of such original 
lessor is filed.
    (3) Election is irrevocable. A general election under this paragraph 
shall be irrevocable as of the time the statement referred to in 
subparagraph (2) of this paragraph is filed with the lessee and shall be 
binding on the lessor and the lessee for the entire taxable year of the 
lessee with respect to which such general election is made.

[[Page 465]]

    (4) Information requirement. If a lessor, with respect to a taxable 
year of the lessee, makes a general election under this paragraph, such 
lessor shall provide such lessee, on or before the date required for 
filing the statement under subparagraph (2) of this paragraph, with a 
statement (or statements) containing the information required by 
paragraphs (f)(1) (iii), (iv), (v), and (vi) of this section with 
respect to all properties possession of which is transferred under lease 
by the lessor to the lessee during such taxable year.
    (h) Signature. The statement referred to in paragraph (f)(1) or 
(g)(2) of this section shall not be valid unless signed by both the 
lessor and the lessee. The signature of the lessee shall constitute the 
consent of the lessee to the election. The statement shall be signed by 
the taxpayer or a duly authorized agent of the taxpayer. For purposes of 
this section, a facsimile signature may be used in lieu of a signature 
manually executed and, if used, shall be as binding as a signature 
manually executed.
    (i) [Reserved]
    (j) Record requirements. The lessor and the lessee shall keep as a 
part of their records the statement referred to in paragraph (f)(1), or 
the statements referred to in paragraphs (g)(2) and (g)(4), of this 
section. The lessor shall attach to his income tax return a summary 
statement of all property leased during his taxable year with respect to 
which an election is made. In the case of a taxable year ending after 
March 31, 1971, and before December 11, 1971, a summary statement may be 
filed on or before the due date (including any extensions of time) of 
the return or on or before October 24, 1972, whichever is later, with 
the Internal Revenue Service Center with which the return has been 
filed. Such summary statement shall contain the following information: 
(1) The name, address, and taxpayer account number of the lessor; and 
(2) in numerical account number order, each lessee's account number, 
name, and address, the estimated useful life category of the property 
(or, if applicable, the estimated useful life expressed in years), and 
the basis or fair market value of the property, whichever is applicable.
    (k) Adjustment of rental deductions--(1) In general. The rules of 
this paragraph apply only to section 38 property placed in service 
before January 1, 1964, and with respect to any such property only for 
taxable years of a lessee beginning before January 1, 1964. If a lessor 
makes a valid election under this section with respect to property 
placed in service by the lessee before January 1, 1964, section 48(g) 
and Sec.  1.48-7 (relating to adjustments to basis of property) shall 
not apply to the lessor with respect to such property. Thus, the lessor 
is not required to reduce under section 48(g)(1) the basis of such 
property. However, if such an election is made, the deductions otherwise 
allowable under section 162 to the lessee for amounts paid or accrued to 
the lessor under the lease shall be adjusted in the manner provided in 
this paragraph. For special adjustment for taxable years beginning after 
December 31, 1963, see paragraph (m) of this section.
    (2) Decrease in rental deduction. (i) The deductions otherwise 
allowable under section 162 to the lessee for amounts paid or accrued to 
the lessor under the lease with respect to leased property placed in 
service before January 1, 1964, shall be decreased under subdivision 
(ii) or (iii) of this subparagraph, whichever is applicable, by an 
amount determined by reference to the credit earned on the leased 
property. The ``credit earned'' on the leased property is determined by 
multiplying the qualified investment (as defined in section 46(c)) with 
respect to such property by 7 percent. Thus, the credit earned (and the 
decrease in deductions) is determined without regard to the limitation 
based on tax which, under section 46(a)(2), may limit the amount of the 
credit the lessee may take into account in any one year.
    (ii) If, in the case of property placed in service before January 1, 
1964, the lessor, under paragraph (f)(1)(v) of this section, supplies 
the lessee with the useful life of such property expressed in years, 
then for each taxable year beginning before January 1, 1964, any part of 
which falls within a period beginning with the month in which the leased 
property is placed in service by the lessee and ending with the close of 
the estimated useful life of such property (as

[[Page 466]]

determined under paragraph (d) of this section), the lessee shall 
decrease the deduction otherwise allowable under section 162 for each 
such taxable year with respect to such property. The decrease for each 
such taxable year shall be equal to (a) the credit earned, divided by 
(b) the estimated useful life of the property (expressed in months), 
multiplied by (c) the number of calendar months in which the leased 
property was held by the lessee during such taxable year. Thus, if 
leased property with a basis of $27,000 in the hands of a calendar-year 
lessee, and with an estimated useful life of 10 years, is placed in 
service by the lessee on July 15, 1963, the lessee must decrease his 
section 162 deduction with respect to the leased property for the 
taxable year 1963 by $94.50 ($1,890 credit earned, divided by 120, 
multiplied by 6).
    (iii) If, in the case of property placed in service before January 
1, 1964, the lessor, under paragraph (f)(1)(v) of this section, supplies 
the lessee with the useful life category of such property, then for each 
taxable year beginning before January 1, 1964, during a period equal to 
the shortest life of the useful life category used by the lessee in 
computing qualified investment under section 46(c) with respect to the 
leased property, the lessee shall decrease the deduction otherwise 
allowable under section 162 for such taxable year with respect to such 
property. The decrease for each such taxable year shall be equal to the 
credit earned divided by such shortest life, that is, 4, 6, or 8. Such 
decreases shall begin with the taxable year during which the lessee 
places the property in service. Thus, if leased property with a basis of 
$30,000 to the lessee, and an estimated useful life falling within the 4 
years or more but less than 6 years useful life category, is placed in 
service by the lessee within the lessee's taxable year ending December 
31, 1962, the lessee must decrease his section 162 deduction with 
respect to the leased property for each of the taxable years 1962 and 
1963 by $175 ($700 credit earned divided by 4).
    (iv) To the extent that a required decrease, under subdivision (ii) 
or (iii) of this subparagraph, is not taken into account for any taxable 
year beginning before January 1, 1964, because the deduction otherwise 
allowable under section 162 for such taxable year with respect to the 
leased property is less than the required decrease for such taxable 
year, then the balance of the required decrease not taken into account 
for such taxable year shall decrease the amount otherwise allowable as a 
deduction under section 162 with respect to such property for the next 
succeeding taxable year (or years) beginning before January 1, 1964, if 
any, for which a deduction is allowable with respect to such property. 
Thus, if the required decrease with respect to leased property is $200 
for 1962 but the lessee's deduction otherwise allowable under section 
162 for such taxable year with respect to such property is only $50, the 
balance of $150 must be applied in 1963 to decrease the deduction 
otherwise allowable to the lessee with respect to the leased property 
for such taxable year.
    (v) See paragraph (b) of Sec.  1.48-7 for reduction of basis in the 
case of an actual purchase of leased property by a lessee (in a taxable 
year of such lessee beginning before January 1, 1964) who has been 
treated as a purchaser of such property under this section.
    (3) Increase in rental deductions on account of early disposition, 
etc. (i) If, as a result of an early disposition, etc., in a taxable 
year beginning before January 1, 1964, with respect to leased property 
placed in service before such date, the lessee's tax is increased under 
section 47(a) (1) or (2), or an adjustment in a carryback or carryover 
is made under section 47(a)(3) by reduction of an unused credit, the 
rental deductions (if any) otherwise allowable under section 162 to such 
lessee for amounts paid or accrued to the lessor under the lease with 
respect to such property shall be increased in an amount equal to the 
total decreases previously made in the lessee's rental deductions under 
subparagraph (2) of this paragraph.
    (ii) Except as provided in subdivision (iii) of this subparagraph, 
the increase in rental deductions described in subdivision (i) of this 
subparagraph shall be taken into account as an increase in rental 
deductions otherwise allowable under section 162 for the taxable year in 
which the early disposition, etc., occurred.

[[Page 467]]

    (iii) If, after the event which caused section 47(a) (1), (2), or 
(3) to apply the lessee continues the use of the property in a trade or 
business or in the production of income, the increase in rental 
deductions described in subdivision (i) of this subparagraph shall be 
taken into account ratably over the remaining portion of the useful life 
of the property which was used in making the decreases in rental 
deductions with respect to the property under subparagraph (2) of this 
paragraph.
    (iv) If subdivision (iii) of this subparagraph applies, and if, 
prior to the expiration of the useful life of the property used in 
making the decreases in rental deductions, the lease is terminated other 
than by actual purchase of the property by the lessee, any increase in 
rental deductions not previously taken into account shall be taken into 
account as an increase in rental deductions for the taxable year in 
which the lease is terminated. In the case of an actual purchase of the 
property by the lessee, see paragraph (e) of Sec.  1.48-7.
    (l) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. X Corporation is engaged in the business of manufacturing 
and leasing new and reconstructed equipment which in its hands has an 
estimated useful life of 12 years. After December 31, 1961, X 
Corporation constructs machine no. 1 at a cost of $20,000 and 
reconstructs machine no. 2 at a cost of $5,000. On February 15, 1962, Y 
Corporation, a calendar-year taxpayer, leases both machines from X 
Corporation and places them in service. The fair market value of machine 
no. 1 on the date on which possession is transferred to Y is $25,200. 
Machine no. 1 would qualify as new section 38 property in Y's hands if 
it had been purchased by Y. If X elects to treat Y as the purchaser of 
machine no. 1, under paragraph (c)(2)(ii) of this section such machine 
will have a basis of $25,200 in Y's hands. Under paragraph (f)(1)(v) of 
this section, X supplies Y with an estimated useful life of 12 years 
(expressed in years rather than useful life category) with respect to 
machine no. 1 for purposes of determining Y's qualified investment. Y's 
credit earned with respect to the property is $1,764 (7 percent of 
$25,200). Under paragraph (k)(2)(ii) of this section, Y's deduction 
attributable to the leased property for 1962 will be decreased by 
$134.75 (credit earned of $1,764, divided by 144, multiplied by 11), and 
for 1963 such deduction will be decreased by $147 ($1,764, divided by 
144, multiplied by 12). The election is not available with respect to 
machine no. 2 since a reconstructed machine would not constitute new 
section 38 property if Y had purchased it. In such case, while X cannot 
make the election to treat Y as a purchaser, X would be entitled to a 
credit under section 38 based on its expenditure of $5,000 as an 
investment in new section 38 property, since such amount represents cost 
of reconstruction after December 31, 1961.
    Example 2. Assume the same facts as in example 1 except that under 
paragraph (f)(1)(v) of this section, X supplies Y with an estimated 
useful life category of 8 years or more (rather than an estimated useful 
life expressed in years) with respect to machine no. 1 for purposes of 
determining Y's qualified investment. Under paragraph (k)(2)(iii) of 
this section, Y's deduction attributable to the leased property will be 
decreased by $220.50 (credit earned of $1,764, divided by 8) for each of 
its taxable years 1962 and 1963.
    Example 3. Assume the same facts as in example 1 except that the 
lessee disposes of his interest in the lease on January 1, 1963, and 
that there is an increase in Y's tax for 1963 under section 47(a)(1) in 
the amount of $1,764. Under paragraph (k)(2) of this section, Y's 
deductions attributable to the leased property are decreased only in 
1962, and the amount of such decrease is $134.75. In 1963 there shall be 
an increase of $134.75 in the deductions otherwise allowable under 
section 162 for such taxable year with respect to the leased property.
    Example 4. Assume the same facts as in example 1 except that during 
the year 1963 the property was used by Y predominantly outside the 
United States within the meaning of paragraph (g) of Sec.  1.48-1, and 
thereafter was used in Y's trade or business. Under paragraph (k)(3) of 
this section, the increase of $134.75 described in example 3 is taken 
into account ratably as an increase in rental deductions otherwise 
allowable under section 162 in the amount of $12.25 ($134.75 divided by 
11 years) for 1963 and each of the 10 succeeding years.

    (m) Increase in rental deductions on account of section 203(a)(2)(B) 
of the Revenue Act of 1964--(1) In general. (i) Under section 
203(a)(2)(B) of the Revenue Act of 1964, if, for any taxable year of a 
lessee beginning before January 1, 1964, the rental deductions otherwise 
allowable under section 162 to such lessee for amounts paid or accrued 
to the lessor under the lease with respect to leased property placed in 
service before January 1, 1964, were decreased under paragraph (k)(2) of 
this

[[Page 468]]

section, such rental deductions shall be increased.
    (ii) The increase in rental deductions described in subdivision (i) 
of this subparagraph shall be in an amount equal to the total decreases 
in the lessee's rental deductions previously made under paragraph (k)(2) 
of this section less any increases in rental deductions made under 
paragraph (k)(3) of this section.
    (iii) Except as provided in subdivision (iv) of this subparagraph, 
the increase in rental deductions described in subdivision (i) of this 
subparagraph shall be taken into account ratably over the remaining 
portion of the useful life of the property commencing with the first day 
of the first taxable year beginning after December 31, 1963. For this 
purpose, the useful life of the property shall be the useful life used 
in making the decreases in rental deductions with respect to the 
property under paragraph (k)(2) of this section.
    (iv) If the lease is terminated other than by the lessee's actual 
purchase of the property during a taxable year beginning after December 
31, 1963, and before the end of the remaining useful life of the 
property used in making the decreases in rental deductions, the amount 
of the increase in rental deductions described in subdivision (i) of 
this subparagraph and not previously taken into account shall be allowed 
as a deduction for the taxable year in which such termination occurs.
    (v) The rental deductions with respect to any section 38 property 
are not to be increased under this paragraph if the lessee dies in a 
taxable year beginning before January 1, 1964.
    (vi) The increase in rental deductions described in subdivision (i) 
of this subparagraph shall ordinarily be taken into account by the 
lessee treated as the purchaser, that is, the lessee entitled to the 
credit. However, if the property under the lease is transferred by the 
lessee to a successor lessee in a transaction described in section 47(b) 
(other than a transfer by reason of death) under which the successor 
lessee assumes the lessee's obligations under the lease, such increase 
in rental deductions shall be taken into account by the successor lessee 
in the manner prescribed in this paragraph.
    (2) Examples. The operation of this paragraph may be illustrated by 
the following examples:

    Example 1. (a) X Corporation acquired on January 1, 1962, an item of 
new section 38 property with a basis of $24,000 and with a useful life 
to the lessor of 10 years. Y Corporation, which makes its returns on the 
basis of a calendar year, leased such property from X Corporation and 
placed it in service on January 2, 1962. Under this section, X 
Corporation made a valid election to treat Y Corporation as having 
purchased such property for purposes of the credit allowed by section 38 
and supplied the lessee with information that the property had a useful 
life of 10 years. The amount of the credit earned with respect to such 
property was $1,680 (7 percent of $24,000). For each of the taxable 
years 1962 and 1963, Y Corporation decreased, under paragraph (k)(2) of 
this section, its deductions otherwise allowable under section 162 with 
respect to such property by $168 ($1,680 multiplied by \12/120\).
    (b) For each of the taxable years 1964 through 1971, Y Corporation 
increases its deductions otherwise allowable under section 162 for 
amounts paid to X Corporation under the lease by $42 ($336 (that is, 
$168 multiplied by 2) divided by the remaining useful life of 8 years).
    Example 2. (a) The facts are the same as in example 1 except that 
the lease is terminated on January 3, 1965.
    (b) For the taxable year 1964, Y Corporation increases its 
deductions otherwise allowable under section 162 by $42.
    (c) For the taxable year 1965, Y Corporation increases its 
deductions otherwise allowable under section 162 for the portion of the 
increase which had not been taken into account as of the time of the 
termination of the lease. Thus, the amount of such increase for the 
taxable year 1965 is $294 ($336 minus $42).

(Sec. 38, 76 Stat. 963; 26 U.S.C. 38)

[T.D. 6731, 29 FR 6080, May 8, 1964; 29 FR 7671, June 16, 1964, as 
amended by T.D. 6838, 30 FR 9060, July 20, 1965; T.D. 7203, 37 FR 17131, 
17132, Aug. 25, 1972]



Sec.  1.48-5  Electing small business corporations.

    (a) In general. (1) In the case of an electing small business 
corporation (as defined in section 1371(b)), the basis of ``new section 
38 property'' and the cost of ``used section 38 property'' placed in 
service during the taxable year shall be apportioned pro rata among the 
persons who are shareholders of such corporation on the last day of such 
corporation's taxable year. Section 38

[[Page 469]]

property shall not (by reason of such apportionment) lose its character 
as new section 38 property or used section 38 property, as the case may 
be. The estimated useful life of such property in the hands of a 
shareholder shall be deemed to be the estimated useful life of such 
property in the hands of the electing small business corporation. The 
bases of all new section 38 properties which have a useful life falling 
within a particular useful life category shall be aggregated; likewise, 
the cost of all used section 38 properties which have a useful life 
falling within a particular useful life category shall be aggregated. 
The total bases of new section 38 properties within each useful life 
category and the total cost of used section 38 properties within each 
useful life category shall be apportioned separately. The useful life 
categories are:
    (i) 3 years or more but less than 5 years; (ii) 5 years or more but 
less than 7 years; and (iii) 7 years or more. There shall be apportioned 
to each person who is a shareholder of the electing small business 
corporation on the last day of the taxable year of such corporation, for 
his taxable year in which or with which the taxable year of such 
corporation ends, his pro rata share of the total bases of new section 
38 properties within each useful life category, and his pro rata share 
of the total cost of used section 38 properties within each useful life 
category. In determining who are shareholders of an electing small 
business corporation on the last day of its taxable year, the rules of 
paragraph (d)(1) of Sec.  1.1371-1 and of paragraph (a)(2) of Sec.  
1.1373-1 shall apply.
    (2) The total cost of used section 38 property that may be 
apportioned by an electing small business corporation to its 
shareholders for any taxable year of such corporation shall not exceed 
$50,000. If the total cost of used section 38 property placed in service 
during the taxable year by the electing small business corporation 
exceeds $50,000 such corporation must select, under paragraph (c)(4) of 
Sec.  1.48-3, the used section 38 property the cost of which is to be 
apportioned to its shareholders.
    (3) A shareholder to whom the basis (or cost) of section 38 property 
is apportioned shall, for purposes of the credit allowed by section 38, 
be treated as the taxpayer with respect to such property. Thus, the 
total cost of used section 38 property apportioned to him by the 
electing small business corporation must be taken into account as cost 
of used section 38 property in determining whether the $50,000 
limitation on the cost of used section 38 property which may be taken 
into account by the shareholder in computing qualified investment for 
any taxable year is exceeded. If a shareholder takes into account in 
determining his qualified investment any portion of the basis (or cost) 
of section 38 property placed in service by an electing small business 
corporation and if such property subsequently is disposed of or 
otherwise ceases to be section 38 property in the hands of the 
corporation, such shareholder shall be subject to the provisions of 
section 47. See Sec.  1.47-4.
    (b) Summary statement. An electing small business corporation shall 
attach to its return a statement showing the apportionment to each 
shareholder of the total bases of new, and the total cost of used, 
section 38 properties within each useful life category.
    (c) Example. This section may be illustrated by the following 
example:

    Example. 1 X Corporation, an electing small business corporation 
which makes its return on the basis of the calendar year, acquires and 
places in service on June 1, 1962, three new assets which qualify as new 
section 38 property and three used assets which qualify as used section 
38 property. The basis of each new, and the cost of each used, section 
38 property and the estimated useful life of each property are as 
follows:

------------------------------------------------------------------------
                                         Basis (or    Estimated useful
               Asset No.                   cost)            life
------------------------------------------------------------------------
1 (new)...............................     $30,000  4 years.
2 (new)...............................      30,000  4 years.
3 (new)...............................      30,000  8 years.
4 (used)..............................      12,000  6 years.
5 (used)..............................      12,000  6 years.
6 (used)..............................      12,000  8 years.
------------------------------------------------------------------------


On December 31, 1962, X Corporation has 10 shares of stock outstanding 
which are owned as follows: A owns 3 shares, B owns 2 shares, and C owns 
5 shares.
    (2) Under this section, the total bases of the new, and the total 
cost of the used, section 38 properties are apportioned to the 
shareholders of X Corporation as follows:

[[Page 470]]



----------------------------------------------------------------------------------------------------------------
                                                    New--4 to 6    New--8 years    Used--6 to 8    Used--8 years
              Useful life category                     years          or more          years          or more
----------------------------------------------------------------------------------------------------------------
  Total bases or total cost.....................         $60,000         $30,000         $24,000         $12,000
                                                 ===============================================================
Shareholder A (\3/10\)..........................          18,000           9,000           7,200           3,600
Shareholder B (\2/10\)..........................          12,000           6,000           4,800           2,400
Shareholder C (\5/10\)..........................          30,000          15,000          12,000           6,000
----------------------------------------------------------------------------------------------------------------

Assume that shareholders A, B and C did not place in service during 
their taxable years in which falls December 31, 1962 (the last day of X 
Corporation's taxable year) any section 38 property and that such 
shareholders did not own any interests in other electing small business 
corporations, partnerships, estates, or trusts. Under section 46(c), the 
qualified investment of shareholder A is $23,400, of shareholder B is 
$15,600, and of shareholder C is $39,000, computed as follows:

------------------------------------------------------------------------
                                                  Applicable   Qualified
                 Basis (or cost)                  percentage  investment
------------------------------------------------------------------------
                              Shareholder A
------------------------------------------------------------------------
$18,000 (new)...................................     33\1/3\      $6,000
$9,000 (new)....................................         100       9,000
$7,200 (used)...................................     66\2/3\       4,800
$3,600 (used)...................................         100       3,600
                                                 -----------------------
    Total.......................................  ..........      23,400
------------------------------------------------------------------------
                              Shareholder B
------------------------------------------------------------------------
$12,000 (new)...................................     33\1/3\      $4,000
$6,000 (new)....................................         100       6,000
$4,800 (used)...................................     66\2/3\       3,200
$2,400 (used)...................................         100       2,400
                                                 -----------------------
    Total.......................................  ..........      15,600
------------------------------------------------------------------------
                              Shareholder C
------------------------------------------------------------------------
$30,000 (new)...................................     33\1/3\     $10,000
$15,000 (new)...................................         100      15,000
$12,000 (used)..................................     66\2/3\       8,000
$6,000 (used)...................................         100       6,000
                                                 -----------------------
    Total...................................................      39,000
------------------------------------------------------------------------


[T.D. 6731, 29 FR 6082, May 8, 1964, as amended by T.D. 6931, 32 FR 
14040, Oct. 10, 1967; T.D. 7203, 37 FR 17133, Aug. 25, 1972]



Sec.  1.48-6  Estates and trusts.

    (a) In general. (1) In the case of an estate or trust, the basis of 
``new section 38 property'' and the cost of ``used section 38 property'' 
placed in service during the taxable year shall be apportioned among the 
estate or trust and its beneficiaries on the basis of the income of such 
estate or trust allocable to each. Section 38 property shall not (by 
reason of such apportionment) lose its character as new section 38 
property or used section 38 property, as the case may be. The estimated 
useful life of such property in the hands of a beneficiary shall be 
deemed to be the estimated useful life of such property in the hands of 
the estate or trust. The bases of all new section 38 properties which 
have a useful life falling within a particular useful life category 
shall be aggregated; likewise, the cost of all used section 38 
properties which have a useful life falling within a particular useful 
life category shall be aggregated. The total bases of new section 38 
properties within each useful life category and the total cost of used 
section 38 properties within each useful life category shall be 
apportioned separately. The useful life categories are:
    (i) 3 years or more but less than 5 years; (ii) 5 years or more but 
less than 7 years; and (iii) 7 years or more. There shall be apportioned 
to the estate or trust for its taxable year, and to each beneficiary of 
such estate or trust for his taxable year in which or with which the 
taxable year of such estate or trust ends, his share (as determined 
under paragraph (b) of this section) of the total bases of new section 
38 properties within each useful life category, and his share of the 
total cost of used section 38 properties within each useful life 
category.
    (2) The total cost of used section 38 property that may be 
apportioned among an estate or trust and its beneficiaries for any 
taxable year of such estate or trust shall not exceed $50,000. If the 
total cost of used section 38 property placed in service during the 
taxable year by the estate or trust exceeds $50,000, such estate or 
trust must select, under paragraph (c)(4) of Sec.  1.48-3, the used 
section 38 property the cost of which is to be apportioned among such 
estate or trust and its beneficiaries.
    (3) A beneficiary to whom the basis (or cost) of section 38 property 
is apportioned shall, for purposes of the credit allowed by section 38, 
be treated

[[Page 471]]

as the taxpayer with respect to such property. Thus, the total cost of 
used section 38 property apportioned to him by the estate or trust must 
be taken into account as cost of used section 38 property in determining 
whether the $50,000 limitation on the cost of used property which may be 
taken into account by the beneficiary in computing qualified investment 
for any taxable year is exceeded. If a beneficiary takes into account in 
determining his qualified investment any portion of the basis (or cost) 
of section 38 property placed in service by an estate or trust and if 
such property subsequently is disposed of or otherwise ceases to be 
section 38 property in the hands of estate or trust, such beneficiary 
shall be subject to the provisions of section 47. See Sec.  1.47-5.
    (4) For purposes of this section, the term ``beneficiary'' includes 
heir, legatee, and devisee.
    (5) If during the taxable year of an estate or trust a beneficiary's 
interest in the income of such estate or trust terminates, the basis (or 
cost) of section 38 property placed in service by such estate or trust 
after such termination shall not be apportioned to such beneficiary.
    (b) Share. A trust's, estate's, or beneficiary's share of the total 
bases of new section 38 properties, and the total cost of used section 
38 properties, within a useful life category shall be--
    (1) The total bases of new (or the total cost of used) section 38 
properties which have a useful life falling within such useful life 
category placed in service in the taxable year of the estate or trust, 
multiplied by
    (2) The amount of income allocable to such estate or trust or to 
such beneficiary for such taxable year, divided by
    (3) The sum of the amounts of income allocable to such estate or 
trust and all its beneficiaries taken into account under subparagraph 
(2) of this paragraph.
    (c) Limitation based on amount of tax. In the case of an estate or 
trust, the $25,000 amount specified in section 46(a)(2), relating to 
limitation based on amount of tax, shall be reduced for the taxable year 
to--
    (1) $25,000, multiplied by
    (2) The qualified investment with respect to the total bases of new 
section 38 properties plus the qualified investment with respect to the 
total cost of used section 38 properties, apportioned to such estate or 
trust under paragraph (a) of this section, divided by
    (3) The qualified investment with respect to the total bases of all 
new section 38 properties plus the qualified investment with respect to 
the total cost of all used section 38 properties, apportioned among such 
estate or trust and its beneficiaries.

For purposes of subparagraph (3) of this paragraph, cost of used section 
38 property shall not be considered as apportioned to any beneficiary to 
the extent that such cost is not taken into account by such beneficiary 
in computing qualified investment in used section 38 property.
    (d) Summary statement. An estate or trust shall attach to its return 
a statement showing the apportionment to such estate or trust and to 
each beneficiary of the total bases of new, and the total cost of used, 
section 38 properties within each useful life category.
    (e) Example. This section may be illustrated by the following 
example:

    Example. 1 XYZ Trust, which makes its return on the basis of the 
calendar year, acquires and places in service on June 1, 1962, three new 
assets which qualify as new section 38 property and three used assets 
which qualify as used section 38 property. The basis of the new, and the 
cost of the used, section 38 property and the estimated useful life of 
each property are as follows:

------------------------------------------------------------------------
                                         Basis (or    Estimated useful
               Asset No.                   cost)            life
------------------------------------------------------------------------
1 (new)...............................     $30,000  4 years.
2 (new)...............................      30,000  4 years.
3 (new)...............................      30,000  8 years.
4 (used)..............................      12,000  6 years.
5 (used)..............................      12,000  6 years.
6 (used)..............................      12,000  8 years.
------------------------------------------------------------------------


For the taxable year 1962 the income of XYZ Trust is $20,000 which is 
allocable as follows: $10,000 to XYZ Trust, $6,000 to beneficiary A, and 
$4,000 to beneficiary B. Beneficiaries A and B make their returns on the 
basis of a calendar year.
    (2) Under this section, the total bases of the new, and the total 
cost of the used, section 38 properties are apportioned to XYZ Trust and 
its beneficiaries as follows:

[[Page 472]]



----------------------------------------------------------------------------------------------------------------
                                                    New--4 to 6    New--8 years    Used--6 to 8    Used--8 years
              Useful life category                     years          or more          years          or more
----------------------------------------------------------------------------------------------------------------
    Total bases or total cost...................         $60,000         $30,000         $24,000         $12,000
                                                 ===============================================================
XYZ Trust ($10,000 / 20,000)....................          30,000          15,000          12,000           6,000
Beneficiary A ($6,000 / 20,000).................          18,000           9,000           7,200           3,600
Beneficiary B ($4,000 / 20,000).................          12,000           6,000           4,800           2,400
----------------------------------------------------------------------------------------------------------------

Assume that beneficiary A placed in service during his taxable year 1962 
new section 38 property with a basis of $10,000 and an estimated useful 
life of 8 years. Also, assume that beneficiary B did not place in 
service during his taxable year 1962 any section 38 property and that 
beneficiaries A and B did not own any interests in other trusts, 
estates, partnerships, or electing small business corporations. Under 
section 46(c), the qualified investment of XYZ Trust is $39,000, of 
beneficiary A is $33,400, and of beneficiary B is $15,600, computed as 
follows:

------------------------------------------------------------------------
                                                  Applicable   Qualified
                 Basis (or cost)                  percentage  investment
------------------------------------------------------------------------
                                XYZ Trust
------------------------------------------------------------------------
$30,000 (new)...................................     33\1/3\     $10,000
$15,000 (new)...................................         100      15,000
$12,000 (used)..................................     66\2/3\       8,000
$6,000 (used)...................................         100       6,000
                                                 -----------------------
    Total.......................................  ..........      39,000
------------------------------------------------------------------------
                              Beneficiary A
------------------------------------------------------------------------
$18,000 (new)...................................     33\1/3\      $6,000
$9,000 (new)....................................         100       9,000
$7,200 (used)...................................     66\2/3\       4,800
$3,600 (used)...................................         100       3,600
                                                             -----------
                                                  ..........      23,400
                                                             ===========
$10,000 (new)...................................         100      10,000
                                                 -----------------------
    Total.......................................  ..........      33,400
------------------------------------------------------------------------
                              Beneficiary B
------------------------------------------------------------------------
$12,000 (new)...................................     33\1/3\      $4,000
$6,000 (new)....................................         100       6,000
$4,800 (used)...................................     66\2/3\       3,200
$2,400 (used)...................................         100       2,400
                                                 -----------------------
    Total.......................................  ..........      15,600
------------------------------------------------------------------------

    (3) In the case of XYZ Trust, the $25,000 amount specified in 
section 46(a)(2) is reduced to $12,500, computed as follows: (i) 
$25,000, multiplied by (ii) $39,000 (qualified investment apportioned to 
the trust), divided by (iii) $78,000 (total qualified investment 
apportioned among such trust ($39,000), beneficiary A ($23,400), and 
beneficiary B ($15,600)).

[T.D. 6731, 29 FR 6083, May 8, 1964, as amended by T.D. 6931, 32 FR 
14040, Oct. 10, 1967; T.D. 6958, 33 FR 9171, June 21, 1968; T.D. 7203, 
37 FR 17133, Aug. 25, 1972]



Sec.  1.48-9  Definition of energy property.

    (a) General rule--(1) In general. Under section 48(l)(2), energy 
property means property that is described in at least one of 6 
categories of energy property and that meets the other requirements of 
this section. If property is described in more than one of these 
categories, or is described more than once in a single category, only a 
single energy investment credit is allowed. In that case, the energy 
investment credit will be allowed under the category the taxpayer 
chooses by indicating the chosen category on Form 3468, Schedule B. The 
6 categories of energy property are:
    (i) Alternative energy property,
    (ii) Solar or wind energy property,
    (iii) Specially defined energy property,
    (iv) Recycling equipment,
    (v) Shale oil equipment, and
    (vi) Equipment for producing natural gas from geopressured brine.
    (2) Depreciable property with 3-year useful life. Property is not 
energy property unless depreciation (or amortization in lieu of 
depreciation) is allowable and the property has an estimated useful life 
(determined at the time when the property is placed in service) of 3 
years or more.
    (3) Effective date rules. To be energy property--
    (i) If property is constructed, reconstructed or erected by the 
taxpayer, the construction, reconstruction, or erection must be 
completed after September 30, 1978, or
    (ii) If the property is acquired, the original use of the property 
must (A) commence with the taxpayer and (B) commence after September 30, 
1978, and before January 1, 1983.

For transitional rules, see section 48(m).
    (4) Cross references. (i) To determine if depreciation (or 
amortization in lieu of

[[Page 473]]

depreciation) is allowable for property, see Sec.  1.48-1(b).
    (ii) For the meaning of ``estimated useful life'', see Sec.  1.46-
3(e)(7).
    (iii) The meaning of ``acquired'', ``original use'', 
``construction'', ``reconstruction'', and ``erection'' is determined 
under the principles of Sec.  1.48-2(b).
    (iv) For the definition of energy investment credit (energy credit), 
see section 48(o)(2).
    (v) For special rules relating to public utility property, see 
paragraph (n) of this section.
    (b) Relationship to section 38 property--(1) In general. (i) Energy 
property is treated under section 48(l)(1) as meeting the general 
requirements for section 38 property set forth in section 48(a)(1). For 
example, structural components of a building may qualify for the energy 
credit. In addition, the exclusion from section 38 property under 
section 48(a)(3) (lodging limitation) does not apply to energy property. 
For purposes of the energy credit, energy property is treated as section 
38 property solely by reason of section 48(l)(1). For example, if 
property ceases to be energy property, it ceases to be section 38 
property for all purposes relating to the energy credit and, thus, if 
subject to recapture under section 47. See Sec.  1.47-1(h).
    (ii) See the effective date rules under paragraph (a)(3) of this 
section for limitations on the eligibility of property as energy 
property.
    (iii) Section 48(l)(1) does not affect the character of property 
under sections of the Code outside the investment credit provisions. For 
example, structural components of a building that are treated as section 
38 property under section 48(l)(1) remain section 1250 property and are 
not section 1245 property.
    (2) Other section 48 rules apply. (i) In general, section 48(a) 
otherwise applies in determining if energy property is section 38 
property. Thus, energy property excluded from the definition of section 
38 property under section 48(a) (except by reason of section 48(a)(1) or 
(a)(3)) is not eligible for the energy credit. For example, energy 
property used predominantly outside the United States (section 48(a)(2)) 
or used by tax exempt organizations (section 48(a)(4)), in general, is 
not treated as section 38 property for any purpose and thus, is not 
eligible for the energy credit.
    (ii) Other rules of section 48, such as those for leased property 
under section 48(d), also apply to energy property.
    (3) Regular credit denied for certain energy property. In computing 
the amount of credit under section 46(a)(2), the regular percentage does 
not apply to any energy property which, but for section 48(l)(1), would 
not be section 38 property. See section 46(a)(2)(D). For example, energy 
property used for lodging (section 48(a)(3)) and, in general, structural 
components of a building (section 48(a)(1)(B)) re not eligible for the 
regular credit even though they may be eligible for the energy credit. 
However, a structural component of a qualified rehabilitated building 
(as defined in section 48(g)(1)) or a single purpose agricultural or 
horticultural structure (as defined in section 48(p)) may qualify for 
the regular credit without regard to section 48(l)(1).
    (c) Alternative energy property--(1) In general. Alternative energy 
property means property described in paragraphs (c)(3) through (10) of 
this section. In general alternative energy property includes certain 
property that uses an alternate substance as a fuel or feedstock or 
converts an alternate substance to a synthetic fuel and certain 
associated equipment.
    (2) Alternate substance. (i) An alternate substance is any substance 
or combination of substances other than an oil or gas substance. 
Alternate substances include coal, wood, and agricultural, industrial, 
and municipal wastes or by-products. Alternate substances do not include 
synthetic fuels or other products that are produced from an alternate 
substance and that have undergone a chemical change as described in 
paragraph (c)(5)(ii) of this section. For example, methane produced from 
landfills is not an alternate substance; rather it is a synthetic fuel 
produced from an alternate substance. However, preparing an alternate 
substance for use as a fuel or feedstock or for conversion into a fuel 
does not create a new product if no chemical change occurs. For example, 
pelletizing, drying, compacting, and liquefying do not result in

[[Page 474]]

a new product if no chemical change occurs.
    (ii) The term ``oil or gas substance'' means--
    (A) Oil or gas and
    (B) Any primary product of oil or gas.
    (iii) For the definition of primary product of oil or gas, see Sec.  
1.993-3(g)(3)(i), (ii), and (vi). Thus, petrochemicals are not primary 
products of oil or gas.
    (3) Boiler. (i) A boiler that uses an alternate substance as its 
primary fuel is alternative energy property.
    (ii) A boiler is a device for producing vapor from a liquid. 
Boilers, in general, have a burner in which fuel is burned. A boiler 
includes a fire box, boiler tubes, the containment shell, pumps, 
pressure and operating controls, and safety equipment, but not pollution 
control equipment (as defined in paragraph (c)(8) of this section).
    (iii) A ``primary fuel'' is a fuel comprising more than 50 percent 
of the fuel requirement of an item of equipment, measured in terms of 
Btu's for the remainder of the taxable year from the date the equipment 
is placed in service and for each taxable year thereafter. Electricity 
and waste heat are not fuels. For example, electric boilers do not 
qualify as alternative energy property even if the electricity is 
derived from an alternate substance.
    (4) Burners. (i) A burner for a combustor other than a burner 
described in paragraph (c)(3)(ii) of this section is alternative energy 
property if the burner uses an alternate substance as its primary fuel 
(as defined in paragraph (c)(3)(iii) of this section).
    (ii) A burner is the part of a combustor that produces a flame. A 
combustor is a process heater which includes ovens, kilns, and furnaces.
    (iii) A burner includes equipment (such as conveyors, flame control 
devices, and safety monitoring devices) located at the site of the 
burner and necessary to bring the alternate substance to the burner.
    (5) Synthetic fuel production equipment. (i) Equipment (synthetic 
fuel equipment) that converts an alternate substance into a synthetic 
solid, liquid, or gaseous fuel (other than coke or coke gas) is 
alternative energy property. Synthetic fuel production equipment does 
not include equipment, such as an oxygen plant, that is not directly 
involved in the treatment of an alternate substance, but produces a 
substance that is, like the alternate substance, a basic feedstock or 
catalyst used in the conversion process. Equipment is not eligible if it 
is used beyond the point at which a substance usable as a fuel has been 
produced. Equipment is eligible only to the extent of the equipment's 
cost or basis allocable to the annual production of substances used as a 
fuel or used in the production of a fuel. For example, assume for the 
taxable year that 50 percent of the output of equipment is used to 
produce alcohol for production of whiskey and 50 percent is used to 
produce alcohol for use in a fuel mixture, such as gasohol. The alcohol 
production equipment qualifies as synthetic fuel equipment but only to 
the extent of one-half of its cost or basis. If, in a later taxable 
year, the equipment is used exclusively to produce whiskey, all of the 
equipment ceases to be synthetic fuel equipment.
    (ii) A fuel is a material that produces usable heat upon combustion. 
To be ``synthetic'', the fuel either must differ significantly in 
chemical composition, as opposed to physical composition, from the 
alternate substance used to produce it or, in the case of solid fuel 
produced from biomass, the chemical change must consist of 
defiberization. Examples of synthetic fuels include alcohol derived from 
coal, peat, and vegetative matter, such as wood and corn, and methane 
from landfills.
    (iii) Synthetic fuel equipment includes coal gasification equipment, 
coal liquefaction equipment, equipment for recovering methane from 
landfill, and equipment that converts biomass to a synthetic fuel.
    (iv) Synthetic fuel equipment does not include equipment that merely 
mixes an alternate substance with another substance. For example, 
synthetic fuel equipment includes neither equipment that mixes coal and 
water to produce a slurry nor equipment that mixes alcohol and gasoline 
to produce gasohol. Equipment used to produce coke or coke gas, such as 
coke ovens, is also ineligible.

[[Page 475]]

    (6) Modification equipment. (i) Alternative energy property includes 
equipment (modification equipment) designed to modify existing 
equipment. For the definition of ``existing,'' see paragraph (l)(1)(i) 
of this section. To be eligible, the modification must result in a 
substitution for the remainder of the taxable year from the date the 
equipment is placed in service and for each taxable year thereafter of 
the items in paragraph (c)(6)(ii)(A) or (B) of this section for all or a 
portion of the oil or gas substance used as a fuel or feedstock. As a 
result of the modification, the substituted alternate substance must 
comprise at least 25 percent of the fuel or feedstock (determined on the 
basis of Btu equivalency). If the modification also increases the 
capacity of the equipment, only the incremental cost (as defined in 
paragraph (k) of this section) of the equipment qualifies.
    (ii) The substitutes for an oil or gas substance are--
    (A) An alternate substance or
    (B) A mixture of oil and an alternate substance.
    (iii) Modification equipment does not include replacements or a 
boiler of burner. If the boiler or burner is replaced, the items must be 
described in paragraph (c) (3) or (4) of this section to qualify as 
alternative energy property. Modification may include, however, 
replacements of components of a boiler or burner, such as a heat 
exchanger.
    (iv) The following examples illustrate this paragraph (c)(6).

    Example 1. On January 1, 1980, corporation X is using oil to fuel 
its boiler. On June 1, 1980, X modifies the boiler to permit 
substitution of a coal and oil mixture for 40 percent of X's oil fuel 
needs. The mixture consists 75 percent of oil and 25 percent of coal. 
The equipment modifying the boiler does not qualify as modification 
equipment because the alternate substance comprises only 10 percent of 
the fuel.
    Example 2. Assume the same facts as in example 1 except 75 percent 
of the mixture is coal. The equipment modifying the boiler qualifies.
    Example 3. Assume the same facts as in example 2 except, instead of 
substituting an oil and coal mixture for 40 percent of X's oil fuel 
needs, X uses the modification to expand the boiler's fuel capacity by 
40 percent using the mixture as additional fuel. The additional fuel 
mixture comprises only 28 percent of X's total fuel needs. Thus, even 
though 75 percent of the additional fuel mixture is an alternate 
substance, the boiler does not qualify as modification equipment because 
the alternate substance comprises only 21 percent of the total fuel.

    (7) Equipment using coal as feedstock. Equipment that uses coal 
(including lignite) to produce a feedstock for the manufacture of 
chemicals, such as petrochemicals, or other products is alternative 
energy property. Equipment is not eligible if it is not directly 
involved in the treatment of coal or a coal product, but produces a 
substance that is, like coal, a basic feedstock or catalyst used in the 
coal conversion process. Equipment is not eligible if it is used beyond 
the point at which the first product marketable as a feedstock has been 
produced. Equipment used to produce coke or coke gas, such as coke 
ovens, is ineligible.
    (8) Pollution control equipment. (i) Pollution control equipment is 
alternative energy property. Eligible equipment is limited to property 
or equipment to the extent it qualifies as a pollution control facility 
under section 103(b)(4)(F) and the regulations thereunder except that, 
if control of pollution is not the only significant purpose (within the 
meaning of those regulations), only the incremental cost (as defined in 
paragraph (k) of this section) of the equipment qualifies. However, if a 
Treasury decision changes the regulations under section 103(b)(4)(F) 
and, thus, the rules reflected in this subdivision (i), the rules as 
changed will apply as of the effective date of the Treasury decision.
    (ii) To be eligible, the equipment must be required by a Federal, 
State, or local government regulation to be installed on, or used in 
connection with, eligible alternative energy property (as defined in 
paragraph (c)(8)(v) of this section).
    (iii) Under section 48(l)(3)(D) equipment is not eligible if 
required by a Federal, State, or local government regulation in effect 
on October 1, 1978, to be installed on, or in connection with, property 
using coal (including lignite) as of October 1, 1978.
    (iv) Under this subparagraph (8), pollution control equipment is 
required by regulation if it would be necessary to

[[Page 476]]

install the equipment to satisfy the requirements of any applicable law, 
including nuisance law. The pollution control equipment need not be 
specifically identified in the applicable law. If several different 
types of equipment may be used to comply with the applicable law, each 
type of equipment is considered necessary to satisfy the requirements of 
the law. An order permitting a taxpayer to delay compliance with any 
applicable law is disregarded.
    (v) Under this subparagraph (8) ``eligible alternative energy 
property'' is energy property (as defined in section 48 (l)(2)) 
described in paragraphs (c) (3) through (7) of this section. If 
equipment otherwise qualifying as pollution control equipment is 
installed on, or used in connection with, both eligible alternative 
energy property and property other than eligible alternative energy 
property, only the incremental cost (as defined in paragraph (k) of this 
section) of the equipment qualifies.
    (vi) Examples. The following examples illustrate this subparagraph 
(8). Assume that the property or equipment in the examples are described 
in Sec.  1.103-8(g)(2)(ii) and that their only purpose is control of 
pollution.

    Example 1. On October 1, 1978, corporation X acquires and places in 
service in State A a paper mill. The facility includes a boiler the 
primary fuel for which is wood chips. The facility includes equipment 
necessary to comply with pollution control standards in effect on 
October 1, 1978 in State A. This equipment qualifies as pollution 
control equipment.
    Example 2. On October 1, 1978, corporation Y was burning coal at its 
facility in State B. The emissions from the facility exceeded State air 
pollution control requirements in effect on October 1, 1978. On January 
1, 1979, X installed cyclone separators to comply with the State 
pollution control requirements. The cyclone separators do not qualify as 
pollution control equipment.
    Example 3. Assume the same facts as in example 2 except that Y 
installs a baghouse instead of cyclone separators to meet more stringent 
standards that take effect on December 31, 1978. The baghouse qualifies 
as pollution control equipment because the baghouse was not necessary to 
meet the standards in effect on October 1, 1978.
    Example 4. On October 1, 1978, corporation Z is burning coal at its 
facility in State C. The emissions from that facility exceed State air 
pollution control standards in effect on October 1, 1978. C orders Z to 
install cyclone separators before January 1, 1979. However, C allows Z 
to operate its facility until January 1, 1979, under less stringent 
interim standards applicable only to Z. The separators do not qualify as 
pollution control equipment. The delayed compliance order is 
disregarded.

    (9) Handling and preparation equipment. (i) Alternative energy 
property includes equipment (handling and preparation equipment) used 
for unloading, transfer, storage, reclaiming from storage, or 
preparation of an alternate substance for use in eligible alternative 
energy property (as defined in paragraph (c)(9)(ii) of this section). 
Handling and preparation equipment must be located at the site the 
alternate substance is used as a fuel or feedstock. For example, 
equipment used to screen and prepare coal for use at a power plant 
qualifies if located at the plant. However, similar equipment located at 
the coal mine would not qualify.
    (ii) Under this subparagraph (9), ``eligible alternative energy 
property'' is energy property (as defined in section 48(l)(2)) described 
in paragraphs (c) (3) through (8) of this section. If equipment 
otherwise qualifying as handling and preparation equipment is installed 
on, or used in connection with, property other than eligible alternative 
energy property, only the incremental cost (as defined in paragraph (k) 
of this section) of the equipment qualifies.
    (iii) The term ``preparation'' includes washing, crushing, drying, 
compacting, and weighing of an alternate substance. Handling and 
preparation equipment also includes equipment for shredding, chopping, 
pulverizing, or screening agricultural or forestry byproducts at the 
site of use.
    (iv) Handling and preparation equipment does not include equipment, 
such as coal slurry pipelines and railroad cars, that transports a fuel 
or a feedstock to the site of its use.
    (10) Geothermal equipment--(i) Alternative energy property includes 
equipment (geothermal equipment) that produces, distributes, or uses 
energy derived from a geothermal deposit (as defined in Sec.  1.44C-
2(h)).
    (ii) In general, production equipment includes equipment necessary 
to bring geothermal energy from the subterranean deposit to the surface, 
including well-head and downhole equipment

[[Page 477]]

(such as screening or slotting liners, tubing, downhole pumps, and 
associated equipment). Reinjection wells required for production also 
may qualify. Production does not include exploration and development.
    (iii) Distribution equipment includes equipment that transports 
geothermal steam or hot water from a geothermal deposit to the site of 
ultimate use. If geothermal energy is used to generate electricity, 
distribution equipment includes equipment that transports hot water from 
the geothermal deposit to a power plant. Distribution equipment also 
includes components of a heating system, such as pipes and ductwork that 
distribute within a building the energy derived from the geothermal 
deposit.
    (iv) Geothermal equipment includes equipment that uses energy 
derived both from a geothermal deposit and from sources other than a 
geothermal deposit (dual use equipment). Such equipment, however, is 
geothermal equipment (A) only if its use of energy from sources other 
than a geothermal deposit does not exceed 25 percent of its total energy 
input in an annual measuring period and (B) only to the extent of its 
basis or cost allocable to its use of energy from a geothermal deposit 
during an annual measuring period. An ``annual measuring period'' for an 
item of dual use equipment is the 365 day period beginning with the day 
it is placed in service or a 365 day period beginning the day after the 
last day of the immediately preceding annual measuring period. The 
allocation of energy use required for purposes of paragraph (c)(10)(iv) 
(A) and (B) of this section may be made by comparing, on a Btu basis, 
energy input to dual use equipment from the geothermal deposit with 
energy input from other sources. However, the Commissioner may accept 
any other method that, in his opinion, accurately establishes the 
relative annual use by dual use equipment of energy derived from a 
geothermal deposit and energy derived from other sources.
    (v) The existence of a backup system designed for use only in the 
event of a failure in the system providing energy derived from a 
geothermal deposit will not disqualify any other equipment. If 
geothermal energy is used to generate electricity, equipment using 
geothermal energy includes the electrical generating equipment, such as 
turbines and generators. However, geothermal equipment does not include 
any electrical transmission equipment, such as transmission lines and 
towers, or any equipment beyond the electrical transmission stage, such 
as transformers and distribution lines.
    (vi) Examples. The following examples illustrate this subparagraph 
(10):

    Example 1. On October 1, 1979, corporation X, a calendar year 
taxpayer, places in service a system which heats its office building by 
circulating hot water heated by energy derived from a geothermal deposit 
through the building. Geothermal equipment includes the circulation 
system, including the pumps and pipes which circulate the hot water 
through the building.
    Example 2. The facts are the same as in Example 1, except that 
corporation X also places in service a boiler to produce hot water for 
heating the building exclusively in the event of a failure of the 
geothermal equipment. Such a boiler is not geothermal equipment, but the 
existence of such a backup system does not serve to disqualify property 
eligible in Example 1.
    Example 3. The facts are the same as in Example 1, except that the 
water heated by energy derived from a geothermal deposit is not hot 
enough to provide sufficient heat for the building. Therefore, the 
system includes an electric boiler in which the water is heated before 
being circulated in the heating system. Assume that, on a Btu basis, 
eighty percent of the total energy input to the circulating system 
during the 365 day period beginning on October 1, 1979, is energy 
derived from a geothermal deposit. The boiler is not geothermal 
equipment. For the 1979 taxable year, eighty percent of the circulating 
system is geothermal equipment because eighty percent of its basis or 
cost is allocable to use of energy from a geothermal deposit. If, in a 
subsequent taxable year, the basis or cost allocable to use of energy 
from a geothermal deposit falls below eighty percent, recapture may be 
required under section 47 and Sec.  1.47-1(h). Thus, if, on a Btu basis, 
only 70 percent of the total energy input to the circulating system for 
the 365 day period beginning October 1, 1980, is energy derived from a 
geothermal deposit, then there will be complete recapture of the credit 
during the 1980 taxable year. If, however, for that 365 day period, the 
portion of the total energy input that is derived from a geothermal 
deposit is less than 80 percent but greater than or equal to 75 percent, 
then only a proportional amount of credit will be recaptured during

[[Page 478]]

the 1980 taxable year. No additional credit is allowable in a subsequent 
taxable year, however, if the portion of the basis or cost allocable to 
use of energy from a geothermal deposit increases above what it was for 
a previous taxable year (see Sec.  1.46-3(d)(4)(i)).
    Example 4. Corporation Y acquires a commercial vegetable dehydration 
system in 1981. The system operates by placing fresh vegetables on a 
conveyor belt and moving them through a dryer. The conveyor belt is 
powered by electricity. The dryer uses solely energy derived from a 
geothermal deposit. The dryer is geothermal equipment while the 
equipment powered by electricity does not qualify.

    (d) Solar energy property--(1) In general. Energy property includes 
solar energy property. The term ``solar energy property'' includes 
equipment and materials (and parts related to the functioning of such 
equipment) that use solar energy directly to (i) generate electricity, 
(ii) heat or cool a building or structure, or (iii) provide hot water 
for use within a building or structure. Generally, those functions are 
accomplished through the use of equipment such as collectors (to absorb 
sunlight and create hot liquids or air), storage tanks (to store hot 
liquids), rockbeds (to store hot air), thermostats (to activate pumps or 
fans which circulate the hot liquids or air), and heat exchangers (to 
utilize hot liquids or air to create hot air or water). Property that 
uses, as an energy source, fuel or energy derived indirectly from solar 
energy, such as ocean thermal energy, fossil fuel, or wood, is not 
considered solar energy property.
    (2) Passive solar excluded--(i) Solar energy property excludes the 
materials and components of ``passive solar systems,'' even if combined 
with ``active solar systems.''
    (ii) An active solar system is based on the use of mechanically 
forced energy transfer, such as the use of fans or pumps to circulate 
solar generated energy.
    (iii) A passive system is based on the use of conductive, 
convective, or radiant energy transfer. Passive solar property includes 
greenhouses, solariums, roof ponds, glazing, and mass or water trombe 
walls.
    (3) Electric generation equipment. Solar energy property includes 
equipment that uses solar energy to generate electricity, and includes 
storage devices, power conditioning equipment, transfer equipment, and 
parts related to the functioning of those items. In general, this 
process involves the transformation of sunlight into electricity through 
the use of such devices as solar cells or other collectors. However, 
solar energy property used to generate electricity includes only 
equipment up to (but not including) the stage that transmits or uses 
electricity.
    (4) Pipes and ducts. Pipes and ducts that are used exclusively to 
carry energy derived from solar energy are solar energy property. Pipes 
and ducts that are used to carry both energy derived from solar energy 
and energy derived from other sources are solar energy property (i) only 
if their use of energy other than solar energy does not exceed 25 
percent of their total energy input in an annual measuring period and 
(ii) only to the extent of their basis or cost allocable to their use of 
solar energy during an annual measuring period. (See paragraph (d)(6) of 
this section for the definition of ``annual measuring period'' and for 
rules relating to the method of allocation.)
    (5) Specially adapted equipment. Equipment that uses solar energy 
beyond the distribution stage is eligible only if specially adapted to 
use solar energy.
    (6) Auxiliary equipment. Solar energy property does not include 
equipment (auxiliary equipment), such as furnaces and hot water heaters, 
that use a source of power other than solar or wind energy to provide 
usable energy. Solar energy property does include equipment, such as 
ducts and hot water tanks, which is utilized by both auxiliary equipment 
and solar energy equipment (dual use equipment). Such equipment is solar 
energy property (i) only if its use of energy from sources other than 
solar energy does not exceed 25 percent of its total energy input in an 
annual measuring period and (ii) only to the extent of its basis of cost 
allocable to its use of solar or wind energy during an annual measuring 
period. An ``annual measuring period'' for an item of dual use equipment 
is the 365 day period beginning with the day it is placed in service or 
a 365 day period beginning the day after the last day of the immediately 
preceding annual measuring period.

[[Page 479]]

The allocation of energy use required for purposes of paragraphs (d)(6) 
(i) and (ii) of this section may be made by comparing, on a Btu basis, 
energy input to dual use equipment from solar energy with energy input 
from other sources. However, the Commissioner may accept any other 
method that, in his opinon, accurately establishes the relative annual 
use by dual use equipment of solar energy and energy derived from other 
sources.
    (7) Solar process heat equipment. Solar energy property does not 
include equipment that uses solar energy to generate steam at high 
temperatures for use in industrial or commercial processes (solar 
process heat).
    (8) Example. The following example illustrates this paragraph (d).

    Example. (a) In 1979, corporation X, a calendar year taxpayer, 
constructs an apartment building and purchases equipment to convert 
solar energy into heat for the building. Corporation X also installs an 
oil-fired water heater and other equipment to provide a backup source of 
heat when the solar energy equipment cannot meet the energy needs of the 
building. For purposes of this example, all equipment is placed in 
service on October 1, 1979. On a Btu basis, eighty percent of the total 
energy input to the dual use equipment during the 365 day period 
beginning October 1, 1979, is from solar energy.
    (b) The items purchased, in addition to the water heater, include a 
roof solar collector, a heat exchanger, a hot water tank, a control 
component, pumps, pipes, fan-coil units, and valves. Assume the fan-coil 
units could be used with energy derived from an oil or gas substance 
without significant modification. All items are depreciable and have a 
useful life of three years or more. The use of the equipment to heat the 
building is the first use to which the equipment has been put.
    (c) Water is pumped from the basement through pipes to the roof 
solar collector. Heated water returns through pipes to a heat exchanger 
which transfers heat to the water in the hot water tank.
    (d) The hot water tank and the oil-fired water heater utilize the 
same distribution pipe. Pumps and valves at the points of connection 
between the hot water tank, the oil-fired water heater, and the 
distribution pipe regulate the auxiliary energy supply use. They also 
prevent the oil-fired water heater from heating water in the hot water 
tank.
    (e) An integrated control component determines whether hot water 
from the hot water tank or from the oil-fired water heater is 
distributed to fan-coil units located throughout the building.
    (f) The roof solar collector is solar energy property. The pump that 
moves the water to the roof collector and the pipes between the roof 
collector and the hot water tank qualify because they are solely related 
to transporting solar heated water. The hot water tank qualifies because 
it stores water heated solely by solar radiation. The heat exchanger 
also qualifies.
    (g) The oil-fired water heater does not qualify as solar energy 
property because it is auxiliary equipment.
    (h)(1) Because the distribution pipe, the control component, and the 
pumps and valves serve the oil-fired water heater as well as the solar 
energy equipment; they qualify only to the extent of eighty percent of 
their cost or basis, the portion allocable to use of solar energy. If, 
in a subsequent taxable year, the basis or cost allocable to their use 
of solar energy falls below eighty percent, recapture may be required 
under section 47 and Sec.  1.47-1(h). Thus, if, on a Btu basis, only 70 
percent of the total energy input to that equipment for the 365 day 
period beginning October 1, 1980, is from solar energy, then there will 
be complete recapture of the credit during the 1980 taxable year. If, 
however, for that 365 day period, the portion of that equipment's total 
energy input that is from solar energy is less than 80 percent but 
greater than or equal to 75 percent, then only a proportional amount of 
credit will be recaptured during the 1980 taxable year. No additional 
credit is allowable for the equipment in a subsequent taxable year, 
however, if the portion of its basis or cost allocable to use of solar 
energy increases above what it was for a previous taxable year (see 
Sec.  1.46-3 (d)(4)(i)).
    (2) The fan-coil units do not qualify as solar energy property 
because they are not specially adapted to use energy derived from solar 
energy.

    (e) Wind energy property--(1) In general. Energy property includes 
wind energy property. Wind energy property is equipment (and parts 
related to the functioning of that equipment) that performs a function 
described in paragraph (e)(2) of this section. In general, wind energy 
property consists of a windmill, wind-driven generator, storage devices, 
power conditioning equipment, transfer equipment, and parts related to 
the functioning of those items. Wind energy property does not include 
equipment that transmits or uses electricity derived from wind energy. 
In addition, limitations apply similar to those set forth in paragraphs 
(d) (5), (6), and (8) of this section. For example, if equipment is used 
by both auxiliary equipment and wind energy equipment,

[[Page 480]]

such equipment is wind energy property only if its use of energy other 
than wind energy does not exceed 25 percent of its total energy input in 
an annual measuring period and only to the extent of its basis or cost 
allocable to its use of wind energy during an annual measuring period.
    (2) Eligible functions. Wind energy property is limited to equipment 
(and parts related to the functioning of that equipment) that--
    (i) Uses wind energy to heat or cool, or provide hot water for use 
in, a building or structure, or
    (ii) Uses wind energy to generate electricity (but not mechanical 
forms of energy).
    (f) Specially defined energy property--(1) In general. Specially 
defined energy property means only those items described in paragraphs 
(f) (4) through (14) of this section that meet the requirements of 
paragraph (f)(2) of this section. The items described in paragraphs (f) 
(4) through (14) of this section also consist of related equipment, such 
as fans, pumps, ductwork, piping, and controls, the installation of 
which is necessary for the specified item to reduce the energy consumed 
or heat wasted by the process.
    (2) General requirements. To be eligible, each item described in 
paragraphs (f) (4) through (14) of this section must be installed in 
connection with an existing industrial or commercial facility. In 
addition, the principal purpose of each of those items must be reduction 
of energy consumed or heat wasted in any existing industrial or 
commercial process. See section 48(l)(10) and paragraph (l) of this 
section. If an item performs more than one function, only the 
incremental cost (as defined in paragraph (k) of this section) of the 
equipment qualifies.
    (3) Industrial or commercial process. (i) A process is a means or 
method of producing a desired result by chemical, physical, or 
mechanical action. For example, equipment installed in connection with 
retail sales, general office use, and residential use are not used in a 
process within the meaning of this paragraph (f)(3).
    (ii) An industrial process includes agricultural processes and 
thermal processes relating to production or manufacture, such as those 
involving boilers and furnaces.
    (iii) A commercial process includes laundering and food preparation.
    (iv) More than one process may be conducted in a single facility. 
The fact that several processes involved in the production of a product 
are integrated does not cause such integrated processes to be treated as 
one process. For example, in a food canning facility, producing prepared 
food from fresh vegetables is not one process but rather an integration 
of several processes including washing, cooking and canning.
    (v) The following example illustrates this paragraph (f)(3).

    Example. Corporation X, an advertising agency, acquires an automatic 
energy control system designed to reduce energy consumed by heating and 
cooling its office building. Although the use of an office for X's 
business is a commercial activity, heating or cooling an office is not 
an industrial or commercial process. The automatic energy control system 
does not qualify because it does not reduce energy consumed in an 
industrial or commercial process.

    (4) Recuperators. Recuperators recover energy, usually in the form 
of waste heat from combustion exhaust gases, hot exiting product, or 
product cooling air, that is used to heat incoming combustion air, raw 
materials, or fuel. Recuperators are configurations of equipment 
consisting in part of fixed heat transfer surfaces between two gas 
flows, and include related baffles, dividers, entrance flanges, 
transition sections, and shells or cases enclosing the other components 
of the recuperator. In general, a fixed heat transfer surface absorbs 
heat from a gas or liquid flow or dissipates heat to the gas or liquid 
flow.
    (5) Heat wheels. Heat wheels recover energy, usually in the form of 
waste heat, from exhaust gases to preheat incoming gases. Heat wheels 
are items of equipment consisting in part of regenerators (which rotate 
between two gas flows) and related drive components, wiper seals, 
entrance flanges, and transition sections.
    (6) Regenerators. Regenerators are devices, such as clinker columns 
or chains, that recover energy by efficiently storing heat while exposed 
to

[[Page 481]]

high temperature gases and releasing heat while exposed to low 
temperature gases, fluids, or solids.
    (7) Heat exchangers. Heat exchangers recover energy, usually in the 
form of waste heat, from high temperature gases, liquids, or solids for 
transfer to low temperature gases, liquids, or solids. Heat exchangers 
consist in part of fixed heat transfer surfaces (described in paragraph 
(f)(4) of this section) separating two media. Heat exchange equipment 
does not include fluidized bed combustion equipment.
    (8) Waste heat boilers. Waste heat boilers use waste heat, usually 
in the form of combustion exhaust gases, as a substantial source of 
energy. A substantial source of energy is one that comprises more than 
20 percent of the energy requirement on the basis of Btu's during the 
course of each taxable year (including the start-up year).
    (9) Heat pipes. Heat pipes recover energy, usually in the form of 
waste heat, from high temperature fluids to heat low temperature fluids. 
A heat pipe consists in part of sealed heat transfer chambers and a 
capillary structure. In general, the heat transfer chambers 
alternatively vaporize and condense a working fluid as it passes from 
one end of the chamber to the other.
    (10) Automatic energy control systems. Automatic energy control 
systems automatically reduce energy consumed in an industrial or 
commercial process for such purposes as environmental space conditioning 
(i.e., lighting, heating, cooling or ventilating, etc.). Automatic 
energy control systems include, for example, automatic equipment 
settings controls, load shedding devices, and relay devices used as part 
of such system. Property such as computer hardware installed as a part 
of the energy control system also qualifies, but only to the extent of 
its incremental cost (as defined in paragraph (k) of this section).
    (11) Turbulators. Turbulators increase the rate of transfer of heat 
from combustion gases to heat exchange surfaces by increasing the 
turbulence in the gases. A turbulator is a baffle placed in a boiler 
firetube or in a heat exchange tube in industrial process equipment to 
deflect gases to the heat transfer surface.
    (12) Preheaters. Preheaters recover energy, usually in the form of 
waste heat, from either combustion exhaust gases or steam, to preheat 
incoming combustion air or boiler feedwater. A preheater consists in 
part of fixed heat transfer surfaces (described in paragraph (f)(4) of 
this section) separating two fluids.
    (13) Combustible gas recovery systems. Combustible gas recovery 
systems are items of equipment used to recover unburned fuel from 
combustion exhaust gases.
    (14) Economizers. Economizers are configurations of equipment used 
to reduce energy demand or recover energy from combustion exhaust gases 
and other high temperature sources to preheat boiler feedwater.
    (15) Other property added by the Secretary. [Reserved]
    (g) Recycling equipment--(1) In general. Recycling equipment is 
equipment used exclusively to sort and prepare, or recycle, solid waste 
(other than animal waste) to recover usable raw materials (``recovery 
equipment''), or to convert solid waste (including animal waste) into 
fuel or other useful forms of energy (``conversion equipment''). 
Recycling equipment may include certain other onsite related equipment.
    (2) Recovery equipment. Recovery equipment includes equipment that--
    (i) Separates solid waste from a mixture of waste,
    (ii) Applies a thermal, mechanical, or chemical treatment to solid 
waste to ensure the waste will properly respond to recycling, or
    (iii) Recycles solid waste to recover usable raw materials, but not 
beyond occurrence of the first of the following:
    (A) The point at which a material has been created that can be used 
in beginning the fabrication of an end-product in the same way as 
materials from a virgin substance. Examples are the fiber stage in 
textile recycling, the newsprint or paperboard stage in paper recycling, 
and the ingot stage for other metals (other than iron and steel). In the 
case of recycling iron or steel, recycling equipment does not include 
any equipment used to reduce solid waste to a molten state or any 
process thereafter.

[[Page 482]]

    (B) The point at which the material is a marketable product (i.e., 
has a value other than for recycling) even if the material is not 
marketed by the taxpayer at that point.
    (3) Conversion equipment. Conversion equipment includes equipment 
that converts solid waste into a fuel or other usable energy, but not 
beyond the point at which a fuel, steam, electricity, hot water, or 
other useful form of energy has been created. Thus, combustors, boilers, 
and similar equipment may be eligible if used for a conversion process, 
but steam and heat distribution systems between the combustor or boiler 
and the point of use are not eligible.
    (4) On-site related equipment. Recycling equipment also includes 
onsite loading and transportation equipment, such as conveyors, 
integrally related to other recycling equipment. This equipment may 
include equipment to load solid waste into a sorting or preparation 
machine and also a conveyor belt system that transports solid waste from 
preparation equipment to other equipment in the recycling process.
    (5) Solid waste. (i) The term ``solid waste'' has the same meaning 
as in Sec.  1.103-8(f)(2)(ii)(b), subject to the following exceptions 
and the other rules of this subparagraph (5):
    (A) The date the equipment is placed in service is substituted in 
the first sentence of Sec.  1.103-8(f)(2)(ii)(b) for the date of issue 
of the obligations, and
    (B) Material that has a market value at the place it is located only 
by reason of its value for recycling is not considered to have a market 
value.
    (ii) Solid waste may include a nominal amount of virgin materials, 
liquids, or gases, not to exceed 10 percent. If more than 10 percent of 
the material recycled during the course of any taxable year (including 
the ``start up'' year) consists of virgin material, liquids, or gases, 
the equipment ceases to be energy property and is subject to recapture 
under section 47. The determination of the portion of virgin material, 
liquids, or gases used is based on volume, weight, or Btu's whichever is 
appropriate.
    (6) Ineligible equipment. Transportation equipment, such as trucks, 
that transfer solid waste between geographically separated sites (e.g., 
the collection point and the recycling point) is not eligible. Steam and 
heat distribution systems are also ineligible.
    (7) Increased recycling capacity. If the equipment both replaces 
recycling capacity and increases that capacity at a particualr site, 
only the incremental cost (as defined in paragraph (k) of this section) 
of increasing the capacity qualifies. Recycling capacity is determined 
by the ability to produce a product not previously produced by the 
taxpayer, or more of an existing product, in a way that does not lower 
overall production.
    (8) Examples. The following examples illustrate this paragraph (g).

    Example 1. Corporation W recycles aluminum scrap metal. W owns a 
junk yard where it collects and crushes the metal into compact units. 
W's trucks bring the scrap metal from the junk yard to its main plant 
located 3 miles away. W's furnace equipment at the main plant reduces 
the scrap to the molten state and W's rolling equipment rolls the 
aluminum into sheets. The furnace qualifies, but for two separate 
reasons the rolling equipment does not qualify. First, the molten 
aluminum would be a marketable product if reduced to ingots prior to 
rolling. It is not necessary that W actually reduce the molten aluminum 
to ingots. Second, the molten aluminum could be used in the same way as 
virgin material.
    Example 2. Corporation X manufactures newsprint using wood chips 
discarded during X's lumber operations. Assume X could sell the wood 
chips to other companies located a short distance from X's mill for use 
as a fuel. None of the equipment used to manufacture the newsprint 
qualifies.
    Example 3. Assume the same facts as in example 2 except X uses old 
newspapers which have no value except for recycling in the area where 
X's mill is located. The equipment qualifies.
    Example 4. Corporation Y recycles municipal waste. Assume the 
municipal waste is ``solid waste'' under paragraph (g)(5) of this 
section. During the first taxable year Y operates the equipment, Y uses 
8,500 pounds of municipal waste and 1,500 pounds of virgin material and 
liquids. No energy credit is allowed for the equipment.
    Example 5. Corporation Z owns a waste recovery facility. The 
corrugated paper portion of the waste stream is picked off a conveyor as 
it enters the facility. The corrugated paper is baled and sold as a 
secondary paper product. Z acquires shredding and air-classification 
equipment. Corrugated paper that is not removed from the conveyor belt 
enters the new equipment for production as a fuel.

[[Page 483]]

Z increases the input of corrugated paper so that the same amount of 
corrugated paper is removed from the conveyor to be baled. The excess 
paper that is not removed for baling enters the shredding and air-
classification equipment. The new equipment qualifies.

    (h) Shale oil equipment--(1) In general. Shale oil equipment used in 
mining or either surface or in situ processing qualifies as energy 
property. Shale oil equipment means equipment used exclusively to mine, 
or produce or extract oil from, shale rock.
    (2) Eligible processes. In general, processing equipment qualifies 
if used in or after the mining stage and up through the retorting 
process. Thus, eligible processes include crushing, loading into the 
retort, and retorting, but not hydrogenation, refining, or any process 
subsequent to retorting. However, with respect to in situ processing, 
eligible processes include creating the underground cavity.
    (3) Eligible equipment. Shale oil equipment includes--
    (i) Heading jumbos, bulldozers, and scaling and bolting rigs used to 
create an underground cavity for in situ processing,
    (ii) On-site water supply and treatment equipment and handling 
equipment for spent shale.
    (iii) Crushing and screening plant equipment, such as hoppers, 
feeders, vibrating screens, and conveyors,
    (iv) Briquetting plant equipment, such as hammer mills and vibratory 
pan feeders, and
    (v) Retort equipment, including direct cooling and condensing 
equipment.
    (i) [Reserved]
    (j) Natural gas from geopressured brine. Equipment used exclusively 
to extract natural gas from geopressured brine described in section 
613A(b)(3)(C)(i) is energy property. Eligible equipment includes 
equipment used to separate the gas from saline water and remove other 
impurities from the gas. Equipment is eligible only up to the point the 
gas may be introduced into a pipeline.
    (k) Incremental cost. The term ``incremental cost'' means the excess 
of the total cost of equipment over the amount that would have been 
expended for the equipment if the equipment were not used for a 
qualifying purpose. For example, assume equipment costing $100 performs 
a pollution control function and another function. Assuming it would 
cost $60 solely to perform the nonqualifying function, the incremental 
cost would be $40.
    (l) Existing--(1) In general. For purposes of section 48(l), the 
term ``existing'' means--
    (i) When used in connection with a facility or equipment, 50 percent 
or more of the basis of that facility or equipment is attributable to 
construction, reconstruction, or erection before October 1, 1978, or
    (ii) When used in connection with an industrial or commercial 
process, that process was carried on in the facility as of October 1, 
1978.
    (2) Industrial or commercial process. (i) A process will be 
considered the same as the process carried on in the facility as of 
October 1, 1978, unless and until capitalizable expenditures are paid or 
incurred for modification of the process. The expenditures need not be 
capitalized in fact; it is sufficient if the taxpayer has an option or 
may elect to capitalize. In general, the date of change will be the date 
the expenditures are properly chargeable to capital account. If the 
taxpayer properly elects to expense a capitalizable expenditure, the 
date of change will be the date the expenditure could have been properly 
chargeable to capital account if the expenditure had been capitalized. 
Recapture will not occur by reason of a change in a process unless the 
process change also changes the use of the equipment. See example (1) of 
Sec.  1.47-1(h)(5).
    (m) Quality and performance standards--(1) In general. Energy 
property must meet quality and performance standards, if any, that have 
been prescribed by the Secretary (after consultation with the Secretary 
of Energy) and are in effect at the time of acquisition.
    (2) Time of acquisition. Under this paragraph (m) the time of 
acquisition is--
    (i) The date the taxpayer enters into a binding contract to acquire 
the property or
    (ii) For property constructed, reconstructed, or erected by the 
taxpayer, (A) the earlier of the date it begins construction, 
reconstruction, or erection of the property, or (B) the date the

[[Page 484]]

taxpayer and another person enter into a binding contract requiring each 
to construct, reconstruct, or erect property and place the property in 
service for an agreed upon use. See example under paragraph (m)(4) of 
this section.
    (3) Binding contract. Under this paragraph (m), a binding contract 
to construct, reconstruct, or erect property, or to acquire property, is 
a contract that is binding at all times on the taxpayer under applicable 
State or local law. A binding contract to construct, reconstruct, or 
erect property or to acquire property, does not include a contract for 
preparation of architect's sketches, blueprints, or performance of any 
other activity not involving the beginning of physical work.
    (4) Example. The following example illustrates this paragraph (m).

    Example. Corporation X owns a junk yard. Corporation Y manufactures 
recycling equipment and operates several recycling facilities. On 
January 1, 1979, X and Y enter into a written contract that is binding 
on both parties on that date and at all times thereafter. Under the 
contract's terms X will supply scrap metals to Y and Y agrees in return 
to build a recycling facility on land adjacent to the junk yard. Y will 
own and operate the facility using the scrap metal supplied by X. Y may 
treat the agreement as a binding contract under paragraph (m) (2) and 
(3) of this section.

    (n) Public utility property--(1) Inclusions. Public utility property 
is included in both of the following categories of energy property:
    (i) Shale oil equipment and
    (ii) Equipment for producing natural gas from geopressured brine.
    (2) Exclusions. Public utility property is excluded from each of the 
following categories of energy property:
    (i) Alternative energy property,
    (ii) Specially defined energy property,
    (iii) Solar or wind energy property, and
    (iv) Recycling equipment.
    (3) Public utility property. The term ``public utility property'' 
has the meaning given in section 46(f)(5).
    (o)-(p) [Reserved]
    (q) Qualified intercity buses--(1) In general. This paragraph (q) 
prescribes rules and definitions for purposes of section 48(l)(2)(A)(ix) 
and (16). Energy property includes qualified intercity buses of an 
eligible taxpayer, but only to the extent of the increase in the 
taxpayer's total operating seating capacity (operating capacity) under 
paragraphs (q) (9), (10), and (11) of this section. For application of 
recapture rules see Sec.  1.47-1(h)(3)(ii).
    (2) Eligible taxpayer. A taxpayer is an eligible taxpayer only if it 
is determined to be both--
    (i) A common carrier regulated by the Interstate Commerce Commission 
or an appropriate State agency and
    (ii) Engaged in the trade or business of furnishing intercity 
transportation by bus.
    (3) Common carrier. The taxpayer is a common carrier only if the 
taxpayer holds itself out to the general public as providing passenger 
bus transportation for compensation over regular or irregular routes, or 
both.
    (4) Appropriate State agency. A State agency is appropriate only if 
it has both--
    (i) Power to regulate intrastate transportation provided by a motor 
carrier, within the meaning of section 10521(b)(1) of the Revised 
Interstate Commerce Act (49 U.S.C. 10521(b)(1)), and
    (ii) Power to initiate an exemption proceeding under section 1025(b) 
of that Act (49 U.S.C. 10525(b)).
    (5) Intercity transportation. Intercity transportation means 
intercity passenger transportation or intercity passenger charter 
service. Intercity transportation does not include transportation 
provided entirely within a municipality, contiguous municipalities, or 
within a zone that is adjacent to, and commercially a part of, the 
municipality or municipalities (within the meaning of section 
10526(b)(1) of the Revised Interstate Commerce Act (49 U.S.C. 
10526(b)(1)). See 49 CFR part 1048 (regulations defining commercial 
zones under that statute).
    (6) Definition of qualified intercity bus. A qualified intercity bus 
(qualifying bus) is an automobile bus--
    (i) The chassis and body of which are exempt (under section 
4063(a)(6)) from the 10-percent excise tax generally imposed under 
section 4061(a) on trucks and buses.

[[Page 485]]

    (ii) With a seating capacity of at least 36 passengers (in addition 
to the driver).
    (iii) With one or more baggage compartments, in an area separated 
from the passenger area, with an aggregate capacity of at least 200 
cubic feet, and
    (iv) Which meets the predominant use test.
    (7) Predominant use test. (i) A bus meets the predominant use test 
for a taxable year only if it meets the following conditions:
    (A) It is used on a full-time basis during the taxable year, and
    (B) At least 70 percent of the total miles driven are driven while 
furnishing intercity transportation.
    (ii) A bus driven from the end point of one trip to the beginning 
point of another trip (``deadheading''), both of which furnish intercity 
transportation of passengers, will be considered to have been driven 
while furnishing intercity transportation of passengers, even if no 
passengers are carried.
    (iii) A bus is considered used on a full-time basis in a taxable 
year if it was driven 10,000 miles in that year. If available, the best 
evidence of annual mileage is the difference between odometer readings 
at the beginning and end of each taxable year. If the bus was placed in 
service during the taxable year, or for a short taxable year described 
in section 441(b)(3), that 10,000 mile figure is prorated on a daily 
basis.
    (iv) If a qualifying bus fails to meet the predominant use test in a 
taxable year, a cessation occurs in that taxable year. See Sec.  1.47-
1(h)(3)(ii).
    (v) The following examples illustrate this paragraph (q)(7):

    Example 1. X, a bus company, used a bus for trips between city M and 
city N, a distance of 100 miles. These trips qualify as furnishing 
intercity transportation. During the taxable year, 300 round trips were 
run carrying passengers both ways and 75 trips were run carrying 
passengers from city M to city N immediately after each of which the bus 
was returned to city M for the next trip. The bus was also driven 20,000 
miles to furnish passenger service which was local transportation. 
During the taxable year, the bus was driven a total of 100,000 miles. X 
makes the following calculations to determine if it met the predominant 
use test for the taxable year.

1. Total miles driven......................................      100,000
2. Intercity miles driven:
    a. Passenger round trips (100 x 2 x 300)...............       60,000
    b. Passenger one-way (75 x 100)........................        7,500
    c. Non-passenger return trips (75 x 100)...............        7,500
3. Total intercity passenger miles (sum of lines 2 a, b,          75,000
 and c)....................................................
4. 79% of line 1...........................................       70,000
 


Since line 1 is not less than 10,000 miles, the full-time use 
requirement is met. Since line 3 is greater than line 4, the 70 percent 
intercity mileage test is met. Thus, for the taxable year, the bus meets 
the predominant use test in paragraph (q)(7)(i) of this section.
    Example 2. The facts are the same as in example 1, except that the 
bus was placed in service on the last day of the taxable year. The bus 
was used only to run one round trip, carrying passengers, between cities 
M and N. 10,000 miles X one day / 365 days = 27.4 miles. Because, for 
the one day of the taxable year that the bus was in service, the bus was 
driven more than 27.4 miles, and all these miles were driven to furnish 
intercity transportation, it met the predominant use test for the 
taxable year.

    (8) Leased buses. (i) A bus which is leased is energy property only 
if it meets the requirements of paragraphs (q)(6) (i), (ii), and (iii) 
of this section, the lessee is an eligible taxpayer, and the bus meets 
the predominant use test in the hands of the lessee. If a leased bus is 
energy property, the energy credit is available only to the lessee 
unless paragraph (q)(8)(ii) of this section applies. The lessor must 
elect under section 48(d) for the lessee to claim the energy credit.
    (ii) If a leased bus is energy property and, on or before October 9, 
1984, either (A) the lessor and lessee enter into a lease and the lessee 
places the bus in service, or (B) the bus is not placed in service but 
the lessor and lessee enter into a binding contract under which the 
amount of the lease payments cannot be modified, then the energy credit 
is available to the lessor even if the lessor is not an eligible 
taxpayer.
    (iii) Notwithstanding Sec.  1.47-2(b)(1) (relating to the effect of 
a disposition by the lessee on the credit claimed by the lessor), if, by 
reason of a lease or the termination of a lease, a bus is used in a 
taxable year subsequent to the credit year by a person other than the 
one whose increase in operating capacity determined the amount of 
qualified investment for the energy credit, a disposition of the bus 
under Sec.  1.47-1(h)(2)

[[Page 486]]

results. However, if the energy credit for a bus was earned in a taxable 
year and a lease of the bus which qualifies under section 168(f)(8) 
(safe-harbor lease) is entered into in a subsequent taxable year, the 
safe-harbor lease is not a disposition of the bus and the lessee under 
that lease is treated as the lessee for purposes of this paragraph 
(q)(8). For the requirement to file an amended return if the energy 
credit was allowed in a prior taxable year, see Sec.  5c.168(f)(8)-
6(b)(2)(ii) (Temporary Income Tax Regulations under the Economic 
Recovery Tax Act of 1981). For the rule for determining whose operating 
capacity determines qualified investment for the energy credit, see 
paragraph (q)(9)(ii) of this section. For the rule for leases to related 
taxpayers, see paragraph (q)(10)(ii) of this section.
    (9) Operating capacity. (i) Qualified investment for a qualifying 
bus is taken into account for the energy credit only to the extent the 
bus increases the taxpayer's operating capacity. To increase operating 
capacity, a bus must be counted in operating capacity. The increase in a 
taxpayer's operating capacity is the excess of the taxpayer's operating 
capacity for the current taxable year over its operating capacity for 
the immediately preceding taxable year. Related taxpayers determine 
operating capacity on a group basis under paragraph (q)(10) of this 
section.
    (ii) Operating capacity for a particular taxable year is determined 
by adding together the seating capacities of all intercity buses used by 
the taxpayer in that year and still owned by the taxpayer at the end of 
that year. An intercity bus is a bus which meets the chassis and body 
test and the predominant use test in paragraph (q)(6) of this section 
whether or not the bus is still in use at the end of the taxable year. 
In the case of a leased bus to which paragraph (q)(8) of this section 
applies, the lessee's operating capacity determines qualified investment 
for the energy credit.
    (iii) The qualified investment for the energy credit for a 
qualifying bus is the bus's qualified investment for the regular credit 
multiplied by a fraction. The numerator of the fraction is the increase 
in the taxpayer's operating capacity for the taxable year. The 
denominator is the added operating capacity for the taxable year. Added 
operating capacity for the taxable year is determined for a taxpayer by 
adding together the seating capacities of the taxpayer's intercity buses 
included in operating capacity for the taxable year which were not 
included in operating capacity for the immediately preceding taxable 
year.
    (iv) In the case of a partnership, each partner's qualified 
investment for the energy credit for a qualifying bus is the partner's 
qualified investment for the regular credit (determined under Sec.  
1.46-3(f) multiplied by the fraction referred to in paragraph 
(q)(9)(iii) of this section for the partnership, as determined for the 
partnership taxable year in which the bus is placed in service.
    (v) The following example illustrates this paragraph (q)(9):

    Example. Corporation Y is a calendar year bus company that is an 
eligible taxpayer under paragraph (q)(2) of this section. Based upon the 
facts as set forth in the following table, Y makes the following 
calculations to determine the energy credit earned in 1981:

1. 1980 operating capacity determined as of 12/31/80:
    a. 5 intercity buses x 50 seats each...................          250
                                                            ------------
    b. Total 1980 operating capacity.......................          250
2. 1981 operating capacity determined as of 12/31/8:
    a. 2 1980 buses used on a full-time basis in 1981......          100
    b. 1981 added capacity:................................
        i. Qualifying buses:
            Bus 1..........................................           45
            Bus 2..........................................           55
            Bus 3..........................................           50
        ii. Intercity bus not a qualifying bus.............           50
        iii. Total 1981 added capacity.....................          200
                                                            ------------
  c. Total 1981 operating capacity.........................          300
3. 1981 increase in operating capacity (line 2c-line 1b)...           50
4. Fraction for determining qualified investment                   \1/4\
 attributable to increase in capacity (line 3 + line 2
 (b)(iii)).................................................
 

    Accordingly, the energy credit earned in 1981 for each of the 
qualifying buses is determined as follows:

------------------------------------------------------------------------
    Qualified
 investment for                                Energy             Energy
   the regular        x     Line 4      x    percentage     =     credit
     credit                                                       earned
------------------------------------------------------------------------
Bus 1: $15,000    .......    \1/4\  .......         10   ......     $375
Bus 2: $20,000    .......    \1/4\  .......         10   ......      500
Bus 3: $25,000    .......    \1/4\  .......         10   ......      625
                 -------------------------------------------------------
  Total energy    .......  .......  .......  ..........  ......    1,500
   credit earned
   in 1981
------------------------------------------------------------------------



[[Page 487]]

    (10) Related taxpayers. (i) Related taxpayers are treated as one 
taxpayer in determining the increase in operating capacity under 
paragraph (q)(9)(ii) of this section and in determining the qualified 
investment in qualified intercity buses for the energy credit under 
paragraph (q)(9)(iii) of this section. Related taxpayers are members of 
a group of trades or businesses that are under common control (as 
defined in Sec.  1.52-1(b)).
    (ii) Related taxpayers make all computations relating to operating 
capacity on a group basis. Also, the determination of whether a bus 
meets the predominant use test is made on a group basis by aggregating 
bus usage by each member of the group. For example, if a bus is acquired 
by one member and used by that member for part of a taxable year and 
used by other members for the remainder, the combined usage is 
aggregated in determining whether the predominant use test is met. In 
addition, all related taxpayers are treated as one person in applying 
paragraph (q)(8) of this section (relating to leasing).
    (iii) The energy credit earned for a qualifying bus is allocated to 
the member which acquired (or is a lessee treated under section 48(d) as 
having acquired) the bus whether or not that member had a separate 
increase in operating capacity for the taxable year.
    (iv) Each member must make its own computation of the group's 
increase in operating capacity for the period comprising its taxable 
year. A member will make this computation as of the end of its taxable 
year ignoring different taxable years of other members. For the period 
comprising its taxable year, the member makes all calculations relating 
to group operating capacity, including the determination of full-time 
use by other members.
    (v) Each member determines the composition of the group as of the 
end of that member's taxable year. For example, if X uses the calendar 
year and makes its computation as of December 31, 1981, and Y is a 
member of X's group at that time, Y's operating capacity determined as 
of the end of X's immediately preceding taxable year (December 31, 1980) 
is taken into account by X for 1980 even if Y was not a member of the 
group for any day prior to December 31, 1981.
    (vi) The following example illustrates this paragraph (q)(10):

    Example (a). Corporations X and Y are related taxpayers. In this 
example, each bus is a qualifying bus with a seating capacity of 50. 
Each bus owned at the close of either X's or Y's taxable year was used 
on a full-time basis for the relevant period corresponding to X's or Y's 
taxable year. Other facts are set forth in the following table:

------------------------------------------------------------------------
                                          X                   Y
------------------------------------------------------------------------
Taxable year ends..............  Dec. 31...........  June 30.
Operating capacity for 1979....  5 buses...........  10 buses.
Buses added....................  3 buses Mar. 1,     3 buses May 15,
                                  1980.               1981.
Buses sold.....................  2 buses Mar. 31,    2 buses Sept. 30,
                                  1981.               1980.
Cost of each added bus.........  $40,000...........  $60,000.
------------------------------------------------------------------------

    (b) X makes the following calculations to determine the energy 
credit earned for calendar year 1980.

1. 1979 operating capacity determined as of 12/31/79:
    a. Attributable to X (5 buses x 50 seats)..................      250
    b. Attributable to Y (10 buses x 50 seats).................      500
                                                                --------
    c. Total 1979 operating capacity...........................      750
2. 1980 operating capacity determined as of 12/31/80:
    a. X's 5 and Y's 8 1979 buses used on a full-time basis in       650
     1980 and still owned on 12/31/80..........................
    b. 1980 added capacity (X's 3 buses x 50 seats)............      150
                                                                --------
    c. Total 1980 operating capacity...........................      800
3. 1980 increase in operating capacity (line 2c-line 1c).......       50
4. Fraction in paragraph (q)(9)(iii) of this section (line 3 /     \1/3\
 line 2b)......................................................
 

    Accordingly, X earned an energy credit of $4,000 in 1980 ($40,000 x 
\1/3\ x 10% x 3 buses).
    (c) Since in calendar year 1981 X placed no qualifying buses in 
service, X earned no energy credit in 1981.
    (d) Since in the taxable year 7/1/79-6/30/80 Y placed no qualifying 
buses in service, Y earned no energy credit in that taxable year.
    (e) Y makes the following calculations to determine the energy 
credit earned in the taxable year 7/1/80-6/30/81.

1. Operating capacity for the taxable year ending 6/30/80
 determined as of the close of that year:
    a. Attributable to X (8 buses x 50 seats)..................      400
    b. Attributable to Y (10 buses x 50 seats).................      500
                                                                --------
    c. Total operating capacity for that year..................      900
2. Operating capacity for the taxable year ending 6/30/81
 determined as of the close of that year:
    a. X's 6 and Y's 8 buses from prior taxable year used on a       700
     full-time basis during current taxable year and still
     owned on 6/30/81..........................................

[[Page 488]]

 
    b. Capacity added during current taxable year (Y's 3 buses       150
     x 50 seats)...............................................
                                                                --------
    c. Total operating capacity for that year..................      850
3. Increase in operating capacity for taxable year ending 6/30/     (50)
 81 (line 2c-line 1c)..........................................
 

    As determined for Y's taxable year ending 6/30/81 the group 
experienced a decrease in operating capacity. Thus, no energy credit is 
available for the buses Y placed in service in its taxable year ending 
6/30/81.

    (11) Section 381(a) transactions. (i) In the case of a transaction 
described in section 381(a), the operating capacity of each transferor 
or distributor corporation, determined as of the date of distribution or 
transfer (within the meaning of Sec.  1.381(b)-1(b)), shall reduce the 
operating capacity of the acquiring corporation (determined without this 
paragraph (q)(11)) for its first taxable year ending on or after that 
date for purposes of determining the acquiring corporation's energy 
credit for that year. This paragraph (q)(11) shall not apply to any case 
to which paragraph (q)(10) of this section (dealing with related 
taxpayers) applies.
    (ii) The following example illustrates this paragraph (q)(11):

    Example. X and Y are unrelated corporations which use the calendar 
year. For 1981, each has an operating capacity of 250 seats (5 buses x 
50 seats). X merges into Y on January 1, 1982. On May 1, 1982, Y retires 
and sells two buses and acquires four 50-seat qualifying buses at a cost 
of $40,000 each. All buses owned by Y on December 31, 1982, are included 
in operating capacity. Y makes the following calculations to determine 
the energy credit earned in taxable year 1982.

1. Y's 1981 operating capacity determined as of 12/31/81.......      250
2.1982 operating capacity determined as of 12/31/82 without
 this paragraph (q)(11):
    a. X's 5 buses plus Y's 5 1981 buses less 2 retired buses        400
     (8 buses x 50 seats)......................................
    b. 1982 added capacity (4 buses x 50 seats)................      200
                                                                --------
    c. Total...................................................      600
3. Operating capacity of transferor (X) on 1/1/82..............      250
                                                                --------
4. Y's 1982 operating capacity (line 2c-line 3)................      350
5. 1982 increase in operating capacity (line 4-line 1).........      100
6. Fraction in paragraph (q)(9)(iii) of this section (line 5 /     \1/2\
 line 2b)......................................................
7. Energy credit earned in 1982 ($40,000 x \1/2\ x 10% x 4        $8,000
 buses)........................................................
 


(Secs. 7805 (68A Stat. 917, 26 U.S.C. 7805) and 38 (b) (76 Stat. 962, 26 
U.S.C. 38) of the Internal Revenue Code of 1954; secs. 38(b) (76 Stat. 
963, 26 U.S.C. 38(b)), 48(l)(16) (94 Stat. 264, 26 U.S.C. 48(l)(16)), 
and 7805 (68A Stat. 917, 26 U.S.C. 7805))

[T.D. 7291, 46 FR 7291, Jan. 23, 1981, as amended by T.D. 7982, 49 FR 
39542, Oct. 9, 1984; 49 FR 41246, Oct. 22, 1984; T.D. 8014, 50 FR 11853, 
Mar. 26, 1985; T.D. 8147, 52 FR 27337, July 21, 1987]



Sec.  1.48-10  Single purpose agricultural or horticultural structures.

    (a) In general--(1) Scope. Under section 48(a)(1)(D), ``section 38 
property'' includes single purpose agricultural and horticultural 
structures, as defined in section 48 (p) and paragraphs (b) and (c) of 
this section. These structures are subject to a special rule for 
recapture of the credit. See paragraph (g) of this section. For the 
relation of this section to section 48(a)(1)(B) (other tangible 
property) and to sections 1245 and 1250 (depreciation recapture), see 
paragraph (h) of this section.
    (2) Effective date. The provisions of section 48(a)(1)(D) and this 
section apply to open taxable years ending after August 15, 1971.
    (b) Definition of single purpose agricultural structure--(1) In 
general. Under section 48(p)(2), a single purpose agricultural structure 
is any structure or enclosure that meets all of the following 
requirements:
    (i) It is specifically designed and constructed for permissible 
purposes (as defined in paragraph (b)(2) of this section). See paragraph 
(d) of this section for the rule regarding ``specifically designed and 
constructed''.
    (ii) It is specifically used exclusively for those permissible 
purposes. See paragraph (e) of this section for the rules regarding 
``specifically used''.
    (iii) It houses equipment necessary to house, raise, and feed 
livestock and their produce. See paragraphs (b)(3) and (4) of this 
section.
    (2) Permissible purposes. The following are the only permissible 
purposes for a single purpose agricultural structure:
    (i) Housing, raising, and feeding a particular type of livestock 
and, at the taxpayer's option, its produce. The term ``housing, raising, 
and feeding'' includes the full range of livestock

[[Page 489]]

breeding and raising activities, including ancillary post-production 
activities (as defined in paragraph (f) of this section). Thus, for 
example, use of a structure for breeding livestock, or for producing 
eggs or livestock, is permitted. The structure may also be used for 
storing feed or machinery, but more than strictly incidental use for 
these purposes will disqualify the structure. See paragraph (e)(1) of 
this section. For the special rule concerning the permissible purposes 
for a milking parlor, see paragraph (b)(2)(iii) of this section.
    (ii) Housing required equipment (including any replacements) as 
defined in paragraph (b)(4) of this section.
    (iii) If the structure is a dairy facility, it will qualify if it is 
used for: (A) activities consisting of the production of milk or of the 
production of milk and the housing, raising, or feeding dairy cattle, 
and (B) housing equipment (including any replacements) necessary for 
these activities. The term ``housing, raising, or feeding'' includes the 
full range of dairy cattle breeding and raising activities including 
ancillary post-production activities (as defined in paragraph (f) of 
this section). The structure may also be used for storing feed or 
machinery, but, more than incidental use for these purposes will 
disqualify the structure. See paragraph (e)(1) of this section.
    (3) Livestock; particular type of livestock--(i) Livestock. 
Livestock qualifying as ``section 38 property'' under Sec.  1.48-1(l) 
constitutes livestock for purposes of this section. Thus, for example, 
horses are not livestock for purposes of this section since they do not 
qualify as ``section 38 property'' under Sec.  1.48-1(l). Under section 
48(p)(6) poultry constitutes livestock for purposes of section 
48(a)(1)(D). The term ``livestock'' includes the offspring of livestock. 
``Livestock'' is distinguished from the produce of livestock, such as 
milk and eggs held for sale. For purposes of this section, eggs held for 
hatching and newborn livestock are considered livestock. A structure 
used solely to house produce of livestock or equipment necessary to 
house produce of livestock will not qualify as a single purpose 
agricultural structure. Thus, for example, a dairy facility used solely 
for storing milk will not qualify.
    (ii) Particular type of livestock. A structure qualifies as a single 
purpose agricultural structure only if it is specifically designed, 
constructed, and used exclusively for permissible purposes with respect 
to one particular type of livestock. For purposes of this section, each 
species is a different type except that all species of poultry are 
considered to be of a single type. Thus, for example, a structure 
specifically designed and constructed as a single purpose hog-raising 
facility will not qualify if it is used to raise dairy cows, but a 
structure specifically designed, constructed, and used to raise poultry 
may house, raise, and feed both chickens and turkeys.
    (4) Required equipment rule. (i) A single purpose agricultural 
structure must also house equipment necessary to house, raise, and feed 
the livestock (``required equipment''). Required equipment must be an 
integral part of the structure, and includes, but is not limited to, 
equipment necessary to contain the livestock, to provide them with water 
or feed, and to control the temperature, lighting, and humidity of the 
interior of the structure. For purposes of this section, equipment is an 
integral part of the structure if it is physically attached to or a part 
of the structure. The useful life of the structure, however, need not be 
contemporaneous with the life of the equipment it houses. A structure 
without required equipment is not a single purpose agricultural 
structure.
    (ii) A single purpose agricultural structure may, but is not 
required to, house equipment (for example, loading chutes) necessary to 
the conduct of ancillary post-production activities as defined in 
paragraph (f) of this section.
    (5) Livestock structure. In section 48(p)(2), the terms ``single 
purpose livestock structure'' and ``single purpose agricultural 
structure'' are interchangeable.
    (c) Definition of single purpose horticultural structure--(1) In 
general. Under section 48(p)(3), a single purpose horticultural 
structure is any structure that meets both of the following 
requirements:
    (i) It is a greenhouse or other structure specifically designed and 
constructed for permissible purposes (as

[[Page 490]]

defined in paragraph (c)(2) of this section). See paragraph (d) of this 
section for the rule regarding ``specifically designed and 
constructed.''
    (ii) It is specifically used exclusively for those permissible 
purposes. See paragraph (e) of this section for the rules regarding 
``specifically used.''
    (2) Permissible purposes. The following are the only permissible 
purposes for a single purpose horticultural structure:
    (i) The commercial production of plants (including plant products 
such as flowers, vegetables, or fruit) in a greenhouse.
    (ii) The commercial production of mushrooms.
    (iii) A single purpose horticultural structure also may, but is not 
required to, house equipment necessary to carry out these permissible 
purposes listed in paragraphs (c)(2) (i) and (ii) of this section.
    (3) Ancillary post-production activities. The terms ``commercial 
production of plants'' and ``commercial production of mushrooms'' 
include ancillary post-production activities (as defined in paragraph 
(f) of this section).
    (d) Specifically designed and constructed. A structure is 
specifically designed and constructed if it is not economic to design 
and construct the structure for the intended qualifying purpose and then 
use the structure for a different purpose. For example, if a hog raising 
structure is designed and constructed in accordance with a standard set 
of plans for such a structure provided by the Department of Agriculture, 
it would not be economic to use the structure for purposes other than 
hog raising.
    (e) Specifically used. There are two aspects of the specific use 
requirement--exclusive use and actual use.
    (1) Exclusive use. (i) A structure qualifies as a single purpose 
agricultural or horticultural structure only if it is used exclusively 
for the permitted purposes by reason of which it qualified for the 
credit. Thus--
    (A) The structure may not be used for any nonpermissible purposes 
(for example, processing, marketing, or more than incidental use for 
storing feed or equipment) and
    (B) It may not be put to any use other than the specific use by 
reason of which it qualifies for the credit.
    (ii) For purposes of this section, the term ``incidental use'' means 
a use which is both related and subordinate to the qualifying purpose. 
Thus, for example, if feed is stored in an agricultural structure which 
will be used for raising hogs, the feed must be used only for the hogs 
in order to be related to the qualifying purpose. In determining whether 
use of the structure for feed storage is subordinate to the qualifying 
purpose, all of the facts and circumstances must be considered, 
including, with respect to feed storage, the following:
    (A) Type of animal involved;
    (B) Number of, and consumption rate for, each animal;
    (C) Climate of area;
    (D) Total volume of storage area; and
    (E) Percentage of structure's total volume devoted to storage.
    (iii) It will be presumed that the storage function is not 
subordinate to the qualifying purpose of the structure if more than one-
third of the structure's total usable volume is devoted to storage. This 
presumption may be rebutted with clear and convincing evidence.
    (iv) A structure may fail the exclusive use test if either of the 
requirements of paragraph (e)(1)(i) of this section is not met. Thus, 
for example, a horticultural structure that contains an area for 
processing plants or plant products will fail the exclusive use test 
because there is a nonpermissible use. An agricultural structure that is 
used to house more than one particular type of livestock fails the 
exclusive use test for the same reason. A change in the use of an 
agricultural structure from one species of livestock to another will 
cause the structure to fail the exclusive use test when the change 
occurs. Thus, for example, a hog-raising facility which qualified for 
the credit when it was placed in service cannot later be modified and 
used for producing broiler chickens even if the structure would have 
qualified for the credit if it had been originally designed, 
constructed, and used exclusively for producing broiler chickens.
    (2) Actual use. (i) A single purpose agricultural or horticultural 
structure

[[Page 491]]

also must actually be used for the permissible purpose by reason of 
which it qualifies for the credit. ``Actual use'' means ``placed in 
service'' (as defined in Sec.  1.46-3(d)). Mere vacancy, on a temporary 
basis, will not disqualify the structure. Thus, for example, a structure 
that is designed and constructed as a hog-raising structure will not 
qualify if it is never placed in service for raising hogs. However, a 
turkey-raising facility will not be disqualified if the turkeys are all 
sent to a packing plant in November and the structure remains vacant 
until the next spring when newly hatched turkeys are placed in the 
structure to be raised.
    (ii) For purposes of this section, ``vacancy on a temporary basis'' 
includes temporary vacancy caused by market fluctuations or other 
economic considerations and vacancy on a seasonal basis.
    (f) Work space; ancillary post-production activities--(1) 
Permissible work space. Under section 48(p)(4), a single purpose 
agricultural or horticultural structure may contain work space only if 
it is used for--
    (i) Stocking, caring for, or collecting livestock, plants, or 
mushrooms,
    (ii) Maintenance of the structure, or
    (iii) Maintenance or replacement of the equipment or stock enclosed 
by or contained in the structure. Thus, for example, an eligible 
structure may not contain space devoted to processing or marketing or 
other nonpermissible purposes.
    (2) Ancillary post-production activities. The term ``stocking, 
caring for, or collecting'' the livestock, plants, or mushrooms includes 
ancillary post-production activities. These activities, therefore, 
constitute permissible purposes when carried on in conjunction with 
other permissible purposes, and a qualifying structure may contain work 
space devoted to such activities. Ancillary post-production activities 
include gathering, sorting, and loading livestock, plants, and mushrooms 
and packing unprocessed plants, mushrooms, and the live offspring and 
unprocessed produce of the livestock. Ancillary post-production 
activities do not include processing activities, such as slaughtering or 
packing meat, nor do they include marketing activities.
    (g) Special rule for recapture under section 47. Under section 
48(p)(5), if a structure which qualifies for the credit under this 
section becomes ineligible because it ceases to be held for the specific 
use by reason of which it qualified (or it is used for other than that 
qualifying use) before the end of the applicable estimated useful life 
or period specified in section 47(a), then the investment credit 
previously allowed with respect to the structure may be partially or 
entirely recaptured under section 47. Unlike other property to which 
section 47 applies, single purpose structures may not be converted from 
one permissible use to another without recapture. See subparagraph 
(e)(2) of this section.
    (h) Relationship to other sections--(1) Relation to section 
48(a)(1)(B). All structures satisfying the requirements of section 
48(a)(1)(B) and (a)(1)(D) will be considered to qualify under either 
provision.
    (2) Relationship to sections 1245 and 1250. For purposes of 
depreciation recapture, property to which section 48(a)(1)(D) applies is 
section 1245 property, except that property placed in service prior to 
January 1, 1981, may, at the option of the taxpayer, be treated as 
section 1250 property if depreciation deductions allowed were not under 
one of the methods authorized only for section 1245 property.
    (i) [Reserved]
    (j) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. A constructs a rectangular structure for use as an egg-
producing facility. The structure has no windows. The walls and roof are 
made of corrugated steel and there is a door which is 4 feet wide and 8 
feet tall at each end of the structure. At the end of each wall are 
louvered openings approximately 4 feet high and 8 feet long. These 
openings house thermostatically controlled fans. In the center of the 
walls are manually operated fresh-air openings. Corrugated steel 
``curtains'' hang from the top of the openings so that the openings can 
be completely closed in cold weather, but the curtains can be propped 
open to admit fresh air. The building is well insulated. A has 
reinforced the roof with extra trusses and rafters and reinforced the 
building with extra wall studs. Two rows of cages are suspended from the 
rafters by thin steel girders and wires. The floor of the structure is a 
sloping concrete slab pierced with long troughs which run the

[[Page 492]]

length of the structure beneath the cages. The troughs are used for 
collection and disposal of chicken wastes. When this structure is placed 
in service it will qualify for an investment credit under this section.
    Example 2. B constructs a greenhouse for the commercial production 
of plants. The greenhouse is a rectangular structure with translucent 
fiberglass walls and roof. The structure is equipped with an automatic 
temperature and humidity control system. Pipes were installed to carry 
water and liquid fertilizer to the plants and to release minute amounts 
of carbon dioxide into the air. When the structure was originally placed 
in service B used the entire structure for growing flowers commercially. 
In September 1978, B began to use the structure for growing tomatoes. 
Because of the success of the venture, in January 1979, B began to use 
the entire structure for growing tomatoes. In February 1980, B set up a 
small counter with a cash register at one end of the structure so that 
workers could sell tomatoes to customers at the greenhouse. Until 
February 1980, the structure would qualify for the credit under this 
section. The change in use from growing flowers to growing tomatoes will 
not affect the eligibility of the structure. Once the cash register is 
installed, however, the structure fails to meet both the exclusive use 
test of paragraph (e)(1) of this section and the work space rule of 
paragraph (f) of this section since a single purpose structure may not 
be used for marketing activities.
    Example 3. C purchases a prefabricated structure and makes 
modifications so that the structure will meet C's requirements. C adds 
gates and constructs a partition which divides the structure into two 
parts. One part of the structure constitutes less than one-third of the 
total usable volume of the structure and is used to house feeder cattle 
while they are fed with hay. This part of the structure has a sloping 
concrete floor. The other part of the structure constitutes more than 
two-thirds of the total usable volume of the structure and is used to 
store the hay used to feed the cattle. This structure will not qualify 
for the credit since it fails the required equipment test. The structure 
does not contain equipment which is an integral part of the structure. 
This structure also fails the ``specifically designed and constructed'' 
test of paragraph (d) of this section since it would be economic to use 
the structure for purposes other than housing, raising, and feeding 
cattle (such as a general purpose barn, for example). Finally, the 
structure fails the incidental use test of paragraph (e) of this section 
because the storage function is presumptively not subordinate to the 
qualifying purpose since more than two-thirds of the structure's total 
usable volume is devoted to storage and none of the facts will serve to 
rebut the presumption.

(Secs. 7805 (68A Stat. 917, 26 U.S.C. 7805) and 38 (b) (76 Stat. 926, 26 
U.S.C. 38))

[T.D. 7900, 48 FR 32768, July 19, 1983; 48 FR 36448, Aug. 11, 1983]



Sec.  1.48-11  Qualified rehabilitated building; expenditures incurred
before January 1, 1982.

    (a) In general. Under section 48(a)(1)(E), that portion of the basis 
of a qualified rehabilitated building which is attributable to qualified 
rehabilitation expenditures qualifies as section 38 property. In 
general, property which is treated as section 38 property by reason of 
section 48(a)(1)(E) is treated as new section 38 property and therefore 
is not subject to the used property limitation. See Sec.  1.48-2(d). 
Section 48(g)(1) and paragraph (b) of this section define the term 
``qualified rehabilitated building''. Section 48(g)(2) and paragraph (c) 
of this section define the term ``qualified rehabilitation 
expenditure''. Paragraph (d) of this section provides guidance for 
coordination of these provisions with other sections of the Code.
    (b) Definition of qualified rehabilitated building--(1) In general. 
The term ``qualified rehabilitated building'' means any building and its 
structural components--
    (i) Which has been rehabilitated (within the meaning of paragraph 
(b)(3) of this section),
    (ii) Which was placed in service (within the meaning of Sec.  1.46-
3(d)) by any person at any time before the beginning of the 
rehabilitation,
    (iii) 75 percent or more of the existing external walls of which are 
retained in place as external walls (within the meaning of paragraph 
(b)(4) of this section) in the rehabilitation process, and
    (iv) Which meets the twenty-year requirement in paragraph (b)(2) of 
this section.

In addition, a major portion of a building may be treated as a separate 
building for purposes of this paragraph if the requirements of paragraph 
(b)(5) of this section are met.
    (2) Twenty-year requirement--(i) In general. A building is 
considered a qualified rehabilitated building only if

[[Page 493]]

a period of at least 20 years has elapsed between the date physical work 
on the rehabilitation of the building began, and the later of--
    (A) The date the building was first placed in service (see Sec.  
1.46-3(d)) by any person as a building, or
    (B) The date the building was placed in service by any taxpayer in 
connection with a prior rehabilitation with respect to which a credit 
was allowed by reason of section 48(a)(1)(E).
    (ii) Vacant periods. The 20-year period includes periods during 
which a building was vacant or devoted to a personal use and is computed 
without regard to the number of owners or the identity of owners during 
the period.
    (iii) Physical work on a rehabilitation. For purposes of this 
section, ``physical work on a rehabilitation'' begins when actual 
construction begins. The term ``physical work on a rehabilitation'' does 
not include preliminary activities such as planning, designing, securing 
financing, exploring, researching, developing plans and specifications, 
or stabilizing a building to prevent deterioration (e.g., placing boards 
over broken windows).
    (iv) Special rule. If a part of a building meets the twenty-years 
requirement in subdivision (i) of this subparagraph and a part (for 
example, an addition) does not, a rehabilitation of that part that meets 
the requirement may qualify for a credit only if that part constitutes a 
major portion (as defined in paragraph (b)(5) of this section) of the 
building.
    (3) Rehabilitation--(i) In general. For purposes of this paragraph, 
rehabilitation includes renovation, restoration, or reconstruction. 
However, the term ``rehabilitation'' does not include enlargement 
(within the meaning of paragraph (c)(7)(ii) of this section), new 
construction, or the completion of new construction after a building has 
been placed in service. For purposes of this paragraph (b)(3), whether 
expenditures are attributable to the rehabilitation of an existing 
building, or to new construction, is determined upon all the facts and 
circumstances.
    (ii) Substantial rehabilitation. For a building to be considered 
rehabilitated, the rehabilitation must be substantial. Whether a 
rehabilitation is substantial is determined upon the basis of all the 
facts and circumstances. In general, to be substantial, the 
rehabilitation must do one of the following:
    (A) Materially extend the useful life of the building;
    (B) Significantly upgrade its usefulness (for either the same or a 
new use); or
    (C) Preserve it in a way that significantly improves its condition 
or enhances its historic value.

A substantial rehabilitation may vary in degree from gutting and 
extensive reconstruction of a building's major structural components to 
the cure of a substantial accumulation of major disrepairs. It may also 
include renovation, alteration, or remodelling for the conversion of a 
structurally sound building to a design and condition required for a new 
use. Cosmetic improvements alone, however, do not qualify as a 
substantial rehabilitation.
    (iii) Aggregation of rehabilitation. In the case where qualified 
rehabilitation expenditures are incurred with respect to a 
rehabilitation of a building by more than one person (e.g., a lessor and 
a lessee, several lessees, or several condominium owners), the 
substantial rehabilitation requirement in this paragraph (b)(3) shall be 
applied by aggregating all the rehabilitation work done by such persons.
    (iv) Special rule by qualified rehabilitation expenditures treated 
as incurred by the taxpayer. In the case where qualified rehabilitation 
expenditures are treated as having been incurred by a taxpayer because 
of the application of paragraph (c)(3)(ii) of this section, the 
substantial rehabilitation test in paragraph (b)(3)(ii) of this section 
will be applied by aggregating the rehabilitation work done by the 
transferor and the transferee.
    (v) Examples. The provisions of this subparagraph (3) may be 
illustrated by the following examples:

    Example 1. Taxpayer A is the owner of a 30-year old building. The 
building is air conditioned by means of window air conditioning units. A 
replaces the window units with a central air conditioning system and no 
other rehabilitation is performed by A. The expenditures incurred by A 
did not materially extend the building's useful life, significantly 
upgrade its usefulness, or preserve it in a manner that significantly 
improves its

[[Page 494]]

condition or enhances its historic value. Although expenditures for 
replacement of window units with a central air conditioning system may 
constitute qualified expenditures as part of an overall rehabilitation, 
alone they do not qualify as a substantial rehabilitation and the 
building is not considered rehabilitated within the meaning of this 
subparagraph.
    Example 2. Taxpayer B is the owner of a 10 story office building 
that is 35 years old. The building is in substantial disrepair and in 
order to modernize it as an office building B installs new plumbing, 
electrical wiring, and heating and air conditioning systems. In 
addition, the layout of each floor is changed by means of tearing down 
many existing interior walls and partitions and building new walls, 
partitions, and doors. Old plaster is removed from many walls and 
replaced by new wall covering. New windows and new flooring are 
installed throughout the building. The improvements made by B materially 
extend the useful life of the building and significantly upgrade its 
usefulness. The building is considered rehabilitated within the meaning 
of the facts and circumstances test in this subparagraph.
    Example 3. Taxpayer C is the owner of a 100-year old building that 
has substantial historic character, although the building is not a 
certified historic structure (as defined in section 191(d)(1) and the 
regulations thereunder). C uncovers and restores the original woodwork, 
wall coverings and moldings throughout the building. The windows and 
doors are replaced with replicas of the original. The improvements made 
by C significantly preserve the building and significantly enhance its 
historic value. Thus, the building is considered rehabilitated within 
the meaning of this subparagraph.

    (4) Retention of 75 percent of external walls--(i) In general. A 
building meets the requirements set forth in paragraph (b)(1)(iii) only 
if 75 percent or more of the existing external walls (as measured by the 
total area of the existing external walls) are retained in place as 
external walls in the rehabilitation process. For this purpose, the area 
of existing external walls includes the area of windows and doors.
    (ii) External wall. For purposes of this paragraph (b)(4), a wall 
includes both the supporting elements of the wall and the nonsupporting 
elements (e.g., a curtain) of the wall. Except as otherwise provided in 
this paragraph (b)(4), the term ``external wall'' includes any wall that 
has one face exposed to the weather, earth, or an abutting wall erected 
on an adjacent property. An external wall also includes a shared wall 
(i.e., a single wall shared with an adjacent building), generally 
referred to as a ``party wall''.
    (iii) Alternative rule. Notwithstanding the definition of external 
wall contained in paragraph (b)(4)(ii) of this section, in any case in 
which the building being rehabilitated would fail to meet the 
requirements of a qualified rehabilitation building if the definition of 
external wall in paragraph (b)(4)(ii) of this section were used, then 
the term ``external wall'' shall be defined as a wall, including its 
supporting elements, with one face exposed to the weather or earth, and 
a common wall shall not be treated as an external wall.
    (iv) Retained in place. An existing external wall is retained in 
place if the supporting elements of the wall are retained in place. An 
existing external wall is not retained in place if the supporting 
elements of the wall are replaced by new supporting elements. An 
external wall is retained in place, however, if the supporting elements 
are reinforced in the rehabilitation, provided that such supporting 
elements of the external wall are retained in place. An external wall is 
retained in place even though it is covered (e.g., with new siding). 
Moreover, the existing curtain may be replaced with a new curtain 
provided that the structural framework that provides for the support of 
the existing curtain is retained in place. An external wall is retained 
in place notwithstanding that the existing doors and windows in the wall 
are modified, eliminated, or replaced. A wall may be disassembled and 
reassembled so long as the same supporting elements are used when the 
wall is reassembled. Thus, for example, in the case of the brick wall, 
the wall is considered retained in place even though the original bricks 
are removed (for cleaning, etc.) and put back to form the wall.
    (v) Retention as an external wall. For purposes of meeting the 75 
percent requirement of this subparagraph (4), an existing external wall 
must be retained in place as an external wall. If an addition is made 
that results in an existing external wall being converted into an

[[Page 495]]

internal wall, the wall is not retained in place as an external wall.
    (vi) Special rule. Solely for the purpose of meeting the 75 percent 
requirement of this subparagraph (4), the walls of an uncovered internal 
shaft designed solely to bring light or air into the center of a 
building which are completely surrounded by external walls of the 
building and which enclose space not designated for occupancy or other 
use by people (other than for maintenance or emergency) are not 
considered external walls. Thus, a wall of a light well in the center of 
an office building is not an external wall. However, walls surrounding 
an uncovered courtyard which is usable by the building's occupants, 
(e.g., at lunch time) are external walls.
    (vii) Examples. The provisions of this subparagraph (4) may be 
illustrated by the following examples:

    Example 1. Taxpayer A rehabilitated a building all of the walls of 
which consisted of wood siding attached to gypsum board sheets (which 
covered the studs). A covered the existing wood siding with aluminum 
siding in a part of a rehabilitation that otherwise qualified under this 
subparagraph. A satisfied the requirement that 75 percent of the 
existing external walls must be retained in place as external walls.
    Example 2. Taxpayer B rehabilitated a building the external walls of 
which had a masonry curtain. The masonry on the wall face was replaced 
with a glass curtain. The steel beam and girders supporting the existing 
curtain were retained in place. B satisfied the requirement that 75 
percent of the existing external walls must be retained in place as 
external walls.
    Example 3. Taxpayer C rehabilitated a building which has two 
external walls measuring 75[foot] x 20[foot] and two other external 
walls measuring 100[foot] x 20[foot]. C tore down one of the larger 
walls, including its supporting elements, which accounted for more than 
25% of the building's external walls and constructed a new wall. C has 
not satisfied the requirement that 75 percent of the existing external 
walls must be retained in place as external walls.
    Example 4. The facts are the same as in example 3, except C does not 
tear down any walls, but makes an addition that results in one of the 
smaller walls becoming an internal wall. In addition, C enlarged 8 of 
the existing windows on the larger walls, increasing them from a size of 
3[foot] x 4[foot] to 6[foot] x 8[foot]. Since the smaller wall accounts 
for less than 25 percent of the total wall area, C has satisfied the 
requirement that 75 percent of the existing external walls must be 
retained in place as external walls in the rehabilitation process. The 
enlargement of the existing windows on the larger wall does not change 
the result.

    (5) Major portion treated as separate building--(i) In general. 
Where there is a separate rehabilitation of a major portion of a 
building, such major portion shall be treated as a separate building. 
Thus, such major portion may qualify as a qualified rehabilitated 
building if the requirements of this paragraph are met with respect to 
such major portion. Expenditures for property that services both a major 
portion of a building and another portion must be specifically allocated 
to each portion to the extent possible. If it is not possible to make 
such an allocation, the expenditures must be allocated to each portion 
on some reasonable basis. What constitutes a reasonable basis for an 
allocation depends on factors such as the type of improvement and how 
the improvement relates functionally to the building. For example, in 
the case of expenditures for an air conditioning system or a roof, a 
reasonable basis for allocating the expenditures would be the volume of 
the major portion served by the improvement relative to the volume of 
the other portion of the building served by the improvement.
    (ii) Major portion defined. Whether a part of a building constitutes 
a major portion of the building is determined upon the basis of all the 
facts and circumstances. A major portion must generally consist of 
clearly identifiable parts of a building (e.g., a wing of a building or 
the first 5 stories of a 7 story building). The following factors shall 
be taken into account:
    (A) Whether the portion comprises an entire leasehold interest or an 
entire ownership (e.g., condominium) interest;
    (B) Whether the portion (as measured by volume) is sufficiently 
large that it would be reasonable to treat it as a separate building; 
and
    (C) Whether the portion is functionally different from other parts 
of the building.
    (6) Special rule for rehabilitation done in phases. If 
rehabilitation which is not continuous is determined under this

[[Page 496]]

subparagraph to be a single rehabilitation done in phases, the 
requirements of this paragraph (b) are to be applied with respect to the 
overall rehabilitation and not merely to a phase of the rehabilitation. 
In such case, a phase of a single overall rehabilitation will not be 
considered as ``prior rehabilitation'' for purposes of subparagraph 
(2)(i)(B) of this paragraph (b). Whether rehabilitation which is not 
continuous is a single rehabilitation that is done in phases is 
determined on the basis of all the facts and circumstances. Generally, 
however, to constitute a single rehabilitation that is done in phases, 
there must exist, prior to the time any rehabilitation work is 
commenced, a set of written plans describing generally all phases of the 
rehabilitation of the building and a reasonable expectation that all 
phases of the rehabilitation will be completed. Such written plans are 
not required to contain detailed working drawings or detailed 
specifications of the material to be used. In addition, the period 
between the time that physical work on the first phase of the overall 
rehabilitation begins and physical work on the last phase of the overall 
rehabilitation begins must be reasonable. In determining whether the 
rehabilitation is completed within a reasonable time, the fact that a 
building is occupied during the rehabilitation, the necessity of 
acquiring a lease (of additional portions of the building), and 
unforeseen delays shall be taken into account. Other factors that are 
relevant in determining whether rehabilitation is a single 
rehabilitation include the length of time between each phase of 
rehabilitation activities and the extent of rehabilitation activity in 
each phase.
    (7) Special rule for adjoining buildings that are combined. For 
purposes of this paragraph (b), if as part of a rehabilitation process 
two or more adjoining buildings are combined and placed in service as a 
single building after the rehabilitation process, then all of the 
requirements of a qualified rehabilitated building in section 48(g)(1) 
and this section may be applied to the constituent adjoining buildings 
in the aggregate. Any party walls or abutting walls between the 
constitutent buildings that would otherwise be treated as external walls 
(within the meaning of paragraph (b)(4)(ii) of this section) would not 
be treated as external walls of the building; the substantial 
rehabilitation test in paragraph (b)(3)(ii) of this section would be 
applied to the aggregate rehabilitation work with respect to all of the 
constitutent buildings.
    (c) Definition of qualified rehabilitation expenditures--(1) In 
general. Except as provided in subparagraph (2) of this paragraph, the 
term ``qualified rehabilitation expenditure'' means any amount--
    (i) Properly chargeable to capital account (as described in 
subparagraph (2) of this paragraph),
    (ii) Incurred after October 31, 1978, for depreciable or amortizable 
property (or additions or improvements to property) with a useful life 
of five years or more, and
    (iii) Made in connection with the rehabilitation of a qualified 
rehabilitated building.
    (2) Chargeable to capital account. For purposes of paragraph 
(c)(1)(i) of this section, amounts paid or incurred are chargeable to 
capital account if under the taxpayer's method of accounting they are 
property includible in computing basis under Sec.  1.46-3. Amounts 
treated as an expense and deducted in the year they are paid or incurred 
are not chargeable to capital account.
    (3) Incurred by the taxpayer--(i) In general. Generally, to qualify 
for a credit under section 48 (a)(1)(E), qualified rehabilitation 
expenditures must be incurred by the taxpayer after October 31, 1978. An 
expenditure is incurred for purposes of this paragraph on the date such 
expenditure would be considered incurred under the accrual method of 
accounting, regardless of the method of accounting used by the taxpayer 
with respect to other items of income and expense. If qualified 
rehabilitation expenditures are treated as having been incurred by a 
taxpayer under paragraph (c)(3)(ii)) of this section, the taxpayer shall 
be treated as having incurred the expenditures on the date such 
expenditures were incurred by the transferor.
    (ii) Qualified rehabilitation expenditures treated as incurred by 
the taxpayer. (A) Where rehabilitation expenditures are incurred with 
respect to a building

[[Page 497]]

by a person (or persons) other than the taxpayer and the taxpayer 
acquires the building, or a portion of the building to which the 
expenditures are allocable, the taxpayer acquiring such property will be 
treated as having incurred the rehabilitation expenditures actually 
incurred by the transferor (or treated as incurred by the transferor 
under this paragraph (c)(3)(ii)) with respect to the acquired property, 
provided that--
    (1) The building, or the portion of the building, acquired by the 
taxpayer was not used after the rehabilitation expenditures were 
incurred and prior to the date of acquisition by the taxpayer, and
    (2) No credit with respect to such qualified rehabilitation 
expenditures is claimed by anyone other than the taxpayer acquiring the 
property.

For purposes of this paragraph (c)(3)(ii), use shall mean actual use, 
whether personal or business.
    (B) The amount of qualified rehabilitation expenditures treated as 
incurred by the taxpayer under this paragraph is the lesser of--
    (1) The qualified rehabilitation expenditures incurred before the 
date on which the taxpayer acquired the building (or portion thereof), 
to which the expenditures are attributable, or
    (2) That portion of the taxpayer's cost or other basis for the 
property which is attributable to the qualified rehabilitation 
expenditures described in paragraph (c)(3)(B)(1) of this section 
incurred before such date.

For purposes of paragraph (c)(6)(ii) of this section, the amount of 
rehabilitation expenditures treated as incurred by the taxpayer under 
this paragraph (c)(3)(ii) shall not be considered to be part of the cost 
of acquiring a building or any interest in the building. The portion of 
the cost of acquiring a building (or an interest therein) which is not 
treated under this paragraph as qualified rehabilitation expenditures 
incurred by the taxpayer is not eligible for a rehabilitation investment 
credit. See paragraph (c)(6)(ii) of this section.
    (C) See paragraph (b)(2)(iv) of this section for rules concerning 
the application of the substantial rehabilitation test to expenditures 
treated as incurred by the taxpayer.
    (iii) Examples. The provisions of this subparagraph may be 
illustrated by the following examples:

    Example 1. In 1978, taxpayer A, a cash basis taxpayer, commenced the 
rehabilitation of a 30-year old building. In June 1978, A signed 
contract with a plumbing contractor for replacement of the plumbing in 
the building. A agreed to pay the contractor as soon as the work was 
completed. The work was completed in September 1978, but A did not pay 
the amount due until November 1, 1978. The expenditures for the plumbing 
are not qualified rehabilitation expenditures because they were not 
incurred after October 31, 1978.
    Example 2. B incurred qualified rehabilitation expenditures of 
$300,000 with respect to an existing building between January 1, 1980, 
and May 15, 1980, and then sold the building to C on June 1, 1980. If 
the property attributable to the expenditures was not placed in service 
by A during the period from January 1, 1980, to June 1, 1980, C will be 
treated as having incurred the expenditures.

    (4) Incurred for 5-year property. An expenditure is incurred for 
depreciable or amortizable property if the amount of the expenditure is 
added to the basis of property which is depreciable or amortizable under 
section 167. The determination of whether property has a useful life of 
five years or more is made by applying the principles of Sec.  1.46-
3(e). In the case of expenditures for property made by a lessee, see 
sections 167 and 178 and the regulations thereunder for rules relating 
to whether improvements made to leased property are depreciable or 
amortizable.
    (5) Made in connection with the rehabilitation of a qualified 
rehabilitated building. Expenditures attributable to work done to 
facilities related to a building (e.g., sidewalk, parking lot, 
landscaping) are not considered made in connection with a rehabilitation 
of a qualified rehabilitated building.
    (6) Certain expenditures excluded from qualified rehabilitation 
expenditures. The term ``qualified rehabilitation expenditures'' does 
not include the following expenditures:
    (i) An expenditure for property which is ``section 38 property'' 
(determined without regard to section 48(a)(1) (E) and (l)).
    (ii) The cost of acquiring a building or any interest in a building 
(including a leasehold interest) except as provided in paragraph 
(c)(3)(ii) of this section.

[[Page 498]]

    (iii) An expenditure attributable to enlargement of a building (as 
defined in paragraph (c)(7) of this section).
    (iv) An expenditure attributable to rehabilitation of a certified 
historic structure (as defined in section 191(d)(1) and the regulations 
thereunder), unless the rehabilitation is a certified rehabilitation (as 
defined in paragraph (c)(8) of this section).
    (7) Expenditures for enlargement distinguished--(i) In general. 
Expenditures attributable to an enlargement of an existing building do 
not qualify as qualified rehabilitated expenditures. A building is 
enlarged to the extent that the total volume of the building is 
increased. An increase in floor space resulting from interior remodeling 
is not considred an enlargement. Generally, the total volume of a 
building is equal to the product of the floor area of the base of the 
building and the height from the underside of the lowest floor 
(including the basement) to the average height of the finished roof (as 
it exists or existed). For this purpose, floor area is measured from the 
exterior faces of external walls (other than shared walls that are 
external walls) and from the centerline of shared walls that are 
external walls. In addition, a building is enlarged to the extent of any 
construction outside the exterior faces of the existing external wall of 
the building.
    (ii) Rehabilitation which includes enlargement. If expenditures for 
property only partially qualify as qualified rehabilitation expenditures 
because some of the expenditures are also attributable to the 
enlargement of the building, the expenditures must be apportioned 
between the original portion of the building and the enlargement. This 
allocation should be made using the principles contained in paragraph 
(b)(5)(i) of this section.
    (8) Certified rehabilitation--(i) In general. For the purpose of 
this paragraph (c) of this section, the term ``certified 
rehabilitation'' means any rehabilitation of a certified historic 
building in a registered historic district which the Secretary of the 
Interior has certified to the Secretary as being consistent with the 
historic character of such building or the district in which such 
building is located.
    (ii) Revoked or invalidated certifications. If the Department of 
Interior revokes or otherwise invalidates a certification after it has 
been provided to a taxpayer, the decertified property will cease to be 
section 38 property described in section 48(a)(1)(e). Such cessation 
shall be effective as of the date the activity giving rise to the 
revocation or invalidation occurred. See section 47 for the rules 
applicable to property that ceases to be section 38 property.
    (d) Coordination with other provisions of the Code--(1) Credit by 
lessees--(i) Rehabilitation performed by lessor. A lessee may take the 
credit for rehabilitation performed by the lessor if the requirements of 
this section and section 48(d) are satisfied. For purposes of applying 
section 48(d), the fair market value of section 38 property described in 
section 48(a)(1)(E) shall be equal to that portion of the lessor's basis 
in a qualified rehabilitated building that is attributable to qualified 
rehabilitation expenditures.
    (ii) Rehabilitation performed by lessee. A lessee may take the 
credit for rehabilitation performed by the lessee, provided that the 
property (or improvements or additions to property) for which the 
rehabilitation expenditures are made is depreciable (or amortizable) by 
the lessee (see sections 167 and 178, and the regulations thereunder) 
and the requirements of this section are satisfied.
    (2) When credit may be claimed. The investment credit for qualified 
rehabilitation expenditures is allowed generally in the taxable year in 
which the property to which the rehabilitation expenditures is 
attributable is placed in service, provided the building is a qualified 
rehabilitated building for the taxable year. See Sec.  1.46-3(d). Under 
certain circumstances, however, the credit may be available prior to the 
date the property is placed in service. See section 46(d) and Sec.  
1.46-5 (relating to qualified progress expenditures).
    (3) Recapture. If property described in section 48(a)(1)(E) is 
disposed of by the taxpayer, or otherwise ceases to be ``section 38 
property,'' recapture may result under section 47. Property will cease 
to be section 38 property, and therefore recapture may occur under

[[Page 499]]

section 47, in any case where the Department of Interior revokes or 
otherwise invalidates a certification of rehabilitation (see section 
48(g)(2)(C)) after the property is placed in service because, for 
example, the taxpayer made modifications to the building inconsistent 
with Department of Interior standards.
    (e) Effective date--(1) General rule. Except as provided in 
paragraph (e)(2) of this section, this Sec.  1.48-11 shall not apply to 
expenditures incurred after December 31, 1981.
    (2) Transitional rule. This Sec.  1.48-11 shall continue to apply to 
expenditures incurred after December 31, 1981, for the rehabilitation of 
a building if--
    (i) The physical work on the rehabilitation began before January 1, 
1982, and
    (ii) The building does not meet the requirements of section 48(g)(1) 
of the Code as amended by the Economic Recovery Tax Act of 1981.

[T.D. 8031, 50 FR 26698, June 28, 1985]



Sec.  1.48-12  Qualified rehabilitated building; expenditures incurred
after December 31, 1981.

    (a) General rule--(1) In general. Under section 48(a)(1)(E), the 
portion of the basis of a qualified rehabilitated building that is 
attributable to qualified rehabilitation expenditures (within the 
meaning of section 48(g) and this section) is section 38 property. 
Property that is section 38 property by reason of section 48(a)(1)(E) is 
treated as new section 38 property and, therefore, is not subject to the 
used property limitation in section 48(c). Section 48(g)(1) and 
paragraph (b) of this section define the term ``qualified rehabilitated 
building.'' Section 48(g)(2) and paragraph (c) of this section define 
the term ``qualified rehabilitation expenditure.'' Section 48(g) 
(2)(B)(iv) and (3) and paragraph (d) of this section describe the rules 
applicable to ``certified historic structures.'' Section 48(q) and 
paragraph (e) of this section provide rules concerning an adjustment to 
the basis of the rehabilitated building. Paragraph (f) of this section 
provides guidance for coordination of these provisions with other 
sections of the Code, including rules for determining when the 
rehabilitation credit may be claimed.
    (2) Effective dates and transition rules--(i) In general. Except as 
otherwise provided in this paragraph (a)(2)(i), this section applies to 
expenditures incurred after December 31, 1981, in connection with the 
rehabilitation of a qualified rehabilitated building. (See paragraph 
(c)(3)(i) of this section for rules concerning the determination of when 
an expenditure is incurred.) If, however, physical work on the 
rehabilitation began before January 1, 1982, and the building does not 
meet the requirements of paragraph (b) of this section, the rules in 
Sec.  1.48-11 shall apply to the expenditures incurred after December 
31, 1981, in connection with such rehabilitation. (See paragraph 
(b)(6)(i) of this section for rules determining when physical work on a 
rehabilitation begins.) The next to last sentence of paragraph (c)(8)(i) 
of this section applies to qualified rehabilitation expenditures that 
are qualified property under section 168(k)(2) or qualified New York 
Liberty Zone property under section 1400L(b) acquired by a taxpayer 
after September 10, 2001, and to qualified rehabilitation expenditures 
that are 50 percent bonus depreciation property under section 168(k)(4) 
acquired by a taxpayer after May 5, 2003. The last sentence of paragraph 
(c)(8)(i) of this section applies to qualified rehabilitation 
expenditures that are qualified property under section 168(k)(2) and 
placed in service by a taxpayer during or after the taxpayer's taxable 
year that includes September 24, 2019. However, a taxpayer may choose to 
apply the last sentence in paragraph (c)(8)(i) of this section for 
qualified rehabilitation expenditures that are qualified property under 
section 168(k)(2) and acquired and placed in service after September 27, 
2017, by the taxpayer during taxable years ending on or after September 
28, 2017. A taxpayer may rely on the last sentence in paragraph 
(c)(8)(i) of this section in regulation project REG-104397-18 (2018-41 
I.R.B. 558) (see Sec.  601.601(d)(2)(ii)(b) of this chapter) for 
qualified rehabilitation expenditures that are qualified property under 
section 168(k)(2) and acquired and placed in service after September 27, 
2017, by

[[Page 500]]

the taxpayer during taxable years ending on or after September 28, 2017, 
and ending before the taxpayer's taxable year that includes September 
24, 2019.
    (ii) Transition rules concerning ACRS lives. (A) For property placed 
in service before March 16, 1984, and any property subject to the 
exception set forth in section 111(g)(2) of Pub. L. 98-369 (Deficit 
Reduction Act of 1984), the references to ``19 years'' in paragraph 
(c)(4)(ii) and (7)(v) shall be replaced with ``15 years'' and the 
reference to ``19-year real property'' in paragraph (c)(4)(ii) shall be 
replaced with ``15-year real property.''
    (B) Except as otherwise provided in paragraph (a)(2)(ii)(A) of this 
section, for property placed in service before May 9, 1985, and any 
property subject to the exception set forth in section 105(b) (2) and 
(5) of Pub. L. 99-121 (99 Stat. 501, 511), the reference to ``19 years'' 
in paragraph (c)(4)(ii) and (7)(v) shall be replaced with ``18 years'' 
and the references to ``19-years real property'' in paragraph (c)(4)(ii) 
shall be replaced with ``18-year real property.''
    (iii) Transition rule concerning external wall definition. 
Notwithstanding the definition of external wall contained in paragraph 
(b)(3)(ii) of this section, in any case in which the written plans and 
specifications for a rehabilitation were substantially completed on or 
before June 28, 1985, and the building being rehabilitated would fail to 
meet the requirement of paragraph (b)(1)(iii) of this section if the 
definition of external wall in paragraph (b)(3)(ii) of this section were 
used, the term ``external wall'' shall be defined as a wall, including 
its supporting elements, with one face exposed to the weather or earth, 
and a common wall shall not be treated as an external wall. See 
paragraph (b)(2)(v) of this section for the definition of written plans 
and specifications.
    (iv) Transition rules concerning amendments made by the Tax Reform 
Act of 1986--(A) In general. Except as otherwise provided in section 
251(d) of the Tax Reform Act of 1986 and this paragraph (a)(2)(iv), the 
amendments made by section 251 of the Tax Reform Act of 1986 shall apply 
to property placed in service after December 31, 1986, in taxable years 
ending after that date, regardless of when the rehabilitation 
expenditures attributable to such property were incurred. If property 
attributable to qualified rehabilitation expenditures is incurred with 
respect to a rehabilitation to a building placed in service in segments 
or phases and some segments are placed in service before January 1, 
1987, and the remaining segments are placed in service after December 
31, 1986, the amendments under the Tax Reform Act would not apply to the 
property placed in service before January 1, 1987, but would apply to 
the segments placed in service after December 31, 1986, unless one of 
the transition rules in paragraph (a)(2)(iv) (B) or (C) of this section 
applies.
    (B) General transition rule. The amendments made by sections 251 and 
201 of the Tax Reform Act of 1986 shall not apply to property that 
qualifies under section 251(d) (2), (3), or (4) of the Tax Reform Act of 
1986. Property qualifies for the general transition rule in section 
251(d)(2) of the Act if such property is placed in service before 
January 1, 1994, and if such property is placed in service as part of--
    (1) A rehabilitation that was completed pursuant to a written 
contract that was binding on March 1, 1986, or
    (2) A rehabilitation incurred in connection with property (including 
any leasehold interest) acquired before March 2, 1986, or acquired on or 
after such date pursuant to a written contract that was binding on March 
1, 1986, if--
    (i) Parts 1 and 2 of the Historic Preservation Certificate 
Application were filed with the Department of the Interior (or its 
designee) before March 2, 1986, or
    (ii) The lesser of $1,000,000 or 5 percent of the cost of the 
rehabilitation is incurred before March 2, 1986, or is required to be 
incurred pursuant to a written contract which was binding on March 1, 
1986.
    (C) Specific rehabilitations. See section 251(d) (3) and (4) of the 
Tax Reform Act of 1986 for additional rehabilitations that are exempted 
from the amendments made by sections 251 and 201 of the Tax Reform Act 
of 1986.
    (b) Definition of qualified rehabilitated building--(1) In general. 
The term ``qualified rehabilitated building''

[[Page 501]]

means any building and its structural components--
    (i) That has been substantially rehabilitated (within the meaning of 
paragraph (b)(2) of this section) for the taxable year,
    (ii) That was placed in service (within the meaning of Sec.  1.46-
3(d)) as a building by any person before the beginning of the 
rehabilitation, and
    (iii) That meets the applicable existing external wall retention 
test or the existing external wall and internal structural framework 
retention test in accordance with paragraph (b)(3) of this section.


The requirement in paragraph (b)(1)(iii) of this section does not apply 
to a certified historic structure. See paragraphs (b) (4) and (5) of 
this section for additional requirements related to the definition of a 
qualified rehabilitated building.
    (2) Substantially rehabilitated building--(i) Substantial 
rehabilitation test. A building shall be treated as having been 
substantially rehabilitated for a taxable year only if the qualified 
rehabilitation expenditures (as defined in paragraph (c) of this 
section) incurred during any 24-month period selected by the taxpayer 
ending with or within the taxable year exceed the greater of--
    (A) The adjusted basis of the building (and its structural 
components), or (B) $5,000.
    (ii) Date to determine adjusted basis of the building--(A) In 
general. The adjusted basis of the building (and its structural 
components) shall be determined as of the beginning of the first day of 
the 24-month period selected by the taxpayer or the first day of the 
taxpayer's holding period of the building (within the meaning of section 
1250(e)), whichever is later. For purposes of determining the holding 
period under section 1250(e), any reconstruction that is part of the 
rehabilitation shall be disregarded.
    (B) Special rules. In the event that a building is not owned by the 
taxpayer, the adjusted basis of the building shall be determined as of 
the date that would have been used if the owner had been the taxpayer. 
The adjusted basis of a building that is being rehabilitated by a 
taxpayer other than the owner shall thus be determined as of the 
beginning of the first day of the 24-month period selected by the 
taxpayer or the first day of the owner's holding period, whichever is 
later. Therefore, if a building that is being rehabilitated by a lessee 
is sold subject to the lease prior to the date that the lessee has 
substantially rehabilitated the building, the lessee's adjusted basis is 
determined as of the beginning of the first day of the new lessor's 
holding period or the beginning of the first day of the 24-month period 
selected by the lessee (the taxpayer), whichever is later. If, 
therefore, the first day of the new lessor's holding period were later 
than the first day of the 24-month period selected by the lessee (the 
taxpayer), the lessee's adjusted basis for purposes of the substantial 
rehabilitation test would be the same as the adjusted basis of the new 
lessor as determined under paragraph (b)(2)(vii) of this section. If a 
building is sold after the date that a lessee has substantially 
rehabilitated the building with respect to the original lessor's 
adjusted basis, however, the lessee's basis may be determined as of the 
first day of the 24-month period selected by the lessee or the first day 
of the original lessor's holding period, whichever is later, and the 
transfer of the building will not affect the adjusted basis for purposes 
of the substantial rehabilitation test. The preceding sentence shall not 
apply, however, if the building is sold to the lessee or a related party 
within the meaning of section 267(b) or section 707(b)(1).
    (iii) Adjusted basis of the building--(A) In general. The term 
``adjusted basis of the building'' means the aggregate adjusted basis 
(within the meaning of section 1011(a)) in the building (and its 
structural components) of all the parties who have an interest in the 
building.
    (B) Special rules. In the case of a building that is leased to one 
or more tenants in whole or inpart, the adjusted basis of the building 
is determined by adding the adjusted basis of the owner (lessor) in the 
building to the adjusted basis of the lessee (or lessees) in the 
leasehold and any leasehold improvements that are structural components 
of the building. Similarly, in the case of a building that is divided 
into condominium units, the adjusted

[[Page 502]]

basis of the building means the aggregate adjusted basis of all of the 
respective condominium owners (including the basis of any lessee in the 
leasehold and leasehold improvements) in the building (and its 
structural components). If the adjusted basis of a building would be 
determined in whole or in part by reference to the adjusted basis of a 
person or persons other than the taxpayer (e.g., a rehabilitation by a 
lessee) and the taxpayer is unable to obtain the required information, 
the taxpayer must establish by clear and convincing evidence that the 
adjusted basis of such person or persons in the building on the date 
specified in paragraph (b)(2)(ii) of this section is an amount that is 
less than the amount of qualified rehabilitation expenditures incurred 
by the taxpayer. If no such amount can be so established, the adjusted 
basis of the building will be deemed to be the fair market value of the 
building on the relevant date. For purposes of determining the adjusted 
basis of a building, the portion of the adjusted basis of a building 
that is allocable to an addition (within the meaning of paragraph 
(b)(4)(ii) of this section) to the building that does not meet the age 
requirement in paragraph (b)(4)(i) of this section shall be disregarded. 
(See paragraph (b)(2)(vii) of this section for the rule applicable to 
the determination of the adjusted basis of a building when qualified 
rehabilitation expenditures are treated as incurred by the taxpayer.)
    (iv) Rehabilitation. Rehabilitation includes renovation, 
restoration, or reconstruction of a building, but does not include an 
enlargement (within the meaning of paragraph (c)(10) of this section) of 
new construction. The determination of whether expenditures are 
attributable to the rehabilitation of an existing building or to new 
construction shall be based upon all the facts and circumstances.
    (v) Special rule for phased rehabilitation. In the case of any 
rehabilitation that may reasonably be expected to be completed in phases 
set forth in written architectural plans and specifications completed 
before the physical work on the rehabilitation begins, paragraphs (b)(2) 
(i), (ii), and (vii) of this section shall be applied by substituting 
``60-month period'' for ``24-month period.'' A rehabilitation may 
reasonably be expected to be completed in phases if it consists of two 
or more distinct stages of development. The determination of whether a 
rehabilitation consists of distinct stages and therefore may reasonably 
be expected to be completed in phases shall be made on the basis of all 
the relevant facts and circumstances in existence before physical work 
on the rehabilitation begins. For purposes of this paragraph and 
paragraph (a)(2)(iii) of this section, written plans that describe 
generally all phases of the rehabilitation process shall be treated as 
written architectural plans and specifications. Such written plans are 
not required to contain detailed working drawings or detailed 
specifications of the materials to be used. In addition, the taxpayer 
may include a description of work to be done by lessees in the written 
plans. For example, where the owner of a vacant four story building 
plans to rehabilitate two floors of the building and plans to require, 
as a condition of any lease, that tenants of the other two floors must 
rehabilitate those floors, the requirements of this paragrpah (b)(2)(v) 
shall be met if the owner provides written plans for the rehabilitation 
work to be done by the owner and a description of the rehabilitation 
work that the tenants will be required to complete. The work required of 
the tenants may be described in the written plans in terms of minimum 
specifications (e.g., as to lighting, wiring, materials, appearance) 
that must be met by such tenants. See paragraph (b)(6)(i) of this 
section for the definition of physical work on a rehabilitation.
    (vi) Treatment of expenses incurred by persons who have an interest 
in the building. For purposes of the substantial rehabilitation test in 
paragraph (b)(2)(i) of this section, the taxpayer may take into account 
qualified rehabilitation expenditures incurred during the same 
rehabilitation process by any other person who has an interest in the 
building. Thus, for example, to determine whether a building has been 
substantially rehabilitated, a lessee may include the expenditures of 
the lessor and of other lessees; a condominium

[[Page 503]]

owner may include the expenditures incurred by other condominium owners; 
and an owner may include the expenditures of the lessees.
    (vii) Special rules when qualified rehabilitation expenditures are 
treated as incurred by the taxpayer. In the case where qualified 
rehabilitation expenditures are treated as having been incurred by a 
taxpayer under paragraph (c)(3)(ii) of this section, the transferee 
shall be treated as having incurred the expenditures incurred by the 
transferor on the date that the transferor incurred the expenditures 
within the meaning of paragraph (c)(3)(i) of this section. For purposes 
of the substantial rehabilitation test in paragrpah (b)(2)(i) of this 
section, the transferee's adjusted basis in the building shall be 
determined as of the beginning of the first day of a 24-month period, or 
the first day of the transferee's holding period, whichever is later, as 
provided in paragraph (b)(2)(ii) of this section. The transferee's basis 
as of the first day of the transferee's holding period for purposes of 
the substantial rehabilitation test in paragraph (b)(2)(i) of this 
section, however, shall be considered to be equal to the transferee's 
basis in the building on such date less--
    (A) The amount of any qualified rehabilitation expenditures incurred 
(or treated as having been incurred) by the transferor during the 24-
month period that are treated as having been incurred by the transferee 
under paragraph (c)(3)(ii) of this section, and
    (B) The amount of qualified rehabilitation expenditures incurred 
before the transfer and during the 24-month period by any other person 
who has an interest in the building (e.g., a lessee of the transferor). 
The preceding sentence shall not apply, however, unless the transferee's 
basis in the building is determined with reference to (1) the 
transferee's cost of the building (including the rehabilitation 
expenditures), (2) the transferor's basis in the building (where such 
basis includes the amount of the expenditures), or (3) any other amount 
that includes the cost of the rehabilitation expenditures. In the event 
that the transferee's basis is determined with reference to an amount 
not described above (e.g., transferee's basis in one building is 
determined with reference to the transferee's basis in another building 
under section 1031(d)), the amount of the expenditures incurred by the 
transferor and treated as having been incurred by the transferee are not 
deducted from the transferee's basis for purposes of the substantial 
rehabilitation test. If a transferee's basis is determined under section 
1014 or section 1022, any expenditures incurred by the decedent within 
the measuring period that are treated as having been incurred by the 
transferee under paragraph (c)(3)(ii) of this section shall decrease the 
transferee's basis for purposes of the substantial rehabilitation test.
    (viii) Statement of adjusted basis, measuring period, and qualified 
rehabilitation expenditures. In the case of any tax return filed after 
August 27, 1985, on which an investment tax credit for property, 
described in section 48(a)(1)(E) is claimed, the taxpayer shall indicate 
by way of a marginal notation on, or a supplemental statement attached 
to, Form 3468--
    (A) The beginning and ending dates for the measuring period selected 
by the taxpayer under section 48(g)(1)(C)(i) and paragraph (b)(2) of 
this section,
    (B) The adjusted basis of the building (within the meaning of 
paragraph (b)(2) (iii) or (vii) of this section) as of the beginning of 
such measuring period, and
    (C) The amount of qualified rehabilitation expenditures incurred, 
and treated as incurred, respectively, during such measuring period.

Furthermore, for returns filed after August 27, 1985, if the adjusted 
basis of the building for purposes of the substantial rehabilitation 
test is determined in whole or in part by reference to the adjusted 
basis of a person, or persons, other than the taxpayer (e.g., a 
rehabilitation by a lessee), the taxpayer must attach to the Form 3468 
filed with the tax return on which the credit is claimed a statement 
addressed to the District Director, signed by such third party, that 
states the first day of the third party's holding period and the amount 
of the adjusted basis of such third party in the building at the 
beginning of the measuring period or the first day of the holding 
period, whichever is later. If the taxpayer is

[[Page 504]]

unable to obtain the required information, that fact should be indicated 
and the taxpayer should state the manner in which the adjusted basis was 
determined and, if different, the fair market value of the building on 
the relevant date.
    (ix) Partnerships and S corporations. If a building is owned by a 
partnership (i.e., the building is partnership property) or an S 
corporation, the substantial rehabilitation test shall be determined at 
the entity level. Thus, the entity shall compare the amount of qualified 
rehabilitation expenditures incurred during the measuring period against 
its basis in the building at the beginning of its holding period or the 
beginning of its measuring period, whichever is later. (See section 
1223(2) for rules concerning the determination of a partnership's 
holding period in the case of a contribution of property to the 
partnership meeting the requirements of section 721.) The adjusted basis 
of the building to a partnership shall be determined by taking into 
account any adjustments to the basis of the building made under section 
743 and section 734. Any adjustments to the building's basis that are 
made under section 743 or section 734 after the beginning of the 
partnership's holding period, but before the end of the measuring 
period, shall be deemed for purposes of the substantial rehabilitation 
test to have been made on the first day of the partnership's holding 
period. However, in such case, the partnership's basis in the building 
shall be reduced by the amount of qualified rehabilitation expenditures 
incurred by the partnership. In the case of any tax return filed after 
January 9, 1989 on which a credit is claimed by a partner or a 
shareholder of an S corporation for rehabilitation expenditures incurred 
by a partnership or an S corporation, the partner or shareholder shall 
indicate on the Form 3468 on which the credit is claimed the name, 
address, and identification number of the partnership or S corporation 
that incurred the rehabilitation expenditures, and the partnership or S 
corporation shall, by way of a marginal notation on or a supplemental 
statement attached to the entity's return, provide the information 
required by paragraph (b)(2)(viii) of this section.
    (x) Examples. The following examples illustrate the application of 
the substantial rehabilitation test in this paragraph (b)(2):

    Example 1. Assume that A, a calendar year taxpayer, purchases a 
building for $140,000 on January 1, 1982, incurs qualified 
rehabilitation expenditures in the amount of $48,000 (at the rate of 
$4,000 per month) in 1982, $100,000 in 1983, and $20,000 (at the rate of 
$2,000 per month) in the first ten months of 1984, and places the 
rehabilitated building in service on October 31, 1984. Assume that A did 
not have written architectural plans and specifications describing a 
phased rehabilitation within the meaning of paragraph (b)(2)(v) of this 
section in existence prior to the beginning of physical work on the 
rehabilitation. For purposes of the substantial rehabilitation test in 
paragraph (b)(2) of this section, A may select any 24-consecutive-month 
measuring period that ends in 1984, the taxable year in which the 
rehabilitated building was placed in service. Assume that on A's 1984 
return, A selects a measuring period beginning on February 1, 1982, and 
ending on January 31, 1984, and specifies that A's basis in the building 
(within the meaning of section 1011(a)) was $144,000 on February 1, 1982 
($140,000 + $4,000). (The $4,000 of rehabilitation expenditures incurred 
during January 1982 are included in A's basis under section 1011 even 
though such property has not been placed in service.) The amount of 
qualified rehabilitation expenditures incurred during the measuring 
period was $146,000 ($44,000 from February 1 to December 31, 1982, plus 
$100,000 in 1983, plus $2,000 in January 1984). The building shall be 
treated as ``substantially rehabilitated'' within the meaning of this 
paragraph (b)(2) for A's 1984 taxable year because the $146,000 of 
expenditures incurred by A during the measuring period exceeded A's 
adjusted basis of $144,000 at the beginning of the period. If the other 
requirements of section 48(g)(1) and this paragraph are met, the 
building is treated as a qualified rehabilitated building, and A can 
treat as qualified rehabilitation expenditures the amount of $168,000 
(i.e., $146,000 of expenditures incurred during the measuring period, 
$4,000 of expenditures incurred prior to the beginning of the measuring 
period as part of the rehabilitation process, and $18,000 of 
expenditures incurred after the measuring period during the taxable year 
within which the measuring period ends (See paragraph (c)(6) of this 
section.)). The result would generally be the same if the property 
attributable to the rehabilitation expenditures was placed in service as 
the expenditures were incurred, but A would have $148,000 of qualified 
rehabilitation expenditures for 1983 and $20,000 of

[[Page 505]]

qualified rehabilitation expenditures for 1984. (See paragraph (f)(2) of 
this section).
    Example 2. Assume the same facts as in example 1, except that 
additional rehabilitation expenditures are incurred after the portion of 
the basis of the building attributable to qualified rehabilitation 
expenditures was placed in service on October 31, 1984. Such 
expenditures are incurred through the end of 1984 and in 1985 when the 
portion of the basis attributable to the additional expenditures is 
placed in service. The fact that the building qualified as a 
substantially rehabilitated building for A's 1984 taxable year has no 
effect on whether the building is a qualified rehabilitated building for 
property placed in service in A's 1985 taxable year. In order to 
determine whether the building is a qualified rehabilitated building for 
A's 1985 taxable year, A must select a measuring period that ends in 
1985 and compare the expenditures incurred within that period with the 
adjusted basis as of the beginning of the period. Solely for the purpose 
of determining whether the building was substantially rehabilitated for 
A's 1985 taxable year, expenditures incurred during 1983 and 1984, even 
though considered in determining whether the building was substantially 
rehabilitated in 1984, may also be used to determine whether the 
building was substantially rehabilitated for A's 1985 taxable year, 
provided the expenditures were incurred during any 24-month measuring 
period selected by A that ends in 1985.
    Example 3. (i) Assume the B purchases a building for $100,000 on 
January 1, 1982, and leases the building to C who rehabilitates the 
building. Assume that C, a calendar year taxpayer, places the property 
with respect to which rehabilitation expenditures were made in service 
in 1982 and selects December 31, 1982, as the end of the measuring 
period for purposes of the substantial rehabilitation test. The 
beginning of the measuring period is January 2, 1982, the beginning of 
B's holding period under section 1250(e), and the adjusted basis of the 
building is $100,000. Accordingly, if C incurred more than $100,000 of 
qualified rehabilitation expenditures during 1982, the building would be 
substantially rehabilitated within the meaning of paragraph (b)(2)(i) of 
this section.
    (ii) Assume the facts of example 3(i), except that after C begins 
physical work on the rehabilitation, but before C incurs $100,000 of 
expenditures, D acquires the building, subject to C's lease, from B for 
$200,000. D's holding period under section 1250(e) begins on the day 
after D acquired the building, and C's adjusted basis for purposes of 
the substantial rehabilitation test is $200,000, less the amount of 
expenditures incurred by C before the transfer. (See paragraphs (b)(2) 
(ii) and (vii) of this section.) Accordingly, if C incurred more than 
$200,000 (less the amount of expenditures incurred prior to the 
transfer) of qualified rehabilitation expenditures during 1982, the 
building would be substantially rehabilitated within the meaning of 
paragraph (b)(2) of this section. Under paragraph (b)(2)(ii)(B) of this 
section, however, C's adjusted basis for purposes of the substantial 
rehabilitation test would be $100,000 if C had substantially 
rehabilitated the building (i.e., incurred more than $100,000 in 
rehabilitation expenditures) prior to B's sale to D.
    Example 4. E owns a building with a basis of $10,000 and E incurs 
$5,000 of rehabilitation expenditures. Before completing the 
rehabilitation project, E sells the building to F for $30,000. Assume 
that F is treated under paragraph (c)(3)(ii) of this section as having 
incurred the $5,000 of rehabilitation expenditures actually incurred by 
E. Because F's basis in the building is determined under section 1011 
with reference to F's $30,000 cost of the building (which includes the 
property attributable to E's rehabilitation expenditures), F's basis for 
purposes of the substantial rehabilitation test is $25,000 ($30,000 cost 
basis less $5,000 rehabilitation expenditures treated as if incurred by 
F). (See paragraph (b)(2)(vii) of this section.) F would thus be 
required to incur more than $20,000 of rehabilitation expenditures (in 
addition to the $5,000 incurred by E and treated as having been incurred 
by F) during a measuring period selected by F to satisfy the substantial 
rehabilitation test.
    Example 5. G owns Building I with a basis of $10,000 and a fair 
market value of $20,000. H owns Building II with a basis of $5,000 and a 
fair market value of $20,000, with respect to which H has incurred 
$1,000 of rehabilitation expenditures. G and H exchange their buildings 
in a transaction that qualifies for nonrecognition treatment under 
section 1031. Assume that G is treated under paragraph (c)(3)(ii) of 
this section as having incurred $1,000 of rehabilitation expenditures. 
G's basis in Building II, computed under section 1031(d), is $10,000. 
G's basis in Building II is not determined with reference to (A) the 
cost of Building II, (B) H's basis in Building II (including the cost of 
the rehabilitation expenditures) or (C) any other amount that includes 
the cost of expenditures, but is instead determined with reference to 
G's basis in other property (Building I). Therefore, G's basis in 
Building II for purposes of the substantial rehabilitation test is not 
reduced by the $1,000 of rehabilitation expenditures treated as if 
incurred by G. (See paragraph (b)(2)(vii) of this section.) Accordingly, 
G's basis in Building II for purposes of the substantial rehabilitation 
test is $10,000, and G must incur additional rehabilitation expenditures 
in excess of $9,000 within a measuring period selected by G to satisfy 
the test.

    (3) Retention of existing external walls and internal structural 
framework--(i) In general--(A) Property placed in service

[[Page 506]]

after December 31, 1986. Except in the case of property that qualifies 
for the transition rules in paragraphs (a)(2)(iv) (B) and (C) of this 
section, in the case of property that is placed in service after 
December 31, 1986, a building (other than a certified historic 
structure) meets the requirement in paragraph (b)(1)(iii) of this 
section only if in the rehabilitation process--
    (1) 50 percent or more of the existing external walls of such 
building are retained in place as external walls;
    (2) 75 percent or more of the existing external walls of such 
building are retained in place as internal or external walls; and
    (3) 75 percent or more of the internal structural framework of such 
building (as defined in paragraph (b)(3)(iii) of this section) is 
retained in place.
    (B) Expenditures incurred before January 1, 1984, for property 
placed in service before January 1, 1987. With respect to rehabilitation 
expenditures incurred before January 1, 1984, for property that is 
either placed in service before January 1, 1987, or that qualifies for 
the transition rules in paragraph (a)(2)(iv) (B) or (C) of this section, 
a building meets the requirement in paragraph (b)(1)(iii) of this 
section only if 75 percent or more of the existing external walls of the 
building are retained in place as external walls in the rehabilitation 
process. If an addition to a building is not treated as part of a 
qualified rehabilitated building because it does not meet the 30-year 
requirement in paragraph (b)(4)(i)(B) of this section, then the external 
walls of such addition shall not be considered to be existing external 
walls of the building for purposes of section 48(g)(1)(A)(iii) (as in 
effect prior to enactment of the Tax Reform Act of 1986), and this 
section.
    (C) Expenditures incurred after December 31, 1983, for property 
placed in service before January 1, 1987. With respect to expenditures 
incurred after December 31, 1983, for property that is either placed in 
service before January 1, 1987, or that qualifies for the transition 
rules in paragraph (a)(2)(iv) (B) or (C) of this section, the 
requirement of paragraph (b)(1)(iii) of this section is satisfied only 
if in the rehabilitation process either the existing external wall 
retention requirement in paragraph (b)(3)(i) (B) of this section is 
satisfied, or:
    (1) 50 percent or more of the existing external walls of the 
building are retained in place as external walls,
    (2) 75 percent or more of the existing external walls are retained 
in place as internal or external walls, and
    (3) 75 percent or more of the existing internal structural framework 
of such building is retained in place.
    (D) Area of external walls and internal structural framework. The 
determinations required by paragraphs (b)(3)(i) (A), (B), and (C) of 
this section shall be based upon the area of the external walls or 
internal structural framework that is retained in place compared to the 
total area of each prior to the rehabilitation. The area of the existing 
external walls and internal structural framework of a building shall be 
determined prior to any destruction, modification, or construction of 
external walls or internal structural framework that is undertaken by 
any party in anticipation of the rehabilitation.
    (ii) Definition of external wall. For purposes of this paragraph 
(b), a wall includes both the supporting elements of the wall and the 
nonsupporting elements, (e.g., a curtain, windows or doors) of the wall. 
Except as otherwise provided in this paragraph (b)(3), the term 
``external wall'' includes any wall that has one face exposed to the 
weather, earth, or an abutting wall of an adjacent building. The term 
``external wall'' also includes a shared wall (i.e., a single wall 
shared with an adjacent building), generally referred to as a ``party 
wall,'' provided that the shared wall has no windows or doors in any 
portion of the wall that does not have one face exposed to the weather, 
earth, or an abutting wall. In general, the term ``external wall'' 
includes only those external walls that form part of the outline or 
perimeter of the building or that surround an uncovered courtyard. 
Therefore, the walls of an uncovered internal shaft, designed solely to 
bring light or air into the center of a building, which are completely 
surrounded by external walls of the building and which enclose space not 
designated for occupancy or other use by people (other than for 
maintenance or

[[Page 507]]

emergency), are not considered external walls. Thus, for example, a wall 
of a light well in the center of a building is not an external wall. 
However, walls surrounding an outdoor space which is usable by people, 
such as a courtyard, are external walls.
    (iii) Definition of internal structural framework. For purposes of 
this section, the term ``internal structural framework'' includes all 
load-bearing internal walls and any other internal structural supports, 
including the columns, girders, beams, trusses, spandrels, and all other 
members that are essential to the stability of the building.
    (iv) Retained in place. An existing external wall is retained in 
place if the supporting elements of the wall are retained in place. An 
existing external wall is not retained in place if the supporting 
elements of the wall are replaced by new supporting elements. An 
external wall is retained in place, however, if the supporting elements 
are reinforced in the rehabilitation, provided that such supporting 
elements of the external wall are retained in place. An external wall 
also is retained in place if it is covered (e.g., with new siding). 
Moreover, an external wall is retained in place if the existing curtain 
is replaced with a new curtain, provided that the structural framework 
that provides for the support of the existing curtain is retained in 
place. An external wall is retained in place notwithstanding that the 
existing doors and windows in the wall are modified, eliminated, or 
replaced. An external wall is retained in place if the wall is 
disassembled and reassembled, provided the same supporting elements are 
used when the wall is reassembled and the configuration of the external 
walls of the building after the rehabilitation is the same as it was 
before the rehabilitation process commenced. Thus, for example, a brick 
wall is considered retained in place even though the original bricks are 
removed (for cleaning, etc.) and replaced to form the wall. The 
principles of this paragraph (b)(3)(iv) shall also apply to determine 
whether internal structural framework of the building is retained in 
place.
    (v) Effect of additions. If an existing external wall is converted 
into an internal wall (i.e., a wall that is not an external wall), the 
wall is not retained in place as an external wall for purposes of this 
section.
    (vi) Examples. The provisions of this paragraph (b)(3) may be 
illustrated by the following examples:

    Example 1. Taxpayer A rehabilitated a building all of the walls of 
which consisted of wood siding attached to gypsum board sheets (which 
covered the supporting elements of the wall, i.e., studs). A covered the 
existing wood siding with aluminum siding as part of a rehabilitation 
that otherwise qualified under this subparagraph. The addition of the 
aluminum siding does not affect the status of the existing external 
walls as external walls and they would be considered to have been 
retained in place.
    Example 2. Taxpayer B rehabilitated a building, the external walls 
of which had a masonry curtain. The masonry on the wall face was 
replaced with a glass curtain. The steel beam and girders supporting the 
existing masonry curtain were retained in place. The walls of the 
building are considered to be retained in place as external walls, 
notwithstanding the replacement of the curtain.
    Example 3. Taxpayer C rehabilitated a building that has two external 
walls measuring 75[foot] x 20[foot] and two other external walls 
measuring 100[foot] x 20[foot]. C demolished one of the larger walls, 
including its supporting elements and constructed a new wall. Because 
one of the larger walls represents more than 25 percent of the area of 
the building's external walls, C has not satisfied the requirements that 
75 percent of the existing external walls must be retained in place as 
either internal or external walls. If however, C had not demolished the 
wall, but had converted it into an internal wall (e.g., by building a 
new external wall), the building would satisfy the external wall 
requirements.
    Example 4. The facts are the same as in example 3, except that C 
does not tear down any walls, but builds an addition that results in one 
of the smaller walls becoming an internal wall. In addition, C enlarged 
8 of the existing windows on one of the larger walls, increasing them 
from a size of 3[foot] x 4[foot] to 6[foot] x 8[foot]. Since the smaller 
wall accounts for less than 25 percent of the total wall area, C has 
satisfied the requirement that 75 percent of the existing external walls 
must be retained in place as external walls in the rehabilitation 
process. The enlargement of the existing windows on the larger wall does 
not affect its status as an external wall.
    Example 5. Taxpayer D rehabilitated a building that was in the 
center of a row of three buildings. The building being rehabilitated by 
D shares its side walls with the buildings on either side. The shared 
walls measure 100[foot] x 20[foot] and the rear and front

[[Page 508]]

walls measure 75[foot] x 20[foot]. As part of a rehabilitation, D tears 
down and replaces the front wall. Because the shared walls as well as 
the front and back walls are considered external walls and the front 
wall accounts for less than 25 percent of the total external wall area 
(including the shared walls), D has satisfied the requirement that 75 
percent of the existing external walls must be retained in place as 
external walls in the rehabilitation process.

    (4) Age requirement--(i) In general--(A) Property placed in service 
after December 31, 1986. Except in the case of property that qualifies 
for the transition rules in paragraph (a)(2)(iv) (B) or (C) of this 
section, a building other than a certified historic structure shall not 
be considered a qualified rehabilitated building unless the building was 
first placed in service (within the meaning of Sec.  1.46-3(d)) before 
January 1, 1936.
    (B) Property placed in service before January 1, 1987, and property 
qualifying under a transition rule. In the case of property placed in 
service before January 1, 1987, and property that qualifies under the 
transition rules in paragraph (a)(2)(iv) (B) or (C) of this section, a 
building other than a certified historic structure is considered a 
qualified rehabilitated building only if a period of at least 30 years 
has elasped between the date physical work on the rehabilitation of the 
building began and the date the building was first placed in service 
(within the meaning of Sec.  1.46-3(d)) as a building by any person.
    (ii) Additions. A building that was first placed in service before 
1936 in the case described in paragraph (b)(4)(i)(A) of this section, or 
at least 30 years before physical work on the rehabilitation began in 
the case described in paragraph (b)(4)(i)(B) of this section, will not 
be disqualified because additions to such building have been added since 
1936 in the case described in paragraph (b)(4)(i)(A) of this section, or 
are less than 30 years old in the case described in paragraph 
(b)(4)(i)(B) of this section. Such additions, however, shall not be 
treated as part of the qualified rehabilitated building. The term 
``addition'' means any construction that resulted in any portion of an 
external wall becoming an internal wall, that resulted in an increase in 
the height of the building, or that increased the volume of the 
building.
    (iii) Vacant periods. The determinations required by paragraph 
(b)(4)(i) of this section include periods during which a building was 
vacant or devoted to a personal use and is computed without regard to 
the number of owners or the identify of owners during the period.
    (5) Location at which the rehabilitation occurs. A building, other 
than a certified historic structure is not a qualified rehabilitated 
building unless it has been located where it is rehabilitated since 
before 1936 in the case described in paragraph (b)(4)(i)(A) of this 
section. Similarly, in the case described in paragraph (b)(4)(i)(B) of 
this section, a building, other than a certified historic structure, is 
not a qualified rehabilitation building unless it has been located where 
it is rehabilitated for the thirty-year period immediately preceding the 
date physical work on the rehabilitation began in the case of a ``30-
year building'' or the forty-year period immediately preceding the date 
physical work on the rehabilitation began in the case of a ``40-year 
building.'' (See Sec.  1.46-1(q)(1)(iii) for the definitions of ``30-
year building'' and ``40-year building.'')
    (6) Definition and special rule--(i) Physical work on a 
rehabilitation. For purposes of this section, ``physical work on a 
rehabilitation'' begins when actual construction, or destruction in 
preparation for construction, begins. The term ``physical work on a 
rehabilitation,'' however, does not include preliminary activities such 
as planning, designing, securing financing, exploring, researching, 
developing plans and specifications, or stabilizing a building to 
prevent deterioration (e.g., placing boards over broken windows).
    (ii) Special rule for adjoining buildings that are combined. For 
purposes of this paragraph (b), if as part of a rehabilitation process 
two or more adjoining buildings are combined and placed in service as a 
single building after the rehabilitation process, then, at the election 
of the taxpayer, all of the requirements for a qualified rehabilitated 
building in section 48(g)(1) and this section may be applied to the 
constituent adjoining buildings in the aggregate. For example, if such 
requirements are applied in the aggregate, any shared

[[Page 509]]

walls or abutting walls between the constituent buildings that would 
otherwise be treated as external walls (within the meaning of paragraph 
(b)(3) of this section) would not be treated as external walls of the 
building, and the substantial rehabilitation test in paragraph (b)(2) of 
this section would be applied to the aggregate expenditures with respect 
to all of the constituent buildings and to the aggregate adjusted basis 
of all of the constituent buildings. A taxpayer shall elect the special 
rule of this paragraph (b)(6)(ii) for adjoining buildings by indicating 
by way of a marginal notation on, or a supplemental statement attached 
to, the Form 3468 on which a credit is first claimed for qualified 
rehabilitation expenditures with respect to such buildings that such 
buildings are a single qualified rehabilitated building because of the 
application of the special rule in this paragraph (b)(6)(ii).
    (c) Definition of qualified rehabilitation expenditures--(1) In 
general. Except as otherwise provided in paragraph (c)(7) of this 
section, the term ``qualified rehabilitation expenditure'' means any 
amount that is--
    (i) Properly chargeable to capital account (as described in 
paragraph (c)(2) of this section),
    (ii) Incurred by the taxpayer after December 31, 1981 (as described 
in paragraph (c)(3) of this section),
    (iii) For property for which depreciation is allowable under section 
168 and which is real property described in paragraph (c)(4) of this 
section, and
    (iv) Made in connection with the rehabilitation of a qualified 
rehabilitated building (as described in paragraph (c)(5) of this 
section).
    (2) Chargeable to capital account. For purposes of paragraph (c)(1) 
of this section, amounts are chargeable to capital account if they are 
properly includible in computing basis of real property under Sec.  
1.46-3(c). Amounts treated as an expense and deducted in the year they 
are paid or incurred or amounts that are otherwise not added to the 
basis of real property described in paragraph (c)(4) of this section do 
not qualify. For purposes of this paragraph (c), amounts incurred for 
architectural and engineering fees, site survey fees, legal expenses, 
insurance premiums, development fees, and other construction related 
costs, satisfy the requirement of this paragraph (c)(2) if they are 
added to the basis of real property that is described in paragraph 
(c)(4) of this section. Construction period interest and taxes that are 
amortized under section 189 (as in effect prior to its repeal by the Tax 
Reform Act of 1986) do not satisfy the requirement of this paragraph 
(c)(2). If, however, such interest and taxes are treated by the taxpayer 
as chargeable to capital account with respect to property described in 
paragraph (c)(4) of this section, they shall be treated in the same 
manner as other costs described in this paragraph (c)(2). Any 
construction period interest or taxes or other fees or costs incurred in 
connection with the acquisition of a building, any interest in a 
building, or land, are subject to paragraph (c)(7)(ii) of this section. 
See paragraph (c)(9) of this section for additional rules concerning 
interest.
    (3) Incurred by the taxpayer--(i) In general. Qualified 
rehabilitation expenditures are incurred by the taxpayer for purposes of 
this section on the date such expenditures would be considered incurred 
under an accrual method of accounting, regardless of the method of 
accounting used by the taxpayer with respect to other items of income 
and expense. If qualified rehabilitation expenditures are treated as 
having been incurred by a taxpayer under paragraph (c)(3)(ii) of this 
section, the taxpayer shall be treated as having incurred the 
expenditures on the date such expenditures were incurred by the 
transferor.
    (ii) Qualified rehabilitation expenditures treated as incurred by 
the taxpayer--(A) Where rehabilitation expenditures are incurred with 
respect to a building by a person (or persons) other than the taxpayer 
and the taxpayer subsequently acquires the building, or a portion of the 
building to which some or all of the expenditures are allocable (e.g., a 
condominium unit to which rehabilitation expenditures have been 
allocated), the taxpayer acquiring such property shall be treated as 
having incurred the rehabilitation expenditures actually incurred by the 
transferor (or treated as incurred by the transferor under this 
paragraph

[[Page 510]]

(c)(3)(ii)) allocable to the acquired property, provided that--
    (1) The building, or the portion of the building, acquired by the 
taxpayer was not used (or, if later, was not placed in service (as 
defined in paragraph (f)(2) of this section)) after the rehabilitation 
expenditures were incurred and prior to the date of acquisition, and
    (2) No credit with respect to such qualified rehabilitation 
expenditures is claimed by anyone other than the taxpayer acquiring the 
property. For purposes of this paragraph (c)(3)(ii), use shall mean 
actual use, whether personal or business. In the case of a building that 
is divided into condominium units, expenditures attributable to the 
common elements shall be allocable to the individual condominium units 
in accordance with the principles of paragraph (c)(10)(ii) of this 
section. Furthermore, for purpose of this paragraph (c)(3)(ii), a 
condominium unit's share of the common elements shall not be considered 
to have been used (or placed in service) prior to the time that the 
particular condominium unit is used.
    (B) The amount of rehabilitation expenditures described in paragraph 
(c)(3)(ii)(A) of this section treated as incurred by the taxpayer under 
this paragraph shall be the lesser of--
    (1) The amount of rehabilitation expenditures incurred before the 
date on which the taxpayer acquired the building (or portion thereof) to 
which the rehabilitation expenditures are attributable, or
    (2) The portion of the taxpayer's cost or other basis for the 
property that is properly allocable to the property resulting from the 
rehabilitation expenditures described in paragraph (c)(3)(ii)(B)(1) of 
this section.
    (C) For purposes of this paragraph (c)(3)(ii), the amount of 
rehabilitation expenditures treated as incurred by the taxpayer under 
this paragraph (c) shall not be treated as costs for the acquisition of 
a building. The portion of the cost of acquiring a building (or an 
interest therein) that is not treated under this paragraph as qualified 
rehabilitation expenditures incurred by the taxpayer is not treated as 
section 38 property in the hands of the acquiring taxpayer. (See 
paragraph (c)(7)(ii) of this section.) (See paragraph (b)(2)(vii) for 
rules concerning the application of the substantial rehabilitation test 
when expenditures are treated as incurred by the taxpayer.)
    (iii) Examples. The provisions of this paragraph (c) may be 
illustrated by the following examples:

    Example 1. In 1981, A, a taxpayer using the cash receipts and 
disbursements method of accounting, commenced the rehabilitation of a 
30-year old building. In June 1981, A signed a contract with a plumbing 
contractor for replacement of the plumbing in the building. A agreed to 
pay the contractor as soon as the work was completed. The work was 
completed in December 1981, but A did not pay the amount due until 
January 15, 1982. The expenditures for the plumbing are not qualified 
rehabilitation expenditures (within the meaning of this paragraph (c)) 
because they were not incurred under an accrual method of accounting 
after December 31, 1981.
    Example 2. B incurred qualified rehabilitation expenditures of 
$300,000 with respect to an existing building between January 1, 1982, 
and May 15, 1982, and then sold the building to C on June 1, 1982. The 
portion of the building to which the expenditures were allocable was not 
used by B or any other person during the period from January 1, 1982, to 
June 1, 1982, and neither B nor any other person claimed the credit. 
Consequently, C will be treated as having incurred the expenditures on 
the dates that B incurred the expenditures.
    Example 3. D, a taxpayer using the cash receipts and disbursements 
method of accounting, begins the rehabilitation of a building on January 
11, 1982. Prior to May 1, 1982, D makes rehabilitation expenditures of 
$16,000. On May 3, 1982, D sells the building, the land, and the 
property attributable to the rehabilitation expenditures to E for 
$35,000. The purchase price is properly allocable as follows:

Land...........................................................   $5,000
Existing building..............................................   11,000
Property attributable to rehabilitation expenditures...........   19,000
                                                                --------
      Total purchase price.....................................   35,000
 

    The property attributable to the rehabilitation expenditures is 
placed in service by E on September 5, 1982. E may treat a portion of 
the $35,000 purchase price as rehabilitation expenditures paid or 
incurred by him. Since the rehabilitation expenditures paid by D 
($16,000) are less than the portion of the purchase price properly 
allocable to property attributable to these expenditures ($19,000), E 
may treat only $16,000 as rehabilitation expenditures paid or incurred 
by him. The excess of the purchase price allocable to rehabilitation 
expenditures ($19,000) over the rehabilitation expenditures paid by D 
($16,000),

[[Page 511]]

or $3,000, is treated as the cost of acquiring an interest in the 
building and is not a qualified rehabilitation expenditure treated as 
incurred by E.
    Example 4. The facts are the same as in example 3, except that the 
purchase price properly allocable to the property attributable to 
rehabilitation expenditures is $15,000. Under these circumstances, E may 
treat only $15,000 of D's $16,000 expenditures as rehabilitation 
expenditures paid by D. The excess of the rehabilitation expenditures 
paid by D ($16,000) over the purchase price allocable to rehabilitation 
expenditures ($15,000), or $1,000, is treated as the cost of acquiring 
an interest in the building and is not a qualified rehabilitation 
expenditure treated as incurred by E.

    (4) Incurred for depreciable real property--(i) Property placed in 
service after December 31, 1986. Except as otherwise provided in 
paragraph (c)(4)(ii) of this section (relating to certain property that 
qualifies under a transition rule), in the case of property placed in 
service after December 31, 1986, an expenditure is incurred for 
depreciable real property for purposes of paragraph (c)(1)(iii) of this 
section, only if it is added to the depreciable basis of depreciable 
property which is--
    (A) Nonresidential real property,
    (B) Residential rental property,
    (C) Real property which has a class life of more than 12.5 years, or
    (D) An addition or improvement to property described in paragraph 
(c)(4)(i) (A), (B), or (C) of this section.

For purposes of this paragraph (c)(4)(i), the terms ``nonresidential 
real property'', ``residential rental property'', and ``class life'' 
have the respective meanings given to such terms by section 168 and the 
regulations thereunder.
    (ii) Property placed in service before January 1, 1987, and property 
that qualifies under a transition rule. In the case of property placed 
in service before January 1, 1987, and property placed in service after 
December 31, 1986, that qualifies for the transition rules in paragraph 
(a)(2)(iv) (B) or (C) of this section, an expenditure attributable to 
such property shall be a qualified rehabilitation expenditure only if 
such expenditure is incurred for property that is real property (or 
additions or improvements to real property) with a recovery period 
(within the meaning of section 168 as in effect prior to its amendment 
by the Tax Reform Act of 1986) of 19 years (15 years for low-income 
housing) and if the other requirements of this paragraph (c) are met. 
For purposes of this section, an expenditure is incurred for recovery 
property having a recovery period of 19 years only if the amount of the 
expenditure is added to the basis of property which is 19-year real 
property or 15-year real property in the case of low-income housing. For 
purposes of this section, the term ``low-income housing'' has the 
meaning given such term by section 168(c)(2)(F) (as in effect prior to 
the amendments made by the Tax Reform Act of 1986).
    (5) Made in connection with the rehabilitation of a qualified 
rehabilitated building. In order for an expenditure to be a qualified 
rehabilitation expenditure, such expenditure must be incurred in 
connection with a rehabilitation (as defined in paragraph (b)(2)(iv) of 
this section) of a qualified rehabilitated building. Expenditures 
attributable to work done to facilities related to a building (e.g., 
sidewalk, parking lot, landscaping) are not considered made in 
connection with the rehabilitation of a qualified rehabilitated 
building.
    (6) When expenditures may be incurred. An expenditure is a qualified 
rehabilitation expenditure only if the building with respect to which 
the expenditures are incurred is substantially rehabilitated (within the 
meaning of paragraph (b)(2) of this section) for the taxable year in 
which the property attributable to the expenditures is placed in service 
(i.e., the building is substantially rehabilitated during a measuring 
period ending with or within the taxable year in which a credit is 
claimed). (See paragraph (f)(2) of this section for rules relating to 
when property is placed in service.) Once the substantial rehabilitation 
test is met for a taxable year, the amount of qualified rehabilitation 
expenditures upon which a credit can be claimed for the taxable year is 
limited to expenditures incurred:
    (i) Before the beginning of a measuring period during which the 
building was substantially rehabilitated that ends with or within the 
taxable year,

[[Page 512]]

provided that the expenditures were incurred in connection with the 
rehabilitation process that resulted in the substantial rehabilitation 
of the building;
    (ii) Within a measuring period during which the building was 
substantially rehabilitated that ends with or within the taxable year, 
and
    (iii) After the end of a measuring period during which the building 
was substantially rehabilitated but prior to the end of the taxable year 
with or within which the measuring period ends.
    (7) Certain expenditures excluded from qualified rehabilitation 
expenditures. The term ``qualified rehabilitation expenditures'' does 
not include the following expenditures:
    (i) Except as otherwise provided in paragraph (c)(8) of this 
section, any expenditure with respect to which the taxpayer does not use 
the straight line method over a recovery period determined under section 
168 (c) and (g).
    (ii) The cost of acquiring a building, any interest in a building 
(including a leasehold interest), or land, except as provided in 
paragraph (c)(3)(ii) of this section.
    (iii) Any expenditure attributable to an enlargement of a building 
(within the meaning of paragraph (c)(10) of this section).
    (iv) Any expenditure attributable to the rehabilitation of a 
certified historic structure or a building located in a registered 
historic district, unless the rehabilitation is a certified 
rehabilitation. (See paragraph (d) of this section which contains 
definitions and special rules applicable to rehabilitations of certified 
historic structures and buildings located in registered historic 
districts.)
    (v) Any expenditure of a lessee of a building or a portion of a 
building, if, on the date the rehabilitation is completed with respect 
to property placed in service by such lessee, the remaining term of the 
lease (determined without regard to any renewal period) is less than the 
recovery period determined under section 168(c) (or 19 years in the case 
of property placed in service before January 1, 1987, and property 
placed in service that qualifies under the transition rules in paragraph 
(a)(2)(iv)(B) or (C) of this section).
    (vi) Any expenditure allocable to that portion of a building which 
is (or may reasonably be expected to be) tax-exempt use property (within 
the meaning of section 168 and the regulations thereunder), except that 
the exclusion in this paragraph (c)(7)(vi) shall not apply for purposes 
of determining whether the building is a substantially rehabilitated 
building under paragraph (b)(2) of this section.
    (8) Requirement to use straight line depreciation--(i) Property 
placed in service after December 31, 1986. The requirement in section 
48(g)(2)(B)(i) and paragraph (c)(7)(i) of this section to use straight 
line cost recovery does not apply to any expenditure to the extent that 
the alternative depreciation system of section 168(g) applies to such 
expenditure by reason of section 168(g)(1) (B) or (C). In addition, the 
requirement in section 48(g)(2)(B)(i) and paragraph (c)(7)(i) of this 
section applies only to the depreciation of the portion of the basis of 
a qualified rehabilitated building that is attributable to qualified 
rehabilitation expenditures. However, see Sec.  1.168(k)-1(f)(10) if the 
qualified rehabilitation expenditures are qualified property or 50-
percent bonus depreciation property under section 168(k) and see Sec.  
1.1400L(b)-1(f)(9) if the qualified rehabilitation expenditures are 
qualified New York Liberty Zone property under section 1400L(b). 
Further, see Sec.  1.168(k)-2(g)(9) if the qualified rehabilitation 
expenditures are qualified property under section 168(k), as amended by 
the Tax Cuts and Jobs Act, Public Law 115-97 (131 Stat. 2054 (December 
22, 2017)).
    (ii) Property placed in service before January 1, 1987, and property 
placed in service after December 31, 1986, that qualifies for a 
transition rule. In the case of expenditures attributable to property 
placed in service before January 1, 1987, and property that qualifies 
for the transition rules in paragraph (a)(2)(iv) (B) or (C) of this 
section, the term ``qualified rehabilitation expenditure'' does not 
include an expenditure with respect to which an election was not made 
under section 168(b)(3) as in effect prior to its amendment by the Tax 
Reform Act of 1986, to use the straight line method of depreciation. In 
such case, the requirement that an election

[[Page 513]]

be made to use straight line cost recovery applies only to the cost 
recovery of the portion of the basis of a qualified rehabilitated 
building that is attributable to qualified rehabilitation expenditures. 
See section 168(f)(1), as in effect prior to its amendment by the Tax 
Reform Act of 1986, for rules relating to the use of different methods 
of cost recovery for different components of a building. In addition, 
such requirement shall not apply to any expenditure to the extent that 
section 168(f)(12) or (j), as in effect prior to the amendments made by 
the Tax Reform Act of 1986, applied to such expenditure.
    (9) Cost of acquisition. For purposes of paragraph (c)(7)(ii) of 
this section, cost of acquisition includes any interest incurred on 
indebtedness the proceeds of which are attributable to the acquisition 
of a building, an interest in a building, or land open which a building 
exists. Interest incurred on a construction loan the proceeds of which 
are used for qualified rehabilitation expenditures, however, is not 
treated as a cost of acquisition.
    (10) Enlargement defined--(i) In general. A building is enlarged to 
the extent that the total volume of the building is increased. An 
increase in floor space resulting from interior remodeling is not 
considered an enlargement. The total volume of a building is generally 
equal to the product of the floor area of the base of the building and 
the height from the underside of the lowest floor (including the 
basement) to the average height of the finished roof (as it exists or 
existed). For this purpose, floor area is measured from the exterior 
faces of external walls (other than shared walls that are external 
walls) and from the centerline of shared walls that are external walls.
    (ii) Rehabilitation that includes enlargement. If expenditures for 
property only partially qualify as qualified rehabilitation expenditures 
because some of the expenditures are attributable to the enlargement of 
the building, the expenditures must be apportioned between the original 
portion of the building and the enlargement. The expenditures must be 
specifically allocated between the original portion of the building and 
the enlargement to the extent possible. If it is not possible to make a 
specific allocation of the expenditures, the expenditures must be 
allocated to each portion on some reasonable basis. The determination of 
a reasonable basis for an allocation depends on factors such as the type 
of improvement and how the improvement relates functionally to the 
building. For example, in the case of expenditures for an air-
conditioning system or a roof, a reasonable basis for allocating the 
expenditures among the two portions generally would be the volume of the 
building, excluding the enlargement, served by the air-conditioning 
system or the roof relative to the volume of the enlargement served by 
the improvement.
    (d) Rules applicable to rehabilitations of certified historic 
structures--(1) Definition of certified historic structure. The term 
``certified historic structure'' means any building (and its structural 
components) that is--
    (i) Listed in the National Register of Historic Places (``National 
Register''); or
    (ii) Located in a registered historic district and certified by the 
Secretary of the Interior to the Internal Revenue Service as being of 
historic significance to the district.

For purposes of this section, a building shall be considered to be a 
certified historic structure at the time it is placed in service if the 
taxpayer reasonably believes on that date the building will be 
determined to be a certified historic structure and has requested on or 
before that date a determination from the Department of Interior that 
such building is a certified historic structure within the meaning of 
this paragraph (d)(1)(i) or (ii) and the Department of Interior later 
determines that the building is a certified historic structure.
    (2) Definition of registered historic district. The term 
``registered historic district'' means any district that is--
    (i) Listed in the National Register, or
    (ii) (A) Designated under a statute of the appropriate State or 
local government that has been certified by the Secretary of the 
Interior to the Internal Revenue Service as containing criteria that 
will substantially achieve

[[Page 514]]

the purpose of preserving and rehabilitating buildings of historic 
significance to the district, and (B) certified by the Secretary of the 
Interior as meeting substantially all of the requirements for the 
listing of districts in the National Register.
    (3) Definition of certified rehabilitation. The term ``certified 
rehabilitation'' means any rehabilitation of a certified historic 
structure that the Secretary of the Interior has certified to the 
Internal Revenue Service as being consistent with the historic character 
of the building and, where applicable, the district in which such 
building is located. The determination of the scope of a rehabilitation 
shall be made on the basis of all the facts and circumstances 
surrounding the rehabilitation and shall not be made solely on the basis 
of ownership. The Secretary of the Interior shall take all of the 
rehabilitation work performed as part of a single rehabilitation, 
including any post-certification work, into account in determining 
whether the rehabilitation complies with the Department of Interior 
standards for rehabilitation and whether the certification should be 
granted, revoked, or otherwise invalidated.
    (4) Revoked or invalidated certification. If the Department of 
Interior revokes or otherwise invalidates a certification after it has 
been issued to a taxpayer, the basis attributable to rehabilitation of 
the decertified property shall cease to be section 38 property described 
in section 48(a)(1)(E). Such cessation shall be effective as of the date 
the activity giving rise to the revocation or invalidation commenced. 
See section 47 for the rules applicable to property that ceases to be 
section 38 property.
    (5) Special rule for certain buildings located in registered 
historic districts. The exclusion in paragraph (c)(7)(iv) of this 
section does not apply to a building in a registered historic district 
if--
    (i) Such building was not a certified historic structure during the 
rehabilitation process; and
    (ii) The Secretary of the Interior certified to the Internal Revenue 
Service that such building was not of historic significance to the 
district.

In general, the certification referred to in paragraph (d)(5)(ii) of 
this section must be requested by the taxpayer prior to the time that 
physical work on the rehabilitation began. If, however, the 
certification referred to in paragraph (d)(5)(ii) of this section is 
requested by the taxpayer after physical work on the rehabilitation of 
the building has begun, the taxpayer must certify to the Internal 
Revenue Service that, prior to the date that physical work on the 
rehabilitation began, the taxpayer in good faith was not aware of the 
requirement of paragraph (d)(5)(ii) of this section. The certification 
referred to in the previous sentence must be attached to the Form 3468 
filed with the tax return for the year in which the credit is claimed.
    (6) Special rule for certain rehabilitations begun before an area is 
designated as a registered historic district. In general, the exclusion 
from the definition of qualified rehabilitation expenditure in paragraph 
(c)(7)(iv) of this section applies to any rehabilitation expenditures 
that are incurred after a building becomes a certified historic 
structure within the meaning of section 48 (g)(3)A) and paragraph (d)(1) 
of this section or the area in which a building is located becomes a 
registered historic district within the meaning of section 48 (g)(3)(B) 
and paragraph (d)(2) of this section. Rehabilitation expenditures 
incurred prior to such date, however, are not disqualified. In addition, 
rehabilitation expenditures made after the date the area in which a 
building is located becomes a registered historic district shall not be 
disqualified under paragraph (c)(7)(iv) of this section in any case in 
which physical work on the rehabilitation of a building begins prior to 
the date the taxpayer knows or has reason to know of an intention to 
nominate the area in which such building is located as a registered 
historic district. For purposes of this paragraph (d)(6), the taxpayer 
knows or has reason to know of such an intention if there is (A) a 
communication (written or oral) to the owner of any building within the 
district from the Department of the Interior, or any agency or 
instrumentality of the appropriate state or local government (or a 
designee of such agency or instrumentality) that the district in which 
the building is located is being considered

[[Page 515]]

for designation as a registered historic district, (B) a legal notice of 
such consideration published in a newspaper, or (C) a public meeting 
held to discuss such consideration. In order to take advantage of the 
special rule of this paragraph (d)(6), the taxpayer must attach to the 
Form 3468 filed for the taxable year in which the credit is claimed a 
statement that the taxpayer in good faith did not know, or have reason 
to know, of an intention to nominate the area in which the building is 
located as a registered historic district.
    (7) Notice of certification--(i) In general. Except as otherwise 
provided in paragraph (d)(7)(ii) of this section, a taxpayer claiming 
the credit for rehabilitation of a certified historic structure (within 
the meaning of section 48(g)(3) and paragraph (d)(1) of this section) 
must attach to the Form 3468 filed with the tax return for the taxable 
year in which the credit is claimed a copy of the final certification of 
completed work by the Secretary of the Interior, and for returns filed 
after January 9, 1989, evidence that the building is a certified 
historic structure.
    (ii) Late certification. If the final certification of completed 
work has not been issued by the Secretary of the Interior at the time 
the tax return is filed for a year in which the credit is claimed, a 
copy of the first page of the Historic Preservation Certification 
Application--Part 2--Description of Rehabilitation (NPS Form 10-168a), 
with an indication that it has been received by the Department of the 
Interior or its designate, together with proof that the building is a 
certified historic structure (or that such status has been requested), 
must be attached to the Form 3468 filed with the return. A notice from 
the Department of the Interior or the State Historic Preservation 
Officer, stating that the nomination or application has been received, 
or a date-stamped nomination or application shall be sufficient 
indication that the nomination or application has been received. The 
building need not be either listed in the National Register or be 
determined to be of historic significance to a registered historic 
district at the time the return is filed for the year in which the 
credit is claimed. (See paragraph (d)(1) of this section.) The taxpayer 
must submit a copy of the final certification as an attachment to Form 
3468 with the first income tax return filed after the receipt by the 
taxpayer of the certification. If the final certification is denied by 
the Department of Interior, the credit will be disallowed for any 
taxable year in which it was claimed. If the taxpayer fails to receive 
final certification of completed work prior to the date that is 30 
months after the date that the taxpayer filed the tax return on which 
the credit was claimed, the taxpayer must submit a written statement to 
the District Director stating such fact prior to the last day of the 
30th month, and the taxpayer shall be requested to consent to an 
agreement under section 6501(c)(4) extending the period of assessment 
for any tax relating to the time for which the credit was claimed. The 
procedure permitted by the preceding sentence shall be used whenever the 
entire rehabilitation project is not fully completed by the date that is 
30 months after the taxpayer filed the tax return upon which the credit 
was claimed (e.g., a phased rehabilitation) and the Secretary of the 
Interior has thus not yet certified the rehabilitation.
    (iii) Effective dates. Paragraph (d)(7)(i) of this section applies 
to returns for taxable years beginning before January 1, 2002. The 
requirement in the fourth sentence of paragraph (d)(7)(ii) of this 
section applies only if the first income tax return filed after receipt 
by the taxpayer of the certification is for a taxable year beginning 
before January 1, 2002. For rules applicable to returns for taxable 
years beginning after December 31, 2001, see paragraph (d)(7)(iv) of 
this section.
    (iv) Returns for taxable years beginning after December 31, 2001--
(A) In general. Except as otherwise provided in paragraph (d)(7)(ii) of 
this section and this paragraph (d)(7)(iv), a taxpayer claiming the 
credit for rehabilitation of a certified historic structure (within the 
meaning of section 47(c)(3) and paragraph (d)(1) of this section) for a 
taxable year beginning after December 31, 2001, must provide with the 
return for the taxable year in which the credit is

[[Page 516]]

claimed, the NPS project number assigned by, and the date of the final 
certification of completed work received from, the Secretary of the 
Interior. If a credit (including a credit for a taxable year beginning 
before January 1, 2002) is claimed under the late certification 
procedures of paragraph (d)(7)(ii) of this section and the first income 
tax return filed by the taxpayer after receipt of the certification is 
for a taxable year beginning after December 31, 2001, the taxpayer must 
provide the NPS project number assigned by, and the date of the final 
certification of completed work received from, the Secretary of the 
Interior with that return.
    (B) Reporting and recordkeeping requirements. The information 
required under paragraph (d)(7)(iv)(A) of this section must be provided 
on Form 3468 (or its successor) filed with the taxpayer's return. In 
addition, the taxpayer must retain a copy of the final certification of 
completed work for as long as its contents may become material in the 
administration of any internal revenue law.
    (C) Passthrough entities. In the case of a credit for qualified 
rehabilitation expenditures of a partnership, S corporation, estate, or 
trust, the requirements of this paragraph (d)(7)(iv) apply only to the 
entity. Each partner, shareholder or beneficiary claiming a credit for 
such qualified rehabilitation expenditures from a passthrough entity 
must, however, provide the employer identification number of the entity 
on Form 3468 (or its successor).
    (e) Adjustment to basis--(1) General rule. Except as otherwise 
provided by this paragraph (e), if a credit is allowed with respect to 
property attributable to qualified rehabilitation expenditures incurred 
in connection with the rehabilitation of a qualified rehabilitated 
building, the increase in the basis of the rehabilitated property that 
would otherwise result from the qualified rehabilitation expenditures 
must be reduced by the amount of the credit allowed. See section 48(q) 
and the regulations there under for other rules concerning adjustments 
to basis in the case of section 38 property.
    (2) Special rule for certain property relating to certified historic 
structures. If a rehabilitation investment credit is allowed with 
respect to property that is placed in service before January 1, 1987, or 
property that qualifies for the transition rules in paragraph (a)(2)(iv) 
(B) or (C) of this section, and such property is attributable to 
qualified rehabilitation expenditures incurred in connection with the 
rehabilitation of a certified historic structure, the increase in the 
basis of the rehabilitated property that would otherwise result from the 
qualified rehabilitation expenditures must be reduced by one-half of the 
amount of the credit allowed.
    (3) Recapture of rehabilitation investment credit. If during any 
taxable year there is a recapture amount determined with respect to any 
credit that resulted in a basis adjustment under paragraph (e) (1) or 
(2) of this section, the basis of such building (immediately before the 
event resulting in such recapture) shall be increased by an amount equal 
to such recapture amount. For purposes of the preceding sentence, the 
term ``recapture amount'' means any increase in tax (or adjustment in 
carrybacks or carryovers) determined under section 47(a)(5).
    (f) Coordination with other provisions of the Code--(1) Credit 
claimed by lessee for rehabilitation performed by lessor. A lessee may 
take the credit for rehabilitation performed by the lessor if the 
requirements of this section and section 48(d) are satisfied. For 
purposes of applying section 48(d), the fair market value of section 38 
property described in section 48(a)(1)(E) shall be limited to that 
portion of the lessor's basis in the qualified rehabilitated building 
that is attributable to qualified rehabilitation expenditures. In the 
case of a portion of a building that is divided into more than one 
leasehold interest, the qualified rehabilitation expenditures 
attributable to the common elements shall be allocated to the individual 
leasehold interests in accordance with the principles of paragraph 
(c)(10)(ii) of this section. Furthermore, a leasehold interest's share 
of the common elements shall not be considered to have been placed in 
service prior to the time that the particular leasehold interest is 
placed in service.
    (2) When the credit may be claimed--(i) In general. The investment 
credit for

[[Page 517]]

qualified rehabilitation expenditures is generally allowed in the 
taxable year in which the property attributable to the expenditure is 
placed in service, provided the building is a qualified rehabilitated 
building for the taxable year. See paragraph (b) of this section and 
section 46(c) and Sec.  1.46-3(d). Under certain circumstances, however, 
the credit may be available prior to the date the property is placed in 
service. See section 46(d) and Sec.  1.46-5 (relating to qualified 
progress expenditures). Solely for purposes of section 46(c), property 
attributable to qualified rehabilitation expenditures will not be 
treated as placed in service until the building with respect to which 
the expenditures are made meets the definition of a qualified 
rehabilitated building (as defined in section 48(g)(1) and paragraph (b) 
of this section) for the taxable year. Accordingly, in the first taxable 
year for which the building becomes a qualified rehabilitated building, 
the property described in section 48(a)(1)(E) attributable to 
expenditures described in paragraph (c) of this section, shall be 
considered to be placed in service, if such property was considered 
placed in service under section 46(c) and the regulations thereunder 
without regard to this paragraph (f)(2)(i) in that taxable year or a 
prior taxable year. For purposes of the preceding sentence, the 
requirement of section 48(g)(1)(A)(iii) and paragraph (b)(3) of this 
section, relating to the definition of a qualified rehabilitated 
building shall be deemed to be met if the taxpayer reasonably expects 
that no rehabilitation work undertaken during the remainder of the 
rehabilitation process will result in a failure to satisfy the 
requirements of paragraph (b)(3) of this section. If the requirements of 
paragraph (b)(3) of this section, are not satisfied, however, the credit 
shall be disallowed for the taxable year in which it was claimed. If a 
taxpayer fails to complete physical work on the rehabilitation prior to 
the date that is 30 months after the date that the taxpayer filed a tax 
return on which the credit is claimed, the taxpayer must submit a 
written statement to the District Director stating such fact prior to 
the last day of the 30th month, and shall be requested to consent to an 
agreement under section 6501(c)(4) extending the period of assessment 
for any tax relating to the item for which the credit was claimed.
    (ii) Section 38 property described in section 48(a)(1)(E). In the 
case of section 38 property described in section 48(a)(1)(E), the 
section 38 property is not the building. Instead, the section 38 
property is the portion of the basis of the building that is 
attributable to qualified rehabilitation expenditures. Therefore, for 
example, for purposes of the determination of when such section 38 
property is placed in service, a determination must be made regarding 
when property attributable to the portion of the basis of the building 
attributable to qualified rehabilitation expenditures is placed in 
service. The issue of when the building is placed in service is thus not 
relevant. In fact, under this test, the building itself may never have 
been taken out of service during the rehabilitation process. If the 
building is rehabilitated over several years in stages (e.g., by 
floors), section 38 property attributable to qualified rehabilitation 
expenditures to a qualified rehabilitated building placed in service in 
each taxable year shall, generally, be treated as a separate item of 
section 38 property.
    (iii) Example. The application of this paragraph (f)(2) may be 
illustrated by the following example:

    Example. Assume that A, a calendar year taxpayer, purchases a four-
story building on January 1, 1983, for $100,000, and incurs $10,000 of 
qualified rehabilitation expenditures in 1983 to rehabilitate floor one, 
$50,000 of qualified rehabilitation expenditures in 1984 to rehabilitate 
floor two, $70,000 of qualified rehabilitation expenditures in 1985 to 
rehabilitate floor three, and $60,000 of qualified rehabilitation 
expenditures in 1986 to rehabilitate floor four. Assume further that A 
places the property attributable to these expenditures in service on the 
last day of the year in which the respective expenditures were incurred 
and that the building is never taken out of service since as each floor 
is rehabilitated, the other three floors are occupied by tenants. Under 
the rule in this paragraph (f)(2), the portion of the basis of the 
building that is attributable to qualified rehabilitation expenditures 
incurred with respect to floor one and two are deemed to be placed in 
service in 1985, because that is the first year that the substantial 
rehabilitation test described in paragraph (b) of this section is met 
($120,000 of expenditures incurred by A

[[Page 518]]

during a measuring period ending on December 31, 1985 is greater than 
the $110,000 basis at the beginning of the period). Assume that as of 
December 31, 1985, at least 75 percent of the external walls of the 
building have been retained during the rehabilitation process and that A 
has a reasonable expectation that no work during the remainder of the 
rehabilitation process will result in less than 75 percent of the 
external walls being retained. A may claim a credit for A's 1985 taxable 
year on $130,000 of qualified rehabilitation expenditures ($10,000 in 
1983, $50,000 in 1984, and $70,000 in 1985). (See paragraph (c)(6) of 
this section for rules applicable to when qualified expenditures may be 
incurred. In addition, see section 46 (d) and Sec.  1.46-5 for rules 
relating to qualified progress expenditures.) The fact that the building 
was a qualified rehabilitated building for A's 1985 taxable year, 
however, has no effect on whether the building is a qualified 
rehabilitated building for A's 1986 taxable year. In order to determine 
whether A is entitled to claim a credit on A's 1986 return for the 
$60,000 of qualified rehabilitation expenditures incurred in 1986, A 
must select a measuring period ending in 1986 and must determine whether 
the building is a qualified rehabilitated building for that year. Solely 
for purposes of determining whether the building was substantially 
rehabilitated, expenditures incurred in 1984 and 1985, even though 
considered in determining whether the building was substantially 
rehabilitated for A's 1985 taxable year, may be used in addition to the 
expenditures incurred in 1986 to determine whether the building was 
substantially rehabilitated for A's 1986 taxable year, provided the 
expenditures were incurred during any measuring period selected by A 
that ends in 1986.

    (3) Coordination with section 47. If property described in section 
48(a)(1)(E) is disposed of by the taxpayer, or otherwise ceases to be 
``section 38 property,'' section 47 may apply. Property will cease to be 
section 38 property, and therefore section 47 may apply, in any case in 
which the Department of Interior revokes or otherwise invalidates a 
certification of rehabilitation after the property is placed in service 
or a building (other than a certified historic structure) is moved from 
the place where it is rehabilitated after the property is placed in 
service. If, for example, the taxpayer made modifications to the 
building inconsistent with Department of Interior standards, the 
Secretary of the Interior might revoke the certification. In addition, 
if all or a portion of a substantially rehabilitated building becomes 
tax-exempt use property (see paragraph (c)(7)(vi) of this section) for 
the first time within five years after the credit is claimed, the credit 
will be recaptured under section 47 at that time as if the building or 
portion of the building which becomes tax-exempt use property had then 
been sold.
    (g) Effective/applicability date. This section applies on and after 
January 19, 2017. For rules before January 19, 2017, see Sec.  1.48-12 
as contained in 26 CFR part 1 revised as of April 1, 2016.

[T.D. 8233, 53 FR 39592, Oct. 11, 1988; 53 FR 43866, Oct. 31, 1988, as 
amended by T.D. 8989, 67 FR 20030, Apr. 24, 2002; T.D. 9040, 68 FR 4920, 
Jan. 31, 2003; T.D. 9283, 71 FR 51737, Aug. 31, 2006; T.D. 9811, 82 FR 
6236, Jan. 19, 2017; T.D. 9874, 84 FR 50125, Sept. 24, 2019]



Sec.  1.50-1  Lessee's income inclusion following election of lessor of
investment credit property to treat lessee as acquirer.

    (a) In general. Section 50(d)(5) provides that, for purposes of 
computing the investment credit, rules similar to the rules of former 
section 48(d) (relating to certain leased property) (as in effect on the 
day before the date of the enactment of the Revenue Reconciliation Act 
of 1990 (Pub. L. 101-508, 104 Stat. 1388 (November 5, 1990))) apply. 
This section provides rules similar to the rules of former section 
48(d)(5) that the Secretary has determined shall apply for purposes of 
determining the inclusion in gross income required when a lessor elects 
to treat a lessee as having acquired investment credit property.
    (b) Coordination with basis adjustment rules. In the case of any 
property with respect to which an election is made under Sec.  1.48-4 by 
a lessor of investment credit property to treat the lessee as having 
acquired the property--
    (1) Basis adjustment. Section 50(c) does not apply with respect to 
such property.
    (2) Amount of credit included ratably in gross income--(i) In 
general. A lessee of the property must include ratably in gross income, 
over the shortest recovery period which could be applicable under 
section 168 with respect to that property, an amount equal to the amount 
of the credit determined under

[[Page 519]]

section 46 with respect to that property. The ratable income inclusion 
under this paragraph begins on the date the investment credit property 
is placed in service and continues on each one year anniversary date 
thereafter until the end of the applicable recovery period. The lessee 
will include in gross income the amount of its credit determined under 
section 46 regardless of limitations on the amount of the credit allowed 
under section 38(c) based on the amount of the lessee's income tax.
    (ii) Special rule for the energy credit. In the case of any energy 
credit determined under section 48(a), paragraph (b)(2)(i) of this 
section applies only to the extent of 50 percent of the amount of the 
credit determined under section 46.
    (3) Special rule for partnerships and S corporations--(i) In 
general. For purposes of paragraph (b)(2) of this section, if the lessee 
of the property is a partnership (other than an electing large 
partnership) or an S corporation, the gross income includible under such 
paragraph is not an item of partnership income to which the rules of 
subchapter K of Chapter 1, subtitle A of the Code apply or an item of S 
corporation income to which the rules of subchapter S of Chapter 1, 
subtitle A of the Code apply. Any partner or S corporation shareholder 
that is an ultimate credit claimant (as defined in paragraph (b)(3)(ii) 
of this section) is treated as a lessee that must include in gross 
income the amounts required under paragraph (b)(2) of this section in 
proportion to the credit determined under section 46 with respect to 
such partner or S corporation shareholder.
    (ii) Definition of ultimate credit claimant. For purposes of this 
section, the term ultimate credit claimant means any partner or S 
corporation shareholder that files (or that would file) Form 3468, 
``Investment Credit,'' with such partner's or S corporation 
shareholder's income tax return to claim an investment credit determined 
under section 46 with respect to such partner or S corporation 
shareholder.
    (c) Coordination with the recapture rules--(1) In general. If 
section 50(a) requires an increase in the lessee's or the ultimate 
credit claimant's tax or a reduction in the carryback or carryover of an 
unused credit (or both) as a result of an early disposition (including a 
lease termination), etc., of leased property for which an election had 
been made under Sec.  1.48-4, the lessee or the ultimate credit claimant 
is required to include in gross income an amount equal to the excess, if 
any, of the amount of the credit that is not recaptured over the total 
increases in gross income previously made under paragraph (b)(2) of this 
section with respect to the property. Such amount is in addition to the 
amounts the lessee or the ultimate credit claimant previously included 
in gross income under paragraph (b)(2) of this section.
    (2) Income inclusion exceeds unrecaptured credit. If section 50(a) 
requires an increase in the lessee's or ultimate credit claimant's tax 
or a reduction in the carryback or carryover of an unused credit (or 
both) as a result of an early disposition (including a lease 
termination), etc., of leased property for which an election had been 
made under Sec.  1.48-4, the lessee's or the ultimate credit claimant's 
gross income shall be reduced by an amount equal to the excess, if any, 
of the total increases in gross income previously included under 
paragraph (b)(2) of this section over the amount of the credit that is 
not recaptured.
    (3) Special rule for the energy credit. In the case of any energy 
credit determined under section 48(a), paragraphs (c)(1) and (2) of this 
section apply by substituting the phrase ``50 percent of the amount of 
the credit that is not recaptured'' for the phrase ``the amount of the 
credit that is not recaptured.''
    (4) Timing of income inclusion or reduction following recapture. Any 
adjustment required by paragraphs (c)(1) and (2) of this section is 
taken into account in the taxable year in which the property is disposed 
of or otherwise ceases to be investment credit property.
    (d) Election to accelerate income inclusion outside of the recapture 
period--(1) In general. If after the recapture period described in 
section 50(a), but prior to the expiration of the recovery period 
described in paragraph (b)(2) of this section, there is a lease 
termination, the lessee otherwise disposes of the lease, or a partner or 
S corporation shareholder that is an ultimate credit

[[Page 520]]

claimant disposes of its entire interest, either direct or indirect, in 
a lessee partnership (other than an electing large partnership) or S 
corporation, the lessee, or, in the case of a partnership or S 
corporation, the ultimate credit claimant may irrevocably elect to take 
into account the remaining amount required to be included in gross 
income under this section in the taxable year of the disposition or 
termination.
    (2) Exceptions. The election provided under paragraph (d)(1) of this 
section is not available to--
    (i) Lessees or ultimate credit claimants required by paragraph (c) 
of this section to account for the remaining amount required to be 
included in gross income after accounting for recapture in the taxable 
year in which the property was disposed of or otherwise ceased to be 
investment credit property under section 50(a); or
    (ii) Former partners or S corporation shareholders that own no 
interest, either direct or indirect, in a lessee partnership or S 
corporation at the time of a lease termination or disposition.
    (3) Manner and time for making election. The election under 
paragraph (d)(1) of this section is made by including the remaining 
amount required to be included under this section in gross income in the 
taxable year of the lease termination or disposition or the disposition 
of the ultimate credit claimant's entire interest, either direct or 
indirect, in a partnership or S corporation. The election must be made 
on or before the due date (including any extension of time) of the 
lessee's income tax return, or, in the case of a partnership or S 
corporation, the ultimate credit claimant's income tax return for the 
taxable year in which the lease termination or disposition or the 
disposition of the ultimate credit claimant's entire interest, either 
direct or indirect, in a partnership or S corporation occurs.
    (e) Examples. The provisions of this section may be illustrated by 
the following examples:
    (1) Example 1. X, a calendar year C corporation, leases 
nonresidential real property from Y. The property is placed in service 
on October 1, 2016. Y elects under Sec.  1.48-4 to treat X as having 
acquired the property. X's investment credit determined under section 46 
for 2016 with respect to such property is $9,750. The shortest recovery 
period that could be available to the property under section 168 is 39 
years. Because Y has elected to treat X as having acquired the property, 
Y does not reduce its basis in the property under section 50(c). 
Instead, X, the lessee of the property, must include ratably in gross 
income over 39 years an amount equal to the credit determined under 
section 46 with respect to such property. Under paragraph (b)(2) of this 
section, X's increase in gross income for each of the 39 years beginning 
with 2016 is $250 ($9,750/39 year recovery period).
    (2) Example 2. The facts are the same as in Example 1 in paragraph 
(e)(1) of this section, except that instead of nonresidential real 
property, X leases from Y solar energy equipment for which an energy 
credit under section 48 is determined under section 46. X's investment 
credit determined under section 46 for 2016 with respect to the property 
is $9,750. The shortest recovery period that could be available to the 
property under section 168 is 5 years. X, the lessee of the property, 
must include ratably in gross income over 5 years an amount equal to 50% 
of the credit determined under section 46 with respect to such property. 
Under paragraph (b)(2) of this section, X's increase in gross income for 
each of the 5 years beginning with 2016 is $975 ($4,875/5 year recovery 
period).
    (3) Example 3. A and B, calendar year taxpayers, form a partnership, 
the AB partnership, that leases nonresidential real property from Y. The 
property is placed in service on October 1, 2016. Y elects under Sec.  
1.48-4 to treat the AB partnership as having acquired the property. A's 
investment credit determined under section 46 for 2016 is $3,900 and B's 
investment credit determined under section 46 for 2016 is $7,800 with 
respect to the property. The shortest recovery period that could be 
available to the property under section 168 is 39 years. Because Y has 
elected to treat the AB partnership as having acquired the property, Y 
does not reduce its basis in the building under section 50(c). Instead, 
A and B, the ultimate credit claimants, must include the

[[Page 521]]

amount of the credit determined with respect to A and B under section 46 
ratably in gross income over 39 years, the shortest recovery period 
available with respect to such property. Therefore, A and B must include 
ratably in gross income over 39 years under paragraph (b)(2) of this 
section an amount equal to $3,900 and $7,800, respectively. Under 
paragraph (b)(2) of this section, A's increase in gross income for each 
of the 39 years beginning with 2016 is $100 ($3,900/39 year recovery 
period) and B's is $200 ($7,800/39 year recovery period). Because the 
gross income A and B are required to include under paragraph (b)(2) of 
this section is not an item of partnership income, the rules under 
subchapter K applicable to items of partnership income do not apply with 
respect to such income. In particular, A and B are not entitled to an 
increase in the outside basis of their partnership interests under 
section 705(a) and are not entitled to an increase in their capital 
accounts under section 704(b).
    (4) Example 4. The facts are the same as in Example 3 in paragraph 
(e)(3) of this section, except that on January 1, 2019, the lease 
between AB partnership and Y terminates (Y retains ownership of the 
property), which is a recapture event under section 50(a). A's and B's 
income tax for 2019 is increased under section 50(a) by $2,340 and 
$4,680, respectively (60% of $3,900 and $7,800, respectively, assuming 
that the aggregate decrease in the credits allowed under section 38 was 
the full amount of the investment credits determined as to A and B under 
section 46). Therefore, the amount of the unrecaptured credit as to A 
and B is $1,560 and $3,120, respectively (40% of $3,900 and $7,800, 
respectively). The amounts that A and B previously included in gross 
income under paragraph (b)(2) of this section are $300 ($100 for each of 
2016, 2017, and 2018) and $600 ($200 for each of 2016, 2017, and 2018), 
respectively. A and B are required under paragraph (c)(1) of this 
section to include in gross income an amount equal to the excess of the 
credit that is not recaptured ($1,560 and $3,120, respectively) over the 
total increases in gross income previously made under paragraph (b)(2) 
of this section with respect to the property ($300 and $600, 
respectively). Therefore, A and B must include in gross income $1,260 
and $2,520, respectively, in the taxable year of the lease termination 
(2019) in addition to the recapture amounts described above.
    (5) Example 5. (i) The facts are the same as in Example 4 in 
paragraph (e)(4) of this section, except that instead of nonresidential 
real property, the AB partnership leases from Y solar energy equipment 
for which an energy credit under section 48 is determined under section 
46. Because the shortest recovery period that could be available to the 
property under section 168 is 5 years, A and B are required under 
paragraph (b)(2)(ii) of this section to include ratably in gross income 
over 5 years an amount equal to 50% of the credit determined under 
section 46 with respect to such property (50% of $3,900/5, or $390, per 
year for A, and 50% of $7,800/5, or $780, per year for B).
    (ii) The January 1, 2019 lease termination requires A's and B's 
income tax for 2019 to be increased under section 50(a) by $2,340 and 
$4,680, respectively (60% of $3,900 and $7,800, respectively). 
Therefore, the amount of the unrecaptured credit as to A and B is $1,560 
and $3,120, respectively (40% of $3,900 and $7,800, respectively). Under 
paragraph (b)(2)(ii) of this section, the amounts A and B previously 
included in gross income are $1,170 ($390 for each of 2016, 2017, and 
2018) and $2,340 ($780 for each of 2016, 2017, and 2018), respectively. 
A and B are entitled to a reduction in gross income under paragraph 
(c)(2) of this section equal to the excess of the total increases in 
gross income made under paragraph (b)(2)(ii) of this section ($1,170 and 
$2,340, respectively) over 50% of the amount of the credit that is not 
recaptured ($780 and $1,560, respectively). Therefore, A and B are 
entitled to a reduction in gross income in the amount of $390 and $780, 
respectively, in the taxable year of the lease termination (2019).
    (6) Example 6. (i) The facts are the same as in Example 3 in 
paragraph (e)(3) of this section, except that on December 1, 2021, A 
sells its entire interest to C, and on January 1, 2022, the lease 
between AB partnership and Y terminates. At the time of the lease 
termination, B is still a partner in the AB partnership. There is no 
recapture

[[Page 522]]

event under section 50(a) because both the lease termination and the 
disposition of A's interest in the partnership occurred outside of the 
recapture period.
    (ii) At the time that A sold its interest in the AB partnership to 
C, A had previously included $500 ($100 for each of 2016-2020) in gross 
income under paragraph (b)(2) of this section. Under paragraph (b)(2) of 
this section, A must continue to include the remaining $3,400 (including 
$100 in 2021) in gross income ratably over the remaining portion of the 
applicable recovery period of 39 years. Alternatively, under paragraph 
(d)(1) of this section, A may irrevocably elect to include the remaining 
$3,400 in gross income in the taxable year that A sold its entire 
interest in the AB partnership to C (2021). Pursuant to paragraph (d)(2) 
of this section, A cannot make this election in the taxable year of the 
lease termination (2022).
    (iii) At the time of the lease termination, B had previously 
included $1,200 ($200 for each of 2016-2021) in gross income under 
paragraph (b)(2) of this section. Under paragraph (b)(2) of this 
section, B must continue to include the remaining $6,600 required in 
gross income ratably over the remaining portion of the applicable 
recovery period of 39 years. Alternatively, under paragraph (d)(1) of 
this section, B may irrevocably elect to include the remaining $6,600 in 
gross income in the taxable year of the lease termination (2022).
    (f) Applicability date. This section applies to property placed in 
service on or after September 19, 2016.

[T.D. 9872, 84 FR 34780, July 19, 2019]

   rules for computing credit for expenses of work incentive programs



Sec.  1.50A-1  Determination of amount.

    (a) In general. Except as otherwise provided in this section and in 
Sec.  1.50A-2, the amount of the work incentive program (WIN) credit 
allowed by section 40 for the taxable year is equal to 20 percent of the 
taxpayer's WIN expenses (as determined under paragraph (a) of Sec.  
1.50B-1). The amount equal to 20 percent of the WIN expenses shall be 
referred to in this section and Sec. Sec.  1.50A-2 through 1.50B-5 as 
the ``credit earned.''
    (b) Limitation based on amount of tax. Notwithstanding the amount of 
the credit earned for the taxable year, under section 50A(a)(2) the 
credit allowed by section 40 for the taxable year is limited to--
    (1) If the liability for tax (as defined in paragraph (c) of this 
section) is $25,000 or less, the liability for tax; or
    (2) If the liability for tax is more than $25,000, then, the first 
$25,000 of the liability for tax plus 50 percent of the liability for 
tax in excess of $25,000. However, such $25,000 amount may be reduced in 
the case of certain married individuals filing separate returns (see 
paragraph (e) of this section); corporations which are members of a 
controlled group (see paragraph (f) of this section); estates and trusts 
(see paragraph (c) of Sec.  1.50B-3); and organizations to which section 
593 applies, regulated investment companies or real estate investment 
trusts subject to taxation under subchapter M, chapter 1 of the Code, 
and cooperative organizations described in section 1381(a) (see Sec.  
1.50B-5). The excess of the credit earned for the taxable year over the 
limitations described in this paragraph for such taxable year is an 
unused credit which may be carried back or forward to other taxable 
years in accordance with Sec.  1.50A-2.
    (c) Liability for tax. For the purpose of computing the limitation 
based on amount of tax, section 50A(a)(3) defines the liability for tax 
as the income tax imposed for the taxable year by chapter 1 of the Code, 
reduced by the sum of the credits allowable under--
    (1) Section 33 (relating to taxes of foreign countries and 
possessions of the United States,
    (2) Section 37 (relating to credit for the elderly),
    (3) Section 38 (relating to investment in certain depreciable 
property), and
    (4) Section 41 (relating to contributions to candidates for public 
office).

For purposes of this paragraph, the tax imposed for the taxable year by 
section 56 (relating to imposition of minimum tax for tax preferences), 
section 72(m)(5)(B) (relating to 10 percent tax on premature 
distributions to owner-employees), section 402(e) (relating to

[[Page 523]]

tax on lump sum distributions), section 408(f) (relating to additional 
tax on income from certain retirement accounts), section 531 (relating 
to imposition of accumulated earnings tax), section 541 (relating to 
imposition of personal holding company tax), or section 1378 (relating 
to tax on certain capital gains of subchapter S corporations), and any 
additional tax imposed for the taxable year by section 1351(d)(1) 
(relating to recoveries of foreign expropriation losses), shall not be 
considered tax imposed by chapter 1 of the Code for such year. Thus, the 
liability for tax for purposes of computing the limitation based on 
amount of tax for the taxable year is determined without regard to any 
tax imposed by sections 56, 72(m)(5)(B), 402(e), 408(f), 531, 541, 
1351(d)(1) or 1378 of the Code. In addition, any increase in tax 
resulting from the application of section 50A (c) and (d) and Sec.  
1.50A-3 (relating to recomputation of credit allowed due to early 
termination of employment by employer, or failure to pay comparable 
wages) shall not be treated as tax imposed by chapter 1 of the Code for 
purposes of computing the liability for tax. See section 50A (c)(3) and 
(d)(2).
    (d) Example. The application of paragraphs (a), (b), and (c) of this 
section may be illustrated by the following example:

    Example. X Corporation's WIN expenses for its taxable year ending 
December 31, 1973, are $500,000. X's credit earned for its taxable year 
is $100,000 (20 percent of $500,000). X's income tax for such year, 
computed without regard to credits against tax and without regard to any 
tax imposed by section 56, 531, 541, 1351(d)(1) or 1378, is $190,000. 
That amount includes $5,000 resulting from the application of section 
50A(c)(3) and Sec.  1.50 A-3. X is allowed under section 33 a foreign 
tax credit of $50,000. X's liability for tax is computed as follows:

Income tax (including increase in tax under section             $190,000
 50A(c)(3), but before any credits and without regard to any
 tax imposed by section 56, 531, 541, 1351(d)(1) or 1378)...
                                                             ===========
Less:
  Increase in tax resulting from application of       $5,000
   section 50A(c)(3)............................
  Foreign tax credit............................      50,000
                                                 ------------
                                                  ..........      55,000
                                                             -----------
    Liability for tax.......................................     135,000
                                                             ===========
 


Under section 50A(a)(2) and paragraph (b) of this section, X's 
limitation based on amount of tax for the taxable year is $80,000 
($25,000 plus 50 percent of $110,000). X Corporation's credit allowed by 
section 40 for the taxable year therefore is $80,000. X has an unused 
credit for the year of $20,000 ($100,000 less $80,000) which it may 
carry back or forward to other taxable years in accordance with Sec.  
1.50A-2.

    (e) Married individuals. If a separate return is filed by a husband 
or wife, the limitation based on amount of tax under paragraph (b) of 
this section shall be computed by substituting a $12,500 amount for the 
$25,000 amount in applying such paragraph (b). However, this reduction 
of the $25,000 amount to $12,500 applies only if the taxpayer's spouse 
is entitled to a credit under section 40 for the taxable year of such 
spouse which ends with, or within, the taxpayer's taxable year. The 
taxpayer's spouse is entitled to a credit under section 40 either 
because of incurring WIN expenses for such taxable year of the spouse 
(whether directly incurred by such spouse or whether apportioned to such 
spouse, for example, from an electing small business corporation, as 
defined in section 1371(b)), or because of a credit carryback or 
carryover to such taxable year under Sec.  1.50A-2. The determination of 
whether an individual is married shall be made under the principles of 
section 143 and the regulations thereunder.
    (f) Apportionment of $25,000 amount among component members of a 
controlled group--(1) In general. In determining the limitation based on 
amount of tax under section 50A(a)(2) in the case of corporations which 
are component members of a controlled group of corporations on a 
December 31, only one $25,000 amount is available to such component 
members for their taxable years that include such December 31. See 
subparagraph (2) of this paragraph for apportionment of such amount 
among such component members. See subparagraph (3) of this paragraph for 
the definition of ``component member.''
    (2) Manner of apportionment. (i) In the case of corporations which 
are component members of a controlled group on a particular December 31, 
the $25,000 amount may be apportioned among such members for their 
taxable years

[[Page 524]]

that include such December 31 in any manner the component members may 
select, provided that each such member less than 100 percent of whose 
stock is owned, in the aggregate, by the other component members of the 
group on such December 31 consents to an apportionment plan. The consent 
of a component member to an apportionment plan with respect to a 
particular December 31 shall be made by means of a statement signed by a 
person duly authorized to act on behalf of the consenting member, 
stating that such member consents to the apportionment plan with respect 
to such December 31. The statement shall set forth the name, address, 
employer identification number, and taxable year of each component 
member of the group on such December 31, the amount apportioned to each 
such member under the plan, and the location of the Internal Revenue 
Service center where the statement is to be filed. The consent of more 
than one component member may be incorporated in a single statement. The 
statement shall be timely filed with the Internal Revenue Service center 
where the component member having the taxable year first ending on or 
after such December 31 files its return for such taxable year and shall 
be irrevocable after such filing. If two or more component members have 
the same such taxable year, a statement of consent may be filed by any 
one of such members. Such statement shall be considered as timely filed 
if filed on or before the due date (including any extensions of time) of 
such member's income tax return which includes such December 31. 
However, if the due date (including any extensions of time) of the 
return of such member is on or before December 15, 1972, the required 
statement shall be considered as timely filed if filed on or before 
March 15, 1973. Each component member of the group on such December 31 
shall keep as a part of its records a copy of the statement containing 
all the required consents.
    (ii) An apportionment plan adopted by a controlled group with 
respect to a particular December 31 shall be valid only for the taxable 
year of each member of the group which includes such December 31. Thus, 
a controlled group must file a separate consent to an apportionment plan 
with respect to each taxable year which includes a December 31 as to 
which an apportionment plan is desired.
    (iii) If an apportionment plan is not timely filed, the $25,000 
amount specified in section 50A(a)(2) shall be reduced for each 
component member of the controlled group, for its taxable year which 
includes a December 31, to an amount equal to $25,000 divided by the 
number of component members of each group on such December 31.
    (iv) If a component member of the controlled group makes its income 
tax return on the basis of a 52-53 week taxable year, the principles of 
section 441(f)(2)(A)(ii) and paragraph (b)(1) of Sec.  1.441-2 apply in 
determining the last day of such taxable year.
    (3) Definitions of controlled group of corporations and component 
member of controlled group. For the purpose of this paragraph, the terms 
``controlled group of corporations'' and ``component member'' of a 
controlled group of corporations shall have the same meaning assigned to 
those terms in section 1563 (a) and (b) and the regulations thereunder. 
For purposes of applying Sec.  1.1563-1(b)(2)(ii)(c), an electing small 
business corporation shall be treated as an excluded member whether or 
not it is subject to the tax imposed by section 1378.
    (4) Members of a controlled group filing a consolidated return. If 
some component members of a controlled group join in filing a 
consolidated return pursuant to Sec.  1.1502-3(a)(3), and other 
component members do not join, then, unless a consent is timely filed 
apportioning the $25,000 amount among the group filing the consolidated 
return and the other component members of the controlled group, each 
component member of the controlled group (including each component 
member which joins in filing the consolidated return) shall be treated 
as a separate corporation for purposes of equally apportioning the 
$25,000 amount under subparagraph (2)(iii) of this paragraph. In such 
case, the limitation based on the amount of tax for the group filing the 
consolidated return shall be computed by substituting for the $25,000 
amount the total of the amount apportioned to

[[Page 525]]

each component member which joins in filing the consolidated return. If 
the affiliated group, filing the consolidated return and the other 
component members of the controlled group adopt an apportionment plan, 
the affiliated group shall be treated as a single member for the purpose 
of applying subparagraph (2)(i) of this paragraph. Thus, for example, 
only one consent executed by the common parent to the apportionment plan 
is required for the group filing the consolidated return. If any 
component member of the controlled group which joins in the filing of 
the consolidated return is an organization to which section 593 applies 
or a cooperative organization described in section 1381(a), rules 
similar to the rules contained in paragraph (a)(3)(ii) of Sec.  1.1502-3 
are applicable.
    (5) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. At all times during 1972 Smith, an individual, owns all 
the stock of corporations X, Y, and Z. Corporation X files an income tax 
return on a calendar year basis. Corporation Y files an income tax 
return on the basis of a fiscal year ending June 30. Corporation Z files 
an income tax return on the basis of a fiscal year ending September 30. 
On December 31, 1972, X, Y, and Z are component members of the same 
controlled group. X, Y, and Z all consent to an apportionment plan in 
which the $25,000 amount is apportioned entirely to Y for its taxable 
year ending June 30, 1973 (Y's taxable year which includes December 31, 
1972). Such consent is timely filed. For purposes of computing the 
credit under section 40, Y's limitation based on amount of tax for its 
taxable year ending June 30, 1973, is so much of Y's liability for tax 
as does not exceed $25,000, plus 50 percent of Y's liability for tax in 
excess of $25,000. X's and Z's limitations for their taxable years 
ending December 31, 1972, and September 30, 1973, respectively, are 
equal to 50 percent of X's liability for tax and 50 percent of Z's 
liability for tax. On the other hand, if an apportionment plan is not 
timely filed, X's limitation would be so much of X's liability for tax 
as does not exceed $8,333.33, plus 50 percent of X's liability in excess 
of $8,333.33, and Y's and Z's limitations would be computed similarly.
    Example 2. At all times during 1972, Jones, an individual, owns all 
the outstanding stock of corporations P, Q, and R. Corporations Q and R 
both file returns for taxable year ending December 31, 1972. P files a 
consolidated return as a common parent for its fiscal year ending June 
30, 1973, with its wholly owned subsidiaries N and O. On December 31, 
1972, N, O, P, Q, and R are component members of the same controlled 
group. No consent to an apportionment plan is filed. Therefore, each 
member is apportioned $5,000 of the $25,000 amount ($25,000 divided 
equally among the five members). The limitation based on the amount of 
tax for the group filing the consolidated return (P, N, and O) for the 
year ending June 30, 1973 (the consolidated taxable year within which 
December 31, 1972, falls), is computed by using $15,000 instead of the 
$25,000 amount. The $15,000 is arrived at by adding together the $5,000 
amounts apportioned to P, N, and O.

[38 FR 6152, Mar. 7, 1973, as amended by T.D. 7636, 44 FR 47049, Aug. 
10, 1979]



Sec.  1.50A-2  Carryback and carryover of unused credit.

    (a) Allowance of unused credit as carryback or carryover--(1) In 
general. Section 50A(b)(1) provides for carrybacks and carryovers of any 
unused credit. An unused credit is the excess of the credit earned for 
the taxable year (as determined under paragraph (a) of Sec.  1.50A-1) 
over the limitation based on amount of tax for such taxable year (as 
determined under paragraph (b) of Sec.  1.50A-1). Subject to the 
limitation contained in paragraph (b) of this section, an unused credit 
shall be added to the amount allowable as a credit under section 40 for 
the years to which the unused credit can be carried. The year with 
respect to which an unused credit arises shall be referred to in this 
section as the ``unused credit year.''
    (2) Taxable years to which unused credit may be carried. An unused 
credit shall be a work incentive program (WIN) credit carryback to each 
of the 3 taxable years preceding the unused credit year and a WIN credit 
carryover to each of the 7 taxable years succeeding the unused credit 
year, except that an unused credit shall be a carryback only to taxable 
years beginning after December 31, 1971. An unused credit must be 
carried first to the earliest of the taxable years to which it may be 
carried, and then to each of the other taxable years (in order of time) 
to the extent that the unused credit may not be added (because of the 
limitation contained in paragraph (b) of this section) to the amount 
allowable as a credit under section 40 for a prior taxable year.

[[Page 526]]

    (b) Limitation on allowance of unused credit. The amount of the 
unused credit from any particular unused credit year which may be added 
to the amount allowable as a credit under section 40 for any of the 
preceding or succeeding taxable years to which such credit may be 
carried shall not exceed the amount by which the limitation based on 
amount of tax for such preceding or succeeding taxable year exceeds the 
sum of (1) the credit earned for such preceding or succeeding year, and 
(2) other unused credits carried to such preceding or succeeding year 
which are attributable to unused credit years prior to the particular 
unused credit year.
    (c) Corporate acquisitions. For the carryover of unused credits in 
the case of certain corporate acquisitions, see section 381(c)(24) and 
the regulations thereunder. [Sec.  1.381(c)(24)-1]
    (d) Periods of less than 12 months. A fractional part of a year 
which is considered as a taxable year under sections 441(b) and 
7701(a)(23) shall be treated as a preceding or a succeeding taxable year 
for the purpose of determining under section 50A(b) and this section the 
taxable years to which an unused credit may be carried.
    (e) Example. The provisions of paragraphs (a) through (d) of this 
section may be illustrated by the following example:

    Example. Corporation X files its income tax return on the basis of 
the calendar year. X's credit earned and its limitation based on amount 
of tax for each of its taxable years 1972 through 1978 are as follows:

------------------------------------------------------------------------
                                              Credit    Limitation based
                                              earned    on amount of tax
------------------------------------------------------------------------
1972......................................    $175,000          $200,000
1973......................................     250,000           160,000
1974......................................     200,000           210,000
1975......................................     210,000           230,000
1976......................................     220,000           260,000
1977......................................     260,000           220,000
1978......................................     270,000           280,000
------------------------------------------------------------------------

    (i) Corporation X's credit earned for 1972, $175,000, is allowable 
in full as a credit under section 40 for 1972 since such amount is less 
than the limitation based on amount of tax for such year, $200,000. 
Since the limitation based on amount of tax for 1973 is $160,000, only 
$160,000 of the $250,000 credit earned for such year is allowable under 
section 40 as a credit for 1973. The unused credit for 1973 of $90,000 
($250,000 less $160,000) is a WIN credit carryback to 1972 and a WIN 
credit carryover to 1974 and subsequent years up to and including 1980. 
The portion of the $90,000 unused credit which shall be added to the 
amount allowable as a credit under section 40 for 1972 and 1974 and 
subsequent years is computed as follows:
    (a) 1972. The portion of the unused credit for 1973 ($90,000) which 
is allowable as a credit for 1972 is $25,000. This amount shall be added 
to the amount allowable as a credit for 1972. The balance of the unused 
credit for 1973 to be carried to 1974 is $65,000. These amounts are 
computed as follows:

Carryback to 1972...........................................     $90,000
1972 limitation based on tax....................    $200,000
Less: Credit earned for 1972........    $175,000
Unused credits attributable to years           0
 preceding 1973.....................
                                     ------------
                                      ..........     175,000
                                                 ------------
Limit on amount of 1973 unused credit which may be added as       25,000
 a credit for 1972..........................................
                                                             -----------
    Balance of 1973 unused credit to be carried to 1974.....      65,000
 

    (b) 1974. The portion of the balance of the unused credit for 1973 
($65,000) allowable as a credit for 1974 is $10,000. This amount shall 
be added to the amount allowable as a credit for 1974. The balance of 
the unused credit for 1973 to be carried to 1975 is $55,000. These 
amounts are computed as follows:

Carryover to 1974..........................................      $65,000
1974 limitation based on tax..................     $210,000
Less: Credit earned for 1974.....     $200,000
Unused credits attributable to               0
 years preceding 1973............
                                          ____      200,000
                                               -------------
Limit on amount of 1973 unused credit which may be added as       10,000
 a credit for 1974.........................................
                                                            ------------
    Balance of 1973 unused credit to be carried to 1975....       55,000
 

    (c) 1975. The portion of the balance of the unused credit for 1973 
($55,000) allowable as a credit for 1975 is $20,000. This amount shall 
be added to the amount allowable as a credit for 1975. The balance of 
the unused credit for 1973 to be carried to 1976 is $35,000. These 
amounts are computed as follows:

Carryover to 1975..........................................      $55,000
1975 limitation based on tax..................     $230,000
Less: Credit earned for 1975.....     $210,000
Unused credits attributable to               0
 years preceding 1973............
                                  -------------

[[Page 527]]

 
                                   ...........      210,000
                                               -------------
Limit on amount of 1973 unused credit which may be added as      $20,000
 a credit for 1975.........................................
                                                            ------------
    Balance of 1973 unused credit to be carried to 1976....       35,000
 

    (d) 1976. The entire balance of the unused credit for 1973 ($35,000) 
is allowable as a credit for 1976, since the limitation based on amount 
of tax for 1976 exceeds the sum of the credit earned for 1976 and unused 
credits attributable to years prior to 1973 by an amount in excess of 
$35,000. Since the balance of the unused credit for 1973 has been fully 
allowed, no portion thereof remains to be carried to subsequent taxable 
years. This is illustrated as follows:

Carryover to 1976..........................................      $35,000
1976 limitation based on tax..................     $260,000
Less: Credit earned for 1976.....     $220,000
Unused credits attributable to               0
 years preceding 1973............
                                  -------------
                                   ...........      220,000
                                               -------------
Limit on amount of 1973 unused credit which may be added as       40,000
 a credit for 1976.........................................
                                                            ------------
    Balance of 1973 unused credit to be carried to 1977....            0
 

    (ii) Since the limitation based on amount of tax for 1977 is 
$220,000, only $220,000 of the $260,000 credit earned for such year is 
allowable as a credit for 1977. The unused credit for 1977 of $40,000 
($260,000 less $220,000) is a WIN credit carryback to 1974, 1975, and 
1976 and a WIN credit carryover to 1978 and subsequent years. The 
portions of the $40,000 unused credit which shall be added to the amount 
allowable as a credit for such years are computed as follows:
    (a) 1974. The portion of the unused credit for 1977 ($40,000) 
allowable as a credit for 1974 is zero. The balance of the unused credit 
for 1977 to be carried to 1975 is $40,000. These amounts are computed as 
follows:

Carryback to 1974..........................................      $40,000
1974 limitation based on tax..................     $210,000
Less: Credit earned for 1974.....     $200,000
Unused credits attributable to          10,000
 years preceding 1977 (unused
 credit from 1973)...............
                                  -------------
                                   ...........     $210,000
                                               --------------
Limit on amount of 1977 unused credit which may be added as            0
 a credit for 1974.........................................
                                                            ------------
    Balance of 1977 unused credit to be carried to 1975....       40,000
 

    (b) 1975. The portion of the unused credit for 1977 ($40,000) 
allowable as a credit for 1975 is zero. The balance of the unused credit 
for 1977 to be carried to 1976 is $40,000. These amounts are computed as 
follows:

Carryback to 1975..........................................      $40,000
1975 limitation based on tax..................     $230,000
Less: Credit earned for 1975.....     $210,000
Unused credits attributable to          20,000
 years preceding 1977 (unused
 credit from 1973)...............
                                          ____      230,000
                                               -------------
Limit on amount of 1977 unused credit which may be added as            0
 a credit for 1975.........................................
                                                            ------------
  Balance of 1977 unused credit to be carried to 1976......       40,000
 

    (c) 1976. The portion of the unused credit for 1977 ($40,000) 
allowable as a credit for 1976 is $5,000. This amount shall be added to 
the amount allowable as a credit for 1976. The balance of the unused 
credit for 1977 to be carried to 1978 is $35,000. These amounts are 
computed as follows:

Carryback to 1976..........................................      $40,000
1976 limitation based on tax..................     $260,000
Less: Credit earned for 1976.....     $220,000
Unused credits attributable to          35,000
 years preceding 1977 (unused
 credit from 1973)...............
                                          ____      255,000
                                               -------------
Limit on amount of 1977 unused credit which may be added as        5,000
 a credit for 1976.........................................
                                                            ------------
    Balance of 1977 unused credit to be carried to 1978....       35,000
 

    (d) 1978. The portion of the balance of the unused credit for 1977 
($35,000) allowable as a credit for 1978 is $10,000. This amount shall 
be added to the amount allowable as a credit for 1978. The balance of 
the unused credit for 1977 to be carried to 1979 and subsequent years is 
$25,000. These amounts are computed as follows:

Carryover to 1978..........................................      $35,000
1978 limitation based on tax..................     $280,000
Less: Credit earned for 1978.....     $270,000
Unused credits attributable to               0
 years preceding 1977............
                                          ____     $270,000
                                               -------------
Limit on amount of 1977 unused credit which may be added as      $10,000
 a credit for 1978.........................................
                                                            ------------
    Balance of 1977 unused credit to be carried to 1979....       25,000
 


[[Page 528]]

    (f) Electing small business corporation. An unused credit of a 
corporation which arises in an unused credit year for which the 
corporation is not an electing small business corporation (as defined in 
section 1371(b)) and which is a carryback or carryover to a taxable year 
for which the corporation is an electing small business corporation 
shall not be added to the amount allowable as a credit under section 40 
to the shareholders of such corporation for any taxable year. However, a 
taxable year for which the corporation is an electing small business 
corporation shall be counted as a taxable year for purposes of 
determining the taxable years to which such unused credit may be 
carried.

[38 FR 6153, Mar. 7, 1973]



Sec.  1.50A-3  Recomputation of credit allowed by section 40.

    (a) General rule--(1) Early termination of employment by employer--
(i) In general. If the employment of any employee, with respect to whom 
work incentive program (WIN) expenses (as defined in paragraph (a) of 
Sec.  1.50B-1) are taken into account under paragraph (a) of Sec.  
1.50A-1, is terminated by the taxpayer at any time during the first 12 
months of such employment (whether or not consecutive) or before the 
close of the 12th calendar month after the calendar month in which such 
employee completes the first 12 months of employment (whether or not 
consecutive) with the taxpayer, then subparagraph (3) of this paragraph 
shall apply. See paragraph (c) of this section for rules relating to the 
determination of the first 12 months of employment (whether or not 
consecutive). See Sec.  1.50A-4 for rules relating to other 
circumstances under which a termination of employment will not be 
treated as a termination of employment to which the provisions of 
subparagraph (3) of this paragraph are applicable.
    (ii) Rules for determining whether a termination of employment has 
occurred. For purposes of this section, the taxpayer is deemed to have 
terminated the employment of any WIN employee (as defined in paragraph 
(h) of Sec.  1.50B-1) if the employment relationship (as determined 
under common law principles) has terminated. A layoff for any reason is 
considered a termination of employment for purposes of the preceding 
sentence. However, a temporary suspension of employment of any WIN 
employee necessitated by the installation of new equipment or by the 
retooling of existing equipment (such as for a model changeover in the 
automobile industry) shall not be deemed to be a termination of 
employment if such suspension is for a period of time no longer than 60 
days. For purposes of this section, the death of the taxpayer is 
considered a termination of the employment relationship between the 
taxpayer and any WIN employee.
    (2) Failure to pay comparable wages--(i) In general. If, at any time 
during the period described in subparagraph (1)(i) of this paragraph, 
the taxpayer pays wages (as defined in section 50B(b) and paragraph (b) 
of Sec.  1.50B-1) to an employee, with respect to whom WIN expenses are 
taken into account under paragraph (a) of Sec.  1.50A-1, which are less 
than the wages paid to other employees of the taxpayer who perform 
comparable services, then subparagraph (3) of this paragraph shall 
apply.
    (ii) Comparable services. (a) For purposes of subdivision (i) of 
this subparagraph, the term ``comparable services'' refers to services 
performed in work positions which require similar education, training, 
and skills. Comparable services are those associated with other work 
positions which require similar levels of judgment and responsibility, 
which make similar physical and mental demands of an employee, and which 
could easily be performed by the employee without substantial additional 
training or experience.
    (b) If substantial training, skill, or experience are material to 
the performance of a particular job, a taxpayer may pay wages to a WIN 
employee which are less than those paid to other employees of the 
taxpayer who possess such training, skill, or experience. However, there 
must be a reasonable relationship between the lower wages or salary of 
such WIN employee and his relative lack of training, skill, or 
experience.
    (3) Recomputation of credit earned. (i) If, by reason of 
subparagraph (1) or (2) of this paragraph, this subparagraph (3)

[[Page 529]]

is applicable, then the credit earned for all credit years (as defined 
in subdivision (ii)(a) of this subparagraph) shall be recomputed under 
the principles of paragraph (a) of Sec.  1.50A-1 by not taking into 
account WIN expenses with respect to the employee (or employees) 
described in subparagraph (1) or (2) of this paragraph. There shall be 
recomputed under the principles of Sec. Sec.  1.50A-1 and 1.50A-2 the 
credit allowed for all credit years and for any other taxable year 
affected by reason of the reduction in credit earned for such credit 
year or years, giving effect to such reduction in the computation of 
carrybacks or carryovers of unused credit from any taxable year. If the 
recomputation described in the preceding sentence results, in the 
aggregate, in a decrease (taking into account any recomputation under 
this paragraph in respect of prior recapture years, as defined in 
subdivision (ii)(b) of this subparagraph) in the credits allowed for any 
credit year and for any other taxable year affected by the reduction in 
credit earned for any credit year, then the income tax for the recapture 
year shall be increased by the amount of such decrease in credits 
allowed. For treatment of such increase in tax, see paragraph (b) of 
this section. For special rules in the case of an electing small 
business corporation (as defined in section 1371(b)), an estate or 
trust, or a partnership, see respectively, Sec.  1.50A-5, Sec.  1.50A-6 
or Sec.  1.50A-7.
    (ii) For purposes of this section and Sec. Sec.  1.50A-4 through 
1.50B-6--
    (a) The term ``credit year'' means a taxable year in which WIN 
expenses with respect to the employee described in subparagraph (1) or 
(2) of this paragraph are taken into account under paragraph (a) of 
Sec.  1.50A-1.
    (b) The term ``recapture year'' means a taxable year in which a 
termination of employment (within the meaning of subparagraph (1) of 
this paragraph) or a failure to pay comparable wages (within the meaning 
of subparagraph (2) of this paragraph) occurs by reason of which the 
rule of subparagraph (3) of this paragraph becomes applicable.
    (c) The term ``recapture determination'' means a recomputation made 
under this paragraph.
    (b) Increase in income tax and reduction of WIN credit carryback and 
carryover--(1) Increase in tax. Except as provided in subparagraph (2) 
of this paragraph, any increase in income tax under this section shall 
be treated as income tax imposed on the taxpayer by chapter 1 of the 
Code for the recapture year notwithstanding that without regard to such 
increase the taxpayer has no income tax liability, has a net operating 
loss for such taxable year, or no income tax return was otherwise 
required for such taxable year.
    (2) Special rule. Any increase in income tax under this section 
shall not be treated as income tax imposed on the taxpayer by chapter 1 
of the Code for purposes of determining the amount of the credits 
allowable to such taxpayer under--
    (i) Section 33 (relating to taxes of foreign countries and 
possessions of the United States),
    (ii) Section 35 (relating to partially tax-exempt interest received 
by individuals),
    (iii) Section 37 (relating to retirement income),
    (iv) Section 38 (relating to investment in certain depreciable 
property),
    (v) Section 39 (relating to certain uses of gasoline, special fuels, 
and lubricating oil),
    (vi) Section 40 (relating to expenses of work incentive programs), 
and
    (vii) Section 41 (relating to contributions to candidates for public 
office).
    (3) Reduction in credit allowed as a result of a net operating loss 
carryback. (i) If a net operating loss carryback from the recapture year 
or from any taxable year subsequent to the recapture year reduces the 
amount allowed as a credit under section 40 for any taxable year up to 
and including the recapture year, then there shall be a new recapture 
determination under paragraph (a) of this section for each recapture 
year affected, taking into account the reduced amount of credit allowed 
after application of the net operating loss carryback.
    (ii) Subdivision (i) of this subparagraph may be illustrated by the 
following example:

    Example. (a) X Corporation, which makes its returns on the basis of 
a calendar year, hired WIN employees on March 1, 1972, and

[[Page 530]]

incurred $10,000 in WIN expenses with respect to these employees for the 
year. For the taxable year 1972, X Corporation's credit earned of $2,000 
(20 percent of $10,000) was allowed under section 40 as a credit against 
its liability for tax of $2,000. In 1973 and 1974 X Corporation had no 
liability for tax and had no WIN expenses. In January 1974, X 
Corporation terminated the employees for whom the WIN expenses had been 
incurred. Since these terminations were not subject to the exceptions 
provided by Sec.  1.50A-4, there was a recapture determination under 
paragraph (a) of this section. The income tax imposed by chapter 1 of 
the Code on X Corporation for the taxable year 1974 was increased by the 
$2,000 decrease in its credit earned for the taxable year 1972 (that is, 
the $2,000 original credit earned minus zero recomputed credit earned).
    (b) For the taxable year 1975, X Corporation has a net operating 
loss which is carried back to the taxable year 1972 and reduces its 
liability for tax, as defined in paragraph (c) of Sec.  1.50A-1, for 
such taxable year to $800. As a result of such net operating loss 
carryback, X Corporation's credit allowed under section 40 for the 
taxable year 1972 is limited to $800 and the excess of $1,200 ($2,000 
credit earned minus the $800 limitation based on amount of tax) is a WIN 
credit carryover to the taxable year 1973.
    (c) For 1975 there is a recapture determination under subdivision 
(i) of this subparagraph for the 1974 recapture year. The $2,000 
increase in the income tax imposed on X Corporation for the taxable year 
1974 is redetermined to be $800 (that is, the $800 credit allowed after 
taking into account the 1975 net operating loss minus zero credit which 
would have been allowed taking into account the 1974 recapture 
determination). In addition, X Corporation's $1,200 WIN credit carryover 
to the taxable year 1973 is reduced by $1,200 ($2,000 minus $800) to 
zero and X Corporation is entitled to a $1,200 refund of the $2,000 tax 
paid as a result of the 1974 recapture determination.

    (4) Statement of recomputation. The taxpayer shall attach to his 
income tax return for the recapture year a separate statement showing in 
detail the computation of the increase in income tax imposed on such 
taxpayer by chapter 1 of the Code and the reduction in any WIN credit 
carryovers.
    (c) Period of employment--(1) Initial date of employment. For 
purposes of this section and Sec. Sec.  1.50A-4 through 1.50B-6, the 
initial date of employment (for purposes of applying paragraph (a) (1) 
and (2) of this section and paragraphs (a)(1) and (f) of Sec.  1.50B-1) 
is the date the WIN employee reports to the taxpayer (or in the case 
where the taxpayer is a partner of a partnership, a beneficiary of an 
estate or trust, or a shareholder of an electing small business 
corporation, to such partnership, estate, trust, or electing small 
business corporation) for work.
    (2) Computation of the first 12 months of employment (whether or not 
consecutive). For purposes of computing the first 12 months of 
employment (whether or not consecutive), the first month of employment 
shall begin with the initial date of employment (as defined in 
subparagraph (1) of this paragraph) of the WIN employee, the second 
month of employment shall begin with the corresponding date in the 
following month, the third month of employment shall begin with the 
corresponding date in the next following month, and so forth. If the WIN 
employee performs any services during any such month (as determined 
under the preceding sentence), that month shall be counted in computing 
the WIN employee's ``first 12 months of employment (whether or not 
consecutive)''. If the WIN employee performs no services during any such 
month, that month shall not be counted in computing the WIN employee's 
``first 12 months of employment (whether or not consecutive)''. Thus, if 
the initial date of employment of a WIN employee is June 15, the first 
month of employment of such employee shall be the period beginning June 
15, and ending July 14. The second month of employment is the period 
beginning July 15 and ending August 14. If during such second month of 
employment the employee performs no services for the taxpayer, that 
month is not counted in determining the employee's first 12 months of 
employment (whether or not consecutive).

[38 FR 6154, Mar. 7, 1973]



Sec.  1.50A-4  Exceptions to the application of Sec.  1.50A-3.

    (a) In general. Notwithstanding the provisions of paragraph (a) of 
Sec.  1.50A-3, a termination of employment shall not be deemed to occur 
if paragraph (b) (relating to voluntary termination of employment), 
paragraph (c) (relating to

[[Page 531]]

termination of employment due to disability), paragraph (d) (relating to 
termination of employment due to misconduct), paragraph (f) (relating to 
transactions to which section 381(a) applies), or paragraph (g) 
(relating to mere change in form of conducting a trade or business) 
applies.
    (b) Voluntary termination of employment. A termination of employment 
shall not be deemed to occur for purposes of paragraph (a) of Sec.  
1.50A-3 if the employee voluntarily leaves the employment of the 
taxpayer. If the taxpayer makes the working conditions of the employee 
so untenable that the employee is, in effect, compelled by the taxpayer 
to quit, or if the employee is coerced into quitting, the employee will 
not be deemed to have voluntarily left the employment of the taxpayer. 
For purposes of the preceding sentence, a substantial reduction in the 
benefits of employment of an employee (such as a substantial decrease in 
the hours of the employee's working week) shall constitute untenable 
working conditions. An employee has voluntarily left the employment of 
the taxpayer if he leaves for any reason external to his employment, 
such as sickness or death in the employee's family which the employee 
feels necessitates his quitting work with the taxpayer to remain at 
home. Any employee who participates in an authorized strike (as finally 
determined by a court, labor relations administrative body, or arbiter) 
will not be deemed to have voluntarily left the employment of the 
taxpayer.
    (c) Termination of employment due to death or disability. A 
termination of employment shall not be deemed to occur for purposes of 
paragraph (a) of Sec.  1.50A-3 if, after the initial date of employment 
(as defined in paragraph (c)(1) of Sec.  1.50A-3) and before the close 
of the period referred to in paragraph (a)(1) of Sec.  1.50A-3, the 
employee becomes disabled, by reason of illness or injury (including a 
disability relating to the employment), to perform the services required 
by such employment, unless, before the close of such period:
    (1) Such disability is removed,
    (2) The employer knows of the removal of the disability, and
    (3) The employer fails to offer reemployment to such employee.

The death of an employee shall not be deemed a termination of employment 
for purposes of paragraph (a) of Sec.  1.50A-3.
    (d) Termination of employment due to misconduct. A termination of 
employment shall not be deemed to occur for purposes of paragraph (a) of 
Sec.  1.50A-3 if it is determined by the appropriate State 
administrative agency or State court that under the applicable State 
unemployment compensation law such termination was due to the misconduct 
of the WIN employee. If the WIN employee is not covered by the 
applicable State unemployment compensation law (or if the employee did 
not work for the minimum period required to qualify for unemployment 
compensation or if the employee did not apply for unemployment 
compensation), a termination of employment shall not be deemed to occur 
for purposes of paragraph (a) of Sec.  1.50A-3 if the taxpayer 
demonstrates by convincing evidence that, were such employee covered by 
the applicable State unemployment compensation law (or if the employee 
had worked for such minimum period or if the employee had applied for 
unemployment compensation), he could reasonably have been found by such 
administrative agency or court to have been terminated for misconduct.
    (e) Recordkeeping requirement. A taxpayer who is claiming that a 
termination of employment falls within the provisions of paragraph (b), 
(c), or (d) of this section shall maintain sufficient records to support 
his claim until the expiration of the pertinent period of limitations.
    (f) Transactions to which section 381(a) applies--(1) General rule. 
The employment relationship between the taxpayer and a WIN employee (as 
defined in paragraph (h) of Sec.  1.50B-1) shall not be deemed 
terminated for purposes of paragraph (a) of Sec.  1.50A-3 in the case of 
a transaction to which section 381(a) (relating to carryovers in certain 
corporate acquisitions) applies. If there is a termination of employment 
(within the meaning of paragraph (a) of Sec.  1.50A-3 and this section) 
by the acquiring corporation with respect to the WIN employee described 
in the preceding sentence, or if the acquiring corporation fails to pay 
comparable wages to

[[Page 532]]

such employee (within the meaning of paragraph (a)(2) of Sec.  1.50A-3), 
then paragraph (a)(3) of Sec.  1.50A-3 shall apply to the acquiring 
corporation with respect to the credit allowed the acquired corporation 
as well as the credit allowed the acquiring corporation with respect to 
such employee. For purposes of the preceding sentence, the initial date 
of employment (as defined in paragraph (c)(1) of Sec.  1.50A-3) of such 
employee with respect to the acquired corporation shall be deemed to be 
the initial date of employment of such employee with respect to the 
acquiring corporation and employment by the acquired corporation shall 
be deemed employment by the acquiring corporation.
    (2) Examples. This paragraph may be illustrated by the following 
examples:

    Example 1. (i) X Corporation, a wholly owned subsidiary of Y 
Corporation, incurred WIN expenses of $12,000 for its taxable year 
ending December 31, 1972, with respect to WIN employees hired on March 
1, 1972. Both X and Y made their returns on the basis of a calendar 
year. For the taxable year 1972 X Corporation's credit earned of $2,400 
(20 percent of $12,000) was allowed under section 40 as a credit against 
its liability for tax. On December 15, 1973, X Corporation is liquidated 
under section 332 and all of its assets and liabilities are transferred 
to Y Corporation in a transaction to which section 334(b)(2) is not 
applicable. In addition, Y Corporation continues the employment of the 
WIN employees which were employed by X Corporation and with respect to 
which X Corporation was allowed the credit for its taxable year 1972.
    (ii) Under subparagraph (1) of this paragraph, a termination of 
employment of the WIN employees shall not be deemed to occur for 
purposes of paragraph (a)(1) of Sec.  1.50A-3 due to the liquidation of 
X Corporation on December 15, 1973. Thus, no recapture determination 
under paragraph (a)(3) of Sec.  1.50A-3 shall be made with respect to X 
Corporation.
    Example 2. (i) The facts are the same as in Example 1 and, in 
addition, on February 2, 1974, Y Corporation terminates the employment 
of the employees with respect to whom X Corporation had incurred WIN 
expenses. The termination is a termination for purposes of paragraph 
(a)(1) of Sec.  1.50A-3. For purposes of applying the period described 
in paragraph (a)(1) of Sec.  1.50A-3, the date the employees reported 
for work at X Corporation is deemed to be the initial date of employment 
of the employees with respect to Y Corporation.
    (ii) Under subparagraph (1) of this paragraph, a termination of 
employment of the WIN employees shall not be deemed to occur for 
purposes of paragraph (a)(1) of Sec.  1.50A-3 due to the liquidation of 
X Corporation on December 15, 1973. However, a termination of employment 
of the WIN employees is deemed to occur for purposes of paragraph (a)(1) 
of Sec.  1.50A-3 on February 2, 1974. Thus, Y Corporation shall make a 
recapture determination under paragraph (a) of Sec.  1.50A-3 with 
respect to the credit allowed X Corporation with respect to the WIN 
employees.

    (g) Mere change in form of conducting a trade or business--(1) 
General rule. (i) The employment relationship between the taxpayer and a 
WIN employee (as defined in paragraph (h) of Sec.  1.50B-1) shall not be 
deemed terminated for purposes of paragraph (a) of Sec.  1.50A-3 in the 
case of a mere change in the form of conducting the trade or business in 
which such employment occurs, provided that the conditions set forth in 
subdivision (ii) of this subparagraph are satisfied.
    (ii) The conditions referred to in subdivision (i) of this 
subparagraph are as follows:
    (a) The WIN employee described in subdivision (i) of this 
subparagraph is retained in the same trade or business,
    (b) The taxpayer retains a substantial ownership interest in such 
trade or business,
    (c) Substantially all the assets necessary to operate such trade or 
business are transferred to the transferee who continues the employment 
of the WIN employee described in subdivision (i) of this subparagraph, 
and
    (d) The basis of the assets described in (c) of this subdivision in 
the hands of the transferee is determined in whole or in part by 
reference to the basis of such assets in the hands of the transferor.


This subparagraph shall not apply if paragraph (e) of this section 
(relating to transactions to which section 381(a) applies) is applicable 
with respect to such transfer.
    (2) Substantial interest. For purposes of this paragraph, the 
taxpayer shall be considered as having retained a substantial ownership 
interest in the trade or business only if, after the change in form, the 
ownership interest in such trade or business by such taxpayer--
    (i) Is substantial in relation to the total ownership interests of 
all persons, or

[[Page 533]]

    (ii) Is equal to or greater than the ownership interest prior to the 
change in form.

Thus, where a taxpayer owns a 5-percent interest in a partnership, and, 
after the incorporation of that partnership, the taxpayer retains at 
least a 5-percent interest in the corporation, the taxpayer will be 
considered as having retained a substantial interest in the trade or 
business as of the date of the change in form because of the application 
of the rule contained in subdivision (ii) of this subparagraph.
    (3) Termination of employment. (i) If employment of a WIN employee 
described in subparagraph (1)(i) of this paragraph is terminated by the 
transferee, the employment of such employee shall be deemed terminated 
by the taxpayer for purposes of paragraph (a) of Sec.  1.50A-3. For 
purposes of determining the period described in paragraph (a)(1) of 
Sec.  1.50A-3 with respect to such taxpayer employment by the transferee 
shall be deemed employment by the transferor.
    (ii) If in any taxable year the taxpayer does not retain a 
substantial ownership interest in the trade or business directly or 
indirectly (through ownership in other entities provided that such other 
entities' bases in such interest are determined in whole or in part by 
reference to the basis of such interest in the hands of the taxpayer) 
then, for purposes of paragraph (a)(1) of Sec.  1.50A-3, there shall be 
deemed to be a termination of employment of the WIN employees described 
in subparagraph (1)(i) of this paragraph on the first date on which such 
taxpayer does not retain a substantial interest in the trade or 
business. For purposes of determining the period described in paragraph 
(a)(1) of Sec.  1.50A-3, employment by the transferee shall be deemed 
employment by the transferor. Any taxpayer who seeks to establish his 
interest in a trade or business under the rule of this subdivision shall 
maintain adequate records to demonstrate his indirect interest in such 
trade or business after any such transfer or transfers.
    (iii) Notwithstanding subparagraph (1) of this paragraph and 
subdivision (ii) of this subparagraph in the case of a mere change in 
the form of a trade or business, if the interest of a taxpayer in the 
trade or business is reduced but such taxpayer has retained a 
substantial interest in such trade or business, paragraph (a)(2) of 
Sec.  1.50A-5 (relating to electing small business corporations), 
paragraph (a)(2) of Sec.  1.50A-6 (relating to estates or trusts), or 
paragraph (a)(2)(ii) of Sec.  1.50A-7 (relating to partnerships) shall 
apply, as the case may be.
    (4) Failure to pay comparable wages. If the transferee fails to pay 
comparable wages (within the meaning of paragraph (a)(2) of Sec.  1.50A-
3) to the WIN employee within the period described in paragraph (a)(1) 
of Sec.  1.50A-3, then such failure shall be deemed to be a failure of 
the transferor (or in a case where the transferor is a partnership, 
estate, trust, or electing small business corporation, the partners, 
beneficiaries, or shareholders), and a recapture determination shall be 
made with respect to such WIN employee as provided in Sec.  1.50A-3. For 
purposes of determining the period described in paragraph (a)(1) of 
Sec.  1.50A-3 with respect to such transferor (or such partners, 
beneficiaries, or shareholders), employment by the transferee shall be 
deemed employment by such transferor. For special rules in the case of 
an electing small business corporation (as defined in section 1371(b)), 
an estate or trust, or a partnership, see respectively, Sec.  1.50A-5, 
Sec.  1.50A-6, or Sec.  1.50A-7.
    (5) Examples. This paragraph may be illustrated by the following 
examples in each of which it is assumed that the transfer satisfies the 
conditions of subparagraphs (1)(ii) (a), (c) and (d) of this paragraph.

    Example 1. (i) On January 1, 1972, A, an individual, employed WIN 
employees in his sole proprietorship. A incurred WIN expenses with 
respect to these employees of $12,000 for the taxable year ending 
December 31, 1972. For the taxable year 1972 A's credit earned of $2,400 
(20 percent of $12,000) was allowed under section 40 as a credit against 
his liability for tax. On March 15, 1973, A transferred all of the 
assets used in his sole proprietorship to X Corporation, a newly formed 
corporation, in exchange for 45 percent of the stock of X Corporation.
    (i) Under subparagraph (1)(i) of this paragraph, paragraph (a) of 
Sec.  1.50A-3 does not apply to the March 15, 1973, transfer to X 
Corporation.
    Example 2. (i) The facts are the same as in Example 1 and in 
addition on June 1, 1973, X

[[Page 534]]

Corporation terminates the employment of WIN employees with respect to 
whom 50 percent of the WIN expenses were incurred during A's 1972 
taxable year.
    (ii) Under subparagraph (1)(i) of this paragraph, paragraph (a) of 
Sec.  1.50A-3 does not apply to the March 15, 1973, transfer to X 
Corporation. However, under subparagraph (3)(i) of this paragraph, 
paragraph (a) of Sec.  1.50A-3 applies to the June 1, 1973, termination 
of WIN employees by X Corporation. The actual period of employment of 
such WIN employees is 1 year and 5 months (that is, the period beginning 
on January 1, 1972, and ending on June 1, 1973). For taxable year 1972, 
A's recomputed credit earned is $1,200 (20 percent of $6,000). The 
income tax imposed by chapter 1 of the Code on A for the taxable year 
1973 is increased by the $1,200 decrease in his credit earned for the 
taxable year 1972 (that is, $2,400 original credit earned minus $1,200 
recomputed credit earned).
    Example 3. (i) The facts are the same as in Example 1 and in 
addition on April 1, 1973, X Corporation begins paying wages to the 
employees referred to in Example 1 which are less than the wages paid to 
its other employees who perform comparable services.
    (ii) Under subparagraph (1)(i) of this paragraph, paragraph (a)(1) 
of Sec.  1.50A-3 does not apply to the March 15, 1973, transfer to X 
Corporation. However, under subparagraph (4) of this paragraph, 
paragraph (a) of Sec.  1.50A-3 applies to the failure of X Corporation 
to pay wages to the WIN employees which are equal to the wages paid to 
its other employees who perform comparable services. For taxable year 
1972, A's recomputed credit earned is zero. The income tax imposed by 
chapter 1 of the Code on A for the taxable year 1973 is increased by the 
$2,400 decrease in his credit earned for the taxable year 1972.
    Example 4. (i) On January 1, 1972, partnership ABC, which makes its 
returns on the basis of a calendar year, employed WIN employees. 
Partnership ABC incurred WIN expenses with respect to these employees of 
$20,000 for the taxable year. Partnership ABC has 10 partners who make 
their returns on the basis of a calendar year and share partnership 
profits equally. Each partner's share of the WIN expenses is 10 percent, 
that is, $2,000. On March 15, 1973, partnership ABC transfers all of the 
assets used in its trade or business to the X Corporation, a newly 
formed corporation, in exchange for its stock and immediately thereafter 
transfers 10 percent of the stock to each of the 10 partners.
    (ii) Under subparagraph (1)(i) of this paragraph, paragraph (a)(1) 
of Sec.  1.50A-1 does not apply to the March 15, 1973, transfer by the 
ABC Partnership to X Corporation.
    Example 5. (i) The facts are the same as in Example 4 except that 
partnership ABC transfers 10 percent of the stock in X Corporation to 
each of eight partners, 20 percent to partner A, and cash to partner B.
    (ii) Under subparagraph (1)(i) of this paragraph, with respect to 
all of the partners (including partner A) except partner B, paragraph 
(a)(1) of Sec.  1.50A-3 does not apply to the March 15, 1973, transfer 
by the ABC Partnership. Paragraph (a)(1) of Sec.  1.50A-3 applies with 
respect to partner B's $2,000 share of the WIN expenses. See paragraph 
(a)(2) of Sec.  1.50A-7.
    Example 6. (i) X Corporation operates a manufacturing business and a 
separate retail sales business. During the month of January 1972, X 
incurred WIN expenses in its manufacturing business. On February 10, 
1973, X transfers all the assets used in its manufacturing business to 
Partnership XY in exchange for a 50 percent interest in such 
partnership.
    (ii) Under subparagraph (1)(i) of this paragraph, paragraph (a)(1) 
of Sec.  1.50A-3 does not apply to the February 10, 1973, transfer to 
Partnership XY.

[T.D. 7263, 38 FR 6156, Mar. 7, 1973; 38 FR 8656, Apr. 5, 1973]



Sec.  1.50A-5  Electing small business corporations.

    (a) In general--(1) Termination of employment by a corporation. If 
an electing small business corporation (as defined in section 1371(b)) 
or a former electing small business corporation terminates (in a 
termination subject to the provisions of paragraph (a) of Sec.  1.50A-3) 
the employment of any WIN employee with respect to whom WIN expenses 
have been paid or incurred, a recapture determination shall be made 
under Sec.  1.50A-3 with respect to each shareholder who is treated, 
under paragraph (a) of Sec.  1.50B-2 as a taxpayer who paid or incurred 
such expenses. Each such recapture determination shall be made with 
respect to the pro rata share of the WIN expenses of such employee which 
were taken into account by such shareholder under paragraph (a) of Sec.  
1.50B-2. For purposes of each such recapture determination the period of 
employment of such employee or employees shall be the period beginning 
with the initial date of employment (as defined in paragraph (c)(1) of 
Sec.  1.50A-3) with respect to the electing small business corporation 
and ending with the date of such employee's termination (as defined in 
paragraph (a)(1)(ii) of Sec.  1.50A-3). For the definition of the term 
``recapture determination'' see paragraph (a)(3) of Sec.  1.50A-3.

[[Page 535]]

    (2) Disposition of shareholder's interest. (i) If--
    (a) WIN expenses are apportioned to a shareholder of an electing 
small business corporation who takes such expenses into account in 
computing his WIN expenses, and
    (b) After the end of the shareholder's taxable year in which such 
apportionment was taken into account and before the close of the period 
to which paragraph (a)(1) of Sec.  1.50A-3 applies with respect to the 
employee to which such WIN expenses relate, such shareholder's 
proportionate stock interest in such corporation is reduced (for 
example, by a sale or redemption, or by the issuance of additional 
shares) below the percentage specified in subdivision (ii) of this 
subparagraph,

then, on the date of such reduction the employment of such employee 
shall be deemed terminated with respect to such shareholder to the 
extent of the actual reduction in such shareholder's proportionate stock 
interest. (For example, if $100 of WIN expenses were apportioned to a 
shareholder and if his proportionate stock interest is reduced from 60 
percent to 30 percent (that is, 50 percent of his original interest), 
then the employment of the employee to which such WIN expenses relate 
shall be deemed terminated as to that shareholder to the extent of $50.) 
Accordingly, a recapture determination shall be made with respect to 
such shareholder. For purposes of such recapture determination the 
period of employment of any employee or employees with respect to whom 
WIN expenses were paid or incurred shall be the period beginning with 
the initial date of employment (as defined in paragraph (c)(1) of Sec.  
1.50A-3) with respect to the electing small business corporation and 
ending with the date on which such reduction occurs.
    (ii) The percentage referred to in subdivision (i)(b) of this 
subparagraph is 66\2/3\ percent of the shareholder's proportionate stock 
interest in the corporation on the date of the apportionment under 
paragraph (a) of Sec.  1.50B-2. However, once employment of an employee 
has been treated under this subparagraph as having terminated with 
respect to the shareholder to any extent, the percentage referred to 
shall be 33\1/3\ percent of the shareholder's proportionate stock 
interest in the corporation on the date of apportionment under paragraph 
(a) of Sec.  1.50B-2.
    (iii) In determining a shareholder's proportionate stock interest in 
a former electing small business corporation for purposes of this 
subparagraph, the shareholder shall be considered to own stock in such 
corporation which he owns directly or indirectly (through ownership in 
other entities provided such other entities' bases in such stock are 
determined in whole or in part by reference to the basis of such stock 
in the hands of the shareholder). For example, if A, who owns all of the 
100 shares of the outstanding stock of corporation X, a corporation 
which was formerly an electing small business corporation, transfers on 
November 1, 1973, 70 shares of X stock to corporation Y in exchange for 
90 percent of the stock of Y in a transaction to which section 351 
applies, then, for purposes of subdivision (i) of this subparagraph, A 
shall be considered to own 93 percent of the stock of X, 30 percent 
directly and 63 percent indirectly (i.e., 90 percent of 70). Any 
taxpayer who seeks to establish his interest in the stock of a former 
electing small business corporation under the rule of this subdivision 
shall maintain adequate records to demonstrate his indirect interest in 
the corporation after any such transfer or transfers.
    (3) Computation of the first 12 months of employment. The period 
described in paragraph (a)(1) of Sec.  1.50A-3 shall not be affected by 
a change in the shareholders in such corporation and shall not be 
affected by a reduction in any shareholder's proportionate stock 
interest in such corporation (for example, by a sale or redemption or by 
the issuance of additional shares). Thus, the first 12 months of 
employment (whether or not consecutive) of any WIN employee shall be the 
same with respect to any shareholder who is allowed a credit under 
section 40 for salaries and wages paid or incurred for services rendered 
by such employee. Also, such first 12 months of employment and the 
period described in section 50B(c)(4) with respect to any WIN employee 
shall not be deemed to begin

[[Page 536]]

again in the case of a corporation making a valid election under section 
1372.
    (b) Election of a small business corporation under section 1372--(1) 
General rule. If a corporation makes a valid election under section 1372 
to be an electing small business corporation (as defined in section 
1371(b)), then on the last day of the first taxable year immediately 
preceding the taxable year for which such election is effective, the 
employment of any WIN employees whose initial date of employment (as 
defined in paragraph (c)(1) of Sec.  1.50A-3) occurred in taxable years 
prior to the first taxable year for which the election is effective (and 
whose employment has not been terminated prior to such last day) shall 
be considered as having been terminated on such last day with respect to 
the WIN expenses paid or incurred by such corporation and Sec.  1.50A-3 
shall apply to such corporation. However, if the corporation and each of 
the persons who are shareholders of the corporation on the first day of 
the first taxable year for which the election under section 1372 is to 
be effective, or on the date of such election, whichever is later, 
execute the agreement specified in subparagraph (2) of this paragraph, 
Sec.  1.50A-3 shall not apply with respect to any such WIN expenses by 
reason of the election by the corporation under section 1372.
    (2) Agreement of shareholders and corporation. (i) The agreement 
referred to in subparagraph (1) of this paragraph shall be signed by the 
shareholders and by the corporation. The agreement shall recite that:
    (a) In the event the employment of any WIN employee described in 
subparagraph (1) of this paragraph is later terminated (in a termination 
subject to the rules contained in paragraph (a) of Sec.  1.50A-3) during 
a taxable year of the corporation for which the election under section 
1372 is effective, each signer agrees to notify the district director or 
the director of the Internal Revenue service center of such termination, 
and agrees to be jointly and severally liable to pay to the district 
director or the director of the Internal Revenue service center an 
amount equal to the increase in tax which would have been imposed by 
Sec.  1.50A-3 on the corporation but for the agreement under this 
paragraph.
    (b) In the event any WIN employee described in subparagraph (1) of 
this paragraph is paid wages (as defined in section 50B(b) and paragraph 
(b) of Sec.  1.50B-1) by such electing corporation, which are less than 
the wages paid to other employees of such electing corporation who 
perform comparable services (as defined in paragraph (a)(2)(ii) of Sec.  
1.50A-3), during a taxable year of the corporation for which the 
election under section 1372 is effective, each signer agrees to notify 
the district director or the director of the Internal Revenue service 
center of such failure to pay equal wages for comparable services, and 
agrees to be jointly and severally liable to pay to the district 
director or the director of the Internal Revenue service center an 
amount equal to the increase in tax which would have been imposed by 
Sec.  1.50A-3 on the corporation as a result of such failure but for the 
election under section 1372.

For purposes of computing the period described in paragraph (a)(1) of 
Sec.  1.50A-3, the period of employment by the corporation before the 
election under section 1372 shall be added to the period of employment 
by the electing small business corporation after such election.
    (ii) The agreement shall set forth the name, address, and taxpayer 
account number of each party and the internal revenue district or 
service center in which each such party files his or its income tax 
return for the taxable year which includes the last day of the 
corporation's taxable year immediately preceding the first taxable year 
for which the election under section 1372 is effective. The agreement 
may be signed on behalf of the corporation by any person who is duly 
authorized. The agreement shall be filed with the district director or 
the director of the Internal Revenue service center with whom the 
corporation files its income tax return for its taxable year immediately 
preceding the first taxable year for which the election under section 
1372 is effective and shall be filed on or before the due date 
(including extensions of time) of such return. For purposes of the 
preceding sentence, the

[[Page 537]]

district director or the director of the Internal Revenue service center 
may, if good cause is shown, permit the agreement to be filed on a later 
date.
    (c) Examples. This section may be illustrated by the following 
examples:

    Example 1. (i) X Corporation, an electing small business corporation 
which makes its returns on the basis of the calendar year, hired 
employees under a WIN program on July 1, 1972, and incurred expenses for 
such employees during the following 12 months at an initial rate of 
$10,000 per month. For taxable year 1972, X Corporation had 20 shares of 
stock outstanding which were owned equally by A and B who make their 
returns on the basis of a calendar year. Under paragraph (a) of this 
section, the WIN expenses were apportioned to the shareholders of X 
Corporation as follows:

 
                                                           Period ending
                                                           Dec. 31, 1973
 
  Total WIN expenses for the taxable year...............         $60,000
Shareholder A (10/20)...................................          30,000
Shareholder B (10/20)...................................          30,000
 


Assuming that during 1972 shareholders A and B did not directly incur 
any WIN expenses and that they did not own any interest in other 
electing small business corporations, partnerships, estates, or trusts 
incurring WIN expenses, the WIN expenses attributable to each 
shareholder is $30,000. For the taxable year 1972, each shareholder's 
credit earned of $6,000 (20 percent of $30,000) was allowed under 
section 40 as a credit against his liability for tax.
    (ii) On January 1, 1973, X Corporation terminates the employment of 
the employees accounting for 50 percent of its WIN expenses incurred to 
that date, or $30,000 in salaries and wages. The actual period of 
employment for these WIN employees was 6 months. For taxable year 1972, 
each shareholder's recomputed credit is $3,000 (20 percent of $15,000). 
The income tax imposed by chapter 1 of the Code on each of the 
shareholders for the taxable year 1973 is increased by the $3,000 
decrease in his credit earned for the taxable year 1972 (that is, $6,000 
original credit earned minus $3,000 recomputed credit earned).
    Example 2. (i) The facts are the same as in subdivision (i) of 
example 1, except that on January 1, 1973, shareholder A sells five of 
his 10 shares of stock in X Corporation to C. No other changes in stock 
ownership occurred during 1973. Under paragraph (a)(2) of this section, 
the WIN expenses of X Corporation were apportioned on December 31, 1973, 
to the shareholders of X Corporation as follows:

 
                                                           Period ending
                                                           Dec. 31, 1972
 
  Total WIN expenses for the taxable year...............         $60,000
Shareholder A (5/20)....................................          15,000
Shareholder B (10/20)...................................          30,000
Shareholder C (5/20)....................................          15,000
 

    (ii) Under paragraph (a)(2) of this section, on January 1, 1973, the 
employment of these WIN employees shall be deemed terminated by 
shareholder A with respect to 50 percent of the WIN expenses allocated 
to him since immediately after the January 1, 1973, sale A's 
proportionate stock interest in X Corporation is reduced to 50 percent 
of the proportionate stock interest in X Corporation which he held for 
taxable year 1972. The actual period of employment of the WIN employees 
accounting for the 50 percent of the WIN expenses originally allocated 
to A is 6 months (that is, the period beginning with July 1, 1972, and 
ending with January 1, 1973). The income tax imposed by chapter 1 of the 
Code on shareholder A for the taxable year 1973 is increased by the 
$3,000 decrease in his credit earned for the taxable year 1972 (that is, 
$6,000 original credit earned minus $3,000 recomputed credit earned).

    (d) Termination or revocation of an election under section 1372. The 
employment of employees with respect to whom WIN expenses were paid or 
incurred shall not be considered to have been terminated solely by 
reason of a termination or revocation of a corporation's election under 
section 1372.

[38 FR 6158, Mar. 7, 1973]



Sec.  1.50A-6  Estates and trusts.

    (a) In general--(1) Termination of employment by an estate or trust. 
If an estate or trust terminates (in a termination subject to the 
provisions of paragraph (a) of Sec.  1.50A-3) the employment of any 
employee with respect to whom WIN expenses have been paid or incurred, a 
recapture determination shall be made under Sec.  1.50A-3 with respect 
to the estate or trust, and each beneficiary who is treated, under 
paragraph (a) of Sec.  1.50B-3 as a taxpayer who paid or incurred such 
expenses. For purposes of each such recapture determination the period 
of employment of such employees shall be the period beginning with the 
initial date of employment (as defined in paragraph (c)(1) of Sec.  
1.50A-3) with respect to the estate or trust and ending with the date of 
such employee or employees' termination (as defined in paragraph 
(a)(1)(ii) of Sec.  1.50A-3). For definition of

[[Page 538]]

``recapture determination'' see paragraph (a)(3) of Sec.  1.50A-3.
    (2) Disposition of interest. (i) If--
    (a) WIN expenses are apportioned to an estate or trust, or to a 
beneficiary of an estate or trust who takes such expenses into account 
in computing his WIN expenses, and
    (b) After the end of the estate's, trust's, or beneficiary's taxable 
year in which such apportionment was taken into account and before the 
close of the period to which paragraph (a)(1) of Sec.  1.50A-3 applies 
with respect to the employees to which such WIN expenses relate, such 
estate's, trust's, or such beneficiary's proportionate interest in the 
income of the estate or trust is reduced (for example, by a sale, or by 
the terms of the estate or trust instrument) below the percentage 
specified in subdivision (ii) of this subparagraph,


then, on the date of such reduction, the employment of such employee 
shall be deemed terminated with respect to such estate, trust, or 
beneficiary to the extent of the actual reduction in such estate's, 
trust's, or beneficiary's proportionate interest in the income of the 
estate or trust. (For example, if $100 of WIN expenses were apportioned 
to a beneficiary and if his proportionate interest in the income of the 
estate or trust is reduced from 60 percent to 30 percent (that is, 50 
percent of his original interest), then the employment of the employee 
to which such WIN expenses relates shall be deemed terminated as to that 
beneficiary to the extent of $50.) Accordingly, a recapture 
determination shall be made with respect to such estate, trust, or 
beneficiary. For purposes of such recapture determination the period of 
employment of any employee or employees with respect to whom WIN 
expenses were paid or incurred shall be the period beginning with the 
initial date of employment (as defined in paragraph (c)(1) of Sec.  
1.50A-3) with respect to the estate or trust and ending with the date on 
which such reduction occurs.
    (ii) The percentage referred to in subdivision (i)(b) of this 
subparagraph is 66\2/3\ percent of the estate's, trust's, or 
beneficiary's proportionate interest in the income of the estate or 
trust for the taxable year of the apportionment under paragraph (a) of 
Sec.  1.50B-3. However, once employment of an employee has been treated 
under this subparagraph as having terminated with respect to the estate, 
trust, or beneficiary to any extent, the percentage referred to shall be 
33\1/3\ percent of the estate's, trust's, or beneficiary's proportionate 
interest in the income of the estate or trust for the taxable year of 
the apportionment under paragraph (a) of Sec.  1.50B-3.
    (iii) In determining a beneficiary's proportionate interest in the 
income of an estate or trust for purposes of this subparagraph, the 
beneficiary shall be considered to own any interest in such an estate or 
trust which he owns directly or indirectly (through ownership in other 
entities provided such other entities' bases in such interests are 
determined in whole or in part by reference to the basis of such 
interest in the hands of the beneficiary). For example, if A, whose 
proportionate interest in the income of trust X is 30 percent, transfers 
all of such interest to corporation Y in exchange for all of the stock 
of Y in a transaction to which section 351 applies, then, for purposes 
of subdivision (i) of this subparagraph, A shall be considered to own a 
30-percent interest in trust X. Any taxpayer who seeks to establish his 
interest in an estate or trust under the rule of this subdivision shall 
maintain adequate records to demonstrate his indirect interest in the 
estate or trust after any such transfer or transfers.
    (b) Computation of the first 12 months of employment. The period 
described in paragraph (a)(1) of Sec.  1.50A-3 shall not be affected by 
a change in the beneficiaries of an estate or trust and shall not be 
affected by a reduction or a termination of a beneficiary's interest in 
the income of such estate or trust. Thus, the period described in 
paragraph (a)(1) of Sec.  1.50A-3 for any WIN employee shall be the same 
with respect to a trust or estate and any beneficiary of such trust or 
estate which is allowed a credit under section 40 for salaries and wages 
paid or incurred for services rendered by such employee. Also, such 
period with respect to any WIN employee shall not be deemed to begin 
again as the result of the acquisition of the interest by another.

[[Page 539]]

    (c) Examples. Paragraph (a) of this section may be illustrated by 
the following examples:

    Example 1. (i) XYZ Trust, which makes its returns on the basis of 
the calendar year, hired employees under the WIN program on July 1, 
1972, and incurred expenses for such employees during the following 12 
months at an initial rate of $10,000 per month. For the taxable year 
1972 the income of XYZ Trust is $60,000, which is allocated equally to 
XYZ Trust and beneficiary A. Beneficiary A makes his returns on the 
basis of a calendar year. Under paragraph (a) of this section, the WIN 
expenses were apportioned to XYZ Trust and to beneficiary A as follows:

 
                                                           Period ending
                                                           Dec. 31, 1972
 
  Total WIN expenses for the taxable year...............         $60,000
XYZ Trust ($30,000/$60,000).............................          30,000
Beneficiary A ($30,000/$60,000).........................          30,000
 


Assuming that during 1972 beneficiary A did not directly incur any WIN 
expenses and that he did not own any interest in other estates, trusts, 
electing small business corporations, or partnerships incurring WIN 
expenses, the WIN expenses incurred by XYZ Trust and by beneficiary A 
are $30,000 each. For the taxable year 1972, XYZ Trust and beneficiary A 
each had a credit earned of $6,000. Each credit earned was allowed under 
section 40 as a credit against the liability for tax.
    (ii) On January 1, 1973, XYZ Trust terminates the employment of its 
employees accounting for 50 percent of its WIN expenses incurred to that 
date, or $30,000 in salaries and wages. The actual period of employment 
for these WIN employees was 6 months. For the taxable year 1972, XYZ 
Trust's and beneficiary A's recomputed credit is $3,000 (20 percent of 
$15,000). The income tax imposed by chapter 1 of the Code on XYZ Trust 
and on beneficiary A for the taxable year 1973 is increased by the 
$3,000 decrease in his credit earned for the taxable year 1972 (that is, 
$6,000 original credit earned minus $3,000 recomputed credit earned).
    Example 2. (i) The facts are the same as in subdivision (i) of 
example 1, except that on January 1, 1973, beneficiary A sells 50 
percent of his interest in the income of XYZ Trust to B. No other 
changes in income interest occurred during 1973. Under paragraph (a)(2) 
of Sec.  1.50B-4, each beneficiary's share and the trust's share of the 
WIN expenses are apportioned as follows:

 
                                                           Period ending
                                                           Dec. 31, 1972
 
  Total WIN expenses for the taxable year...............         $60,000
XYZ Trust ($30,000/$60,000).............................          30,000
Beneficiary A ($15,000/$60,000).........................          15,000
Beneficiary B ($15,000/$60,000).........................          15,000
 

    (ii) Under paragraph (a)(2) of this section, on January 1, 1973, the 
employment of these WIN employees shall be deemed terminated by 
beneficiary A with respect to 50 percent of the WIN expenses allocated 
to him since immediately after the January 1, 1973, sale A's 
proportionate interest in the income of XYZ Trust is reduced to 50 
percent of his proportionate interest in the income of XYZ Trust for the 
taxable year 1972. The period of employment of the WIN employees 
accounting for the 50 percent of the WIN expense originally allocated to 
A is 6 months (that is, the period beginning with July 1, 1972, and 
ending with December 31, 1972). For the taxable year 1972 beneficiary 
A's recomputed credit earned is $3,000 (20 percent of $15,000). The 
income tax imposed by chapter 1 of the Code on beneficiary A for the 
taxable year 1973 is increased by the $3,000 decrease in his credit 
earned for the taxable year 1972 (that is, $6,000 original credit earned 
minus $3,000 recomputed credit earned).

[38 FR 6159, Mar. 7, 1973]



Sec.  1.50A-7  Partnerships.

    (a) In general--(1) Termination of employment by a partnership. If a 
partnership terminates (in a termination subject to the provisions of 
paragraph (a) of Sec.  1.50A-3) the employment of any WIN employee with 
respect to whom WIN expenses have been paid or incurred, a recapture 
determination shall be made under Sec.  1.50A-3 with respect to each 
partner who is treated, under paragraph (a) of Sec.  1.50B-4, as a 
taxpayer with respect to such expenses. Each such recapture 
determination shall be made with respect to the share of the WIN 
expenses with respect to such employee which were taken into account by 
such partner under paragraph (a) of Sec.  1.50B-4. For purposes of each 
such recapture determination the period of employment of any such 
employee shall be the period beginning with the initial date of 
employment (as defined in paragraph (c)(1) of Sec.  1.50A-3) with 
respect to the partnership and ending with the date of such employee's 
termination (as defined in paragraph (a)(1)(ii) of Sec.  1.50A-3). For 
the definition of ``recapture determination'' see paragraph (a)(3) of 
Sec.  1.50A-3.
    (2) Disposition of partner's interest. (i) If--
    (a) WIN expenses are allocated to a partner of a partnership who 
takes such expenses into account in computing his WIN expenses, and

[[Page 540]]

    (b) After the end of the partner's taxable year in which such 
allocation was taken into account and before the close of the period to 
which paragraph (a)(1) of Sec.  1.50A-3 applies with respect to the 
employee to which such WIN expenses relate, such partner's proportionate 
interest in the general profits of the partnership (or in the particular 
expenses) is reduced (for example, by a sale, by a change in the 
partnership agreement, or by the admission of a new partner) below the 
percentage specified in subdivision (ii) of this subparagraph,


then, on the date of such reduction the employment of such employee 
shall be deemed terminated with respect to such partner to the extent of 
the actual reduction in such partner's proportionate interest in the 
general profits (or in the particular expenses) of the partnership. (For 
example, if $100 of WIN expenses were taken into account by a partner 
and if his proportionate interest in the general profits of the 
partnership is reduced from 60 percent to 30 percent (that is, 50 
percent of his original interest), then the employment of the employee 
to which such WIN expenses relate shall be deemed terminated as to that 
partner to the extent of $50.) Accordingly, a recapture determination 
shall be made with respect to such partner. For purposes of such 
recapture determination the period of employment of any employee or 
employees with respect to whom WIN expenses were paid or incurred shall 
be the period beginning with the initial date of employment (as defined 
in paragraph (c)(1) of Sec.  1.50A-3) with respect to the partnership 
and ending with the date on which such reduction occurs.
    (ii) The percentage referred to in subdivision (i)(b) of this 
subparagraph is 66\2/3\ percent of the partner's proportionate interest 
in the general profits (or in the WIN expenses) of the partnership for 
the year of the apportionment under Sec.  1.50B-4(a). However, once 
employment of an employee has been treated under this subparagraph as 
having terminated with respect to the partner to any extent, the 
percentage referred to shall be 33\1/3\ percent of the partner's 
proportionate interest in the general profits (or in the WIN expenses) 
of the partnership for the taxable year of the apportionment under 
paragraph (a) of Sec.  1.50B-4.
    (iii) In determining a partner's proportionate interest in the 
general profits (or in the WIN expenses) of a partnership for purposes 
of this subparagraph, the partner shall be considered to own any 
interest in such a partnership which he owns directly or indirectly 
(through ownership in other entities provided the other entities' bases 
in such interests are determined in whole or in part by reference to the 
basis of such interest in the hands of the partner). For example, if A, 
whose proportionate interest in the general profits of partnership X is 
20 percent, transfers all of such interest to Corporation Y in exchange 
for all of the stock of Y in a transaction to which section 351 applies 
then, for purposes of subdivision (i) of this subparagraph, A shall be 
considered to own a 20 percent interest in partnership X. Any taxpayer 
who seeks to establish his interest in a partnership under the rule of 
this subdivision shall maintain adequate records to demonstrate his 
indirect interest in the partnership after any such transfer or 
transfers.
    (3) Computation of the first 12 months of employment. The period 
described in paragraph (a)(1) of Sec.  1.50A-3 shall not be affected by 
a change in the partners of such partnership and shall not be affected 
by a change in the ratio in which the partners divide the general 
profits (or the WIN expenses) of the partnership. Thus, such period for 
any WIN employee shall be the same with respect to any partner claiming 
a credit under section 40 for salaries and wages paid or incurred for 
services rendered by such employee.
    (b) Examples. Paragraph (a) of this section may be illustrated by 
the following examples:

    Example 1. (i) AB partnership, which makes its returns on the basis 
of the calendar year, hired employees under the WIN program on July 1, 
1972, and incurred expenses for such employees during the following 12 
months at an initial rate of $10,000 per month. Partners A and B, who 
make their returns on the basis of a calendar year, share the profits 
and losses of AB partnership equally. Under paragraph (a)(2) of this 
section, each partner's share of the WIN expenses was approportioned as 
follows:

[[Page 541]]



 
                                                           Period ending
                                                           Dec. 31, 1972
 
  Total WIN expenses for the taxable year...............         $60,000
Partner A's share (50 percent)..........................          30,000
Partner B's share (50 percent)..........................          30,000
 


Assuming that during 1972 A and B did not directly incur any WIN 
expenses and that they did not own any interest in other partnerships, 
electing small business corporations, estates, or trusts incurring WIN 
expenses, each partner's share of the WIN expenses is $30,000. For the 
taxable year 1972, each partner's credit earned of $6,000 (20 percent of 
$30,000) was allowed under section 40 as a credit against his liability 
for tax.
    (ii) On January 1, 1973, AB partnership terminates the employment of 
its employees accounting for 50 percent of its WIN expenses incurred to 
that date, or $30,000 in salaries and wages. The actual period of 
employment for these WIN employees was 6 months. For the taxable year 
1972, each partner's recomputed credit earned is $3,000 (20 percent of 
$15,000). The income tax imposed by chapter 1 of the Code on each of the 
partners for the taxable year 1973 is increased by the $3,000 decrease 
in his credit earned for the taxable year 1972 (that is, $6,000 original 
credit earned minus $3,000 recomputed credit earned).
    Example 2. (i) The facts are the same as in subdivision (i) of 
example 1, except that on January 1, 1973, partner A sells one-half of 
his 50 percent interest in AB partnership to C, to form the ABC 
partnership. No other changes in the partners' proportionate interest in 
the general profits of the partnership occurred during 1973. Under 
paragraph (a)(2) of this section, each partner's share of the WIN 
expenses was apportioned on December 31, 1973, as follows:

 
                                                           Period ending
                                                           Dec. 31, 1973
 
  Total WIN expenses for the taxable year...............         $60,000
Partner A's share (25 percent)..........................          15,000
Partner B's share (50 percent)..........................          30,000
Partner C's share (25 percent)..........................          15,000
 

    (ii) Under paragraph (a)(2) of this section, on January 1, 1973, the 
employment of these WIN employees shall be deemed terminated by partner 
A with respect to 50 percent of the WIN expenses allocated to him since 
immediately after the January 1, 1973, sale, A's proportionate interest 
in the general profits of ABC partnership is reduced to 50 percent of 
his proportionate interest in the general profits of AB partnership for 
1972. The period of employment of the WIN employees accounting for the 
50 percent of the WIN expenses originally allocated to A is 6 months 
(that is, the period beginning with July 1, 1972, and ending with 
December 31, 1972). For the taxable year 1972 partner A's recomputed 
credit earned is $3,000 (20 percent of $15,000). The income tax imposed 
by chapter 1 of the Code on partner A for the taxable year 1973 is 
increased by the $3,000 decrease in his credit earned for the taxable 
year 1972 (that is, $6,000 original credit earned minus $3,000 
recomputed credit earned).

[38 FR 6160, Mar. 7, 1973]



Sec.  1.50B-1  Definitions of WIN expenses and WIN employees.

    (a) WIN expenses--(1) In general. Except as otherwise provided in 
paragraphs (b) through (g) of this section, for purposes of Sec. Sec.  
1.50A-1 through 1.50B-5, the term ``work incentive program expenses'' 
(referred to in Sec. Sec.  1.50A-1 through 1.50B-5 as ``WIN expenses'') 
means the salaries and wages paid or incurred by the taxpayer for 
services rendered during the first 12 months of employment (whether or 
not consecutive) by an employee who is certified by the Secretary of 
Labor as--
    (i) Having been placed in employment by the taxpayer (or if the 
taxpayer is a partner of a partnership, beneficiary of an estate or 
trust, or a shareholder of an electing small business corporation, by 
such partnership, estate, trust, or electing small business corporation) 
under a work incentive (WIN) program established under section 432(b)(1) 
of the Social Security Act (42 U.S.C. 632(b)(1)), and
    (ii) Not having displaced any individual from employment.

The term ``WIN expenses'' includes only salaries and wages paid or 
incurred in taxable years beginning after December 31, 1971. See 
paragraph (c) of Sec.  1.50A-3 for rules relating to the determination 
of the first 12 months of employment (whether or not consecutive).
    (2) Examples. The provisions of subparagraph (1) of this paragraph 
may be illustrated by the following examples:

    Example 1. X Corporation, an accrual basis taxpayer which files its 
return on the basis of the calendar year, hired an employee on July 1, 
1971, who was certified by the Secretary of Labor under this paragraph. 
The first 12 months of employment were continuous. X is entitled to the 
credit provided by section 40 with respect to the salaries or wages 
incurred during its taxable year beginning January 1, 1972, for services 
rendered by that employee during the period beginning July 1, 1971, and 
ending June 30, 1972.
    Example 2. Y, a cash basis taxpayer who files his return on the 
basis of the calendar year, employed A, an employee certified by

[[Page 542]]

the Secretary of Labor under this paragraph, on July 1, 1971. A's first 
12 months of employment were continuous. Y paid A on the basis of a 
semimonthly payroll period, but paid his payroll 2 days after the close 
of the payroll period during which the wages were earned. Thus, Y paid A 
on January 2, 1972, for services rendered between December 16, 1971, and 
December 31, 1971. Y is entitled to the credit provided by section 40 
with respect to the wages paid for services rendered by A during the 
period beginning December 16, 1971, and ending June 30, 1972, because 
those wages were paid by Y in a taxable year beginning after December 
31, 1971.

    (b) Salaries and wages. For purposes of this section, the term 
``salaries and wages'' means only cash remuneration including a check. 
Amounts deducted and withheld from the employee's pay (for example, 
taxes and contributions to health and retirement plans) shall be deemed 
to be cash remuneration even though not actually paid directly to the 
employee.
    (c) Trade or business expenses. The term ``WIN expenses'' includes 
only salaries and wages which are paid or incurred in a trade or 
business of the taxpayer and which are deductible in computing taxable 
income. Thus, salaries and wages paid to domestic employees in a private 
home are not ``WIN expenses''.
    (d) Reimbursed expenses--(1) In general. The term ``WIN expenses'' 
does not include salaries and wages to the extent that the taxpayer is 
reimbursed for such salaries or wages from any source.
    (2) Example. Subparagraph (1) of this paragraph may be illustrated 
by the following example:

    Example. X Company, which makes its return on the basis of the 
calendar year, hired WIN employees on January 1, 1972. X Company has a 
cost-plus construction contract with the Federal Government. The fact 
that X has a construction contract with the Federal Government or anyone 
else does not change its character from a normal business transaction in 
which there has been a sale of materials and services. Thus, the 
salaries or wages paid or incurred for services rendered by these WIN 
employees would not be reimbursed expenses, and X would be entitled to 
the credit provided by section 40.

    (e) Geographical limitation--(1) In general. The term ``WIN 
expenses'' does not include salaries and wages paid or incurred for 
services rendered outside the United States (as defined in sections 638 
(relating to Continental Shelf areas) and 7701(a)(9). However, services 
rendered by any WIN employee outside the United States (as defined in 
sections 638 (relating to Continental Shelf areas) and 7701(a)(9)) shall 
contribute to such employee's first 12 months of employment (whether or 
not consecutive) for purposes of paragraph (a) of Sec.  1.50A-3 and 
paragraph (a) of this section.
    (2) Example. Subparagraph (1) of this paragraph may be illustrated 
by the following example:

    Example. X Corporation, which files its return on the basis of the 
calendar year, hired A, a WIN employee, on January 1, 1972, and 
continuously employed him for the following 24-month period. During 
January and February of 1972, X paid A's wages while he received 
training conducted in Puerto Rico. For the remainder of the calendar 
year A performed services for X within the United States. For purposes 
of paragraph (a) of Sec.  1.50A-3 and paragraph (a) of this section, A's 
first 12 months of employment are January 1, 1972, to December 31, 1972. 
Under subparagraph (1) of this paragraph no wages paid to A for services 
rendered during the months of January and February of 1972 may be taken 
into account by X under paragraph (a) of this section as WIN expenses 
because the services were rendered outside the United States. However, X 
may take into account wages he has incurred with respect to A for the 
period March 1, 1972, to December 31, 1972.

    (f) Maximum period of training or instruction. The term ``WIN 
expenses'' does not include salaries and wages paid or incurred for 
services rendered by a WIN employee after the end of the 24-month period 
beginning with the date of initial employment (as defined in paragraph 
(c)(1) of Sec.  1.50A-3) of the WIN employee.
    (g) Ineligible individuals. The term ``WIN expenses'' does not 
include salaries and wages paid or incurred for services rendered by a 
WIN employee who--
    (1) Bears any of the relationships described in paragraphs (1) 
through (8) of section 152(a) of the Code to the taxpayer, or, if the 
taxpayer is a corporation, to an individual who owns, directly or 
indirectly, more than 50 percent in value of the outstanding stock of 
the corporation (determined with

[[Page 543]]

the application of section 267(c) of the Code),
    (2) If the taxpayer is an estate or trust, is a grantor, 
beneficiary, or fiduciary of the estate or trust, or is an individual 
who bears any of the relationships described in paragraphs (1) through 
(8) of section 152(a) of the Code to a grantor, beneficiary, or 
fiduciary of the estate or trust, or
    (3) Is a dependent (described in section 152(a)(9) of the Code) of 
the taxpayer, or, if the taxpayer is a corporation, of an individual 
described in subparagraph (1), or, if the taxpayer is an estate or 
trust, of a grantor, beneficiary, or fiduciary of the estate or trust.
    (h) WIN employee. For purposes of Sec. Sec.  1.50A-1 through 1.50B-5 
the term ``WIN employee'' means an employee who is certified by the 
Secretary of Labor as meeting the requirements of paragraphs (a)(1) (i) 
and (ii) of this section.
    (i) [Reserved]
    (j) Special rule applicable to transactions to which section 381(a) 
applies and transactions involving a mere change in form of conducting a 
trade or business. The first 12 months of employment (whether or not 
consecutive) and the period described in section 50B (c)(4) of any WIN 
employee, for purposes of determining the amount of WIN expenses (as 
defined in paragraph (a) of Sec.  1.50B-1), shall not be affected by 
transactions to which the rule contained in paragraph (f) (relating to 
transaction to which section 381(a) (relating to certain corporate 
acquisitions) applies), or paragraph (g) (relating to a mere change in 
form of conducting a trade or business) of Sec.  1.50A-4 applies.

[38 FR 6161, Mar. 7, 1973]



Sec.  1.50B-2  Electing small business corporations.

    (a) General rule--(1) In general. In the case of an electing small 
business corporation (as defined in section 1371 (b)), WIN expenses (as 
defined in paragraph (a) of Sec.  1.50B-1) shall be apportioned pro rata 
among the persons who are shareholders of such corporation on the last 
day of such corporation's taxable year, and shall be taken into account 
for the taxable years of such shareholders within which or with which 
the taxable year of such corporation ends. The WIN expenses for each 
employee shall be apportioned separately. In determining who are 
shareholders of an electing small business corporation on the last day 
of its taxable year, the rules of paragraph (d)(1) of Sec.  1.1371-1 and 
of paragraph (a)(2) of Sec.  1.1373-1 shall apply.
    (2) Shareholder as taxpayer. A shareholder to whom WIN expenses are 
apportioned shall, for purposes of the credit allowed by section 40, be 
treated as the taxpayer who paid or incurred the expenses allocated to 
him. If a shareholder takes into account in determining his WIN expenses 
any WIN expenses with respect to an employee of an electing small 
business corporation, and if the employment of such employee is 
terminated in a termination subject to the rules contained in paragraph 
(a) of Sec.  1.50A-3, or if the electing small business corporation 
fails to pay comparable wages and such failure is subject to the rules 
contained in paragraphs (a) (2) and (3) of Sec.  1.50A-3, then such 
shareholder shall make a recapture determination under the provisions of 
section 50A (c) and (d) of the Code and Sec.  1.50A-3. See Sec.  1.50A-
5.
    (3) Computation of the first 12 months of employment. The first 12 
months of employment (whether or not consecutive) and the period 
described in section 50B(c)(4) of any WIN employee for purposes of 
determining the amount of WIN expenses (as defined in paragraph (a) of 
Sec.  1.50B-1) shall not be affected by a change in the shareholders in 
such corporation and shall not be affected by a reduction in any 
shareholder's proportionate stock interest in such corporation (for 
example, by a sale or redemption or by the issuance of additional 
shares). Thus, the first 12 months of employment (whether or not 
consecutive) of any WIN employee shall be the same with respect to any 
shareholder claiming a credit under section 40 for salaries and wages 
paid or incurred for services rendered by such employee. Also, such 
first 12 months of employment and the period described in section 
50B(c)(4), with respect to any WIN employee, shall not be deemed to 
begin again because of the making of a valid election under section 
1372.

[[Page 544]]

    (b) Summary statement. An electing small business corporation shall 
attach to its return a statement showing the apportionment to each 
shareholder of its WIN expenses with respect to each WIN employee.
    (c) Examples. Paragraph (a) of this section may be illustrated by 
the following examples:

    Example 1. (i) X Corporation, an electing small business corporation 
which files its returns on the basis of the calendar year, hired WIN 
employees on July 1, 1972, whose employment was continuous for the next 
24 months. A, a shareholder, has a 10 percent interest in X Corporation. 
X Corporation incurred $24,000 in wages with respect to these WIN 
employees in calendar year 1972, and $48,000 in calendar year 1973. 
Assuming that during 1972 shareholder A did not directly incur any other 
WIN expenses and did not own any other interest in other electing small 
business corporations, partnerships, estates, or trusts that incurred 
WIN expenses, for taxable year 1972 shareholder A's credit earned of 
$480 (10 percent (A's ownership interest) multiplied by $24,000 of WIN 
expenses multiplied by 20 percent) was allowed under section 40 as a 
credit against his liability for tax.
    (ii) On March 1, 1973, shareholder A sold all of his interest to B, 
a new shareholder. Therefore, the employment of the WIN employees is 
deemed terminated for purposes of paragraph (a) of Sec.  1.50A-3 with 
respect to shareholder A. For taxable year 1972, A's recomputed credit 
is zero because the termination occurred before the end of the period 
described in paragraph (a)(1) of Sec.  1.50A-3. The income tax imposed 
by chapter 1 of the Code on A for the taxable year 1973 is increased by 
the $480 decrease in his credit earned for the taxable year 1972 (that 
is, $480 original credit earned minus zero recomputed credit earned). 
Under paragraph (a) of this section A has no credit earned for 1973.
    (iii) Under paragraph (a)(1) of this section, assuming that during 
1973 shareholder B did not directly incur any other WIN expenses and 
that he did not own any interest in other electing small business 
corporations, partnerships, estates, or trusts that incurred WIN 
expenses, shareholder B's credit earned is $480 (10 percent (B's 
ownership interest) multiplied by $24,000 of WIN expenses multiplied by 
20 percent) and is allowable under section 40 as a credit against his 
liability for tax. Under paragraph (a)(3) for purposes of determining 
the period of employment that may be taken into account by B the initial 
date of employment of these WIN employees relates back to the date they 
were first employed, i.e., July 1, 1972. Thus, the first 12 months of 
employment ends on June 30, 1973.
    Example 2. (i) Y Corporation, an electing small business corporation 
which files its return on the basis of the calendar year, hires five WIN 
employees in 1972. The WIN expenses incurred with respect to each 
employee are as follows:

------------------------------------------------------------------------
                    WIN employee No.                       WIN expenses
------------------------------------------------------------------------
1.......................................................          $6,000
2.......................................................           5,000
3.......................................................           4,000
4.......................................................           4,000
5.......................................................           3,000
                                                         ---------------
    Total...............................................          22,000
------------------------------------------------------------------------


On December 31, 1972, Y Corporation has 10 shares of stock outstanding 
which are owned as follows: A owns 3 shares, B owns 2 shares, and C owns 
5 shares.

    (ii) Under this section, the WIN expenses are apportioned to the 
shareholders of Y Corporation as follows:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                      WIN employees                              1               2               3               4               5             Total
--------------------------------------------------------------------------------------------------------------------------------------------------------
  Total WIN expenses....................................          $6,000          $5,000          $4,000          $4,000          $3,000
                                                         ===============================================================================================
Shareholder A (3/10)....................................           1,800           1,500           1,200           1,200             900           6,600
Shareholder B (2/10)....................................           1,200           1,000             800             800             600           4,400
Shareholder C (5/10)....................................           3,000           2,500           2,000           2,000           1,500          11,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

Assume that shareholders A, B, and C did not directly incur any other 
WIN expenses during their taxable year in which falls December 31, 1972 
(the last day of Y Corporation's taxable year), and that such 
shareholders did not own any interest in other electing small business 
corporations, partnerships, estates or trust that incurred WIN expenses. 
The total WIN expenses of shareholder A are $6,600, of shareholder B are 
$4,400, and of shareholder C are $11,000.

[38 FR 6162, Mar. 7, 1973]



Sec.  1.50B-3  Estates and trusts.

    (a) General rule--(1) In general. In the case of an estate or trust, 
WIN expenses (as defined in paragraph (a) of Sec.  1.50B-1) shall be 
apportioned among the estate or trust and its beneficiaries on the basis 
of the income of such estate or trust allocable to each. There shall be 
apportioned to the estate or trust for its taxable year, and to each

[[Page 545]]

beneficiary of such estate or trust for his taxable year in which or 
with which the taxable year of such estate or trust ends, his share (as 
determined under paragraph (b) of this section) of the total WIN 
expenses. The WIN expenses for each employee shall be apportioned 
separately.
    (2) Beneficiary as taxpayer. A beneficiary to whom WIN expenses are 
apportioned shall, for purposes of the credit allowed by section 40, be 
treated as the taxpayer who paid or incurred such WIN expenses allocated 
to him. If a beneficiary takes into account in determining his WIN 
expenses any portion of the WIN expenses paid or incurred by an estate 
or trust and if the employee with respect to which the WIN expenses were 
paid or incurred is terminated in a termination subject to the rules in 
paragraph (a) of Sec.  1.50A-3, or if there is a failure (which is 
subject to the rules is paragraphs (a) (2) and (3) of Sec.  1.50A-3) to 
pay such employee comparable wages then such beneficiary shall make a 
recapture determination under the provisions of section 50A (c) and (d) 
of the Code and Sec.  1.50A-3. See Sec.  1.50A-6.
    (3) Beneficiary. For purposes of this section, the term 
``beneficiary'' includes heir, legatee, and devisee.
    (4) Special rule for termination of interest. If during the taxable 
year of an estate or trust a beneficiary's interest in the income of 
such estate or trust terminates, WIN expenses paid or incurred by such 
estate or trust after such termination shall not be apportioned to such 
beneficiary.
    (b) Share. A trust's, estate's, or beneficiary's share of the WIN 
expenses with respect to each employee shall be:
    (1) The total WIN expenses incurred in the taxable year of the 
estate or trust with respect to such employee, multiplied by
    (2) The amount of income allocable to such estate or trust or to 
such beneficiary for such taxable year, divided by
    (3) The sum of the amounts of income allocable to such estate or 
trust and all its beneficiaries taken into account under subparagraph 
(2) of this paragraph.
    (c) Limitation based on amount of tax. In the case of an estate or 
trust, the $25,000 amount specified in section 50A(a)(2), relating to 
limitation based on amount of tax, shall be reduced for the taxable year 
to--
    (1) $25,000, multiplied by
    (2) The WIN expenses apportioned to such estate or trust under 
paragraph (a) of this section, divided by
    (3) The WIN expenses apportioned among such estate or trust and its 
beneficiaries.
    (d) Computation of the first 12 months of employment. The first 12 
months of employment (whether or not consecutive) and the period 
described in section 50B(c)(4) of any WIN employee for purposes of 
determining the amount of WIN expenses (as defined in paragraph (a) of 
Sec.  1.50B-1) shall not be affected by a change in the beneficiaries of 
an estate or trust and shall not be affected by a reduction or a 
termination of a beneficiary's interest in the income of such estate or 
trust. Thus, the first 12 months of employment (whether or not 
consecutive) of any WIN employee shall be the same with respect to trust 
or estate, and any beneficiary of such trust or estate claiming a credit 
under section 40 for salaries and wages paid or incurred for services 
rendered by such employee.
    (e) Summary statement. An estate or trust shall attach to its return 
a statement showing the apportionment of WIN expenses with respect to 
each employee to such estate or trust and to each beneficiary.
    (f) Examples. This section may be illustrated by the following 
examples:

    Example 1. (1) XYZ trust, which makes its return on the basis of the 
calendar year, hires five WIN employees in 1972. The WIN expenses 
incurred with respect to each employee are as follows:

------------------------------------------------------------------------
                    WIN employee No.                       WIN expenses
------------------------------------------------------------------------
1.......................................................          $6,000
2.......................................................           5,000
3.......................................................           4,000
4.......................................................           4,000
5.......................................................           3,000
                                                         ---------------
    Total...............................................          22,000
                                                         ===============
------------------------------------------------------------------------


For the taxable year 1972 the income of XYZ trust is $10,000 which is 
allocable as follows: $5,000 to XYZ trust, $2,000 to beneficiary A, and 
$3,000 to beneficiary B. Beneficiaries A

[[Page 546]]

and B make their returns on the basis of a calendar year.
    (2) Under this section, the WIN expenses are apportioned to XYZ 
trust and to its beneficiaries as follows:

----------------------------------------------------------------------------------------------------------------
           WIN employees                 1            2            3            4            5          Total
----------------------------------------------------------------------------------------------------------------
  Total WIN expenses..............       $6,000       $5,000       $4,000       $4,000       $3,000
                                   =============================================================================
XYZ Trust: $5,000/10,000..........        3,000        2,500        2,000        2,000        1,500      $11,000
Beneficiary A: $2,000/10,000......        1,200        1,000          800          800          600        4,400
Beneficiary B: $3,000/10,000......        1,800        1,500        1,200        1,200          900        6,600
----------------------------------------------------------------------------------------------------------------

Assume that beneficiary A hired a WIN employee during his taxable year 
1972 and incurred $6,000 in wages. Also, assume that beneficiary B did 
not hire WIN employees during his taxable year 1972 and that 
beneficiaries A and B did not own any interests in other trusts, 
estates, partnerships, or electing small business corporations that 
hired WIN employees. The WIN expenses of XYZ trust are $11,000, of 
beneficiary A are $10,400, and of beneficiary B are $6,600.
    (3) In the case of XYZ trust, the $25,000 amount specified in 
section 50A(a)(2) is reduced to $12,500, computed as follows: (i) 
$25,000 multiplied by (ii) $11,000 (WIN expense apportioned to the 
trust), divided by (iii) $22,000 (total WIN expenses apportioned among 
such trust ($11,000), beneficiary A ($4,400), and beneficiary B 
($6,600)).
    Example 2. The facts are the same as in example 1 except that 
beneficiary A's interest is reduced to zero. Under paragraph (a)(2) for 
purposes of determining the period of employment that may be taken into 
account by XYZ trust and by beneficiary B, the initial date of 
employment of the WIN employees relates back to the date they were first 
employed.

[38 FR 6163, Mar. 7, 1973]



Sec.  1.50B-4  Partnerships.

    (a) General rule--(1) In general. In the case of a partnership, each 
partner shall take into account separately, for his taxable year with or 
within which the partnership taxable year ends, his share (as determined 
under subparagraph (3) of this paragraph) of the WIN expenses (as 
defined in paragraph (a) of Sec.  1.50B-1) of employees employed by the 
partnership during such partnership's taxable year. The WIN expenses for 
each employee shall be allocated separately.
    (2) Partner as taxpayer. Each partner shall be treated as the 
taxpayer who paid or incurred the share of the WIN expenses allocated to 
him. If a partner takes into account in determining his WIN expenses the 
WIN expenses of an employee of a partnership, and if the employment of 
such employee is terminated in a termination subject to the rules 
contained in paragraph (a) of Sec.  1.50A-3, or if the partnership fails 
to pay comparable wages and such failure is subject to the rules 
contained in paragraphs (a) (2) and (3) of Sec.  1.50A-3, then such 
partner shall make a recapture determination under the provisions of 
section 50A (c) and (d) of the Code and Sec.  1.50A-3. See Sec.  1.50A-
7.
    (3) Determination of partner's share. (i) Each partner's share of 
the WIN expenses shall be determined in accordance with the ratio in 
which the partners divide the general profits of the partnership (that 
is, the taxable income of the partnership as described in section 702 
(a)(9)) regardless of whether the partnership has a profit or a loss for 
the taxable year during which the WIN expenses are paid or incurred. 
However, if the ratio in which the partners divide the general profits 
of the partnership changes during the taxable year of the partnership, 
the ratio effective for the date on which the WIN expenses are paid or 
incurred shall apply.
    (ii) Notwithstanding subdivision (i) of this subparagraph, if the 
deduction with respect to any WIN expenses is specially allocated and if 
such special allocation is recognized under section 704 (a) and (b) and 
paragraph (b) of Sec.  1.704-1, then each partner's share of the WIN 
expenses shall be determined by reference to such special allocation 
effective for the date on which the WIN expenses are paid or incurred.
    (4) Computation of the first 12 months of employment. The first 12 
months of employment (whether or not consecutive) and the period 
described in section 50B(c)(4) with respect to any WIN employee for 
purposes of determining the amount of WIN expenses (as defined in 
paragraph (a) of Sec.  1.50B-1) shall not be affected by a change in the 
partners

[[Page 547]]

of such partnership and shall not be affected by a change in the ratio 
in which the partners divide the general profits of the partnership. 
Thus, the first 12 months of employment (whether or not consecutive) and 
the 24-month period described in section 50B(c)(4) of any WIN employee 
shall be the same with respect to any partner claiming a credit under 
section 40 for salaries and wages paid or incurred for services rendered 
by such employee.
    (b) Summary statement. A partnership shall attach to its return a 
statement showing the allocation to each partner of its WIN expenses 
with respect to each WIN employee.
    (c) Examples. Paragraph (a) of this section may be illustrated by 
the following examples:

    Example 1. Partnership ABCD hires a WIN employee on January 1, 1972, 
and hires a second WIN employee on September 1, 1972. The ABCD 
partnership and each of its partners reports income on the basis of the 
calendar year. Partners A, B, C, and D share partnership profits 
equally. Each partner's share of the WIN expenses incurred with respect 
to these employees is 25 percent.
    Example 2. Assume the same facts as in example 1 and the following 
additional facts: A dies on June 30, 1972, and B purchases A's interest 
as of such date. Each partner's share of the profits from January 1 to 
June 30 is 25 percent. From July 1 to December 31, B's share of the 
profits is 50 percent, and C and D's share of the profits is 25 percent 
each. B shall take into account 25 percent of the WIN expenses incurred 
during the period beginning January 1 and ending June 30 and 50 percent 
of the WIN expenses incurred during the remainder of the year with 
respect to the employee hired on January 1, 1972. Also, B shall take 
into account 50 percent of the WIN expenses incurred with respect to the 
employee hired on September 1, C and D shall each take into account 25 
percent of the WIN expenses incurred with respect to the employees 
employed by the partnership in 1972. Under paragraph (a)(3), for 
purposes of determining the period of employment that may be taken into 
account by B, the initial date of employment of the WIN employee hired 
on January 1 relates back to the date he was first employed, i.e., 
January 1, 1972.
    Example 3. Partnership SH is engaged in manufacturing. Under the 
terms of the partnership agreements deductions attributable to the 
employment of WIN employees are specially allocated 70 percent to 
partner S and 30 percent to partner H. In all other respects S and H 
share profits and losses equally. If the special allocation with respect 
to the WIN expenses is recognized under section 704 (a) and (b) and 
paragraph (b) of Sec.  1.704-1, the WIN expenses shall be taken into 
account, 70 percent by S and 30 percent by H.
    Example 4. (i) LMN partnership, which files its return on the basis 
of the calendar year, hires five WIN employees in 1973. The WIN expenses 
incurred with respect to each employee are as follows:

------------------------------------------------------------------------
                    WIN employee No.                       WIN expenses
------------------------------------------------------------------------
1.......................................................          $6,000
2.......................................................           5,000
3.......................................................           4,000
4.......................................................           4,000
5.......................................................           3,000
                                                         ---------------
    Total...............................................          22,000
------------------------------------------------------------------------


On December 31, 1973, the ratio in which the partners divide the general 
profits of the LMN partnership is as follows: L receives three-tenths of 
the general profits, M receives two-tenths of the general profits, and N 
receives five-tenths of the general profits.
    (ii) Under this section the WIN expenses are apportioned to the 
partners of LMN partnership as follows:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                      WIN employees                              1               2               3               4               5             Total
--------------------------------------------------------------------------------------------------------------------------------------------------------
  Total WIN expenses....................................          $6,000          $5,000          $4,000          $4,000          $3,000         $22,000
                                                         ===============================================================================================
Partner L (3/10)........................................           1,800           1,500           1,200           1,200             900           6,600
Partner M (2/10)........................................           1,200           1,000             800             800             600           4,400
Partner N (5/10)........................................           3,000           2,500           2,000           2,000           1,500          11,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

Assume that partners L, M, and N did not directly incur any other WIN 
expenses during their taxable year in which falls December 31, 1973 (the 
last day of LMN partnership's taxable year) and that such partners did 
not own any interest in other partnerships, electing small business 
corporations, estates, or trusts that incurred WIN expenses. The total 
WIN expenses of partner L are $6,600, of partner M are $4,400, and of 
partner N are $11,000.

[38 FR 6164, Mar. 7, 1973]

[[Page 548]]



Sec.  1.50B-5  Limitations with respect to certain persons.

    (a) Mutual savings institutions. In the case of an organization to 
which section 593 applies (that is, a mutual savings bank, a cooperative 
bank, or a domestic building and loan association)--
    (1) WIN expenses shall be 50 percent of the amount otherwise 
determined under paragraph (a) of Sec.  1.50B-1, and
    (2) The $25,000 amount specified in section 50A(a)(2), relating to 
limitation based on amount of tax, shall be reduced by 50 percent of 
such amount.

For example, a domestic building and loan association incurs $30,000 in 
WIN expenses (as determined under paragraph (a) of Sec.  1.50B-1) during 
its taxable year. However, under this paragraph such amount is reduced 
to $15,000 (50 percent of $30,000). If an organization to which section 
593 applies is a member of a controlled group (as defined in section 
50A(a)(5)), the $25,000 amount specified in section 50A(a)(2) shall be 
reduced in accordance with the provisions of paragraph (f) of Sec.  
1.50A-1 before such amount is further reduced under this paragraph.
    (b) Regulated investment companies and real estate investment 
trusts. (1) In the case of a regulated investment company or a real 
estate investment trust subject to taxation under subchapter M, chapter 
1 of the Code--
    (i) The WIN expenses determined under paragraph (a) of Sec.  1.50B-
1, and
    (ii) The $25,000 amount specified in section 50A(a)(2), relating to 
limitation based on amount of tax,

shall be reduced to such person's ratable share of each such amount. If 
a regulated investment company or a real estate investment trust is a 
member of a controlled group (as defined in section 50A (a)(5)), the 
$25,000 amount specified in section 50A(a)(2) shall be reduced in 
accordance with the provisions of paragraph (f) of Sec.  1.50A-1 before 
such amount is further reduced under this paragraph.
    (2) A person's ratable share of the amount described in subparagraph 
(1)(i) and the amount described in subparagraph (1)(ii) of this 
paragraph shall be the ratio which--
    (i) Taxable income for the taxable year, bears to,
    (ii) Taxable income for the taxable year plus the amount of the 
deduction for dividends paid taken into account under section 
852(b)(2)(D) in computing investment company taxable income, or under 
section 857(b)(2)(B) (section 857(b)(2)(C), as then in effect, for 
taxable years ending before October 5, 1976) in computing real estate 
investment trust taxable income, as the case may be.

For purposes of the preceding sentence, the term ``taxable income'' 
means, in the case of a regulated investment company, its investment 
company taxable income (within the meaning of section 852(b)(2)) and, in 
the case of a real estate investment trust its real estate investment 
trust, taxable income (within the meaning of section 857(b)(2)). In the 
case of a taxable year ending after October 4, 1976, real estate 
investment trust taxable income, for purposes of this paragraph, is 
determined by excluding any net capital gain, and by computing the 
deduction for dividends paid without regard to capital gains dividends 
(as defined in section 857(b)(3)(C)). The amount of the deduction for 
dividends paid includes the amount of deficiency dividends (other than 
capital gains deficiency dividends) taken into account in computing 
investment company taxable income or real estate investment trust 
taxable income for the taxable year. See section 860(f) for the 
definition of deficiency dividends.
    (3) This paragraph may be illustrated by the following example:

    Example. (i) Corporation X, a regulated investment company subject 
to taxation under section 852 of the Code, which makes its return on the 
basis of the calendar year, incurs WIN expenses of $30,000 during the 
year 1974. Corporation X's investment company taxable income under 
section 852 (b)(2) is $10,000 after taking into account a deduction for 
dividends paid of $90,000.
    (ii) Under this paragraph, Corporation X's WIN expenses for the 
taxable year 1974 is $3,000, computed as follows: (a) $30,000 (WIN 
expenses), multiplied by (b) $10,000 (taxable income), divided by (c) 
$100,000 (taxable income plus the deduction for dividends paid). For 
1974, the $25,000 amount specified in section 50A(a)(2) is reduced to 
$2,500.

    (c) Cooperatives. (1) In the case of a cooperative organization 
described in section 1381(a)--

[[Page 549]]

    (i) The WIN expenses determined under paragraph (a) of Sec.  1.50B-
1, and
    (ii) The $25,000 amount specified in section 50A(a)(2), relating to 
limitation based on amount of tax,

shall be reduced to such cooperative's ratable share of each such amount 
(as determined under subparagraph (2) of this paragraph). If a 
cooperative organization described in section 1381(a) is a member of a 
controlled group (as defined in section 50A(a)(5)), the $25,000 amount 
specified in section 50A(a)(2) shall be reduced in accordance with the 
provisions of paragraph (f) of Sec.  1.50A-1 before such amount is 
further reduced under this paragraph.
    (2) A cooperative's ratable share of the amount described in 
subparagraph (1)(i) and the amount described in subparagraph (1)(ii) of 
this paragraph shall be the ratio which--
    (i) Taxable income for the taxable year, bears to
    (ii) Taxable income for the taxable year plus the sum of (a) the 
amount of the deductions allowed under section 1382(b), and (b) the 
amount of the deductions allowed under section 1382(c), and (c) amounts 
similar to the amounts described in (a) and (b) of this subdivision the 
tax treatment of which is determined without regard to subchapter T, 
chapter 1 of the Code and the regulations thereunder.
    (3) This paragraph may be illustrated by the following example:

    Example. (i) Cooperative X, an organization described in section 
1381(a) which makes its return on the basis of the calendar year, incurs 
WIN expenses of $30,000 for the taxable year 1972. Cooperative X's 
taxable income is $10,000 after taking into account deductions of 
$30,000 allowed under section 1382(b), and deductions of $60,000 allowed 
under section 1382(c).
    (ii) Under this paragraph, Cooperative X's WIN expenses for the 
taxable year 1972 are $3,000, computed as follows: (a) $30,000 (WIN 
expenses), multiplied by (b) $10,000 (taxable income), divided by (c) 
$100,000 (taxable income plus the sum of deductions allowed under 
sections 1382(b) and 1382(c)). For 1972, the $25,000 amount specified in 
section 50A(a)(2) is reduced to $2,500.

(Sec. 860(e) (92 Stat. 2849, 26 U.S.C. 860(e)); sec. 860(g) (92 Stat. 
2850, 26 U.S.C. 860(g)); sec. 7805 (68A Stat. 917, 26 U.S.C. 7805))

[38 FR 6164, Mar. 7, 1973, as amended by T.D. 7767, 46 FR 11262, Feb. 6, 
1981; T.D. 7936, 49 FR 2105, Jan. 18, 1984]



Sec.  1.51-1  Amount of credit.

    (a) Determination of amount--(1) General rule. Except as provided in 
paragraph (a)(2) of this section, the amount of the targeted jobs credit 
for purposes of section 38 (formerly designated section 44B) for the 
taxable year equals 50 percent of the qualified first-year wages (minus 
any qualified first-year wages paid to individuals while such 
individuals are qualified summer youth employees) plus 25 percent of the 
qualified second-year wages.
    (2) Special rule for employment of qualified summer youth employees. 
In the case of an employer who pays or incurs qualified wages after 
April 30, 1983, to a qualified summer youth employee beginning work for 
the employer after such date, the amount of the targeted jobs credit for 
the taxable year is equal to the amount determined under paragraph 
(a)(1) of this section plus an amount equal to 85 percent of the first 
$3,000 of qualified wages paid to each qualified summer youth employee 
during the taxable year. Such wages must be attributable to services 
tendered by the qualified summer youth employee during any 90-day period 
beginning on or after May 1 and ending on or before September 15.
    (3) Limitation. See section 38(c) for rules limiting the amount of 
the credit to a percentage of the amount of the taxpayer's net tax 
liability.
    (b) Definitions--(1) Qualified wages. The term ``qualified wages'' 
means wages (as defined in paragraph (b)(4)) paid or incurred by the 
employer during the taxable year to individuals who are members of a 
targeted group (within the meaning of section 51(d)).
    (2) Qualified first-year wages--(i) General rule. Except in the case 
of qualified summer youth employees, the term ``qualified first-year 
wages'' means the first $6,000 of wages (as defined in paragraph (b)(4) 
of this section) attributable to service rendered by a member

[[Page 550]]

of a targeted group during the 1-year period beginning with the day the 
individual first begins work for the employer. In the case of a 
vocational rehabilitation referral (as defined in section 51(d)(2)) who 
begins work for the employer before July 19, 1984, the one-year period 
begins with the day the individual begins work for the employer on or 
after the beginning of such individual's rehabilitation plan. However, 
with the exception of vocational rehabilitation referrals for whom the 
employer claimed a credit under section 44B (as in effect prior to 
enactment of the Revenue Act of 1978) for a taxable year beginning 
before January 1, 1979, members of a targeted group who are first hired 
after September 26, 1978, and before January 1, 1979, will be treated as 
if they first began work for the employer on January 1, 1979. The date 
on which the wages are paid is not determinative of whether the wages 
are first-year wages; rather, the wages must be attributed to the period 
during which the work was performed. See paragraph (f)(1) of this 
section for an additional limitation on the term ``qualified first-year 
wages''. (See examples 1, 2, 3, 4, 5, and 6 in paragraph (j) of this 
section for examples illustrating the application of the rules in this 
paragraph (b)(2)).
    (ii) Special rule for qualified summer youth employees. In the case 
of a qualified summer youth employee, qualified first-year wages for 
purposes of the 85 percent credit referred to in paragraph (a)(2) of 
this section include only wages attributable to services rendered by a 
qualified summer youth employee during any 90-day period beginning on or 
after May 1 and ending on or before September 15. If the individual is 
retained by the employer after the 90-day period and recertified as a 
member of another targeted group, the term ``qualified first-year 
wages'' for purposes of the 50 percent credit described by section 
51(a)(1) has the meaning assigned that term in paragraph (b)(2)(i) of 
this section except that the $6,000 limitation for qualified first-year 
wages shall be reduced by wages up to, but not more than, $3,000 
attributable to services rendered during the 90-day period.
    (3) Qualified second-year wages. The term ``qualified second-year 
wages'' means the first $6,000 of wages attributable to services 
rendered by a member of a targeted group, other than a qualified summer 
youth employee, during the 1-year period beginning on the day after the 
last day of the period for qualified first-year wages. The date on which 
the wages are paid is not determinative of whether the wages are second-
year wages; rather, the wages must be attributed to the period during 
which the work was performed.
    (4) Wages--(i) General rule. Except as otherwise provided in 
paragraphs (b)(4) (ii) and (iii) of this section, the term ``wages'' 
shall only include amounts paid or incurred after December 31, 1978, for 
taxable years ending after December 31, 1978. For purposes of this 
section, the term ``wages'' has the meaning assigned such term by 
section 3306(b) (determined without regard to any dollar limitation 
contained in such subsection).
    (ii) Special rules. In the case of agricultural labor or railway 
labor, the term ``wages'' means unemployment insurance wages within the 
meaning of subparagraph (A) or (B) of section 51(h)(1). The term 
``wages'' shall not include any amounts paid or incurred by an employer 
for any pay period to any individual for whom the employer receives 
federally funded payments for on-the-job training for such individual 
for such pay period. (See example 7 in paragraph (j) of this section.) 
The amount of wages which would otherwise be qualified wages under this 
section with respect to an individual for a taxable year shall be 
reduced by an amount equal to the amount of payments made to the 
employer (however utilized by such employer) with respect to such 
individual for such taxable year under a program established under 
section 414 of the Social Security Act. In addition, the term ``wages'' 
shall not include any amount paid or incurred by the employer in a 
taxable year beginning before January 1, 1982, to an individual with 
respect to whom the employer claims a credit under section 40 (relating 
to expenses of work incentive programs). For youths participating in a 
qualified cooperative education program:

[[Page 551]]

    (A) Section 3306(c)(10)(C) (relating to the definition of employment 
for certain students) does not apply in determining wages under this 
section; and
    (B) The term ``wages'' shall include only those amounts paid or 
incurred by the employer that are attributable to services rendered by 
the individual while he or she meets the conditions specified in section 
51(d)(8)(A). For purposes of the preceding sentence, an employee who met 
the requirement in section 51(d)(8)(A)(iv), dealing with economically 
disadvantaged status, when hired, shall be deemed to continuously meet 
the requirement in section 51(d)(8)(A)(iv) during the time the employee 
is in the cooperative education program. See also paragraph (e) of this 
section for rules relating to the exclusion of wages paid to certain 
individuals.
    (iii) Termination. The term ``wages'' shall not include any amount 
paid or incurred to an individual who begins work for the employer after 
December 31, 1985.
    (5) Special rule for eligible work incentive employees. In the case 
of an eligible work incentive employee (as defined in Sec.  1.51-
1(c)(4)), this paragraph (b) shall be applied for taxable years 
beginning after December 31, 1981, as if such employee had been a member 
of a targeted group for taxable years beginning before January 1, 1982. 
(See example 8 in paragraph (j) of this section.)
    (c) Members of targeted groups--(1) In general. An individual is a 
member of a targeted group if the individual is certified as (i) a 
vocational rehabilitation referral, (ii) an economically disadvantaged 
youth, (iii) an economically disadvantaged Vietnam-era veteran, (iv) an 
SSI recipient, (v) a general assistance recipient, (vi) a youth 
participating in a cooperative education program, (vii) an economically 
disadvantaged ex-convict, (viii) an eligible work incentive employee, 
(ix) a qualified summer youth employee, or (x) an involuntarily 
terminated CETA employee. Except as provided below, see section 51(d) of 
this section for a definition of these groups. See paragraph (d) of this 
section for rules concerning the certification of individuals as members 
of one of these targeted groups.
    (2) Youths participating in a qualified cooperative education 
Program--(i) Student requirements. For an individual to qualify as a 
youth participating in a qualified cooperative education program, the 
individual must meet each of the following conditions (A) through (D)--
    (A) The youth must have attained the age of 16 but not 20. (An 
individual reaching 19 will be treated as a youth participating in a 
qualified cooperative education program only for wages paid or incurred 
after November 26, 1979.)
    (B) The youth must not have graduated from a high school or 
vocational school.
    (C) The youth must be enrolled in and actively pursuing a qualified 
cooperative education program (as defined in paragraph (c)(2)(iii) of 
this section).
    (D) With respect to wages paid or incurred after December 31, 1981, 
the youth must be a member of an economically disadvantaged family when 
initially hired.
    (ii) Economically disadvantaged family. See section 51(d)(11) for 
the rules relating to the determination of whether an individual is a 
member of an economically disadvantaged family.
    (iii) Qualified cooperative education program. The term ``qualified 
cooperative education program'' means a program of vocational education 
for individuals who (through written cooperative arrangements between a 
qualified school and one or more employers) receive instruction 
(including required academic instruction) by alternation of study in 
school with a job in any occupational field (but only if these two 
experiences are planned by the school and employer so that each 
contributes to the student's education and employability). See section 
51(d)(8)(C) for the definition of a ``qualified school.'' For purposes 
of this paragraph, the term ``program of vocational education'' means an 
organized educational program which is directly related to the 
preparation of individuals for employment, or for additional preparation 
for a career requiring other than a baccalaureate or advanced degree. An 
``organized educational program'' means only instruction related to the 
occupation or occupations for which the students are in training or 
instruction

[[Page 552]]

necessary for students to benefit from such training. The student's 
employment contributes to his or her education and employability only if 
it is related to the occupation, or a cluster of closely related 
occupations, for which the student is in training in school. However, 
the student's employment need not be directly related to or in the same 
technical field as the training the student receives in school. For 
example, a student studying carpentry does not have to work as a 
carpenter for the program to constitute a ``qualified cooperative 
education program.'' The program will qualify if, for example, the 
student works at a hardware store because the student's work would 
familiarize the student with the materials and tools used by carpenters. 
The program would not qualify, however, if the student works at a 
restaurant and generally performs tasks in such employment not related 
to carpentry.
    (iv) Actively pursuing. For purposes of this paragraph (c)(2), a 
youth will not be considered to be ``actively pursuing'' a school's 
qualified cooperative education program (within the meaning of paragraph 
(c)(2)(iii) of this section) during summer vacation unless that school 
program continues during the summer vacation. Whether the school program 
continues during the summer vacation will be determined by examining the 
written agreement between the school and the employer. Thus, if a 
written agreement specifically covers the summer vacation period and 
provides for a significant degree of involvement by school personnel to 
provide supervision for the students in the program during that period, 
the school program will be considered to continue during the summer, 
regardless of whether classes are held during the vacation period.
    (3) General assistance recipients. In order for an individual to 
qualify as a general assistance recipient, the individual, or another 
member of the assistance unit (within the meaning of 45 CFR 
205.40(a)(1)) that the individual is a member of, must receive 
assistance for a period of not less than 30 days ending within the 
preemployment period (as defined in section 51(d)(13)) from a qualified 
general assistance program. A qualified general assistance program is a 
program of a State or a political sudivision of a State that the 
Secretary (after consultation with the Secretary of Health and Human 
Services) has designated as providing general assistance (or similar 
assistance) which is based on need and consists of money payments or 
voucher or scrip. For purposes of the preceding sentences, a program 
qualifying as a general assistance program by reason of non-cash 
assistance (i.e., voucher or scrip) shall be so treated only with 
respect to amounts paid or incurred after July 1, 1982, to individuals 
beginning work for the employer after such date. For purposes of this 
subparagraph, the term ``money'' means cash or an instrument convertible 
into cash (e.g., a check).
    (4) Eligible work incentive employees. An eligible work incentive 
employee means an individual who has been certified by the designated 
local agency (as defined in paragraph (d)(10) of this section) as--
    (i) Being eligible for financial assistance under part A of title IV 
of the Social Security Act and as having continuously received such 
financial assistance during the 90-day period which immediately precedes 
the date on which such individual is hired by the employer, or
    (ii) Having been placed in employment under a work incentive program 
established under section 432(b)(1) or 445 of the Social Security Act.

The provisions of this paragraph (c)(4) are effective with respect to 
taxable years of the employer beginning after December 31, 1981. (See 
paragraph (b)(5) of this section for a special rule relating to eligible 
work incentive employees.)
    (5) Involuntarily terminated CETA employees--(i) In general. An 
involuntarily terminated CETA employee is an individual who first began 
work for an employer after August 13, 1981, in taxable years of the 
employer ending after August 13, 1981, and is certified by the 
designated local agency (as defined in paragraph (d)(10) of this 
section) as having been involuntarily terminated after December 31, 
1980, from employment financed in whole, or in part, under a program 
under part D of title

[[Page 553]]

II or title VI of the Comprehensive Employment and Training Act.
    (ii) Termination. Section 51(d)(10) and this paragraph (c)(5) shall 
not apply to any individual who begins work for the employer after 
December 31, 1982.
    (d) Certification--(1) General rule. Except as otherwise provided in 
this paragraph, an individual shall not be treated as a member of a 
targeted group unless, on or before the day on which such individual 
begins work for the employer, the employer has received, or has 
requested in writing, a certification that the individual is a member of 
a targeted group from the designated local agency (as defined in 
paragraph (d)(10) of this section). In addition, the employer must 
receive a certification before the targeted jobs credit can be claimed. 
However, with respect to individuals who began work for the employer on 
or before May 11, 1982, the certification will be timely only if 
requested or received before the day the individual began work for the 
employer. In the case of a request in writing mailed via the United 
States Postal Service, the request shall be deemed to be made on the 
date of the postmark stamped on the cover in which such request was 
mailed to the designated local agency provided the request is mailed in 
accordance with the mailing requirements in Sec.  301.7502-1(c) and 
delivered in accordance with the delivery requirements in Sec.  
301.7502-1(d). In the case of a deadline that but for this sentence 
would fall on a Saturday, Sunday, or a legal holiday, the deadline for 
making a timely request in writing for a certification or receiving a 
timely certification shall be the next succeeding day which is not a 
Saturday, Sunday, or legal holiday. (See section 7503 for the definition 
of ``legal holiday.'') See paragraph (d)(2) of this section for 
transitional rules applicable to certain employees who began work for 
the employer before September 26, 1981. See paragraph (d)(3) of this 
section for special rules applicable to cooperative education students 
and paragraph (d)(4) of this section for special rules applicable to 
eligible work incentive employees.
    (2) Timeliness of certification in the case of an individual to whom 
a written preliminary eligibility determination has been issued. If on 
or before the day on which an individual begins work for the employer, 
such individual has received from a designated local agency (or other 
agency or organization designated pursuant to a written agreement with 
such designated local agency) a written preliminary determination that 
such individual is a member of a targeted group, then such individual 
may be treated as a member of a targeted group if on or before the fifth 
day after the day such individual begins work for the employer such 
employer receives, or requests in writing, from the designated local 
agency a certification that such individual is a member of a targeted 
group. This paragraph (d)(2) only applies to individuals who begin work 
for the employer after July 18, 1984.
    (3) Transitional rules for certain employees who began work for the 
employer on or before September 26, 1981. In the case of an individual, 
other than a cooperative education student, who began work for the 
employer before June 29, 1981, the employer must either receive, or 
request in writing, a certification before July 23, 1981. In the case of 
an individual, other than a cooperative education student, who began 
work for the employer after June 28, 1981, and on or before September 
26, 1981, the employer must either receive, or request in writing, a 
certification before September 26, 1981.
    (4) Cooperative education students. In the case of cooperative 
education students, the school administering the cooperative education 
program must issue the certification. Form 6199 is provided for this 
purpose. If the student begins work for the employer after September 26, 
1981, see the general rule in Sec.  1.51-1(d)(1) for the date when this 
certification must be received or requested. If the student begins work 
for the employer on or before September 26, 1981, the employer must 
receive the certification or request it in writing before September 26, 
1981. In order for an employer to claim a credit on wages paid or 
incurred to a cooperative education student after December 31, 1981, the 
employer must receive or request in writing a determination

[[Page 554]]

that the student is a member of an economically disadvantaged family. A 
request for economic eligibility determination for a cooperative 
education student must be made in writing by the employer to the 
participating school. If the student begins work for the employer on or 
before September 26, 1981, the employer must receive or request in 
writing such determination before September 26, 1981. However, a request 
in writing on or after August 13, 1981, to a participating school for 
certification will be deemed to include a request for an economic 
eligibility determination. In addition, any certification issued by a 
school after August 13, 1981, will be deemed to be issued in response to 
a request for certification which includes a request for an economic 
eligibility determination. The rule in the preceding sentence does not 
eliminate the requirement that the employer receive a certification that 
includes an economic eligibility determination in order to claim a 
credit for wages paid or incurred after December 31, 1981. If a 
certification issued by a school after August 13, 1984, does not contain 
an economic eligibility determination and the employer wishes to claim a 
credit for wages paid or incurred after December 31, 1981, the employer 
must receive a completed certification before the date on which the 
credit is claimed.
    (5) Eligible work incentive employees. In the case of eligible work 
incentive employees, the employer must either receive, or request in 
writing, a certification within the time requirements of paragraph (d) 
(1), (2), or (3) of this section, whichever is applicable. Before 
October 12, 1981 (the date the Economic Recovery Tax Act of 1981 
codified the State employment security agency as the designated local 
agency for certifying targeted groups), a certificate may be received or 
requested in writing from either the designated local agency (as defined 
in paragraph (d)(10) of this section) or the office or agency that 
properly issued certifications under former section 50B(h)(1) (relating 
to the work incentive credit).
    (6) Certifications that are not timely. Any certification that is 
not timely received or requested by the employer in accordance with the 
rules of this paragraph will be treated as invalid. Thus, the employer 
will not be allowed to claim a credit under section 51 with respect to 
any wages paid or incurred to an employee whose certification or request 
for certification is not timely. A timely request for certification does 
not eliminate the need for the employer to receive a certification 
before claiming the credit. In the case of a request for certification 
that was denied, resubmitted, and then approved, the timeliness of the 
request shall be determined by the timeliness of the first request.
    (7) Incorrect certification--(i) In general. Except as otherwise 
provided in paragraph (d)(7)(ii) of this section, if an individual has 
been certified as a member of a targeted group, and such certification 
is based on false information provided by such individual, the 
certification shall be revoked and wages paid by the employer after the 
date on which notice of revocation is received by the employer shall not 
be treated as qualified wages. For purposes of this paragraph, a 
certification will be revoked only if the individual would not have been 
certified had correct information been provided to the issuer of the 
certification. Thus, false information that is not material to an 
individual's eligibility as a member of a targeted group will not 
invalidate an otherwise valid certification.
    (ii) Employer's knowledge that the certification was incorrect. In 
the case of an employer who knew, or had reason to know, at the time of 
certification that the information provided to the designated local 
agency was false, none of the wages paid by such employer to an 
individual to whom an incorrect certification has been issued will be 
qualified wages.
    (8) Certifications issued to certain rehires. This paragraph (d)(8) 
applies in the case of an employee who first began work for the employer 
before August 13, 1981, and was dismissed and rehired by the employer. A 
certification received or requested by an employer with respect to such 
an employee will be considered timely only if there was a valid business 
reason, unrelated to the availability of the credit, for the dismissal 
and rehire and if the employer did not dismiss and then rehire the 
employee in order to meet the

[[Page 555]]

timing requirement with respect to certification. An individual who is 
dismissed and then rehired for the purpose described in the preceding 
sentence will be considered for purposes of section 51(d)(16) and this 
paragraph to have been continuously employed by the employer during the 
time between the dismissal and the rehire. Whether the employer was 
motivated by reason of the certification rules in section 51(d)(16) and 
this paragraph to dismiss and then rehire an employee is a question of 
fact to be determined from all the circumstances surrounding the 
dismissal and rehire. (See paragraph (e)(2) of this section for a 
separate rule disallowing the credit in the case of nonqualifying 
rehires.)
    (9) Individuals who continue to be employed by the same employer but 
as a member of another targeted group. This paragraph (d)(9) applies in 
the case of an employee who continues to be employed by the same 
employer but no longer qualifies as a member of the targeted group for 
which such employee was first certified (e.g., the employee was 
orginally certified as a qualified summer youth employee with respect to 
a ninety-day period between May 1 and September 15, but such ninety-day 
period has ended). In such case, the employer may request a 
certification that the employee is a member of another targeted group, 
and if any wages paid to such individual are qualified first-year wages 
or qualified second-year wages, the employer may be entitled to a 
targeted jobs credit with respect to such wages. The second 
certification will not be invalid merely because it was requested or 
received after the individual began work for the employer; only the 
first certification (for example, the certification with respect to an 
individual hired first as a qualified summer youth employee) must meet 
the requirement of section 51(d)(16) that a certification must be 
requested or received by an employer on or before the day on which the 
individual begins work for the employer. In the case of a former 
qualified summer youth employee or a youth participating in a qualified 
cooperative education program who is recertified as an economically 
disadvantaged youth, the term ``hiring date'' in section 51(d)(3)(B) 
does not mean the day the individual is hired by the employer but means 
the day the individual is certified as a member of the new targeted 
group. Accordingly, the age requirement of section 51(d)(3)(B) shall be 
applied as of the day the individual is certified as a member of the 
second targeted group. In addition, see section 51(d)(11) for rules 
concerning the viability of the original economic eligibility 
determination.
    (10) Certification where a trade or business has been transferred to 
a new employer. In the case of a transfer of a trade or business in 
which an individual who is a member of a targeted group is retained as 
an employee in the trade or business, the certification obtained for 
such employee by the transferor-employer will apply with respect to the 
transferee-employer.
    (11) Designated local agency--(i) In general. For the period before 
October 12, 1981, the term ``designated local agency'' means the agency 
for any locality designated jointly by the Secretary and the Secretary 
of Labor to perform certifications of employees for employers in that 
locality. On or after October 12, 1981, the term ``designated local 
agency'' means a State employment security agency established in 
accordance with the Act of June 6, 1933, as amended (29 U.S.C. 49 
through 49n).
    (ii) Jurisdiction. The designated local agency is the agency that 
has, pursuant to its charter, jurisdiction over the individual that is 
sought to be certified. Thus, any certification that is issued with 
respect to an individual who is not within the jurisdiction of the 
designated local agency that issued the certification will be invalid. 
Notwithstanding any other provision of this section, a request in 
writing for certification to the appropriate designated local agency 
that is made before January 23, 1984, will be considered to be timely if 
it is made after an otherwise timely request in writing for 
certification was made to a designated local agency that does not have 
jurisdiction over the individual sought to be certified.
    (e) Certain ineligible individuals--(1) Related individuals. For 
purposes of section 51(a), ``qualified wages'' does not include any 
amounts paid or incurred

[[Page 556]]

by a taxpayer to any of the following individuals:
    (i) An individual who is related (within the meaning of any of 
paragraphs (1) through (8) of section 152 (a)) to the taxpayer;
    (ii) An individual who is a dependent (within the meaning of section 
152(a)(9)) of the taxpayer;
    (iii) An individual who is related (within the meaning of any of 
paragraphs (1) through (8) of section 152(a)) to a shareholder who owns 
(within the meaning of section 267(c)) more than 50 percent in value of 
the outstanding stock of the taypayer, if the taxpayer is a corporation;
    (iv) An individual who is a dependent (within the meaning of section 
152(a)(9)) of a shareholder described in paragraph (e)(1)(iii) of this 
section;
    (v) An individual who is a grantor, beneficiary or fiduciary of the 
taxpayer, if the taxpayer is an estate or trust;
    (vi) An individual who is a dependent (within the meaning of section 
152(a)(9)) of an individual described in paragraph (e)(1)(v) of this 
section; or
    (vii) An individual who is related (within the meaning of any of 
paragraphs (1) through (8) of section 152(a)) to an individual described 
in paragraph (e)(1)(v) of this section.
    (2) Nonqualifying rehires. For purposes of section 51(a), 
``qualified wages'' does not include wages paid to an employee who had 
been employed by the employer prior to the current hiring date of the 
employee if at any time during such prior employment the employee was 
not a member of a targeted group. The preceding sentence shall not apply 
to an employee who was previously timely certified as a member of a 
targeted group with respect to the same employer. An employee shall be 
treated as not having been a member of a targeted group if the 
certification requirements of section 51(d)(16) were not met. (See 
example 8 in paragraph (j) of this section.)
    (3) Effective date. The provisions of this paragraph (e) are 
effective with respect to employees first beginning work for an employer 
after August 13, 1981.
    (f) Limitations--(1) Limitation on qualified first-year wages. With 
respect to taxable years beginning before January 1, 1982, the amount of 
the qualified first-year wages which may be taken into account for 
purposes of the targeted jobs credit for any taxable year shall not 
exceed 30 percent of the aggregate unemployment insurance wages paid by 
the employer during the calendar year ending in such taxable year. In 
the case of a group of trades or businesses under common control (as 
defined in Sec.  1.52-1(b)), the qualified first-year wages cannot 
exceed 30 percent of the aggregate unemployment insurance wages paid to 
all employees of that group of trades or businesses under common control 
during the calendar year ending in such taxable year. For this purpose, 
the term ``unemployment insurance wages'' has the same meaning given to 
the term ``wages'' as defined in Sec.  1.51-1(b)(4). In this case of 
agricultural or railway labor, see section 51(h)(1) for the applicable 
definition of unemployment insurance wages. (See examples 13 and 14 in 
paragraph (j) of this section.)
    (2) Remuneration must be for trade or business employment. 
Remuneration paid by an employer to an employee during any taxable year 
shall be taken into account only if more than one-half of the 
remuneration paid by the employer to an employee is for services in a 
trade or business of the employer. This determination shall be made by 
each employer without regard to section 52 (a) or (b). Accordingly, 
employees of corporations that are members of a controlled group or 
employees of partnerships, proprietorships, and other trades or 
businesses (whether or not incorporated) which are under common control 
will be treated as being employed by each separate employer for this 
purpose. For this purpose, the term ``year'' means the taxable year of 
the employer. (See example 15 in paragraph (j) of this section.)
    (g) Election not to claim the targeted jobs credit. The election 
under section 51(j) (as amended by section 474(p) of the Tax Reform Act 
of 1984) not to claim the targeted jobs credit is available for taxable 
years beginning after December 31, 1983, and shall be made for the 
taxable year in which such credit is available by not claiming such

[[Page 557]]

credit on an original return or amended return at any time before the 
expiration of the 3-year period beginning on the last date prescribed by 
law for filing the return for the taxable year (determined without 
regard to extensions). The election may be revoked within the 3-year 
period by filing an amended return on which the credit is claimed.
    (h) Treatment of successor-employers. In the case of a successor-
employer referred to in section 3306(b)(1), the determination of the 
amount of credit under this section with respect to wages paid by such 
successor-employer shall be made in the same manner as if such wages 
were paid by the predecessor-employer referred to in such section. Thus, 
the 1-year period referred to in Sec.  1.51-1(b)(2)(i) will be 
considered to begin with the day the employee first began work for the 
transferor-employer, and the amount of qualified first-year wages and 
qualified second-year wages paid or incurred with respect to the 
employee must be reduced by the amount of any such wages paid or 
incurred by the transferor-employer. (See examples 10 and 11 in 
paragraph (j) of this section.) Also, see paragraph (d)(10) of this 
section for rules concerning the viability of the employee's 
certification.
    (i) Treatment of employees performing services for other persons. No 
credit shall be determined under this section with respect to 
remuneration paid by an employer to an employee for services performed 
by such employee for another person unless the amount reasonably 
expected to be received by the employer for such services from such 
other person exceeds the remuneration paid by the employer to such 
employee for such services.
    (j) Examples. The application of this section may be illustrated by 
the following examples which, except as otherwise stated, assume that 
the limitations imposed by Sec. Sec.  1.51-1(f)(2) and 1.53-3 are 
inapplicable:

    Example 1. Corporation M is a calendar year, cash receipts and 
disbursements method taxpayer. A, an economically disadvantaged youth, 
first began work for Corporation M on October 1, 1978. Qualified first-
year wages with respect to A are wages attributable to the period 
beginning on January 1, 1979 (since A was first hired after September 
26, 1978, he is treated as having begun work on January 1, 1979) and 
ending on December 31, 1979. In the 1979 taxable year, Corporation M 
pays A $5,000 of qualified first-year wages attributable to services 
performed in 1979. Corporation M's allowable credit is equal to $2,500 
(50 percent of $5,000).
    Example 2. Assume the same facts as in example 1, except that in 
1980 Corporation M pays to A $100 of wages attributable to services 
rendered in 1979. These wages will still be considered as qualified 
first-year wages, but the credit may not be claimed until the 1980 
taxable year.
    Example 3. Corporation O is a calendar year, cash receipts and 
disbursements method taxpayer. C, a vocational rehabilitation referral, 
first began work for Corporation O on July 1, 1978. Corporation O 
claimed a credit under section 44B (as in effect prior to enactment of 
the Revenue Act of 1978) for $3,000 of wages paid to C in the 1978 
taxable year. Corporation O paid C $6,000 for services performed from 
January 1, 1979 to June 30, 1979. The period during which qualified 
first-year wages are determined begins on July 1, 1978, and ends on June 
30, 1979. Amounts paid before January 1, 1979, however, are not taken 
into consideration in determining the amount of qualified first-year 
wages. Accordingly, only the wages attributable to services performed 
from January 1, 1979, through June 30, 1979, are considered as qualified 
first-year wages. Corporation O's allowable credit is equal to $3,000 
(50 percent of $6,000).
    Example 4. I first began work for Corporation Q, a cash receipts and 
disbursements method taxpayer, on January 1, 1981, and was not a member 
of a targeted group. On March 1, 1981, I was convicted of a felony and 
sentenced to prison. I quit working for Corporation Q, and served the 
prison sentence. On November 1, 1981, I again was hired by Corporation Q 
and began work on that date. On the November 1, 1981 hiring date, I was 
an economically disadvantaged ex-convict for whom Corporation Q received 
a certificate. Corporation Q paid I $500 of wages for services performed 
from November 1, 1981, to December 31, 1981, and $6,000 of wages for 
services performed during 1982. The $500 of wages paid for services 
performed from November 1, 1981, to December 31, 1981, would be 
qualified first-year wages because these qualified wages were paid for 
services performed during the 1-year period beginning on the date I 
first began work for Corporation Q (January 1, 1981). The $6,000 of 
wages paid for services performed during 1982 would be qualified second-
year wages because these qualified wages were paid for services 
performed during the 1-year period beginning on the day after the first 
1-year period. Accordingly, Corporation Q has an allowable credit of 
$250 attributable to qualified first-year wages and $1,500 attributable 
to qualified second-year wages.

[[Page 558]]

    Example 5. Assume the same facts as in example 4, except that all 
dates are 1 year later. Thus, I first began work for Corporation Q on 
January 1, 1982, was convicted on March 1, 1982, and was rehired on 
November 1, 1982. Under these facts, Q is not entitled to take a 
targeted jobs credit with respect to I's wages because I is a 
nonqualifying rehire.
    Example 6. J, an economically disadvantaged youth, first began work 
for Corporation R, a calendar year cash receipts and disbursements 
method taxpayer, on December 1, 1979. On July 1, 1980, J was laid off by 
Corporation R and began work for Corporation S, which is unrelated to 
Corporation R, on July 2, 1980. On November 1, 1980, J again began work 
for Corporation R and continued working for Corporation R until January 
1, 1982. At the time J first began work for Corporation S, J no longer 
met the qualifications of an economically disadvantaged youth. 
Corporation S may not claim a credit for wages paid to J because J was 
not a member of a targeted group at the time he began work for 
Corporation S. Corporation R, however, may claim a credit for wages paid 
to J because J was a member of a targeted group when he was hired by 
Corporation R. Corporation R's qualified first-year wages paid to J are 
the wages paid for services performed by J from December 1, 1979, to 
July 1, 1980, and from November 1, 1980, to November 30, 1980. 
Corporation R's qualified second-year wages paid to J are wages paid for 
services performed by J from December 1, 1980, to November 30, 1981. 
Corporation R may not claim a credit for wages paid for services 
performed by J after November 30, 1981.
    Example 7. K, a member of a targeted group, first began work for 
Corporation T on January 1, 1979. For the pay periods from January 1, 
1979, to March 31, 1979, Corporation T received federally funded 
payments for on-the-job training for K and paid wages of $2,000 to K. 
During the remainder of 1979 Corporation T paid wages of $7,000 to K. 
Corporation T may claim a credit on $6,000 of qualified first-year 
wages. Amounts paid to K by Corporation T during the pay periods for 
which Corporation T received federally funded payments for on-the-job 
training for K are not considered wages for purposes of the credit. 
However, Corporation T may consider $6,000 of the total $7,000 of wages 
paid after March 31, 1979, as qualified first-year wages.
    Example 8. P first began work for Corporation X on January 1, 1981, 
as an individual who was certified to be an eligible employee for 
purposes of the WIN credit provided in section 40. Corporation X paid P 
$6,000 of wages during its taxable year beginning on January 1, 1981, 
and $6,000 of wages during its taxable year beginning on January 1, 
1982. X can claim a targeted jobs credit for the wages paid in 1982 if 
the requirements of section 51 are met. For purposes of section 51 (a), 
P's qualified first-year wages are the wages paid from January 1, 1981, 
to December 31, 1981, and P's qualified second-year wages are the wages 
paid from January 1, 1982, to December 31, 1982. Thus, Corporation X is 
only entitled to claim a targeted job credit based on P's qualified 
second-year wages.
    Example 9. (i) L, 15 years of age, first began work for Corporation 
U on August 1, 1979. On September 3, 1979, L began her junior year in 
high school and enrolled in a qualified cooperative education program 
that was to run for her junior and senior years. On October 1, 1979, 
when L turned 16, she met all the requirements of Sec.  1.51-1(c)(2)(i) 
and qualified as a youth participating in a qualified cooperative 
education program. Corporation U is entitled to claim a credit on wages 
paid or incurred for services performed by L after September 30, 1979, 
so long as L meets the requisite requirements. L's summer vacation began 
on June 1, 1980. Assume that the cooperative education program L was 
enrolled in did not continue during the summer vacation (i.e., the 
written agreement between the employer and the school did not cover the 
summer vacation). Thus, during her summer vacation, L did not meet the 
requirement of actively pursuing a qualified cooperative education 
program. Accordingly, Corporation U may not claim a credit on wages paid 
for services performed by L during L's summer vacation. On September 2, 
1980, L began her senior year, and again met all the requirements of 
Sec.  1.51-1(c)(2)(i). She continued to meet these requirements until 
June 5, 1981, when she graduated from high school. Accordingly, 
Corporation U may claim a credit on wages paid for services performed 
after September 1, 1980, and before June 5, 1981.
    (ii) Assume the same facts as in (i), above, except that all dates 
are 3 years later. Under these facts, U is not entitled to claim a 
targeted jobs credit with respect to any of L's wages because L has not 
been timely certified under section 51(d)(16) and Sec.  1.51-1(d)(3).
    Example 10. D began work for a drugstore owned by E as a sole 
proprietor on January 1, 1979, and was certified as a member of a 
targeted group with respect to E. On June 1, 1979, E sold the drugstore 
where D worked to F, who continued to operate the drugstore with D as an 
employee. D's qualification as a member of a targeted group is not 
required to be redetermined in order for F to qualify for the targeted 
jobs credit. F will take into account the certification of D's 
eligibility that was provided to E. F will have qualified first-year 
wages consisting of the first $6,000 of wages paid or incurred to D by E 
and F from January 1, 1979 to December 31, 1979 (reduced by any 
qualified wages paid or incurred by E to D from January 1, 1979, to May 
31, 1979). F's qualified second-year wages

[[Page 559]]

will consist of the first $6,000 of wages paid or incurred to D by F 
from January 1, 1980, to December 31, 1980.
    Example 11. G began work in a machine shop owned by H as a sole 
proprietor on January 1, 1979, and was certified as a member of a 
targeted group with respect to H. On June 1, 1980, H transferred all the 
assets of the machine shop to newly formed Corporation P. Corporation P 
retained G as an employee in the machine shop. G's qualification as a 
member of a targeted group is not required to be redetermined in order 
for P to qualify for the targeted jobs credit. H has qualified first-
year wages in the amount of the first $6,000 of wages paid or incurred 
to G by H from January 1, 1979, to December 31, 1979. Corporation P has 
qualified second-year wages in the amount of the first $6,000 of wages 
paid or incurred to G by H and Corporation P from January 1, 1980, to 
December 31, 1980 (reduced by any qualified second-year wages paid by H 
to G).
    Example 12. W operates a retail store as a sole proprietor. On June 
1, 1982, W hires S after receiving a written determination from a local 
community organization that S meets the requirements of an economically 
disadvantaged youth. W does not request a certification from the State 
employment security agency as to S's eligibility. W is not entitled to 
claim a credit with respect to wages paid to S because W did not 
receive, or request in writing, a certification from the State 
employment security agency as to S's eligibility on or before the day on 
which S began work for W.
    Example 13. Corporation V is a cash receipts and disbursements 
method taxpayer with a July 1 through June 30 taxable year. In the 
taxable year ending June 30, 1980, the aggregate unemployment insurance 
wages paid by V were $150,000. In calendar year 1979 the aggregate 
unemployment insurance wages paid by Corporation V were $110,000. 
Corporation V's qualified first-year wages are limited to 30 percent of 
the aggregate unemployment insurance wages paid by it in calendar year 
1979 or $33,000 (30 percent of $110,000), even though the aggregate 
unemployment insurance wages paid by it in the taxable year ending June 
30, 1980, were $150,000.
    Example 14. Assume the same facts as in example 13, except that all 
dates are 3 years later. Since the limitation on qualified first-year 
wages does not apply to taxable years beginning after December 31, 1981, 
Corporation V's qualified first-year wages are $150,000.
    Example 15. M operates a retail store as a sole proprietor. N and O, 
both members of a targeted group, first began work for M on January 1, 
1979. M paid N total qualified first-year wages of $6,000 in 1979. Three 
thousand one hundred dollars of those wages were for services in M's 
retail store, and $2,900 of those wages were for services as M's maid. M 
paid O total qualified first-year wages of $6,000 in 1979. Three 
thousand dollars of those wages were for services in M's store and 
$3,000 of those wages were for services as M's chauffeur. M has an 
allowable credit of $3,000 in 1979 on all $6,000 of qualified first-year 
wages paid to N because more than one-half of the remuneration paid by M 
to N was for services in M's trade or business. M may not take into 
account the wages paid to O because not more than one-half of the 
remuneration paid by M to O was for services in M's trade or business. 
Acordingly, M may not claim a credit on wages paid to O.

[T.D. 8062, 50 FR 45998, Nov. 6, 1985]

                              Tax Surcharge



Sec.  1.52-1  Trades or businesses that are under common control.

    (a) Apportionment of jobs credit among members of a group of trades 
or businesses that are under common control--(1) Targeted jobs credit. 
(i) In the case of a group of trades or businesses that are under common 
control (within the meaning of paragraph (b) of this section) at any 
time during the calendar year, the amount of the targeted jobs credit 
(computed under section 51 as if all the organizations that are under 
common control are one trade or business) under section 4-1B must be 
apportioned among the members of the group on the basis of each member's 
proportionate share of the wages giving rise to such credit. If the 
group of trades or businesses that are under common control have 
different taxable years, the credit shall be computed as if all the 
organizations have the same taxable year as the organization for which a 
determination of the proportionate share of the credit is being made. 
For taxable years beginning before January 1, 1982, the amount of the 
qualified first-year wages cannot exceed 30 percent of the aggregate 
unemployment insurance wages paid by the group of trades or businesses 
under common control during the calendar year ending in the taxable year 
of the organization for which a determination of the proportionate share 
of the credit is being made. The limitations in section 53 and the 
regulations thereunder apply to each organization individually 
(although, in applying these limitations, an affiliated group of 
corporations electing to make a consolidated

[[Page 560]]

return shall be treated as one organization).
    (ii) The application of the subparagraph may be illustrated by the 
following examples:

    Example 1. (a) Corporation M and its three subsidiaries, 
Corporations N, O, and P, are a group of businesses that are under 
common control and each uses the cash receipts and disbursements method 
of accounting and has a calendar year taxable year. Corporations M, N, 
O, and P paid out the following amounts in unemployment insurance wages, 
qualified first-year wages and qualified second-year wages during 1980.

------------------------------------------------------------------------
                                      Unemployment  Qualified  Qualified
                                        insurance    1st-Year   2d-year
                                          wages       wages      wages
------------------------------------------------------------------------
Corporation:
  M.................................     $600,000    $184,000    $75,000
  N.................................      300,000      85,000     90,000
  O.................................      360,000     120,000    115,000
  P.................................       24,000      24,000          0
                                     -----------------------------------
    Total...........................    1,284,000     413,000    280,000
------------------------------------------------------------------------

    (b) Since Corporations M, N, O, and P are under common control, the 
amount of qualified first-year wages paid by the group is limited to 30 
percent of the aggregate unemployment insurance wages paid by the group 
in the calendar year ending in the group's taxable year. Since the 
qualified first-year wages of $413,000 exceeds 30% of the aggregate 
unemployment insurance wages, the group is limited to qualified first-
year wages of $385,200 (30% of $1,284,000). The amount of the targeted 
jobs credit attributable to qualified first-year wages is equal to 
$192,600 (50% of $385,200). The amount of the credit attributable to 
qualified second-year wages is equal to $70,000 (25% of $280,000).
    (c) The credit is apportioned among Corporations M, N, O, and P on 
the basis of their proportionate share of the qualified first-year wages 
or qualified second-year wages giving rise to the credit. Each 
corporation's share of the credit attributable to qualified first-year 
wages would be computed as follows:
[GRAPHIC] [TIFF OMITTED] TC14NO91.145

    Each corporation's share of the credit attributable to qualified 
second-year wages is computed as follows:
[GRAPHIC] [TIFF OMITTED] TC14NO91.146

    Example 2. Assume the facts in example 1 with these additional 
facts. A, a member of a targeted group, worked for more than one of the 
members of the controlled group in the taxable year. A first began work 
for Corporation M on January 1, 1980, and later worked for Corporations 
N and O during 1980. For services rendered by A during 1980, the 
following wages were paid to A: Corporation M paid A $2,500 of qualified 
first-year wages: Corporation N paid A $1,500 of qualified first-year 
wages; Corporation O paid A $3,000 of qualified first-year wages. 
Corporations M, N, and O paid A a total of $7,000 of wages during 1980. 
Only $6,000 of qualified first-year wages per year per employee may be 
taken into account for purposes of the credit. See Sec.  1.51-1(d)(1). 
Since Corporations M, N, and O are treated as a single employer under 
section 52(a), the maximum $6,000 of qualified first-year wages paid A 
by the group must be apportioned among Corporations M, N, and O as 
follows:

[[Page 561]]

[GRAPHIC] [TIFF OMITTED] TC14NO91.147

    Example 3. (a) Corporation Q and its two subsidiaries, Corporations 
R and S, are a group of businesses that are under common control and 
each uses the cash receipts and disbursements method of accounting. 
Corporation Q has a calendar year taxable year. Corporation R has a July 
1 through June 30 taxable year. Corporation S has an October 1 through 
September 30 taxable year. For purposes of determining Corporation R's 
proportionate share of the credit, the credit is computed as if 
Corporations Q and S have the same taxable year as Corporation R. 
Accordingly, Corporation R would compute its share of the credit for its 
1979-1980 taxable year as set forth below.

------------------------------------------------------------------------
                                                  Qualified wages paid
                                                  from July 1, 1979, to
                                  Unemployment        June 30, 1980
                                    insurance  -------------------------
                                   wages, 1979    1st year     2d year
                                                   wages        wages
------------------------------------------------------------------------
Corporation:
  Q.............................      $500,000     $150,000      $80,000
  R.............................       300,000      110,000       50,000
  S.............................       100,000       25,000       10,000
                                 ---------------------------------------
    Total.......................       900,000      285,000      140,000
------------------------------------------------------------------------

    (b) Since Corporations Q, R, and S are under common control, the 
amount of qualified first-year wages is limited to 30 percent of the 
aggregate unemployment insurance wages paid by the group during the 
calendar year ending in Corporation R's taxable year. Since the 
qualified first-year wages of $285,000 exceeds 30 percent of the 
aggregate unemployment insurance wages, the group is limited to 
qualified first-year wages of $270,000 (30% of $900,000). The amount of 
the targeted jobs credit attributable to qualified first-year wages paid 
by members of the group during the period of the taxpayer's taxable year 
is $135,000 (50% of $270,000). The amount of the credit attributable to 
qualified second-year wages paid or incurred by members of the group 
during the period of the taxpayer's taxable year is $35,000 (25% of 
$140,000).
    (c) The credit is apportioned to Corporation R on the basis of its 
proportionate share of the qualified first-year wages and qualified 
second-year wages giving rise to the credit. Corporation R's share of 
the credit attributable to qualified first-year wages is $52,105.26
[GRAPHIC] [TIFF OMITTED] TC14NO91.148


Corporation R's share of the credit attributable to qualified second-
year wages is $12,500
[GRAPHIC] [TIFF OMITTED] TC14NO91.149

Corporation R's share of the credit for its 1979-1980 taxable year is 
$64,605.26 ($52,105.26 + $12,500).

    (2) New jobs credit. In the case of a group of trades or businesses 
that are under common control at any time during the calendar year, the 
amount of the new jobs credit (computed under section 51 as if all the 
organizations that are under common control are one trade or business) 
under section 44B (as in effect prior to enactment of the Revenue Act of 
1978) must be apportioned among the members of the group on the basis of 
each member's proportionate contribution to the increase in unemployment 
insurance wages for the entire group. The limitations in section 53 (as 
in effect prior to enactment of the Revenue Act of 1978) and the 
regulations thereunder apply to each organization individually 
(although, in applying these limitations, an affiliated group of 
corporations electing to make a consolidated return shall be treated as 
one organization). The application of this subparagraph may be 
illustrated by the following example:

    Example. (a) Corporation T and its three subsidiaries, U, V, and W, 
are a group of businesses that are under common control and each has a 
calendar year taxable year. Corporations T, U, V, and W have paid out 
the following amounts in unemployment insurance wages during 1976 and 
1977:

------------------------------------------------------------------------
                                                             Increase in
                                                              FUTA wages
                                       1976         1977       in 1977
                                                              over 1976
------------------------------------------------------------------------
Corporation.
  T..............................   $1,000,000   $1,015,000    + $15,000
  U..............................      500,000      650,000    + 150,000
  V..............................      600,000      580,000      -20,000
  W..............................       40,000      100,000     + 60,000
                                  --------------------------------------
    Total........................    2,140,000    2,345,000      205,000
------------------------------------------------------------------------


[[Page 562]]

    (b) Since all employees of trades or, businesses that are under 
common control are treated as employed by a single employer, the 
computations in section 51 are performed as if all the organizations 
which are under common control are one trade or business. Consequently, 
the amounts of the total unemployment insurance wages of the group in 
1976 (i.e., $2,140,000) and 1977 (i.e., $2,345,000) are used to 
determine the increase in unemployment insurance wages in 1977 over the 
1976 wage base. Since the amount equal to 102 percent of the 1976 
unemployment insurance wages ($2,182,800) is greater than the amount 
equal to 50 percent of the 1977 unemployment insurance wages 
($1,172,500), the increase in unemployment insurance wages in 1977 over 
the 1976 wage base is $162,200 ($2,345,000-$2,182,800). The limitations 
in section 51(c), (d), and (g) (as in effect prior to enactment of the 
Revenue Act of 1978) must also be computed as though all the 
organizations under common control are one trade or business. For 
purposes of this example, it is assumed that none of those limitations 
reduce the amount of increase in unemployment insurance wages. As a 
result, the amount of the new jobs credit allowed to the group of 
business is $81,100 (50% of $162,200).
    (c) The credit is apportioned among Corporations T, U, and W on the 
basis of their proportionate contributions to the increase in 
unemployment insurance wages. No credit would be allowed to Corporation 
V because it did not contribute to the increase in the group's 
unemployment insurance wages. Corporation T's share of the credit would 
be $5,406.66 ($81,100 x ($15,000 / $225,000 (i.e., $15,000 + $150,000 + 
$60,000))), Corporation U's share would be $54,066.67 ($81,100 x 
($150,000 / 225,000)), and Corporation W's share would be $21,626.67 
($81,100 x ($60,000 / $225,000)).

    (b) Trades or businesses that are under common control. For purposes 
of this section, the term ``trades or businesses that are under common 
control'' means any group of trades or businesses that is either a 
``parent-subsidiary group under common control'' as defined in paragraph 
(c) of this section, a ``brother-sister group under common control'' as 
defined in paragraph (d) of this section, or a ``combined group under 
common control'' as defined in paragraph (e) of this section. For 
purposes of this section and Sec. Sec.  1.52-2 and 1.52-3, the term 
``organization'' means a sole proprietorship, a partnership, a trust, an 
estate, or a corporation. An organization may be a member of only one 
group of trades or businesses under common control. If, without the 
application of this paragraph, an organization would be a member of more 
than one such group, that organization shall indicate in its timely 
filed return the group in which it is being included. If the 
organization does not so indicate, then the district director with audit 
jurisdiction of the organization's return will determine the group in 
which the organization is to be included.
    (c) Parent-subsidiary group under common control--(1) In general. 
The term ``parent-subsidiary group under common control'' means one or 
more chains of organizations conducting trades or businesses that are 
connected through ownership of a controlling interest with a common 
parent organization if--
    (i) A controlling interest in each of the organizations, except the 
common parent organization, is owned (directly and with the application 
of Sec.  1.414(c)-4(b)(1), relating to options) by one or more of the 
other organizations; and
    (ii) The common parent organization owns (directly and with the 
application of Sec.  1.414(c)-4(b)(1), relating to options) a 
controlling interest in at least one of the other organizations, 
excluding, in computing the controlling interest, any direct ownership 
interest by the other organizations.
    (2) Controlling interest defined. For purposes of this paragraph, 
the term ``controlling interest'' means:
    (i) In the case of a corporation, ownership of stock possessing more 
than 50 percent of the total combined voting power of all classes of 
stock entitled to vote or more than 50 percent of the total value of the 
shares of all classes of stock of the corporation;
    (ii) In the case of a trust or estate, ownership of an actuarial 
interest (determined under paragraph (f) of this section) of more than 
50 percent of the trust or estate;
    (iii) In the case of a partnership, ownership of more than 50 
percent of the profit interest or capital interest of the partnership; 
and
    (iv) In the case of a sole proprietorship, ownership of the sole 
proprietorship.
    (d) Brother-sister group under common control--(1) In general. The 
term ``brother-sister group under common

[[Page 563]]

control'' means two or more organizations conducting trades or 
businesses if--
    (i) The same five or fewer persons who are individuals, estates, or 
trusts own (directly and with the application of Sec.  1.414(c)-4), a 
controlling interest of each organization; and
    (ii) Taking into account the ownership of each person only to the 
extent that person's ownership is identical with respect to each 
organization, such persons are in effective control of each 
organization.

The five or fewer persons whose ownership is considered for purposes of 
the controlling interest requirement for each organization must be the 
same persons whose ownership is considered for purposes of the effective 
control requirement.
    (2) Controlling interest defined. For purposes of this paragraph, 
the term ``controlling interest'' means:
    (i) In the case of a corporation, ownership of stock possessing at 
least 80 percent of the total combined voting power of all classes of 
stock entitled to vote or at least 80 percent of the total value of the 
shares of all classes of stock of the corporation;
    (ii) In case of a trust or estate, ownership of an actuarial 
interest (determined under paragraph (f) of this section) of a least 80 
percent of the trust or estate;
    (iii) In the case of a partnership, ownership of at least 80 percent 
of the profit interest or capital interest of the partnership; and
    (iv) In the case of a sole proprietorship, ownership of the sole 
proprietorship.
    (3) Effective control defined. For purposes of this paragraph 
``effective control'' means:
    (i) In the case of a corporation, ownership of stock possessing more 
than 50 percent of the total combined voting power of all classes of 
stock entitled to vote or more than 50 percent of the total value of the 
shares of all classes of stock of the corporation;
    (ii) In the case of a trust or estate, ownership of an actuarial 
interest (determined under paragraph (f) of this section) of more than 
50 percent of the trust or estate;
    (iii) In the case of a partnership, ownership of more than 50 
percent of the profit interest or capital interest of the partnership; 
and
    (iv) In the case of a sole proprietorship, ownership of the sole 
proprietorship.
    (e) Combined group under common control. The term ``combined group 
under common control'' means a group of three or more organizations, in 
which (1) each organization is a member of either a parent-subsidiary 
group under common control or brother-sister group under common control, 
and (2) at least one organization is the common parent organization of a 
parent-subsidiary group under common control and also a member of a 
brother-sister group under common control.
    (f) Actuarial interest. For purposes of this section, the actuarial 
interest of each beneficiary of a trust or estate shall be determined by 
assuming the maximum exercise of discretion by the fiduciary in favor of 
the beneficiary. The factors and method prescribed in Sec.  20.2031-7 
or, for certain prior periods, 20.2031-7A of this chapter (Estate Tax 
Regulations) for use in ascertaining the value of an interest in 
property for estate tax purposes will be used to determine a 
beneficiary's actuarial interest.
    (g) Exclusion of certain interests and stock in determining control. 
In determining control under this paragraph, the term ``interest'' and 
the term ``stock'' do not include an interest that is treated as not 
outstanding under Sec.  1.414(c)-3. In addition, the term ``stock'' does 
not include treasury stock or nonvoting stock that is limited and 
preferred regarding dividends.
    (h) Transitional rule--(1) In general. Paragraph (d) of this 
section, as amended by T.D. 8179, applies to all taxable years to which 
section 52(b) applies.
    (2) Election. In the case of taxable years ending before March 2, 
1988.
    (i) If, pursuant to paragraph (b) of this section, an organization 
indicated in a timely filed return that it chose to be a member of a 
brother-sister group under common control, and it is not a member of 
such group because of the amendments to paragraph (d) of this

[[Page 564]]

section made by T.D. 8179 such organization may make the choice 
described in paragraph (b) of this section by filing an amended return 
on or before September 2, 1988 if such organization would otherwise 
still be a member of more than one group of trades or businesses under 
common control, and
    (ii) If an organization--
    (A) Is a member of a brother-sister group of trades or businesses 
under common control under Sec.  1.52-1(d)(1) as in effect before 
amendment by T.D. 8179 (``old group''), for such taxable year, and
    (B) Is not such a member for such taxable year because of the 
amendments made by such Treasury decision,


such organization (whether or not a corporation) nevertheless will be 
treated as a member of such old group if all the organizations (whether 
or not corporations) that are members of the old group meet all the 
requirements of Sec.  1.1563-1(d)(3) with respect to such taxable year.

(Secs. 44B, 381, and 7805 of the Internal Revenue Code of 1954 (92 Stat. 
2834, 26 U.S.C. 44B); 91 Stat. 148, 26 U.S.C. 381(c)(26); 68A Stat. 917, 
26 U.S.C. 7805)

[T.D. 7553, 43 FR 31322, July 21, 1978, as amended by T.D. 7921, 48 FR 
52904, Nov. 23, 1983; T.D. 7955, 49 FR 19975, May 11, 1984; T.D. 8179, 
53 FR 6605, Mar. 2, 1988; 53 FR 8302, Mar. 14, 1988; 53 FR 16408, May 9, 
1988; T.D. 8540, 59 FR 30102, June 10, 1994; T.D. 8179, 84 FR 33002, 
July 11, 2019]



Sec.  1.52-2  Adjustments for acquisitions and dispositions.

    (a) General rule. The provisions in this section only apply to the 
computation of the new jobs credit. If, after December 31, 1975, an 
employer acquires the major portion of a trade or business or the major 
portion of a separate unit of a trade or business, then, for purposes of 
computing the new jobs credit for any calendar year ending after the 
acquisition, both the amount of unemployment insurance wages and the 
amount of total wages considered to have been paid by the acquiring 
employer, for both the year in which the acquisition occurred and the 
preceding year, must be increased, respectively, by the amount of 
unemployment insurance wages and the amount of total wages paid by the 
predecessor employer that are attributable to the acquired portion of 
the trade or business or separate unit. If the predecessor employer 
informs the acquiring employer in writing of the amount of unemployment 
insurance wages and the amount of total wages attributable to the 
acquired portion of the trade or business that have been paid during the 
periods preceding the acquisition, then, for purposes of computing the 
credit for any calendar year ending after the acquisition the amount of 
unemployment insurance wages and the amount of total wages considered 
paid by the predecessor employer shall be decreased by those amounts. 
Regardless of whether the predecessor employer so informs the acquiring 
employer, the predecessor employer shall not be allowed a credit for the 
amount of any increase in the employment insurance wages or the total 
wages in the calendar year of the acquisition attributable to the 
acquired portion of the trade or business over the amount of such wages 
in the calendar year preceding the acquisition.
    (b) Meaning of terms--(1) Acquisition. (i) For the purposes of this 
section, the term ``acquisition'' includes a lease agreement if the 
effect of the lease is to transfer the major portion of the trade or 
business or of a separate unit of the trade or business for the period 
of the lease. For instance, if one company leases a factory (including 
equipment) to another company for a 2-year period, the employees are 
retained by the second company, and the factory is used for the same 
general purposes as before, then for purposes of this section the lessee 
has acquired the lessor's trade or business for the period of the lease.
    (ii) Neither the major portion of a trade or business nor the major 
portion of a separate unit of a trade or business is acquired merely by 
acquiring physical assets. The acquisition must transfer a viable trade 
or business.
    (iii) Subdivision (ii) of this subparagraph may be illustrated by 
the following examples:

    Example 1. R Co., a restaurant, sells its building and all its 
restaurant equipment to S Co. and moves into a larger, more modern 
building across the street. R Co. purchases

[[Page 565]]

new equipment, retains its name and continues to operate as a 
restaurant. S Co. opens a new restaurant in the old R Co. building. S 
Co. has merely acquired the old R Co. assets; it has not acquired any 
portion of R Co.'s business.
    Example 2. The facts are the same as in Example 1, except that R Co. 
also sells its name and goodwill to S Co. and ceases to operate a 
restaurant business. S Co. operates its restaurant using the old R Co. 
name. In this situation, S Co. has acquired R Co.'s business.

    (2) Separate unit. (i) A separate unit is a segment of a trade or 
business capable of operating as a self-sustaining enterprise with minor 
adjustments. The allocation of a portion of the goodwill of a trade or 
business to one of its segments is a strong indication that that segment 
is a separate unit.
    (ii) The following examples are illustrations of the acquisition of 
a separate unit of a trade or business:

    Example 1. The M Corp., which has been engaged in the sale and 
repair of boats, leases the repair shop building and all the property 
used in its boat repair operations to the N Co. for four years and gives 
the N Co. a covenant not to compete in the boat repair business for the 
period of the lease. The N Co. is considered to have acquired a separate 
unit of M Corp.'s business for the period of the lease.
    Example 2. (a) The P Co. is engaged in the operation of a chain of 
department stores. There are eight divisions, each division is located 
in a different metropolitan area of the country, and each division 
operates under a different name. Although certain buying and 
merchandising functions are centralized, each division's day-to-day 
operations are independent of the others. The Q Corp. acquires all of 
the physical and intangible assets of one of the divisions, including 
the division's name. Other than making those minor adjustments necessary 
to give the division buying and merchandising departments, the Q Corp. 
allows the division to continue doing business in the same manner as it 
had been operating prior to the acquisition. The Q Corp. has acquired a 
separate unit of the P Co.'s business.
    (b) The facts are the same as in paragraph (a) of example 2, except 
that Q Corporation buys the division merely to obtain its store 
locations. Before the Q Corporation takes over, the division liquidates 
its inventory in a going-out-of-business sale. The Q Corporation has 
merely acquired assets in this transaction, not a separate unit of P 
Company's business.
    Example 3. The R Company processes and distributes meat products. 
Both the processing division and the distributorship are self-
sustaining, profitable operations. The acquisition of either the meat 
processing division or the distributorship would be an acquisition of a 
separate unit of the R Company's business.
    Example 4. The S Corporation is engaged in the manufacture and sale 
of steel and steel products. S Corporation also owns a coal mine, which 
it operates for the sole purpose of supplying its coal requirements for 
its steel manufacturing operations. The acquisition of the coal mine 
would be an acquisition of a separate unit of the S company's business.
    Example 5. The T Company, which is engaged in the business of 
operating a chain of drug stores, sells its only downtown drug store to 
the V Company and agrees not to open another T Company store in the 
downtown area for five years. Included in the purchase price is an 
amount that is charged for the goodwill of the store location. The V 
Company has acquired a separate unit of the T Company's business.
    Example 6. The W Company, which is engaged in the business of 
operating a chain of drug stores sells one of its stores to the X 
Company, but continues to operate another drug store three blocks away. 
The X Company opens the store doing business under its own name. The X 
Company has not acquired a separate unit of the W Company's business.
    Example 7. (a) The Y Corporation, which is engaged in the 
manufacture of mattresses, sells one of its three factories to the Z 
Company. At the time of the sale, the factory is capable of profitably 
manufacturing mattresses on its own. Z Company has acquired a separate 
unit of the Y Corporation.
    (b) The facts are the same as in (a) above, except that a profitable 
manufacturing operation cannot be conducted in the factory standing on 
its own. Z Company has not acquired a separate unit of the Y 
Corporation.
    Example 8. The O Construction Company is owned by A, B, and C, who 
are unrelated individuals. It owns equipment valued at 1.5 million 
dollars and construction contracts valued at 6 million dollars. A, 
wishing to start his own company, exchanges his interest in O Company 
for 2 million dollars of contracts and a sufficient amount of equipment 
to enable him to begin business immediately. A has acquired a separate 
unit of the O Company's business.

    (3) Major portion. All the facts and circumstances surrounding the 
transaction shall be taken into account in determining what constitutes 
a major portion of a trade or business (or separate unit). Factors to be 
considered include:
    (i) The fair market value of the assets in the portion relative to 
the fair

[[Page 566]]

market value of the other assets of the trade or business (or separate 
unit);
    (ii) The proportion of goodwill attributable to the portion of the 
trade or business (or separate unit);
    (iii) The proportion of the number of employees of the trade or 
business (or separate unit) attributable to the portion in the periods 
immediately preceding the transaction; and
    (iv) The proportion of the sales or gross receipts, net income, and 
budget of the trade or business (or separate unit) attributable to the 
portion.

(Secs. 44B, 381, and 7805 of the Internal Revenue Code of 1954 (92 Stat. 
2834, 26 U.S.C. 44B); 91 Stat. 148, 26 U.S.C. 381(c)(26); 68A Stat. 917, 
26 U.S.C. 7805)

[T.D. 7553, 43 FR 31323, July 21, 1978, as amended by T.D. 7921, 48 FR 
52906, Nov. 23, 1983]



Sec.  1.52-3  Limitations with respect to certain persons.

    (a) Mutual savings institutions. In the case of an organization to 
which section 593 applies (that is, a mutual savings bank, a cooperative 
bank or a domestic building and loan association), the amount of the 
targeted jobs credit (new jobs credit in the case of wages paid before 
1979) allowable under section 44B shall be 50 percent of the amount 
otherwise determined under section 51, or, in the case of an 
organization under common control, under Sec.  1.52-1 (a) and (b).
    (b) Regulated investment companies and real estate investment 
trusts. In the case of a regulated investment company or a real estate 
investment trust subject to taxation under subchapter M, chapter 1 of 
the Code, the amount of the targeted jobs credit (new jobs credit in the 
case of wages paid before 1979) allowable under section 44B shall be 
reduced to the company's or trust's ratable share of the credit. The 
ratable share shall be determined in accordance with rules similar to 
the rules provided in section 46(e)(2)(B) and the regulations 
thereunder. For purposes of computing the ratable share, the reduction 
of the deduction for wage or salary expenses under Sec.  1.280C-1 shall 
not be taken into account.
    (c) Cooperatives--(1) Taxable years ending after October 31, 1978. 
For taxable years ending after October 31, 1978, in the case of a 
cooperative organization described in section 1381(a), rules similar to 
rules provided in section 46(h) and the regulations thereunder shall 
apply in determining the distribution of the amount of the targeted jobs 
credit (new jobs credit in the case of wages paid before 1979) allowable 
to the cooperative organization and its patrons under section 44B.
    (2) Taxable years ending before November 1, 1978. For taxable years 
ending before November 1, 1978, in the case of a cooperative 
organization described in section 1381(a), the amount of new jobs credit 
allowable under section 44B shall be reduced to the cooperative's 
ratable share of the credit. The ratable share shall be the ratio which 
the taxable income of the cooperative for the taxable year bears to its 
taxable income increased by the amount of the deductions allowed under 
section 1382 (b) and (c). For purposes of computing the ratable share, 
the reduction of the deduction for wage or salary expenses under Sec.  
1.280C-1 shall not be taken into account.

(Secs. 44B, 381, and 7805 of the Internal Revenue Code of 1954 (92 Stat. 
2834, 26 U.S.C. 44B); 91 Stat. 148, 26 U.S.C. 381(c)(26); 68A Stat. 917, 
26 U.S.C. 7805)

[T.D. 7921, 48 FR 52906, Nov. 23, 1983]



Sec.  1.53-1  Limitation based on amount of tax.

    (a) General rule--(1) Targeted jobs credit. For taxable years 
beginning after December 31, 1978, the amount of the targeted jobs 
credit allowed by section 44B (as amended by the Revenue Act of 1978) 
shall not exceed 90 percent of the tax imposed by chapter 1, reduced by 
the credits enumerated in section 53(a).
    (2) New jobs credit. For taxable years beginning before January 1, 
1979, the amount of the new jobs credit allowed by section 44B (as in 
effect prior to enactment of the Revenue Act of 1978) shall not exceed 
the tax imposed by chapter 1, reduced by the credits enumerated in 
section 53(a).
    (b) Special rule for 1978-79 fiscal year. In the case of a taxable 
year beginning before January 1, 1979, and ending after that date, the 
sum of the targeted jobs credit (determined without regard to the tax 
liability limitation in paragraph (a)(1) of this section) and the new

[[Page 567]]

jobs credit (determined without regard to the tax liability limitation 
in (a)(2) of this section) shall not exceed the tax imposed by chapter 
1, reduced by the credits enumerated in section 53(a).

(Secs. 44B, 381, and 7805 of the Internal Revenue Code of 1954 (92 Stat. 
2834, 26 U.S.C. 44B); 91 Stat. 148, 26 U.S.C. 381(c)(26); 68A Stat. 917, 
26 U.S.C. 7805)

[T.D. 7921, 48 FR 52906, Nov. 23, 1983]



Sec.  1.53-2  Carryback and carryover of unused credit.

    (a) Allowance of unused credit as a carryback or carryover--(1) In 
general. Section 53(b) (formerly designated as section 53(c) for taxable 
years beginning before 1979) provides for carrybacks and carryovers of 
unused targeted jobs credit (new jobs credit in the case of wages paid 
before 1979). An unused credit is the excess of the credit determined 
under section 51 for the taxable year over the limitation provided by 
Sec.  1.53-1 for such taxable year. Subject to the limitations contained 
in paragraph (b) of this section and paragraph (f) of Sec.  1.53-3, an 
unused credit shall be added to the amount allowable as a credit under 
section 44B for the years to which an unused credit can be carried. The 
year with respect to which an unused credit arises shall be referred to 
in this section as the ``unused credit year.''
    (2) Taxable years to which unused credit may be carried. An unused 
targeted jobs credit (new jobs credit in the case of wages paid before 
1979) shall be a new employee credit carryback to each of the 3 taxable 
years preceding the unused credit year and a new employee credit 
carryover to each of the 15 taxable years succeeding the unused credit 
year. An unused credit must be carried first to the earliest of the 
taxable years to which it may be carried, and then to each of the other 
taxable years (in order of time) to the extent that the unused credit 
may not be added (because of the limitation contained in paragraph (b) 
of this section) to the amount allowable as a credit under section 44B 
for a prior taxable year.
    (b) Limitations on allowance of unused credit--(1) In general. The 
amount of the unused targeted jobs credit (new jobs credit in the case 
of wages paid before 1979) from any particular unused credit year which 
may be added under section 53(b)(1) (section 53(c)(1) in the case of a 
new jobs credit) to the amount allowable as a credit under section 44B 
for any of the preceding or succeeding taxable years to which such 
credit may be carried shall not exceed the amount by which the 
limitation in Sec.  1.53-1 for such preceding or succeeding taxable year 
exceeds the sum of (i) the credit allowable under section 44B for such 
preceding or succeeding taxable year, and (ii) other unused credits 
carried to such preceding or succeeding taxable year which are 
attributable to unused credit years prior to the particular unused 
credit year. Thus, in determining the amount, if any, of an unused 
credit from a particular unused credit year which shall be added to the 
amount allowable as a credit for any preceding or succeeding taxable 
year, the credit earned for such preceding or succeeding taxable year, 
plus any unused credits originating in taxable years prior to the 
particular unused credit year, shall first be applied against the 
limitation based on amount of tax for such preceding or succeeding 
taxable year. To the extent the limitation based on amount of tax for 
the preceding or succeeding year exceeds the sum of the credit earned 
for such year and other unused credits attributable to years prior to 
the particular unused credit year, the unused credit from the particular 
unused credit year shall be added to the amount allowable as a credit 
under section 44B for such preceding or succeeding year. If any portion 
of the unused credit is a carryback to a taxable year beginning before 
January 1, 1977, section 44B shall be deemed to have been in effect for 
such taxable year for purposes of allowing such carryback as a credit 
under section 44B. To the extent that an unused credit cannot be added 
for a particular preceding or succeeding taxable year because of the 
limitation contained in this paragraph, such unused credit shall be 
available as a carryback or carryover to the next succeeding taxable 
year to which it may be carried.
    (2) Special rules for an electing small business corporation. An 
unused targeted jobs credit (new jobs credit in the case of wages paid 
before 1979) under section 44B of a corporation which

[[Page 568]]

arises in an unused credit year for which the corporation is not an 
electing small business corporation (as defined in section 1371(b)) and 
which is a carryback or carryover to a taxable year for which the 
corporation is an electing small business corporation shall not be added 
to the amount allowable as a credit under section 44B to the 
shareholders of such corporation for any taxable year. However, a 
taxable year for which the corporation is an electing small business 
corporation shall be counted as a taxable year for purposes of 
determining the taxable years to which such unused credit may be 
carried.
    (3) Corporate acquisitions. For the carryover of unused credits 
under section 44B in the case of certain corporate acquisitions, see 
section 381(c)(26) and Sec.  1.381(c)(26)-1.
    (4) Examples. This paragraph may be illustrated by the following 
examples.

    Example 1. In 1978, A, a calendar year taxpayer, had an unused new 
jobs credit of $2,000. In 1979, A has a targeted jobs credit of $2,000 
and a tax liability imposed by chapter 1 of the Code of $4,000 after all 
credits listed in section 53(a) have been taken into account. The amount 
of A's targeted jobs credit allowable under section 44B for 1979 is 90 
percent of A's tax liability. The amount of the new jobs credit that may 
be carried to 1979 is limited to $1,600 ($3,600 [90% of $4,000]-$2,000).
    Example 2. In 1979, B, a calendar year taxpayer, has a tax liability 
imposed by chapter 1 of the Code of $10,000 after all credits listed in 
section 53(a) have been taken. B's targeted jobs credit for that taxable 
year is limited to 90 percent of his income tax liability or $9,000. B 
had a $15,000 targeted jobs credit in 1979 resulting in an unused 
targeted jobs credit of $5,000 for that year. In 1976 and 1977 B had tax 
liabilities imposed by chapter 1 of the Code of $3,000 and $4,000 
respectively after all credits listed in section 53(a) had been taken. 
For purposes of carrying back an unused targeted jobs credit to a 
taxable year beginning before January 1, 1977, section 44B as amended by 
the Revenue Act of 1978 is deemed to have been in effect for such 
taxable year. Accordingly, the applicable tax liability limitation for 
1976 would be governed by section 53(a) (as amended by the Revenue Act 
of 1978) which limits the amount of targeted jobs credit allowed to 90 
percent of the tax imposed by chapter 1 of the Code after all credits 
listed in section 53(a) have been taken. B may carry back $2,700 (90% of 
$3,000) of the 1979 unused targeted jobs credit to 1976. B may carry 
back $4,000 of the unused targeted jobs credit to 1977 because section 
53(a) as it applied to the 1977 taxable year limited the amount of the 
credit to 100 percent of the taxpayer's tax liability imposed by chapter 
1 of the Code after all credits listed in section 53(a) had been taken.

(Secs. 44B, 381, and 7805 of the Internal Revenue Code of 1954 (92 Stat. 
2834, 26 U.S.C. 44B); 91 Stat. 148, 26 U.S.C. 381(c)(26); 68A Stat. 917, 
26 U.S.C. 7805)

[T.D. 7921, 48 FR 52906, Nov. 23, 1983]



Sec.  1.53-3  Separate rule for pass-through of jobs credit.

    (a) In general. Under section 53(b), in the case of a new jobs 
credit or targeted jobs credit earned under section 44B by a 
partnership, estate or trust, or subchapter S corporation, the amount of 
the credit that may be taken into account by a partner, beneficiary, or 
shareholder may not exceed a limitation under section 53(b) separately 
computed with respect to the partner's, beneficiary's, or shareholder's 
interest in the entity. A credit is subject to the limitation of section 
53(b) with respect to a partner, beneficiary, or shareholder if it is 
earned by a partnership, estate or trust, or subchapter S corporation in 
a taxable year ending within, or ending before, a taxable year beginning 
before January 1, 1979 of the partner, beneficiary, or shareholder. See 
paragraph (f) of this section for rules on carryback or carryover of a 
credit subject to separate limitation. This section prescribes rules, 
under the authority of section 44B(b), relating to the computation of 
the separate limitation. For purposes of this section, references to 
section 53(a) and (b) are to that section as it existed before it was 
amended by the Revenue Act of 1978. This paragraph may be illustrated by 
the following examples:

    Example 1. A, a calendar year taxpayer, is a partner in P, a 
calendar year partnership. A's pro rata portion of the credit earned by 
P in 1978 is $200. The $200 credit to be claimed on A's 1978 return is 
subject to the separate limitation in section 53(b) because the 
limitation applies to taxable years of the taxpayer beginning before 
January 1, 1979.
    Example 2. B, a calendar year taxpayer, is a shareholder in 
Corporation M, a subchapter S corporation with a July to June fiscal 
year. B's pro rata portion of the credit earned by Corporation M in its 
taxable year beginning in 1978 is $100. The $100 credit to be claimed on 
B's 1979 return is not subject to

[[Page 569]]

the separate limitation requirement of section 53(b) because the 
limitation only applies to taxable years of the taxpayer beginning 
before 1979, notwithstanding the credit was earned by Corporation M 
before 1979.

    (b) Application of credit earned. A credit earned under section 44B 
by a partnership, estate or trust, or subchapter S corporation shall be 
applied by a partner, beneficiary, or shareholder, to the extent allowed 
under section 53(b), before applying any other credit earned under 
section 44B. For example, if an individual has a new jobs credit from a 
proprietorship of $2,000 and from a partnership (after applying section 
53(b)) of $1,800, but the credit must be limited under section 53(a) to 
$3,000, the entire $1,800 credit from the partnership would be applied 
before any part of the $2,000 amount is applied.
    (c) Amount of separate limitation. The amount of the separate 
limitation is equal to the partner's, beneficiary's, or shareholder's 
limitation under section 53(a) for the taxable year multiplied by a 
fraction. The numerator of the fraction is the portion of the taxpayer's 
taxable income for the year attributable to the taxpayer's interest in 
the entity. The denominator of the fraction is the taxpayer's total 
taxable income for the year reduced by the zero bracket amount, if any.
    (d) Portion of taxable income attributable to an interest in a 
partnership, estate or trust, or subchapter S corporation--(1) General 
rule. The portion of a taxpayer's taxable income attributable to an 
interest in a partnership, estate or trust, or subchapter S corporation 
is the amount of income from that entity the taxpayer is required to 
include in gross income, reduced by--
    (i) The amount of the deductions allowed to the taxpayer that are 
attributable to the taxpayer's interest in the entity; and
    (ii) A proportionate share of the deductions allowed to the taxpayer 
not attributable to a specific activity (as defined in paragraph (e)).

If a deduction comprises both an item that is attributable to the 
taxpayer's interest in the entity and an item or items that are not 
attributable to the interest in the entity, and if the deduction is 
limited by a provision of the Code (such as section 170(b), relating to 
limitations on charitable contributions), the deduction must be prorated 
among the items taken into account in computing the deduction. For 
example, if an individual makes a charitable contribution of $5,000 and 
his distributive share of a partnership includes $2,000 in charitable 
contributions made by the partnership, and if the charitable 
contribution deduction is limited to $3,500 under section 170(b), then 
the portion of the deduction allowed to the taxpayer that is not 
attributable to a specific activity is $2,500 ($3,500 x ($5,000 / 
$7,000)) and the portion of the deduction allowed to the taxpayer that 
is attributable to the interest in the partnership is $1,000 ($3,500 x 
($2,000 / $7,000)).
    (2) Deductions attributable to an interest in an entity. Examples of 
deductions that are attributable to the taxpayer's interest in an entity 
include (but are not limited to) a deduction under section 1202 
attributable to a net capital gain passed through the entity, and a 
deduction attributable to a deductible item (such as a charitable 
contribution) that has been passed through the entity.
    (3) Computation of the proportionate share of deductions not 
attributable to a specific activity. The proportionate share of a 
deduction of the taxpayer not attributable to a specific activity is 
obtained by multiplying the amount of the deduction by a fraction. The 
numerator of the fraction is the income from the entity that the 
taxpayer is required to include in gross income, reduced by the amount 
of the deductions of the taxpayer that are attributable to the 
taxpayer's interest in the entity. The denominator is the taxpayer's 
gross income reduced by the amount of all the deductions attributable to 
specific activities.
    (4) Examples. The method of determining the amount of taxable income 
attributable to an interest in a partnership, estate or trust, or 
subchapter S corporation is illustrated by the following examples:

    Example 1. (a) A, a single individual, is a shareholder in S 
Corporation, a subchapter S corporation. A is required to include the 
following amounts from S corporation is his gross income:

[[Page 570]]



Salary......................................................      $3,000
                                                             ===========
Undistributed taxable income:
  Ordinary income...........................................       8,000
  Net capital gain..........................................       2,000
                                                             -----------
    Total...................................................      10,000
                                                             ===========
    Total...................................................      13,000
                                                             ===========
 


A has income from other activities:

  Ordinary income...........................................       6,000
  Net capital gain..........................................       4,000
                                                             -----------
    Total...................................................      10,000
 

    (b) In order to determine the taxable income attributable to A's 
interest in S Corporation, it is necessary to reduce the amount of 
income from S Corporation that A is required to include in gross income 
by the amount of A's deductions attributable to the interest in S 
Corporation and by a proportionate share of A's deductions not 
attributable to a specific activity. These computations are made in 
paragraph (c) of this example. However, before the computation reducing 
A's income by a proportionate share of the deductions not attributable 
to a specific activity can be made, the ratio described in subparagraph 
(3) of this paragraph (d) must be determined. The numerator of the ratio 
(the amount of income from S Corporation that A is required to include 
in gross income, reduced by the amount of the deductions attributable to 
A's interest in S Corporation) is obtained in paragraph (c) of this 
example in the process of computing A's taxable income attributable to 
the interest in S Corporation. The determination of the denominator (A's 
gross income reduced by the amount of all deductions attributable to 
specific activities), however, require a separate computation, which 
follows:

Gross income:
  Income from S Corporation.................................     $13,000
  Income from other sources.................................      10,000
                                                             -----------
    Total...................................................      23,000
Less: Deductions attributable to specific activities:
  Section 1202 deduction (50 percent. of $6,000)............       3,000
                                                             -----------
  A's gross income reduced by the amount of the deductions        20,000
   attributable to specific activities (denominator of the
   ratio for determining the proportionate share of
   deductions not attributable to a specific activity)......
 

    (c) Computation of the amount of A's taxable income attributable to 
the interest in S Corporation:

Income from S Corporation that A is required to include in
 gross income:
  Ordinary income...........................................     $11,000
  Net capital gain..........................................       2,000
                                                             -----------
    Total...................................................      13,000
Less: Deductions of the taxpayer attributable to the
 interest in S Corporation:
  Section 1202 deduction (50 pct. of $2,000)................       1,000
                                                             -----------
  (Numerator of the ratio for determining the proportionate       12,000
   share of deductions not attributable to a specific
   activity)................................................
                                                             ===========
Less: Proportionate share of the deductions of the taxpayer
 not attributable to a specific activity:
  Personal exemption deduction ($750 x $12,000/$20,000).....         450
  Zero bracket amount ($2,200 x $12,000/$20,000)............       1,320
                                                             -----------
    Total...................................................       1,770
                                                             ===========
  Portion of A's taxable income attributable to interest in       10,230
   S Corporation............................................
 

    Example 2. (a) C, a married individual with two children, is a 
partner in the CD Company. C's distributive share of the CD Company 
consists of the following:

  Ordinary income (other than guaranteed payment)...........     $38,420
  Guaranteed payment........................................      20,000
  Net long-term capital gain................................       6,000
  Net short-term capital loss...............................       2,000
  Dividends qualifying for exclusion........................         100
  Charitable contributions..................................         500
 


C also has items of income from other sources and deductions, as 
follows:

  Ordinary income...........................................     $21,680
  Short-term capital gain...................................       2,000
  Dividends qualifying for exclusion........................         400
Deductions:
  Deductible medical expenses...............................      16,000
  Charitable contributions..................................       4,000
  Alimony...................................................      18,000
  Interest and taxes on home................................       8,000
  Loss relating to another specific activity................       4,000
 

    (b) In order to determine C's taxable income attributable to the 
interest in the partnership, it is necessary to reduce the amount of 
income from the partnership that C is required to include in gross 
income by the amount of C's deductions attributable to the interest in 
the partnership and by a proportionate share of C's deductions not 
attributable to a specific activity. These computations are made in 
paragraph (c) of this example. However, before the computation reducing 
C's income by a proportionate share of the deductions not attributable 
to a specific activity can be made, the ratio described in paragraph 
(d)(3) of this section must be determined. The numerator of the ratio is 
determined in paragraph (c) of this example in the process of computing 
C's taxable income attributable to the interest in the partnership. The 
denominator, however, requires a separate computation, reducing C's 
gross income by the amount of all deductions attributable to specific 
activities. This computation is as follows:

Gross income: Income from the partnership:
  Ordinary income...........................................     $58,420
  Net long-term capital gain................................       6,000
                                                             ===========

[[Page 571]]

 
  Dividends.................................................         100
  Less: Proportionate share of dividend exclusion ($100 x             20
   $100/$500)...............................................
                                                             -----------
                                                                      80
                                                             ===========
                                                                  64,500
Income from other sources:
  Ordinary income...........................................      21,680
  Net short/term capital gain...............................       2,000
                                                             ===========
  Dividends.................................................         400
  Less: Proportionate share of dividend exclusion ($100 x            $80
   $400/$500)...............................................
                                                             -----------
                                                                     320
                                                             ===========
                                                                  24,000
                                                             ===========
                                                                  88,500
                                                             ===========
Less: Deductions attributable to specific activities:
  Net short-term capital loss passed through the partnership       2,000
  Loss related to another specific activity.................       4,000
  Section 1202 deduction attributable to the interest in the       2,000
   partnership..............................................
  Charitable contribution deduction passed through the               500
   partnership..............................................
                                                             -----------
                                                                   8,500
                                                             ===========
  C's gross income, reduced by the amount of the deductions       80,000
   attributable to specific activities (denominator of the
   ratio for determining the proportionate share of
   deductions not attributable to a specific activity)......
 

    (c) Computation of the amount of C's taxable income attributable to 
the interest in the partnership:

  Distributive share of ordinary income (other than              $38,420
   guaranteed payments).....................................
  Guaranteed payment........................................      20,000
  Distributive share of dividends less share of exclusion...          80
  Distributive share of net long-term capital gain..........       6,000
                                                             -----------
                                                                  64,500
                                                             ===========
  Section 1202 deduction (50 pct. of $4,000)................       2,000
  Charitable contribution passed through the partnership....         500
  Net short-term capital loss passed through the partnership       2,000
                                                             -----------
                                                                   4,500
                                                             ===========
  (Numerator of the ratio for determining the proportionate       60,000
   share of deductions not attributable to a specific
   activity)................................................
                                                             ===========
  Section 1202 deduction ($1,000 x $60,000/$80,000).........         750
  Deductible medical expenses ($16,000 x $60,000/$80,000)...      12,000
  Charitable contributions ($4,000 x $60,000/$80,000).......       3,000
  Alimony ($18,000 x $60,000/$80,000).......................      13,500
  Interest and taxes on home ($8,000 x $60,000/$80,000).....       6,000
  Personal exemption deduction ($3,000 x $60,000/$80,000)...       2,250
                                                             -----------
    Total...................................................      37,500
                                                             ===========
  Portion of C's taxable income attributable to the interest      22,500
   in the partnership.......................................
 

    C has a deduction under section 1202 of $3,000. Of that deduction, 
$2,000 is attributable directly to C's interest in the partnership (50 
percent of the net capital gain that would result from offsetting the 
$6,000 net long-term capital gain and the $2,000 net short-term capital 
loss that are attributable to C's interest in the partnership). Since 
the remaining $1,000 deduction under section 1202 cannot be attributed 
directly to either C's income from the partnership or any other specific 
activity, it must be treated as a deduction not attributable to a 
specific activity.

    (e) Deductions not attributable to a specific activity--(1) Specific 
activity defined. A specific activity means a course of continuous 
conduct involving a particular line of endeavor, whether or not the 
activity is carried on for profit. Examples of a specific activity are:
    (i) A trade or business carried on by the taxpayer;
    (ii) A trade or business carried on by an entity in which the 
taxpayer has an interest;
    (iii) An activity with respect to which the taxpayer is entitled to 
a deduction under section 212;
    (iv) The operation of a farm as a hobby.
    (2) Types of deductions not attributable to a specific activity. 
Examples of deductions not attributable to a specific activity include 
charitable contributions made by the partner, beneficiary, or 
shareholder; medical expenses; alimony; interest on personal debts of 
the partner, beneficiary, or shareholder; and real estate taxes on the 
personal residence of the partner, beneficiary, or shareholder. For 
purposes of this section, in cases in which deductions are not itemized, 
the zero bracket amount is considered to be a deduction not attributable 
to a specific activity.
    (f) Carryback or carryover of credit subject to separate limitation. 
A credit subject to the separate limitation under section 53(b) that is 
carried back or carried over to a taxable year beginning before January 
1, 1979, is also subject to the separate limitation in the carryback or 
carryover year. For purposes of the preceding sentence, a credit that is 
earned by a partnership, a

[[Page 572]]

trust, or estate, or a subchapter S corporation in a taxable year of 
such entity ending within, or after, the taxable year of a partner 
beneficiary or shareholder beginning after December 31, 1978, will not 
be subject to the separate limitation in section 53(b) with respect to 
such partner, beneficiary, or shareholder. The taxpayer to whom the 
credit has been passed through shall not be prevented from applying the 
unused portion in a carryback or carryover year merely because the 
entity that earned the credit changes its form of conducting business if 
the nature of its trade or business essentially remains the same. The 
computation of the separate limitation in such a case shall reflect the 
income attributable to the taxpayer's interest in the entity in its 
revised form. Thus, a shareholder carrying over a credit from a 
subchapter S corporation may include dividends declared by that 
corporation after the subchapter S election had been terminated as 
income attributable to that person's interest in the entity. Similarly, 
if a partnership incorporates in a carryover year, any income 
attributable to an interest in the corporation will be regarded, for 
purposes of computing the separate limitation under section 53(b), as 
income attributable to an interest in the entity. This paragraph may be 
illustrated by the following examples:

    Example 1. A, a calendar year taxpayer, is a shareholder in 
Corporation M, a subchapter S corporation. In 1977, A's pro rata share 
of the new jobs credit earned by Corporation M was $10,000. A could only 
use $2,000 of the credit in 1977 because of the separate limitation 
under section 53(b). In 1978, A carries the unused credit over from 
1977. The carryover credit is subject to the separate limitation under 
section 53(b).
    Example 2. Assume the same facts as in example 1 except that the 
unused credit is carried over to 1979. The carryover credit is not 
subject to the separate limitation under section 53(b) because that 
limitation does not apply to taxable years of a taxpayer beginning after 
December 31, 1978.
    Example 3. B, a calendar year taxpayer, is a shareholder in 
Corporation W, a subchapter S corporation. In 1979, B's pro rata share 
of the targeted jobs credit covered by Corporation W was $5,000 but B 
could only use $3,000 of the credit in 1979. B carries back the unused 
credit to 1978. The carryback credit is not subject to the separate 
limitation under section 53(b).

(Secs. 44B, 381, and 7805 of the Internal Revenue Code of 1954 (92 Stat. 
2834, 26 U.S.C. 44B); 91 Stat. 148, 26 U.S.C. 381(c)(26); 68A Stat. 917, 
26 U.S.C. 7805)

[T.D. 7560, 43 FR 60445, Dec. 28, 1978. Redesignated and amended by T.D. 
7921, 48 FR 52906, 52907, Nov. 23, 1983]



Sec.  1.55-1  Alternative minimum taxable income.

    (a) General rule for computing alternative minimum taxable income. 
Except as otherwise provided by statute, regulations, or other published 
guidance issued by the Commissioner, all Internal Revenue Code 
provisions that apply in determining the regular taxable income of a 
taxpayer also apply in determining the alternative minimum taxable 
income of the taxpayer.
    (b) Items based on adjusted gross income or modified adjusted gross 
income. In determining the alternative minimum taxable income of a 
taxpayer other than a corporation, all references to the taxpayer's 
adjusted gross income or modified adjusted gross income in determining 
the amount of items of income, exclusion, or deduction must be treated 
as references to the taxpayer's adjusted gross income or modified 
adjusted gross income as determined for regular tax purposes.
    (c) Effective date. These regulations are effective for taxable 
years beginning after December 31, 1993.

[T.D. 8569, 59 FR 60557, Nov. 25, 1994]



Sec.  1.56-0  Table of contents to Sec.  1.56-1, adjustment for book 
income of corporations.

    (a) Computation of the book income adjustment.
    (1) In general.
    (2) Taxpayers subject to the book income adjustment.
    (3) Consolidated returns.
    (4) Examples.
    (b) Adjusted net book income.
    (1) In general.
    (2) Net book income.
    (i) In general.
    (ii) Measures of net book income.
    (iii) Tax-free transactions and tax-free income.
    (iv) Treatment of dividends and other amounts.
    (3) Additional rules for consolidated groups.

[[Page 573]]

    (i) consolidated adjusted net book income.
    (ii) Consolidated net book income.
    (iii) Consolidated pre-adjustment alternative minimum taxable 
income.
    (iv) Cross references.
    (4) Computation of adjusted net book income when taxable year and 
financial accounting year differ.
    (i) In general.
    (ii) Estimating adjusted net book income.
    (iii) Election to compute adjusted net book income based on the 
financial statement for the year ending within the taxable year.
    (A) In general.
    (B) Time of making election.
    (C) Eligibility to make and manner of making election.
    (D) Election or revocation of election made on an amended return.
    (iv) Quarterly statement filed with the Securities and Exchange 
Commission (SEC).
    (5) Computation of net book income using current earnings and 
profits.
    (i) In general.
    (ii) Current earnings and profits of a consolidated group.
    (6) Additional rules for computation of net book income of a foreign 
corporate taxpayer.
    (i) Adjusted net book income of a foreign taxpayer.
    (ii) Effectively connected net book income of a foreign taxpayer.
    (A) In general.
    (B) Certain exempt amounts.
    (iii) Computation of net book income of a foreign taxpayer using 
current earnings and profits.
    (7) Examples.
    (c) Applicable financial statement.
    (1) In general.
    (i) Statement required to be filed with the Securities and Exchange 
Commission (SEC).
    (ii) Certified audited financial statement.
    (iii) Financial statement provided to a government regulator.
    (iv) Other financial statements.
    (v) Required use of current earnings and profits.
    (2) Election to treat net book income as equal to current earnings 
and profits for the taxable year.
    (i) In general.
    (ii) Time of making election.
    (iii) Eligibility to make and manner of making election.
    (iv) Election by common parent of consolidated group.
    (v) Election or revocation of election made on an amended return.
    (3) Priority among statements.
    (i) In general.
    (ii) Special priority rules for use of certified audited financial 
statements and other financial statements.
    (iii) Priority among financial statements provided to a government 
regulator.
    (iv) Statements of equal priority.
    (A) In general.
    (B) Exceptions to the general rule in paragraph (c)(3)(iv)(A).
    (4) Use of financial statement for a substantial non-tax purpose.
    (5) Special rules.
    (i) Applicable financial statement of related corporations.
    (A) Applicable financial statement of a consolidated group.
    (B) Special rule for statements of equal priority.
    (C) Special rule for related corporations.
    (D) Anti-abuse rule.
    (ii) Applicable financial statement of foreign corporation with a 
United States trade or business.
    (A) In general.
    (B) Special rules for applicable financial statement of a trade or 
business of a foreign taxpayer.
    (C) Special rule for statements of equal priority.
    (D) Anti-abuse rule.
    (iii) Supplement or amendment to an applicable financial statement.
    (A) Excluding a restatement of net book income.
    (B) Restatement of net book income.
    (6) Examples.
    (d) Adjustments to net book income.
    (1) In general.
    (2) Definitions.
    (i) Historic practice.
    (ii) Accounting literature.
    (3) Adjustments for certain taxes.
    (i) In general.
    (ii) Exception for certain foreign taxes.
    (iii) Certain valuation adjustments.
    (iv) Examples.
    (4) Adjustments to prevent omission or duplication.
    (i) In general.
    (ii) Special rule for depreciating an asset below is cost.
    (iii) Consolidated group using current earnings and profits.
    (iv) Restatement of a prior year's applicable financial statement.
    (A) In general.
    (B) Reconciliation of owner's equity in applicable financial 
statements.
    (B) Use of different priority applicable financial statements in 
consecutive taxable years.
    (D) First successor year defined.
    (E) Exceptions.
    (v) Adjustment for items previously taxed as subpart F income.
    (vi) Adjustment for pooling of interests.
    (vii) Adjustment for certain deferred foreign taxes.
    (viii) Examples.
    (5) Adjustments resulting from disclosure.
    (i) Adjustment for footnote disclosure or other supplementary 
information.
    (A) In general.

[[Page 574]]

    (B) Disclosures not specifically authorized in the accounting 
literature.
    (ii) Equity adjustments.
    (A) In general.
    (B) Definition of equity adjustment.
    (iii) Amount disclosed in an accountant's opinion.
    (iv) Accounting method changes that result in cumulative adjustments 
to the current year's applicable financial statement.
    (A) In general.
    (B) Exception.
    (v) Examples.
    (6) Adjustments applicable to related corporations.
    (i) Consolidated returns.
    (A) In general.
    (B) Corporations included in the consolidated Federal income tax 
return but excluded from the applicable financial statement.
    (C) Corporations included in the applicable financial statement but 
excluded from the consolidated tax return.
    (ii) Adjustment under the principles of section 482.
    (iii) Adjustment for dividends received from section 936 
corporations.
    (A) In general.
    (B) Treatment as foreign taxes.
    (C) Treatment of taxes imposed on section 936 corporations.
    (iv) Adjustment to net book income on sale of certain investments.
    (v) Examples.
    (7) Adjustments for foreign taxpayers with a United States trade or 
business.
    (i) In general.
    (ii) Example.
    (8) Adjustment for corporations subject to subchapter F.
    (e) Special rules.
    (1) Cooperatives.
    (2) Alaska Native Corporations.
    (3) Insurance companies.
    (4) Estimating the net book income adjustment for purposes of 
estimated tax liability.
    (5) Effective/applicability date.

[T.D. 8307, 55 FR 33675, Aug. 17, 1990, as amended by T.D. 9347, 72 FR 
44347, Aug. 7, 2007]

Regulations Applicable to Taxable Years Beginning in 1969 and Ending in 
                                  1970



Sec.  1.56(g)-0  Table of Contents.

    This section lists the paragraphs contained in Sec.  1.56(g)-1.

               Sec.  1.56(g)-1 Adjusted current earnings.

    (a) Adjustment for adjusted current earnings.
    (1) Positive adjustment.
    (2) Negative adjustment.
    (i) In general.
    (ii) Limitation on negative adjustments.
    (iii) Example.
    (3) Negative amounts.
    (4) Taxpayers subject to adjustment for adjusted current earnings.
    (5) General rule for applying Internal Revenue Code provisions in 
determining adjusted current earnings.
    (i) In general.
    (ii) Example.
    (6) Definitions.
    (i) Pre-adjustment alternative minimum taxable income.
    (ii) Adjusted current earnings.
    (iii) Earnings and profits.
    (7) Application to foreign corporations.
    (b) Depreciation allowed.
    (1) Property placed in service after 1989.
    (2) Property subject to new ACRS.
    (i) In general.
    (ii) Rules for computing the depreciation deduction.
    (iii) Example.
    (3) Property subject to original ACRS.
    (i) In general.
    (ii) Rules for computing the depreciation deduction.
    (iii) Example.
    (4) Special rule for certain section 168(f) property.
    (5) Certain property not subject to ACRS.
    (c) Inclusion in adjusted current earnings of items included in 
earnings and profits.
    (1) In general.
    (2) Certain amounts not taken into account in determining whether an 
item is permanently excluded.
    (3) Allowance of offsetting deductions.
    (4) Special rules.
    (i) Income from the discharge of indebtedness.
    (ii) Federal income tax refunds.
    (iii) Income earned on behalf of states and municipalities.
    (5) Treatment of life insurance contracts.
    (i) In general.
    (ii) Inclusion of inside buildup.
    (iii) Calculation of income on the contract.
    (iv) Treatment of distributions under the life insurance contract.
    (v) Treatment of death benefits.
    (vi) Other rules.
    (A) Term life insurance contracts without net surrender values.
    (B) Life insurance contracts involving divided ownership.
    (vii) Examples.
    (6) Partial list of income items excluded from gross income but 
included in earnings and profits.
    (7) Partial list of items excluded from both pre-adjustment 
alternative minimum taxable income and adjusted current earnings.
    (d) Disallowance of items not deductible in computing earnings and 
profits.
    (1) In general.

[[Page 575]]

    (2) Deductions for certain dividends received.
    (i) Certain amounts deducted under sections 243 and 245.
    (ii) Special rules.
    (A) Dividends received from a foreign sales corporation.
    (B) Dividends received from a section 936 corporation.
    (iii) Special rule for certain dividends received by certain 
cooperatives.
    (3) Partial list of items not deductible in computing earnings and 
profits.
    (4) Partial list of items deductible for purposes of computing both 
pre-adjustment alternative minimum taxable income and adjusted current 
earnings.
    (e) Treatment of income items included, and deduction items not 
allowed, in computing pre-adjustment alternative minimum taxable income.
    (f) Certain other earnings and profits adjustments.
    (1) Intangible drilling costs.
    (2) Certain amortization provisions do not apply.
    (3) LIFO recapture adjustment.
    (i) In general.
    (ii) Beginning LIFO and FIFO inventory.
    (iii) Definitions.
    (A) LIFO recapture amount.
    (1) Definition.
    (2) Assets included.
    (B) FIFO method.
    (C) LIFO method.
    (D) Inventory amounts.
    (iv) Exchanges under sections 351 and 721.
    (v) Examples.
    (vi) Effective date.
    (4) Installment sales.
    (i) In general.
    (ii) Exception for prior dispositions.
    (iii) Special rules for obligations to which section 453A applies.
    (A) In general.
    (B) Limitation on application of installment method.
    (C) Treatment of the ineligible portion.
    (D) Treatment of the eligible portion.
    (E) Coordination with the pledge rule.
    (F) Example.
    (g) Disallowance of loss on exchange of debt pools. [Reserved]
    (h) Policy acquisition expenses of life insurance companies.
    (1) In general.
    (2) Reasonably estimated life.
    (3) Reasonable allowance for amortization.
    (4) Safe harbor for public financial statements.
    (i) [Reserved]
    (j) Depletion.
    (k) Treatment of certain ownership changes.
    (1) In general.
    (2) Definition of ownership change.
    (3) Determination of net unrealized built-in loss immediately before 
an ownership change.
    (4) Example.
    (l) [Reserved]
    (m) Adjusted current earnings of a foreign corporation.
    (1) In general.
    (2) Definitions.
    (i) Effectively connected pre-adjustment alternative minimum taxable 
income.
    (ii) Effectively connected adjusted current earnings.
    (3) Rules to determine effectively connected pre-adjustment 
alternative minimum taxable income and effectively connected adjusted 
current earnings.
    (4) Certain exempt amounts.
    (n) Adjustment for adjusted current earnings of consolidated groups.
    (1) Positive adjustments.
    (2) Negative adjustments.
    (i) In general.
    (ii) Limitation on negative adjustments.
    (3) Definitions.
    (i) Consolidated pre-adjustment alternative minimum taxable income.
    (ii) Consolidated adjusted current earnings.
    (4) Example.
    (o) [Reserved]
    (p) Effective dates for corporate partners in partnerships.
    (1) In general.
    (2) Application of effective dates.
    (3) Example.
    (q) Treatment of distributions of property to shareholders.
    (1) In general.
    (2) Examples.
    (r) Elections to use simplified inventory methods to compute 
alternative minimum tax.
    (1) In general.
    (2) Effect of election.
    (i) Inventories.
    (ii) Modifications required.
    (A) In general.
    (B) Negative modifications allowed.
    (iii) LIFO recapture adjustment.
    (3) Time and manner of making election.
    (i) Prospective election.
    (ii) Retroactive election.
    (iii) Taxpayers under examination.
    (A) In general.
    (1) Year of change under examination.
    (2) Other open years under examination.
    (B) Statement required.
    (C) Year of change.
    (D) Treatment of additional tax liability.
    (iv) Election as method of accounting.
    (v) Untimely election to use simplified inventory method.
    (4) Example.
    (5) Election to use alternative minimum tax inventories to compute 
adjusted current earnings.

[[Page 576]]

    (s) Adjustment for alternative tax energy preference deduction.
    (1) In general.
    (2) Example.

[T.D. 8340, 56 FR 11083, Mar. 15, 1991, as amended by T.D. 8454, 57 FR 
60476, Dec. 21, 1992]



Sec.  1.56(g)-1  Adjusted current earnings.

    (a) Adjustment for adjusted current earnings--(1) Positive 
adjustment. For taxable years beginning after December 31, 1989, the 
alternative minimum taxable income of any taxpayer described in 
paragraph (a)(4) of this section is increased by the adjustment for 
adjusted current earnings. The adjustment for adjusted current earnings 
is 75 percent of the excess, if any, of--
    (i) The adjusted current earnings (as defined in paragraph 
(a)(6)(ii) of this section) of the taxpayer for the taxable year over.
    (ii) The pre-adjustment alternative minimum taxable income (as 
defined in paragraph (a)(6)(i) of this section) of the taxpayer for the 
taxable year.
    (2) Negative adjustment--(i) In general. For taxable years beginning 
after December 31, 1989, the alternative minimum taxable income of any 
taxpayer is decreased, subject to the limitation of paragraph (a)(2)(ii) 
of this section, by 75 percent of the excess, if any, of pre-adjustment 
alternative minimum taxable income (as defined in paragraph (a)(6)(i) of 
this section), over adjusted current earnings (as defined in paragraph 
(a)(6)(ii) of this section).
    (ii) Limitation on negative adjustments. The amount of the negative 
adjustment for any taxable year is limited to the excess, if any, of--
    (A) The aggregate increases in alternative minimum taxable income in 
prior years under paragraph (a)(1) of this section over
    (B) The aggregate decreases in alternative minimum taxable income in 
prior years under this paragraph (a)(2).
    Any excess of pre-adjustment alternative minimum taxable income over 
adjusted current earnings that is not allowed as a negative adjustment 
for the taxable year because of the limitation in this paragraph 
(a)(2)(ii) is not applied to reduce any positive adjustment in any other 
taxable year.
    (iii) Example. The following example illustrates the provisions of 
this paragraph (a)(2):

    (A) Corporation P is a calendar-year taxpayer and has pre-adjustment 
alternative minimum taxable income and adjusted current earnings in the 
following amounts for 1990 through 1993:

------------------------------------------------------------------------
                                                    Pre-
                                                 adjustment
                                                alternative    Adjusted
                     Year                         minimum      current
                                                  taxable      earnings
                                                   income
------------------------------------------------------------------------
1990..........................................     $800,000     $700,000
1991..........................................      600,000      900,000
1992..........................................      500,000      400,000
1993..........................................      500,000      100,000
------------------------------------------------------------------------

    (B) Under these facts, corporation P has the following positive and 
negative adjustments for adjusted current earnings:

------------------------------------------------------------------------
                                                  Negative     Positive
                     Year                        adjustment   adjustment
------------------------------------------------------------------------
1990..........................................            0            0
1991..........................................            0     $225,000
1992..........................................      $75,000            0
1993..........................................      150,000            0
------------------------------------------------------------------------

    (C) In 1990, P has a potential negative adjustment (before the 
cumulative limitation) of $75,000 (75 percent of the $100,000 excess of 
pre-adjustment alternative minimum taxable income over adjusted current 
earnings). Nonetheless, P is not permitted a negative adjustment because 
P had no prior increases in its alternative minimum taxable income due 
to an adjustment for adjusted current earnings.
    (D) In 1991, P has a positive adjustment of $225,000 (75 percent of 
the $300,000 excess of adjusted current earnings over pre-adjustment 
alternative minimum taxable income). P is not allowed to use the prior 
year's excess of pre-adjustment alternative minimum taxable income over 
adjusted current earnings to reduce its 1991 positive adjustment.
    (E) In 1992, P is permitted a negative adjustment of $75,000, the 
full amount of 75 percent of the $100,000 excess of pre-adjustment 
alternative minimum taxable income over adjusted current earnings for 
the taxable year. This is because P's prior cumulative increases in 
alternative minimum taxable income due to the positive adjustments for 
adjusted current earnings exceed the negative adjustment for the year.
    (F) In 1993, P has a potential negative adjustment (before the 
cumulative limitation) of $300,000 (75 percent of the $400,000 excess of 
pre-adjustment alternative minimum taxable income over adjusted current 
earnings). P's net cumulative increases in alternative minimum taxable 
income due to the adjustment for adjusted current earnings are $150,000 
($225,000 increase in 1991, less $75,000

[[Page 577]]

decrease in 1992). Thus, P's negative adjustment in 1993 is limited to 
$150,000. P may not use the remaining portion ($150,000) of the negative 
adjustment for 1993 to reduce positive adjustments in other taxable 
years.

    (3) Negative amounts. In determining whether an excess exists under 
paragraph (a)(1) or (a)(2) of this section, a positive amount exceeds a 
negative amount by the sum of the absolute numbers, and a smaller 
negative amount exceeds a larger negative amount by the difference 
between the absolute numbers. Thus, for example, a positive amount of 
adjusted current earnings of $30 exceeds a negative amount (or loss) of 
pre-adjustment AMTI of $10 by the sum of the absolute numbers, or $40 
(30 + 10). Accordingly, the adjustment for adjusted current earnings 
would be 75 percent of $40, or $30. In contrast, a negative amount of 
adjusted current earnings of $10 exceeds a negative amount (or loss) of 
pre-adjustment alternative minimum taxable income of $30 by the 
difference between the absolute numbers, or $20 (30-10). Accordingly, 
the adjustment for adjusted current earnings would be 75 percent of $20, 
or $15.
    (4) Taxpayers subject to adjustment for adjusted current earnings. 
The adjustment for adjusted current earnings applies to any corporation 
other than--
    (i) An S corporation as defined in section 1361,
    (ii) A regulated investment company as defined in section 851,
    (iii) A real estate investment trust as defined in section 856, or
    (iv) A real estate mortgage investment conduit as defined in section 
860A.
    (5) General rule for applying Internal Revenue Code provisions in 
determining adjusted current earnings--(i) In general. Except as 
otherwise provided by regulations or other guidance issued by the 
Internal Revenue Service, all Internal Revenue Code provisions that 
apply in determining the regular taxable income of a taxpayer also apply 
in determining adjusted current earnings. For example, the rules of part 
V of subchapter P (relating to original issue discount and similar 
matters) of the Code apply in determining the amount (and the timing) of 
any interest income included in adjusted current earnings under this 
section. In applying Code provisions, however, the adjustments of 
section 56(g) and this section are also taken into account. For example, 
in applying the capitalization provisions of section 263A, the amount of 
depreciation to be capitalized is based on the amount of depreciation 
allowed in computing adjusted current earnings.
    (ii) Example. The following example illustrates the provisions of 
this paragraph (a)(5):

    (A) Corporation N is a calendar year manufacturer of golf clubs. N 
places new manufacturing equipment in service in 1990. The regular tax 
depreciation allowable for this equipment is $80,000; the pre-adjustment 
alternative minimum taxable income depreciation is $60,000; and the 
adjusted current earnings depreciation is $40,000. All of the golf clubs 
N produces in 1990 are unsold and are in ending inventory.
    (B) Pursuant to section 263A and Sec.  1.263A-1(e)(3)(ii)(I), N must 
capitalize the depreciation allowed for the year for the new 
manufacturing equipment in the ending inventory of golf clubs. Thus, 
when N sells the golf clubs (or is deemed to have sold them under its 
normal method of accounting), the cost of goods sold attributable to the 
capitalized depreciation will be $80,000 in computing regular taxable 
income; $60,000 in computing pre-adjustment alternative minimum taxable 
income; and $40,000 in computing adjusted current earnings.

    (6) Definitions. The following terms have the following meanings for 
purpose of this section.
    (i) Pre-adjustment alternative minimum taxable income. Pre-
adjustment alternative minimum taxable income is the alternative minimum 
taxable income of the taxpayer for the taxable year, determined under 
section 55(b)(2), but without the adjustment for adjusted current 
earnings under section 56(g) and this section, without the alternative 
tax net operating loss deduction under section 56(a)(4), and without the 
alternative tax energy preference deduction under section 56(h).
    (ii) Adjusted current earnings. Adjusted current earnings is the 
pre-adjustment alternative minimum taxable income of the taxpayer for 
the taxable year, adjusted as provided in section 56(g) and this 
section. To the extent an amount is included (or deducted) in computing 
pre-adjustment alternative

[[Page 578]]

minimum taxable income for the taxable year (whether because an 
adjustment is made under section 56 or 58, because of a tax preference 
item under section 57, or because the item is reflected in taxable 
income), that amount is not again included (or deducted) in computing 
adjusted current earnings for the taxable year.
    (iii) Earnings and profits. Earnings and profits means current 
earnings and profits within the meaning of section 316(a)(2), that is, 
earnings and profits for the taxable year computed as of the close of 
the taxable year of the corporation without diminution by reason of any 
distributions made during the taxable year.
    (7) Application to foreign corporations. See paragraph (m) of this 
section for rules relating to the application of this section to foreign 
corporations.
    (b) Depreciation allowed. The depreciation deduction allowed in 
computing adjusted current earnings is determined under the rules of 
this paragraph (b). Generally, the rules for computing the adjusted 
current earnings depreciation deduction differ depending on the taxable 
year in which the property is placed in service and the method used in 
computing the depreciation deduction for taxable income purposes. See 
Sec.  1.168(i)-1(k) for an election to use general asset accounts.
    (1) Property placed in service after 1989. The depreciation 
deduction for property placed in service in a taxable year beginning 
after December 31, 1989, is the amount determined by using the 
alternative depreciation system of section 168(g). This paragraph (b)(1) 
does not apply to property to which paragraph (b)(4) of this section 
applies (relating to certain property described in sections 168 (f)(1) 
through (f)(4)).
    (2) Property subject to new ACRS--(i) In general. This paragraph 
(b)(2) provides the rules for computing the depreciation deduction for 
property to which the amendments made by section 201 of the Tax Reform 
Act of 1986 (new ACRS) apply (generally property placed in service after 
December 31, 1986), and that is placed in service in a taxable year 
beginning before January 1, 1990. This paragraph (b)(2) does not apply 
to property described in paragraph (b)(4) of this section (relating to 
certain property described in sections 168 (f)(1) through (f)(4)) or to 
property described in paragraph (b)(5)(i) of this section (relating to 
certain churning transactions described in section 168(f)(5)).
    (ii) Rules for computing the depreciation deduction. The 
depreciation deduction for property described in this paragraph (b)(2) 
is the amount determined by using--
    (A) The adjusted basis of the property as determined in computing 
alternative minimum taxable income as of the close of the last taxable 
year beginning before January 1, 1990,
    (B) The straight-line method, and
    (C) The recovery period that consists of the remainder of the 
recovery period applicable to the property under the alternative 
depreciation system of section 168(g).

Thus, the recovery period begins on the first day of the first taxable 
year beginning after December 31, 1989, and ends on the last day of the 
recovery period that would have applied had the recovery period for the 
property originally been determined under section 168(g). In determining 
the recovery period that would have applied, the property is deemed 
placed in service on the date it was considered placed in service under 
the depreciation convention that would have applied to the property 
under section 168(d).
    (iii) Example. The following example illustrates the provisions of 
this paragraph (b)(2).

    Example. Corporation X, a calendar-year taxpayer, purchases and 
places in service on August 1, 1987, computer-based telephone central 
office switching equipment. This is the only item of depreciable 
property X places in service during 1987. Thus, the applicable 
convention under section 168(d) is the half-year convention. As of 
December 31, 1989, the adjusted basis of the property used in computing 
alternative minimum taxable income is $42,000. The recovery period that 
would have applied to the property under section 168(g)(2) is 9.5 years 
(from July 1, 1987 to December 31, 1996). Thus, the recovery period for 
computing adjusted current earnings under section 56(g)(4)(A)(ii) and 
this paragraph (b)(2) begins on January 1, 1990, and ends on December 
31, 1996. X's 1990 depreciation deduction for computing adjusted current 
earnings is $6,000, determined under the straight-line method by 
dividing $42,000 (adjusted basis) by 7 (recovery period).


[[Page 579]]


    (3) Property subject to original ACRS--(i) In general. This 
paragraph (b)(3) provides the rules for computing the depreciation 
deduction for property to which section 168 as in effect on the day 
before the date of enactment of the Tax Reform Act of 1986 (original 
ACRS) applies and that is placed in service in a taxable year beginning 
before January 1, 1990 (generally property that was placed in service 
after December 31, 1980 and before January 1, 1987). In determining 
whether original ACRS applies to property, the fact that the unadjusted 
basis of the property is reduced or eliminated under section 
168(d)(4)(A)(i) of original ACRS is not taken into account. This 
paragraph (b)(3) does not apply to property described in paragraph 
(b)(4) or (b)(5)(i) of this section (relating to certain section 168(f) 
property).
    (ii) Rules for computing the depreciation deduction. The 
depreciation deduction for property described in this paragraph (b)(3) 
is the amount determined by using--
    (A) The adjusted basis of the property as determined in computing 
taxable income as of the close of the last taxable year beginning before 
January 1, 1990,
    (B) The straight-line method, and
    (C) The recovery period that consists of the remainder of the 
recovery period applicable to the property under the alternative 
depreciation system of section 168(g). Thus, the recovery period begins 
on the first day of the first taxable year beginning after December 31, 
1989, and ends on the last day of the recovery period that would have 
applied had the recovery period for the property originally been 
determined under section 168(g)(2). In determining the recovery period 
that would have applied, the property is deemed placed in service on the 
date it was considered placed in service under the depreciation 
convention that would have applied to the property under section 168(d) 
(without regard to section 168(d)(3)).
    (iii) Example. The following example illustrates the provisions of 
this paragraph (b)(3).

    Example. Corporation Y, a calendar-year taxpayer, purchases and 
places in service on December 1, 1986, computer-based telephone central 
office switching equipment. The depreciation convention that would have 
applied to this property under section 168(d) (without regard to section 
168(d)(3)) is the half-year convention. As of December 31, 1989, the 
adjusted basis of the property used in computing taxable income is 
$21,000. The recovery period for the property under section 168(g)(2) is 
9.5 years (from July 1, 1986 to December 31, 1995). Thus, the recovery 
period for computing adjusted current earnings under section 
56(g)(4)(A)(iii) and this paragraph (b)(3) begins on January 1, 1990, 
and ends on December 31, 1995. Y's 1990 depreciation deduction for 
computing adjusted current earnings is $3,500, determined under the 
straight-line method by dividing $21,000 (adjusted basis) by 6 (recovery 
period).

    (4) Special rule for certain section 168(f) property. The 
depreciation or amortization deduction for property described in section 
168(f) (1) through (4) is determined in the same manner as used in 
computing taxable income, without regard to when the property is placed 
in service.
    (5) Certain property not subject to ACRS. The depreciation or 
amortization deduction for property not described in paragraphs (b) (1) 
through (4) of this section is determined in the same manner as used in 
computing taxable income. Thus, this paragraph (b)(5) applies to--
    (i) Property placed in service after December 31, 1980, in a taxable 
year beginning before January 1, 1990, and that is excluded from the 
application of original ACRS or new ACRS by section 168(e)(4) of 
original ACRS or section 168(f)(5)(A)(i) of new ACRS, and
    (ii) Property placed in service before January 1, 1981.
    (c) Inclusion in adjusted current earnings of items included in 
earnings and profits--(1) In general. Except as otherwise provided in 
paragraph (c)(4) of this section, adjusted current earnings includes all 
income items that are permanently excluded from (i.e., not taken into 
account in determining) pre-adjustment alternative minimum taxable 
income but that are taken into account in determining earnings and 
profits. An income item is considered taken into account in determining 
pre-adjustment alternative minimum taxable income without regard to the 
timing of its inclusion. Thus, this paragraph (c)(1) does not apply to 
any income item that is, has been, or will be included in pre-

[[Page 580]]

adjustment alternative minimum taxable income. For example, a taxpayer 
eligible to use the completed contract method of accounting for long-
term construction contracts does not take income (or expenses) into 
account in determining pre-adjustment alternative minimum taxable income 
for taxable years before the taxable year the contract is completed. The 
taxpayer is required under section 312(n)(6) to include income (and 
expenses) in earnings and profits throughout the term of the contract 
under the percentage of completion method. This paragraph (c)(1) does 
not require the income on the contract to be included in adjusted 
current earnings, however, because the income will be taken into account 
in the taxable year the contract is completed and therefore is 
considered to be taken into account in determining pre-adjustment 
alternative minimum taxable income.
    (2) Certain amounts not taken into account in determining whether an 
item is permanently excluded. The fact that proceeds from an income item 
may eventually be reflected in pre-adjustment alternative minimum 
taxable income of another taxpayer on the liquidation or disposal of a 
business, or similar circumstances, is not taken into account in 
determining whether the item is permanently excluded from pre-adjustment 
alternative minimum taxable income. Thus, for example, a corporation's 
adjusted current earnings include interest excluded from pre-adjustment 
alternative minimum taxable income under section 103 even though the 
interest might eventually be reflected in the pre-adjustment alternative 
minimum taxable income of a corporate shareholder as gain on the 
liquidation of the corporation.
    (3) Allowance of offsetting deductions. In determining adjusted 
current earnings under this paragraph (c), a deduction is allowed for 
all items that relate to income required to be included in adjusted 
current earnings under this paragraph (c) and that would be deductible 
in computing pre-adjustment alternative minimum taxable income if the 
income items to which the items of deduction relate were included in 
pre-adjustment alternative minimum taxable income for any taxable year. 
For example, deductions disallowed under section 265(a)(2) for the costs 
of carrying tax-exempt obligations, the interest on which is excluded 
from pre-adjustment alternative minimum taxable income under section 103 
but is included in adjusted current earnings under this paragraph (c), 
are generally allowed as deductions in computing adjusted current 
earnings. Amounts deductible under this paragraph (c)(3) are taken into 
account using the taxpayer's method of accounting and are subject to any 
provisions or limitations of the Code that would have applied if the 
amounts had been deductible in determining pre-adjustment alternative 
minimum taxable income. For example, section 267(a)(2) may affect the 
timing of a deduction otherwise disallowed under section 265(a)(2).
    (4) Special rules. Adjusted current earnings does not include the 
following amounts.
    (i) Income from the discharge of indebtedness. Amounts that are 
excluded from gross income under section 108 of the Internal Revenue 
Code of 1986 or any corresponding provision of prior law (including the 
Bankruptcy Tax Act of 1980, case law, income tax regulations and 
administrative pronouncements).
    (ii) Federal income tax refunds. Refunds of federal income taxes.
    (iii) Income earned on behalf of states and municipalities. Amounts 
that are excluded from gross income under section 115.
    (5) Treatment of life insurance contracts--(i) In general. This 
paragraph (c)(5) addresses the treatment of life insurance contracts in 
determining adjusted current earnings. These rules apply to life 
insurance contracts as defined in section 7702. Generally, death 
benefits under a life insurance contract are included in adjusted 
current earnings, and all other distributions (including surrenders) are 
taxed in accordance with the principles of section 72(e), taking into 
account the taxpayer's basis in the contract for purposes of adjusted 
current earnings. If the adjusted basis in the contract for purposes of 
adjusted current earnings exceeds the amount of death benefits received 
or the amount received when the contract is surrendered (increased

[[Page 581]]

by the amount of any outstanding policy loan), the resulting loss is 
allowed as a deduction under paragraph (c)(3) of this section in 
computing adjusted current earnings for the taxable year. In addition, 
undistributed income on the contract is included in adjusted current 
earnings as provided in paragraph (c)(5)(ii) of this section. Paragraph 
(c)(5)(vi)(A) of this section provides special rules for term insurance 
that has no net surrender value.
    (ii) Inclusion of inside buildup. Income on a life insurance 
contract with respect to a taxable year (or any shorter period either 
ending or beginning with the date of a distribution from the contract) 
is included in adjusted current earnings for the taxable year. Thus, 
income on the contract is calculated from the beginning of a taxable 
year to the date of any distribution, from immediately after any 
distribution to the date of the next distribution, and from the last 
distribution during the taxable year through the end of the taxable 
year. Income on a life insurance contract is not included in adjusted 
current earnings for any taxable year in which the insured dies or the 
contract is completely surrendered for its entire net surrender value. 
Solely for purposes of computing adjusted current earnings, the 
taxpayer's adjusted basis in the contract (as determined under section 
72(e)(6)) is increased to reflect any positive income on the contract 
included in adjusted current earnings under this paragraph (c)(5)(ii). 
The manner in which the income on the contract is determined for 
adjusted current earnings purposes is prescribed in paragraph 
(c)(5)(iii) of this section. If the income on the contract determined 
under paragraph (c)(5)(iii) of this section is a negative amount, income 
on the contract is not included in adjusted current earnings and no 
deduction from adjusted current earnings is allowed for the negative 
amount.
    (iii) Calculation of income on the contract. For purposes of 
determining adjusted current earnings, the income on a life insurance 
contract for any period, including a taxable year, is the excess, if 
any, of--
    (A) The sum of the contract's net surrender value (as defined in 
section 7702(f)(2)(B)) at the end of the period, and any distributions 
under the contract during the period that, in accordance with the 
principles of section 72(e), are not taxed because they represent 
recoveries of the taxpayer's basis in the contract for adjusted current 
earnings, over
    (B) The sum of the contract's net surrender value at the end of the 
preceding period, and any premiums paid under the contract during the 
period.
    (iv) Treatment of distributions under the life insurance contract. 
Any distribution under a life insurance contract (whether a partial 
withdrawal or an amount received on complete surrender of the contract) 
is included in adjusted current earnings in accordance with the 
principles of section 72(e), taking into account the taxpayer's basis in 
the contract for purposes of computing adjusted current earnings. The 
taxpayer's basis in the contract is equal to the basis at the end of the 
immediately preceding period plus any premiums paid before the 
distribution. The taxpayer's basis in the contract for purposes of 
adjusted current earnings is reduced, in accordance with the principles 
of section 72(e), to the extent that the distribution is not included in 
adjusted current earnings because it represents a recovery of that 
basis.
    (v) Treatment of death benefits. The excess of the contractual death 
benefit of a life insurance contract over the taxpayer's adjusted basis 
in the contract for purposes of computing adjusted current earnings at 
the time of the insured's death is included in adjusted current earnings 
as provided by paragraph (c)(6)(i) of this section. The amount of the 
death benefit that is taken into account for adjusted current earnings 
includes the amount of any outstanding policy loan treated as forgiven 
or discharged by the insurance company upon the death of the insured.
    (vi) Other rules--(A) Term life insurance contract without net 
surrender values. Except as provided in this paragraph (c)(5)(vi), the 
requirements of paragraph (c)(5) of this section do not apply to term 
life insurance contracts that provide no net surrender value. Adjusted 
current earnings are reduced by any premiums paid under such a contract 
that are allocable to the taxable year. Any premiums paid that are

[[Page 582]]

not allocable to the taxable year must be included in the basis of the 
contract. The death benefit under such a term insurance contract is 
included in adjusted current earnings as provided by paragraph (c)(5)(v) 
of this section.
    (B) Life insurance contracts involving divided ownership. If the 
ownership of a life insurance contract is divided between different 
persons (for example, a split-dollar arrangement), the requirements of 
paragraph (c)(5) of this section apply to the separate ownership 
interests as though each interest were a separate contract.
    (vii) Examples. The following examples illustrate the provisions of 
this paragraph (c)(5).

    Example 1. (i) On January 1, 1987, corporation X, a calendar year 
taxpayer, purchased a flexible premium life insurance contract with a 
death benefit of $100,000 and planned annual gross premiums of $2,200 
payable on January 1 of each year. The net surrender value of the 
contract at the end of 1987 and subsequent years, together with the 
cumulative premiums for the contract at the end of each year, are set 
forth in the following table:

------------------------------------------------------------------------
                                                               Year-end
                                                 Cumulative      net
                     Year                         premiums    surrender
                                                    paid        value
------------------------------------------------------------------------
1987..........................................       $2,200       $2,420
1988..........................................        4,400        5,082
1989..........................................        6,600        8,010
1990..........................................        8,800       11,231
1991..........................................       11,000       14,774
------------------------------------------------------------------------

    (ii) Under paragraph (c)(5)(ii) of this section, X must include 
$1,021 in adjusted current earnings for 1990. The inclusion is computed 
by subtracting from the net surrender value of the contract at the end 
of the taxable year ($11,231) the sum of the net surrender value of the 
contract at the end of the preceding taxable year ($8,010) plus the 
premiums paid during the taxable year ($2,200). See paragraph 
(c)(5)(iii) of this section. For purposes of determining adjusted 
current earnings, X's adjusted basis in the contract would be increased 
at the end of 1990 from $8,800 to $9,821 to reflect the $1,021 
inclusion. See paragraph (c)(5)(ii) of this section. The income under 
the contract attributable to taxable years prior to 1990 does not 
increase X's adjusted basis in the contract.
    (iii) For 1991, the income on the contract included in adjusted 
current earnings is determined in the same manner as the preceding year, 
and there is a corresponding increase in X's adjusted basis in the 
contract. Thus, for 1991, the income on the contract is $1,343, which is 
determined by subtracting from the net surrender value of the contract 
at the end of the taxable year ($14,774) the sum of the net surrender 
value at the end of the preceding taxable year ($11,231) plus the 
premiums paid during the taxable year ($2,200). At the end of 1991, X's 
adjusted basis in the contract for adjusted current earnings is $13,364, 
which reflects the basis of the contract at the beginning of 1991, 
increased by the premium paid during the year ($2,200) and the income on 
the contract that has been included in adjusted current earnings for the 
taxable year ($1,343).
    Example 2. The facts are the same as in example 1, except that, 
after the payment of the premium for 1991, the insured dies and X 
receives the $100,000 death benefit under the contract. Under paragraph 
(c)(5)(ii) of this section, no amount is included in adjusted current 
earnings for income on the contract for the taxable year in which the 
insured dies. Instead, under paragraph (c)(5)(v) of this section, X must 
include the adjusted current earnings for 1991 the excess of the death 
benefit ($100,000) over the adjusted basis in the contract for purposes 
of computing adjusted current earnings at the time of the insured's 
death ($12,021), which equals X's adjusted basis in the contract at the 
end of 1990 ($9,821), increased by X's premium payment for 1991 
($2,200).
    Example 3. (i) The facts are the same as in example 1, except that 
in addition to making the $2,200 planned premium payment for 1992, X 
receives a $16,200 distribution under the contract on February 1, 1992, 
leaving a net surrender value of $915 immediately following the 
distribution. On March 1, 1992, X pays an additional premium of $5,000 
under the contract. The net surrender value of the contract at the end 
of 1992 is $6,417.
    (ii) Treatment of the distribution. Under paragraph (c)(5)(iv) of 
this section, the $16,200 distribution in 1992 is included in adjusted 
current earnings as an amount taxable in accordance with the principles 
of section 72(e) to the extent that the distribution ($16,200) exceeds 
X's adjusted basis for adjusted current earnings, as determined at the 
end of the immediately preceding period, and including premiums paid 
through the period ending on the date of the distribution ($15,564). 
Thus, X must include $636 in adjusted current earnings for 1992 as an 
amount taxable in accordance with the principles of section 72(e).
    (iii) Determination of the income on the contract. Under paragraph 
(c)(5)(iii) of this section, for 1992, the income on the contract must 
be separately determined for the period beginning with the first day of 
the taxable year to the date of the distribution and for the period 
beginning immediately after the distribution to the end of the taxable 
year, using the contract's net surrender values at

[[Page 583]]

the beginning and end of each of these periods. The income on the 
contract for the period beginning on January 1, 1992 and ending on 
February 1, 1992 (the date of the distribution) is equal to the excess, 
if any, of (A) the sum of the net surrender value at the end of the 
period ($915) and the amount of the distribution that is allocable to 
X's basis in the contract for adjusted current earnings ($15,564), over 
(B) the sum of the net surrender value at the end of the preceding 
taxable year ($14,774) plus any premiums paid on the contract during the 
period ($2,200). Because the net result of this computation is a 
negative amount (($915 + $15,564)-($14,774 + $2,200)=-495), no income on 
the contract for the period ending with the date of the distribution is 
included in adjusted current earnings for 1992.
    (iv) Under paragraph (c)(5)(ii), X must also determine the income on 
the contract for the period beginning immediately after the distribution 
through the end of the taxable year. The income on the contract for this 
period is $502, which is equal to the excess of the net surrender value 
at the end of the taxable year ($6,417) over the sum of the net 
surrender value at the end of the preceding period ($915), plus any 
premiums paid during the period ($5,000). At the end of 1992, X's 
adjusted basis in the contract for adjusted current earnings is $5,502, 
determined by adding the income on the contract ($502) and the premiums 
paid during the period ($5,000) to the basis at the end of the preceding 
period ($0).
    (v) Thus, X must include a total of $1,138 ($636 + 502) in adjusted 
current earnings for 1992. This inclusion reflects both the 
undistributed income on the contract for the taxable year plus the 
amount of income from distributions under the contract that is taxed in 
accordance with the principles of section 72(e) using X's adjusted basis 
in the contract for adjusted current earnings.

    (6) Partial list of income items excluded from gross income but 
included in earnings and profits. The following is a partial list of 
items that are permanently excluded from pre-adjustment alternative 
minimum taxable income but that are included in earnings and profits, 
and are therefore included in adjusted current earnings under this 
paragraph (c).
    (i) Proceeds of life insurance contracts that are excluded under 
section 101, to the extent provided in paragraph (c)(5)(v) or (c)(5)(vi) 
of this section.
    (ii) Interest that is excluded under section 103.
    (iii) Amounts received as compensation for injuries or sickness that 
are excluded under section 104.
    (iv) Income taxes of a lessor of property that are paid by a lessee 
and are excluded under section 110.
    (v) Income attributable to the recovery of an item deducted in 
computing earnings and profits in a prior year that is excluded under 
section 111.
    (vi) Amounts received as proceeds from sports programs that are 
excluded under section 114.
    (vii) Cost-sharing payments that are excluded under section 126, to 
the extent section 126(e) does not apply.
    (viii) Interest on loans used to acquire employer securities that is 
excluded under section 133.
    (ix) Financial assistance that is excluded under section 597.
    (x) Amounts that are excluded from pre-adjustment alternative 
minimum taxable income as a result of an election under section 831(b) 
(allowing certain insurance companies to compute their pre-adjustment 
alternative minimum taxable income using only their investment income).

Items described in paragraph (c)(1) of this section must be included in 
earnings and profits (and therefore in adjusted current earnings) even 
if they are not identified in this paragraph (c)(6). The Commissioner 
may identify additional items described in paragraph (c)(1) in other 
published guidance.
    (7) Partial list of items excluded from both pre-adjustment 
alternative minimum taxable income and adjusted current earnings. The 
following is a partial list of items that are excluded from both pre-
adjustment alternative minimum taxable income and adjusted current 
earnings, and for which no adjustment is allowed under this section.
    (i) The value of improvements made by a lessee to a lessor's 
property that is excluded from the lessor's income under section 109.
    (ii) contributions to the capital of a corporation by a non-
shareholder that are excluded from the corporation's income under 
section 118.

The Commissioner may identify additional items described in this 
paragraph (c)(7) in other published guidance.

[[Page 584]]

    (d) Disallowance of items not deductible in computing earnings and 
profits--(1) In general. Except as otherwise provided in this paragraph 
(d), no deduction is allowed in computing adjusted current earnings for 
any items that are not taken into account in determining earnings and 
profits for any taxable year, even if the items are taken into account 
in determining pre-adjustment alternative minimum taxable income. These 
items therefore increase adjusted current earnings to the extent they 
are deducted in computing pre-adjustment alternative minimum taxable 
income. An item of deduction is considered taken into account without 
regard to the timing of its deductibility in computing earnings and 
profits. Thus, to the extent an item is, has been, or will be deducted 
for purposes of determining earnings and profits, it does not increase 
adjusted current earnings in the taxable year in which it is deducted 
for purposes of determining pre-adjustment alternative minimum taxable 
income. For example, a deduction allowed (in determining pre-adjustment 
alternative minimum taxable income) under section 196 for unused 
research credits allowable under section 41 is taken into account in 
computing earnings and profits because the costs that gave rise to the 
credit were deductible in computing earnings and profits when incurred. 
Therefore, the deduction does not increase adjusted current earnings. As 
a further example, payments by a United States parent corporation with 
respect to employees of certain foreign subsidiaries, which are 
deductible under section 176, are considered contributions to the 
capital of the foreign subsidiary for purposes of computing earnings and 
profits. Although the payments are not deductible in computing the 
earnings and profits of the United States parent corporation in the year 
incurred, the payments do increase the parent's basis in its stock in 
the foreign subsidiary. This basis increase will reduce any gain the 
parent may later realize for purposes of computing earnings and profits 
on the disposition of the stock of the foreign subsidiary. Therefore, 
the amount of the payment by the parent is considered taken into account 
in computing the earnings and profits of the parent and does not 
increase adjusted current earnings. Thus, only deduction items that are 
never taken into account in computing earnings and profits are 
disallowed in computing adjusted current earnings under this paragraph 
(d).
    (2) Deductions for certain dividends received--(i) Certain amounts 
deducted under sections 243 and 245. Paragraph (d)(1) of this section 
does not apply to, and adjusted current earnings therefore are not 
increased by, amounts deducted under sections 243 and 245 that qualify 
as 100-percent deductible dividends under sections 243(a), 245(b) or 
245(c), or to any dividend received from a 20-percent owned corporation 
(as defined in section 243(c)(2)), to the extent that the dividend 
giving rise to the deductions is attributable to earnings of the paying 
corporation that are subject to federal income tax. Earnings are 
considered subject to federal income tax return (that is filed or, if 
not, that should be filed) of an entity subject to United States 
taxation, even if there is no resulting United States tax liability 
(e.g., because of net operating losses or tax credits, other than the 
credit provided for in section 936).
    (ii) Special rules--(A) [Reserved]
    (B) Dividends received from a section 936 corporation. For example, 
assume that a section 936 corporation earns $100 of income in its 
current taxable year, $10 of which is not eligible for the credit under 
section 936. If the section 936 corporation makes a distribution of $50 
during that year, $5 of that distribution ($10 of income not eligible 
for the section 936 credit divided by $100 of income, times $50 
distributed) is deemed to be attributable to earnings of the paying 
corporation that are subject to federal income tax.
    (iii) Special rule for certain dividends received by certain 
cooperatives. Paragraph (d)(1) of this section does not apply to, and 
adjusted current earnings do not include, any dividend received by any 
organization to which part I of subchapter T of the Code applies and 
that is engaged in the marketing of agricultural or horticultural 
products, if the dividend is paid by a FSC and is allowable as a 
deduction under section 245(c).

[[Page 585]]

    (3) Partial list of items not deductible in computing earnings and 
profits. The following is a partial list of items that are not taken 
into account in computing earnings and profits and thus are not 
deductible in computing adjusted current earnings.
    (i) Unrecovered losses attributable to certain damages that are 
deductible under section 186, to the extent those damages were 
previously deducted in computing earnings and profits.
    (ii) The deduction for small life insurance companies allowed under 
section 806.
    (iii) Dividends deductible under the following sections of the Code:
    (A) Dividends received by corporations that are deductible under 
section 243, to the extent paragraph (d)(2)(i) of this section does not 
apply.
    (B) Dividends received on certain preferred stock that are 
deductible under section 244.
    (C) Dividends received from certain foreign corporations that are 
deductible under section 245, to the extent neither paragraph (d)(2)(i) 
nor (d)(2)(iii) of this section applies.
    (D) Dividends paid on certain preferred stock of public utilities 
that are deductible under section 247.
    (E) Dividends paid to an employee stock ownership plan that are 
deductible under section 404(k).
    (F) Non-patronage dividends that are paid and deductible under 
section 1382(c)(1).

Items described in paragraph (d)(1) of this section are not taken into 
account in computing earnings and profits (and thus are not deductible 
in computing adjusted current earnings) even if they are not identified 
in this paragraph (d)(3). The Commissioner may identify additional items 
described in paragraph (d)(1) of this section in other published 
guidance.
    (4) Partial list of items deductible for purposes of computing both 
pre-adjustment alternative minimum taxable income and adjusted current 
earnings. The following is a partial list of items that are deductible 
for purposes of computing both pre-adjustment alternative minimum 
taxable income and adjusted current earnings, and for which no 
adjustment is allowed under this section.
    (i) Payments by a United States corporation with respect to 
employees of certain foreign corporations that are deductible under 
section 176.
    (ii) Dividends paid on deposits by thrift institutions that are 
deductible under section 591.
    (iii) Life insurance policyholder dividends that are deductible 
under section 808.
    (iv) Dividends paid by cooperatives that are deductible under 
sections 1382(b) or 1382(c)(2) and that are not paid with respect to 
stock.

The Commissioner may identify additional items described in this 
paragraph (d)(4) in other published guidance.
    (e) Treatment of income items included, and deduction items not 
allowed, in computing pre-adjustment alternative minimum taxable income. 
Adjusted current earnings includes any income item that is included in 
pre-adjustment alternative minimum taxable income, even if that income 
item is not included in earnings and profits for the taxable year. 
Except as specifically provided in paragraph (c)(3) or (c)(5) of this 
section, no deduction is allowed for an item in computing adjusted 
current earnings if the item is not deductible in computing pre-
adjustment alternative minimum taxable income for the taxable year, even 
if the item is deductible in computing earnings and profits for the 
year. Thus, for example, capital losses in excess of capital gains for 
the taxable year are not deductible in computing adjusted current 
earnings for the taxable year.
    (f) Certain other earnings and profits adjustments--(1) Intangible 
drilling costs. For purposes of computing adjusted current earnings, the 
amount allowable as a deduction for intangible drilling costs (as 
defined in section 263(c)) for amounts paid or incurred in taxable years 
beginning after December 31, 1989, is determined as provided in section 
312(n)(2)(A). See section 56(h) for an additional adjustment to 
alternative minimum taxable income based on energy preferences for 
taxable years beginning after 1990.
    (2) Certain amortization provisions do not apply. For purposes of 
computing adjusted current earnings, sections 173 (relating to 
circulation expenditures)

[[Page 586]]

and 248 (relating to organizational expenditures) do not apply to 
amounts paid or incurred in taxable years beginning after December 31, 
1989. If an election is made under section 59(e) to amortize circulation 
expenditures described in section 173 over a three-year period, the 
expenditures to which the election applies are deducted ratably over the 
three-year period for purposes of computing taxable income, pre-
adjustment alternative minimum taxable income, and adjusted current 
earnings.
    (3) LIFO recapture adjustment--(i) In general. Adjusted current 
earnings are generally increased or decreased by the increase or 
decrease in the taxpayer's LIFO recapture amount (as defined in 
paragraph (f)(3)(iii)(A) of this section) as of the close of each 
taxable year.
    (ii) Beginning LIFO and FIFO inventory. For purposes of computing 
the increase or decrease in the LIFO recapture amount, the beginning 
LIFO and FIFO inventory amounts for the first taxable year beginning 
after December 31, 1989, are--
    (A) The ending LIFO inventory amount used in computing pre-
adjustment alternative minimum taxable income for the last year 
beginning before January 1, 1990; and
    (B) The ending FIFO inventory amount for the last year beginning 
before January 1, 1990, computed with the adjustments described in 
section 56 (other than the adjustment described in section 56(g)) and 
section 58, the items of tax preference described in section 57 and 
using the methods used in computing pre-adjustment alternative minimum 
taxable income.
    (iii) Definitions--(A) LIFO recapture amount--(1) Definition. The 
taxpayer's LIFO recapture amount is the excess, if any, of--
    (i) the inventory amount of its assets under the FIFO method, 
computed using the rules of this section; over
    (ii) the inventory amount of its assets under the LIFO method, 
computed using the rules of this section.
    (2) Assets included. Only the assets for which the taxpayer uses the 
LIFO method to compute pre-adjustment alternative minimum taxable income 
are taken into account in determining the LIFO recapture amount.
    (B) FIFO Method. For purposes of this paragraph, the LIFO method is 
the first in, first out method described in section 471, determined by 
using--
    (1) The retail method if that is the method the taxpayer uses in 
computing pre-adjustment alternative minimum taxable income; or
    (2) The lower of cost or market method for all other taxpayers.
    (C) LIFO method. The LIFO method is the last in, first out method 
authorized by section 472.
    (D) Inventory amounts. Except as otherwise provided, inventory 
amounts are computed using the methods used in computing pre-adjustment 
alternative minimum taxable income. To the extent inventory is treated 
as produced or acquired during taxable years beginning after December 
31, 1989, the inventory amount is determined with the adjustments 
described in sections 56 and 58 and the items of tax preference 
described in section 57. Thus, for example, the amount of depreciation 
to be capitalized under section 263A with respect to inventory produced 
in taxable years beginning after December 31, 1989, is based on the 
depreciation allowed under the rules of paragraph (b) of this section. 
See paragraph (a)(5) of this section.
    (iv) Exchanges under sections 351 and 721. For purposes of this 
section, any decrease in a transferor's LIFO recapture amount that 
occurs as a result of a transfer of inventories in an exchange to which 
section 351 or section 721 applies cannot be used to decrease the 
adjusted current earnings of the transferor. A decrease that is 
disallowed under the preceding sentence is instead carried over to 
reduce any LIFO recapture adjustment that the transferee (or its 
corporate partners, if section 721 applies) would otherwise make (in the 
absence of this paragraph (f)(3)(iv)) solely by reason of its carryover 
basis in inventories received in the section 351 or section 721 
exchange. Nothing in this paragraph (f)(3)(iv), however, alters the 
computation of the LIFO recapture amount of the transferor or transferee 
as of the close of any taxable year.
    (v) Examples. The following examples illustrate the provisions of 
this paragraph (f)(3).


[[Page 587]]


    Example 1. M Corporation, a calendar-year taxpayer, uses the LIFO 
method of accounting for its inventory for purposes of computing pre-
adjustment alternative minimum taxable income. M's ending LIFO inventory 
for all of its pools for purposes of computing pre-adjustment 
alternative minimum taxable income on December 31, 1989, is $300. M 
computes a $500 FIFO inventory amount on that date, after applying the 
provisions of section 263A along with the adjustments and preferences 
required in computing pre-adjustment alternative minimum taxable income. 
M's FIFO and LIFO ending inventory amounts at the close of its taxable 
years, its LIFO reserves, and its adjustment under this paragraph 
(f)(3), are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                  1989         1990         1991         1992
----------------------------------------------------------------------------------------------------------------
Ending inventory:
    A. FIFO.................................................     \1\ $500         $360         $560         $600
    B. LIFO.................................................      \2\ 300          180          320          440
                                                             ---------------------------------------------------
LIFO recapture amount:
    A-B.....................................................          200          180          240          160
                                                             ===================================================
Change in LIFO recapture amount and adjustment under          ...........         (20)           60         (80)
 paragraph (f)(3)...........................................
----------------------------------------------------------------------------------------------------------------
\1\ Beginning FIFO inventory amount under paragraph (f)(3)(ii).
\2\ Beginning LIFO inventory amount under paragraph (f)(3)(ii).

    Example 2. (A) X Corporation, a calendar-year taxpayer, uses the 
LIFO method for purposes of computing pre-adjustment alternative minimum 
taxable income. X's LIFO recapture amount is $300 as of December 31, 
1992, and is $200 as of December 31, 1993. Immediately prior to 
calculating its LIFO recapture amount as of December 31, 1993, X 
transfers inventory with an adjusted current earnings (ACE) basis of 
$500 to Y Corporation in an exchange to which section 351 applies. X 
determines that the $100 decrease in its LIFO recapture amount occurred 
as a result of its transfer of inventories to Y in the section 351 
exchange. Thus, under paragraph (f)(3)(iv) of this section, X cannot 
decrease its adjusted current earnings by that amount. In computing its 
1994 LIFO recapture adjustment, X will use $200 as its LIFO recapture 
amount as of December 31, 1993, even though it was not entitled to 
reduce adjusted current earnings by the $100 decrease in its LIFO 
recapture amount in 1993.
    (B) For purposes of computing its ACE, Y takes a $500 carryover 
basis in the inventories received from X. If Y, a newly formed calendar-
year taxpayer, engages in no other inventory transactions in 1993 and 
adopts the LIFO inventory method on its 1993 tax return, it will have a 
LIFO recapture amount of $0 as of December 31, 1993 (because its FIFO 
inventory amount and its LIFO inventory amount are both $500). Assume 
that at December 31, 1994, Y has a LIFO recapture amount of $200 ($1,000 
FIFO inventory amount-$800 LIFO inventory amount). Under paragraph 
(f)(3)(i) of this section, Y computes a LIFO recapture adjustment for 
1994 of $200 ($200-$0). If any portion of Y's $200 LIFO recapture 
adjustment occurs solely by reason of its carryover basis in the 
inventories it received from X, Y reduces its $200 LIFO recapture 
adjustment by that portion under paragraph (f)(3)(iv). In any event, 
however, Y will use its $200 LIFO recapture amount as of December 31, 
1994, in computing its 1995 LIFO recapture adjustment.

    (vi) Effective date. Paragraph (f)(3) is effective for taxable years 
beginning after December 18, 1992. A taxpayer may choose to apply this 
paragraph, however, to all taxable years beginning after December 31, 
1989.
    (4) Installment sales--(i) In general. Adjusted current earnings are 
computed without regard to the installment method, except as provided in 
this paragraph (f)(4).
    (ii) Exception for prior dispositions. Paragraph (f)(4)(i) of this 
section does not apply to any disposition in a taxable year beginning 
before January 1, 1990, that is taken into account under the installment 
method for purposes of computing pre-adjustment alternative minimum 
taxable income. Thus, for any disposition in a taxable year beginning 
before January 1, 1990, the installment method applies in computing 
adjusted current earnings for taxable years beginning after December 31, 
1989, to the same extent it applies in determining pre-adjustment 
alternative minimum taxable income for the taxable year.
    (iii) Special rules for obligations to which section 453A applies--
(A) In general. The following special rules apply to any installment 
sale occurring in a taxable year beginning after December 31, 1989, that 
results in an installment

[[Page 588]]

obligation to which section 453A(a)(1) applies and with respect to which 
preadjustment alternative minimum taxable income is determined under the 
installment method. As explained in paragraph (f)(4)(iii)(B) of this 
section, for purposes of computing adjusted current earnings, a portion 
of the contract price is eligible for the installment method, and the 
remainder of the contract price is not eligible for the installment 
method. Payments under the obligation are allocated pro-rata between the 
two accounting methods.
    (B) Limitation on application of installment method. Only a portion 
of the contract price of an installment sale described in paragraph 
(f)(4)(iii)(A) of this section is eligible to be accounted for under the 
installment method for purposes of computing adjusted current earnings. 
The portion eligible for the installment method is equal to the total 
contract price of the sale multiplied by the applicable percentage (as 
determined under section 453A(c)(4)) for the taxable year of the sale. 
The remainder of the contract price is not eligible to be accounted for 
under the installment method for purposes of computing adjusted current 
earnings. The gross profit ratio is determined without regard to this 
bifurcated treatment of the sale.
    (C) Treatment of the ineligible portion. The gain on the sale that 
is taken into account in the taxable year of the sale for purposes of 
computing adjusted current earnings is equal to the gross profit ratio 
multiplied by the entire portion of the contract price that is 
ineligible for the installment method.
    (D) Treatment of the eligible portion. For purposes of calculating 
adjusted current earnings, the amount of gain recognized in a taxable 
year on the portion of the contract price that is eligible for the 
installment method is equal to--
    (1) The amount of payments received during the taxable year, 
multiplied by
    (2) The applicable percentage for the taxable year of the sale, 
multiplied by
    (3) The gross profit ratio.
    (E) Coordination with the pledge rule. For purposes of determining 
the amount of payments received during the taxable year under paragraph 
(f)(4)(iii)(D), the rules of section 453A(d) (relating to the treatment 
of certain pledge proceeds as payments) apply. This includes the rules 
under section 453A(d)(3) that relate to treating later payments as 
receipts of amounts on which tax has already been paid.
    (F) Example. The following example illustrates the provisions of 
this paragraph (f)(4)(iii):

    (1) On January 1, 1990, corporation A, a calendar-year taxpayer, 
sells a building with an adjusted basis for purposes of computing 
adjusted current earnings of $10 million, for $5 million and an 
installment obligation bearing adequate stated interest with a principal 
amount of $20 million. The installment obligation calls for 4 annual 
payments of $5 million on January 1 of 1991, 1992, 1993, and 1994. A 
does not elect out of the installment method, and disposes of no other 
property under the installment method during 1990. No gain with respect 
to the sale is recaptured pursuant to section 1250.
    (2) The gross profit percentage for purposes of computing adjusted 
current earnings on the sale is 60 percent, computed as follows: gross 
profit of $15 million ($25 million contract price less $10 million 
adjusted basis) divided by $25 million contract price. The applicable 
percentage on the sale is 75 percent, computed as follows: $15 million 
($20 million of installment obligations arising during and outstanding 
at the end of 1990 less $5 million) divided by $20 million of 
installment obligations arising during and outstanding at the end of 
1990. See section 453A(c)(4). The portion of the contract price eligible 
for accounting under the installment method for purposes of computing 
adjusted current earnings is $18.75 million, or $25 million total 
contract price times applicable percentage of 75 percent. The portion of 
the contract price ineligible for the installment method is $6.25 
million, or $25 million less $18.75 million.
    (3) In computing adjusted current earnings for 1990, A must include 
$3.75 million of the gain on the sale. This amount is equal to the 
portion of the contract price that is ineligible for the installment 
method times the gross profit ratio, or $6.25 million times 60 percent. 
A must also include $2.25 million of gain from the $5 million payment 
received in 1990. This amount is computed as follows: the eligible 
portion of the payment, $3.75 million ($5 million payment times the 
applicable percentage of 75 percent), times the gross profit ratio of 60 
percent. Thus, the total amount of gain from the sale that A must 
include in adjusted current earnings for 1990 is $6 million ($3.75 
million of gain from the portion of the contract price that is not 
eligible for the installment method, plus $2.25 million of gain from the 
1990 payment).

[[Page 589]]

    (4) A does not pledge or otherwise accelerate payments on the note 
in any other taxable year. In computing adjusted current earnings for 
1991, 1992, 1993, and 1994, A therefore includes $2.25 million of gain 
on the installment sale, computed as follows: $5 million payment times 
the applicable percentage of 75 percent, times the gross profit ratio of 
60 percent.

    (g) Disallowance of loss on exchange of debt pools. [Reserved]
    (h) Policy acquisition expenses of life insurance companies--(1) In 
general. This paragraph (h) addresses the treatment of policy 
acquisition expenses of life insurance companies in determining adjusted 
current earnings. Policy acquisition expenses are those expenses that, 
under generally accepted accounting principles in effect at the time the 
expenses are incurred, are considered to vary with and to be primarily 
related to the acquisition of new and renewal insurance policies. 
Generally, these acquisition expenses must be capitalized and amortized 
for purposes of adjusted current earnings over the reasonably estimated 
life of the acquired policy, using a method that provides a reasonable 
allowance for amortization. This method of amortization is treated as if 
it applied to all taxable years in determining the amount of policy 
acquisition expenses deducted for adjusted current earnings. The rules 
in this paragraph (h) apply to any life insurance company, as defined in 
section 816(a).
    (2) Reasonably estimated life. The reasonably estimated life of an 
acquired policy is determined based on the facts with respect to each 
policy (such as the age, sex, and health of the insured), and the 
company's experience (such as mortality, lapse rate and renewals) with 
similar policies. A company may treat as the reasonably estimated life 
of an acquired policy the period for amortizing expenses of the acquired 
policy that would be required by the Financial Accounting Standards 
Board (FASB) at the time the acquisition expenses are incurred. If the 
FASB has not established such a period, the period for amortizing 
acquisition expense of an acquired policy under guidelines issued by the 
American Institute of Certified Public Accountants in effect at the time 
the acquisition expenses are incurred may be treated as the reasonably 
estimated life of the acquired policy.
    (3) Reasonable allowance for amortization. For purposes of 
determining a reasonable allowance for amortization, a company may use a 
method that amortizes acquisition expenses in the same proportion that 
gross premiums and gross investment income for the taxable year bear to 
total anticipated receipts of gross premiums (including anticipated 
renewal premiums) and gross investment income to be realized over the 
reasonably estimated life of the policy.
    (4) Safe harbor for public financial statements. Any company that is 
required to file with the Securities and Exchange Commission (SEC) a 
financial statement with respect to the taxable year will be treated as 
having complied with paragraph (h)(1) of this section if it accounts for 
acquisition expenses for adjusted current earnings purposes in the same 
manner as it accounts for those expenses on its financial statements 
filed with the SEC.
    (i) [Reserved]
    (j) Depletion. For purposes of computing adjusted current earnings, 
the allowance for depletion with respect to any property placed in 
service in a taxable year beginning after December 31, 1989 is 
determined under the cost depletion method of section 611.
    (k) Treatment of certain ownership changes--(1) In general. In the 
case of any corporation that has an ownership change as defined in 
paragraph (k)(2) of this section in a taxable year beginning after 
December 31, 1989, and that also has a net unrealized built-in loss (as 
defined in paragraph (k)(3) of this section) immediately before the 
ownership change, the adjusted basis of each asset of the corporation 
for purposes of computing adjusted current earnings following the 
ownership change shall be its proportionate share (determined on the 
basis of the respective fair market values of each asset) of the fair 
market value of the assets of the corporation immediately before the 
ownership change. The rules of Sec.  1.338-6(b), if otherwise applicable 
to the transaction, are applied in making this allocation of basis. If 
such rules apply, the limitations of Sec. Sec.  1.338-6(c) (1) and (2) 
also

[[Page 590]]

apply in allocating basis under this paragraph (k)(1).
    (2) Definition of ownership change. A corporation has an ownership 
change for purposes of section 56(g)(4)(G)(i) and this paragraph (k) if 
there is an ownership change under section 382(g) for purposes of 
computing the corporation's amount of taxable income that may be offset 
by pre-change losses or the regular tax liability that may be offset by 
pre-change credits. See Sec.  1.382-2T for rules to determine whether a 
corporation has an ownership change. Accordingly, in order for an 
ownership change to occur for purposes of this paragraph (k), a 
corporation must be a loss corporation as defined in Sec.  1.382-
2(a)(1). In determining whether the corporation is a loss corporation, 
the determination of whether there is a net unrealized built-in loss is 
made by using the aggregate adjusted basis of the assets of the 
corporation used in computing taxable income. The aggregate adjusted 
basis of the corporation's assets for purposes of computing adjusted 
current earnings is not relevant in determining whether the corporation 
is a loss corporation. See part (iv) of the example in paragraph (k)(4) 
of this section.
    (3) Determination of net unrealized built-in loss immediately before 
an ownership change. In order to determine whether it has a net 
unrealized built-in loss for purposes of section 56(g)(4)(G)(ii) and 
paragraph (k)(1) of this section, a corporation that has an ownership 
change as defined in paragraph (k)(2) of this section must use the 
aggregate adjusted basis of its assets that it uses in computing its 
adjusted current earnings. The rules of section 382 (including sections 
382(h)(3)(B)(i) and 382(h)(8)) otherwise apply in determining whether 
the corporation has a net unrealized built-in loss.
    (4) Example. The following example illustrates the provisions of 
this paragraph (k):

    (i) Individual A has owned all the issued and outstanding stock of 
corporation L for the past 5 years. A sells all of his stock in L to 
unrelated individual B. On the date of the sale, L owns the following 
assets (all numbers are in millions):

------------------------------------------------------------------------
                                                  Adjusted
                                     Adjusted    basis for
                                    basis for    computing   Fair market
              Asset                 computing     adjusted      value
                                     taxable      current
                                      income      earnings
------------------------------------------------------------------------
x................................          $45          $50          $50
y................................           55           60           30
z................................           10           10           20
                                  --------------------------------------
                                          $110         $120         $100
------------------------------------------------------------------------

For purposes of computing taxable income, L has a $500 million net 
operating loss carryforward to the taxable year in which the sale 
occurs. Therefore, L is a loss corporation. As a result of the transfer 
of shares of L from A to B, L has had an ownership change.
    (ii) L has no net unrealized built-in loss for purposes of computing 
taxable income because the amount by which the aggregate adjusted basis 
of its assets for that purpose exceeds their fair market value is $10 
million, which is less than 15 percent of their fair market value and is 
not greater than $10 million. See section 381(h)(3)(B)(i). L, however, 
does have a net unrealized built-in loss for purposes of computing 
adjusted current earnings because the aggregate adjusted basis of its 
assets for the purpose exceeds their fair market value by $20 million, 
and that amount is greater than $10 million.
    (iii) Under paragraph (k)(1) of this section, L must restate the 
adjusted basis of its assets for purposes of computing adjusted current 
earnings to their fair market values, as follows (all numbers are in 
millions):

------------------------------------------------------------------------
                                                                 New
                           Asset                               adjusted
                                                                basis
------------------------------------------------------------------------
x..........................................................          $50
y..........................................................           30
z..........................................................           20
------------------------------------------------------------------------

L must use these new adjusted bases for all purposes in determining 
adjusted current earnings, including computing depreciation and any gain 
or loss on disposition.
    (iv) If L did not have the net operating loss carryforward, and had 
no other loss or credit carryovers or other attributes described in 
Sec.  1.382-2(a)(1) for purposes of computing the amount of its taxable 
income that may be offset by pre-change losses or its regular tax 
liability that may be offset by pre-change credits, it would not have 
been a loss corporation on the date of the sale and therefore would not 
be treated as having had an ownership change for purposes of computing 
adjusted current earnings. This would be true even though L had a net 
unrealized built-in loss for purposes of computing adjusted current 
earnings. Therefore, this paragraph (k) would not have applied.

    (l) [Reserved]

[[Page 591]]

    (m) Adjusted current earnings of a foreign corporation--(1) In 
general. The alternative minimum taxable income of a foreign corporation 
is increased by 75 percent of the excess of--
    (i) Its effectively connected adjusted current earnings for the 
taxable year; over
    (ii) Its effectively connected pre-adjustment alternative minimum 
taxable income for the taxable year.
    (2) Definitions--(i) Effectively connected pre-adjustment 
alternative minimum taxable income. Effectively connected pre-adjustment 
alternative minimum taxable income is the effectively connected taxable 
income of the foreign corporation for the taxable year, determined with 
the adjustments under sections 56 and 58 (except for the adjustment for 
adjusted current earnings, the alternative tax net operating loss and 
the alternative tax energy preference deduction) and increased by the 
tax preference items of section 57, but taking into account only items 
of income of the foreign corporation that are effectively connected (or 
treated as effectively connected) with the conduct of a trade or 
business in the United States, and any expense, loss or deduction that 
is properly allocated and apportioned to that income.
    (ii) Effectively connected adjusted current earnings. Effectively 
connected adjusted current earnings is the effectively connected pre-
adjustment alternative minimum taxable income of the foreign corporation 
for the taxable year, adjusted under section 56(g) and this section, but 
taking into account only items of income of the foreign corporation that 
are effectively connected (or treated as effectively connected) with the 
conduct of a trade or business in the United States, and any expense, 
loss or deduction that is properly allocated and apportioned to that 
income.
    (3) Rules to determine effectively connected pre-adjustment 
alternative minimum taxable income and effectively connected adjusted 
current earnings. The principles of section 864 (c) (and the regulations 
thereunder) and any other applicable provision of the Internal Revenue 
Code apply to determine whether items of income of the foreign 
corporation are effectively connected (or treated as effectively 
connected) with the conduct of a trade or business in the United States, 
and whether any expense, loss or deduction is properly allocated and 
apportioned to that income.
    (4) Certain exempt amounts. Effectively connected adjusted current 
earnings and effectively connected pre-adjustment alternative minimum 
taxable income do not include any item of income, or any expense, loss 
or deduction that is properly allocated and apportioned to income that 
is exempt from United States taxation under section 883 or an applicable 
income tax treaty. See section 894.
    (n) Adjustment for adjusted current earnings of consolidated 
groups--(1) Positive adjustments. For taxable years beginning after 
December 31, 1989, the alternative minimum taxable income of a 
consolidated group (as defined in Sec.  1.1502-1T) is increased by 75 
percent of the excess, if any, of--
    (i) The consolidated adjusted current earnings for the taxable year, 
over
    (ii) The consolidated pre-adjustment alternative minimum taxable 
income for the taxable year.
    (2) Negative adjustments--(i) In general. The alternative minimum 
taxable income of a consolidated group is decreased, subject to the 
limitation of paragraph (n)(2)(ii) of this section, by 75 percent of the 
excess, if any, of the consolidated pre-adjustment alternative minimum 
taxable income over consolidated adjusted current earnings.
    (ii) Limitation on negative adjustments. The amount of the negative 
adjustment for any taxable year shall be limited to the excess, if any, 
of--
    (A) The aggregate increases in the alternative minimum taxable 
income of the group in prior years under this section, over
    (B) The aggregate decreases in the alternative minimum taxable 
income of the group in prior years under this section.
    (3) Definitions--(i) Consolidated pre-adjustment alternative minimum 
taxable income. Consolidated pre-adjustment alternative minimum taxable 
income is the consolidated taxable income (as defined in Sec.  1.1502-
11) of a consolidated group for the taxable year, determined

[[Page 592]]

with the adjustments provided in sections 56 and 58 (except for the 
adjustment for adjusted current earnings and the alternative tax net 
operating loss determined under section 56(a)(4)) and increased by the 
preference items described in section 57.
    (ii) Consolidated adjusted current earnings. The consolidated 
adjusted current earnings of a consolidated group is the consolidated 
pre-adjustment alternative minimum taxable income of the consolidated 
group for the taxable year, adjusted as provided in section 56(g) and 
this section.
    (4) Example. The following example illustrates the provisions of 
this paragraph (n):

    (i) P is the common parent of a consolidated group. In 1990, the 
group has consolidated pre-adjustment alternative minimum taxable income 
of $1,400,000 and consolidated adjusted current earnings of $1,600,000. 
Thus, the group has a consolidated adjustment for adjusted current 
earnings for 1990 of $150,000 (75 percent of the $200,000 excess of 
consolidated adjusted current earnings over consolidated pre-adjustment 
alternative minimum taxable income), and alternative minimum taxable 
income of $1,550,000 ($1,400,000 plus $150,000).
    (ii) In 1991, the group has consolidated pre-adjustment alternative 
minimum taxable income of $1,500,000 and consolidated adjusted current 
earnings of $1,100,000. Thus, the group can reduce its alternative 
minimum taxable income by $150,000. The potential negative adjustment of 
$300,000 (75 percent of the $400,000 excess of consolidated pre-
adjustment alternative minimum taxable income over consolidated adjusted 
current earnings) is limited to the $150,000 consolidated adjustment for 
adjusted current earnings taken into account in 1990.

    (o) [Reserved]
    (p) Effective dates for corporate partners in partnerships--(1) In 
general. The provisions of this section apply to a corporate partner's 
distributive share of items of income and expense from a partnership for 
any taxable year of the partnership ending within or with any taxable 
year of the corporate partner beginning after December 31, 1989.
    (2) Application of effective dates. Solely for purposes of the 
effective date provisions of this section, a partnership event (such as 
placing property in service, paying or incurring a cost, or closing an 
installment sale) is deemed to occur on the last day of the 
partnership's taxable year.
    (3) Example. The following example illustrates the provisions of 
this paragraph (p):

    (i) X is a calendar-year corporation that is a partner in P, an 
accrual-basis partnership with a taxable year ending March 31. During 
P's taxable year ending March 31, 1990, P earned ratably throughout the 
year interest income on tax-exempt obligations. In addition, P incurred 
intangible drilling costs in November 1989 and in February 1990.
    (ii) X's adjusted current earnings for 1990 includes X's 
distributive share of the interest on the tax-exempt obligations earned 
by P for its taxable year ending March 31, 1990. This is true even 
though P earned a portion of the interest prior to January 1, 1990.
    (iii) For purposes of computing X's adjusted current earnings for 
1990, the adjustment provided in paragraph (f)(1) of this section 
applies to X's distributive share of P's November 1989 and February 1990 
intangible drilling costs.

    (q) Treatment of distributions of property to shareholders--(1) In 
general. If a distribution of an item of property by a corporation with 
respect to its stock gives rise to more than one adjustment to earnings 
and profits under section 312, all of the adjustments with respect to 
that item of property (including the adjustment described in section 
312(c) with respect to liabilities to which the item is subject or which 
are assumed in connection with the distribution) are combined for 
purposes of determining the corporation's adjusted current earnings for 
the taxable year. If the amount included in pre-adjustment alternative 
minimum taxable income with respect to a distribution of an item of 
property exceeds the net increase in earnings and profits caused by the 
distribution, pre-adjustment alternative minimum taxable income is not 
reduced in computing adjusted current earnings. If the net increase in 
earnings and profits caused by a distribution of an item of property 
exceeds the amount included in pre-adjustment alternative minimum 
taxable income with respect to the distribution, that excess is added to 
pre-adjustment alternative minimum taxable income in computing adjusted 
current earnings.

[[Page 593]]

    (2) Examples. The following examples illustrate the provisions of 
this paragraph (q).
    (i) Example 1. K corporation distributes property with a fair market 
value of $150 and an adjusted basis of $100. The adjusted basis is the 
same for purposes of computing taxable income, pre-adjustment 
alternative minimum taxable income, adjusted current earnings, and 
earnings and profits. Under section 312(a)(3), as modified by section 
312(b)(2), K decreases its earnings and profits by the fair market value 
of the property, or $150. Under section 312(b)(1), K increases its 
earnings and profits by the excess of the fair market value of the 
property over its adjusted basis, or $50. As a result of the 
distribution, there is a net decrease in K's earnings and profits of 
$100. K recognizes $50 of gain under section 311(b) as a result of the 
distribution as if K sold the property for $150. K thus has no amount 
permanently excluded from pre-adjustment alternative minimum taxable 
income that is taken into account in determining current earnings and 
profits, and thus has no adjustment under paragraph (c)(1) of this 
section.
    (ii) Example 2. The facts are the same as in example 1, except that 
the distribution shareholder assumes a $190 liability in connection with 
the disribution. Under section 312(c)(1), K must adjust the adjustments 
to its earnings and profits under section 312 (a) and (b) to account for 
the liability the shareholder assumes. K adjusts the $100 net decrease 
in its earnings and profits to reflect the $190 liability, resulting in 
an increase in its earnings and profits of $90. Because section 
311(b)(2) makes the rules of section 336(b) apply, the fair market value 
of the property is not less than the amount of the liability, or $190. K 
therefore is treated as if it sold the property for $190, recognizing 
$90 of gain. K thus has no amount permanently excluded from pre-
adjustment alternative minimum taxable income that is taken into account 
in determining current earnings and profits, and thus has no adjustment 
under paragraph (c)(1) of this section.
    (r) Elections to use simplified inventory methods to compute 
alternative minimum tax--(1) In general. If a taxpayer makes an election 
under this paragraph (r) (and does not make the election in paragraph 
(r)(5) of this section), the rules of paragraph (r)(2) of this section 
apply in computing the taxpayer's pre-adjustment alternative minimum 
taxable income and adjusted current earnings.
    (2) Effect of election--(i) Inventories. The taxpayer's inventory 
amounts as determined for purposes of computing taxable income are used 
for purposes of computing pre-adjustment alternative minimum taxable 
income and adjusted current earnings. Subject to the further 
modification described in paragraph (r)(2)(ii) of this section, the 
taxpayer's cost of sales as determined for purposes of computing taxable 
income is also used for purposes of computing pre-adjustment alternative 
minimum taxable income and adjusted current earnings.
    (ii) Modifications required--(A) In general. If a taxpayer makes an 
election under this paragraph (r), pre-adjustment alternative minimum 
taxable income and adjusted current earnings are computed with the 
modifications described in this paragraph. The items of adjustment under 
sections 56 and 58 and the items of tax preference under section 57 are 
computed without regard to the portion of those adjustments and 
preferences which, but for the election described in this paragraph, 
would have been capitalized in ending inventory. For example, pre-
adjustment alternative minimum taxable income is increased by the excess 
of the depreciation allowable for the taxable year under section 168 for 
purposes of computing taxable income (determined without regard to 
section 263A) over the depreciation allowable for the taxable year under 
section 56(a)(1) and section 57 for purposes of computing pre-adjustment 
alternative minimum taxable income (determined without regard to section 
263A). Similarly, adjusted current earnings is further increased by the 
excess of the depreciation allowable for the taxable year under section 
56(a)(1) and section 57 for purposes of computing pre-adjustment 
alternative minimum taxable income (determined without regard to section 
263A) over the depreciation allowable

[[Page 594]]

for the taxable year under section 56(g)(4)(A) for purposes of computing 
adjusted current earnings (determined without regard to section 263A). 
Thus, the modifications described in the preceding sentence do not 
duplicate amounts that are taken into account in computing pre-
adjustment alternative minimum taxable income. See paragraph (a)(6)(ii) 
of this section.
    (B) Negative modifications allowed. An election under this paragraph 
(r) does not affect the taxpayer's ability to make negative adjustments. 
Thus, if an election is made under this paragraph (r) and the amount of 
any adjustment under section 56 or 58, determined after modification 
under paragraph (r)(2)(ii)(A) of this section, is a negative amount, 
then this amount reduces pre-adjustment alternative minimum taxable 
income or adjusted current earnings. However, no negative adjustment 
under this paragraph (r)(2)(ii)(B) is allowed for the items of tax 
preference under section 57.
    (iii) LIFO recapture adjustment. If a taxpayer makes an election 
under this paragraph (r) and uses the LIFO method for some assets, for 
purposes of computing the LIFO recapture adjustment under paragraph 
(f)(3) of this section for taxable years beginning after December 31, 
1989--
    (A) The LIFO inventory amount as determined for purposes of 
computing taxable income is used in lieu of the LIFO inventory amount as 
determined under paragraph (f)(3)(iii) of this section;
    (B) The FIFO inventory amount is computed without regard to the 
adjustments under sections 56 (including the adjustments of section 
56(g)(4)) and 58 and the items of tax preference of section 57; and
    (C) The beginning LIFO and FIFO inventory amounts under paragraph 
(f)(3)(ii) of this section are the ending LIFO inventory amount as 
determined for purposes of computing taxable income and the ending FIFO 
inventory amount computed without regard to the adjustments under 
sections 56 (including the adjustments of sections 56(g)(4)) and 58 and 
the items of tax preference of section 57 for the last taxable year 
beginning before January 1, 1990.
    (3) Time and manner of making election--(i) Prospective election. 
(A) A prospective election under this paragraph (r) may be made by any 
taxpayer--
    (1) That has computed pre-adjustment alternative minimum taxable 
income and adjusted current earnings for all prior taxable years in 
accordance with the method described in this paragraph (r); or
    (2) That has not computed pre-adjustment alternative minimum taxable 
income and adjusted current earnings for all prior tax years in 
accordance with the method described in this paragraph (r), but for 
which the use of the method described in this paragraph (r) for all 
prior taxable years would not have changed the taxpayer's tax liability 
(as shown on returns filed as of the date the election is made) for any 
prior taxable year for which the period of limitations under section 
6501(a) has not expired (as of the date the election is made).
    (B) A prospective election under this paragraph (r) may only be made 
by attaching a statement to the taxpayer's timely filed (including 
extensions) original Federal income tax return for any taxable year that 
is no later than its first taxable year to which this paragraph (r) 
applies and in which the taxpayer's tentative minimum tax (computed 
under the provisions of this paragraph (r)) exceeds its regular tax. 
However, in the case of a taxpayer described in paragraph 
(r)(3)(i)(A)(1) of this section that had tentative minimum tax in excess 
of its regular tax for any prior taxable year, the election may only be 
made by attaching a statement to its timely filed (including extensions) 
original Federal income tax return for the first taxable year ending 
after December 18, 1992. The statement must--
    (1) Give the name, address and employer identification number of the 
taxpayer; and
    (2) Identify the election as made under this paragraph (r).
    (C) The determination of whether a taxpayer is described in 
paragraph (r)(3)(i)(A)(2) of this section is to be made as of the time 
the taxpayer makes a prospective election in accordance with the 
procedures in paragraph (r)(3)(i)(B) of this section.

[[Page 595]]

    (D) Any taxpayer described in paragraph (r)(3)(i)(A)(2) of this 
section that makes a prospective election will be deemed to have used 
the method described in this paragraph (r) in computing pre-adjustment 
alternative minimum taxable income and adjusted current earnings for all 
prior taxable years.
    (ii) Retroactive election--(A) A retroactive election under this 
paragraph (r) may be made by any taxpayer not described in paragraph 
(r)(3)(i)(A) (1) or (2) of this section. Except as provided in paragraph 
(r)(3)(iii) of this section, a retroactive election may only be made by 
attaching a statement to the taxpayer's amended Federal income tax 
return for the earliest taxable year for which the period of limitations 
under section 6501(a) has not expired and which begins after December 
31, 1986. The amended return to which the election under this paragraph 
(r)(3)(ii) is attached must be filed no later than June 21, 1993.
    (B) The amended return must contain the statement described in 
paragraph (r)(3)(i)(B) of this section. In addition, the statement must 
contain a representation that the taxpayer will modify its pre-
adjustment alternative minimum taxable income and adjusted current 
earnings for all open taxable years in accordance with paragraph (r)(2) 
of this section. Upon this change in method of accounting, the taxpayer 
must include the entire adjustment required under section 481(a), if 
any, in preadjustment alternative minimum taxable income and adjusted 
current earnings on the amended return for the year of the election. The 
taxpayer must also reflect the method of accounting described in 
paragraph (r)(2) of this section on amended returns filed for all 
taxable years after the year of the election for which returns were 
originally filed before making the election (and for which the period of 
limitations under section 6501(a) has not expired).
    (C) Provided a taxpayer meets the requirements of this paragraph 
(r), any change in method of accounting arising as a result of making a 
retroactive election will be treated as made with the advance consent of 
the Commissioner.
    (D) Any retroactive election under this paragraph (r) that is made 
without filing amended returns required under this paragraph (r)(3)(ii) 
shall constitute a change in method of accounting made without the 
consent of the Commissioner.
    (iii) Taxpayers under examination--(A) In general. A taxpayer that 
wishes to make a retroactive election under section (r)(3)(ii) of this 
section may use the procedures in paragraph (r)(3)(iii)(A) (1) or (2) in 
lieu of filing an amended return for any taxable year that is under 
examination by the Internal Revenue Service.
    (1) Year of change under examination. If the year of the change is 
under examination at the time the taxpayer timely makes the election, 
the taxpayer may (in lieu of filing an amended return for the year of 
the change) furnish the written statement described in paragraph 
(r)(3)(iii)(B) of this section to the revenue agent responsible for 
examining the taxpayer's return no later than June 21, 1993. It is the 
taxpayer's responsibility to make a timely election either by furnishing 
the statement to the revenue agent or by filing amended returns by June 
21, 1993.
    (2) Other open years under examination. If any other year for which 
the taxpayer must modify its pre-adjustment alternative minimum taxable 
income and adjusted current earnings (see paragraph (r)(3)(ii)(B) of 
this section) is examined, the taxpayer may (in lieu of filing an 
amended return) furnish the amount of the conforming adjustment to the 
revenue agent responsible for examining the taxpayer's return. It is the 
taxpayer's responsibility to timely modify its pre-adjustment 
alternative minimum taxable income and adjusted current earnings for 
each year other than the year of change, either by furnishing the amount 
of the adjustment to the revenue agent or by filing amended returns.
    (B) Statement required. The statement required under paragraph 
(r)(3)(iii)(A)(1) of this section must include all of the items required 
under paragraph (r)(3)(ii)(B) of this section, as well as--
    (1) The caption ``Election to use regular tax inventories for AMT 
purposes;''

[[Page 596]]

    (2) A description of the nature and amount of all items that would 
result in adjustments and that the taxpayer would have reported if the 
taxpayer had used the method described in this paragraph (r) for all 
prior taxable years for which the period of limitations under section 
6501(a) has not expired and which begin after December 31, 1986; and
    (3) The following declaration signed by the person authorized to 
sign the return for the taxpayer: ``Under penalties of perjury, I 
declare that I have examined this written statement, and to the best of 
my knowledge and belief this written statement is true, correct, and 
complete.''
    (C) Year of change. The year of change is the earliest taxable year 
for which the period of limitations under section 6501(a) has not 
expired at the time the statement is submitted to the appropriate 
revenue agent and that begins after December 31, 1986. Thus, the 
adjustments required to be included on the statement must include any 
adjustment under section 481(a) determined as if the method described in 
this paragraph (r) had been used in all taxable years prior to the year 
of change that begin after December 31, 1986.
    (D) Treatment of additional tax liability. Any additional tax 
liability that results from the adjustments identified in the written 
statement described in paragraph (r)(3)(iii)(B) of this section is 
treated as an additional amount of tax shown on an amended return.
    (iv) Election as method of accounting. The elections provided in 
paragraphs (r)(3) (i) and (ii) of this section constitute either 
adoptions of, or changes in, methods of accounting. These elections, 
once made, may be revoked only with the consent of the Commissioner in 
accordance with the rules of section 446(e) and Sec.  1.446-1(e).
    (v) Untimely election to use simplified inventory method. If a 
taxpayer makes an election described in this paragraph (r) after the 
times set forth in paragraph (r)(3) (i) or (ii) of this section, the 
taxpayer must comply with the requirements of Sec.  1.446-1(e)(3) in 
order to secure the consent of the Commissioner to change to the method 
of accounting prescribed in this paragraph (r). The taxpayer generally 
will be subject to terms and conditions designed to place the taxpayer 
in a position no more favorable than a taxpayer that timely complied 
with paragraph (r)(3) (i) and (ii) of this section, whichever is 
applicable.
    (4) Example. The following example illustrates the provisions of 
this paragraph (r).

    Example. (i) Corporation L is a calendar year manufacturer of 
baseball bats and uses the LIFO method of accounting for inventories. 
During 1987, 1988, and 1989, L's cost of goods sold in computing taxable 
income was as follows:

------------------------------------------------------------------------
                                       1987         1988         1989
------------------------------------------------------------------------
Beginning LIFO inventory.........      $3,000       $4,000       $5,000
Purchases and other costs........       9,000        9,000        9,000
Ending LIFO inventory............      (4,000)      (5,000)      (6,000)
                                  --------------------------------------
Cost of goods sold...............       8,000        8,000        8,000
------------------------------------------------------------------------

    (ii) L has no preferences under section 57 during 1987, 1988, and 
1989. L's sole adjustment in computing alternative minimum tax during 
1987, 1988, and 1989 was the depreciation adjustment under section 
56(a)(1). Depreciation determined for both production and non-production 
assets under section 168 and under section 56(a)(1) during 1987, 1988, 
and 1989 was as follows:

------------------------------------------------------------------------
                                       1987         1988         1989
------------------------------------------------------------------------
Section 168 depreciation.........      $1,800       $1,800       $1,800
Section 56(a)(1) depreciation....        (900)        (900)        (900)
                                  --------------------------------------
Depreciation difference..........         900          900          900
Portion of difference capitalized        (100)        (100)        (100)
 in the increase in inventory....
                                  --------------------------------------
Adjustment required under section         800          800          800
 56(a)(1)........................
------------------------------------------------------------------------


[[Page 597]]

    (iii) In computing taxable income, a portion of each year's section 
168 depreciation attributable to production assets is deducted currently 
and a portion is capitalized into the increase in ending inventory. For 
1987, 1988, and 1989, L computed alternative minimum tax by deducting 
the cost of goods sold which was reflected in taxable income ($8,000) in 
accordance with paragraph (r)(2)(i) of this section. For 1987, 1988, and 
1989, L also modified its adjustments under sections 56 and 58 and its 
preferences under section 57 to disregard the portion of any adjustment 
or preference that was capitalized in inventory. Thus, under section 
56(a)(1), L increased alternative minimum taxable income during each 
year by $900.
    (iv) L is eligible to make the election under paragraph (r)(1) of 
this section in accordance with paragraph (r)(3)(i) of this section (a 
prospective election).
    (v) L must compute its LIFO recapture adjustment for each year by 
reference to--
    (A) The FIFO inventory amount after applying the provisions of 
section 263A but before applying the adjustments of sections 56 and 58 
and the items of preference in section 57; and
    (B) The LIFO inventory amount used in computing taxable income.

    (5) Election to use alternative minimum tax inventories to compute 
adjusted current earnings. A taxpayer may elect under this paragraph 
(r)(5) to use the inventory amounts used to compute pre-adjustment 
alternative minimum taxable income in computing its adjusted current 
earnings. Rules similar to those of paragraphs (r)(2) and (r)(3) of this 
section apply for purposes of this election.
    (s) Adjustment for alternative tax energy preference deduction--(1) 
In general. For purposes of computing adjusted current earnings, any 
taxpayer claiming a deduction under section 56(h) must properly decrease 
basis by the portion of the deduction allowed under section 56(h) which 
is attributable to adjustments under section 56(g)(4). In taxable years 
following the taxable year in which the section 56(h) deduction is 
claimed, basis recovery (including amortization, depletion, and gain on 
sale) must properly take into account this basis reduction.
    (2) Example. The following example illustrates the provisions of 
this paragraph (s):

    Example. Corporation A, a calendar year taxpayer, incurs $100 of 
intangible drilling costs on January 1, 1994 and as a result of these 
intangible drilling costs A claims a deduction under section 56(h) of 
$40. Assume that $20 of A's deduction under section 56(h) is 
attributable to the adjustment under paragraph (f)(1) of this section. A 
must reduce by $20 the amount of intangible drilling costs to be 
amortized under paragraph (f)(1) of this section in 1995 through 1998 
(the balance of the 60-month amortization period).

[T.D. 8340, 56 FR 11084, Mar. 15, 1991, as amended by T.D. 8352, 56 FR 
29433, June 27, 1991; T.D. 8454, 57 FR 60477, Dec. 21, 1992; T.D. 8482, 
58 FR 42207, Aug. 9, 1993; T.D. 8566, 59 FR 51371, Oct. 11, 1994; T.D. 
8858, 65 FR 1237, Jan. 7, 2000; T.D. 8940, 66 FR 9929, Feb. 13, 2001; 
T.D. 9849, 84 FR 9232, Mar. 14, 2019]

                       Tax Preference Regulations



Sec.  1.57-0  Scope.

    For purposes of the minimum tax for tax preferences (subtitle A, 
chapter I, part VI), the items of tax preference are:
    (a) Excess investment interest,
    (b) The excess of accelerated depreciation on section 1250 property 
over straight line depreciation,
    (c) The excess of accelerated depreciation on section 1245 property 
subject to a net lease over straight line depreciation,
    (d) The excess of the amortization deduction for certified pollution 
control facilities over the depreciation otherwise allowable,
    (e) The excess of the amortization deduction for railroad rolling 
stock over the depreciation otherwise allowable,
    (f) The excess of the fair market value of a share of stock received 
pursuant to a qualified or restricted stock option over the exercise 
price,
    (g) The excess of the addition to the reserve for losses on bad 
debts of financial institutions over the amount which have been 
allowable based on actual experience,
    (h) The excess of the percentage depletion deduction over the 
adjusted basis of the property, and
    (i) The capital gains deduction allowable under section 1202 or an 
equivalent amount in the case of corporations.

Accelerated depreciation on section 1245 property subject to a net lease 
and excess investment interest are not items of tax preference in the 
case of a corporation, other than a personal holding company (as defined 
in section

[[Page 598]]

542) and an electing small business corporation (as defined in section 
1371(b)). In addition, excess investment interest is an item of tax 
preference only for taxable years beginning before January 1, 1972. 
Rules for the determination of the items of tax preference are contained 
in Sec. Sec.  1.57-1 through 1.57-5. Generally, in the case of a 
nonresident alien or foreign corporation, the application of Sec. Sec.  
1.57-1 through 1.57-5 will be limited to cases in which the taxpayer has 
income effectively connected with the conduct of a trade or business 
within the United States. Special rules for the treatment of items of 
tax preference in the case of certain entities and the treatment of 
items of tax preference relating to income from sources outside the 
United States are provided in section 58 and in Sec. Sec.  1.58-1 
through 1.58-8.

[T.D. 7564, 43 FR 40470, Sept. 12, 1978]



Sec.  1.57-1  Items of tax preference defined.

    (a) [Reserved]
    (b) Accelerated depreciation on section 1250 property--(1) In 
general. Section 57(a)(2) provides that, with respect to each item of 
section 1250 property (as defined in section 1250(c)), there is to be 
included as an item of tax preference the amount by which the deduction 
allowable for the taxable year for depreciation or amortization exceeds 
the deduction which would have been allowable for the taxable year if 
the taxpayer had depreciated the property under the straight line method 
for each year of its useful life for which the taxpayer has held the 
property. The determination of the excess under section 57(a)(2) is made 
with respect to each separate item of section 1250 property. 
Accordingly, where the amount of depreciation which would have been 
allowable with respect to one item of section 1250 property if the 
taxpayer had originally used the straight line method exceeds the 
allowable depreciation or amortization with respect to such property, 
such excess may not be used to reduce the amount of the item of tax 
preference resulting from another item of section 1250 property.
    (2) Separate items of section 1250 property. The determination of 
what constitutes a separate item of section 1250 property is to be made 
on the facts and circumstances of each individual case. In general, each 
building (or component thereof, if the taxpayer uses the component 
method of computing depreciation) is a separate item of section 1250 
property. However, for purposes of this section, assets placed in a 
group, classified, or composite account are to be treated as a single 
item by a taxpayer, provided that such account contains only property 
placed in service during a single taxable year. In addition, two or more 
items may be treated as one item of section 1250 property for purposes 
of this paragraph where, with respect to each such item:
    (i) The period for which depreciation is taken begins on the same 
date, (ii) the same estimated useful life has continually been used for 
purposes of taking depreciation or amortization, and (iii) the same 
method (and rate) of depreciation or amortization has continually been 
used. For example, assume a taxpayer constructed a 40-unit rental 
townhouse development and began taking declining balance depreciation on 
all 40 units as of January 1, 1970, at a uniform rate and has 
consistently taken depreciation on all 40 units on this same basis. 
Although each townhouse is a separate item of section 1250 property, all 
40 townhouses may be treated as one item of section 1250 property for 
purposes of the minimum tax since the conditions of subdivisions (i), 
(ii), and (iii) of this subparagraph are met. This would be true even if 
the 40 townhouses comprised two 20-unit developments located apart from 
each other. However, if the taxpayer constructed an additional 
development or new section on the existing development for which he 
began taking depreciation on July 1, 1970, at a uniform rate for all the 
additional units, the additional units and the original units may not be 
treated as one item of section 1250 property since the condition of 
subdivision (i) of this subparagraph is not met. Where a portion of an 
item of section 1250 property has been depreciated or amortized under a 
method (or rate) which is different from the method (or rate) under 
which the other portion or portions of such item have been depreciated 
or amortized, such portion is considered a separate item of section

[[Page 599]]

1250 property for purposes of this paragraph.
    (3) Allowable depreciation or amortization. The phrase ``deduction 
allowable for the taxable year for exhaustion, wear and tear, 
obsolescence, or amortization'' and references in this paragraph to 
``allowable depreciation or amortization'' include deductions allowable 
for the taxable year under sections 162, 167, 212, or 611 for the 
depreciation or amortization of section 1250 property. Such phrase does 
not include depreciation allowable in the year in which the section 1250 
property is disposed of. For the determination of ``allowable 
depreciation or amortization'' for taxable years in which the taxpayer 
has taken no deduction, see Sec.  1.1016-3(a)(2).
    (4) Straight line depreciation. (i) For purposes of computing the 
depreciation which would have been allowable for the taxable year if the 
taxpayer had depreciated the property under the straight line method for 
each taxable year of its useful life, the taxpayer must use the same 
useful life and salvage value as was used for the first taxable year in 
which the taxpayer depreciated or amortized the property (subject to 
redeterminations made pursuant to Sec.  1.167(a)-1 (b) and (c)). If, 
however, for any taxable year, no useful life was used under the method 
of depreciation or amortization used or an artificial period was used, 
such as, for example, by application of section 167(k), or salvage value 
was not taken into account in determining the annual allowances, such 
as, for example, under the declining balance method, then, for purposes 
of computing the depreciation which would have been allowable under the 
straight line method for the taxable year--
    (a) There is to be used the useful life and salvage value which 
would have been proper if depreciation had actually been determined 
under the straight line method (without reference to an artificial life) 
throughout the period the property was held, and
    (b) Such useful life and such salvage value is to be determined by 
taking into account for each taxable year the same facts and 
circumstances as would have been taken into account if the taxpayer had 
used such method throughout the period the property was held.


If an election under Sec.  1.167(a)-11(f), Sec.  1.167(a)-12(e), or 
Sec.  1.167(a)-12(f) is applicable to the property, the salvage value of 
the property shall be determined in accordance with such election, and 
the asset depreciation period (or asset guideline period) applicable to 
the property pursuant to such election shall be considered to be the 
useful life of the property for the purposes of this section.
    (ii) Where the taxpayer acquires property in a transaction to which 
section 381(a) applies or from another member of an affiliated group 
during a consolidated return year and an ``accelerated'' method of 
depreciation as described in section 167(b) (2), (3), or (4) or section 
167(j)(1) (B) or (C) is permitted (see Sec.  1.381(c)(6)-1 and Sec.  
1.1502-12(g)), the depreciation which would have been allowable under 
the straight line method is determined as if the property had been 
depreciated under the straight line method since depreciation was first 
taken on the property by the transferor of such property. In such cases, 
references in this paragraph to the period for which the property is 
held or useful life of the property are treated as including the period 
beginning with the commencement of the original use of the property.
    (iii) For purposes of section 57(a)(2), the straight line method 
includes the method of depreciation described in Sec.  1.167(b)-1 or any 
other method which provides for a uniform proration of the cost or other 
basis (less salvage value) of the property over the estimated useful 
life of the property to the taxpayer (in terms of years, hours of use, 
or other similar time units) or estimated number of units to be produced 
over the life of the property to the taxpayer. If a method other than 
the method described in Sec.  1.167(b)-1 is used, the estimated useful 
life or estimated units of production shall be determined in a manner 
consistent with subdivision (i) of this subparagraph.
    (iv) In the case of property constructed by or improvements made by 
a lessee, the useful life is to be determined in accordance with Sec.  
1.167(a)-4.
    (5) Application for partial period. If an item is section 1250 
property for less

[[Page 600]]

than the entire taxable year, the allowable depreciation or amortization 
includes only the depreciation or amortization for that portion of the 
taxable year during which the item is section 1250 property and the 
amount of the depreciation which would have been allowable under the 
straight line method is determined only with regard to such portion of 
the taxable year.
    (6) No section 1250 and basis adjustment. No adjustment is to be 
made as a result of the minimum tax either to the basis of section 1250 
property or with respect to computations under section 1250.
    (7) Example. The principles of this paragraph may be illustrated by 
the following example:

    Example. The taxpayer's only item of section 1250 property is an 
office building with respect to which operations were commenced on 
January 1, 1971. The taxpayer depreciates the component parts of the 
building on the declining balance method. The useful life and costs of 
the component parts for depreciation purposes are as follows:

------------------------------------------------------------------------
                                                               Salvage
              Asset                Useful life      Cost        value
------------------------------------------------------------------------
Building shell...................           50     $400,000      $50,000
Partitions and walls.............           10       40,000
Ceilings.........................           10       20,000
Electrical system................           25       40,000        2,500
Heating and air-conditioning                25       60,000        2,500
 system..........................
------------------------------------------------------------------------


For purposes of computing the item of tax preference under this 
paragraph for the taxpayer, the partitions, walls, and ceilings may be 
grouped together and the electrical, heating, and air-conditioning 
systems may be grouped together since the period for which depreciation 
is taken began with respect to the assets within these two groups on the 
same date and the assets within each group have continually had the same 
useful life and have continually been depreciated under the same method 
(and rate).
    (a) The taxpayer's 1971 item of tax preference under this paragraph 
would be determined as follows:

----------------------------------------------------------------------------------------------------------------
                               (1)                                      (2)             (3)             (4)
----------------------------------------------------------------------------------------------------------------
                                                                     Declining
                      Item of 1250 property                           balance      Straight line   Excess of (2)
                                                                   depreciation    depreciation      over (3)
----------------------------------------------------------------------------------------------------------------
1. Shell........................................................         $12,000          $7,000          $5,000
2. Partitions, walls, ceilings..................................           9,000           6,000           3,000
3. Electrical, heating and air-conditioning systems.............           6,000           3,800           2,200
                                                                 -----------------------------------------------
  1971 preference...............................................  ..............  ..............          10,200
----------------------------------------------------------------------------------------------------------------

    (b) Assuming the above facts are the same for 1974, the taxpayer's 
1974 item of tax preference under this paragraph would be determined as 
follows:

----------------------------------------------------------------------------------------------------------------
                               (1)                                      (2)             (3)             (4)
----------------------------------------------------------------------------------------------------------------
                                                                     Declining
                      Item of 1250 property                           balance      Straight line   Excess of (2)
                                                                   depreciation    depreciation      over (3)
----------------------------------------------------------------------------------------------------------------
1. Shell........................................................         $10,952          $7,000          $3,952
2. Partitions, walls, ceilings..................................           5,529           6,000            None
3. Electrical, heating and air-conditioning systems.............           4,983           3,800           1,183
                                                                 -----------------------------------------------
  1974 preference...............................................  ..............  ..............           5,135
----------------------------------------------------------------------------------------------------------------


    (c) Accelerated depreciation on section 1245 property subject to a 
net lease--(1) In general. Section 57(a)(3) provides that, with respect 
to each item of section 1245 property (as defined in section 1245(a)(3)) 
which is the subject of a net lease for the taxable year, there is to be 
included as an item of tax preference the amount by which the deduction 
allowable for the taxable year for depreciation or amortization exceeds 
the deduction which would have been allowable for the taxable year if 
the taxpayer had depreciated the property under the straight line method 
for each year of its useful life for which the taxpayer has held the 
property. Except as provided in paragraph (b)(1)(ii) of this

[[Page 601]]

section, the determination of the excess under section 57(a)(3) is made 
with respect to each separate item of section 1245 property. 
Accordingly, where the amount of depreciation which would have been 
allowable with respect to one item of section 1245 property if the 
taxpayer had originally used the straight line method exceeds the 
allowable depreciation or amortization with respect to such property, 
such excess may not be used to reduce the amount of the item of tax 
preference resulting from another item of section 1245 property.
    (2) Separate items of property. The determination of what 
constitutes a separate item of section 1245 property must be made on the 
facts and circumstances of each individual case. Such determination 
shall be made in a manner consistent with the principles expressed in 
paragraph (b)(2) of this section.
    (3) Allowable depreciation or amortization. The phrase ``deduction 
allowable for the taxable year for exhaustion, wear and tear, 
obsolescence, or amortization'' and references in this paragraph to 
``allowable depreciation or amortization'' include deductions allowable 
for the taxable year under sections 162, 167 (including depreciation 
allowable under section 167 by reason of section 179), 169, 184, 185, 
212, or 611 for the depreciation or amortization of section 1245 
property. Such phrase does not include depreciation allowable in the 
year in which the section 1245 property is disposed of. Amortization of 
certified pollution control facilities under section 169, and 
amortization of railroad rolling stock under section 184 are not to be 
treated as amortization for purposes of section 57(a)(3) to the extent 
such amounts are treated as an item of tax preference under section 
57(a) (4) or (5) (see paragraphs (d) and (e) of this section). For the 
determination of ``allowable depreciation or amortization'' for taxable 
years in which the taxpayer has taken no deduction, see Sec.  1.1016-
3(a)(2).
    (4) Straight line method of depreciation. The determination of the 
depreciation which would have been allowable under the straight line 
method shall be made in a manner consistent with paragraph (b)(4) of 
this section. Such amount shall include any amount allowable under 
section 167 by reason of section 179 (relating to additional first-year 
depreciation for small business).
    (5) Application for partial period. If an item is section 1245 
property for less than the entire taxable year or subject to a net lease 
for less than the entire taxable year the allowable depreciation or 
amortization includes only the depreciation or amortization for that 
portion of the taxable year during which the item was both section 1245 
property and subject to a net lease and the amount of the depreciation 
which would have been allowable under the straight line method is to be 
determined only with regard to such portion of the taxable year.
    (6) Net lease. Section 57(a)(3) applies only if the section 1245 
property is the subject of a net lease for all or part of the taxable 
year. See Sec.  1.57-3 for the determination of when an item is 
considered the subject of a net lease. p
    (7) No section 1245 and basis adjustment. No adjustment is to be 
made as a result of the minimum tax either to the basis of section 1245 
property or with respect to computations under section 1245.
    (8) Nonapplicability to corporations. Section 57(a)(3) does not 
apply to a corporation other than an electing small business corporation 
(as defined in section 1371(b)) and a personal holding company (as 
defined in section 542).
    (d) Amortization of certified pollution control facilities--(1) In 
general. Section 57(a)(4) provides that, with respect to each certified 
pollution control facility for which an election is in effect under 
section 169, there is to be included as an item of tax preference the 
amount by which the deduction allowable for the taxable year under such 
section exceeds the depreciation deduction which would otherwise be 
allowable under section 167. The determination under section 57(a)(4) is 
made with respect to each separate certified pollution control facility. 
Accordingly, where the amount of the depreciation deduction which would 
otherwise be allowable under section 167 with respect to one facility 
exceeds the allowable amortization deduction under section 169 with 
respect to such facility, such excess may not be used to offset an item 
of

[[Page 602]]

tax preference resulting from another facility.
    (2) Separate facilities. The determination of what constitutes a 
separate facility must be made on the facts and circumstances of each 
individual case. Generally, each facility with respect to which a 
separate election is in effect under section 169 shall be treated as a 
separate facility for purposes of this paragraph. However, if the 
depreciation or amortization which would have been allowable without 
regard to section 169 with respect to any part of a facility is based on 
a different useful life, date placed in service, or method of 
depreciation or amortization from the other part or parts of such 
facility, such part is considered a separate facility for purposes of 
this paragraph. For example, if a building constitutes a certified 
pollution control facility and various component parts of the building 
have different useful lives, each group of component parts with the same 
useful life would be treated as a separate facility for purposes of this 
paragraph. Two or more facilities may be treated as one facility for 
purposes of this paragraph where, with respect to each such facility: 
(i) The initial amortization under section 169 commences on the same 
date, (ii) the facility is placed in service on the same date, (iii) the 
estimated useful life which would be the basis for depreciation or 
amortization other than under section 169 has continually been the same, 
and (iv) the method of depreciation or amortization which could have 
been used without regard to section 169 could have continually been the 
same.
    (3) Amount allowable under section 169. For purposes of the 
determination of the amount of the deduction allowable under section 
169, see section 169 and the regulations thereunder. Such amount, 
however, does not include amortization allowable in the year in which 
the pollution control facility is disposed of.
    (4) Otherwise allowable deduction. (i) The determination of the 
amount of the depreciation deduction otherwise allowable under section 
167 is made as if the taxpayer had depreciated the property under 
section 167 for each year of its useful life for which the property has 
been held. This amount may be determined under Sec.  1.167(a)-(11)(c) if 
the property is eligible property (as defined in Sec.  1.167(a)-
11(b)(2)) and, during the taxable year in which the property was first 
placed in service, the taxpayer--
    (a) Has made an election under Sec.  1.167(a)-11(f) with respect to 
eligible property first placed in service in such taxable year, or
    (b) Has placed no eligible property in service other than property 
described in Sec.  1.167(a)-11(b)(5) (iii), (iv), or (v).

The amount determined pursuant to the preceding sentence shall be 
determined as if the taxpayer had depreciated the property in accordance 
with Sec.  1.167(a)-11 for all years to which such section applies and 
during which the taxpayer held the property. This amount may be 
determined under Sec.  1.167(a)-12(a)(5) if the property is qualified 
property (as defined in Sec.  1.167(a)-12(a)(3)) and the taxpayer has 
made an election with respect to such property under Sec.  1.167(a)-
12(e). If the taxpayer has made an election under Sec.  1.167(a)-
12(f)(1) for a taxable year ending before January 1, 1971, this amount 
shall be determined for such year in accordance with such election. For 
purposes of this determination, any method selected by the taxpayer 
which would have been permissible under section 167 for such taxable 
year, including accelerated methods, may be used. Any additional amount 
which would have been allowable by reason of section 179 (relating to 
additional first-year depreciation for small business) may be included 
provided such amount is reflected in the determination made under this 
paragraph in subsequent years.
    (ii) If a deduction for depreciation has not been taken by the 
taxpayer in any taxable year under section 167 with respect to the 
facility--
    (a) There is to be used the useful life and salvage value which 
would have been proper under section 167.
    (b) Such useful life and salvage value is determined by taking into 
account for each taxable year the same facts and circumstances as would 
have been taken into account if the taxpayer had used such method 
throughout the period the property has been held, and

[[Page 603]]

    (c) The date the property is placed in service is, for purposes of 
this section, deemed to be the first day of the first month for which 
the amortization deduction is taken with respect to the facility under 
section 169.

If, prior to the date amortization begins under section 169, a deduction 
for depreciation has been taken by the taxpayer in any taxable year 
under section 167 with respect to the facility, the useful life, salvage 
value, etc., used for that purpose is deemed to be the appropriate 
useful life, salvage value, etc., for purposes of this paragraph, with 
such adjustments as are appropriate in light of the facts and 
circumstances which would have been taken into account since the time 
the last such depreciation deduction was taken, unless it is established 
by clear and convincing evidence that some other useful life, salvage 
value, or date the property is placed in service is more appropriate.
    (iii) For purposes of section 57(a)(4) and this paragraph, if the 
deduction for amortization or depreciation which would have been 
allowable had no election been made under section 169 would have been--
    (a) An amortization deduction based on the term of a leasehold or
    (b) A depreciation deduction determined by reference to section 611,

such deduction is to be deemed to be a deduction allowable under section 
167.
    (iv) If a facility is subject to amortization under section 169 for 
less than the entire taxable year, the otherwise allowable depreciation 
deduction under section 167 shall be determined only with regard to that 
portion of the taxable year during which the election under section 169 
is in effect.
    (v) If less than the entire adjusted basis of a facility is subject 
to amortization under section 169, the otherwise allowable depreciation 
deduction under section 167 shall be determined only with regard to that 
portion of the adjusted basis subject to amortization under section 169.
    (5) No section 1245 and basis adjustment. No adjustment is to be 
made as a result of the minimum tax either to the basis of a certified 
pollution control facility or with respect to computations under 
sections 1245.
    (6) Relationship to section 57(a)(3). See paragraph (c)(3) with 
respect to an adjustment in the amount treated as amortization under 
that provision where both paragraphs (3) and (4) of section 57(a) are 
applicable to the same item of property.
    (7) Example. The principles of this paragraph may be illustrated by 
the following example:

    Example. A calendar year taxpayer has a certified pollution control 
facility on which an election is in effect under section 169 commencing 
with January 1, 1971. No part of the facility is section 1250 property. 
The original basis of the facility is $100,000 of which $75,000 
constitutes amortizable basis. The useful life of the facility is 20 
years. The taxpayer depreciates the $25,000 portion of the facility 
which is not amortizable basis under the double declining method and 
began taking depreciation on January 1, 1971.
    (a) The taxpayer's 1971 item of tax preference under this paragraph 
would be determined as follows:

1. Amortization deduction...................................     $15,000
2. Depreciation deduction on amortizable basis (double             7,500
 declining method)..........................................
                                                             -----------
    1971 preference (excess of 1 over 2)....................       7,500
 


    (b) If the taxpayer terminated his election under section 169 in 
1972 effective as of July 1, 1972, the taxpayer's 1972 item of tax 
preference would be determined as follows:

1. Amortization deduction...................................      $7,500
2. Depreciation deduction on amortizable basis:
  Full year ($75,000 (original basis) less $7,500                  6,750
   (``depreciation'' to 1-1-72) equals adjusted basis of
   $67,500; multiplied by 0.10 (double declining rate)).....
                                                             ===========
  Portion of full year's depreciation attributable to              3,375
   amortization period (one-half)...........................
                                                             -----------
    1972 preference (excess of 1 over 2)....................       4,125
 


    (e) Amortization of railroad rolling stock--(1) In general. Section 
57(a)(5) provides that, with respect to each unit of railroad rolling 
stock for which an election is in effect under section 184, there is to 
be included as an item of tax preference the amount by which the 
deduction allowable for the taxable year under such section exceeds the 
depreciation deduction which would otherwise be allowable under section 
167. The determination under section 57(a)(5) is made with respect to 
each separate unit of rolling stock. Accordingly, where the amount of 
the depreciation deduction which would otherwise be allowable under 
section 167

[[Page 604]]

with respect to one unit exceeds the allowable amortization deduction 
under section 184 with respect to such unit, such excess may not be used 
to offset an item of tax preference resulting from another unit.
    (2) Separate units of rolling stock. The determination of what 
constitutes a separate unit of rolling stock must be made on the facts 
and circumstances of each individual case. Such determination shall be 
made in a manner consistent with the manner in which the comparable 
determination is made with respect to separate certified pollution 
control facilities under paragraph (d) (2) of this section.
    (3) Amount allowable under section 184. For purposes of the 
determination of the amount of the deduction allowable under section 
184, see section 184. Such amount, however, does not include 
amortization allowable in the year in which the rolling stock is 
disposed of.
    (4) Otherwise allowable deduction. The determination of the amount 
of the depreciation deduction otherwise allowable under section 167 is 
to be made in a manner consistent with the manner in which the 
comparable deduction with respect to certified pollution control 
facilities is determined under paragraph (d)(4) of this section.
    (5) No section 1245 or basis adjustment. No adjustment is to be made 
as a result of the minimum tax either to the basis of a unit of railroad 
rolling stock or with respect to computations under section 1245.
    (6) Relationship to section 57(a)(3). See paragraph (c)(3) of this 
section with respect to an adjustment in the amount treated as 
amortization under that provision where both paragraphs (3) and (5) of 
section 57(a) are applicable to the same item.
    (f) Stock options--(1) In general. Section 57(a)(6) provides that 
with respect to each transfer of a share of stock pursuant to the 
exercise of a qualified stock option or a restricted stock option, there 
shall be included by the transferee as an item of tax preference the 
amount by which the fair market value of the share at the time of 
exercise exceeds the option price. The stock option item of tax 
preference is subject to tax under section 56(a) in the taxable year of 
the transferee in which the transfer is made.
    (2) Definitions. See generally Sec.  1.421-7 (e), (f), and (g) for 
the definitions of ``option price,'' ``exercise,'' and ``transfer,'' 
respectively; however, in the case of a transfer of a share of stock 
pursuant to the exercise of a qualified stock option or a restricted 
stock option after the death of an employee by the estate of the 
decedent (or by a person who acquired the right to exercise such option 
by bequest or inheritance or by reason of the death of the decedent), 
the term ``option price'' shall, for purposes of this paragraph, include 
both the consideration paid by the estate (or such person) for such 
share of stock and so much of the basis of the option as is attributable 
to such share of stock. For the definition of a qualified stock option 
see section 422(b) and Sec.  1.422-2. For the definition of a restricted 
stock option see section 424(b) and Sec.  1.424-2. The definitions and 
special rules contained in section 425 and the regulations thereunder 
are applicable to this paragraph.
    (3) Fair market value. In accordance with the principles of section 
83(a)(1), the fair market value of a share of stock received pursuant to 
the exercise of a qualified or restricted stock option is to be 
determined without regard to restrictions (other than nonlapse 
restrictions within the meaning of Sec.  1.83-3(h)). Notwithstanding any 
valuation date given in section 83(a)(1), for purposes of this section, 
fair market value is determined as of the date the option is exercised.
    (4) Foreign source options. In the case of an option attributable to 
sources within any foreign country or possession, see section 58(g) and 
Sec.  1.58-8.
    (5) Inapplicability in certain cases. (i) Section 57(a)(6) is 
inapplicable if during the same taxable year in which stock is 
transferred pursuant to the exercise of an option, the transferee makes 
a disposition (within the meaning of section 425(c)) of such stock. In 
the case of a nonresident alien, section 57(a)(6) is inapplicable to the 
extent the stock option is attributable (in accordance with the 
principles of sections 861 through 863 and the regulations thereunder) 
to sources without the United States.

[[Page 605]]

    (ii) Section 57(a)(6) is inapplicable if section 421(a) does not 
apply to the transfer because of employment requirements of section 
422(a)(2) or 424(a)(2).
    (6) Proportionate applicability. Where, by reason of section 422 
(b)(7) and (c)(3) (relating to percentage ownership limitations), only a 
portion of a transfer qualifies for application of section 421, the fair 
market value and option price shall be determined only with regard to 
that portion of the transfer which so qualifies.
    (7) No basis adjustment. No adjustment shall be made to the basis of 
the stock received pursuant to the exercise of a qualified or restricted 
stock option as a result of the minimum tax.
    (g) Reserves for losses on bad debts of financial institutions--(1) 
In general. Section 57(a)(7) provides that, in the case of a financial 
institution to which section 585 or 593 (both relating to reserves for 
losses on loans) applies, there shall be included as an item of tax 
preference the amount by which the deduction allowable for the taxable 
year for a reasonable addition to a reserve for bad debts exceeds the 
amount that would have been allowable had the institution maintained its 
bad debt reserve for all taxable years on the basis of the institution's 
actual experience.
    (2) Taxpayers covered. Section 57(a)(7) applies only to an 
institution (or organization) to which section 585 or 593 applies. See 
sections 585(a) and 593(a) and the regulations thereunder for a 
description of those institutions.
    (3) Allowable deduction. For purposes of this paragraph, the amount 
of the deduction allowable for the taxable year for a reasonable 
addition to a reserve for bad debts is the amount of the deduction 
allowed under section 166(c) by reference to section 585 or 593.
    (4) Actual experience. (i) For purposes of this paragraph, the 
determination of the amount which would have been allowable had the 
institution maintained its reserve for bad debts on the basis of actual 
experience is the amount determined under section 585(b)(3)(A) and the 
regulations thereunder. For this purpose, the beginning balance for the 
first taxable year ending in 1970 is the amount which bears the same 
ratio to loans outstanding at the beginning of the taxable year as (a) 
the total bad debts sustained during the 5 preceding taxable years, 
adjusted for recoveries of bad debts during such period, bears to (b) 
the sum of the loans outstanding at the close of such 5 taxable years. 
The taxpayer may, however, select a more appropriate balance based on 
its actual experience during a shorter period subject to the approval of 
the district director upon examination of the return provided there are 
unusual circumstances which indicate that such period is more indicative 
of the taxpayer's actual loss experience. Any such selection and 
approval shall be made in a manner consistent with the selection and 
approval of a bad debt reserve method under Sec.  1.166-1(b). In the 
case of an institution which has been in existence for less than 5 
taxable years as of the beginning of the first taxable year ending in 
1970, the above formula for determining the beginning balance is applied 
by substituting the number of taxable years for which the institution 
has been in existence as of the beginning of the taxable year for ``5'' 
each time it appears. If any taxable year utilized in the above formula 
for determining the beginning balance is a short taxable year the amount 
of the bad debts, adjusted for recoveries, for such taxable year is 
modified by dividing such amount by the number of days in the taxable 
year and multiplying the resulting amount by 365. The beginning balance 
for any subsequent taxable year is the amount of the beginning balance 
of the preceding taxable year, decreased by bad debt losses during such 
year, increased by recoveries of bad debts during such year and 
increased by the lower of the maximum amount determined under section 
585(b)(3)(A) for such year or the amount of the deduction allowed for 
such year. The application of this subdivision (i) may be illustrated by 
the following example:

    Example. The Y Bank, a calendar year taxpayer, uses the reserve 
method of acounting for bad debts. On December 31, 1969, Y determines 
the balance of its reserve for bad debts to be $70,000 under the 
percentage method. On the same date Y's 5-year moving average is 
$52,000. Y incurs net bad debt losses (bad debt losses less recoveries 
of bad debts) of $3,000 for each of the years 1970, 1971, and 1972, 
which it charges to its reserve for bad

[[Page 606]]

debts. Y's 6-year moving averages computed under section 585(b)(3)(A) at 
the close of 1970, 1971, and 1972 are $50,000, $49,000, and $51,000, 
respectively. Y's preference items are computed as follows based upon 
additional facts assumed:

------------------------------------------------------------------------
                                            1970       1971       1972
------------------------------------------------------------------------
1. Bad debt reserve--percentage method:
  (a) Balance beginning of year            $70,000    $70,000    $68,000
   (closing balance prior year)........
  (b) Net bad debts charged to reserve.      3,000      3,000      3,000
                                        --------------------------------
  (c) Subtotal.........................     67,000     67,000     65,000
  (d) Deduction allowed................      3,000      1,000      4,000
                                        --------------------------------
  (e) Balance end of year..............     70,000     68,000     69,000
2. Bad debt reserve--``actual
 experience'':
  (a) Beginning balance (for 1970, 5-       52,000     50,000     48,000
   year moving average; for other
   years, closing balance prior year)..
  (b) Net bad debts charged to reserve.      3,000      3,000      3,000
                                        --------------------------------
  (c) Subtotal.........................     49,000     47,000     45,000
  (d) Maximum amount under section 585       1,000      2,000      6,000
   (b)(3)(A) (6-year moving average
   minus (c))..........................
  (e) Deduction allowed (line 1(d))....      3,000      1,000      4,000
  (f) Lower of (d) or (e)..............      1,000      1,000      4,000
                                        --------------------------------
  (g) Closing balance (line (c) + (f)).     50,000     48,000     49,000
3. Preference item under section
 57(a)(7):
  (a) Deduction allowed................      3,000      1,000      4,000
  (b) Maximum amount under section           1,000      2,000      6,000
   585(b)(3)(A)........................
                                        --------------------------------
  (c) Preference item (excess of (a)         2,000          0          0
   over (b))...........................
------------------------------------------------------------------------


    (ii) In the case of a new institution whose first taxable year ends 
after 1969, its beginning balance for its reserve for bad debts, for 
purposes of this paragraph, is zero and its reasonable addition to the 
reserve for such taxable year is determined on the basis of the actual 
experience of similar institutions located in the area served by the 
taxpayer.
    (h) Depletion--(1) In general. Section 57(a)(8) provides that with 
respect to each property (as defined in section 614), there is to be 
included as an item of tax preference the amount by which the deduction 
allowable for the taxable year under section 611 for depletion for the 
property exceeds the adjusted basis of the property at the end of the 
taxable year (determined without regard to the depletion deduction for 
that taxable year). The determination under section 57(a)(8) is made 
with respect to each separate property. Thus, for example, if one 
mineral property has an adjusted basis remaining at the end of the 
taxable year, such basis may not be used to reduce the amount of an item 
of tax preference resulting from another mineral property.
    (2) Allowable depletion. For the determination of the amount of the 
deduction for depletion allowable for the taxable year see section 611 
and the regulations thereunder.
    (3) Adjusted basis. For the determination of the adjusted basis of 
the property at the end of the taxable year see section 1016 and the 
regulations thereunder.
    (4) No basis adjustment. No adjustment is to be made to the basis of 
property subject to depletion as a result ot the minimum tax.
    (i) Capital gains--(1) Taxpayers other than corporations. Section 
57(a)(9)(A) provides that, in the case of a taxpayer other than a 
corporation, there is to be included as an item of tax preference one-
half of the amount by which the taxpayer's net long-term capital gain 
for the taxable year exceeds the taxpayer's net short-term capital loss 
for the taxable year. For this purpose, for taxable years beginning 
after December 31, 1971, the taxpayer's net long-term capital gain does 
not include an amount equal to the deduction allowable under section 163 
(relating to interest expense) by reason of subsection (d)(1)(C) of that 
section, and the excess described in the preceding sentence is reduced 
by an amount equal to the reduction of disallowed interest expense by 
reason of section 163(d)(2)(B). Furthermore, the net long-term capital

[[Page 607]]

gain of an estate or trust does not include capital gains described in 
section 642(c)(4). Included in the computation of the taxpayer's capital 
gains item of tax preference are amounts reportable by the taxpayer as 
distributive shares of gain or loss from partnerships, estates or 
trusts, electing small business corporations, common trust funds, etc. 
See section 58 and the regulations thereunder with respect to the above 
entities.

    Example. For 1971, A, a calendar year individual taxpayer, 
recognized $50,000 from the sale of securities held for more than 6 
months. In addition, A received a $15,000 dividend from X Fund, a 
regulated investment company, $12,000 of which was designated as a 
capital gain dividend by the company pursuant to section 852(b)(3)(C). 
The AB partnership recognized a gain of $20,000 from the sale of section 
1231 property held by the partnership. The AB partnership agreement 
provides that A is entitled to 50 percent of the income and gains of the 
partnership. A had net short-term capital loss for the year of $10,000. 
A's 1971 capital gains item of tax preference is computed as follows:

Capital gain recognized from securities.....................     $50,000
Capital gain dividend from regulated investment company.....      12,000
Distributive share of partnership capital gain..............      10,000
                                                             -----------
    Total net long-term capital gain........................      72,000
Less: net short-term capital loss...........................    (10,000)
                                                             -----------
Excess of net long-term capital gain over net short-term          62,000
 capital loss...............................................
                                                             ===========
One-half of above excess....................................      31,000
 

    (2) Corporations. (i) Section 57(a)(9)(B) provides that in the case 
of corporations there is to be included as an item of tax preference 
with respect to a corporation's net section 1201 gain an amount equal to 
the product obtained by multiplying the excess of the net long-term 
capital gain over the net short-term capital loss by a fraction. The 
numerator of this fraction is the sum of the normal tax rate and the 
surtax rate under section 11 minus the alternative tax rate under 
section 1201(a) for the taxable year, and the denominator of the 
fraction is the sum of the normal tax rate and the surtax rate under 
section 11 for the taxable year. Included in the above computation are 
amounts reportable by the taxpayer as distributive shares of gain or 
loss from partnerships, estates or trusts, common trust funds, etc. In 
certain cases the amount of the net section 1201 gain which results in 
preferential treatment will be less than the amount determined by 
application of the statutory formula. Therefore, in lieu of the 
statutory formula, the capital gains item of tax preference for 
corporations may in all cases be determined by dividing--
    (a) The amount of tax which would have been imposed under section 11 
if section 1201(a) did not apply minus--
    (b) The amount of the taxes actually imposed

by the sum of the normal tax rate plus the surtax rate under section 11. 
In case of foreign source capital gains and losses which are not taken 
into account pursuant to sections 58(g)(2)(B) and 1.58-8, the amount 
determined in the preceding sentence shall be multiplied by a fraction 
the numerator of which is the corporation's net section 1201 gain 
without regard to such gains and losses which are not taken into account 
and the denominator of which is the corporation's net section 1201 gain. 
The computation of the corporate capital gains item of tax preference 
may be illustrated by the following examples:

    Example 1. For 1971, A, a calendar year corporate taxpayer, has 
ordinary income of $10,000 and net section 1201 gain of $50,000, none of 
which is subsection (d) gain (as defined in sec. 1201(d)) and none of 
which is attributable to foreign sources. A's 1971 capital gain item of 
tax preference may be computed as follows:

1. Tax under section 11:
  Normal tax (0.22 x $60,000)...............................     $13,200
  Surtax (0.26 x $35,000)...................................       9,100
                                                             -----------
                                                  ..........      22,300
2. Tax under section 1201:
  (a) Normal tax on ordinary income (0.22 x $10,000)........      $2,200
  Tax on net section 1201 gain (0.30 x $50,000).     $15,000     $17,200
                                                 -----------------------
3. Excess...................................................       5,100
                                                 -------------
4. Normal tax rate plus surtax rate.........................         .48
5. Capital gains preference (line 3 divided by line 4)......      10,625
 

    Example 2. For 1971, A, a calendar year corporate taxpayer, has a 
loss from operations of $30,000 and net section 1201 gain of $150,000, 
none of which is subsection (d) gain (as defined in section 1201(d)) and 
none of which is attributable to foreign sources. A's 1971 capital gain 
item of tax preference may be computed as follows:

1. Tax under section 11:
  Normal tax (0.22 x $120,000)..............................     $26,400

[[Page 608]]

 
  Surtax (0.26 x $95,000)...................................      24,700
                                                             -----------
                                                  ..........      51,100
2. Tax under section 1201(a):
  Normal tax on ordinary income.................        None
  Tax on net section 1201 gain (0.30 x $150,000)      45,000      45,000
                                                             -----------
3. Excess...................................................       6,100
                                                 -------------
4. Normal tax rate plus surtax rate.........................         .48
5. Capital gain preference (line 3 divided by line 4).......      12,708
 

    (ii) In the case of organizations subject to the tax imposed by 
section 511(a), mutual savings banks conducting a life insurance 
business (see section 594), life insurance companies (as defined in 
section 801), mutual insurance companies to which part II of subchapter 
L applies, insurance companies to which part III of subchapter L 
applies, regulated investment companies subject to tax under part I of 
subchapter M, real estate investment trusts subject to tax under part II 
of subchapter M, or any other corporation not subject to the taxes 
imposed by sections 11 and 1201(a), the capital gains item of tax 
preference may be computed in accordance with subdivision (i) of this 
subparagraph except that, in lieu of references to section 11, there is 
to be substituted the section which imposes the tax comparable to the 
tax imposed by section 11 and, in lieu of references to section 1201(a), 
there is to be substituted the section which imposes the alternative or 
special tax applicable to the capital gains of such corporation.
    (iii) For purposes of this paragraph, where the net section 1201 
gain is not in any event subject to the tax comparable to the normal tax 
and the surtax under section 11, such as in the case of regulated 
investment companies subject to tax under subchapter M, such comparable 
tax shall be computed as if it were applicable to net section 1201 gain 
to the extent such gain is subject to the tax comparable to the 
alternative tax under section 1201(a). Thus, in the case of a regulated 
investment company subject to tax under subchapter M, the tax comparable 
to the normal tax and the surtax would be the tax computed under section 
852(b)(1) determined as if the amount subject to tax under section 
852(b)(3) were included in investment company taxable income. The 
principles of this subdivision (iii) may be illustrated by the following 
example:

    Example. M, a calendar year regulated investment company, in 1971, 
has investment company taxable income (subject to tax under sec. 
852(b)(1)) of $125,000 and net long-term capital gain of $800,000. M 
company has no net short-term capital loss but has a deduction for 
dividends paid (determined with reference to capital gains only) of 
$700,000, M's 1971 capital gains item of tax preference is computed as 
follows:

1. Section 852(b)(1) tax computed as if
 it were applicable to all income
 including capital gains:
    Amount subject to section 852(b)(1)...........   $125,000
    Net section 1201 gain..............   $800,000
    Less: Dividends paid deduction.....    700,000
                                        -----------
    Net section 1201 gain subject to tax at the       100,000
     company level................................
                                        -----------
                                         .........    225,000
    Normal tax (0.22 x $225,000).............................    $49,500
    Surtax (0.26 x 200,000)..................................     52,000
                                        --------------------------------
                                         .........  .........    101,500
                                        ================================
2. Tax comparable to section 1201(a) tax section 852(b)(1) tax:
    Normal tax (0.22 x 125,000)........    $27,500
    Surtax (0.26 x 100,000)............     26,000    $53,500
                                        -----------
    Section 852(b)(3) tax (0.30 x 100,000)........     30,000
                                                   -----------
                                         .........  .........    $83,500
                                                              ==========
3. Excess....................................................     18,000
                                        ============
4. Normal tax rate plus surtax rate..........................        .48
5. Capital gains preference (line 3 divided by line 4).......     37,500
------------------------------------------------------------------------
 


[[Page 609]]

    (iv) For the computation of the capital gains item of tax preference 
in the case of an electing small business corporation (as defined in 
section 1371(b)), see Sec.  1.58-4(c).
    (3) Nonresident aliens, foreign corporations. In the case of a 
nonresident alien individual or foreign corporation, there shall be 
included in computing the capital gains item of tax preference under 
section 57(a)(9) only those capital gains and losses included in the 
computation of income effectively connected with the conduct of a trade 
or business within the United States as provided in section 871(b) or 
882.

[T.D. 7564, 43 FR 40470, Sept. 12, 1978]



Sec. Sec.  1.57-2--1.57-3  [Reserved]



Sec.  1.57-4  Limitation on amounts treated as items of tax preference
for taxable years beginning before January 1, 1976.

    (a) In general. If in any taxable year beginning before January 1, 
1976, a taxpayer has deductions in excess of gross income and all or a 
part of any item of tax preference described in Sec.  1.57-1 results in 
no tax benefit due to modifications required under section 172(c) or 
section 172(b)(2) in computing the amount of the net operating loss or 
the net operating loss to be carried to a succeeding taxable year, then, 
for purposes of section 56(a)(1), the sum of the items of tax preference 
determined under section 57(a) (and Sec.  1.57-1) is to be limited as 
provided in paragraph (b) of this section.
    (b) Limitation. The sum of the items of tax preference, for purposes 
of section 56(a)(1) and Sec.  1.56A-1(a), is limited to an amount 
determined under subparagraphs (1) and (2) of this paragraph.
    (1) Loss year. If the taxpayer has no taxable income for the taxable 
year without regard to the net operating loss deduction, the amount of 
the limitation is equal to--
    (i) In cases where the taxpayer does not have a net operating loss 
for the taxable year, the amount of the recomputed income (as defined in 
paragraph (c) of this section) or
    (ii) In cases where the taxpayer has a net operating loss for the 
taxable year, the amount of the net operating loss (expressed as a 
positive amount) increased by the recomputed income or decreased by the 
recomputed loss for the taxable year (as defined in paragraph (c) of 
this section,

plus the amount of the taxpayer's stock option item of tax preference 
(as described in Sec.  1.57-1(f)).
    (2) Loss carryover and carryback years. Except in cases to which 
subparagraph (1)(ii) of this paragraph applies, if, in any taxable year 
to which a net operating loss is carried, a capital gains deduction is 
disallowed under section 172(b)(2) in computing the amount of such net 
operating loss which may be carried to succeeding taxable years, the 
amount of the limitation is equal to the amount, if any, by which the 
sum of the items of tax preference (computed with regard to subparagraph 
(1)(i) of this paragraph) exceeds the lesser of--
    (i) The amount by which such loss is reduced because of a 
disallowance of the capital gains deduction in such taxable year, or
    (ii) The capital gains deduction.

The amount determined pursuant to the preceding sentence shall be 
increased by the amount, if any, that such reduction is attributable to 
that portion of such a net operating loss described in section 
56(b)(1)(B) and Sec.  1.56A-2(a)(2) (relating to excess tax 
preferences).
    (c) Recomputed income or loss. For purposes of this section, the 
phrase ``recomputed income or loss'' means the taxable income or net 
operating loss for the taxable year computed without regard to the 
amounts described in Sec.  1.57-1 except paragraph (i)(2) of that 
section (relating to corporate capital gains) and without regard to the 
net operating loss deduction. For this purpose, the reference to the 
amounts described in Sec.  1.57-1 is a reference to that portion of the 
deduction allowable in computing taxable income under the appropriate 
section equal to the amount which is determined in each paragraph of 
Sec.  1.57-1. For example, the amount described in Sec.  1.57-1(h) 
(relating to excess of percentage depletion over basis) is that portion 
of the deduction allowable for depletion under section 611 which is 
equal to the amount determined under Sec.  1.57-1(h). For purposes of

[[Page 610]]

this paragraph, the amount described in Sec.  1.57-1(i)(1) (relating to 
capital gains) is to be considered as the amount of the deduction 
allowable for the taxable year under section 1202.
    (d) Determination of preferences reduced. When, pursuant to 
paragraph (b)(1) of this section, the sum of the items of tax preference 
(determined without regard to this section) are reduced, such reduction 
is first considered to be from the capital gains item of tax preference 
(described in Sec.  1.57-1(i)(1)) and each item of tax preference 
relating to a deduction disallowed in computing the net operating loss 
pursuant to section 172(d), pro rata. The balance of the reduction, if 
any, is considered to be from the remaining items of tax preference, pro 
rata. For purposes of this subparagraph, deductions not attributable to 
the taxpayer's trade or business which do not relate to items of tax 
preference are considered as being applied in reducing gross income not 
derived from such trade or business before such deductions which do 
relate to items of tax preferences.
    (e) Examples. The principles of this section may be illustrated by 
the following examples in each of which the deduction for the personal 
exemption is disregarded and the taxpayer is an individual who is a 
calendar year taxpayer.

    Example 1. The taxpayer has the following items of income and 
deduction for 1970:

Gross income (all business income)..........................    $120,000
Deductions:
  Nonbusiness deductions....................................      30,000
  Items of tax preference (excess accelerated depreciation        80,000
   on real property held in taxpayer's business)............
  Other business deductions.................................      50,000
 


Based on the above figures, the taxpayer has a net operating loss of 
$10,000 (business deductions of $130,000 less business income of 
$120,000, the nonbusiness deductions having been disallowed by reason of 
section 172(d)(4)). The limitation on the amount treated as items of tax 
preference is computed as follows:

Tax preferences..............................................    $80,000
                                        ============
Net operating loss................................    $10,000
Recomputed income or loss:
  Gross income.........................   $120,000
  Deductions other than tax preference      80,000
   items...............................
                                        ------------
Recomputed income.................................     40,000
                                        ------------
Sum of net operating loss and recomputed income...     50,000
Stock options preference..........................          0
                                        ------------
Limitation........................................     50,000
 

Thus, the minimum tax computed under section 56(a) would be 10 percent 
of $20,000 (items of tax preference of $50,000 less the minimum tax 
exemption of $30,000), $1,000 of which would be deferred tax liability 
pursuant to section 56(b).
    Example 2. Assume the same facts as in example 1 except that the 
other business deductions are $130,000, resulting in a net operating 
loss of $90,000. The limitation on the amount treated as items of tax 
preference is computed as follows:

Tax preferences..............................................    $80,000
                                        ============
Net operating loss................................    $90,000
Recomputed income or loss:
  Gross income.........................   $120,000
  Deductions other than tax preference     160,000
   items...............................
                                        ------------
                                          (40,000)
Disallowance of nonbusiness deductions      30,000
 under sec. 172(d).....................
                                        -----------
Recomputed loss...................................     10,000
                                        -----------
Net operating loss less recomputed loss...........     80,000
Stock options preference..........................          0
                                        -----------
Limitation...................................................     80,000
 


[[Page 611]]


Thus, the minimum tax computed under section 56(a) would be 10 percent 
of $50,000 (items of tax preference of $80,000 less the minimum tax 
exemption of $30,000), all of which will be deferred tax liability 
pursuant to section 56(b).
    Example 3. The taxpayer has the following items of income and 
deduction for 1970:

Gross income (all from business):
Ordinary.....................................................    $50,000
  Net section 1201 gains.....................................    120,000
Deductions:
  Items of tax preference:
    Excess amortization of certified pollution        $45,000
     control facilities...........................
    Capital gains deduction.......................     60,000    105,000
                                                   -----------
  Other business deductions............  .........  .........     75,000
 


In addition, the taxpayer has a $55,000 item of tax preference resulting 
from qualified stock options. Based on the above figures, the taxpayer 
has no taxable income and no net operating loss as the capital gains 
deduction is disallowed in determining the net operating loss pursuant 
to section 172(d). The limitation on the amount treated as items of tax 
preference is computed as follows:

Tax preferences..............................................   $160,000
                                        ============
Net operating loss................................          0
Recomputed income or loss:
  Gross income.........................   $170,000
  Deductions other than tax preference      75,000
   items...............................
                                        ------------
Recomputed income.................................    $95,000
  Plus: Stock options preference..................     55,000
                                        -----------
Limitation...................................................    150,000
 

Thus, the minimum tax computed under section 56 would be 10 percent of 
$120,000 (items of tax preference of $150,000 less the minimum tax 
exemption of $30,000).
    Example 4. Assume the same facts as in example (3) except that the 
taxpayer has a net operating loss carryover from 1969 of $80,000. The 
taxpayer has $160,000 of tax preferences which are limited to $150,000 
pursuant to Sec.  1.57-4(b)(1). In order to determine the amount of the 
1969 net operating loss which remains as a carryover to 1971, the 1970 
taxable income is redetermined in accordance with section 172(b)(2) and 
the regulations thereunder, as follows:

Gross income--1970..............................    $170,000
Deductions:
  Capital gains deduction disallowed business       $120,000     120,000
   deductions...................................
                                                 -----------------------
    Taxable income for section 172(b)(2)....................      50,000
 


Thus, the 1969 net operating loss which remains as a carryover to 1971 
is $30,000. Pursuant to paragraph (b)(2) of this section, the limitation 
on the amount treated as items of tax preference is computed as follows:

Items of tax preference computed with regard to Sec.   1.57-    $150,000
 4(b)(1) (per example (3))..................................
Less: Lesser of capital gains deduction ($60,000) or amount       50,000
 of reduction in carryover due to its disallowance ($50,000)
                                                 -------------
    Limitation..............................................     100,000
 

Thus, the minimum tax computed under section 56 would be 10 percent of 
$70,000 (items of tax preference of $100,000 less the minimum tax 
exemption of $30,000).
    Example 5. The taxpayer has the following items of income and 
deduction for the taxable year 1970 without regard to any net operating 
loss deduction:

Gross income (all from business):
  Ordinary........................................    $50,000
  Net section 1201 gain...........................     40,000
                                                   ------------
                                                    .........    $90,000
Deductions:
  Capital gains deduction.........................     20,000
  Medical expenses ($4,100 actually paid but            2,000
   allowable only to the extent in excess of 3
   percent of adjusted gross income of $70,000)...
  Other itemized deductions.......................     40,000
                                                   ------------
                                                    .........     62,000
                                                              ----------
    Taxable income (before net operating loss deduction).....     28,000
 


In addition, the taxpayer has an item of tax preference of $35,000 
resulting from qualified stock options. In 1973, the taxpayer has a net 
operating loss of $60,000 (no portion of which is attributable to excess 
tax preferences pursuant to Sec.  1.56A-2) which is carried back to 1970 
resulting in no taxable income in 1970. In order to determine the amount 
of the 1973

[[Page 612]]

net operating loss which remains as a carryover to 1971, the 1970 
taxable income is redetermined, in accordance with section 172(b)(2) and 
the regulations thereunder, as follows:

Gross income.................................................    $90,000
Deductions:
  Capital gains deduction disallowed..............
  Medical expenses ($4,100 actually paid but           $1,400
   allowable only to the extent in excess of 3
   percent of adjusted gross income of $90,000)...
  Other itemized deductions.......................     40,000
                                                   ------------
                                                    .........    $41,400
    Taxable income for section 172(b)(2)..........  .........     48,600
 

    The limitation on the amount treated as items of tax preference is 
computed as follows:

Items of tax preference:
  Capital gains.................................  ..........     $20,000
  Stock options.................................  ..........      35,000
                                                             -----------
                                                  ..........      55,000
Less:
  Lesser of capital gains deduction ($20,000) or amount of      (20,000)
   reduction in carryover due to its disallowance ($20,600).
                                                 -------------
    Limitation..............................................      35,000
 

Thus, the minimum tax for 1970 under section 56 would be 10 percent of 
$5,000 (items of tax preference of $35,000 less the minimum tax 
exemption of $30,000).
    Example 6. Assume the same facts as in example (5) except that the 
1973 net operating loss was $45,000. In this case, the $20,600 increase 
in the 1970 taxable income as redetermined, results in a decrease of 
$17,000 (i.e., the remaining 1973 net operating loss after an initial 
decrease of $28,000 resulting from the 1970 taxable income before 
redetermination). The limitation on the amount treated as items of tax 
preference is computed as follows:

Items of tax preference computed without regard to this          $55,000
 section....................................................
Less: Lesser of capital gains deduction ($20,000) or amount     (17,000)
 of reduction in carryover due to its disallowance ($17,000)
                                                 -------------
    Limitation..............................................      38,000
 


Thus, the minimum tax for 1970 under section 56 would be 10 percent of 
$8,000 (items of tax preference of $38,000 less the minimum tax 
exemption of $30,000).
    Example 7. The taxpayer has the following items of income and 
deduction for 1973 without regard to any net operating loss deduction:

Gross income (all from business):
  Ordinary....................................     $100,000
  Net section 1201 gains......................      120,000
                                               --------------
                                                ...........     $220,000
Deductions:
Items of tax preference:
  Excess amortization of certified pollution         45,000
   control facilities.........................
  Capital gains deduction.....................       60,000
                                               -------------
                                                    105,000
  Other business deductions...................       75,000
                                               --------------
                                                ...........     $180,000
    Taxable income (before net operating loss deduction)...       40,000
 


In 1972, the taxpayer had a net operating loss of $70,000 which is 
carried forward to 1973; $20,000 of this net operating loss is 
attributable to excess tax preferences. In order to determine the amount 
of the 1972 net operating loss which remains as a carryover to 1974, the 
1973 taxable income is redetermined, in accordance with section 
172(b)(2) and the regulations thereunder, as follows:

Gross income................................................    $220,000
Deductions:
  Capital gains deduction...................................  Disallowed
  Business deductions.......................................     120,000
                                                 -------------
    Taxable income per section 172(b)(2)....................     100,000
 

In this case, the $60,000 increase in the 1972 taxable income as 
redetermined and the $30,000 decrease in the amount of the 1973 net 
operating loss remaining as a carryover to 1974 (i.e., the remaining 
1972 net operating loss after an initial decrease of $40,000 resulting 
from the 1973 taxable income before redetermination) is entirely 
attributable to the disallowance of the capital gains deduction. The 
limitation on the amount treated as items of tax preference is computed 
as follows:

Items of tax preference computed without regard to this
 section:
  Capital gains.............................................     $60,000
  Excess amortization of certified pollution control              45,000
   facilities...............................................
                                                 -------------
                                                                 105,000
Less: Lesser of capital gains deduction (60,000) or amount      (30,000)
 of reduction in carryover due to its disallowance ($30,000)
                                                 -------------
                                                                  75,000
Plus: Amount of reduction of carryover (due to disallowance       20,000
 of capital gains deduction) attributable to excess tax
 preferences................................................
                                                 -------------
    Limitation..............................................      95,000
 


[T.D. 7564, 43 FR 40476, Sept. 12, 1978, as amended by T.D. 8138, 52 FR 
15309, Apr. 28, 1987]



Sec.  1.57-5  Records to be kept.

    (a) In general. The taxpayer shall have available permanent records 
of all the facts necessary to determine with

[[Page 613]]

reasonable accuracy the amounts described in Sec.  1.57-1. Such records 
shall include:
    (1) In the case of amounts described in paragraph (a) of Sec.  1.57-
1: the amount and nature of indebtedness outstanding for the taxable 
year and the date or dates on which each such indebtedness was incurred 
or renewed in any form; the amount expended for property held for 
investment during any taxable year during which such indebtedness was 
incurred or renewed; and the manner in which it was determined that 
property was or was not held for investment.
    (2) In the case of amounts described in paragraphs (b), (c), (d), 
(e), and (h) of Sec.  1.57-1:
    (i) The dates, and manner in which, the property was acquired and 
placed in service,
    (ii) The taxpayer's basis on the date the property was acquired and 
the manner in which the basis was determined,
    (iii) An estimate of the useful life (in terms of months, hours of 
use, etc., whichever is appropriate) of the property on the date placed 
in service or an estimate of the number of units to be produced by the 
property on the date the property is placed in service, whichever is 
appropriate, and the manner in which such estimate was determined,
    (iv) The amount and date of all adjustments by the taxpayer to the 
basis of the property and an explanation of the nature of such 
adjustments, and
    (v) In the case of property which has an adjusted basis reflecting 
adjustments taken by another taxpayer with respect to the property or 
taken by the taxpayer with respect to other property, the information 
described in paragraph (a)(2)(i) through (iv) of this section, with 
respect to such other property or other taxpayer.
    (3) In the case of amounts described in paragraph (f) of Sec.  1.57-
1, the fair market value of the shares of stock at the date of exercise 
of the option and the option price and the manner in which each was 
determined.
    (4) In the case of amounts described in paragraph (g) of Sec.  1.57-
1, the amount of debts written off and the amount of the loans 
outstanding for the taxable year and the 5 preceding taxable years or 
such shorter or longer period as is appropriate.
    (b) Net operating losses. The taxpayer shall have available 
permanent records for the first taxable year in which a portion of a net 
operating loss was attributable to items of tax preference (within the 
meaning of Sec.  1.56A-2 (b)) and each succeeding taxable year in which 
there is a net operating loss or a net operating loss carryover a 
portion of which is so attributable. Such records shall include all the 
facts necessary to determine with reasonable accuracy the amount of 
deferred tax liability under section 56, including the amount of the net 
operating loss in each taxable year in which there are items of tax 
preference in excess of the minimum tax exemption (as determined under 
Sec.  1.58-1), the amount of the items of tax preference for each such 
taxable year, the amount by which each such net operating loss reduces 
taxable income in any taxable year, and the amount by which each such 
net operating loss is reduced in any taxable year.

[T.D. 7564, 43 FR 40479, Sept. 12, 1978, as amended by T.D. 8138, 52 FR 
15309, Apr. 28, 1987]



Sec.  1.58-1  [Reserved]



Sec.  1.58-2  General rules for conduit entities; partnerships and
partners.

    (a) General rules for conduit entities. Sections 1.58-3 through 
1.58-6 provide rules under which items of tax preference of an estate, 
trust, electing small business corporation, common trust fund, regulated 
investment company, or real estate investment trust (referred to in this 
paragraph as the ``conduit entity'') are treated as items of tax 
preference of the beneficiaries, shareholders, participants, etc. 
(referred to in this paragraph as the ``distributees''). Where an item 
of tax preference of a conduit entity is so apportioned to a 
distributee, the item of tax preference retains its character in the 
hands of the distributee and is adjusted to reflect:
    (1) The separate items of income and deduction of the distributee 
and (2) the tax status of the distributee as an individual, corporation, 
etc. For example, if a trust has $100,000 of capital gains

[[Page 614]]

for the taxable year, all of which are distributed to A, an individual, 
the item of tax preference apportioned to A under section 57(a)(9) (and 
Sec.  1.57-1(i)(1)) is $50,000. If, however, A had a net capital loss 
for the taxable year of $60,000 without regard to the distribution from 
the trust, the trust tax preference would be adjusted in the hands of A 
to reflect the separate items of income and deduction passed through to 
the distributee, or, in this case, to reflect the net section 1201 gain 
to A of $40,000. Thus, A's capital gains items of tax preference would 
be $20,000. By application of this rule, A, in effect, treats capital 
gains distributed to him from the trust the same as his other capital 
gains in computing his capital gains item of tax preference. If A had 
been a corporation, the trust tax preference would be adjusted both to 
reflect the capital loss and to reflect A's tax status by recomputing 
the capital gains item of tax preference (after adjustment for the 
capital loss) under section 57(a)(9)(B) and Sec.  1.57-1(i)(2). 
Similarly, if depreciation on section 1245 property subject to a net 
lease (as defined in section 57(a)(3) and Sec.  1.57-1(c)) is 
apportioned from a conduit entity to a corporation (other than a 
personal holding company or electing small business corporation), the 
amount so apportioned to the corporation is not treated as an item of 
tax preference to such corporation since such item is not an item of tax 
preference in the case of a corporation (other than a personal holding 
company or an electing small business corporation).
    (b) Partnerships and partners. (1) Section 701 provides that a 
partnership as such is not subject to the income tax imposed by chapter 
1. Thus, a partnership as such is not subject to the minimum tax for tax 
preferences. Section 702 provides that, in determining his income tax, 
each partner is to take into account separately his distributive share 
of certain items of income, deductions, etc. of the partnership and 
other items of income, gain, loss, deduction, or credit of the 
partnership to the extent provided by regulations prescribed by the 
Secretary or his delegate. Accordingly, each partner, in computing his 
items of tax preference, must take into account separately those items 
of income and deduction of the partnership which enter into the 
computation of the items of tax preference in accordance with 
subparagraph (2) of this paragraph.
    (2) Pursuant to section 702, each partner must, solely for purposes 
of the minimum tax for tax preferences (to the extent not otherwise 
required to be taken into account separately under section 702 and the 
regulations thereunder), take into account separately in the manner 
provided in subchapter K and the regulations thereunder those items of 
income and deduction of the partnership which enter into the computation 
of the items of tax preference specified in section 57 and the 
regulations thereunder. A partner must, for this purpose, take into 
account separately his distributive share of:
    (i) Investment interest expense (as defined in section 57(b)(2)(D) 
determined at the partnership level;
    (ii) Investment income (as defined in section 57(b)(2)(B) determined 
at the partnership level;
    (iii) Investment expenses (as defined in section 57(b)(2)(C)) 
determined at the partnership level;
    (iv) With respect to each section 1250 property (as defined in 
section 1250(c)), the amount of the deduction allowable for the taxable 
year for exhaustion, wear and tear, obsolescence, or amortization and 
the deduction which would have been allowable for the taxable year had 
the property been depreciated under the straight line method each 
taxable year of its useful life (determined without regard to section 
167(k)) for which the partnership has held the property;
    (v) With respect to each item of section 1245 property (as defined 
in section 1245(a)(3)) which is subject to a net lease, the amount of 
the deduction allowable for exhaustion, wear and tear, obsolescence, or 
amortization and the deduction which would have been allowable for the 
taxable year had the property been depreciated under the straight line 
method for each taxable year of its useful life for which the 
partnership has held the property;
    (vi) With respect to each certified pollution control facility for 
which an election is in effect under section 169, the amount of the 
deduction allowable

[[Page 615]]

for the taxable year under such section and the deduction which would 
have been allowable under section 167 had no election been in effect 
under section 169;
    (vii) With respect to each unit of railroad rolling stock for which 
an election is in effect under section 184, the amount of the deduction 
allowable for the taxable year under such section and the deduction 
which would have been allowable under section 167 had no election been 
in effect under section 184;
    (viii) In the case of a partnership which is a financial institution 
to which section 585 or 593 applies, the amount of the deduction 
allowable for the taxable year for a reasonable addition to a reserve 
for bad debts and the amount of the deduction that would have been 
allowable for the taxable year had the institution maintained its bad 
debt reserve for all taxable years on the basis of actual experience; 
and
    (ix) With respect to each mineral property, the deduction for 
depletion allowable under section 611 for the taxable year and the 
adjusted basis of the property at the end of the taxable year 
(determined without regard to the depreciation deduction for the taxable 
year).

If, pursuant to section 743 (relating to optional adjustment to basis), 
the basis of partnership property is adjusted with respect to a 
transferee partner due to an election being in effect under section 754 
(relating to manner of electing optional adjustment), items representing 
amortization, depreciation, depletion, gain or loss, and the adjusted 
basis of property subject to depletion, described above, shall be 
adjusted to reflect the basis adjustment under section 743.
    (3) The minimum tax is effective for taxable years ending after 
December 31, 1969. Thus, subparagraph (2) of this paragraph is 
inapplicable in the case of items of income or deduction paid or accrued 
in a partnership's taxable year ending on or before December 31, 1969.

[T.D. 7564, 43 FR 40481, Sept. 12, 1978]



Sec.  1.58-3  Estates and trusts.

    (a) In general. (1) Section 58(c)(1) provides that the sum of the 
items of tax preference of an estate or trust shall be apportioned 
between the estate or trust and the beneficiary on the basis of the 
income of the estate or trust allocable to each. Income for this purpose 
is the income received or accrued by the trust or estate which is not 
subject to current taxation either in the hands of the trust or estate 
or the beneficiary by reason of an item of tax preference. The character 
of the amounts distributed is determined under section 652(b) or 662(b) 
and the regulations thereunder.
    (2) Additional computations required by reason of excess 
distributions are to be made in accordance with the principles of 
sections 665 through 669 and the regulations thereunder.
    (3) In the case of a charitable remainder annuity trust (as defined 
in section 664(d)(1) and Sec.  1.664-2) or a charitable remainder 
unitrust (as defined in section 664(d)(2) and Sec.  1.664-3), the 
determination of the income not subject to current taxation by reason of 
an item of tax preference is to be made as if such trust were generally 
subject to taxation. Where income of such a trust is not subject to 
current taxation in accordance with this section and is distributed to a 
beneficiary in a taxable year subsequent to the taxable year in which 
the trust received or accrued such income, the items of tax preference 
relating to such income are apportioned to the beneficiary in such 
subsequent year (without credit for minimum tax paid by the trust with 
respect to items of tax preference which are subject to the minimum tax 
by reason of section 664(c)).
    (4) Items of tax preference apportioned to a beneficiary pursuant to 
this section are to be taken into account by the beneficiary in his 
taxable year within or with which ends the taxable year of the estate or 
trust during which it has such items of tax preference.
    (5) Where a trust or estate has items of income or deduction which 
enter into the computation of the excess investment interest item of tax 
preference, but such items do not result in an item of tax preference at 
the trust or estate level, each beneficiary must take into account, in 
computing his excess investment interest, the portion of

[[Page 616]]

such items distributed to him. The determination of the portion of such 
items distributed to each beneficiary is made in accordance with the 
character rules of section 652(b) or 662(b) and the regulations 
thereunder.
    (6) Where, pursuant to subpart E of part 1 of subchapter J (sections 
671 through 678), the grantor of a trust or another person is treated as 
the owner of any portion of the trust, there shall be included in 
computing the items of tax preference of such person those items of 
income, deductions, and credits against tax of the trust which are 
attributable to that portion of the trust to the extent such items are 
taken into account under section 671 and the regulations thereunder. Any 
remaining portion of the trust is subject to the provisions of this 
section.
    (b) Examples. The principles of this section may be illustrated by 
the following examples in each of which it is assumed that none of the 
distributions are accumulation distributions (see sections 665 through 
669 and the regulations thereunder):

    Example 1. Trust A, with one income beneficiary, has the following 
items of income and deduction without regard to the deduction for 
distributions:

Income:
  Business income...........................................    $200,000
  Investment income.........................................      20,000
                                                             -----------
                                                                 220,000
                                                             ===========
Deductions:
  Business deductions (nonpreference).......................     100,000
  Investment interest expense...............................      80,000
                                                             -----------
                                                                 180,000
 


Based on the above figures, the trust has $100,000 of taxable income 
without regard to items which enter into the computation of excess 
investment interest and the deduction for distributions. The trust also 
has $60,000 of excess investment interests, resulting in $40,000 of 
distributable net income. Thus, $60,000 of the $100,000 of noninvestment 
income is not subject to current taxation by reason of the excess 
investment interest.
    (a) If $40,000 is distributed to the beneficiary, the beneficiary 
will normally be subject to tax on the full amount received and the 
``sheltered'' portion of the income will remain at the trust level. 
Thus, none of the excess investment interest item of tax preference is 
apportioned to the beneficiary.
    (b) If the beneficiary receives $65,000 from the trust, the 
beneficiary is still subject to tax on only $40,000 (the amount of the 
distributable net income) and thus, is considered to have received 
$25,000 of business income ``sheltered'' by excess investment interest. 
Thus, $25,000 of the $60,000 of excess investment interest of the trust 
is apportioned to the beneficiary.
    Example 2. Trust B has $150,000 of net section 1201 gain.
    (a) If none of the gain is distributed to the beneficiaries, none of 
the capital gains item of tax preference is apportioned to the 
beneficiaries.
    (b) If all or a part of the gain is distributed to the 
beneficiaries, a proportionate part of the capital gains item of tax 
preference is apportioned to the beneficiaries. If any of the 
beneficiaries are corporations the capital gains item of tax preference 
is adjusted in the hands of the corporations as provided in Sec.  1.58-
2(a).
    Example 3. Trust C has taxable income of $200,000 computed without 
regard to depreciation on section 1250 property and the deduction for 
distributions. The depreciation on section 1250 property held by the 
trust is $160,000. The trust instrument provides for income to be 
retained by the trust in an amount equal to the depreciation on the 
property determined under the straight line method (which method has 
been used for this purpose for the entire period the trust has held the 
property) which, in this case is equal to $100,000. The $60,000 excess 
of the accelerated depreciation of $160,000 over the straight line 
amount which would have resulted had the property been depreciated under 
that method for the entire period for which the trust has held the 
property is an item of tax preference pursuant to section 57(a)(2). Of 
the remaining $100,000 of net income of the trust (after the reserve for 
depreciation), 80 percent is distributed to the beneficiaries. Pursuant 
to sections 167(h) and 642(e), 80 percent of the remaining $60,000 of 
depreciation deduction (or $48,000) is taken as a deduction directly by 
the beneficiaries and ``shelters'' the income received by the 
beneficiaries. Thus, the full $48,000 deduction taken by the 
beneficiaries is ``excess accelerated depreciation'' on section 1250 
property and is an item of tax preference in the hands of the 
beneficiaries. None of the remaining $12,000 of ``excess accelerated 
depreciation'' is apportioned to the beneficiaries since this amount 
``shelters'' income retained at the trust level.
    Example 4. G creates a trust the ordinary income of which is payable 
to his adult son. Ten years from the date of the transfer, corpus is to 
revert to G. G retains no other right or power which would cause him to 
be treated as an owner under subpart E of part 1 of subchapter J 
(section 671 and following). Under the terms of the trust instrument and 
applicable local law capital gains must be applied to corpus. During the 
taxable year

[[Page 617]]

1970 the trust has $200,000 income from dividends and interest and a net 
long-term capital gain of $100,000. Since the capital gain is held or 
accumulated for future distribution to G, he is treated under section 
677(a)(2) as an owner of a portion of the trust to which the gain is 
attributable. Therefore, he must include the capital gain in the 
computation of his taxable income in 1970 and the capital gain item of 
tax preference is treated as being directly received by G. Accordingly, 
no adjustment is made to the trust's minimum tax exemption by reason of 
the capital gain.
    Example 5. For its taxable year 1971 the trust referred to in 
example (4) has taxable income of $200,000 computed without regard to 
depreciation on section 1250 property and the deduction for 
distributions. The depreciation on section 1250 property held by the 
trust is $160,000. The trust instrument provides for income to be 
retained by the trust in an amount equal to the depreciation on the 
property determined for purposes of the Federal income tax. If the 
property had been depreciated under the straight line method for the 
entire period for which the trust held the property the resulting 
depreciation deduction would have been $100,000. The $60,000 excess is, 
therefore, an item of tax preference pursuant to section 57(a)(2) and 
Sec.  1.57-1(d). Since this amount of ``income'' is held or accumulated 
for future distributions to G, he is treated under section 677(a)(2) as 
an owner of a portion of the trust to which such income is attributable. 
Therefore, section 671 requires that in computing the tax liability of 
the grantor the income, deductions, and credits against tax of the trust 
which are attributable to such portion shall be taken into account. 
Thus, the grantor has received $160,000 of income and is entitled to a 
depreciation deduction in the same amount. The $60,000 item of tax 
preference resulting from the excess depreciation is treated as being 
directly received by G as he has directly received the income sheltered 
by that preference. Accordingly, no adjustment is made to the trust's 
minimum tax exemption by reason of such depreciation.

[T.D. 7564, 43 FR 40482, Sept. 12, 1978]



Sec.  1.58-3T  Treatment of non-alternative tax itemized deductions by
trusts and estates and their beneficiaries in taxable years beginning 
after December 31, 1982 (temporary).

    For purposes of section 58(c), in taxable years beginning after 
December 31, 1982, itemized deductions of a trust or estate which are 
not alternative tax itemized deductions (as defined in section 
55(e)(1)), shall be treated as items of tax preference and apportioned 
between trusts and their beneficiaries, and estates and their 
beneficiaries.

[T.D. 8083, 51 FR 15320, Apr. 23, 1986]



Sec.  1.58-4  Electing small business corporations.

    (a) In general. Section 58(d)(1) provides rules for the 
apportionment of the items of tax preference of an electing small 
business corporation among the shareholders of such corporation. Section 
58(d)(2) provides rules for the imposition of the minimum tax on an 
electing small business corporation with respect to certain capital 
gains. For purposes of section 58(d) and this section, the items of tax 
preference are computed at the corporate level as if section 57 
generally applied to the corporation. However, the items of tax 
preference so computed are treated as items of tax preference of the 
shareholders of such corporation and not as items of tax preference of 
such corporation (except as provided in paragraph (c) of this section). 
The items of tax preference specified in section 57(a)(1) and Sec.  
1.57-1(a) (excess investment interest) and section 57(a)(3) and Sec.  
1.57-1(c) (accelerated depreciation on section 1245 property subject to 
a net lease), while generally inapplicable to corporations, are included 
as items of tax preference in the case of an electing small business 
corporation.
    (b) Apportionment to shareholders. (1) The items of tax preference 
of an electing small business corporation, other than the capital gains 
item of tax preference described in paragraph (c) of this section, are 
apportioned pro rata among the shareholders of such corporation in a 
manner consistent with section 1374(c)(1). Thus, with respect to the 
items of tax preference of the electing small business corporation, 
there is to be treated as items of tax preference of each shareholder a 
pro rata share of such items computed as follows:
    (i) Divide the total amount of such items of tax preference of the 
corporation by the number of days in the taxable year of the 
corporation, thus determining the daily amount of such items of tax 
preference.
    (ii) Determine for each day the shareholder's portion of the daily 
amount of each such item of tax preference by applying to such amount 
the ratio which

[[Page 618]]

the stock owned by the shareholder on that day bears to the total stock 
outstanding on that day.
    (iii) Total the shareholder's daily portions of each such item of 
tax preference of the corporation for it taxable year.

Amounts taken into account by shareholders in accordance with this 
paragraph are considered to consist of a pro rata share of each item of 
tax preference of the corporation. Thus, for example, if the corporation 
has $50,000 of excess investment interest and $150,000 of excess 
accelerated depreciation on section 1250 property and a shareholder, in 
accordance with this paragraph, takes into account $60,000 of the total 
$200,000 of tax preference items of the corporation, one-fourth ($50,000 
/ $200,000) of the $60,000, or $15,000, taken into account by the 
shareholder is considered excess investment interest and three-fourths 
of the $60,000, or $45,000, is considered excess accelerated 
depreciation on section 1250 property.
    (2) Items of tax preference apportioned to a shareholder pursuant to 
subparagraph (1) of this paragraph are taken into account by the 
shareholder for the shareholder's taxable year in which or with which 
the taxable year of the corporation ends, except that, in the case of 
the death of a shareholder during any taxable year of the corporation 
(during which the corporation is an electing small business 
corporation), the items of tax preference of the corporation for such 
taxable year are taken into account for the final taxable year of the 
shareholder.
    (c) Capital gains. (1) Capital gains of an electing small business 
corporation, other than those capital gains subject to tax under section 
1378, do not result in an item of tax preference at the corporate level 
since, in applying the formula specified in sections 57(a)(9)(B) and 
Sec.  1.57-1(i)(2), the rate of tax on capital gains (and the resulting 
tax) at the corporate level is zero. Under section 1375 (a) shareholders 
of an electing small business corporation take into account the capital 
gains of the corporation (including capital gains subject to tax under 
section 1378). Therefore, the computation of the capital gains item of 
tax preference at the shareholder level, with respect to such capital 
gains, is taken into account automatically by operation of section 
57(a)(9) and Sec.  1.57-1(i). To avoid double inclusion of the capital 
gains item of tax preference by a shareholder with respect to capital 
gains subject to tax under section 1378, the capital gains item of tax 
preference which results at the corporate level by reason of section 58 
(d)(2) is not treated under section 58 (d)(1) as an item of tax 
preference of the shareholders of the corporation.
    (2) The capital gains item of tax preference of an electing small 
business corporation subject to the tax imposed by section 1378 is the 
excess of the amount of tax computed under section 1378(b)(2) over the 
sum of--
    (i) The amount of tax that would be computed under section 
1378(b)(2) if the following amount were excluded:
    (a) That portion of the net section 1201 gain of the corporation 
described in section 1378(b)(1), or
    (b) If section 1378(c)(3) applies, that portion of the net section 
1201 gain attributable to the property described in section 1378(c)(3), 
and
    (ii) The amount of tax imposed under section 1378 divided by the sum 
of the normal tax rate and the surtax rate under section 11 for the 
taxable year.
    (3) The principles of this paragraph may be illustrated by the 
following example.

    Example. Corporation X is a calendar year taxpayer and an electing 
small business corporation. For its taxable year 1971 the corporation 
has net section 1201 gain of $650,000 and taxable income of $800,000 
(including the net section 1201 gain). Although X's election under 
section 1372(a) has been in effect for its three immediately preceding 
taxable years, X is subject to the tax imposed by section 1378 for 1971 
since it has net section 1201 gain (in the amount of $200,000) 
attributable to property with a substituted basis. The tax computed 
under section 1378(b)(1) is $187,500 (30 percent of ($650,000 minus 
$25,000)) and under section 1378(b)(2) is $377,500 (22 percent of 
$800,000 plus 26 percent of $775,000). By reason of the limitation 
imposed by section 1378(c) the tax actually imposed by section 1378 is 
$60,000 (30 percent of $200,000, the net section 1201 gain). The tax 
computed under section 1378(b)(2) with the modification required under 
subparagraph (2)(i) of this paragraph is $281,500 (22 percent of 
$600,000 plus 26 percent of $575,000). Thus, the 1971 capital gains item 
of tax preference X is $75,000 computed as follows:

1. Tax computed under 1378(b) (2)...........................    $377,500

[[Page 619]]

 
2. Tax computed under 1378(b) (2) with modification.........     281,500
                                                             -----------
3. Excess...................................................      96,000
4. Tax actually imposed under 1378..........................      60,000
                                                             -----------
5. Difference...............................................      36,000
                                                             ===========
6. Normal tax rate plus surtax rate.........................         .48
7. Tax preference (line 5 divided by line 6)................     $75,000
 


In addition each shareholder of X will take into account his 
distributive share of the $650,000 of net section 1201 gain of X less 
the taxes paid by X under sections 56 and 1378 on the gain

[T.D. 7564, 43 FR 40483, Sept. 12, 1978]



Sec.  1.58-5  Common trust funds.

    Section 58(e) provides that each participant in a common trust fund 
(as defined in section 584 and the regulations thereunder) is to treat 
as items of tax preference his proportionate share of the items of tax 
preference of the fund computed as if the fund were an individual 
subject to the minimum tax. The participant's proportionate share of the 
items of tax preference of the fund is determined as if the participant 
had realized, or incurred, his pro rata share of items of income, gain, 
loss, or deduction of the fund directly from the source from which 
realized or incurred by the fund. The participant's pro rata share of 
such items is determined in a manner consistent with section 1.584-2(c). 
Items of tax preference apportioned to a participant pursuant to this 
paragraph are taken into account by the participant for the 
participant's taxable year in which or with which the taxable year of 
the trust ends.

[T.D. 7564, 43 FR 40484, Sept. 12, 1978]



Sec.  1.58-6  Regulated investment companies; real estate investment trusts.

    (a) In general. Section 58(f) provides rules with respect to the 
determination of the items of tax preference of regulated investment 
companies (as defined in section 851) and their shareholders and real 
estate investment trusts (as defined in section 856) and their 
shareholders, or holders of beneficial interest. In general, the items 
of tax preference of such companies and such trusts are determined at 
the company or trust level and the items of tax preference so determined 
(other than the capital gains item of tax preference (sections 57(a)(9) 
and Sec.  1.57-1(i)) and, in the case of a real estate investment trust, 
accelerated depreciation on section 1250 property (sections 57(a)(2) and 
Sec.  1.57-1(b)) are treated as items of tax preference of the 
shareholders, or holders of beneficial interest, in the same proportion 
that the dividends (other than capital gains dividends) paid to each 
such shareholder, or holder of beneficial interest, bear to the taxable 
income of such company or such trust determined without regard to the 
deduction for dividends paid. In no case, however, is such proportion to 
be considered in excess of 100 percent. For example, if a regulated 
investment company has items of tax preference of $500,000 for the 
taxable year, none of which resulted from capital gains, and distributes 
dividends in an amount equal to 90 percent of its taxable income, each 
shareholder treats his share of 90 percent of the company's items of tax 
preference, or (a proportionate share of) $450,000, as items of tax 
preference of the shareholder. The remaining $50,000 constitutes items 
of tax preference of the company. Amounts treated under this paragraph 
as items of tax preference of the shareholders, or holders of beneficial 
interest, are deemed to be derived proportionately from each item of tax 
preference of the company or trust, other than the capital gains item of 
tax preference and, in the case of a real estate investment trust, 
accelerated depreciation on section 1250 property. Such amounts are 
taken into account by the shareholders, or holders of beneficial 
interest, in the same taxable year in which the dividends on which the 
apportionment is based are includible in income. The minimum tax 
exemption of the trust or company shall not be reduced because a portion 
of the trust's or company's items of tax preference are allocated to the 
shareholders or holders of beneficial interests.
    (b) Capital gains. Section 58(g)(1) provides that a regulated 
investment company or real estate investment trust does not treat as an 
item of tax preference the capital gains item of tax preference under 
section 57(a)(9) (and Sec.  1.57-1(i)) to the extent that such item is 
attributable to amounts taken into income by the shareholders of such 
company under section 852(b)(3) or by

[[Page 620]]

the shareholders or holders of beneficial interest of such trust under 
section 857(b)(3). Thus, such a company or trust computes its capital 
gains item of tax preference on the basis of its net section 1201 gain 
less the sum of (1) the capital gains dividend (as defined in section 
852(b)(3)(C) or 857(b)(3)(C)) for the taxable year of the company or 
trust plus (2), in the case of a regulated investment company, that 
portion of the undistributed capital gains designated, pursuant to 
section 852(b)(3)(D) and the regulations thereunder, by the company to 
be includible in the shareholder's return as long-term capital gains for 
the shareholders's taxable year in which the last day of the company's 
taxable years falls. Amounts treated under section 852(b)(3) or 
857(b)(3) as long-term capital gains of shareholders, or holders of 
beneficial interest, are automatically included, pursuant to sections 
57(a)(9) and 1.57-1(i), in the computation of the capital gains item of 
tax preference of the shareholders, or holders of beneficial interest.
    (c) Accelerated depreciation on section 1250 property. In the case 
of a real estate investment trust, all of the items of tax preference 
resulting from accelerated depreciation on section 1250 property held by 
the trust (section 57(a)(2) and Sec.  1.57-1(b)) are treated as items of 
tax preference of the trust, and, thus, none are treated as items of tax 
preference of the shareholder, or holder of beneficial interest.

[T.D. 7564, 43 FR 40484, Sept. 12, 1978]



Sec.  1.58-7  Tax preferences attributable to foreign sources;
preferences other than capital gains and stock options.

    (a) In general. Section 58(g)(1) provides that except in the case of 
the stock options item of tax preference (section 57(a)(6) and Sec.  
1.57-1(f)) and the capital gains item of tax preference (section 
57(a)(9) and Sec.  1.57-1(i)), items of tax preference which are 
attributable to sources within any foreign country or possession of the 
United States shall, for purposes of section 56, be taken into account 
only to the extent that such items reduce the tax imposed by chapter 1 
(other than the minimum tax under section 56) on income derived from 
sources within the United States. Items of tax preference from sources 
within any foreign country or possession of the United States reduce the 
chapter 1 tax on income from sources within the United States to the 
extent the deduction relating to such preferences, in combination with 
other foreign deductions, exceed the income from such sources and, in 
effect, offset income from sources within the United States. Items of 
tax preference, for this purpose, are determined after application of 
Sec.  1.57-4 (relating to limitation on amounts treated as items of tax 
preference). In the case of a taxpayer who deducted foreign taxes under 
section 164 for a taxable year, the provisions of this section shall be 
applied (without regard to section 275(a)(4)) as if he had elected the 
overall foreign tax credit limitation under section 904(a) (2) for such 
year.
    (b) Preferences attributable to foreign sources--(1) Preferences 
other than excess investment interest. Except in the case of excess 
investment interest (see subparagraph (2) of this paragraph), an item of 
tax preference to which this section applies is attributable to sources 
within a foreign country or possession of the United States to the 
extent such item is attributable to a deduction properly allocable or 
apportionable to an item or class of gross income from sources within a 
foreign country or possession of the United States under the principles 
of section 862(b), or section 863, and the regulations thereunder. 
Where, in the case of income partly from sources within the United 
States and partly from sources within a foreign country or possession of 
the United States, taxable income is computed before apportionment to 
domestic and foreign sources, and is then apportioned by processes or 
formulas of general apportionment (pursuant to section 863(b) and the 
regulations thereunder), deductions attributable to such taxable income 
are considered to be proportionately from sources within the United 
States and within the foreign country or possession of the United States 
on the same basis as taxable income.
    (2) Excess investment interest--(i) Per-country limitation--(a) In 
the case of a taxpayer on the per-country foreign

[[Page 621]]

tax credit limitation under section 904(a) for the taxable year, excess 
investment interest (as defined in section 57(b)(1)), and the resulting 
item of tax preference, is attributable to sources within a foreign 
country or a possession of the United States to the extent that 
investment interest expense attributable to income from sources within 
such foreign country or possession of the United States exceeds the net 
investment income from sources within such foreign country or such 
possession. For this purpose, net investment income from within a 
foreign country or possession of the United States is the excess (if 
any) of the investment income from sources within such country or 
possession over the investment expenses attributable to income from 
sources within such country or such possession. For the definition of 
investment interest expense see section 57(b)(2)(D); for the definition 
of investment income see section 57(b)(2)(B); for the definition of 
investment expense see section 57(b)(2)(C).
    (b) If the taxpayer's excess investment interest computed on a 
worldwide basis is less than the taxpayer's total separately determined 
excess investment interest (as defined in this subdivision (b)), the 
amount of the taxpayer's excess investment interest from each foreign 
country or possession is the amount which bears the same relationship to 
the taxpayer's excess investment interest from each such country or 
possession, determined without regard to this subdivision (b), as the 
taxpayer's worldwide excess investment interest bears to the taxpayer's 
total separately determined excess investment interest. For purposes of 
this subdivision (b), the taxpayer's total separately determined excess 
investment interest is the sum of the total excess investment interest 
determined without regard to this subdivision (b) plus the taxpayer's 
excess investment interest from sources within the United States 
determined in a manner consistent with (a) of this subdivision (i).
    (ii) Overall limitation. In the case of a taxpayer who has elected 
the overall foreign tax credit limitation under section 904(a)(2) for 
the taxable year, excess investment interest (as defined in section 
57(b)(1)), and the resulting item of tax preference, is attributable to 
sources within any foreign country or possession of the United States to 
the extent that investment interest expense attributable to income from 
such sources exceeds the sum of (a) the net investment income from such 
sources plus (b) the excess, if any, of net investment income from 
sources within the United States over investment interest expense 
attributable to sources within the United States. For this purpose, net 
investment income from sources within any foreign country or possession 
of the United States is the excess (if any) of the investment income 
from all such sources over the investment expenses attributable to 
income from such sources. For the definition of investment interest 
expense see section 57(b)(2)(D) for the definition of investment income 
see section 57(b)(2)(B); for the definition of investment expense see 
section 57(b)(2)(C).
    (iii) Allocation of expenses. The determination of the investment 
interest expense and investment expenses attributable to a foreign 
country or possession of the United States is made in a manner 
consistent with subparagraph (1) of this paragraph.
    (iv) Attribution of certain interest deductions to foreign sources. 
Where net investment income from sources within any foreign country or 
possession has the effect of offsetting investment interest expense 
attributable to income from sources within the United States, the 
deductions for the investment interest expense so offset are, for 
purposes of Sec.  1.58-7(c) (relating to reduction in taxes on United 
States source income), treated as deductions attributable to income from 
sources within the foreign country or possession from which such net 
investment income is derived. Such an offset will occur where there is 
an excess of investment interest expense attributable to income from 
sources within the United States over net investment income from such 
sources and (a) in the case of a taxpayer on the per-country foreign tax 
credit limitation, an excess of net investment income from sources 
within a foreign country or possession of the United States over 
investment interest

[[Page 622]]

expense from within such foreign country or possession, or (b) in the 
case of a taxpayer who has elected the overall foreign tax credit 
limitation, there is an excess of net investment income from sources 
within foreign countries or possessions of the United States over 
investment interest expense attributable to income from within such 
sources.
    (v) Separate limitation on interest income. Where a taxpayer has 
income described in section 904(f)(2) (relating to interest income 
subject to the separate foreign tax credit limitation) or expenses 
attributable to such income, the determination of the excess investment 
interest resulting therefrom must be determined separately with respect 
to such income and the expenses properly allocable or apportionable 
thereto in the same manner as such determination is made in the case of 
a taxpayer on the per-country foreign tax credit limitation for the 
taxable year (see subdivision (i) of this subparagraph).
    (vi) Examples. The principles of this subparagraph may be 
illustrated by the following examples in each of which the taxpayer is 
an individual and a citizen of the United States:
    Example 1. The taxpayer's only items of income and deduction 
relating to excess investment interest are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                    United
                                                                    States      France      Germany      Total
----------------------------------------------------------------------------------------------------------------
Investment income from sources within...........................   $150,000    $120,000    $180,000    $450,000
Investment expenses relating to income from sources within......   (100,000)    (90,000)   (120,000)   (310,000)
                                                                 -----------------------------------------------
Net investment income...........................................     50,000      30,000      60,000     140,000
Investment interest expense relating to income from sources        (110,000)    (70,000)    (50,000)   (230,000)
 within.........................................................
                                                                 -----------------------------------------------
(Excess) of investment interest expense over net investment         (60,000)    (40,000)    *10,000     (90,000)
 income.........................................................
----------------------------------------------------------------------------------------------------------------
*Excess of net investment income over investment interest expense.


(a) If the taxpayer has elected the overall foreign tax credit 
limitation, his excess investment interest from sources within any 
foreign countries or possessions of the United States determined under 
subdivision (ii) of this subparagraph is computed as follows:

Investment interest:
  French...........................   ($70,000)
  German...........................    (50,000)  ...........  ($120,000)
                                    ------------
Net investment income:
  Investment income:
    French.........................    120,000
    German.........................    180,000     $300,000
                                    ------------
Less:
  Investment expenses:
    French.........................    (90,000)
    German.........................   (120,000)    (210,000)     90,000
                                    ------------------------------------
  Excess of U.S. net income over
   investment interest expenses:
      Total foreign excess           ..........  ...........    (30,000)
       investment interest.........
------------------------------------------------------------------------
 

    (b) If the taxpayer is on the per-country foreign tax credit 
limitation, his excess investment interest from France and Germany 
determined under subdivision (i)(a) of this subparagraph is $40,000 and 
zero, respectively. Since the taxpayer's worldwide excess investment 
interest ($90,000) is less than his total separately determined excess 
investment interest ($60,000 (United States) plus $40,000 (French) plus 
zero (German), or $100,000), the limitation in subdivision (i) (b) of 
this subparagraph applies and the excess investment interest 
attributable to France is limited as follows:

Total worldwide excess ($90,000) / Total separately determined excess 
          ($100,000) x French excess ($40,000) = $36,000

The taxpayer's total excess investment interest attributable to sources 
within any foreign country or possession of the United States is, thus, 
$36,000 ($36,000 (French) plus

[[Page 623]]

zero (German)). The taxpayer's excess investment interest attributable 
to sources within the United States is $54,000

($90,000 / $100,000 x $60,000).

Since, in making the latter determination, $6,000 of the $60,000 of U.S. 
investment interest expense in excess of U.S. net investment income is, 
in effect, offset by German net investment income, for purposes of Sec.  
1.58-7(c), $6,000 of interest deductions attributable to income from 
sources within the United States are, pursuant to subdivision (iv) of 
this subparagraph, treated as deductions attributable to income from 
sources within Germany.
    Example 2. Assume the same facts as in example (1) except that the 
items of income and deduction in Germany and the United States are 
reversed. The worldwide excess investment interest, thus, remains 
$90,000 and the items of income and deduction relating to excess 
investment interest are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                    United
                                                                    States      France      Germany      Total
----------------------------------------------------------------------------------------------------------------
Investment income from sources within...........................   $180,000    $120,000    $150,000    $450,000
Investment expenses relating to income from sources within......   (120,000)    (90,000)   (100,000)   (310,000)
                                                                 -----------------------------------------------
Net investment income...........................................     60,000      30,000      50,000     140,000
Investment interest expense relating to income from sources         (50,000)    (70,000)   (110,000)   (230,000)
 within.........................................................
                                                                 -----------------------------------------------
(Excess) of investment interest expense over net investment          10,000     (40,000)    (60,000)    (90,000)
 income.........................................................
----------------------------------------------------------------------------------------------------------------

    (a) If the taxpayer has elected the overall limitation, his excess 
investment interest from sources within any foreign countries or 
possessions of the United States determined under subdivision (ii) of 
this subparagraph is determined as follows:

Foreign investment interest:
    French..........................   ($70,000)
    German..........................   (110,000)  ..........  ($180,000)
                                     ------------
Foreign net investment income:
    French..........................    120,000
    German..........................    150,000    $270,000
                                     ------------
Less:
  Investment expenses:
    French..........................    (90,000)
    German..........................   (100,000)   (190,000)     80,000
                                     -----------------------------------
Excess of U.S. net investment income  ..........  ..........     10,000
 over U.S. investment interest
 expense............................
                                                             -----------
Excess investment interest            ..........  ..........    (90,000)
 attributable to foreign sources....
 

    (b) If the taxpayer has not elected the overall foreign tax credit 
limitation, his excess investment interest from France and Germany 
determined under subdivision (i) of this subparagraph (without regard to 
the limitation to worldwide excess investment interest) is $40,000 and 
$60,000 respectively, and his total separately determined excess 
investment interest is, thus, $10,000. Since the total separately 
determined excess would exceed the worldwide excess, the limitation to 
the worldwide excess in subdivision (i) applies and the excess 
investment interest is determined as follows:


France:
$90,000 / $100,000 x $40,000 = $36,000

Germany:
$90,000 / $100,000 x $60,000 = $54,000

Total excess investment interest attributable to sources within any 
          foreign countries and possessions--$90,000.
    Example 3. Assume the same facts as in example (1) except that the 
taxpayer, in addition has investment income, investment expenses, and 
investment interest subject to the separate limitation under section 
904(f).
    (a) If the taxpayer has elected the overall foreign tax credit 
limitation, his excess investment interest from sources within any 
foreign countries or possessions of the United States determined under 
subdivision (ii) of this subparagraph is the same as in (a) of example 
(1) of this subdivision (vi). He then treats such amount as separately 
determined excess investment interest attributable to a single foreign 
country as determined under subdivision (i) of this subparagraph and 
proceeds as in (b) of example (1) of this subdivision (vi) treating 
items of income and deduction subject to section 904(f) and from each 
separate foreign country or possession separately in making the 
additional

[[Page 624]]

determinations under subdivisions (i) and (iv) of this subparagraph.
    (b) If the taxpayer has not elected the overall foreign tax credit 
limitation, his excess investment interest from sources within any 
foreign country or possession of the United States would be determined 
in the same manner as in (b) of example (1) treating items of income and 
deduction which are subject to section 904(f) and from each separate 
foreign country or possession separately in making the determinations 
under subdivisions (i) and (iv) of this subparagraph.

    (c) Reduction in taxes on United States source income--(1) Overall 
limitation--(i) In general. If a taxpayer is on the overall foreign tax 
credit limitation under section 904(a)(2), the items of tax preference 
determined to be attributable to foreign sources under paragraph (b) of 
this section reduce the tax imposed by chapter 1 (other than the minimum 
tax imposed under section 56) on income from sources within the United 
States for the taxable year to the extent of the smallest of the 
following three amounts:
    (a) Items of tax preference (other than stock options and capital 
gains) attributable to sources within a foreign country or possession of 
the United States,
    (b) The excess (if any) of the total deductions properly allocable 
or apportionable to items or classes of gross income from sources within 
foreign countries and possessions of the United States over the gross 
income from such sources, or
    (c) Taxable income from sources within the United States.

See Sec.  1.58-7(b)(2)(iv) with respect to the attribution of certain 
interest deductions to foreign sources in cases involving the excess 
investment interest item of tax preference.
    (ii) Net operating loss. Where there is an overall net operating 
loss for the taxable year, to the extent that the lesser of the amounts 
determined under (a) or (b) of subdivision (i) of this subparagraph 
exceeds the taxpayer's taxable income from sources within the United 
States (and, therefore do not offset taxable income from sources within 
the United States for the taxable year) the amount of such excess is 
treated as ``suspense preferences.'' Suspense preferences are converted 
to actual items of tax preference, arising in the loss year and subject 
to the provisions of section 56, as the net operating loss is used in 
other taxable years, in the form of a net operating loss deduction under 
section 172, to offset taxable income from sources within the United 
States. Suspense preferences which, in other taxable years, reduce 
taxable income from sources within any foreign country or possession of 
the United States lose their character as suspense preferences and, 
thus, are never converted into actual items of tax preference. The 
amount of the suspense preferences which are converted into actual items 
of tax preference is equal to that portion of the net operating loss 
attributable to the suspense preferences which offset taxable income 
from sources within the United States in taxable years other than the 
loss year. The determination of the component parts of the net operating 
loss and the determination of the amount by which the portion of the net 
operating loss attributable to suspense preferences offsets taxable 
income from sources within the United States is made on a year-by-year 
basis in the same order as the net operating loss is used in accordance 
with section 172(b). Such determination is made by applying deductions 
attributable to U.S. source income first against such income and 
deductions attributable to foreign source income first against such 
foreign source income and in accordance with the following principles:
    (a) Deductions attributable to items or classes of gross income from 
sources within the United States offset taxable income from sources 
within the United States before any remaining portion of the net 
operating loss;
    (b) Deductions attributable to items or classes of gross income from 
sources within foreign countries or possessions of the United States 
offset taxable income from such sources before any remaining portion of 
the net operating loss;
    (c) Deductions described in (b) of the subdivision (ii) which are 
not suspense preferences (referred to in this subparagraph as ``other 
foreign deductions'') offset taxable income from sources within foreign 
countries and possessions of the United States before suspense 
preferences; and

[[Page 625]]

    (d) Suspense preferences offset taxable income from sources within 
the United States before other foreign deductions.

For purposes of the above computations, taxable income is computed with 
the modifications specified in section 172(b)(2) or section 172(c), 
whichever is applicable. However, the amount of suspense preferences 
which are converted into actual items of tax preference in accordance 
with the above principles is reduced to the extent suspense preferences 
offset increases in taxable income from sources within the United States 
due to the modifications specified in section 172(b)(2) or section 
172(c). For this purpose, suspense preferences are considered to offset 
an increase in taxable income due to the section 172(b)(2) modifications 
only after reducing taxable income computed before the section 172(b)(2) 
or section 172(c) modifications.
    (iii) Examples. The principles of this subparagraph may be 
illustrated by the following examples. In each example the taxpayer is 
an individual citizen of the United States and has elected the overall 
foreign tax credit limitation. Personal deductions and exemptions are 
disregarded for purposes of these examples.

    Example 1. In 1974, the taxpayer has the following items of income 
and deduction:

United States taxable income:
  Gross income......................  ..........   $750,000
  Deductions........................  ..........   (250,000)   $500,000
                                                 ------------
Foreign source loss:
  Gross income......................  ..........    200,000
  Deductions:
    Preference items (excess of        $550,000
     percentage depletion over
     basis).........................
    Other...........................     50,000    (600,000)   (400,000)
                                     ------------------------
Overall taxable income..............  ..........  ..........    100,000
 


Pursuant to subdivision (i) of this subparagraph the smallest of (a) the 
items of tax preference attributable to the foreign sources ($550,000), 
(b) the foreign source loss ($400,000), or (c) the taxable income from 
sources within the United States ($500,000) reduces the tax imposed by 
chapter 1 (other than the minimum tax) on income from sources within the 
United States. Thus, $400,000 of the $550,000 of excess depletion is 
treated as an item of tax preference in 1974 subject to the minimum tax.
    Example 2. Assume the same facts as in example (1) except that the 
gross income from sources within the United States is $350,000 resulting 
in U.S. taxable income of $100,000 and an overall net operating loss of 
$300,000. Pursuant to subdivision (i) of this subparagraph, $100,000 of 
the $550,000 excess depletion would be treated as an item of tax 
preference in 1974 subject to the minimum tax. In addition, pursuant to 
subdivision (ii) of this subparagraph, the excess of the items of tax 
preference from foreign sources ($550,000) or the foreign source loss 
($400,000), whichever is less, over the U.S. taxable income ($100,000), 
or, in this example, $300,000, is treated as suspense preferences.
    (a) If, in 1971, the taxpayer's total items of income and deduction 
result in $350,000 of taxable income all of which is from sources within 
the United States, the entire $300,000 net operating loss, all of which 
is attributable to suspense preferences, is used to offset U.S. taxable 
income. Accordingly, the full $300,000 of suspense preferences are 
converted into actual items of tax preference arising in 1974 and are 
subject to tax under section 56.
    (b) If the $350,000 in 1971 is modified taxable income resulting 
from the denial of a section 1202 capital gains deduction of $175,000 by 
reason of section 172(b)(2), the $300,000, otherwise treated as actual 
items of tax preference, is reduced by $125,000, i.e., the extent to 
which the suspense preferences offset U.S. taxable income attributable 
to the increase in taxable income resulting from the denial of the 
section 1202 deduction.
    Example 3. In 1974, the taxpayer has the following items of income 
and deduction:

United States loss:
    Gross income....................  ..........    $75,000
    Deductions......................  ..........   (225,000)
                                                 -------------
                                      ..........  ..........  ($150,000)
Foreign loss:
    Gross income....................  ..........    400,000

[[Page 626]]

 
    Deductions:
      Preference items (excess of      $200,000
       accelerated depreciation on
       sec. 1250 property over
       straight-line amount)........
      Other.........................    550,000    (750,000)   (350,000)
                                     -----------------------------------
Overall net operating loss..........  ..........  ..........   (500,000)
 


Since the nonpreference deductions reduce the foreign source income 
before the preference portion, the $350,000 foreign source loss consists 
of $200,000 of suspense preferences and $150,000 of other deductions. In 
1971, 1972, and 1973 the taxpayer had taxable income from sources within 
the United States of $100,000, $200,000, and $300,000, respectively and 
taxable income from sources within foreign countries of $80,000 each 
year. Of the $200,000 of suspense preferences, $150,000 are converted 
into actual items of tax preference, subject to the minimum tax in 1974, 
determined as follows:

                                            [In thousands of dollars]
----------------------------------------------------------------------------------------------------------------
                                                Taxable income                             Foreign deductions
                                        ------------------------------                 -------------------------
           Year--Explanation                                           U.S. deductions    Suspense
                                         U.S. source   Foreign source                   preferences     Other
----------------------------------------------------------------------------------------------------------------
1971 End of year balance before section         100               80              150          200          150
 58(g) computations....................
    1. U.S. deductions against U.S.            (100)
     income............................
                                         ...........  ...............            (100)
    2. Other foreign deductions against  ...........             (80)  ...............  ...........         (80)
     foreign income....................
1972 End of year balance before section         200               80               50          200           70
 58(g) computations....................
    1. U.S. deductions against U.S.             (50)  ...............             (50)
     income............................
    2. Other foreign deductions against  ...........             (70)  ...............  ...........         (70)
     foreign income....................
    3. Suspense preferences against      ...........             (10)  ...............         (10)
     foreign income....................
    4. Suspense preferences against           *(150)  ...............  ...............       *(150)
     U.S. income.......................
1973 End of year balance before section         300               80   ...............          40
 58(g) computations....................
    1. U.S. deductions against U.S.      ...........  ...............  Not applicable
     income............................
    2. Other foreign deductions against  ...........  ...............  Not applicable
     foreign income....................
    3. Suspense preference against       ...........             (40)  ...............         (40)
     foreign income....................
    4. Suspense preferences against      ...........  ...............  Not applicable
     U.S. income.......................
    Balances...........................         300               40
----------------------------------------------------------------------------------------------------------------
*Suspense preferences converted to actual items of tax preference.

    Example 4. In 1970, the taxpayer's total items of income and 
deduction, all of which are attributable to foreign sources, are as 
follows:

Foreign loss:
  Gross income..............................................    $400,000
  Deductions:
    Preferences (excess of accelerated              $200,000
     depreciation on section 1250 property over
     straight-line).............................
                                                 -----------------------
Net operating loss..........................................     350,000
 


Pursuant to subdivision (i) of this subparagraph, none of the 
preferences attributable to foreign sources reduce the tax imposed by 
chapter 1 (other than the minimum tax) on taxable income from sources 
within the United States. Pursuant to subdivision (ii) of this 
subparagraph, the $200,000 portion of the net operating loss resulting 
from the excess accelerated depreciation constitutes suspense 
preferences. No part of the net operating loss that is carried back to 
previous years is reduced in such previous years. In 1971 and 1972, the 
taxpayer's income (before the net operating loss deduction) consists of 
the following:

1971 taxable income:
  United States.............................................    $160,000
  Foreign...................................................      70,000
                                                 -------------
    Total...................................................     230,000
                                                 =============

[[Page 627]]

 
1972 taxable income:
  United States.............................................      25,000
  Foreign...................................................     105,000
                                                 -------------
    Total...................................................     130,000
 

    (a) In 1971, the conversion of suspense preferences into actual 
items of tax preference under section 58(g) (and this paragraph) and the 
imposition of the minimum tax on 1970 items of tax preference under 
section 56(b) and (Sec.  1.56A-2) are determined as follows:

Conversion of suspense preferences:

                                             1970 Net Operating Loss
                                            [In thousands of dollars]
----------------------------------------------------------------------------------------------------------------
                                        U.S.                                                            Other
                                      taxable        Foreign        U.S. deductions       Suspense     foreign
                                       income    taxable income                         preferences   deductions
----------------------------------------------------------------------------------------------------------------
                                          $160              $70  .....................        $200         $150
                                   -----------------------------------------------------------------------------
1. U.S. deductions against U.S.     ...........  ..............  Not applicable.......
 income.
2. Other foreign deductions         ...........              70  .....................  ...........         (70)
 against foreign income.
3. Suspense preference against      ...........  ..............  Not applicable.......
 foreign income.
4. Suspense preference against           *(160)  ..............  .....................        (160)
 U.S. income.
                                   -----------------------------------------------------------------------------
    Balance to 1972...................................................................          40           80
----------------------------------------------------------------------------------------------------------------
*Suspense preferences converted into actual items of tax preference.

Imposition of minimum tax on 1970 items of tax preference:

                                             1970 Net Operating Loss
                                            [In thousands of dollars]
----------------------------------------------------------------------------------------------------------------
                                                1971 taxable    Nonpreference      Preference        Suspense
                                                   income          portion          portion          portion
----------------------------------------------------------------------------------------------------------------
                                                        $230             $150   ...............            $200
                                             -------------------------------------------------------------------
1. 1971 conversion of suspense preferences    ...............          \1\ 30             $130             (160)
 pursuant to sec. 58(g).....................
    Adjusted NOL............................  ...............             180              130               40
2. Nonpreference portion against taxable                (180)            (180)
 income.....................................
3. Preference portion against taxable income         \2\ (50)  ...............             (50)
                                             -------------------------------------------------------------------
    Balance to 1972...........................................................              80               40
----------------------------------------------------------------------------------------------------------------
\1\ Represents the 1970 minimum tax exemption.
\2\ Imposition of 1970 minimum tax (10 pct x $50,000 = $5,000).

    (b) In 1972, the conversion of suspense preferences into actual 
items of tax preferences under section 58(g) (and this paragraph) and 
the imposition of the minimum tax on 1970 items of tax preference under 
section 56(b) (and Sec.  1.56A-2) are determined as follows:
Conversion of suspense preferences:

                                             1970 Net Operating Loss
                                            [In thousands of dollars]
----------------------------------------------------------------------------------------------------------------
                                             U.S.                                                       Other
                                           taxable    Foreign taxable  U.S. deductions    Suspense     foreign
                                            income         income                       preferences   deductions
----------------------------------------------------------------------------------------------------------------
                                                $25             $105   ...............         $40          $80
                                        ------------------------------------------------------------------------
1. U.S. deduction against U.S. income..  ...........  ...............   Not applicable
2. Other foreign deductions against      ...........             (80)  ...............  ...........         (80)
 foreign income........................
3. Suspense preferences against foreign  ...........             (25)  ...............         (25)
 income................................
4. Suspense preference against U.S.         \1\ (15)  ...............  ...............         (15)
 income................................
                                        ------------------------------------------------------------------------

[[Page 628]]

 
    Balance............................          10
----------------------------------------------------------------------------------------------------------------
\1\ Suspense preferences converted into actual items of tax preference.

Imposition of minimum tax on 1970 items of tax preference:

                                             1970 Net Operating Loss
                                            [In thousands of dollars]
----------------------------------------------------------------------------------------------------------------
                                                1972 taxable    Nonpreference      Preference        Suspense
                                                   income          portion          portion          portion
----------------------------------------------------------------------------------------------------------------
                                                        $130   ...............             $80              $40
                                             -------------------------------------------------------------------
1. 1972 conversion of suspense preferences    ...............             $25               15              (40)
 pursuant to sec. 58(g).....................
    Adjusted NOL............................  ...............              25               95
2. Nonpreference portion against taxable                 (25)             (25)
 income.....................................
3. Preference portion against taxable income         \1\ (95)  ...............             (95)
                                             -------------------------------------------------------------------
    Balance.................................              10
----------------------------------------------------------------------------------------------------------------
\1\ Imposition of 1970 minimum tax (10 pct x $95,000 = $9,500).


    (2) Per-country limitation--(i) In general. If a taxpayer is on the 
per-country foreign tax credit limitation for the taxable year, the 
amount by which the items of tax preference to which this section 
applies reduce the tax imposed by chapter 1 (other than the minimum tax 
under section 56) on income from sources within the United States is 
determined separately with respect to each foreign country or possession 
of the United States. Such determination is made in a manner consistent 
with subparagraph (1) of this paragraph as modified in subdivision (ii) 
of this subparagraph. In applying subparagraph (1)(i) of this paragraph 
to a taxpayer on the per-country limitation, if the total potential 
preference amounts (as defined in this subdivision (i)) exceed the 
taxpayer's taxable income from sources within the United States, then, 
for purposes of subparagraph (1)(i)(c) of this paragraph (relating to 
the U.S. taxable income limitation on the amount treated as a reduction 
of U.S. taxable income), the taxable income from sources within the 
United States which is reduced by potential preference amounts with 
respect to each foreign country or possession is an amount which bears 
the same relationship to such income as the potential preference amount 
with respect to such foreign country or possession bears to the total of 
the potential preference amounts with respect to all foreign countries 
and possessions. For purposes of this subparagraph, the potential 
preference amount with respect to a foreign country or possession is the 
lesser of the amount of foreign source preference (described in 
subparagraph (1)(i)(a) of this paragraph) attributable to such country 
or possession or the amount of foreign source loss (described in 
subparagraph (1)(i)(b) of this paragraph) attributable to such country 
or possession.
    (ii) Net operating loss. Where there is an overall net operating 
loss for the taxable year and the total of the potential preference 
amounts with respect to all foreign countries and possessions exceeds 
the taxpayer's taxable income from sources within the United States, the 
amount of such excess is treated as ``suspense preferences''. The 
suspense preferences are converted into actual items of tax preference, 
arising in the loss year and subject to the provisions of section 56, as 
the net operating loss is used in other taxable years, in the form of a 
net operating loss deduction

[[Page 629]]

under section 172, to offset taxable income from sources within the 
United States. Suspense preferences attributable to a foreign country or 
possession which, in other taxable years, reduce taxable income from 
sources within such country or possession or offset taxable income from 
sources within any other foreign country or possession lose their 
character as suspense preferences and, thus, are never converted into 
actual items of tax preference. The amount of the suspense preferences 
which are converted into actual items of tax preference is equal to that 
portion of the net operating loss attributable to the suspense 
preferences which offsets taxable income from sources within the United 
States in taxable years other than the loss year. The determination of 
the component parts of the net operating loss and the determination of 
the amount by which the portion of the net operating loss attributable 
to the suspense preferences offsets taxable income from sources within 
the United States is made on a year-by-year basis in the same order as 
the net operating loss is used in accordance with section 172(b). Such 
determination is made by applying deductions attributable to United 
States source income first against such income and applying deductions 
attributable to income from sources within a foreign country or 
possession of the United States first against income from sources within 
such country or possession and in accordance with the following 
principles:
    (a) Deductions attributable to items or classes of gross income from 
sources within the United States offset taxable income from sources 
within the United States before any remaining deductions;
    (b) Deductions attributable to items or classes of gross income from 
sources within any foreign country or possession of the United States 
which are not suspense preferences (referred to in this paragraph as 
``other foreign deductions'') offset taxable income from sources within 
such country or possession before any remaining deductions;
    (c) Suspense preferences attributable to items or classes of gross 
income from sources within a foreign country or possession offset any 
remaining taxable income from sources within such foreign country or 
possession after application of (b) of this subdivision (ii) before any 
remaining deductions;
    (d) Suspense preferences from each foreign country and possession 
(remaining after application of (c) of this subdivision (ii)) offset 
taxable income from sources within the Unted States (remaining after 
application of (a) of this subdivision (ii)) before other foreign 
deductions pro rata on the basis of the total of such suspense 
preferences;
    (e) Other foreign deductions from each foreign country and 
possession (remaining after application of (b) of this subdivision (ii)) 
offset taxable income from sources within the United States (remaining 
after application (a) and (b) of this subdivision (ii)) pro rata on the 
basis of the total of such other foreign deductions;
    (f) Deductions attributable to income from sources within the United 
States (remaining after application of (a) of this subdivision (ii)) 
offset taxable income from sources within any foreign country or 
possession before any foreign deductions;
    (g) Other foreign deductions from each foreign country and 
possession (remaining after application of (b) and (e) of this 
subdivision (ii)) offset taxable income from sources within any other 
foreign countries or possessions (remaining after application of (f) of 
this subdivision (ii)) pro rata on the basis of the total of such other 
foreign deductions; and
    (h) Suspense preferences (remaining after the application of (c) and 
(d) of this subdivision (ii)) offset taxable income from sources within 
any foreign country or possession (remaining after the application of 
paragraphs (f) and (g) of this subdivision (ii)) pro rata on the basis 
of the total of such suspense preferences.

For purposes of the above computations, taxable income is computed with 
the modifications specifed in section 172(b)(2) or section 172(c), 
whichever is applicable. However, the amount of suspense preferences 
which are converted into actual items of tax preference in accordance 
with the above principles is reduced to the extent the suspense 
preferences offset increases in taxable income from sources within the

[[Page 630]]

United States due to the modifications specified in section 172(b)(2) or 
section 172(c). For this purpose, suspense preferences are considered to 
offset an increase in taxable income due to section 172(b)(2) or section 
172(c) modifications only after reducing taxable income computed before 
such modifications.
    (iii) Examples. The principles of this subparagraph may be 
illustrated by the following examples in each of which the per-country 
foreign tax credit limitation is applicable. For purposes of these 
examples, personal deductions and exemptions are disregarded.

    Example (1). The taxpayer has the following items of income and 
deduction for the taxable year 1971:

----------------------------------------------------------------------------------------------------------------
                                                                   United                               United
                                                                   States       France      Germany     Kingdom
----------------------------------------------------------------------------------------------------------------
Gross income..................................................    $180,000     $165,000     $50,000     $75,000
Deductions:
  Preference..................................................  ...........  ...........  ..........    (45,000)
  Other.......................................................    (120,000)    (125,000)    (80,000)   (100,000)
                                                               -------------------------------------------------
    Taxable income (or loss)..................................      60,000       40,000     (30,000)    (70,000)
----------------------------------------------------------------------------------------------------------------

    (a) Pursuant to subdivision (i) of this subparagraph, the potential 
preference amount in the case of the United Kingdom is the lesser of the 
preferences attributable to the United Kingdom ($45,000) or the excess 
of deductions over gross income from sources within the United Kingdom 
($70,000) and the potential preference amounts in the case of France and 
Germany are zero in both cases since the preferences attributable to 
both countries are zero. Since the total potential preference amounts 
($45,000) is less than the taxable income from sources within the United 
States ($60,000), no modification of U.S. taxable income is required. 
Thus, the amount by which the U.K. preferences reduce the tax on taxable 
income from sources within the United States, determined in a manner 
consistent with subparagraph (1)(i) of this paragraph, is the smallest 
of (1) the items of tax preference attributable to the United Kingdom 
($45,000), (2) the excess of deductions over gross income attributable 
to the United Kingdom ($70,000), or (3) taxable income from sources 
within the United States ($60,000). The full $45,000 of U.K. preference 
items are, therefore, taken into account as items of tax preference in 
1971 and subject to the minimum tax. Since there is no net operating 
loss, subdivision (ii) of this subparagraph does not apply.
    (b) If the French taxable income is $15,000 instead of $40,000, a 
$25,000 net operating loss (on a worldwide basis) results. The 
determination of the foreign preference items taken into account 
pursuant to subdivision (i) of this subparagraph is the same as in (a) 
of this example. Subdivision (ii) of this subparagraph again does not 
apply since the total potential preference amounts ($45,000) is less 
than the U.S. taxable income ($60,000).
    Example 2. For the taxable year 1972, the taxpayer has a net 
operating loss of $35,000 consisting of the following items of income 
and deduction:

----------------------------------------------------------------------------------------------------------------
                                                        United                              United
                                                        States      France      Germany     Kingdom     Belgium
----------------------------------------------------------------------------------------------------------------
Gross income.......................................    $250,000     $50,000     $60,000      $5,000     $45,000
Deductions:
  Preferences......................................  ...........    (35,000)    (70,000)    (95,000)
  Other............................................    (100,000)    (75,000)    (30,000)  ..........    (40,000)
                                                    ------------------------------------------------------------
    Taxable income (or loss).......................     150,000     (60,000)    (40,000)    (90,000)      5,000
----------------------------------------------------------------------------------------------------------------

    (a) Pursuant to subdivision (i) of this subparagraph the potential 
preference amount with respect to each country is the lesser of the 
amount shown as preferences with respect to such country or the amount 
of the loss from such country. Thus, the potential preference amounts in 
this case are:

France......................................................     $35,000
Germany.....................................................      40,000
United Kingdom..............................................      90,000
Belgium.....................................................           0
                                                             -----------
  Total.....................................................     165,000
 


Since the total of the potential preference amounts exceeds the U.S. 
taxable income, in applying the principles of subparagraph (1)(i) of 
this paragraph, U.S. taxable income which is reduced by potential 
preference amounts with respect to each country is a pro-rata

[[Page 631]]

amount based on the total potential preference amounts as follows:

France.....................................          (35,000 / 165,000 x
                                                      $150,000)--$31,818
Germany....................................          (40,000 / 165,000 x
                                                      $150,000)--$36,364
United Kingdom.............................          (90,000 / 165,000 x
                                                      $150,000)--$81,818
Belgium....................................   (0 / 165,000 x $150,000)--
                                                                      $0
                                            ----------------------------
  Total....................................                     $150,000
 

The amount by which the foreign preference items offset U.S. taxable 
income pursuant to subdivision (i) of this subparagraph is then 
determined as follows:

----------------------------------------------------------------------------------------------------------------
                                                        (a)             (b)             (c)             (d)
                                                 ---------------------------------------------------------------
                                                                                                    Smallest of
                                                    Preferences        Loss        U.S. taxable    (a), (b), or
                                                                                      income            (c)
----------------------------------------------------------------------------------------------------------------
France..........................................         $35,000         $60,000         $81,818         $31,818
Germany.........................................          70,000          40,000          36,364          36,364
United Kingdom..................................          95,000          90,000          81,818          81,818
Belgium.........................................
                                                 ---------------------------------------------------------------
    Total.......................................  ..............  ..............  ..............         150,000
----------------------------------------------------------------------------------------------------------------

Thus, $150,000 of the total foreign preference items will be taken into 
account pursuant to subdivision (i) of this subparagraph as items of tax 
preference in 1972 and subject to the provisions of section 56.
    (b) Pursuant to subdivision (ii) of this subparagraph, the 1972 net 
operating loss of $35,000 will consist of suspense preferences of 
$15,000 and other foreign deductions of $20,000 attributable to each 
foreign country as shown below and determined as follows:

----------------------------------------------------------------------------------------------------------------
                                                                  Deductions
                             -----------------------------------------------------------------------------------
         Explanation                              France                  Germany            United
                                United   ------------------------------------------------   Kingdom     Belgium
                                States    Preferences    Other    Preferences    Other    preferences    other
----------------------------------------------------------------------------------------------------------------
                               $100,000     $35,000     $75,000     $70,000     $30,000     $95,000     $40,000
1. U.S. deductions against     (100,000)
 U.S. income ($250,000).....
2. Other foreign deductions   ..........  ...........   (50,000)  ...........   (30,000)  ...........   (40,000)
 against foreign income (per-
 country) \1\...............
3. Suspense preferences       ..........  ...........  .........    (30,000)   .........     (5,000)
 against remaining foreign
 income (per-country).......
4. Suspense preferences
 against remaining U.S.
 income:
    France (35,000 / 165,000  ..........    (31,818)
     x $150,000)............
    Germany (40,000 /         ..........  ...........  .........    (36,364)
     165,000 x $150,000)....
    U.K. (90,000 / 165,000 x  ..........  ...........  .........  ...........  .........    (81,818)
     $150,000)..............
5. Other foreign deductions        (\2\)       (\2\)       (\2\)       (\2\)       (\2\)       (\2\)       (\2\)
 against remaining U.S.
 income (0).................
6. U.S. deductions against         (\2\)       (\2\)       (\2\)       (\2\)       (\2\)       (\2\)       (\2\)
 other foreign income.......
7. Other foreign deductions   ..........  ...........    (5,000)
 against remaining foreign
 income ($5,000)............
8. Suspense preferences            (\2\)       (\2\)       (\2\)       (\2\)       (\2\)       (\2\)       (\2\)
 against remaining foreign
 income (0):
      Balance (components of  ..........      3,182      20,000       3,636    .........      8,182
       NOL).................
----------------------------------------------------------------------------------------------------------------
\1\ Foreign income amounts before step 2 are: France--$50,000; Germany--$60,000; United Kingdom--$5,000;
  Belgium--$45,000.
\2\ Not applicable.

    Example 3. In 1973, the taxpayer has taxable income (computed 
without regard to the net operating loss deduction) from the following 
sources and in the following amounts:

------------------------------------------------------------------------
                                                                United
            United States               France      Germany     Kingdom
------------------------------------------------------------------------
$100,000............................     $60,000     $20,000     $30,000
------------------------------------------------------------------------



[[Page 632]]

    In addition, the taxpayer has a net operating loss deduction of 
$235,000 resulting from a 1972 net operating loss consisting of the 
following amounts:

Deductions attributable to income from sources within            $25,000
 the United States......................................
Suspense preferences attributable to income from sources         $75,000
 within France..........................................
Deductions other than suspense preferences attributable          $85,000
 to income from sources within France...................
Deductions other than suspense preferences attributable          $50,000
 to sources within the Netherlands......................
 

    (a) Pursuant to subdivision (ii) of this subparagraph, the converted 
suspense preferences and the remaining portions of the 1972 net 
operating loss carried over to 1974 are computed as follows:

                                            [In thousands of dollars]
----------------------------------------------------------------------------------------------------------------
                                            1973 income                        1972 net operating loss
                               ---------------------------------------------------------------------------------
                                                                                French      French       Dutch
                                 United   France  Germany   United   United    suspense      other       other
                                 States                    Kingdom   States  preferences  deductions  deductions
----------------------------------------------------------------------------------------------------------------
                                    100       60       20       30       25         75           85          50
U.S. deductions against U.S.       (25)  .......  .......  .......     (25)
 income.......................
Other foreign deductions        .......     (60)  .......  .......  .......  ...........       (60)
 against foreign income (per-
 country).....................
Suspense preferences against      (\2\)    (\2\)    (\2\)    (\2\)    (\2\)      (\2\)        (\2\)       (\2\)
 remaining foreign income (per-
 country).....................
Suspense preferences against       (\1\  .......  .......  .......  .......       (75)
 remaining U.S. income........      75)
Other foreign deductions          (\2\)    (\2\)    (\2\)    (\2\)    (\2\)      (\2\)        (\2\)       (\2\)
 against remaining U.S. income
U.S. deductions against           (\2\)    (\2\)    (\2\)    (\2\)    (\2\)      (\2\)        (\2\)       (\2\)
 remaining foreign income.....
  Other foreign deductions
   against remaining foreign
   income:
    French (25,000/75,000 x     .......  .......   (16.7)  .......  .......  ...........     (16.7)
     $50,000).................
    Dutch (50,000/75,000 x      .......  .......   (33.3)  .......  .......  ...........  ..........     (33.3)
     $50,000).................
Suspense preferences against      (\2\)    (\2\)    (\2\)    (\2\)    (\2\)      (\2\)        (\2\)       (\2\)
 remaining foreign income.....
Balance (1972 carryover to      .......  .......  .......  .......  .......  ...........        8.3        16.7
 1974)........................
----------------------------------------------------------------------------------------------------------------
\1\ Suspense preferences converted to actual items of tax preference.
\2\ Not applicable.

    (b) If, in 1972, there had been no items of tax preference without 
regard to the suspense preferences, the conversion of the suspense 
preferences in 1973 would result in a 1972 minimum tax liability under 
section 56(a) of $4,500 (10 percent x ($75,000-$30,000)), all of which 
would have been deferred by reason of section 56(b). Further, by 
application of section 56(b) and Sec.  1.56A-2, $20,000 of the $45,000 
preference portion of the 1972 net operating loss would be treated as 
having reduced taxable income in 1973 resulting in the imposition in 
1973 of $2,000 of the deferred 1972 minimum tax liability.

    (3) Separate limitation under section 904(f). In the case of a 
taxpayer subject to the separate limitation on interest income under 
section 904(f), the provisions of this paragraph shall be applied in the 
same manner as in subparagraph (2) of this paragraph. If the taxpayer 
has elected the overall foreign tax credit limitation, subparagraph (2) 
of this paragraph shall be applied as if all income from sources within 
any foreign countries or possessions of the United States and deductions 
relating to income from such sources other than income or deductions 
subject to the separate limitation under section 904(f) were from a 
single foreign country.
    (4) Carryover of excess taxes. For rules relating to carryover of 
excess taxes described in paragraph (1) of section 56(c) when suspense 
preferences are converted to actual items of tax preference, see Sec.  
1.56A-5(f).
    (5) Character of amounts. Where the amounts from sources within a 
foreign country or possession of the United States (or all such 
countries or possessions in the case of a taxpayer who has elected the 
overall foreign tax credit limitation) which are treated as reducing 
chapter 1 tax on income from sources within the United States or as

[[Page 633]]

suspense preferences are less than the total items of tax preference 
described in subparagraph (1)(i)(a) of this paragraph attributable to 
such sources, the amounts so treated are considered derived 
proportionately from each such item of tax preference.

[T.D. 7564, 43 FR 40484, Sept. 12, 1978, as amended by T.D. 8138, 52 FR 
15309, Apr. 28, 1987]



Sec.  1.58-8  Capital gains and stock options.

    (a) In general. Section 58(g)(2) provides that the items of tax 
preference specified in section 57(a)(6), and Sec.  1.57-1(b) (stock 
options), and section 57(a)(9), and Sec.  1.57-1(i) (capital gains), 
which are attributable to sources within any foreign country or 
possession of the United States shall not be taken into account as items 
of tax preference if, under the tax laws of such country or possession, 
preferential treatment is not accorded:
    (1) In the case of stock options, to the gain, profit, or other 
income realized from the transfer of shares of stock pursuant to the 
exercise of an option which is under United States tax law a qualified 
or restricted stock option (under section 422 or section 424); and
    (2) In the case of capital gains, to gain from the sale or exchange 
of capital assets (or property treated as capital assets under United 
States tax law).

Where capital gains are not accorded preferential treatment within a 
foreign country, capital losses as well as capital gains from such 
country are not taken into account for purposes of the minimum tax.
    (b) Source of capital gains and stock options. Generally, in 
determining whether the capital gain or stock option item of tax 
preference is attributable to sources within any foreign country or 
possession of the United States, the principles of sections 861-863 and 
the regulations thereunder are applied. Thus, the stock option item of 
tax preference, representing compensation for personal services, is 
attributable, in accordance with Sec.  1.861-4, to sources within the 
country in which the personal services were performed. Where the capital 
gain item of tax preference represents gain from the purchase and sale 
of personal property, such gain is attributable, in accordance with 
Sec.  1.861-7, entirely to sources within the country in which the 
property is sold. In accordance with paragraph (c) of Sec.  1.861-7, in 
any case in which the sales transaction is arranged in a particular 
manner for the primary purpose of tax avoidance, all factors of the 
transaction, such as negotiations, the execution of the agreement, the 
location of the property, and the place of payment, will be considered, 
and the sale will be treated as having been consummated at the place 
where the substance of the sale occurred.
    (c) Preferential treatment. For purposes of this section, gain, 
profit, or other income is accorded preferential treatment by a foreign 
country or possession of the United States if (1) recognition of the 
income, for foreign tax purposes, is deferred beyond the taxpayer's 
taxable year or comparable period for foreign tax purposes which 
coincides with the taxpayer's U.S. taxable year in cases where other 
items of profit, gain, or other income may not be deferred; (2) it is 
subject to tax at a lower effective rate (including no rate of tax) than 
other items of profit, gain, or other income, by means of a special rate 
of tax, artifical deductions, exemptions, exclusions, or similar 
reductions in the amount subject to tax; (3) it is subject to no 
significant amount of tax; or (4) the laws of the foreign country or 
possession by any other method provide tax treatment for such profit, 
gain, or other income more beneficial than the tax treatment otherwise 
accorded income by such country or possession. For the purpose of the 
preceding sentence, gain, profit, or other income is subject to no 
significant amount of tax if the amount of taxes imposed by the foreign 
country or possession of the United States is equal to less than 2.5 
percent of the gross amount of such income.
    (d) Examples. The principles of this section may be illustrated by 
the following examples:

    Example 1. The Bahamas imposes no income tax on individuals or 
corporations,

[[Page 634]]

whether resident or nonresident. Since capital gains are subject to no 
tax in the Bahamas, capital gains are considered to be accorded 
preferential treatment and will be taken into account for purposes of 
the minimum tax.
    Example 2. In France, except in certain cases involving the sale of 
large blocks of stock, a nonresident individual is not subject to tax on 
isolated capital gains transactions. Since such capital gains are not 
subject to tax in France, they are considered to be accorded 
preferential treatment irrespective of the treatment accorded other 
capital gains in France and such gains will be taken into account for 
purposes of the minimum tax.
    Example 3. In Germany, in the case of the sale within 1 taxable year 
of 1 percent or more of the shares of a corporation in which an 
individual taxpayer is regarded as holding a substantial interest, the 
gains on the sale of the large block of stock will be taxed as 
extraordinary income at one-half the ordinary income tax rate. Since 
these gains are taxed as a reduced rate of tax in comparison to other 
income, they are considered to be accorded preferential treatment and 
will be taken into account for purposes of the minimum tax.
    Example 4. In Belgium, gains derived by an individual in the course 
of regular speculative transactions are taxed as ordinary income, but 
with an upper limit of 30 percent. Rates of tax on individuals in 
Belgium range from approximately 30 percent to approximately 60 percent. 
Since the gains on speculative transactions are taxed at a maximum rate 
which is more beneficial then the rates accorded to other income, such 
gains are considered to be accorded preferential treatment and will be 
taken into account for purposes of the minimum tax.
    Example 5. In France, gains derived by a company on the sale of 
fixed assets held for less than 2 years are treated as short-term gains. 
The excess of short-term gains in any fiscal year is taxed at the full 
company tax rate of 50 percent. However, this tax may be paid in equal 
portions over the 5 years immediately following the realization of such 
short-term gains. Since recognition of the short-term gains for tax 
purposes is subject to deferral over a 5-year period, such gains are 
considered to be accorded preferential treatment and will be taken into 
account for purposes of the minimum tax.
    Example 6. Also in France, in the case of the sale or exchange by a 
company of depreciable assets and nondepreciable asset owned for at 
least 2 years, the excess of long-term capital gains over long-term 
capital losses in a fiscal year is subject to an immediate tax at the 
reduced rate of 10 percent. Such excess, reduced by the 10-percent tax, 
is carried in a special reserve account on the taxpayer's books. If the 
excess is reinvested in other fixed asset within a stated period, no 
further tax is due. If the amounts in the special reserve are 
distributed, they will be treated as ordinary income for the fiscal year 
in which the distribution is made. Since such gains (other than those 
distributed in the same fiscal year they are realized) are subject to 
deferral or a reduced rate of tax, they are (except to the extent 
distributed in the year of realization) considered to be accorded 
preferential treatment and are taken into account for purposes of the 
minimum tax.
    Example 7. In Sweden, in the case of gains derived by an individual 
on the sale of shares or bonds held for 5 years or less, 25 percent of 
the gains are taxed if the holding period is 4 to 5 years, 50 percent of 
the gain is taxed if the holding period is 3 to 4 years, and 75 percent 
of the gain is taxed if the holding period is 2 to 3 years. The gain is 
fully taxable at ordinary income rates if held for less than 2 years. 
Thus, gains on shares or bonds held for 2 years or more are considered 
accorded preferential treatment in Sweden since they are either subject 
to exemption or treatment comparable to the U.S. capital gains deduction 
and are taxed at a reduced rate. Thus, such gains are taken into account 
for purposes of the minimum tax.
    Example 8. Pursuant to Article XIV of the United States-United 
Kingdom Income Tax Convention, a resident of the United States is exempt 
from United Kingdom tax on most capital gains. Since such capital gains 
are exempt from United Kingdom taxation, they are considered to be 
accorded preferential treatment and are taken into account for purposes 
of the minimum tax.
    Example 9. An individual resident of the United States, is desirous 
of selling his stock in a corporation listed on the New York Stock 
Exchange. He requests the stock certificates from his broker in the 
United States, travels to a foreign country, delivers the certificates 
to a broker in that country, and has the foreign broker execute the sale 
which takes place on the New York Stock Exchange. Since the sale was 
consummated in the United States, pursuant to paragraph (b) of this 
section and Sec.  1.861-7, the resulting capital gain item of tax 
preference is attributable to sources within the United States.
    Example 10. Two individuals, both residing in the United States, 
negotiate and reach agreement in New York City for the sale of stock of 
a closed corporation. Prior to the transfer of the stock, in order to 
avoid imposition of the minimum tax, both individuals travel to a 
foreign country which does not accord preferential treatment to capital 
gains, but imposes a 5-percent rate of income tax which would be fully 
creditable against U.S. tax under sections 901 and 904 if the capital 
gains were sourced in that country. The stock is actually transferred 
and consideration paid in the foreign country. Since the primary purpose 
of consummating the sale

[[Page 635]]

in the foreign country was the avoidance of tax, pursuant to paragraph 
(b) of this section, and Sec.  1.861-7(c), the resulting capital gain 
item of tax preference will be considered attributable to sources within 
the country in which the substance of sale took place or, in this case, 
the United States.

[T.D. 7564, 43 FR 40492, Sept. 12, 1978]



Sec.  1.59-1  Optional 10-year writeoff of certain tax preferences.

    (a) In general. Section 59(e) allows any qualified expenditure to 
which an election under section 59(e) applies to be deducted ratably 
over the 10-year period (3-year period in the case of circulation 
expenditures described in section 173) beginning with the taxable year 
in which the expenditure was made (or, in the case of intangible 
drilling and development costs deductible under section 263(c), over the 
60-month period beginning with the month in which the expenditure was 
paid or incurred).
    (b) Election--(1) Time and manner of election. An election under 
section 59(e) shall only be made by attaching a statement to the 
taxpayer's income tax return (or amended return) for the taxable year in 
which the amortization of the qualified expenditures subject to the 
section 59(e) election begins. The statement must be filed no later than 
the date prescribed by law for filing the taxpayer's original income tax 
return (including any extensions of time) for the taxable year in which 
the amortization of the qualified expenditures subject to the section 
59(e) election begins. Additionally, the statement must include the 
following information--
    (i) The taxpayer's name, address, and taxpayer identification 
number; and
    (ii) The type and amount of qualified expenditures identified in 
section 59(e)(2) that the taxpayer elects to deduct ratably over the 
applicable period described in section 59(e)(1).
    (2) Elected amount. A taxpayer may make an election under section 
59(e) with respect to any portion of any qualified expenditure paid or 
incurred by the taxpayer in the taxable year to which the election 
applies. An election under section 59(e) must be for a specific dollar 
amount and the amount subject to an election under section 59(e) may not 
be made by reference to a formula. The amount elected under section 
59(e) is properly chargeable to a capital account under section 
1016(a)(20), relating to adjustments to basis of property.
    (c) Revocation--(1) In general. An election under section 59(e) may 
be revoked only with the consent of the Commissioner. Such consent will 
only be granted in rare and unusual circumstances. The revocation, if 
granted, will be effective in the first taxable year in which the 
section 59(e) election was applicable. However, if the period of 
limitations for the first taxable year the section 59(e) election was 
applicable has expired, the revocation, if granted, will be effective in 
the earliest taxable year for which the period of limitations has not 
expired.
    (2) Time and manner for requesting consent. A taxpayer requesting 
the Commissioner's consent to revoke a section 59(e) election must 
submit the request prior to the end of the taxable year the applicable 
amortization period described in section 59(e)(1) ends. The application 
for consent to revoke the election must be submitted to the Internal 
Revenue Service in the form of a letter ruling request.
    (3) Information to be provided. A request to revoke a section 59(e) 
election must contain all of the information necessary to demonstrate 
the rare and unusual circumstances that would justify granting 
revocation.
    (4) Treatment of unamortized costs. The unamortized balance of the 
qualified expenditures subject to the revoked section 59(e) election as 
of the first day of the taxable year the revocation is effective is 
deductible in the year the revocation is effective (subject to the 
requirements of any other provision under the Code, regulations, or any 
other published guidance) and the taxpayer will be required to amend any 
federal income tax returns affected by the revocation.
    (d) Effective date. These regulations apply to a section 59(e) 
election made for a taxable year ending, or a request to revoke a 
section 59(e) election submitted, on or after December 22, 2004.

[T.D. 9168, 69 FR 76616, Dec. 22, 2004]



Sec.  1.59A-0  Table of contents.

    This section contains a listing of the headings for Sec. Sec.  
1.59A-1, 1.59A-2, 1.59A-3,

[[Page 636]]

1.59A-4, 1.59A-5, 1.59A-6, 1.59A-7, 1.59A-8, 1.59A-9, and 1.59A-10.

Sec.  1.59A-1 Base erosion and anti-abuse tax.

    (a) Purpose.
    (b) Definitions.
    (1) Aggregate group.
    (2) Applicable section 38 credits.
    (3) Applicable taxpayer.
    (4) Bank.
    (5) Base erosion and anti-abuse tax rate.
    (6) Business interest expense.
    (7) Deduction.
    (8) Disallowed business interest expense carryforward.
    (9) Domestic related business interest expense.
    (10) Foreign person.
    (11) Foreign related business interest expense.
    (12) Foreign related party.
    (13) Gross receipts.
    (14) Member of an aggregate group.
    (15) Registered securities dealer.
    (16) Regular tax liability.
    (17) Related party.
    (i) In general.
    (ii) 25-percent owner.
    (iii) Application of section 318.
    (18) TLAC long-term debt required amount.
    (19) TLAC securities amount.
    (20) TLAC security.
    (21) Unrelated business interest expense.

Sec.  1.59A-2 Applicable taxpayer.

    (a) Scope.
    (b) Applicable taxpayer.
    (c) Aggregation rules.
    (1) In general.
    (2) Aggregate group determined with respect to each taxpayer.
    (i) In general.
    (ii) Change in the composition of an aggregate group.
    (3) Taxable year of members of an aggregate group.
    (4) Periods before and after a corporation is a member of an 
aggregate group.
    (i) In general.
    (ii) Deemed taxable year-end.
    (iii) Items allocable to deemed taxable years before and after 
deemed taxable year-end.
    (5) Short taxable year.
    (i) Short period of the taxpayer.
    (A) In general.
    (B) Determining the gross receipts and base erosion percentage of 
the aggregate group of a taxpayer for a short period.
    (ii) Short period of a member of the taxpayer's aggregate group.
    (A) Multiple taxable years of a member of the taxpayer's aggregate 
group comprised of more than 12 months.
    (B) Short period or periods of a member of the taxpayer's aggregate 
group comprised of fewer than 12 months from change in taxable year.
    (iii) Anti-abuse rule.
    (6) Treatment of predecessors.
    (i) In general.
    (ii) No duplication.
    (7) Partnerships.
    (8) Transition rule for aggregate group members with different 
taxable years.
    (9) Consolidated groups.
    (d) Gross receipts test.
    (1) Amount of gross receipts.
    (2) Taxpayer not in existence for entire three-year period.
    (3) Gross receipts of foreign corporations.
    (4) Gross receipts of an insurance company.
    (5) Reductions in gross receipts.
    (e) Base erosion percentage test.
    (1) In general.
    (2) Base erosion percentage test for banks and registered securities 
dealers.
    (i) In general.
    (ii) Aggregate groups.
    (iii) De minimis exception for banking and registered securities 
dealer activities.
    (3) Computation of base erosion percentage.
    (i) In general.
    (ii) Certain items not taken into account in denominator.
    (iii) Effect of treaties on base erosion percentage determination.
    (iv) Amounts paid or accrued between members of a consolidated 
group.
    (v) Deductions and base erosion tax benefits from partnerships.
    (vi) Mark-to-market positions.
    (vii) Reinsurance losses incurred and claims payments.
    (viii) Certain payments that qualify for the effectively connected 
income exception and another base erosion payment exception.
    (f) Examples.
    (1) Example 1: Mark-to-market.
    (i) Facts.
    (ii) Analysis.
    (2) Example 2: Member leaving an aggregate group.
    (i) Facts.
    (ii) Analysis.

Sec.  1.59A-3 Base erosion payments and base erosion tax benefits.

    (a) Scope.
    (b) Base erosion payments.
    (1) In general.
    (2) Operating rules.
    (i) In general.
    (ii) Amounts paid or accrued in cash and other consideration.
    (iii) Transactions providing for net payments.
    (iv) Amounts paid or accrued with respect to mark-to-market 
position.
    (v) Coordination among categories of base erosion payments.
    (vi) Certain domestic passthrough entities.
    (A) In general.
    (B) Amount of base erosion payment.

[[Page 637]]

    (C) Specified domestic passthrough.
    (D) Specified foreign related party.
    (vii) Transfers of property to related taxpayers.
    (viii) Reductions to determine gross income.
    (ix) Losses recognized on the sale or transfer of property.
    (3) Exceptions to base erosion payment.
    (i) Certain services cost method amounts.
    (A) In general.
    (B) Eligibility for the services cost method exception.
    (C) Adequate books and records.
    (D) Total services cost.
    (ii) Qualified derivative payments.
    (iii) Effectively connected income.
    (A) In general.
    (B) Application to certain treaty residents.
    (C) Application to partnerships.
    (iv) Exchange loss on a section 988 transaction.
    (v) Amounts paid or accrued with respect to TLAC securities and 
foreign TLAC securities.
    (A) In general.
    (B) Limitation on exclusion for TLAC securities.
    (C) Scaling ratio.
    (D) Average domestic TLAC securities amount.
    (E) Average TLAC long-term debt required amount.
    (F) Limitation on exclusion for foreign TLAC securities.
    (1) In general.
    (2) Foreign TLAC long-term debt required amount.
    (3) No specified minimum provided by local law.
    (4) Foreign TLAC security.
    (vi) Amounts paid or accrued in taxable years beginning before 
January 1, 2018.
    (vii) Business interest carried forward from taxable years beginning 
before January 1, 2018.
    (viii) Specified nonrecognition transactions.
    (A) In general.
    (B) Other property transferred to a foreign related party in a 
specified nonrecognition transaction.
    (C) Other property received from a foreign related party in certain 
specified nonrecognition transactions.
    (D) Definition of other property.
    (E) Allocation of other property.
    (ix) Reinsurance losses incurred and claims payments.
    (A) In general.
    (B) Regulated foreign insurance company.
    (4) Rules for determining the amount of certain base erosion 
payments.
    (i) Interest expense allocable to a foreign corporation's 
effectively connected income.
    (A) Methods described in Sec.  1.882-5.
    (B) U.S.-booked liabilities determination.
    (C) U.S.-booked liabilities in excess of U.S.-connected liabilities.
    (D) Election to use financial statements.
    (E) Coordination with certain tax treaties.
    (1) In general.
    (2) Hypothetical Sec.  1.882-5 interest expense defined.
    (3) Consistency requirement.
    (F) Coordination with exception for foreign TLAC securities.
    (ii) Other deductions allowed with respect to effectively connected 
income.
    (iii) Depreciable property.
    (iv) Coordination with ECI exception.
    (v) Coordination with certain tax treaties.
    (A) Allocable expenses.
    (B) Internal dealings under certain income tax treaties.
    (vi) Business interest expense arising in taxable years beginning 
after December 31, 2017.
    (c) Base erosion tax benefit.
    (1) In general.
    (2) Exception to base erosion tax benefit.
    (i) In general.
    (ii) Branch-level interest tax.
    (3) Effect of treaty on base erosion tax benefit.
    (4) Application of section 163(j) to base erosion payments.
    (i) Classification of payments or accruals of business interest 
expense based on the payee.
    (A) Classification of payments or accruals of business interest 
expense of a corporation.
    (B) Classification of payments or accruals of business interest 
expense by a partnership.
    (C) Classification of payments or accruals of business interest 
expense paid or accrued to a foreign related party that is subject to an 
exception.
    (1) ECI exception.
    (2) TLAC interest and interest subject to withholding tax.
    (ii) Ordering rules for business interest expense that is limited 
under section 163(j)(1) to determine which classifications of business 
interest expense are deducted and which classifications of business 
interest expense are carried forward.
    (A) In general.
    (B) Ordering rules for treating business interest expense deduction 
and disallowed business interest expense carryforwards as foreign 
related business interest expense, domestic related business interest 
expense, and unrelated business interest expense.
    (1) General ordering rule for allocating business interest expense 
deduction between classifications.
    (2) Ordering of business interest expense incurred by a corporation.
    (3) Ordering of business interest expense incurred by a partnership 
and allocated to a corporate partner.
    (5) Allowed deduction.

[[Page 638]]

    (6) Election to waive allowed deductions.
    (i) In general.
    (ii) Time and manner for election to waive deduction.
    (A) In general.
    (B) Information required to make the election to waive allowed 
deductions.
    (iii) Effect of election to waive deduction.
    (A) In general.
    (1) Consistent treatment.
    (2) No allocation and apportionment of waived deductions.
    (3) Effect of waiver of deductions described in Sec. Sec.  1.861-10 
and 1.861-10T.
    (4) Effect of the election to waive deductions on the stock basis of 
a consolidated group member.
    (B) Effect of the election to waive deductions disregarded for 
certain purposes.
    (C) Not a method of accounting.
    (D) Effect of the election in determining section 481(a) 
adjustments.
    (iv) Rules applicable to partners and partnerships.
    (A) In general.
    (B) Rule for determining the adjusted basis of a partner's interest 
in a partnership.
    (C) Rule for applying section 163(j).
    (D) Limited application of election to waive deductions with respect 
to adjustments made pursuant to audit procedures under sections 6221 
through 6241.
    (v) Rule applicable to premium and other consideration paid or 
accrued by the taxpayer for any reinsurance payments that are taken into 
account under section 803(a)(1)(B) or 832(b)(4)(A).
    (d) Examples.
    (1) Example 1: Determining a base erosion payment.
    (i) Facts.
    (ii) Analysis.
    (2) Example 2: Interest allocable under Sec.  1.882-5.
    (i) Facts.
    (ii) Analysis.
    (3) Example 3: Interaction with section 163(j).
    (i) Facts.
    (ii) Analysis.
    (A) Classification of business interest.
    (B) Ordering rules for disallowed business interest expense 
carryforward.
    (4) Example 4: Interaction with section 163(j); carryforward.
    (i) Facts.
    (ii) Analysis.
    (A) Classification of business interest.
    (B) Ordering rules for disallowed business interest expense 
carryforward.
    (5) Example 5: Interaction with section 163(j); carryforward.
    (i) Facts.
    (ii) Analysis.
    (6) Example 6: Interaction with section 163(j); partnership.
    (i) Facts.
    (ii) Partnership level analysis.
    (iii) Partner level allocations analysis.
    (iv) Partner level allocations for determining base erosion tax 
benefits.
    (v) Computation of modified taxable income.
    (7) Example 7: Transfers of property to related taxpayers.
    (i) Facts.
    (ii) Analysis.
    (A) Year 1.
    (B) Year 2.
    (8) Example 8: Effect of election to waive deduction on method of 
accounting.
    (i) Facts.
    (ii) Analysis.
    (9) Example 9: Change of accounting method when taxpayer has waived 
a deduction.
    (i) Facts.
    (ii) Analysis.
    (A) Computation of the section 481(a) adjustment.
    (B) Computation of basis adjustments.

Sec.  1.59A-4 Modified taxable income.

    (a) Scope.
    (b) Computation of modified taxable income.
    (1) In general.
    (2) Modifications to taxable income.
    (i) Base erosion tax benefits.
    (ii) Certain net operating loss deductions.
    (3) Rule for holders of a residual interest in a REMIC.
    (c) Examples.
    (1) Example 1: Current year loss.
    (i) Facts.
    (ii) Analysis.
    (2) Example 2: Net operating loss deduction.
    (i) Facts.
    (ii) Analysis.

Sec.  1.59A-5 Base erosion minimum tax amount.

    (a) Scope.
    (b) Base erosion minimum tax amount.
    (1) In general.
    (2) Calculation of base erosion minimum tax amount.
    (3) Credits that do not reduce regular tax liability.
    (i) Taxable years beginning on or before December 31, 2025.
    (ii) Taxable years beginning after December 31, 2025.
    (c) Base erosion and anti-abuse tax rate.
    (1) In general.
    (i) Calendar year 2018.
    (ii) Calendar years 2019 through 2025.
    (iii) Calendar years after 2025.
    (2) Increased rate for banks and registered securities dealers.
    (i) In general.
    (ii) De minimis exception to increased rate for banks and registered 
securities dealers.
    (3) Application of section 15 to tax rates in section 59A.
    (i) New tax.

[[Page 639]]

    (ii) Change in tax rate pursuant to section 59A(b)(1)(A).
    (iii) Change in rate pursuant to section 59A(b)(2).

Sec.  1.59A-6 Qualified derivative payment.

    (a) Scope.
    (b) Qualified derivative payment.
    (1) In general.
    (2) Reporting requirements.
    (i) In general.
    (ii) Failure to satisfy the reporting requirement.
    (iii) Reporting of aggregate amount of qualified derivative 
payments.
    (iv) Transition period for qualified derivative payment reporting.
    (3) Amount of any qualified derivative payment.
    (i) In general.
    (ii) Net qualified derivative payment that includes a payment that 
is a base erosion payment.
    (c) Exceptions for payments otherwise treated as base erosion 
payments.
    (d) Derivative defined.
    (1) In general.
    (2) Exceptions.
    (i) Direct interest.
    (ii) Insurance contracts.
    (iii) Securities lending and sale-repurchase transactions.
    (A) Multi-step transactions treated as financing.
    (B) Special rule for payments associated with the cash collateral 
provided in a securities lending transaction or substantially similar 
transaction.
    (C) Anti-abuse exception for certain transactions that are the 
economic equivalent of substantially unsecured cash borrowing.
    (3) American depository receipts.
    (e) Examples.
    (1) Example 1: Notional principal contract as QDP.
    (i) Facts.
    (ii) Analysis.
    (2) Example 2: Securities lending anti-abuse rule.
    (i) Facts.
    (ii) Analysis.

Sec.  1.59A-7 Application of base erosion and anti-abuse tax to 
          partnerships.

    (a) Scope.
    (b) Application of section 59A to partnerships.
    (c) Base erosion payment.
    (1) Payments made by or to a partnership.
    (2) Transfers of certain property.
    (3) Transfers of a partnership interest.
    (i) In general.
    (ii) Transfers of a partnership interest by a partner.
    (iii) Certain issuances of a partnership interest by a partnership.
    (iv) Partnership interest transfers defined.
    (4) Increased basis from a distribution.
    (5) Operating rules applicable to base erosion payments.
    (i) Single payment characterized as separate transactions.
    (ii) Ordering rule with respect to transfers of a partnership 
interest.
    (iii) Consideration for base erosion payment or property resulting 
in base erosion tax benefits.
    (iv) Non-cash consideration.
    (v) Allocations of income in lieu of deductions.
    (d) Base erosion tax benefit for partners.
    (1) In general.
    (2) Exception for base erosion tax benefits of certain small 
partners.
    (i) In general.
    (ii) Attribution.
    (e) Other rules for applying section 59A to partnerships.
    (1) Partner's distributive share.
    (2) Gross receipts.
    (i) In general.
    (ii) Foreign corporation.
    (3) Registered securities dealers.
    (4) Application of sections 163(j) and 59A(c)(3) to partners.
    (5) Tiered partnerships.
    (f) Foreign related party.
    (g) Examples.
    (1) Facts.
    (2) Examples.
    (i) Example 1: Contributions to a partnership on partnership 
formation.
    (A) Facts.
    (B) Analysis.
    (ii) Example 2: Section 704(c) and remedial allocations.
    (A) Facts.
    (B) Analysis.
    (iii) Example 3: Sale of a partnership interest without a section 
754 election.
    (A) Facts.
    (B) Analysis.
    (iv) Example 4: Sale of a partnership interest with section 754 
election.
    (A) Facts.
    (B) Analysis.
    (v) Example 5: Purchase of depreciable property from a partnership.
    (A) Facts.
    (B) Analysis.
    (vi) Example 6: Sale of a partnership interest to a second 
partnership.
    (A) Facts.
    (B) Analysis.
    (vii) Example 7: Distribution of cash by a partnership to a foreign 
related party.
    (A) Facts.
    (B) Analysis.
    (viii) Example 8: Distribution of property by a partnership to a 
taxpayer.
    (A) Facts.
    (B) Analysis.
    (ix) Example 9: Distribution of property by a partnership in 
liquidation of a foreign related party's interest.

[[Page 640]]

    (A) Facts.
    (B) Analysis.
    (x) Example 10: Section 704(c) and curative allocations.
    (A) Facts.
    (B) Analysis.

Sec.  1.59A-8 [Reserved].
Sec.  1.59A-9 Anti-abuse and recharacterization rules.

    (a) Scope.
    (b) Anti-abuse rules.
    (1) Transactions involving unrelated persons, conduits, or 
intermediaries.
    (2) Transactions to increase the amount of deductions taken into 
account in the denominator of the base erosion percentage computation.
    (3) Transactions to avoid the application of rules applicable to 
banks and registered securities dealers.
    (4) Nonrecognition transactions.
    (5) Transactions involving derivatives on a partnership interest.
    (6) Allocations to eliminate or reduce a base erosion payment.
    (c) Examples.
    (1) Facts.
    (2) Example 1: Substitution of payments that are not base erosion 
payments for payments that otherwise would be base erosion payments 
through a conduit or intermediary.
    (i) Facts.
    (ii) Analysis.
    (3) Example 2: Alternative transaction to base erosion payment.
    (i) Facts.
    (ii) Analysis.
    (4) Example 3: Alternative financing source.
    (i) Facts.
    (ii) Analysis.
    (5) Example 4: Alternative financing source that is a conduit.
    (i) Facts.
    (ii) Analysis.
    (6) Example 5: Intermediary acquisition.
    (i) Facts.
    (ii) Analysis.
    (7) Example 6: Offsetting transactions to increase the amount of 
deductions taken into account in the denominator of the base erosion 
percentage computation.
    (i) Facts.
    (ii) Analysis.
    (8) Example 7: Ordinary course transactions that increase the amount 
of deductions taken into account in the denominator of the base erosion 
percentage computation.

    (i) Facts.
    (ii) Analysis.
    (9) Example 8: Transactions to avoid the application of rules 
applicable to banks and registered securities dealers.
    (i) Facts.
    (ii) Analysis.
    (10) Example 9: Transactions that do not avoid the application of 
rules applicable to banks and registered securities dealers.
    (i) Facts.
    (ii) Analysis.
    (11) Example 10: Acquisition of depreciable property in a 
nonrecognition transaction.
    (i) Facts.
    (ii) Analysis.
    (12) Example 11: Transactions between related parties with a 
principal purpose of increasing the adjusted basis of property.
    (i) Facts.
    (ii) Analysis.

Sec.  1.59A-10 Applicability date.
    (a) General applicability date.
    (b) Exception.
    This section contains a listing of the headings for Sec. Sec.  
1.59A-1, 1.59A-2, 1.59A-3, 1.59A-4, 1.59A-5, 1.59A-6, 1.59A-7, 1.59A-8, 
1.59A-9, and 1.59A-10.

Sec.  1.59A-1 Base erosion and anti-abuse tax.

    (a) Purpose.
    (b) Definitions.
    (1) Aggregate group.
    (2) Applicable section 38 credits.
    (3) Applicable taxpayer.
    (4) Bank.
    (5) Base erosion and anti-abuse tax rate.
    (6) Business interest expense.
    (7) Deduction.
    (8) Disallowed business interest expense carryforward.
    (9) Domestic related business interest expense.
    (10) Foreign person.
    (11) Foreign related business interest expense.
    (12) Foreign related party.
    (13) Gross receipts.
    (14) Member of an aggregate group.
    (15) Registered securities dealer.
    (16) Regular tax liability.
    (17) Related party.
    (i) In general.
    (ii) 25-percent owner.
    (iii) Application of section 318.
    (18) TLAC long-term debt required amount.
    (19) TLAC securities amount.
    (20) TLAC security.
    (21) Unrelated business interest expense.

Sec.  1.59A-2 Applicable taxpayer.

    (a) Scope.
    (b) Applicable taxpayer.
    (c) Aggregation rules.
    (1) In general.
    (2) Aggregate group determined with respect to each taxpayer.
    (i) In general.
    (ii) Change in the composition of an aggregate group.
    (3) Taxable year of members of an aggregate group.
    (4) Periods before and after a corporation is a member of an 
aggregate group.

[[Page 641]]

    (i) In general.
    (ii) Deemed taxable year-end.
    (iii) Items allocable to deemed taxable years before and after 
deemed taxable year-end.
    (5) Short taxable year.
    (i) Short period of the taxpayer.
    (A) In general.
    (B) Determining the gross receipts and base erosion percentage of 
the aggregate group of a taxpayer for a short period.
    (ii) Short period of a member of the taxpayer's aggregate group.
    (A) Multiple taxable years of a member of the taxpayer's aggregate 
group comprised of more than 12 months.
    (B) Short period or periods of a member of the taxpayer's aggregate 
group comprised of fewer than 12 months from change in taxable year.
    (iii) Anti-abuse rule.
    (6) Treatment of predecessors.
    (i) In general.
    (ii) No duplication.
    (7) Partnerships.
    (8) Transition rule for aggregate group members with different 
taxable years.
    (9) Consolidated groups.
    (d) Gross receipts test.
    (1) Amount of gross receipts.
    (2) Taxpayer not in existence for entire three-year period.
    (3) Gross receipts of foreign corporations.
    (4) Gross receipts of an insurance company.
    (5) Reductions in gross receipts.
    (e) Base erosion percentage test.
    (1) In general.
    (2) Base erosion percentage test for banks and registered securities 
dealers.
    (i) In general.
    (ii) Aggregate groups.
    (iii) De minimis exception for banking and registered securities 
dealer activities.
    (3) Computation of base erosion percentage.
    (i) In general.
    (ii) Certain items not taken into account in denominator.
    (iii) Effect of treaties on base erosion percentage determination.
    (iv) Amounts paid or accrued between members of a consolidated 
group.
    (v) Deductions and base erosion tax benefits from partnerships.
    (vi) Mark-to-market positions.
    (vii) Reinsurance losses incurred and claims payments.
    (viii) Certain payments that qualify for the effectively connected 
income exception and another base erosion payment exception.
    (f) Examples.
    (1) Example 1: Mark-to-market.
    (i) Facts.
    (ii) Analysis.
    (2) Example 2: Member leaving an aggregate group.
    (i) Facts.
    (ii) Analysis.

Sec.  1.59A-3 Base erosion payments and base erosion tax benefits.

    (a) Scope.
    (b) Base erosion payments.
    (1) In general.
    (2) Operating rules.
    (i) In general.
    (ii) Amounts paid or accrued in cash and other consideration.
    (iii) Transactions providing for net payments.
    (iv) Amounts paid or accrued with respect to mark-to-market 
position.
    (v) Coordination among categories of base erosion payments.
    (vi) Certain domestic passthrough entities.
    (A) In general.
    (B) Amount of base erosion payment.
    (C) Specified domestic passthrough.
    (D) Specified foreign related party.
    (vii) Transfers of property to related taxpayers.
    (viii) Reductions to determine gross income.
    (ix) Losses recognized on the sale or transfer of property.
    (3) Exceptions to base erosion payment.
    (i) Certain services cost method amounts.
    (A) In general.
    (B) Eligibility for the services cost method exception.
    (C) Adequate books and records.
    (D) Total services cost.
    (ii) Qualified derivative payments.
    (iii) Effectively connected income.
    (A) In general.
    (B) Application to certain treaty residents.
    (C) Application to partnerships.
    (iv) Exchange loss on a section 988 transaction.
    (v) Amounts paid or accrued with respect to TLAC securities and 
foreign TLAC securities.
    (A) In general.
    (B) Limitation on exclusion for TLAC securities.
    (C) Scaling ratio.
    (D) Average domestic TLAC securities amount.
    (E) Average TLAC long-term debt required amount.
    (F) Limitation on exclusion for foreign TLAC securities.
    (1) In general.
    (2) Foreign TLAC long-term debt required amount.
    (3) No specified minimum provided by local law.
    (4) Foreign TLAC security.
    (vi) Amounts paid or accrued in taxable years beginning before 
January 1, 2018.
    (vii) Business interest carried forward from taxable years beginning 
before January 1, 2018.
    (viii) Specified nonrecognition transactions.

[[Page 642]]

    (A) In general.
    (B) Other property transferred to a foreign related party in a 
specified nonrecognition transaction.
    (C) Other property received from a foreign related party in certain 
specified nonrecognition transactions.
    (D) Definition of other property.
    (E) Allocation of other property.
    (ix) Reinsurance losses incurred and claims payments.
    (A) In general.
    (B) Regulated foreign insurance company.
    (4) Rules for determining the amount of certain base erosion 
payments.
    (i) Interest expense allocable to a foreign corporation's 
effectively connected income.
    (A) Methods described in Sec.  1.882-5.
    (B) U.S.-booked liabilities determination.
    (C) U.S.-booked liabilities in excess of U.S.-connected liabilities.
    (D) Election to use financial statements.
    (E) Coordination with certain tax treaties.
    (1) In general.
    (2) Hypothetical Sec.  1.882-5 interest expense defined.
    (3) Consistency requirement.
    (F) Coordination with exception for foreign TLAC securities.
    (ii) Other deductions allowed with respect to effectively connected 
income.
    (iii) Depreciable property.
    (iv) Coordination with ECI exception.
    (v) Coordination with certain tax treaties.
    (A) Allocable expenses.
    (B) Internal dealings under certain income tax treaties.
    (vi) Business interest expense arising in taxable years beginning 
after December 31, 2017.
    (c) Base erosion tax benefit.
    (1) In general.
    (2) Exception to base erosion tax benefit.
    (i) In general.
    (ii) Branch-level interest tax.
    (3) Effect of treaty on base erosion tax benefit.
    (4) Application of section 163(j) to base erosion payments.
    (i) Classification of payments or accruals of business interest 
expense based on the payee.
    (A) Classification of payments or accruals of business interest 
expense of a corporation.
    (B) Classification of payments or accruals of business interest 
expense by a partnership.
    (C) Classification of payments or accruals of business interest 
expense paid or accrued to a foreign related party that is subject to an 
exception.
    (1) ECI exception.
    (2) TLAC interest and interest subject to withholding tax.
    (ii) Ordering rules for business interest expense that is limited 
under section 163(j)(1) to determine which classifications of business 
interest expense are deducted and which classifications of business 
interest expense are carried forward.
    (A) In general.
    (B) Ordering rules for treating business interest expense deduction 
and disallowed business interest expense carryforwards as foreign 
related business interest expense, domestic related business interest 
expense, and unrelated business interest expense.
    (1) General ordering rule for allocating business interest expense 
deduction between classifications.
    (2) Ordering of business interest expense incurred by a corporation.
    (3) Ordering of business interest expense incurred by a partnership 
and allocated to a corporate partner.
    (5) Allowed deduction.
    (6) Election to waive allowed deductions.
    (i) In general.
    (ii) Time and manner for election to waive deduction.
    (A) In general.
    (B) Information required to make the election to waive allowed 
deductions.
    (iii) Effect of election to waive deduction.
    (A) In general.
    (1) Consistent treatment.
    (2) No allocation and apportionment of waived deductions.
    (3) Effect of waiver of deductions described in Sec. Sec.  1.861-10 
and 1.861-10T.
    (4) Effect of the election to waive deductions on the stock basis of 
a consolidated group member.
    (B) Effect of the election to waive deductions disregarded for 
certain purposes.
    (C) Not a method of accounting.
    (D) Effect of the election in determining section 481(a) 
adjustments.
    (iv) Rules applicable to partners and partnerships.
    (A) In general.
    (B) Rule for determining the adjusted basis of a partner's interest 
in a partnership.
    (C) Rule for applying section 163(j).
    (D) Limited application of election to waive deductions with respect 
to adjustments made pursuant to audit procedures under sections 6221 
through 6241.
    (v) Rule applicable to premium and other consideration paid or 
accrued by the taxpayer for any reinsurance payments that are taken into 
account under section 803(a)(1)(B) or 832(b)(4)(A).
    (d) Examples.
    (1) Example 1: Determining a base erosion payment.
    (i) Facts.
    (ii) Analysis.
    (2) Example 2: Interest allocable under Sec.  1.882-5.
    (i) Facts.
    (ii) Analysis.
    (3) Example 3: Interaction with section 163(j).

[[Page 643]]

    (i) Facts.
    (ii) Analysis.
    (A) Classification of business interest.
    (B) Ordering rules for disallowed business interest expense 
carryforward.
    (4) Example 4: Interaction with section 163(j); carryforward.
    (i) Facts.
    (ii) Analysis.
    (A) Classification of business interest.
    (B) Ordering rules for disallowed business interest expense 
carryforward.
    (5) Example 5: Interaction with section 163(j); carryforward.
    (i) Facts.
    (ii) Analysis.
    (6) Example 6: Interaction with section 163(j); partnership.
    (i) Facts.
    (ii) Partnership level analysis.
    (iii) Partner level allocations analysis.
    (iv) Partner level allocations for determining base erosion tax 
benefits.
    (v) Computation of modified taxable income.
    (7) Example 7: Transfers of property to related taxpayers.
    (i) Facts.
    (ii) Analysis.
    (A) Year 1.
    (B) Year 2.
    (8) Example 8: Effect of election to waive deduction on method of 
accounting.
    (i) Facts.
    (ii) Analysis.
    (9) Example 9: Change of accounting method when taxpayer has waived 
a deduction.
    (i) Facts.
    (ii) Analysis.
    (A) Computation of the section 481(a) adjustment.
    (B) Computation of basis adjustments.

Sec.  1.59A-4 Modified taxable income.

    (a) Scope.
    (b) Computation of modified taxable income.
    (1) In general.
    (2) Modifications to taxable income.
    (i) Base erosion tax benefits.
    (ii) Certain net operating loss deductions.
    (3) Rule for holders of a residual interest in a REMIC.
    (c) Examples.
    (1) Example 1: Current year loss.
    (i) Facts.
    (ii) Analysis.
    (2) Example 2: Net operating loss deduction.
    (i) Facts.
    (ii) Analysis.

Sec.  1.59A-5 Base erosion minimum tax amount.

    (a) Scope.
    (b) Base erosion minimum tax amount.
    (1) In general.
    (2) Calculation of base erosion minimum tax amount.
    (3) Credits that do not reduce regular tax liability.
    (i) Taxable years beginning on or before December 31, 2025.
    (ii) Taxable years beginning after December 31, 2025.
    (c) Base erosion and anti-abuse tax rate.
    (1) In general.
    (i) Calendar year 2018.
    (ii) Calendar years 2019 through 2025.
    (iii) Calendar years after 2025.
    (2) Increased rate for banks and registered securities dealers.
    (i) In general.
    (ii) De minimis exception to increased rate for banks and registered 
securities dealers.
    (3) Application of section 15 to tax rates in section 59A.
    (i) New tax.
    (ii) Change in tax rate pursuant to section 59A(b)(1)(A).
    (iii) Change in rate pursuant to section 59A(b)(2).

Sec.  1.59A-6 Qualified derivative payment.

    (a) Scope.
    (b) Qualified derivative payment.
    (1) In general.
    (2) Reporting requirements.
    (i) In general.
    (ii) Failure to satisfy the reporting requirement.
    (iii) Reporting of aggregate amount of qualified derivative 
payments.
    (iv) Transition period for qualified derivative payment reporting.
    (3) Amount of any qualified derivative payment.
    (i) In general.
    (ii) Net qualified derivative payment that includes a payment that 
is a base erosion payment.
    (c) Exceptions for payments otherwise treated as base erosion 
payments.
    (d) Derivative defined.
    (1) In general.
    (2) Exceptions.
    (i) Direct interest.
    (ii) Insurance contracts.
    (iii) Securities lending and sale-repurchase transactions.
    (A) Multi-step transactions treated as financing.
    (B) Special rule for payments associated with the cash collateral 
provided in a securities lending transaction or substantially similar 
transaction.
    (C) Anti-abuse exception for certain transactions that are the 
economic equivalent of substantially unsecured cash borrowing.
    (3) American depository receipts.
    (e) Examples.
    (1) Example 1: Notional principal contract as QDP.
    (i) Facts.
    (ii) Analysis.
    (2) Example 2: Securities lending anti-abuse rule.

[[Page 644]]

    (i) Facts.
    (ii) Analysis.

Sec.  1.59A-7 Application of base erosion and anti-abuse tax to 
          partnerships.

    (a) Scope.
    (b) Application of section 59A to partnerships.
    (c) Base erosion payment.
    (1) Payments made by or to a partnership.
    (2) Transfers of certain property.
    (3) Transfers of a partnership interest.
    (i) In general.
    (ii) Transfers of a partnership interest by a partner.
    (iii) Certain issuances of a partnership interest by a partnership.
    (iv) Partnership interest transfers defined.
    (4) Increased basis from a distribution.
    (5) Operating rules applicable to base erosion payments.
    (i) Single payment characterized as separate transactions.
    (ii) Ordering rule with respect to transfers of a partnership 
interest.
    (iii) Consideration for base erosion payment or property resulting 
in base erosion tax benefits.
    (iv) Non-cash consideration.
    (v) Allocations of income in lieu of deductions.
    (d) Base erosion tax benefit for partners.
    (1) In general.
    (2) Exception for base erosion tax benefits of certain small 
partners.
    (i) In general.
    (ii) Attribution.
    (e) Other rules for applying section 59A to partnerships.
    (1) Partner's distributive share.
    (2) Gross receipts.
    (i) In general.
    (ii) Foreign corporation.
    (3) Registered securities dealers.
    (4) Application of sections 163(j) and 59A(c)(3) to partners.
    (5) Tiered partnerships.
    (f) Foreign related party.
    (g) Examples.
    (1) Facts.
    (2) Examples.
    (i) Example 1: Contributions to a partnership on partnership 
formation.
    (A) Facts.
    (B) Analysis.
    (ii) Example 2: Section 704(c) and remedial allocations.
    (A) Facts.
    (B) Analysis.
    (iii) Example 3: Sale of a partnership interest without a section 
754 election.
    (A) Facts.
    (B) Analysis.
    (iv) Example 4: Sale of a partnership interest with section 754 
election.
    (A) Facts.
    (B) Analysis.
    (v) Example 5: Purchase of depreciable property from a partnership.
    (A) Facts.
    (B) Analysis.
    (vi) Example 6: Sale of a partnership interest to a second 
partnership.
    (A) Facts.
    (B) Analysis.
    (vii) Example 7: Distribution of cash by a partnership to a foreign 
related party.
    (A) Facts.
    (B) Analysis.
    (viii) Example 8: Distribution of property by a partnership to a 
taxpayer.
    (A) Facts.
    (B) Analysis.
    (ix) Example 9: Distribution of property by a partnership in 
liquidation of a foreign related party's interest.
    (A) Facts.
    (B) Analysis.
    (x) Example 10: Section 704(c) and curative allocations.
    (A) Facts.
    (B) Analysis.

Sec.  1.59A-8 [Reserved].
Sec.  1.59A-9 Anti-abuse and recharacterization rules.

    (a) Scope.
    (b) Anti-abuse rules.
    (1) Transactions involving unrelated persons, conduits, or 
intermediaries.
    (2) Transactions to increase the amount of deductions taken into 
account in the denominator of the base erosion percentage computation.
    (3) Transactions to avoid the application of rules applicable to 
banks and registered securities dealers.
    (4) Nonrecognition transactions.
    (5) Transactions involving derivatives on a partnership interest.
    (6) Allocations to eliminate or reduce a base erosion payment.
    (c) Examples.
    (1) Facts.
    (2) Example 1: Substitution of payments that are not base erosion 
payments for payments that otherwise would be base erosion payments 
through a conduit or intermediary.
    (i) Facts.
    (ii) Analysis.
    (3) Example 2: Alternative transaction to base erosion payment.
    (i) Facts.
    (ii) Analysis.
    (4) Example 3: Alternative financing source.
    (i) Facts.
    (ii) Analysis.
    (5) Example 4: Alternative financing source that is a conduit.
    (i) Facts.
    (ii) Analysis.
    (6) Example 5: Intermediary acquisition.

[[Page 645]]

    (i) Facts.
    (ii) Analysis.
    (7) Example 6: Offsetting transactions to increase the amount of 
deductions taken into account in the denominator of the base erosion 
percentage computation.
    (i) Facts.
    (ii) Analysis.
    (8) Example 7: Ordinary course transactions that increase the amount 
of deductions taken into account in the denominator of the base erosion 
percentage computation.

    (i) Facts.
    (ii) Analysis.
    (9) Example 8: Transactions to avoid the application of rules 
applicable to banks and registered securities dealers.
    (i) Facts.
    (ii) Analysis.
    (10) Example 9: Transactions that do not avoid the application of 
rules applicable to banks and registered securities dealers.
    (i) Facts.
    (ii) Analysis.
    (11) Example 10: Acquisition of depreciable property in a 
nonrecognition transaction.
    (i) Facts.
    (ii) Analysis.
    (12) Example 11: Transactions between related parties with a 
principal purpose of increasing the adjusted basis of property.
    (i) Facts.
    (ii) Analysis.

Sec.  1.59A-10 Applicability date.
    (a) General applicability date.
    (b) Exception.

[T.D. 9910, 85 FR 64340, Oct. 9, 2020]



Sec.  1.59A-1  Base erosion and anti-abuse tax.

    (a) Purpose. This section and Sec. Sec.  1.59A-2 through 1.59A-10 
(collectively, the ``section 59A regulations'') provide rules under 
section 59A to determine the amount of the base erosion and anti-abuse 
tax. Paragraph (b) of this section provides definitions applicable to 
the section 59A regulations. Section 1.59A-2 provides rules regarding 
how to determine whether a taxpayer is an applicable taxpayer. Section 
1.59A-3 provides rules regarding base erosion payments and base erosion 
tax benefits. Section 1.59A-4 provides rules for calculating modified 
taxable income. Section 1.59A-5 provides rules for calculating the base 
erosion minimum tax amount. Section 1.59A-6 provides rules relating to 
qualified derivative payments. Section 1.59A-7 provides rules regarding 
the application of section 59A to partnerships. Section 1.59A-8 is 
reserved for rules regarding the application of section 59A to certain 
expatriated entities. Section 1.59A-9 provides anti-abuse rules to 
prevent avoidance of section 59A. Finally, Sec.  1.59A-10 provides the 
applicability date for the section 59A regulations.
    (b) Definitions. For purposes of this section and Sec. Sec.  1.59A-2 
through 1.59A-10, the following terms have the meanings provided in this 
paragraph (b).
    (1) Aggregate group. The term aggregate group means the group of 
corporations determined by--
    (i) Identifying a controlled group of corporations as defined in 
section 1563(a), except that the phrase ``more than 50 percent'' is 
substituted for ``at least 80 percent'' each place it appears in section 
1563(a)(1) and the determination is made without regard to sections 
1563(a)(4) and (e)(3)(C), and
    (ii) Once the controlled group of corporations is determined, 
excluding foreign corporations except with regard to income that is, or 
is treated as, effectively connected with the conduct of a trade or 
business in the United States under an applicable provision of the 
Internal Revenue Code or regulations published under 26 CFR chapter I. 
Notwithstanding the foregoing, if a foreign corporation is subject to 
tax on a net basis pursuant to an applicable income tax treaty of the 
United States, it is excluded from the controlled group of corporations 
except with regard to income taken into account in determining its net 
taxable income.
    (2) Applicable section 38 credits. The term applicable section 38 
credits means the credits allowed under section 38 for the taxable year 
that are properly allocable to--
    (i) The low-income housing credit determined under section 42(a),
    (ii) The renewable electricity production credit determined under 
section 45(a), and
    (iii) The investment credit determined under section 46, but only to 
the extent properly allocable to the energy credit determined under 
section 48.
    (3) Applicable taxpayer. The term applicable taxpayer means a 
taxpayer that meets the requirements set forth in Sec.  1.59A-2(b).
    (4) Bank. The term bank has the meaning provided in section 581.

[[Page 646]]

    (5) Base erosion and anti-abuse tax rate. The term base erosion and 
anti-abuse tax rate means the percentage that the taxpayer applies to 
its modified taxable income for the taxable year to calculate its base 
erosion minimum tax amount. See Sec.  1.59A-5(c) for the base erosion 
and anti-abuse tax rate applicable for the relevant taxable year.
    (6) Business interest expense. The term business interest expense, 
with respect to a taxpayer and a taxable year, has the meaning provided 
in Sec.  1.163(j)-1(b)(3).
    (7) Deduction. The term deduction means any deduction allowable 
under chapter 1 of subtitle A of the Internal Revenue Code.
    (8) Disallowed business interest expense carryforward. The term 
disallowed business interest expense carryforward has the meaning 
provided in Sec.  1.163(j)-1(b)(11).
    (9) Domestic related business interest expense. The term domestic 
related business interest expense for any taxable year is the taxpayer's 
business interest expense paid or accrued to a related party that is not 
a foreign related party.
    (10) Foreign person. The term foreign person means any person who is 
not a United States person. For purposes of the preceding sentence, a 
United States person has the meaning provided in section 7701(a)(30), 
except that any individual who is a citizen of any possession of the 
United States (but not otherwise a citizen of the United States) and who 
is not a resident of the United States is not a United States person. 
See Sec.  1.59A-7(b) for rules applicable to partnerships.
    (11) Foreign related business interest expense. The term foreign 
related business interest expense for any taxable year is the taxpayer's 
business interest expense paid or accrued to a foreign related party.
    (12) Foreign related party. The term foreign related party means a 
foreign person, as defined in paragraph (b)(10) of this section, that is 
a related party, as defined in paragraph (b)(17) of this section, with 
respect to the taxpayer. In addition, for purposes of Sec.  1.59A-
3(b)(4)(v)(B) (relating to internal dealings under certain income tax 
treaties), a foreign related party also includes the foreign 
corporation's home office or a foreign branch of the foreign 
corporation. See Sec.  1.59A-7(b), (c), and (f) for rules applicable to 
partnerships.
    (13) Gross receipts. The term gross receipts has the meaning 
provided in Sec.  1.448-1T(f)(2)(iv).
    (14) Member of an aggregate group. The term member of an aggregate 
group means a corporation that is included in an aggregate group, as 
defined in paragraph (b)(1) of this section.
    (15) Registered securities dealer. The term registered securities 
dealer means any dealer as defined in section 3(a)(5) of the Securities 
Exchange Act of 1934 that is registered, or required to be registered, 
under section 15 of the Securities Exchange Act of 1934.
    (16) Regular tax liability. The term regular tax liability has the 
meaning provided in section 26(b).
    (17) Related party--(i) In general. A related party, with respect to 
an applicable taxpayer, is--
    (A) Any 25-percent owner of the taxpayer;
    (B) Any person who is related (within the meaning of section 267(b) 
or 707(b)(1)) to the taxpayer or any 25-percent owner of the taxpayer; 
or
    (C) A controlled taxpayer within the meaning of Sec.  1.482-1(i)(5) 
together with, or with respect to, the taxpayer.
    (ii) 25-percent owner. With respect to any corporation, a 25-percent 
owner means any person who owns at least 25 percent of--
    (A) The total voting power of all classes of stock of the 
corporation entitled to vote; or
    (B) The total value of all classes of stock of the corporation.
    (iii) Application of section 318. Section 318 applies for purposes 
of paragraphs (b)(17)(i) and (ii) of this section, except that--
    (A) ``10 percent'' is substituted for ``50 percent'' in section 
318(a)(2)(C); and
    (B) Section 318(a)(3)(A) through (C) are not applied so as to 
consider a United States person as owning stock that is owned by a 
person who is not a United States person.
    (18) TLAC long-term debt required amount. The term TLAC long-term 
debt required amount means the specified minimum amount of debt that is 
required pursuant to 12 CFR 252.162(a).

[[Page 647]]

    (19) TLAC securities amount. The term TLAC securities amount is the 
sum of the adjusted issue prices (as determined for purposes of Sec.  
1.1275-1(b)) of all TLAC securities issued and outstanding by the 
taxpayer, without regard to whether interest thereunder would be a base 
erosion payment absent Sec.  1.59A-3(b)(3)(v).
    (20) TLAC security. The term TLAC security means an eligible 
internal debt security, as defined in 12 CFR 252.161.
    (21) Unrelated business interest expense. The term unrelated 
business interest expense for any taxable year is the taxpayer's 
business interest expense paid or accrued to a party that is not a 
related party.

[T.D. 9885, 84 FR 67017, Dec. 6, 2019, as amended by T.D. 9910, 85 FR 
64363, Oct. 9, 2020]



Sec.  1.59A-2  Applicable taxpayer.

    (a) Scope. This section provides rules for determining whether a 
taxpayer is an applicable taxpayer. Paragraph (b) of this section 
defines an applicable taxpayer. Paragraph (c) of this section provides 
rules for determining whether a taxpayer is an applicable taxpayer by 
reference to the aggregate group of which the taxpayer is a member. 
Paragraph (d) of this section provides rules regarding the gross 
receipts test. Paragraph (e) of this section provides rules regarding 
the base erosion percentage test. Paragraph (f) of this section provides 
examples illustrating the rules of this section.
    (b) Applicable taxpayer. For purposes of section 59A, a taxpayer is 
an applicable taxpayer with respect to any taxable year if the 
taxpayer--
    (1) Is a corporation, but not a regulated investment company, a real 
estate investment trust, or an S corporation;
    (2) Satisfies the gross receipts test of paragraph (d) of this 
section; and
    (3) Satisfies the base erosion percentage test of paragraph (e) of 
this section.
    (c) Aggregation rules--(1) In general. Solely for purposes of this 
section and Sec.  1.59A-4, a taxpayer that is a member of an aggregate 
group determines its gross receipts and its base erosion percentage on 
the basis of the aggregate group. For these purposes, transactions that 
occur between members of the taxpayer's aggregate group that were 
members of the aggregate group as of the time of the transaction are not 
taken into account. In the case of a foreign corporation that is a 
member of an aggregate group, only transactions that occur between 
members of the aggregate group and that relate to income effectively 
connected with, or treated as effectively connected with, the conduct of 
a trade or business in the United States are not taken into account for 
this purpose. In the case of a foreign corporation that is a member of 
an aggregate group and that is subject to tax on a net basis pursuant to 
an applicable income tax treaty of the United States, only transactions 
that occur between members of the aggregate group and that relate to 
income that is taken into account in determining its net taxable income 
are not taken into account for this purpose. For purposes of this 
paragraph (c)(1), each payment or accrual is treated as a separate 
transaction.
    (2) Aggregate group determined with respect to each taxpayer--(i) In 
general. Solely for purposes of this section, an aggregate group is 
determined with respect to each taxpayer. As a result, the aggregate 
group of one taxpayer may be different than the aggregate group of 
another member of the taxpayer's aggregate group.
    (ii) Change in the composition of an aggregate group. A change in 
ownership of the taxpayer (for example, a sale of the taxpayer to a 
third party) does not cause the taxpayer to leave its own aggregate 
group. Instead, any members of the taxpayer's aggregate group before the 
change in ownership that are no longer members following the change in 
ownership are treated as having left the taxpayer's aggregate group, and 
any new members that become members of the taxpayer's aggregate group 
following the change in ownership are treated as having joined the 
taxpayer's aggregate group. A change in ownership of another member of 
the aggregate group of the taxpayer (for example, a sale of the member 
to a third party) may result in the member joining or leaving the 
aggregate group of the taxpayer. See paragraph (c)(4) of

[[Page 648]]

this section for the treatment of members joining or leaving the 
aggregate group of a taxpayer.
    (3) Taxable year of members of an aggregate group. Solely for 
purposes of this section, a taxpayer that is a member of an aggregate 
group measures the gross receipts and base erosion percentage of the 
aggregate group for a taxable year by reference to the taxpayer's gross 
receipts, base erosion tax benefits, and deductions for the taxable year 
and the gross receipts, base erosion tax benefits, and deductions of 
each member of the aggregate group for the taxable year of the member 
that ends with or within the taxpayer's taxable year.
    (4) Periods before and after a corporation is a member of an 
aggregate group--(i) In general. Solely for purposes of this section, to 
determine the gross receipts and the base erosion percentage of the 
aggregate group of a taxpayer, the taxpayer takes into account only the 
portion of another corporation's taxable year during which the 
corporation is a member of the aggregate group of the taxpayer. The 
gross receipts, base erosion tax benefits, and deductions of a 
corporation that are properly included in the gross receipts and base 
erosion percentage of the aggregate group of a taxpayer are not reduced 
as a result of the member leaving the aggregate group of the taxpayer.
    (ii) Deemed taxable year-end. Solely for purposes of this paragraph 
(c), if a corporation leaves or joins the aggregate group of a taxpayer, 
the corporation is treated as ceasing to be a member of the aggregate 
group at the time of its taxable year-end, or becoming a member of the 
aggregate group immediately after the time of its taxable year-end, 
resulting from the transaction. For purposes of this paragraph (c), if a 
corporation joins or leaves an aggregate group in a transaction that 
does not result in the corporation having a taxable year-end, the 
corporation is treated as having a taxable year-end (``deemed taxable 
year-end'') at the end of the day on which the transaction occurs.
    (iii) Items allocable to deemed taxable years before and after 
deemed taxable year-end. Solely for purposes of this paragraph (c), a 
corporation that has a deemed taxable year-end determines gross 
receipts, base erosion tax benefits, and deductions attributable to the 
deemed taxable year ending upon, or beginning immediately after, the 
deemed taxable year-end by either treating the corporation's books as 
closing (``deemed closing of the books'') at the deemed taxable year-end 
or, in the case of items other than extraordinary items, allocating 
those items on a pro-rata basis without a closing of the books. 
Extraordinary items are allocated to the deemed taxable year ending 
upon, or beginning immediately after, the deemed taxable year-end based 
on the day that they are taken into account. For purposes of applying 
this paragraph (c)(4)(iii), extraordinary items that are attributable to 
a transaction that occurs during the portion of the corporation's day 
after the event resulting in the corporation joining or leaving the 
aggregate group are treated as taken into account at the beginning of 
the following day. Additionally, for purposes of applying this paragraph 
(c)(4)(iii), ``extraordinary items'' include the items enumerated in 
Sec.  1.1502-76(b)(2)(ii)(C) as well as any other payment not made in 
the ordinary course of business that would be treated as a base erosion 
payment.
    (5) Short taxable year--(i) Short period of the taxpayer--(A) In 
general. Solely for purposes of this section, if a taxpayer has a 
taxable year of fewer than 12 months (a short period), the gross 
receipts, base erosion tax benefits, and deductions of the taxpayer are 
annualized by multiplying the total amount for the short period by 365 
and dividing the result by the number of days in the short period.
    (B) Determining the gross receipts and base erosion percentage of 
the aggregate group of a taxpayer for a short period. When a taxpayer 
has a taxable year that is a short period and a member of the taxpayer's 
aggregate group does not have a taxable year that ends with or within 
the taxpayer's taxable year as a result of the taxpayer's short period, 
the taxpayer must use a reasonable approach to determine the gross 
receipts and base erosion percentage of

[[Page 649]]

its aggregate group for the short period. A reasonable approach should 
neither over-count nor under-count the gross receipts, base erosion tax 
benefits, and deductions of the aggregate group of the taxpayer. A 
reasonable approach does not include an approach that does not take into 
account the gross receipts, base erosion tax benefits, or deductions of 
the member. The taxpayer must consistently apply the reasonable 
approach. Examples of a reasonable approach may include an approach that 
takes into account 12 months of gross receipts, base erosion tax 
benefits, and deductions of the member by reference to--
    (1) The 12-month period ending on the last day of the short period;
    (2) The member's taxable year that ends nearest to the last day of 
the short period or that begins nearest to the first day of the short 
period; or
    (3) An average of the two taxable years of the member ending before 
and after the short period.
    (ii) Short period of a member of the taxpayer's aggregate group--(A) 
Multiple taxable years of a member of the taxpayer's aggregate group 
comprised of more than 12 months. If a member of a taxpayer's aggregate 
group has more than one taxable year ending with or within the 
taxpayer's taxable year, and the member's taxable years ending with or 
within the taxpayer's taxable year are comprised of more than 12 months 
in total, then the aggregate group member's gross receipts, base erosion 
tax benefits, and deductions are annualized for purposes of determining 
the gross receipts and base erosion percentage of the taxpayer's 
aggregate group. The aggregate group member's gross receipts, base 
erosion tax benefits, and deductions are annualized by multiplying the 
total amount for the member's taxable years by 365 and dividing the 
result by the total number of days in the multiple taxable years.
    (B) Short period or periods of a member of the taxpayer's aggregate 
group comprised of fewer than 12 months from change in taxable year. If, 
as a result of a member of a taxpayer's aggregate group changing its 
taxable year-end (other than as a result of the application of Sec.  
1.1502-76(a)), the member's taxable year or years ending with or within 
the taxpayer's taxable year are comprised of fewer than 12 months in 
total, then the aggregate group member's gross receipts, base erosion 
tax benefits, and deductions are annualized for purposes of determining 
the gross receipts and base erosion percentage of the taxpayer's 
aggregate group. The aggregate group member's gross receipts, base 
erosion tax benefits, and deductions are annualized by multiplying the 
total amount for the member's taxable year or years by 365 and dividing 
the result by the total number of days in the taxable year or years.
    (iii) Anti-abuse rule. If a taxpayer or a member of a taxpayer's 
aggregate group enters into a transaction (or series of transactions), 
plan, or arrangement with another corporation that is a member of the 
aggregate group or a foreign related party that has a principal purpose 
of changing the period taken into account under the gross receipts test 
or the base erosion percentage test to avoid applicable taxpayer status 
under paragraph (b) of this section, then the gross receipts test or 
base erosion percentage test, respectively, applies as if that 
transaction (or series of transactions), plan, or arrangement had not 
occurred.
    (6) Treatment of predecessors--(i) In general. Solely for purposes 
of this section, in determining gross receipts under paragraph (d) of 
this section, any reference to a taxpayer includes a reference to any 
predecessor of the taxpayer. For this purpose, a predecessor is the 
distributor or transferor corporation in a transaction described in 
section 381(a) in which the taxpayer is the acquiring corporation. For 
purposes of determining the gross receipts of a predecessor that are 
taken into account by a taxpayer, the operating rules set forth in this 
paragraph (c) and in paragraph (d) of this section are applied to the 
same extent they were applied to the predecessor.
    (ii) No duplication. If the taxpayer or any member of its aggregate 
group is also a predecessor of the taxpayer or any member of its 
aggregate group, the gross receipts of each member are taken into 
account only once.
    (7) Partnerships. For the treatment of partnerships for purposes of 
determining gross receipts and base erosion

[[Page 650]]

tax benefits, see Sec.  1.59A-7(e)(2) and (d), respectively.
    (8) Transition rule for aggregate group members with different 
taxable years. If the taxpayer has a different taxable year than another 
member of the taxpayer's aggregate group (other member), and the other 
member is eligible for the exception in Sec.  1.59A-3(b)(3)(vi) (amounts 
paid or accrued in taxable years beginning before January 1, 2018) with 
respect to a taxable year ending with or within the taxpayer's taxable 
year (``excepted taxable year''), the excepted taxable year of the other 
member is not taken into account for purposes of paragraph (e) of this 
section. This rule applies solely for purposes of determining whether a 
taxpayer is an applicable taxpayer under this section.
    (9) Consolidated groups. For the treatment of consolidated groups 
for purposes of determining gross receipts and base erosion tax 
benefits, see Sec.  1.1502-59A(b).
    (d) Gross receipts test--(1) Amount of gross receipts. A taxpayer, 
or the aggregate group of which the taxpayer is a member, satisfies the 
gross receipts test of this section if it has average annual gross 
receipts of at least $500,000,000 for the three-taxable-year period 
ending with the preceding taxable year.
    (2) Taxpayer not in existence for entire three-year period. If a 
taxpayer was not in existence for the entire three-year period referred 
to in paragraph (d)(1) of this section, the taxpayer determines a gross 
receipts average for the period that it was in existence (which includes 
gross receipts in the current year).
    (3) Gross receipts of foreign corporations. With respect to any 
foreign corporation, only gross receipts that are taken into account in 
determining income that is, or is treated as, effectively connected with 
the conduct of a trade or business within the United States are taken 
into account for purposes of paragraph (d)(1) of this section. In the 
case of a foreign corporation that is a member of an aggregate group and 
that is subject to tax on a net basis pursuant to an applicable income 
tax treaty of the United States, the foreign corporation includes only 
gross receipts that are attributable to transactions taken into account 
in determining its net taxable income.
    (4) Gross receipts of an insurance company. Solely for purposes of 
this section, for any corporation that is subject to tax under 
subchapter L or any corporation that would be subject to tax under 
subchapter L if that corporation were a domestic corporation, gross 
receipts are reduced by return premiums (within the meaning of section 
803(a)(1)(B) and section 832(b)(4)(A)), but are not reduced by any 
reinsurance premiums paid or accrued.
    (5) Reductions in gross receipts. For purposes of this section, 
gross receipts for any taxable year are reduced by returns and 
allowances made during that taxable year.
    (6) Gross receipts of consolidated groups. For purposes of this 
section, the gross receipts of a consolidated group are determined by 
aggregating the gross receipts of all of the members of the consolidated 
group. See Sec.  1.1502-59A(b).
    (e) Base erosion percentage test--(1) In general. A taxpayer, or the 
aggregate group of which the taxpayer is a member, satisfies the base 
erosion percentage test if its base erosion percentage is three percent 
or higher.
    (2) Base erosion percentage test for banks and registered securities 
dealers--(i) In general. A taxpayer that is a member of an affiliated 
group (as defined in section 1504(a)(1)) that includes a bank (as 
defined in Sec.  1.59A-1(b)(4)) or a registered securities dealer (as 
defined in section Sec.  1.59A-1(b)(15)) satisfies the base erosion 
percentage test if its base erosion percentage is two percent or higher.
    (ii) Aggregate groups. An aggregate group of which a taxpayer is a 
member and that includes a bank or a registered securities dealer that 
is a member of an affiliated group (as defined in section 1504(a)(1)) is 
subject to the base erosion percentage threshold described in paragraph 
(e)(2)(i) of this section.
    (iii) De minimis exception for banking and registered securities 
dealer activities. An aggregate group that includes a bank or a 
registered securities dealer that is a member of an affiliated group (as 
defined in section 1504(a)(1)) is not treated as including a bank or 
registered securities dealer for purposes of

[[Page 651]]

paragraph (e)(2)(i) of this section for a taxable year, if, for that 
taxable year, the total gross receipts of the aggregate group 
attributable to the bank or the registered securities dealer (or 
attributable to all of the banks and registered securities dealers in 
the group, if more than one) represent less than two percent of the 
total gross receipts of the aggregate group, as determined under 
paragraph (d) of this section. When there is no aggregate group, a 
consolidated group that includes a bank or a registered securities 
dealer is not treated as including a bank or registered securities 
dealer for purposes of paragraph (e)(2)(i) of this section for a taxable 
year, if, for that taxable year, the total gross receipts of the 
consolidated group attributable to the bank or the registered securities 
dealer (or attributable to all of the banks or registered securities 
dealers in the group, if more than one) represent less than two percent 
of the total gross receipts of the consolidated group, as determined 
under paragraph (d) of this section.
    (3) Computation of base erosion percentage--(i) In general. The 
taxpayer's base erosion percentage for any taxable year is determined by 
dividing--
    (A) The aggregate amount of the taxpayer's (or in the case of a 
taxpayer that is a member of an aggregate group, the aggregate group's) 
base erosion tax benefits (as defined in Sec.  1.59A-3(c)(1)) for the 
taxable year, by
    (B) The sum of--
    (1) The aggregate amount of the deductions (including deductions for 
base erosion tax benefits described in Sec.  1.59A-3(c)(1)(i) and base 
erosion tax benefits described in Sec.  1.59A-3(c)(1)(ii)) allowable to 
the taxpayer (or in the case of a taxpayer that is a member of an 
aggregate group, any member of the aggregate group) under chapter 1 of 
Subtitle A for the taxable year;
    (2) The base erosion tax benefits described in Sec.  1.59A-
3(c)(1)(iii) with respect to any premiums or other consideration paid or 
accrued by the taxpayer (or in the case of a taxpayer that is a member 
of an aggregate group, any member of the aggregate group) to a foreign 
related party for any reinsurance payment taken into account under 
sections 803(a)(1)(B) or 832(b)(4)(A) for the taxable year; and
    (3) Any amount paid or accrued by the taxpayer (or in the case of a 
taxpayer that is a member of an aggregate group, any member of the 
aggregate group) resulting in a reduction of gross receipts described in 
Sec.  1.59A-3(c)(1)(iv) for the taxable year.
    (ii) Certain items not taken into account in denominator. Except as 
provided in paragraph (e)(3)(viii) of this section, the amount under 
paragraph (e)(3)(i)(B) of this section is determined by not taking into 
account--
    (A) Any deduction allowed under section 172, 245A, or 250 for the 
taxable year;
    (B) Any deduction for amounts paid or accrued for services to which 
the exception described in Sec.  1.59A-3(b)(3)(i) applies;
    (C) Any deduction for qualified derivative payments that are not 
treated as base erosion payments by reason of Sec.  1.59A-3(b)(3)(ii);
    (D) Any exchange loss within the meaning of Sec.  1.988-2 from a 
section 988 transaction as described in Sec.  1.988-1(a)(1) that is not 
treated as a base erosion payment by reason of Sec.  1.59A-3(b)(3)(iv);
    (E) Any deduction for amounts paid or accrued to foreign related 
parties with respect to TLAC securities and foreign TLAC securities that 
are not treated as base erosion payments by reason of Sec.  1.59A-
3(b)(3)(v);
    (F) Any reinsurance losses incurred and claims payments described in 
Sec.  1.59A-3(b)(3)(ix); and
    (G) Any deduction not allowed in determining taxable income for the 
taxable year.
    (iii) Effect of treaties on base erosion percentage determination. 
See Sec.  1.59A-3(c)(2) and (3).
    (iv) Amounts paid or accrued between members of a consolidated 
group. See Sec.  1.1502-59A(b).
    (v) Deductions and base erosion tax benefits from partnerships. See 
Sec.  1.59A-7(b), (d), and (e).
    (vi) Mark-to-market positions. For any position with respect to 
which the taxpayer (or in the case of a taxpayer that is a member of an 
aggregate group, a member of the aggregate group) applies

[[Page 652]]

a mark-to-market method of accounting for U.S. federal income tax 
purposes, the taxpayer must determine its gain or loss with respect to 
that position for any taxable year by combining all items of income, 
gain, loss, or deduction arising with respect to the position during the 
taxable year, regardless of how each item arises (including from a 
payment, accrual, or mark) for purposes of paragraph (e)(3) of this 
section. See paragraph (f)(1) of this section (Example 1) for an 
illustration of this rule. For purposes of section 59A, a taxpayer 
computes its losses resulting from positions subject to a mark-to-market 
regime under the Internal Revenue Code based on a single mark for the 
taxable year on the earlier of the last business day of the taxpayer's 
taxable year and the disposition (whether by sale, offset, exercise, 
termination, expiration, maturity, or other means) of the position, 
regardless of how frequently a taxpayer marks to market for other 
purposes. See Sec.  1.59A-3(b)(2)(iii) for the application of this rule 
for purposes of determining the amount of base erosion payments.
    (vii) Reinsurance losses incurred and claims payments. Except as 
provided in paragraph (e)(3)(ii)(F) of this section, amounts paid for 
losses incurred (as defined in section 832(b)(5)) and claims and 
benefits under section 805(a)(1) are taken into account for purposes of 
paragraph (e)(3)(i)(B)(1) of this section.
    (viii) Certain payments that qualify for the effectively connected 
income exception and another base erosion payment exception. Subject to 
paragraph (c) of this section (transactions that occur between members 
of the taxpayer's aggregate group), a payment that qualifies for the 
effectively connected income exception described in Sec.  1.59A-
3(b)(3)(iii) and either the service cost method exception described in 
Sec.  1.59A-3(b)(3)(i), the qualified derivative payment exception 
described in Sec.  1.59A-3(b)(3)(ii), or the TLAC exception described in 
Sec.  1.59A-3(b)(3)(v) is not subject to paragraph (e)(3)(ii)(B), (C), 
or (E) of this section and those amounts are included in the denominator 
of the base erosion percentage if the foreign related party who received 
the payment is not a member of the aggregate group.
    (f) Examples. The following examples illustrate the rules of this 
section.
    (1) Example 1: Mark-to-market--(i) Facts. (A) Foreign Parent (FP) is 
a foreign corporation that owns all of the stock of domestic corporation 
(DC). FP is a foreign related party of DC under Sec.  1.59A-1(b)(12). DC 
is a registered securities dealer that does not hold any securities for 
investment. On January 1 of year 1, DC enters into two interest rate 
swaps for a term of two years, one with unrelated Customer A as the 
counterparty (position A) and one with unrelated Customer B as the 
counterparty (position B). Each of the swaps provides for semiannual 
periodic payments to be made or received on June 30 and December 31. No 
party makes any payment to any other party upon initiation of either of 
the swaps (that is, they are entered into at-the-money). DC is required 
to mark-to-market positions A and B for U.S. federal income tax 
purposes. DC is a calendar year taxpayer.
    (B) For position A in year 1, DC makes a payment of $150x on June 
30, and receives a payment of $50x on December 31. There are no other 
payments in year 1. On December 31, position A has a value to DC of 
$110x (that is, position A is in-the-money by $110x).
    (C) For position B in year 1, DC receives a payment of $120x on June 
30, and makes a payment of $30x on December 31. There are no other 
payments in year 1. On December 31, position B has a value to DC of 
($130x) (that is, position B is out-of-the-money by $130x).
    (ii) Analysis. (A) With respect to position A, based on the total 
amount of payments made and received in year 1, DC has a net deduction 
of $100x. In addition, DC has a mark-to-market gain of $110x. As 
described in paragraph (e)(3)(vi) of this section, the mark-to-market 
gain of $110x is combined with the net deduction of $100x resulting from 
the payments. Therefore, with respect to position A, DC has a gain of 
$10x, and thus has no deduction in year 1 for purposes of section 59A.
    (B) With respect to position B, based on the total amount of 
payments made and received in year 1, DC has net income of $90x. In 
addition, DC has a

[[Page 653]]

mark-to-market loss of $130x. As described in paragraph (e)(3)(vi) of 
this section, the mark-to-market loss of $130x is combined with the net 
income of $90x resulting from the payments. Therefore, with respect to 
position B, DC has a loss of $40x, and thus has a $40x deduction in year 
1 for purposes of section 59A.
    (2) Example 2: Member leaving an aggregate group--(i) Facts. Parent 
Corporation wholly owns Corporation 1 and Corporation 2. Each 
corporation is a domestic corporation and a calendar-year taxpayer that 
does not file a consolidated return. The aggregate group of Corporation 
1 includes Parent Corporation and Corporation 2. At noon on June 30, 
Year 1, Parent Corporation sells the stock of Corporation 2 to 
Corporation 3, an unrelated domestic corporation, in exchange for cash 
consideration. Before the acquisition, Corporation 3 was not a member of 
an aggregate group. Corporation 2 and Corporation 3 do not file a 
consolidated return.
    (ii) Analysis. (A) For purposes of section 59A, to determine the 
gross receipts and base erosion percentage of the aggregate group of 
Corporation 1 for calendar Year 1, Corporation 2 is treated as having a 
taxable year-end at the end of the day on June 30, Year 1, as a result 
of the sale. Corporation 2 leaves the aggregate group of Corporation 1 
and Parent Corporation at the end of the day on June 30, Year 1. The 
aggregate group of Corporation 1 takes into account only the gross 
receipts, base erosion tax benefits, and deductions of Corporation 2 
allocable to the period from January 1 to the end of the day on June 30, 
Year 1, in accordance with paragraph (c)(4)(ii) and (iii) of this 
section. The same results apply to the aggregate group of Parent 
Corporation for calendar Year 1. See paragraph (d)(1) and (2) of this 
section for the periods taken into account in determining whether the 
taxpayer or its aggregate group satisfies the gross receipts test.
    (B) For purposes of section 59A, to determine the gross receipts and 
base erosion percentage of the aggregate group of Corporation 2 for 
calendar Year 1, each of Parent Corporation, Corporation 1, and 
Corporation 3 are treated as having a taxable year-end at the end of the 
day on June 30, Year 1. Because Corporation 2 does not have a short 
taxable year, paragraph (c)(5)(i) of this section does not apply. The 
aggregate group of Corporation 2 takes into account the gross receipts, 
base erosion tax benefits, and deductions of Parent Corporation and 
Corporation 1 allocable to the period from January 1 to the end of the 
day on June 30, Year 1, and the gross receipts, base erosion tax 
benefits, and deductions of Corporation 3 allocable to the period from 
July 1 to December 31, Year 1 in accordance with paragraph (c)(4)(ii) 
and (iii) of this section. See paragraph (d)(1) and (2) of this section 
for the periods taken into account in determining whether the taxpayer 
or its aggregate group satisfies the gross receipts test.
    (2) Example 2: Member leaving an aggregate group--(i) Facts. Parent 
Corporation wholly owns Corporation 1 and Corporation 2. Each 
corporation is a domestic corporation and a calendar-year taxpayer that 
does not file a consolidated return. The aggregate group of Corporation 
1 includes Parent Corporation and Corporation 2. At noon on June 30, 
Year 1, Parent Corporation sells the stock of Corporation 2 to 
Corporation 3, an unrelated domestic corporation, in exchange for cash 
consideration. Before the acquisition, Corporation 3 was not a member of 
an aggregate group. Corporation 2 and Corporation 3 do not file a 
consolidated return.
    (ii) Analysis. (A) For purposes of section 59A, to determine the 
gross receipts and base erosion percentage of the aggregate group of 
Corporation 1 for calendar Year 1, Corporation 2 is treated as having a 
taxable year-end at the end of the day on June 30, Year 1, as a result 
of the sale. Corporation 2 leaves the aggregate group of Corporation 1 
and Parent Corporation at the end of the day on June 30, Year 1. The 
aggregate group of Corporation 1 takes into account only the gross 
receipts, base erosion tax benefits, and deductions of Corporation 2 
allocable to the period from January 1 to the end of the day on June 30, 
Year 1, in accordance with paragraph (c)(4)(ii) and (iii) of this 
section. The same results apply to the

[[Page 654]]

aggregate group of Parent Corporation for calendar Year 1. See paragraph 
(d)(1) and (2) of this section for the periods taken into account in 
determining whether the taxpayer or its aggregate group satisfies the 
gross receipts test.
    (B) For purposes of section 59A, to determine the gross receipts and 
base erosion percentage of the aggregate group of Corporation 2 for 
calendar Year 1, each of Parent Corporation, Corporation 1, and 
Corporation 3 are treated as having a taxable year-end at the end of the 
day on June 30, Year 1. Because Corporation 2 does not have a short 
taxable year, paragraph (c)(5)(i) of this section does not apply. The 
aggregate group of Corporation 2 takes into account the gross receipts, 
base erosion tax benefits, and deductions of Parent Corporation and 
Corporation 1 allocable to the period from January 1 to the end of the 
day on June 30, Year 1, and the gross receipts, base erosion tax 
benefits, and deductions of Corporation 3 allocable to the period from 
July 1 to December 31, Year 1 in accordance with paragraph (c)(4)(ii) 
and (iii) of this section. See paragraph (d)(1) and (2) of this section 
for the periods taken into account in determining whether the taxpayer 
or its aggregate group satisfies the gross receipts test.

[T.D. 9885, 84 FR 67017, Dec. 6, 2019, as amended by T.D. 9910, 85 FR 
64343, Oct. 9, 2020]



Sec.  1.59A-3  Base erosion payments and base erosion tax benefits.

    (a) Scope. This section provides definitions and related rules 
regarding base erosion payments and base erosion tax benefits. Paragraph 
(b) of this section provides definitions and rules regarding base 
erosion payments. Paragraph (c) of this section provides rules for 
determining the amount of base erosion tax benefits. Paragraph (d) of 
this section provides examples illustrating the rules described in this 
section.
    (b) Base erosion payments--(1) In general. Except as provided in 
paragraph (b)(3) of this section, a base erosion payment means--
    (i) Any amount paid or accrued by the taxpayer to a foreign related 
party of the taxpayer and with respect to which a deduction is allowable 
under chapter 1 of subtitle A of the Internal Revenue Code;
    (ii) Any amount paid or accrued by the taxpayer to a foreign related 
party of the taxpayer in connection with the acquisition of property by 
the taxpayer from the foreign related party if the character of the 
property is subject to the allowance for depreciation (or amortization 
in lieu of depreciation);
    (iii) Any premium or other consideration paid or accrued by the 
taxpayer to a foreign related party of the taxpayer for any reinsurance 
payments that are taken into account under section 803(a)(1)(B) or 
832(b)(4)(A); or
    (iv) Any amount paid or accrued by the taxpayer that results in a 
reduction of the gross receipts of the taxpayer if the amount paid or 
accrued is with respect to--
    (A) A surrogate foreign corporation, as defined in section 
59A(d)(4)(C)(i), that is a related party of the taxpayer (but only if 
the corporation first became a surrogate foreign corporation after 
November 9, 2017); or
    (B) A foreign person that is a member of the same expanded 
affiliated group, as defined in section 59A(d)(4)(C)(ii), as the 
surrogate foreign corporation.
    (2) Operating rules--(i) In general. The determination of the amount 
paid or accrued, and the identity of the payor and recipient of any 
amount paid or accrued, is made under general U.S. federal income tax 
law.
    (ii) Amounts paid or accrued in cash and other consideration. For 
purposes of paragraph (b)(1) of this section, an amount paid or accrued 
includes an amount paid or accrued using any form of consideration, 
including cash, property, stock, a partnership interest, or the 
assumption of a liability, including any exchange transaction. A 
distribution of property that is not part of an exchange (such as a 
distribution under section 301, without regard to whether section 
301(c)(1), (c)(2), or (c)(3) applies), is not received with respect to 
an amount paid or accrued and does not give rise to a base erosion 
payment. In contrast, a redemption of stock by a corporation within the 
meaning of section 317(b) (such as a redemption described in section 
302(a) or

[[Page 655]]

(d) or section 306(a)(2)), or a transaction in which there is an 
exchange for stock (such as a section 304 or section 331 transaction), 
is an amount paid or accrued by the shareholder to the corporation (or 
by the acquiring corporation to the transferor in a section 304 
transaction), without regard to the treatment of such transaction for 
U.S. federal income tax purposes. See paragraph (b)(3)(viii) of this 
section for an exception for specified nonrecognition transactions (as 
defined in paragraph (b)(3)(viii)(A) of this section).
    (iii) Transactions providing for net payments. Except as otherwise 
provided in paragraph (b)(2)(iv) of this section or as permitted by the 
Internal Revenue Code or the regulations, the amount of any base erosion 
payment is determined on a gross basis, regardless of any contractual or 
legal right to make or receive payments on a net basis. For this 
purpose, a right to make or receive payments on a net basis permits the 
parties to a transaction or series of transactions to settle obligations 
by offsetting any amounts to be paid by one party against amounts owed 
by that party to the other party. For example, any premium or other 
consideration paid or accrued by a taxpayer to a foreign related party 
for any reinsurance payments is not reduced by or netted against other 
amounts owed to the taxpayer from the foreign related party or by 
reserve adjustments or other returns.
    (iv) Amounts paid or accrued with respect to mark-to-market 
position. For any transaction with respect to which the taxpayer applies 
the mark-to-market method of accounting for U.S. federal income tax 
purposes, the rules set forth in Sec.  1.59A-2(e)(3)(vi) apply to 
determine the amount of the base erosion payment.
    (v) Coordination among categories of base erosion payments. A 
payment that does not satisfy the criteria of one category of base 
erosion payment may be a base erosion payment described in one of the 
other categories.
    (vi) Certain domestic passthrough entities--(A) In general. If a 
taxpayer pays or accrues an amount that would be a base erosion payment 
except for the fact that the payment is made to a specified domestic 
passthrough, then the taxpayer will be treated as making a base erosion 
payment to each specified foreign related party for purposes of section 
59A and Sec. Sec.  1.59A-2 through 1.59A-10. This rule has no effect on 
the taxation of the specified domestic passthrough under subchapter J or 
subchapter M of the Code (as applicable).
    (B) Amount of base erosion payment. The amount of the base erosion 
payment is equal to the lesser of the amount paid or accrued by the 
taxpayer to or for the benefit of the specified domestic passthrough and 
the amount of the deduction allowed under section 561, 651, or 661 to 
the specified domestic passthrough with respect to amounts paid, 
credited, distributed, deemed distributed, or required to be distributed 
to a specified foreign related party.
    (C) Specified domestic passthrough. For purposes of this paragraph 
(b)(2)(vi), specified domestic passthrough means:
    (1) A domestic trust that is not a grantor trust under subpart E of 
subchapter J of chapter 1 of the Code (``domestic trust'') and which 
domestic trust is allowed a deduction under section 651 or section 661 
with respect to amounts paid, credited, or required to be distributed to 
a specified foreign related party;
    (2) A real estate investment trust (as defined in Sec.  1.856-1(a)) 
that pays, or is deemed to pay, a dividend to a specified foreign 
related party for which a deduction is allowed under section 561; or
    (3) A regulated investment company (as defined in Sec.  1.851-1(a)) 
that pays, or is deemed to pay, a dividend to a specified foreign 
related party for which a deduction is allowed under section 561.
    (D) Specified foreign related party. For purposes of this paragraph 
(b)(2)(vi), specified foreign related party means, with respect to a 
specified domestic passthrough, any foreign related party of a taxpayer 
that is a direct or indirect beneficiary or shareholder of the specified 
domestic passthrough.
    (vii) Transfers of property to related taxpayers. If a taxpayer owns 
property of a character subject to the allowance for depreciation (or 
amortization in lieu of depreciation) with respect to

[[Page 656]]

which paragraph (c)(1)(ii) of this section applies, and the taxpayer 
sells, exchanges, or otherwise transfers the property to another 
taxpayer that is a member of an aggregate group that includes the 
taxpayer (taking into account Sec.  1.59A-7), any deduction for 
depreciation (or amortization in lieu of depreciation) by the transferee 
taxpayer remains subject to paragraph (c)(1)(ii) of this section to the 
same extent the amounts would have been so subject in the hands of the 
transferor. See paragraph (d)(7) of this section (Example 7) for an 
illustration of this rule.
    (viii) Reductions to determine gross income. For purposes of 
paragraphs (b)(1)(i) and (ii) of this section, any amount resulting in a 
reduction to determine gross income under section 61, including an 
amount properly treated as cost of goods sold under the Code, is not a 
base erosion payment.
    (ix) Losses recognized on the sale or transfer of property. If a 
taxpayer recognizes a loss on a sale or transfer of property to a 
foreign related party, the loss recognized with respect to the sale or 
transfer is not a deduction that would cause the payment to be treated 
as a base erosion payment under paragraph (b)(1)(i) of this section. 
However, if a taxpayer uses property to make a payment to a foreign 
related party and the payment otherwise meets the requirements of 
paragraph (b)(1) of this section, the amount of the payment that is 
treated as a base erosion payment equals the fair market value of the 
property at the time of the transfer.
    (3) Exceptions to base erosion payment. Paragraph (b)(1) of this 
section does not apply to the types of payments or accruals described in 
paragraphs (b)(3)(i) through (ix) of this section.
    (i) Certain services cost method amounts--(A) In general. Amounts 
paid or accrued by a taxpayer to a foreign related party for services 
that meet the requirements in paragraph (b)(3)(i)(B) of this section, 
but only to the extent of the total services cost of those services. 
Thus, any amount paid or accrued to a foreign related party in excess of 
the total services cost of services eligible for the services cost 
method exception (the mark-up component) remains a base erosion payment. 
For this purpose, services are an activity as defined in Sec.  1.482-
9(l)(2) performed by a foreign related party (the renderer) that 
provides a benefit as defined in Sec.  1.482-9(l)(3) to the taxpayer 
(the recipient).
    (B) Eligibility for the services cost method exception. To be 
eligible for the services cost method exception, all of the requirements 
of Sec.  1.482-9(b) must be satisfied, except that:
    (1) The requirements of Sec.  1.482-9(b)(5) do not apply for 
purposes of determining eligibility for the service cost method 
exception in this section; and
    (2) Adequate books and records must be maintained as described in 
paragraph (b)(3)(i)(C) of this section, instead of as described in Sec.  
1.482-9(b)(6).
    (C) Adequate books and records. Permanent books of account and 
records must be maintained for as long as the costs with respect to the 
services are incurred by the renderer. The books and records must be 
adequate to permit verification by the Commissioner of the amount 
charged for the services and the total services costs incurred by the 
renderer, including a description of the services in question, 
identification of the renderer and the recipient of the services, 
calculation of the amount of profit mark-up (if any) paid for the 
services, and sufficient documentation to allow verification of the 
methods used to allocate and apportion the costs to the services in 
question in accordance with Sec.  1.482-9(k). For example, where a 
renderer incurs costs that are attributable to performing a service for 
the taxpayer that includes services eligible for the services cost 
method exception under this section (regardless of whether the taxpayer 
determined its payments for those services based on the services cost 
method) and another service that is not eligible for the services cost 
method exception, books and records must be maintained that show, among 
other things: the total amount of costs that are attributable to each of 
those services, the method chosen under Sec.  1.482-9(k) to apportion 
the costs between the service eligible for the services cost method 
under this section and the other service, and the application of that 
method in calculating the amount eligible for the services cost method 
exception. This paragraph

[[Page 657]]

(b)(3)(i)(C) does not affect the recordkeeping requirements imposed by 
any other provision, including Sec.  1.6001-1.
    (D) Total services cost. For purposes of this section, total 
services cost has the same meaning as total services costs in Sec.  
1.482-9(j).
    (ii) Qualified derivative payments. Any qualified derivative payment 
as described in Sec.  1.59A-6.
    (iii) Effectively connected income--(A) In general. Except as 
provided in paragraph (b)(3)(iii)(B) of this section, amounts paid or 
accrued to a foreign related party that are subject to U.S. federal 
income taxation as income that is, or is treated as, effectively 
connected with the conduct of a trade or business in the United States 
under an applicable provision of the Internal Revenue Code or 
regulations. Paragraph (b)(3)(iii) of this section applies only if the 
taxpayer receives a withholding certificate on which the foreign related 
party claims an exemption from withholding under section 1441 or 1442 
because the amounts are effectively connected income.
    (B) Application to certain treaty residents. If a foreign related 
party determines its taxable income pursuant to the business profits 
provisions of an applicable income tax treaty, amounts paid or accrued 
to the foreign related party that are taken into account in determining 
its taxable income.
    (C) Application to partnerships. To the extent that paragraph 
(b)(3)(iii)(A) or (B) of this section would apply to a payment or 
accrual made directly by a taxpayer to a foreign related party, 
paragraph (b)(3)(iii)(A) or (B) of this section apply to an amount 
treated as paid or accrued by a taxpayer to a foreign related party 
under Sec.  1.59A-7(b) or (c) (generally applying aggregate principles 
to treat partnership transactions as partner-level transactions for 
purposes of section 59A). The certification requirement in paragraph 
(b)(3)(iii)(A) of this section is met if the taxpayer receives a written 
statement from the foreign related party that is comparable to the 
certification provided in paragraph (b)(3)(iii)(A) of this section but 
based on the deemed transaction under Sec.  1.59A-7(b) or (c) and the 
extent to which paragraph (b)(3)(iii)(A) or (B) of this section would 
have applied to that deemed transaction. The taxpayer may rely on the 
written statement unless it has reason to know or actual knowledge that 
the statement is incorrect.
    (iv) Exchange loss on a section 988 transaction. Any exchange loss 
within the meaning of Sec.  1.988-2 from a section 988 transaction 
described in Sec.  1.988-1(a)(1) that is an allowable deduction and that 
results from a payment or accrual by the taxpayer to a foreign related 
party.
    (v) Amounts paid or accrued with respect to TLAC securities and 
foreign TLAC securities--(A) In general. Except as provided in paragraph 
(b)(3)(v)(B) and (F) of this section, amounts paid or accrued to foreign 
related parties with respect to TLAC securities and foreign TLAC 
securities.
    (B) Limitation on exclusion for TLAC securities. The amount excluded 
under paragraph (b)(3)(v)(A) of this section is no greater than the 
product of the scaling ratio and amounts paid or accrued to foreign 
related parties with respect to TLAC securities for which a deduction is 
allowed.
    (C) Scaling ratio. For purposes of this paragraph (b)(3)(v), the 
scaling ratio for a taxable year of a taxpayer is a fraction the 
numerator of which is 115 percent of the average TLAC long-term debt 
required amount and the denominator of which is the average TLAC 
securities amount. The scaling ratio may in no event be greater than 
one.
    (D) Average TLAC securities amount. The average TLAC securities 
amount for a taxable year is the average of the TLAC securities amounts 
for the year, computed at regular time intervals in accordance with this 
paragraph. The TLAC securities amount used in calculating the average 
TLAC securities amount is computed on a monthly basis.
    (E) Average TLAC long-term debt required amount. The average TLAC 
long-term debt required amount for a taxable year is the average of the 
TLAC long-term debt required amounts, computed on a monthly basis.
    (F) Limitation on exclusion for foreign TLAC securities--(1) In 
general. The amount excluded under paragraph (b)(3)(v)(A) of this 
section for foreign

[[Page 658]]

TLAC securities is limited to the extent that interest deducted by a 
U.S. trade or business or permanent establishment with respect to 
foreign TLAC securities exceeds the interest expense associated with the 
foreign TLAC long-term debt required amount, applying the scaling ratio 
principles set forth under paragraphs (b)(3)(v)(B) through (E) of this 
section.
    (2) Foreign TLAC long-term debt required amount. For purposes of 
paragraph (b)(3)(v) of this section, the term foreign TLAC long-term 
debt required amount means in the case of a trade or business or a 
permanent establishment in the United States, the lesser of--
    (i) The specified minimum amount of debt, if any, required pursuant 
to a bank regulatory requirement imposed under the laws or regulations 
of a foreign country that are comparable to 12 CFR 252.160-167; or
    (ii) The specified minimum amount of debt, if any, that would be 
required pursuant to 12 CFR 252.162(a) if the trade or business or 
permanent establishment were a U.S. person (as determined under Federal 
Reserve regulations).
    (3) No specified minimum provided by local law. For purposes of 
paragraph (b)(3)(v)(F)(2)(ii) of this section, if the bank regulatory 
requirements imposed under the laws or regulations of a foreign country 
do not specify a minimum amount, the limitation for purposes of 
paragraph (b)(3)(v)(F)(2) of this section is determined by reference 
solely to paragraph (b)(3)(v)(F)(2)(ii) of this section.
    (4) Foreign TLAC security. For purposes of paragraph (b)(3)(v) of 
this section, the term foreign TLAC security means an internal debt 
security issued under a bank regulatory requirement imposed under the 
laws or regulations of a foreign country that is comparable to 12 CFR 
252.160-167. The laws or regulations of a foreign country are comparable 
to 12 CFR 252.160-167 if the requirement is imposed by a Financial 
Stability Board member state and those laws or regulations are 
substantially consistent with TLAC standards of the Financial Stability 
Board.
    (vi) Amounts paid or accrued in taxable years beginning before 
January 1, 2018. Any amount paid or accrued in taxable years beginning 
before January 1, 2018.
    (vii) Business interest carried forward from taxable years beginning 
before January 1, 2018. Any disallowed business interest described in 
section 163(j)(2) that is carried forward from a taxable year beginning 
before January 1, 2018.
    (viii) Specified nonrecognition transactions--(A) In general. 
Subject to paragraph (b)(3)(viii)(B) and (C) of this section, any amount 
transferred to, or exchanged with, a foreign related party pursuant to a 
transaction to which sections 332, 351, 355, or 368 apply (``specified 
nonrecognition transaction''). See Sec.  1.59A-9(b)(4) for anti-abuse 
rules.
    (B) Other property transferred to a foreign related party in a 
specified nonrecognition transaction. If a taxpayer transfers other 
property (as defined in paragraph (b)(3)(viii)(D) of this section) to a 
foreign related party pursuant to a specified nonrecognition 
transaction, the other property is treated as an amount paid or accrued 
to which paragraph (b)(3) of this section does not apply, regardless of 
whether gain is recognized on the transaction.
    (C) Other property received from a foreign related party in certain 
specified nonrecognition transactions. If, in a transaction described in 
section 351, 355, or 368, the taxpayer transfers property and receives 
other property (as defined in paragraph (b)(3)(viii)(D) of this section) 
from a foreign related party, the property transferred by the taxpayer 
is treated as an amount paid or accrued to which paragraph (b)(3) of 
this section does not apply, regardless of whether gain is recognized on 
the transaction.
    (D) Definition of other property. Solely for purposes of this 
paragraph (b)(3)(viii), the term other property has the meaning of the 
phrase ``other property or money'' as used in section 351(b), with 
respect to a transaction to which section 351 applies, and as used in 
sections 356(a)(1)(B) and 361(b), with respect to a transaction to which 
sections 355 or 368 apply, as applicable, including liabilities treated 
as money under section 357(b). However, the term other property does not 
include the sum of any money and the fair market value of any other 
property to which section 361(b)(3) applies. The term other

[[Page 659]]

property also includes liabilities that are assumed by the taxpayer in 
the specified nonrecognition transaction, but only to the extent of the 
amount of gain recognized under section 357(c).
    (E) Allocation of other property. Other property is treated as 
exchanged for property in a specified nonrecognition transaction in a 
manner consistent with U.S. federal income tax law. For purposes making 
the allocation under this paragraph (b)(3)(viii)(E), liabilities 
described in paragraph (b)(3)(viii)(D) of this section are treated as 
money received.
    (ix) Reinsurance losses incurred and claims payments--(A) In 
general. Any amounts paid by a taxpayer subject to tax under subchapter 
L to a foreign related party that is a regulated insurance company under 
a reinsurance contract between the taxpayer and the regulated foreign 
insurance company for losses incurred (as defined in section 832(b)(5)) 
and claims and benefits under section 805(a)(1), to the extent that the 
amounts paid or accrued are properly allocable to amounts required to be 
paid by the regulated foreign insurance company (or indirectly through 
another regulated foreign insurance company), pursuant to an insurance, 
annuity, or reinsurance contract, to a person other than a related 
party. For purposes of this paragraph (b)(3)(ix), the determination of 
whether a contract is an insurance contract or an annuity contract is 
made without regard to sections 72(s), 101(f), 817(h), and 7702, 
provided that the contract is regulated as a life insurance or annuity 
contract in its jurisdiction of issuance and no policyholder, insured, 
annuitant or beneficiary with respect to the contract is a United States 
person.
    (B) Regulated foreign insurance company. The term regulated foreign 
insurance company means any foreign corporation which--
    (1) Is subject to regulation as an insurance (or reinsurance) 
company by the country in which the corporation is created, organized, 
or maintains its registered office, and is licensed, authorized, or 
regulated by the applicable insurance regulatory body for that country 
to sell insurance, annuity, or reinsurance contracts to persons other 
than related parties in that country, and
    (2) Would be subject to tax under subchapter L if it were a domestic 
corporation.
    (4) Rules for determining the amount of certain base erosion 
payments. The following rules apply in determining the amount that is a 
base erosion payment.
    (i) Interest expense allocable to a foreign corporation's 
effectively connected income--(A) Methods described in Sec.  1.882-5. A 
foreign corporation that has interest expense allocable under section 
882(c) to income that is, or is treated as, effectively connected with 
the conduct of a trade or business within the United States applying the 
method described in Sec.  1.882-5(b) through (d) or the method described 
in Sec.  1.882-5(e) has base erosion payments under paragraph (b)(1)(i) 
of this section for the taxable year equal to the sum of--
    (1) The interest expense on a liability described in Sec.  1.882-
5(a)(1)(ii)(A) or (B) (direct allocations) that is paid or accrued by 
the foreign corporation to a foreign related party;
    (2) The interest expense on U.S.-booked liabilities, as described in 
Sec.  1.882-5(d)(2), determined by taking into account paragraph 
(b)(4)(i)(B) of this section, that is paid or accrued by the foreign 
corporation to a foreign related party; and
    (3) The interest expense on U.S.-connected liabilities, as described 
in Sec.  1.882-5(d) or 1.882-5(e), in excess of interest expense on 
U.S.-booked liabilities as described in Sec.  1.882-5(d)(2), if any 
(hereafter, excess U.S.-connected liabilities), multiplied by a 
fraction, the numerator of which is the foreign corporation's average 
worldwide interest expense due to a foreign related party, and the 
denominator of which is the foreign corporation's average total 
worldwide interest expense. The numerator and denominator of this 
fraction are determined by translating interest expense into the 
functional currency of the foreign corporation using any reasonable 
method, consistently applied. Any interest expense that is interest 
expense on a U.S.-booked liability or is subject to a direct allocation 
is excluded from both the numerator and the denominator of the fraction.

[[Page 660]]

    (B) U.S.-booked liabilities determination. For purposes of paragraph 
(b)(4)(i)(A) of this section, the determination of the interest expense 
on U.S.-booked liabilities, as described in Sec.  1.882-5(d)(2), is made 
without regard to whether the foreign corporation applies the method 
described in Sec.  1.882-5(b) through (d) or the method described in 
Sec.  1.882-5(e) for purposes of determining interest expense.
    (C) U.S.-booked liabilities in excess of U.S.-connected liabilities. 
For purposes of paragraph (b)(4)(i)(A)(2) of this section, if a foreign 
corporation has U.S.-booked liabilities, as described in Sec.  1.882-
5(d)(2), in excess of U.S.-connected liabilities, as described in Sec.  
1.882-5(d) or Sec.  1.882-5(e), the foreign corporation applies the 
scaling ratio pro-rata to all interest expense on U.S.-booked 
liabilities consistent with Sec.  1.882-5(d)(4) for purposes of 
determining the amount of allocable interest expense on U.S.-booked 
liabilities that is a base erosion payment. This paragraph (b)(4)(i)(C) 
applies without regard to whether the foreign corporation applies the 
method described in Sec.  1.882-5(b) through (d) or the method described 
in Sec.  1.882-5(e) for purposes of determining its interest expense.
    (D) Election to use financial statements. A foreign corporation may 
elect to calculate the fraction described in paragraph (b)(4)(i)(A)(3) 
of this section on the basis of its applicable financial statement 
rather than U.S. tax principles. For purposes of this section, an 
applicable financial statement has the meaning provided in section 
451(b)(3). The applicable financial statement must be the applicable 
financial statement of the foreign corporation, not a consolidated 
applicable financial statement. A foreign corporation makes this 
election in accordance with the requirements of Form 8991 (or 
successor).
    (E) Coordination with certain tax treaties--(1) In general. If a 
foreign corporation elects to determine its taxable income pursuant to 
business profits provisions of an income tax treaty rather than 
provisions of the Internal Revenue Code, or the regulations published 
under 26 CFR chapter I, for determining effectively connected income, 
and the foreign corporation does not apply Sec.  1.882-5 to allocate 
interest expense to a permanent establishment, then paragraph 
(b)(4)(i)(A) through (D) of this section applies to determine the amount 
of hypothetical Sec.  1.882-5 interest expense that is a base erosion 
payment under paragraph (b)(1) of this section. Interest expense allowed 
to the permanent establishment in excess of the hypothetical Sec.  
1.882-5 interest expense, if any, is treated as an amount paid or 
accrued by the permanent establishment to the foreign corporation's home 
office or to another branch of the foreign corporation and is a base 
erosion payment to the extent that the payment or accrual is described 
under paragraph (b)(1) of this section.
    (2) Hypothetical Sec.  1.882-5 interest expense defined. The 
hypothetical Sec.  1.882-5 interest expense is equal to the amount of 
interest expense that would have been allocable under section 882(c) to 
income that is, or is treated as, effectively connected with the conduct 
of a trade or business within the United States if the foreign 
corporation determined interest expense in accordance with section Sec.  
1.882-5. However, the hypothetical Sec.  1.882-5 interest expense shall 
not exceed the amount of interest expense allowed to the permanent 
establishment.
    (3) Consistency requirement. For purposes of determining the amount 
described in paragraph (b)(4)(i)(E)(2) of this section and applying 
paragraph (b)(4)(i)(A) through (D) of this section, the elections of 
Sec.  1.882-5 must be applied consistently and are subject to the rules 
and limitations of Sec.  1.882-5, including limitations on the time 
period in which an election may be made or revoked. If a foreign 
corporation otherwise meets the requirements for making or revoking an 
election under Sec.  1.882-5, then solely for purposes of this section, 
the foreign corporation is treated as making or revoking the election in 
accordance with the requirements of Form 8991 (or successor) and its 
instructions.
    (F) Coordination with exception for foreign TLAC securities. For 
purposes of paragraph (b)(4)(i)(A) of this section, amounts paid or 
accrued to a foreign related party with respect to securities that are 
eligible for the foreign TLAC exception in paragraph (b)(3)(v) of this

[[Page 661]]

section are not treated as paid to a foreign related party.
    (ii) Other deductions allowed with respect to effectively connected 
income. A deduction allowed under Sec.  1.882-4 for an amount paid or 
accrued by a foreign corporation to a foreign related party (including a 
deduction for an amount apportioned in part to effectively connected 
income and in part to income that is not effectively connected income) 
is a base erosion payment under paragraph (b)(1) of this section.
    (iii) Depreciable property. Any amount paid or accrued by a foreign 
corporation to a foreign related party of the taxpayer in connection 
with the acquisition of property by the foreign corporation from the 
foreign related party if the character of the property is subject to the 
allowance for depreciation (or amortization in lieu of depreciation) is 
a base erosion payment to the extent the property so acquired is used, 
or held for use, in the conduct of a trade or business within the United 
States.
    (iv) Coordination with ECI exception. For purposes of paragraph 
(b)(4) of this section, amounts paid or accrued to a foreign related 
party treated as effectively connected income (or, in the case of a 
foreign related party that determines taxable income pursuant to the 
business profits provisions of an applicable income tax treaty, such 
amounts that are taken into account in determining taxable income) are 
not treated as paid to a foreign related party.
    (v) Coordination with certain tax treaties--(A) Allocable expenses. 
Except as provided in paragraph (b)(4)(i)(E) of this section with 
respect to interest, if a foreign corporation determines its taxable 
income on a net basis pursuant to an applicable income tax treaty rather 
than provisions of the Internal Revenue Code, or the regulations 
published under 26 CFR chapter I, for determining effectively connected 
income, then the foreign corporation must determine whether each 
allowable deduction is a base erosion payment under paragraph (b)(1) of 
this section.
    (B) Internal dealings under certain income tax treaties. Except as 
provided in paragraph (b)(4)(i)(E) of this section with respect to 
interest, if, pursuant to the terms of an applicable income tax treaty, 
a foreign corporation determines the profits attributable to a permanent 
establishment based on the assets used, risks assumed, and functions 
performed by the permanent establishment, then any deduction 
attributable to any amount paid or accrued (or treated as paid or 
accrued) by the permanent establishment to the foreign corporation's 
home office or to another branch of the foreign corporation (an 
``internal dealing'') is a base erosion payment to the extent that the 
payment or accrual is described under paragraph (b)(1) of this section.
    (vi) Business interest expense arising in taxable years beginning 
after December 31, 2017. Any disallowed business interest expense 
described in section 163(j)(2) that resulted from a payment or accrual 
to a foreign related party that first arose in a taxable year beginning 
after December 31, 2017, is treated as a base erosion payment under 
paragraph (b)(1)(i) of this section in the year that the business 
interest expense initially arose. See paragraph (c)(4) of this section 
for rules that apply when business interest expense is limited under 
section 163(j)(1) in order to determine whether the disallowed business 
interest is attributed to business interest expense paid to a person 
that is not a related party, a foreign related party, or a domestic 
related party.
    (c) Base erosion tax benefit--(1) In general. Except as provided in 
paragraph (c)(2) of this section, a base erosion tax benefit means:
    (i) In the case of a base erosion payment described in paragraph 
(b)(1)(i) of this section, any deduction that is allowed under chapter 1 
of subtitle A of the Internal Revenue Code for the taxable year with 
respect to that base erosion payment;
    (ii) In the case of a base erosion payment described in paragraph 
(b)(1)(ii) of this section, any deduction allowed under chapter 1 of 
subtitle A of the Internal Revenue Code for the taxable year for 
depreciation (or amortization in lieu of depreciation) with respect to 
the property acquired with that payment;
    (iii) In the case of a base erosion payment described in paragraph 
(b)(1)(iii)

[[Page 662]]

of this section, any reduction under section 803(a)(1)(B) in the gross 
amount of premiums and other consideration on insurance and annuity 
contracts for premiums and other consideration arising out of indemnity 
reinsurance, or any deduction under section 832(b)(4)(A) from the amount 
of gross premiums written on insurance contracts during the taxable year 
for premiums paid for reinsurance; or
    (iv) In the case of a base erosion payment described in paragraph 
(b)(1)(iv) of this section, any reduction in gross receipts with respect 
to the payment in computing gross income of the taxpayer for the taxable 
year for purposes of chapter 1 of subtitle A of the Internal Revenue 
Code.
    (2) Exception to base erosion tax benefit--(i) In general. Except as 
provided in paragraph (c)(3) of this section, any base erosion tax 
benefit attributable to any base erosion payment is not taken into 
account as a base erosion tax benefit if tax is imposed on that payment 
under section 871 or 881, and the tax has been deducted and withheld 
under section 1441 or 1442. If a payment is taken into account for 
purposes of the fraction described in paragraph (b)(4)(i)(A)(3) of this 
section, and tax is imposed on the payment under section 871 or 881, and 
the tax has been deducted and withheld under section 1441 or 1442, the 
payment is treated as not paid or accrued to a foreign related party.
    (ii) Branch-level interest tax. Except as provided in paragraph 
(c)(3) of this section, any base erosion tax benefit of a foreign 
corporation attributable to any base erosion payment determined under 
paragraph (b)(4)(i)(A)(3) of this section or attributable to interest 
expense in excess of the hypothetical section 1.882-5 interest expense 
determined under paragraph (b)(4)(i)(E)(1) of this section is not taken 
into account as a base erosion tax benefit to the extent of the amount 
of excess interest, as defined in Sec.  1.884-4(a)(2), if any, on which 
tax is imposed on the foreign corporation under section 884(f) and Sec.  
1.884-4, if the tax is properly reported on the foreign corporation's 
income tax return and paid in accordance with Sec.  1.884-4(a)(2)(iv).
    (3) Effect of treaty on base erosion tax benefit. If any treaty 
between the United States and any foreign country reduces the rate of 
tax imposed by section 871 or 881, the amount of base erosion tax 
benefit that is not taken into account under paragraph (c)(2) of this 
section is equal to the amount of the base erosion tax benefit before 
the application of paragraph (c)(2) of this section multiplied by a 
fraction of--
    (i) The rate of tax imposed under the treaty; over
    (ii) The rate of tax imposed without regard to the treaty.
    (4) Application of section 163(j) to base erosion payments--(i) 
Classification of payments or accruals of business interest expense 
based on the payee. The following rules apply for corporations and 
partnerships:
    (A) Classification of payments or accruals of business interest 
expense of a corporation. For purposes of this section, in the year that 
business interest expense of a corporation is paid or accrued the 
business interest expense is classified as foreign related business 
interest expense, domestic related business interest expense, or 
unrelated business interest expense.
    (B) Classification of payments or accruals of business interest 
expense by a partnership. For purposes of this section, in the year that 
business interest expense of a partnership is paid or accrued, the 
business interest expense that is allocated to a partner is classified 
separately with respect to each partner in the partnership as foreign 
related business interest expense, domestic related business interest 
expense, or unrelated business interest expense.
    (C) Classification of payments or accruals of business interest 
expense paid or accrued to a foreign related party that is subject to an 
exception--(1) ECI exception. For purposes of paragraph (c)(4)(i)(A) and 
(B) of this section, business interest expense paid or accrued to a 
foreign related party to which the exception in paragraph (b)(3)(iii) of 
this section (effectively connected income) applies is classified as 
domestic related business interest expense.
    (2) TLAC interest and interest subject to withholding tax. For 
purposes of paragraph (c)(4)(i)(A) and (B) of this section, if the 
exception in paragraph

[[Page 663]]

(b)(3)(v) of this section (TLAC securities) or paragraph (c)(2) or (3) 
of this section (withholding tax) applies to business interest expense 
paid or accrued to a foreign related party, that business interest 
expense remains classified as foreign related business interest expense, 
and retains its classification as eligible for those exceptions, on a 
pro-rata basis with other foreign related business interest expense.
    (ii) Ordering rules for business interest expense that is limited 
under section 163(j)(1) to determine which classifications of business 
interest expense are deducted and which classifications of business 
interest expense are carried forward--(A) In general. Section 163(j) and 
the regulations published under 26 CFR chapter I provide a limitation on 
the amount of business interest expense allowed as a deduction in a 
taxable year by a corporation or a partner in a partnership. In the case 
of a corporation with a disallowed business interest expense 
carryforward, the regulations under section 163(j) determine the 
ordering of the business interest expense deduction that is allowed on a 
year-by-year basis by reference first to business interest expense 
incurred in the current taxable year and then to disallowed business 
interest expense carryforwards from prior years. To determine the amount 
of base erosion tax benefit under paragraph (c)(1) of this section, this 
paragraph (c)(4)(ii) sets forth ordering rules that determine the amount 
of the deduction of business interest expense allowed under section 
163(j) that is classified as paid or accrued to a foreign related party 
for purposes of paragraph (c)(1)(i) of this section. This paragraph 
(c)(4)(ii) also sets forth similar ordering rules that apply to 
disallowed business interest expense carryforwards for which a deduction 
is permitted under section 163(j) in a later year.
    (B) Ordering rules for treating business interest expense deduction 
and disallowed business interest expense carryforwards as foreign 
related business interest expense, domestic related business interest 
expense, and unrelated business interest expense--(1) General ordering 
rule for allocating business interest expense deduction between 
classifications. For purposes of paragraph (c)(1) of this section, if a 
deduction for business interest expense is not subject to the limitation 
under section 163(j)(1) in a taxable year, the deduction is treated 
first as foreign related business interest expense and domestic related 
business interest expense (on a pro-rata basis), and second as unrelated 
business interest expense. The same principle applies to business 
interest expense of a partnership that is deductible at the partner 
level under Sec.  1.163(j)-6(f).
    (2) Ordering of business interest expense incurred by a corporation. 
If a corporation's business interest expense deduction allowed for any 
taxable year is attributable to business interest expense paid or 
accrued in that taxable year and to disallowed business interest expense 
carryforwards from prior taxable years, the ordering of business 
interest expense deduction provided in paragraph (c)(4)(ii)(B)(1) of 
this section among the classifications described therein applies 
separately for the carryforward amount from each taxable year, following 
the ordering set forth in Sec.  1.163(j)-5(b)(2). Corresponding 
adjustments to the classification of disallowed business interest 
expense carryforwards are made consistent with this year-by-year 
approach. For purposes of section 59A and this section, an acquiring 
corporation in a transaction described in section 381(a) will succeed to 
and take into account the classification of any disallowed business 
interest expense carryforward. See Sec.  1.381(c)(20)-1.
    (3) Ordering of business interest expense incurred by a partnership 
and allocated to a corporate partner. For a corporate partner in a 
partnership that is allocated a business interest expense deduction 
under Sec.  1.163(j)-6(f), the ordering rule provided in paragraph 
(c)(4)(ii)(B)(1) of this section applies separately to the corporate 
partner's allocated business interest expense deduction from the 
partnership; that deduction is not comingled with the business interest 
expense deduction addressed in paragraph (c)(4)(ii)(B)(1) or (2) of this 
section or the corporate partner's items from any other partnership. 
Similarly, when a corporate partner in a partnership is allocated excess 
business interest expense from a partnership under the rules set forth 
in

[[Page 664]]

Sec.  1.163(j)-6(f) and the excess interest expense becomes deductible 
to the corporate partner, that partner applies the ordering rule 
provided in paragraph (c)(4)(ii)(B)(1) of this section separately to 
that excess interest expense on a year-by-year basis. Corresponding 
adjustments to the classification of disallowed business interest 
expense carryforwards are made consistent with this year-by-year and 
partnership-by-partnership approach.
    (5) Allowed deduction. Solely for purposes of paragraph (c)(1) of 
this section, all deductions (and any premium or other consideration 
paid or accrued by the taxpayer for any reinsurance payments that are 
taken into account under section 803(a)(1)(B) or 832(b)(4)(A)) that 
could be properly claimed by a taxpayer for the taxable year (determined 
after giving effect to the taxpayer's permissible method of accounting 
and to any election, such as the election under section 173 to 
capitalize circulation expenditures or the election under section 
168(g)(7) to use the alternative depreciation system of depreciation) 
are treated as allowed deductions under chapter 1 of subtitle A of the 
Internal Revenue Code.
    (6) Election to waive allowed deductions--(i) In general. If a 
taxpayer elects to waive certain deductions, in whole or in part, 
pursuant to this paragraph (c)(6)(i), the amount of allowed deductions 
as described in paragraph (c)(5) of this section is reduced by the 
amounts that are properly waived. In order to make the election or 
increase the amount of the deduction waived, the taxpayer must determine 
that it could satisfy the requirements of Sec.  1.59A-2(b) absent the 
election to waive certain deductions. For rules applicable to partners 
and partnerships, see paragraph (c)(6)(iv) of this section. For rules 
addressing waiver of premium or other consideration paid or accrued by a 
taxpayer for any reinsurance payments that are taken into account under 
section 803(a)(1)(B) or 832(b)(4)(A), see paragraph (c)(6)(v) of this 
section.
    (ii) Time and manner for election to waive deduction--(A) In 
general. A taxpayer may make the election described in paragraph 
(c)(6)(i) of this section on its original filed Federal income tax 
return. In addition, a taxpayer may elect to waive deductions or 
increase the amount of deductions waived pursuant to the election 
described in paragraph (c)(6)(i) of this section on an amended Federal 
income tax return filed within the later of three years from the date 
the original return was filed, taking into account section 6501(b)(1), 
for the taxable year for which the election is made or the period 
described in section 6501(c)(4), or during the course of an examination 
of the taxpayer's income tax return for the relevant taxable year 
pursuant to procedures prescribed by the Commissioner. However, a 
taxpayer may not decrease the amount of deductions waived by the 
election, or otherwise revoke the election that is described in 
paragraph (c)(6)(i) of this section on any amended Federal income tax 
return or during the course of an examination. To make the election, a 
taxpayer must complete the appropriate part of Form 8991, Tax on Base 
Erosion Payments of Taxpayers With Substantial Gross Receipts (or 
successor), including the information described in paragraph 
(c)(6)(ii)(B) of this section and any other information required by the 
form or instructions. A taxpayer makes the election described in 
paragraph (c)(6)(i) of this section on an annual basis, and the taxpayer 
does not need the consent of the Commissioner if the taxpayer chooses 
not to make the election for a subsequent taxable year. The election 
described in paragraph (c)(6)(i) of this section may not be made in any 
other manner than as described in this paragraph (c)(6)(ii) (for 
example, by filing an application for a change in accounting method).
    (B) Information required to make the election to waive allowed 
deductions. To make this election, a taxpayer must maintain 
contemporaneous documentation and provide information related to each 
deduction waived as required by applicable forms and instructions issued 
by the Commissioner, including--
    (1) A description of the item or property to which the deduction 
relates, including sufficient information to identify that item or 
property on the taxpayer's books and records;
    (2) The date on which, or period in which, the waived deduction was 
paid or accrued;

[[Page 665]]

    (3) The provision of the Internal Revenue Code (and regulations, as 
applicable) that allows the deduction for the item or property to which 
the election relates;
    (4) The amount of the deduction that is claimed for the taxable year 
with respect to the item or property;
    (5) The amount of the deduction being waived for the taxable year 
with respect to the item or property;
    (6) A description of where the deduction is reflected (or would have 
been reflected) on the Federal income tax return (such as a line 
number); and
    (7) The name, Taxpayer Identification Number (or, if the foreign 
person does not have a Taxpayer Identification Number, the foreign 
equivalent), and country of organization of the foreign related party 
that is or will be the recipient of the payment that generates the 
deduction.
    (iii) Effect of election to waive deduction--(A) In general--(1) 
Consistent treatment. Except as otherwise provided in this paragraph 
(c)(6)(iii), any deduction waived under paragraph (c)(6)(i) of this 
section is treated as having been waived for all purposes of the 
Internal Revenue Code and regulations.
    (2) No allocation and apportionment of waived deductions. The waiver 
of deductions described in paragraph (c)(6)(i) of this section is 
treated as occurring before the allocation and apportionment of 
deductions under Sec. Sec.  1.861-8 through 1.861-14T and 1.861-17 (such 
as for purposes of section 904).
    (3) Effect of waiver of deductions described in Sec. Sec.  1.861-10 
and 1.861-10T. To the extent that any waived deduction is interest 
expense that would have been directly allocated under the rules of Sec.  
1.861-10 or 1.861-10T and would have resulted in the reduction of value 
of any assets for purposes of allocating other interest expense under 
Sec. Sec.  1.861-9 and 1.861-9T, the value of the assets is reduced to 
the same extent as if the taxpayer had not elected to waive the 
deduction.
    (4) Effect of the election to waive deductions on the stock basis of 
a consolidated group member. For purposes of Sec.  1.1502-32, any 
deduction waived under paragraph (c)(6)(i) of this section is a 
noncapital, nondeductible expense under Sec.  1.1502-32(b)(2)(iii).
    (B) Effect of the election to waive deductions disregarded for 
certain purposes. If a taxpayer makes the election to waive a deduction, 
in whole or in part, under paragraph (c)(6)(i) of this section, the 
election is disregarded for determining--
    (1) The taxpayer's overall method of accounting, or the taxpayer's 
method of accounting for any item, under section 446;
    (2) Whether a change in the taxpayer's overall plan of accounting or 
the taxpayer's treatment of a material item is a change in method of 
accounting under section 446(e) and Sec.  1.446-1(e);
    (3) The amount allowable under subtitle A of the Internal Revenue 
Code for depreciation or amortization for purposes of section 167(c) and 
section 1016(a)(2) or section 1016(a)(3) and any other adjustment to 
basis under section 1016(a);
    (4) For purposes of applying the exclusive apportionment rule in 
Sec.  1.861-17(b), the geographic source where the research and 
experimental activities which account for more than fifty percent of the 
amount of the deduction for research and experimentation was performed;
    (5) The application of section 482;
    (6) The amount of the taxpayer's earnings and profits; and
    (7) Any other item as necessary to prevent a taxpayer from receiving 
the benefit of a waived deduction.
    (C) Not a method of accounting. The election described in paragraph 
(c)(6)(i) of this section is not a method of accounting under section 
446.
    (D) Effect of the election in determining section 481(a) 
adjustments. A taxpayer making the election described in paragraph 
(c)(6)(i) of this section agrees that if the method of accounting for a 
waived deduction is changed, the amount of adjustment taken into account 
under section 481(a)(2) is determined without regard to the election 
described in paragraph (c)(6)(i) of this section. As a result, a waived 
deduction has no effect on the amount of a section 481(a) adjustment 
compared to what the adjustment would have been if the deduction had not 
been waived. See paragraph (d)(9) of this section (Example 9).

[[Page 666]]

    (iv) Rules applicable to partners and partnerships--(A) In general. 
Except as provided in paragraph (c)(6)(iv)(D) of this section, 
deductions allocated to a corporate partner by a partnership may only be 
waived by the partner and not by the partnership, and then only to the 
extent the partner otherwise qualifies for the waiver under paragraph 
(c)(6) of this section. For purposes of complying with the documentation 
requirements in paragraph (c)(6)(ii)(B) of this section, the partner is 
not required to report the information in paragraphs (c)(6)(ii)(B)(2) 
and (3) of this section, and in lieu of reporting the information in 
paragraphs (c)(6)(ii)(B)(1) of this section, the partner is required to 
report the partnership from which the item is allocated.
    (B) Rule for determining the adjusted basis of a partner's interest 
in a partnership. If a partner elects to waive a deduction or increases 
the amount of deduction waived with respect to deductions allocated to 
it by a partnership, the partner treats the waived amount as a 
nondeductible expenditure under section 705(a)(2)(B).
    (C) Rule for applying section 163(j). If a partner waives a 
deduction pursuant to paragraph (c)(6)(iv)(A) of this section that was 
taken into account by the partnership in determining the partnership's 
adjusted taxable income for purposes of section 163(j), then the 
increase in the partner's income resulting from the waiver is treated by 
the partner (but not the partnership) as a partner basis item (as 
defined in Sec.  1.163(j)-6(b)(2)) for purposes of section 163(j).
    (D) Limited application of election to waive deductions with respect 
to adjustments made pursuant to audit procedures under sections 6221 
through 6241. Except as provided in this paragraph (c)(6)(iv)(D), a 
partner is not permitted to waive any adjustment by the Secretary to any 
partnership-related items that is made pursuant to subchapter C of 
chapter 63. A partner in a partnership subject to subchapter C of 
chapter 63 may only make an election to waive any increase in a 
deduction due to an adjustment made under subchapter C of chapter 63 
that the partner takes into account under section 6225(c)(2)(A), 6226, 
or 6227 in a manner consistent with paragraph (c)(6) of this section. If 
the partner makes an election under paragraph (c)(6)(i) of this section, 
the partner will compute its additional reporting year tax (as described 
in Sec.  301.6226-3 of this chapter) or amount due under Sec.  301.6225-
2(d)(2)(ii)(A) of this chapter taking into account the rules in 
paragraph (c)(6) of this section with respect to the increase in the 
deduction that is waived.
    (v) Rule applicable to premium and other consideration paid or 
accrued by the taxpayer for any reinsurance payments that are taken into 
account under section 803(a)(1)(B) or 832(b)(4)(A). For purposes of 
paragraph (c)(6)(i) of this section, a taxpayer may elect to waive (or 
increase the amount waived of) any premium or other consideration paid 
or accrued by the taxpayer for any reinsurance payments that are taken 
into account under section 803(a)(1)(B) or 832(b)(4)(A) that would be a 
base erosion tax benefit within the meaning of section 
59A(c)(2)(A)(iii), in accordance with the rules and principles of this 
paragraph (c)(6).
    (d) Examples. The following examples illustrate the application of 
this section. For purposes of all the examples, assume that the taxpayer 
is an applicable taxpayer and all payments apply to a taxable year 
beginning after December 31, 2017.
    (1) Example 1: Determining a base erosion payment--(i) Facts. FP is 
a foreign corporation that owns all of the stock of FC, a foreign 
corporation, and DC, a domestic corporation. FP has a trade or business 
in the United States with effectively connected income (USTB). DC owns 
FDE, a foreign disregarded entity. DC pays interest to FDE and FC. FDE 
pays interest to USTB. All interest paid by DC to FC and by FDE to USTB 
is deductible by DC in the current year for regular income tax purposes. 
FDE also acquires depreciable property from FP during the taxable year. 
FP's income from the sale of the depreciable property is not effectively 
connected with the conduct of FP's trade or business in the United 
States. DC and FP (based only on the activities of USTB) are applicable 
taxpayers under Sec.  1.59A-2(b).
    (ii) Analysis. The payment of interest by DC to FC is a base erosion 
payment

[[Page 667]]

under paragraph (b)(1)(i) of this section because the payment is made to 
a foreign related party and the interest payment is deductible. The 
payment of interest by DC to FDE is not a base erosion payment because 
the transaction is not a payment to a foreign person and the transaction 
is not a deductible payment. With respect to the payment of interest by 
FDE to USTB, if FP's USTB treats the payment of interest by FDE to USTB 
as income that is effectively connected with the conduct of a trade or 
business in the United States pursuant to section 864 or as profits 
attributable to a U.S. permanent establishment of a tax treaty resident, 
and if DC receives a withholding certificate from FP with respect to the 
payment, then the exception in paragraph (b)(3)(iii) of this section 
applies. Accordingly, the payment from DC, through FDE, to USTB is not a 
base erosion payment even though the payment is to the USTB of FP, a 
foreign related party. The acquisition of depreciable property by DC, 
through FDE, from FP is a base erosion payment under paragraph 
(b)(1)(ii) of this section because there is a payment to a foreign 
related party in connection with the acquisition by the taxpayer of 
property of a character subject to the allowance for depreciation and 
the exception in paragraph (b)(3)(iii) of this section does not apply 
because FP's income from the sale of the depreciable property is not 
effectively connected with the conduct of FP's trade or business in the 
United States. See Sec.  1.59A-2 for the application of the aggregation 
rule with respect to DC and FP's USTB.
    (2) Example 2: Interest allocable under Sec.  1.882-5--(i) Facts. 
FC, a foreign corporation, has income that is effectively connected with 
the conduct of a trade or business within the United States. FC 
determines its interest expense under the three-step process described 
in Sec.  1.882-5(b) through (d) with a total interest expense of $125x. 
The total interest expense is comprised of interest expense of $100x on 
U.S.- booked liabilities ($60x paid to a foreign related party and $40x 
paid to unrelated persons) and $25x of interest on excess U.S.-connected 
liabilities. FC has average worldwide interest expense (not including 
interest expense on U.S.-booked liabilities) of $500x, of which $100x is 
interest expense paid to a foreign related party. FC is an applicable 
taxpayer with respect to its effectively connected income. Assume all of 
the interest expense is deductible in the current taxable year and that 
none of the interest is subject to the effectively connected income 
exception in paragraph (b)(3)(iii) of this section.
    (ii) Analysis. Under paragraph (b)(4)(i) of this section, the total 
amount of interest expense determined under Sec.  1.882-5 that is a base 
erosion payment is $65x ($60x + 5x). FC has $60x of interest on U.S.-
booked liabilities that is paid to a foreign related party and that is 
treated as a base erosion payment under paragraph (b)(4)(i)(A)(2) of 
this section. Additionally, $5x of the $25x of interest expense on 
excess U.S.-connected liabilities is treated as a base erosion payment 
under paragraph (b)(4)(i)(A)(3) of this section ($25x * ($100x/$500x)).
    (3) Example 3: Interaction with section 163(j)--(i) Facts. Foreign 
Parent (FP) is a foreign corporation that owns all of the stock of DC, a 
domestic corporation that is an applicable taxpayer. DC does not conduct 
a utility trade or business as described in section 163(j)(7)(A)(iv), an 
electing real property trade or business as described in section 
163(j)(7)(B), or an electing farming business as described in section 
163(j)(7)(C). In Year 1, DC has adjusted taxable income, as defined in 
section 163(j)(8), of $1000x and pays the following amounts of business 
interest expense: $420x that is paid to unrelated Bank, and $360x that 
is paid to FP. DC does not earn any business interest income or incur 
any floor plan financing interest expense in Year 1. None of the 
exceptions in paragraph (b)(3) of this section apply, and the interest 
is not subject to withholding.
    (ii) Analysis--(A) Classification of business interest. In Year 1, 
DC is permitted to deduct only $300x of business interest expense under 
section 163(j)(1) ($1000x x 30%). Paragraph (c)(4)(ii)(B) of this 
section provides that for purposes of paragraph (c)(1) of this section 
the deduction is treated first as foreign related business interest 
expense and domestic related business interest expense (here, only FP); 
and second as

[[Page 668]]

unrelated business interest expense (Bank). As a result, the $300x of 
business interest expense that is permitted under section 163(j)(1) is 
treated entirely as the business interest paid to the related foreign 
party, FP. All of DC's $300x deductible interest is treated as an add-
back to modified taxable income in the Year 1 taxable year for purposes 
of Sec.  1.59A-4(b)(2)(i).
    (B) Ordering rules for disallowed business interest expense 
carryforward. Under section 163(j)(2), the $480x of disallowed business 
interest ($420x + $360x-$300x) is carried forward to the subsequent 
year. Under paragraph (c)(4)(ii)(B)(1) and (2) of this section, the 
disallowed business interest carryforward is correspondingly treated 
first as unrelated business interest expense, and second pro-rata as 
foreign related business interest expense and domestic related business 
interest expense. As a result, $420x of the $480x disallowed business 
interest expense carryforward is treated first as business interest 
expense paid to Bank and the remaining $60x of the $480x disallowed 
business interest expense carryforward is treated as interest paid to FP 
and as an add-back to modified taxable income.
    (4) Example 4: Interaction with section 163(j); carryforward--(i) 
Facts. The facts are the same as in paragraph (d)(3) of this section 
(the facts in Example 3), except that in addition, in Year 2, DC has 
adjusted taxable income of $250x, and pays the following amounts of 
business interest expense: $50x that is paid to unrelated Bank, and $45x 
that is paid to FP. DC does not earn any business interest income or 
incur any floor plan financing interest expense in Year 2. None of the 
exceptions in paragraph (b)(3) of this section apply.
    (ii) Analysis--(A) Classification of business interest. In Year 2, 
for purposes of section 163(j)(1), DC is treated as having paid or 
accrued total business interest expense of $575x, consisting of $95x 
business interest expense actually paid in Year 2 and $480x of business 
interest expense that is carried forward from Year 1. DC is permitted to 
deduct $75x of business interest expense in Year 2 under the limitation 
in section 163(j)(1) ($250x x 30%). Section 1.163(j)-5(b)(2) provides 
that, for purposes of section 163(j), the allowable business interest 
expense is first attributed to amounts paid or accrued in the current 
year, and then attributed to amounts carried over from earlier years on 
a first-in-first-out basis from the earliest year. Accordingly, the $75x 
of deductible business interest expense is deducted entirely from the 
$95x business interest expense incurred in Year 2 for section 163(j) 
purposes. Because DC's business interest expense deduction is limited 
under section 163(j)(1) and because DC's total business interest expense 
is attributable to more than one taxable year, paragraph 
(c)(4)(ii)(B)(2) of this section provides that the ordering rule in 
paragraph (c)(4)(ii)(B)(1) of this section is applied separately to each 
annual amount of section 163(j) disallowed business interest expense 
carryforward. With respect to the Year 2 layer, which is deducted first, 
paragraph (c)(4)(ii)(B) of this section provides that, for purposes of 
paragraph (c)(1) of this section, the Year 2 $75x deduction is treated 
first as foreign related business interest expense and domestic related 
business interest expense (here, only FP, $45x); and second as unrelated 
business interest expense (Bank, $30x). Consequentially, all of the $45x 
deduction of business interest expense that was paid to FP in Year 2 is 
treated as a base erosion tax benefit and an add-back to modified 
taxable income for the Year 2 taxable year for purposes of Sec.  1.59A-
4(b)(2)(i).
    (B) Ordering rules for disallowed business interest expense 
carryforward. The disallowed business interest expense carryforward of 
$20x from Year 2 is correspondingly treated first as business interest 
expense paid to Bank under paragraph (c)(4)(i) of this section. The 
disallowed business interest expense carryforward of $480x from the Year 
1 layer that is also not allowed as a deduction in Year 2 remains 
treated as $420x paid to Bank and $60 paid to FP.
    (5) Example 5: Interaction with section 163(j); carryforward--(i) 
Facts. The facts are the same as in paragraph (d)(4) of this section 
(the facts in Example 4), except that in addition, in Year 3, DC has 
adjusted taxable income of $4000x and pays no business interest expense. 
DC does not earn any business interest income or incur any floor plan 
financing interest expense in Year 3.

[[Page 669]]

    (ii) Analysis. In Year 3, DC is treated as having paid or accrued 
total business interest expense of $500x, consisting of $480x of 
business interest expense that is carried forward from Year 1 and $20x 
of business interest expense that is carried forward from Year 2 for 
purposes of section 163(j)(1). DC is permitted to deduct $1200x of 
business interest expense in Year 3 under the limitation in section 
163(j)(1) ($4000x x 30%). For purposes of section 163(j), DC is treated 
as first deducting the business interest expense from Year 1 then the 
business interest expense from Year 2. See Sec.  1.163(j)-5(b)(2). 
Because none of DC's $500x business interest expense is limited under 
section 163(j), the stacking rule in paragraph (c)(4)(ii) of this 
section for allowed and disallowed business interest expense does not 
apply. For purposes of Sec.  1.59A-4(b)(2)(i), DC's add-back to modified 
taxable income is $60x determined by the classifications in paragraph 
(c)(4)(i)(A) of this section ($60x treated as paid to FP from Year 1).
    (6) Example 6: Interaction with section 163(j); partnership--(i) 
Facts. The facts are the same as in paragraph (d)(4) of this section 
(the facts in Example 4), except that in addition, in Year 2, DC forms a 
domestic partnership (PRS) with Y, a domestic corporation that is not 
related to DC within the meaning of Sec.  1.59A-1(b)(17). PRS does not 
conduct a utility trade or business as described in section 
163(j)(7)(A)(iv), an electing real property trade or business as 
described in section 163(j)(7)(B) or an electing farming business as 
described in section 163(j)(7)(C) subject to section 163(j). PRS is not 
a small business described in section 163(j)(3). DC and Y are equal 
partners in partnership PRS. In Year 2, PRS has ATI of $100x and $48x of 
business interest expense. $12x of PRS's business interest expense is 
paid to Bank, and $36x of PRS's business interest expense is paid to FP. 
PRS allocates the items comprising its $100x of ATI $50x to DC and $50x 
to Y. PRS allocates its $48x of business interest expense $24x to DC and 
$24x to Y. DC classifies its $24x of business interest expense as $6x 
unrelated business interest expense (Bank) and $18x as foreign related 
business interest expense (FP) under paragraph (c)(4)(i)(B) of this 
section. Y classifies its $24x of business interest expense as entirely 
unrelated business interest expense of Y (Bank and FP) under paragraph 
(c)(4)(i)(B) of this section. None of the exceptions in paragraph (b)(3) 
of this section apply.
    (ii) Partnership level analysis. In Year 2, PRS's section 163(j) 
limit is 30 percent of its ATI, or $30x ($100x x 30 percent). Thus, PRS 
has $30x of deductible business interest expense and $18x of excess 
business interest expense ($48x-$30x). The $30x of deductible business 
interest expense is includible in PRS's non-separately stated income or 
loss, and is not subject to further limitation under section 163(j) at 
the partners' level.
    (iii) Partner level allocations analysis. Pursuant to Sec.  
1.163(j)-6(f)(2), DC and Y are each allocated $15x of deductible 
business interest expense and $9x of excess business interest expense. 
At the end of Year 2, DC and Y each have $9x of excess business interest 
expense from PRS, which under Sec.  1.163(j)-6 is not treated as paid or 
accrued by the partner until such partner is allocated excess taxable 
income or excess business interest income from PRS in a succeeding year. 
Pursuant to Sec.  1.163(j)-6(e), DC and Y, in computing their limit 
under section 163(j), do not increase any of their section 163(j) items 
by any of PRS's section 163(j) items.
    (iv) Partner level allocations for determining base erosion tax 
benefits. The $15x of deductible business interest expense allocated to 
DC is treated first as foreign related business interest expense (FP) 
under paragraph (c)(4)(ii)(B) of this section. DC's excess business 
interest expense from PRS of $9x is classified first as the unrelated 
business interest expense with respect to Bank ($6x) and then as the 
remaining portion of the business interest expense paid to FP ($3x, or 
$18x-$15x). Under paragraph (c)(4)(ii)(B)(3) of this section, these 
classifications of the PRS items apply irrespective of the 
classifications of DC's own interest expense as set forth in paragraph 
(d)(4) of this section (Example 4).
    (v) Computation of modified taxable income. For Year 2, DC is 
treated as having incurred base erosion tax benefits

[[Page 670]]

of $60x, consisting of the $15x base erosion tax benefit with respect to 
its interest in PRS that is computed in paragraph (d)(6)(iii) of this 
section (Example 6) and $45x that is computed in paragraph (d)(4) of 
this section (Example 4).
    (7) Example 7: Transfers of property to related taxpayers--(i) 
Facts. FP is a foreign corporation that owns all of the stock of DC1 and 
DC2, both domestic corporations. DC1 and DC2 are both members of the 
same aggregate group but are not members of the same consolidated tax 
group under section 1502. In Year 1, FP sells depreciable property to 
DC1. On the first day of the Year 2 tax year, DC1 sells the depreciable 
property to DC2.
    (ii) Analysis--(A) Year 1. The acquisition of depreciable property 
by DC1 from FP is a base erosion payment under paragraph (b)(1)(ii) of 
this section because there is a payment to a foreign related party in 
connection with the acquisition by the taxpayer of property of a 
character subject to the allowance for depreciation.
    (B) Year 2. The acquisition of the depreciable property in Year 2 by 
DC2 is not itself a base erosion payment because DC2 did not acquire the 
property from a foreign related party. However, under paragraph 
(b)(2)(viii) of this section any depreciation expense taken by DC2 on 
the property acquired from DC1 is a base erosion payment and a base 
erosion tax benefit under paragraph (c)(1)(ii) of this section because 
the acquisition of the depreciable property was a base erosion payment 
by DC1 and the property was sold to a member of the aggregate group; 
therefore, the depreciation expense continues as a base erosion tax 
benefit to DC2 as it would have been to DC1 if it continued to own the 
property.
    (8) Example 8: Effect of election to waive deduction on method of 
accounting--(i) Facts. DC, a domestic corporation, purchased and placed 
in service a depreciable asset (Asset A) from a foreign related party on 
the first day of its taxable year 1 for $100x. DC elects to use the 
alternative depreciation system under section 168(g) to depreciate all 
properties placed in service during taxable year 1. Asset A is not 
eligible for the additional first year depreciation deduction. Beginning 
in taxable year 1, DC depreciates Asset A under the alternative 
depreciation system using the straight-line depreciation method, a 5-
year recovery period, and the half-year convention. This depreciation 
method, recovery period, and convention are permissible for Asset A 
under section 168(g). On its timely filed original Federal income tax 
return for taxable year 1, DC does not elect to waive any deductions and 
DC claims a depreciation deduction of $10x for Asset A. On its timely 
filed original Federal income tax return for taxable year 2, DC does not 
elect to waive any deductions and DC claims a depreciation deduction of 
$20x for Asset A. During taxable year 3, DC files an amended return for 
taxable year 1 to elect to waive the depreciation deduction for Asset A 
and reports in accordance with paragraph (c)(6)(ii) of this section with 
its amended return for taxable year 1 that the amount of the waived 
depreciation deduction for Asset A is $10x and the amount of the claimed 
depreciation deduction is $0x.
    (ii) Analysis. Pursuant to paragraph (c)(6)(iii)(B)(1) of this 
section, DC's election to waive the depreciation deduction for Asset A 
for taxable year 1 is disregarded for determining DC's method of 
accounting for Asset A. Accordingly, after DC's election to waive the 
depreciation deduction for Asset A for taxable year 1, DC's method of 
accounting for depreciation for Asset A continues to be the straight-
line depreciation method, a 5-year recovery period, and the half-year 
convention. Pursuant to paragraph (c)(6)(iii)(C) of this section, the 
election made by DC in taxable year 3 on its amended return for taxable 
year 1 is not a method of accounting.
    (9) Example 9: Change of accounting method when taxpayer has waived 
a deduction--(i) Facts. DC, a domestic corporation, purchased and placed 
in service a depreciable asset (Asset B) from a foreign related party on 
the first day of its taxable year 1 for $100x. DC elects to use the 
alternative depreciation system under section 168(g) to depreciate all 
properties placed in service during taxable year 1. Asset B is not 
eligible for the additional first year depreciation deduction. Beginning 
in taxable year 1, DC depreciates Asset B under

[[Page 671]]

the alternative depreciation system using the straight-line depreciation 
method, a 10-year recovery period, and the half-year convention. Under 
this method of accounting, the depreciation deductions for Asset B are 
$5x for taxable year 1 and $10x for taxable year 2. However, for taxable 
years 1 and 2, DC elects to waive $3x and $6x, respectively, of the 
depreciation deductions for Asset B and reports the information required 
under paragraph (c)(6)(ii) of this section with its returns. In taxable 
year 3, DC realizes that the correct recovery period for Asset B is 5 
years. If DC had used the correct recovery period for Asset B, the 
depreciation deductions for Asset B would have been $10x for taxable 
year 1 and $20x for taxable year 2. DC timely files a Form 3115 to 
change its method of accounting for Asset B from a 10-year recovery 
period to a 5-year recovery period, beginning with taxable year 3. DC 
was not under examination as of the date on which it timely filed this 
Form 3115.
    (ii) Analysis--(A) Computation of the section 481(a) adjustment. In 
determining the net negative section 481(a) adjustment for this method 
change, DC compares the depreciation deductions under its present method 
of accounting to the depreciation deductions under its proposed method 
of accounting. Pursuant to paragraph (c)(6)(iii)(D) of this section, DC 
agreed that, by making the election to waive depreciation deductions for 
Asset B, DC will not take into account the fact that depreciation 
deductions for Asset B were waived under paragraph (c)(6)(i) of this 
section. Accordingly, DC's net negative section 481(a) adjustment for 
this method change is $15x, which is calculated by determining the 
difference between the depreciation deductions for Asset B for taxable 
years 1 and 2 under DC's present method of accounting ($15x) and the 
depreciation deductions that would have been allowable for Asset B for 
taxable years 1 and 2 under DC's proposed method of accounting ($30x).
    (B) Computation of basis adjustments. Pursuant to paragraph 
(c)(6)(iii)(B)(3) of this section, DC's elections to waive the 
depreciation deductions for Asset B for taxable years 1 and 2 are 
disregarded for determining the amount allowable for depreciation for 
purposes of section 1016(a)(2). The amount allowable for depreciation of 
Asset B is determined based on the proper method of computing 
depreciation for Asset B. Accordingly, Asset B's adjusted basis at the 
end of taxable year 1 is $90x ($100x-$10x) and at the end of taxable 
year 2 is $70x ($90x-$20x).

[T.D. 9885, 84 FR 67017, Dec. 6, 2019, as amended by T.D. 9910, 85 FR 
64365, Oct. 9, 2020]



Sec.  1.59A-4  Modified taxable income.

    (a) Scope. Paragraph (b)(1) of this section provides rules for 
computing modified taxable income. Paragraph (b)(2) of this section 
provides rules addressing how base erosion tax benefits and net 
operating losses affect modified taxable income. Paragraph (b)(3) of 
this section provides a rule for a holder of a residual interest in a 
REMIC. Paragraph (c) of this section provides examples illustrating the 
rules described in this section.
    (b) Computation of modified taxable income--(1) In general. The term 
modified taxable income means a taxpayer's taxable income, as defined in 
section 63(a), determined with the additions described in paragraph 
(b)(2) of this section. Notwithstanding the foregoing, the taxpayer's 
taxable income may not be reduced to an amount less than zero as a 
result of a net operating loss deduction allowed under section 172. See 
paragraphs (c)(1) and (2) of this section (Examples 1 and 2).
    (2) Modifications to taxable income. The amounts described in this 
paragraph (b)(2) are added back to a taxpayer's taxable income to 
determine its modified taxable income.
    (i) Base erosion tax benefits. The amount of any base erosion tax 
benefit as defined in Sec.  1.59A-3(c)(1).
    (ii) Certain net operating loss deductions. The base erosion 
percentage, as described in Sec.  1.59A-2(e)(3), of any net operating 
loss deduction allowed to the taxpayer under section 172 for the taxable 
year. For purposes of determining modified taxable income, the net 
operating loss deduction allowed does not exceed taxable income before 
taking into account the net operating loss deduction. See paragraph 
(c)(1) and (2) of this section (Examples 1 and 2). The base erosion 
percentage for the taxable

[[Page 672]]

year that the net operating loss arose is used to determine the addition 
under this paragraph (b)(2)(ii). For a net operating loss that arose in 
a taxable year beginning before January 1, 2018, the base erosion 
percentage for the taxable year is zero.
    (3) Rule for holders of a residual interest in a REMIC. For purposes 
of paragraph (b)(1) of this section, the limitation in section 
860E(a)(1) is not taken into account in determining the taxable income 
amount that is used to compute modified taxable income for the taxable 
year.
    (c) Examples. The following examples illustrate the rules of 
paragraph (b) of this section.
    (1) Example 1: Current year loss--(i) Facts. A domestic corporation 
(DC) is an applicable taxpayer that has a calendar taxable year. In 
2020, DC has gross income of $100x, a deduction of $80x that is not a 
base erosion tax benefit, and a deduction of $70x that is a base erosion 
tax benefit. In addition, DC has a net operating loss carryforward to 
2020 of $400x that arose in 2016.
    (ii) Analysis. DC's starting point for computing modified taxable 
income is $(50x), computed as gross income of $100x, less a deduction of 
$80x (non-base erosion tax benefit) and a deduction of $70x (base 
erosion tax benefit). Under paragraph (b)(2)(ii) of this section, DC's 
starting point for computing modified taxable income does not take into 
account the $400x net operating loss carryforward because the allowable 
deductions for 2020, not counting the NOL deduction, exceed the gross 
income for 2020. DC's modified taxable income for 2020 is $20x, computed 
as $(50x) + $70x base erosion tax benefit.
    (2) Example 2: Net operating loss deduction--(i) Facts. The facts 
are the same as in paragraph (c)(1)(i) of this section (the facts in 
Example 1), except that DC's gross income in 2020 is $500x.
    (ii) Analysis. DC's starting point for computing modified taxable 
income is $0x, computed as gross income of $500x, less: A deduction of 
$80x (non-base erosion tax benefit), a deduction of $70x (base erosion 
tax benefit), and a net operating loss deduction of $350x (which is the 
amount of taxable income before taking into account the net operating 
loss deduction, as provided in paragraph (b)(2)(ii) of this section 
($500x-$150x)). DC's modified taxable income for 2020 is $70x, computed 
as $0x + $70x base erosion tax benefit. DC's modified taxable income is 
not increased as a result of the $350x net operating loss deduction in 
2020 because the base erosion percentage of the net operating loss that 
arose in 2016 is zero under paragraph (b)(2)(ii) of this section.

[T.D. 9885, 84 FR 67017, Dec. 6, 2019]



Sec.  1.59A-5  Base erosion minimum tax amount.

    (a) Scope. Paragraph (b) of this section provides rules regarding 
the calculation of the base erosion minimum tax amount. Paragraph (c) of 
this section describes the base erosion and anti-abuse tax rate 
applicable to the taxable year.
    (b) Base erosion minimum tax amount--(1) In general. For each 
taxable year, an applicable taxpayer must determine its base erosion 
minimum tax amount.
    (2) Calculation of base erosion minimum tax amount. With respect to 
any applicable taxpayer, the base erosion minimum tax amount for any 
taxable year is, the excess (if any) of--
    (i) An amount equal to the base erosion and anti-abuse tax rate 
multiplied by the modified taxable income of the taxpayer for the 
taxable year, over
    (ii) An amount equal to the regular tax liability as defined in 
Sec.  1.59A-1(b)(16) of the taxpayer for the taxable year, reduced (but 
not below zero) by the excess (if any) of--
    (A) The credits allowed under chapter 1 of subtitle A of the Code 
against regular tax liability over
    (B) The sum of the credits described in paragraph (b)(3) of this 
section.
    (3) Credits that do not reduce regular tax liability. The sum of the 
following credits are used in paragraph (b)(2)(ii)(B) of this section to 
limit the amount by which the credits allowed under chapter 1 of 
subtitle A of the Internal Revenue Code reduce regular tax liability--
    (i) Taxable years beginning on or before December 31, 2025. For any 
taxable year beginning on or before December 31, 2025--

[[Page 673]]

    (A) The credit allowed under section 38 for the taxable year that is 
properly allocable to the research credit determined under section 
41(a);
    (B) The portion of the applicable section 38 credits not in excess 
of 80 percent of the lesser of the amount of those applicable section 38 
credits or the base erosion minimum tax amount (determined without 
regard to this paragraph (b)(3)(i)(B)); and
    (C) Any credits allowed under sections 33, 37, and 53.
    (ii) Taxable years beginning after December 31, 2025. For any 
taxable year beginning after December 31, 2025, any credits allowed 
under sections 33, 37, and 53.
    (c) Base erosion and anti-abuse tax rate--(1) In general. For 
purposes of calculating the base erosion minimum tax amount, the base 
erosion and anti-abuse tax rate is--
    (i) Calendar year 2018. For taxable years beginning in calendar year 
2018, five percent.
    (ii) Calendar years 2019 through 2025. For taxable years beginning 
after December 31, 2018, through taxable years beginning before January 
1, 2026, 10 percent.
    (iii) Calendar years after 2025. For taxable years beginning after 
December 31, 2025, 12.5 percent.
    (2) Increased rate for banks and registered securities dealers--(i) 
In general. In the case of a taxpayer that is a member of an affiliated 
group (as defined in section 1504(a)(1)) that includes a bank or a 
registered securities dealer, the percentage otherwise in effect under 
paragraph (c)(1) of this section is increased by one percentage point.
    (ii) De minimis exception to increased rate for banks and registered 
securities dealers. Paragraph (c)(2)(i) of this section does not apply 
to a taxpayer that is a member of an affiliated group (as defined in 
section 1504(a)(1)) that includes a bank or registered securities dealer 
if, in that taxable year, the total gross receipts of the affiliated 
group attributable to the bank or the registered securities dealer (or 
attributable to all of the banks and registered securities dealers in 
the group, if more than one) represent less than two percent of the 
total gross receipts of the affiliated group, as determined under Sec.  
1.59A-2(d).
    (3) Application of section 15 to tax rates in section 59A--(i) New 
tax. Section 15 does not apply to any taxable year that includes January 
1, 2018.
    (ii) Change in tax rate pursuant to section 59A(b)(1)(A). Section 15 
does not apply to any taxable year that includes January 1, 2019.
    (iii) Change in rate pursuant to section 59A(b)(2). Section 15 
applies to the change in tax rate pursuant to section 59A(b)(2)(A).

[T.D. 9885, 84 FR 67017, Dec. 6, 2019]



Sec.  1.59A-6  Qualified derivative payment.

    (a) Scope. This section provides additional guidance regarding 
qualified derivative payments. Paragraph (b) of this section defines the 
term qualified derivative payment. Paragraph (c) of this section 
provides guidance on certain payments that are not treated as qualified 
derivative payments. Paragraph (d) defines the term derivative for 
purposes of section 59A. Paragraph (e) of this section provides examples 
illustrating the rules of this section.
    (b) Qualified derivative payment--(1) In general. A qualified 
derivative payment means any payment made by a taxpayer to a foreign 
related party pursuant to a derivative with respect to which the 
taxpayer--
    (i) Recognizes gain or loss as if the derivative were sold for its 
fair market value on the last business day of the taxable year (and any 
additional times as required by the Internal Revenue Code or the 
taxpayer's method of accounting);
    (ii) Treats any gain or loss so recognized as ordinary; and
    (iii) Treats the character of all items of income, deduction, gain, 
or loss with respect to a payment pursuant to the derivative as 
ordinary.
    (2) Reporting requirements--(i) In general. No payment is a 
qualified derivative payment under paragraph (b)(1) of this section for 
any taxable year unless the taxpayer (whether or not the taxpayer is a 
reporting corporation as defined in Sec.  1.6038A-1(c)) reports the 
information required in Sec.  1.6038A-2(b)(7)(ix) for the taxable year. 
To report its

[[Page 674]]

qualified derivative payments, a taxpayer must include the payment in 
the aggregate amount of qualified derivative payments on Form 8991 (or 
successor).
    (ii) Failure to satisfy the reporting requirement. If a taxpayer 
fails to satisfy the reporting requirement described in paragraph 
(b)(2)(i) of this section with respect to any payments, those payments 
are not eligible for the qualified derivative payment exception 
described in Sec.  1.59A-3(b)(3)(ii) and are base erosion payments 
unless an exception in Sec.  1.59A-3(b)(3) otherwise applies. A 
taxpayer's failure to report a payment as a qualified derivative payment 
does not impact the eligibility of any other payment which the taxpayer 
properly reported under paragraph (b)(2)(i) of this section from being a 
qualified derivative payment.
    (iii) Reporting of aggregate amount of qualified derivative 
payments. The aggregate amount of qualified derivative payments is the 
sum of the amount described in paragraph (b)(3) of this section for each 
derivative. To the extent that the taxpayer is treated as receiving a 
payment, as determined in Sec.  1.59A-2(e)(3)(vi), for the taxable year 
with respect to a derivative, the payment is not included in the 
aggregate qualified derivative payments.
    (iv) Transition period for qualified derivative payment reporting. 
Before paragraph (b)(2)(i) of this section is applicable, a taxpayer 
will be treated as satisfying the reporting requirement described 
section 59A(h)(2)(B) to the extent that the taxpayer reports the 
aggregate amount of qualified derivative payments on Form 8991 (or 
successor). See Sec.  1.6038A-2(g) (applicability date for Sec.  
1.6038A-2(b)(7)(ix)). Until paragraph (b)(2)(i) of this section is 
applicable, paragraph (b)(2)(ii) of this section will not apply to a 
taxpayer who reports the aggregate amount of qualified derivative 
payments in good faith.
    (3) Amount of any qualified derivative payment--(i) In general. The 
amount of any qualified derivative payment excluded from the denominator 
of the base erosion percentage as provided in Sec.  1.59A-2(e)(3)(ii)(C) 
is determined as provided in Sec.  1.59A-2(e)(3)(vi).
    (ii) Net qualified derivative payment that includes a payment that 
is a base erosion payment. Any net amount determined in paragraph 
(b)(3)(i) of this section must be reduced by any gross items that are 
treated as a base erosion payment pursuant to paragraph (c) of this 
section.
    (c) Exceptions for payments otherwise treated as base erosion 
payments. A payment does not constitute a qualified derivative payment 
if--
    (1) The payment would be treated as a base erosion payment if it 
were not made pursuant to a derivative, including any interest, royalty, 
or service payment; or
    (2) In the case of a contract that has derivative and nonderivative 
components, the payment is properly allocable to the nonderivative 
component.
    (d) Derivative defined--(1) In general. For purposes of this 
section, the term derivative means any contract (including any option, 
forward contract, futures contract, short position, swap, or similar 
contract) the value of which, or any payment or other transfer with 
respect to which, is (directly or indirectly) determined by reference to 
one or more of the following:
    (i) Any share of stock in a corporation;
    (ii) Any evidence of indebtedness;
    (iii) Any commodity that is actively traded;
    (iv) Any currency; or
    (v) Any rate, price, amount, index, formula, or algorithm.
    (2) Exceptions. The following contracts are not treated as 
derivatives for purposes of section 59A.
    (i) Direct interest. A derivative contract does not include a direct 
interest in any item described in paragraph (d)(1)(i) through (v) of 
this section.
    (ii) Insurance contracts. A derivative contract does not include any 
insurance, annuity, or endowment contract issued by an insurance company 
to which subchapter L applies (or issued by any foreign corporation to 
which the subchapter would apply if the foreign corporation were a 
domestic corporation).
    (iii) Securities lending and sale-repurchase transactions--(A) 
Multi-step transactions treated as financing. For purposes of paragraph 
(d)(1) of this section, a derivative does not include any

[[Page 675]]

securities lending transaction, sale-repurchase transaction, or 
substantially similar transaction that is treated as a secured loan for 
federal tax purposes. Securities lending transaction and sale-repurchase 
transaction have the meanings provided in Sec.  1.861-2(a)(7).
    (B) Special rule for payments associated with the cash collateral 
provided in a securities lending transaction or substantially similar 
transaction. For purposes of paragraph (d)(1) of this section, a 
derivative does not include the cash collateral component of a 
securities lending transaction (or the cash payments pursuant to a sale-
repurchase transaction, or similar payments pursuant to a substantially 
similar transaction).
    (C) Anti-abuse exception for certain transactions that are the 
economic equivalent of substantially unsecured cash borrowing. For 
purposes of paragraph (d)(1) of this section, a derivative does not 
include any securities lending transaction or substantially similar 
transaction that is part of an arrangement that has been entered into 
with a principal purpose of avoiding the treatment of any payment with 
respect to that transaction as a base erosion payment and that provides 
the taxpayer with the economic equivalent of a substantially unsecured 
cash borrowing. The determination of whether the securities lending 
transaction or substantially similar transaction provides the taxpayer 
with the economic equivalent of a substantially unsecured cash borrowing 
takes into account arrangements that effectively serve as collateral due 
to the taxpayer's compliance with any U.S. regulatory requirements 
governing such transaction.
    (3) American depository receipts. For purposes of section 59A, 
American depository receipts (or any similar instruments) with respect 
to shares of stock in a foreign corporation are treated as shares of 
stock in that foreign corporation.
    (e) Examples. The following examples illustrate the rules of this 
section.
    (1) Example 1: Notional principal contract as QDP--(i) Facts. 
Domestic Corporation (DC) is a dealer in securities within the meaning 
of section 475. On February 1, 2019, DC enters into a contract (Interest 
Rate Swap) with Foreign Parent (FP), a foreign related party, for a term 
of five years. Under the Interest Rate Swap, DC is obligated to make a 
payment to FP each month, beginning March 1, 2019, in an amount equal to 
a variable rate determined by reference to the prime rate, as determined 
on the first business day of the immediately preceding month, multiplied 
by a notional principal amount of $50x. Under the Interest Rate Swap, FP 
is obligated to make a payment to DC each month, beginning March 1, 
2019, in an amount equal to 5% multiplied by the same notional principal 
amount. The Interest Rate Swap satisfies the definition of a notional 
principal contract under Sec.  1.446-3(c). DC recognizes gain or loss on 
the Interest Rate Swap pursuant to section 475. DC reports the 
information required to be reported for the taxable year under Sec.  
1.6038A-2(b)(7)(ix).
    (ii) Analysis. The Interest Rate Swap is a derivative as described 
in paragraph (d) of this section because it is a contract that 
references the prime rate and a fixed rate for determining the amount of 
payments. The exceptions described in paragraph (c) of this section do 
not apply to the Interest Rate Swap. Because DC recognizes ordinary gain 
or loss on the Interest Rate Swap pursuant to section 475(d)(3), it 
satisfies the condition in paragraph (b)(1)(ii) of this section. Because 
DC satisfies the requirement relating to the information required to be 
reported under paragraph (b)(2) of this section, any payment to FP with 
respect to the Interest Rate Swap will be a qualified derivative 
payment. Therefore, under Sec.  1.59A-3(b)(3)(ii), the payments to FP 
are not base erosion payments.
    (2) Example 2: Securities lending anti-abuse rule--(i) Facts. (A) 
Foreign Parent (FP) is a foreign corporation that owns all of the stock 
of domestic corporation (DC) and foreign corporation (FC). FP and FC are 
foreign related parties of DC under Sec.  1.59A-1(b)(12) but not members 
of DC's aggregate group. On January 1 of year 1, with a principal 
purpose of providing financing to DC without DC making a base erosion 
payment to FC, FC lends 100x U.S. Treasury bills with a remaining 
maturity of 11 months (Securities A) to DC (Securities Lending 
Transaction 1) for a period of six months. Pursuant to the terms of

[[Page 676]]

Securities Lending Transaction 1, DC is obligated to make substitute 
payments to FC corresponding to the interest payments on Securities A. 
DC does not post cash collateral with respect to Securities Lending 
Transaction 1, and no other arrangements of FC or DC effectively serve 
as collateral under any U.S. regulatory requirements governing the 
transaction. Immediately thereafter, DC sells Securities A for cash.
    (B) On June 30 of year 1, FC lends 100x U.S. Treasury bills with a 
remaining maturity of 11 months (Securities B) to DC (Securities Lending 
Transaction 2) for a period of six months. Pursuant to the terms of 
Securities Lending Transaction 2, DC is obligated to make substitute 
payments to FC corresponding to the interest payments on Securities B. 
Immediately thereafter, DC sells Securities B for cash and uses the cash 
to purchase U.S. Treasury bills with a remaining maturity equal to the 
Securities A bills that DC then transfers to FC in repayment of 
Securities Lending Transaction 1.
    (ii) Analysis. Securities Lending Transaction 1 and Securities 
Lending Transaction 2 are not treated as derivatives for purposes of 
paragraph (d)(1) of this section because the transactions are part of an 
arrangement that has been entered into with a principal purpose of 
avoiding the treatment of any payment with respect to Securities Lending 
Transaction 1 and Securities Lending Transaction 2 as a base erosion 
payment and provides DC with the economic equivalent of a substantially 
unsecured cash borrowing by DC. As a result, pursuant to paragraph 
(d)(2)(iii)(C) of this section, the substitute payments made by DC to FC 
with respect to Securities A and Securities B are not eligible for the 
exception in Sec.  1.59A-3(b)(3)(ii) (qualified derivative payment).

[T.D. 9885, 84 FR 67017, Dec. 6, 2019]



Sec.  1.59A-7  Application of base erosion and anti-abuse tax to 
partnerships.

    (a) Scope. This section provides rules regarding how partnerships 
and their partners are treated for purposes of making certain 
determinations under section 59A, including whether there is a base 
erosion payment or base erosion tax benefit. All references to 
partnerships in this section include domestic and foreign partnerships. 
This section applies to payments to a partnership and payments from a 
partnership as well as transfers of partnership interests (as defined in 
paragraph (c)(3)(iv) of this section). The aggregate principle described 
in this section does not override the treatment of partnership items 
under any Code section other than section 59A. The aggregate principles 
provided in this section apply without regard to any tax avoidance 
purpose relating to a particular partnership. See Sec.  1.701-2(e). 
Paragraph (b) of this section describes how the aggregate approach to 
partnerships applies for purposes of certain section 59A determinations. 
Paragraph (c) of this section provides rules for determining whether 
there is a base erosion payment with respect to a payment to or from a 
partnership. Paragraph (d) of this section provides rules for 
determining the base erosion tax benefits of a partner. Paragraph (e) of 
this section provides additional rules relating to the application of 
section 59A to partnerships. Paragraph (f) of this section provides a 
rule for determining whether a person is a foreign related party. 
Paragraph (g) of this section provides examples that illustrate the 
application of the rules of this section.
    (b) Application of section 59A to partnerships. The purpose of this 
section is to provide a set of operating rules for the application of 
section 59A to partnerships and partners in a manner consistent with the 
purposes of section 59A. Except for purposes of determining a partner's 
base erosion tax benefits under paragraph (d)(1) of this section and 
whether a taxpayer is a registered securities dealer under paragraph 
(e)(3) of this section, section 59A determinations are made at the 
partner level in the manner described in this section. The provisions of 
section 59A must be interpreted in a manner consistent with this 
approach. If a transaction is not specifically described in this 
section, whether the transaction gives rise to a base erosion payment or 
base erosion tax benefit is determined in accordance with the principles 
of this section and the purposes of section 59A.

[[Page 677]]

    (c) Base erosion payment. For purposes of determining whether a 
taxpayer has made a base erosion payment as described in Sec.  1.59A-
3(b), the taxpayer must treat a payment to or from a partnership as made 
to or from each partner and the assets and liabilities of the 
partnership as assets and liabilities of each partner. This paragraph 
(c) provides specific rules for determining whether a partner has made 
or received a payment, including as a result of a partnership interest 
transfer (as defined in paragraph (c)(3)(iv) of this section).
    (1) Payments made by or to a partnership. For purposes of 
determining whether a payment or accrual by a partnership is a base 
erosion payment described in Sec.  1.59A-3(b)(1)(i), any amount paid or 
accrued by the partnership (including any guaranteed payment described 
in section 707(c)) is treated as paid or accrued by each partner based 
on the partner's distributive share of the item of deduction with 
respect to that amount. For purposes of determining whether a payment or 
accrual to a partnership is a base erosion payment described in Sec.  
1.59A-3(b)(1)(i) or (iii), any amount paid or accrued to the partnership 
(including any guaranteed payment described in section 707(c)) is 
treated as paid or accrued to each partner based on the partner's 
distributive share of the item of income with respect to that amount. 
See paragraph (e)(1) of this section to determine the partner's 
distributive share.
    (2) Transfers of certain property. When a partnership transfers 
property, each partner is treated as transferring its proportionate 
share of the property transferred for purposes of determining whether 
there is a base erosion payment described in Sec.  1.59A-3(b)(1)(ii) or 
(iv). When a partnership acquires property, each partner is treated as 
acquiring its proportionate share of the property acquired for purposes 
of determining whether there is a base erosion payment described in 
Sec.  1.59A-3(b)(1)(ii) or (iv). For purposes of this paragraph (c)(2), 
a transfer of property does not include a transfer of a partnership 
interest (as defined in paragraph (c)(3)(iv) of this section). See 
paragraph (c)(3) of this section for rules applicable to transfers of 
partnership interests. See paragraphs (g)(2)(v) and (vi) of this section 
(Example 5 and Example 6) for examples illustrating the application of 
this paragraph (c)(2).
    (3) Transfers of a partnership interest--(i) In general. A transfer 
of a partnership interest (as defined in paragraph (c)(3)(iv) of this 
section) is generally treated as a transfer by each partner in the 
partnership of its proportionate share of the partnership's assets to 
the extent of any change in its proportionate share of any partnership 
asset, as well as any assumption of associated liabilities by the 
partner. Paragraphs (c)(3)(ii) and (iii) of this section provide rules 
for applying the general rule to transfers of a partnership interest by 
a partner and issuances of a partnership interest by the partnership for 
contributed property, respectively. See paragraph (g)(2)(vii) of this 
section (Example 7) for an example illustrating the application of this 
paragraph (c)(3)(i).
    (ii) Transfers of a partnership interest by a partner. A transfer of 
a partnership interest (as defined in paragraph (c)(3)(iv) of this 
section) by a partner is treated as a transfer by the transferor to the 
recipient of the transferor's proportionate share of each of the 
partnership assets and an assumption by the recipient of the 
transferor's proportionate share of the partnership liabilities. If the 
partner's entire partnership interest is not transferred, only the 
proportionate share of each of the partnership assets and liabilities 
associated with the transferred partnership interest is treated as 
transferred and assumed. See paragraphs (g)(2)(iii), (iv), and (vi) of 
this section (Example 3, Example 4, and Example 6) for examples 
illustrating the application of this paragraph (c)(3)(ii).
    (iii) Certain issuances of a partnership interest by a partnership. 
If a partnership issues an interest in the partnership in exchange for a 
contribution of property to the partnership, the contributing partner is 
treated as exchanging a portion of the contributed property and assuming 
any liabilities associated with the transferred partnership interest for 
a portion of the partners' pre-contribution interests in

[[Page 678]]

the partnership's assets and the partners' assumption of any liabilities 
transferred to the partnership. For purposes of this paragraph 
(c)(3)(iii), a reference to the ``partnership's assets'' includes the 
assets contributed by the contributing partner and any other assets that 
are contributed to the partnership at the same time. Each partner whose 
proportionate share in a partnership asset (including the assets 
contributed to the partnership as part of the transaction) is reduced as 
a result of the transaction is treated as transferring the asset to the 
extent of the reduction, and each person who receives a proportionate 
share or an increased proportionate share in an asset as a result of the 
transaction is treated as receiving an asset to the extent of the 
increase, proportionately from the partners' reduced interests. For 
example, if a person contributes property to a partnership in which each 
of two existing partners has a 50 percent pro-rata interest in the 
partnership in exchange for a one-third pro-rata partnership interest, 
each of the pre-contribution partners is treated as transferring a one-
third interest in their share of existing partnership assets to the 
contributing partner, and the contributing partner is treated as 
transferring a one-third interest in the contributed assets to each of 
the original partners. See paragraphs (g)(2)(i) and (ii) of this section 
(Example 1 and Example 2) for additional examples illustrating the 
application of this paragraph (c)(3)(iii).
    (iv) Partnership interest transfers defined. For purposes of 
paragraphs (c)(3) and (4) of this section, a transfer of a partnership 
interest includes any issuance of a partnership interest by a 
partnership; any sale of a partnership interest; any increase or 
decrease in a partner's proportionate share of any partnership asset as 
a result of a contribution of property or services to a partnership, a 
distribution, or a redemption; or any other transfer of a proportionate 
share of any partnership asset (other than a transfer of a partnership 
asset that is not a partnership interest by the partnership to a person 
not acting in a partner capacity), whether by a partner or the 
partnership (including as a result of a deemed or actual sale or a 
capital shift).
    (4) Increased basis from a distribution. If a distribution of 
property from a partnership to a partner results in an increase in the 
tax basis of either the distributed property or other partnership 
property, such as under section 732(b) or 734(b), the increase in tax 
basis attributable to a foreign related party is treated as if it was 
newly purchased property acquired by the taxpayer (to the extent of its 
proportionate share) from the foreign related party that is placed in 
service when the distribution occurs. See Sec.  1.734-1(e). This 
increased basis treated as newly purchased property is treated as 
acquired with a base erosion payment, unless an exception in Sec.  
1.59A-3(b) applies. For this purpose, in the case of a distribution to a 
foreign related party, the increased basis in the remaining partnership 
property that is treated as newly purchased property is entirely 
attributable to the foreign related party. In the case of a distribution 
to a taxpayer, the increased basis in the distributed property that is 
treated as newly purchased property is attributable to each foreign 
related party in proportion to the foreign related party's proportionate 
share of the asset immediately before the distribution. If the 
distribution is to a person other than a taxpayer or a foreign related 
party, there is no base erosion payment caused by the distribution under 
this paragraph (c)(4). See paragraphs (g)(2)(vii), (viii), and (ix) of 
this section (Example 7, Example 8, and Example 9) for examples 
illustrating the application of this paragraph (c)(4).
    (5) Operating rules applicable to base erosion payments--(i) Single 
payment characterized as separate transactions. If a single transaction 
is partially characterized in one manner and partially characterized in 
another manner, each part of the transaction is separately analyzed. For 
example, if a contribution of property to a partnership is partially 
treated as a contribution and partially treated as a disguised sale, the 
contribution and sale are separately analyzed under paragraph (c) of 
this section.

[[Page 679]]

    (ii) Ordering rule with respect to transfers of a partnership 
interest. If a partnership interest is transferred (within the meaning 
of paragraph (c)(3)(iv) of this section), paragraph (c)(3) of this 
section first applies to determine the assets deemed transferred by the 
transferor(s) to the transferee(s) and liabilities deemed assumed by the 
parties. Then, to the extent applicable (such as where a partnership 
makes a contribution in exchange for an interest in another partnership 
or when a partnership receives an interest in another partnership as a 
contribution to it), paragraph (c)(2) of this section applies for 
purposes of determining the proportionate share of the property received 
by the partners in a partnership. See paragraph (g)(2)(vi) of this 
section (Example 6) for an illustration of this rule.
    (iii) Consideration for base erosion payment or property resulting 
in base erosion tax benefits. When a partnership pays or receives 
property, services, or other consideration, each partner is deemed to 
pay or receive the property, services, or other consideration paid or 
received by the partnership for purposes of determining if there is a 
base erosion payment, except as otherwise provided in paragraph (c) of 
this section. See paragraphs (g)(2)(v) and (vi) of this section (Example 
5 and Example 6) for illustrations of this rule.
    (iv) Non-cash consideration. When both parties to a transaction use 
non-cash consideration, each party must separately apply paragraph (c) 
of this section to determine its base erosion payment with respect to 
each property. For example, if two partnerships, each with a domestic 
corporation and a foreign corporation as partners, all of whom are 
related, exchange depreciable property, each transfer of property would 
be separately analyzed to determine whether it is a base erosion 
payment.
    (v) Allocations of income in lieu of deductions. If a partnership 
adopts the curative method of making section 704(c) allocations under 
Sec.  1.704-3(c), an allocation of income to the partner to whom any 
built-in gain or built-in loss would be allocable under section 704(c) 
(the 704(c) partner), in an amount necessary to offset the effect of the 
ceiling rule (as defined in Sec.  1.704-3(b)(1)), in lieu of a deduction 
allocation to a partner other than the 704(c) partner (a non-704(c) 
partner), is treated as a deduction to the non-704(c) partner for 
purposes of section 59A in an amount equal to the income allocation. See 
paragraph (g)(2)(x) of this section (Example 10) for an example 
illustrating the application of this paragraph (c)(5)(v).
    (d) Base erosion tax benefit for partners--(1) In general. A 
partner's distributive share of any deduction or reduction in gross 
receipts attributable to a base erosion payment (including as a result 
of sections 704(b) and (c), 707(a) and (c), 732(b) and (d), 734(b) and 
(d), 737, 743(b) and (d), and 751(b)) is the partner's base erosion tax 
benefit, subject to the exceptions in Sec.  1.59A-3(c)(2). See paragraph 
(e)(1) of this section to determine the partner's distributive share for 
purposes of section 59A. A partner's base erosion tax benefit may be 
more than the partner's base erosion payment. For example, if a 
partnership makes a payment to a foreign related party of its domestic 
partner to acquire a depreciable asset, and the partnership specially 
allocates more depreciation deductions to a partner than its 
proportionate share of the asset, the partner's base erosion tax benefit 
includes the specially allocated depreciation deduction even if the 
total allocated deduction exceeds the partner's share of the base 
erosion payment made to acquire the asset. Base erosion tax benefits are 
determined separately for each asset, payment, or accrual, as 
applicable, and are not netted with other items. A taxpayer determines 
its base erosion tax benefits for non-partnership items pursuant to 
Sec.  1.59A-3(c).
    (2) Exception for base erosion tax benefits of certain small 
partners--(i) In general. For purposes of determining a partner's amount 
of base erosion tax benefits attributable to a base erosion payment made 
by a partnership, a partner does not take into account its distributive 
share of any base erosion tax benefits from the partnership for the 
taxable year if--
    (A) The partner's interest in the partnership represents less than 
ten percent of the capital and profits of the partnership at all times 
during the taxable year;

[[Page 680]]

    (B) The partner is allocated less than ten percent of each 
partnership item of income, gain, loss, deduction, and credit for the 
taxable year; and
    (C) The partner's interest in the partnership has a fair market 
value of less than $25 million on the last day of the partner's taxable 
year, determined using a reasonable method.
    (ii) Attribution. For purposes of paragraph (d)(2)(i) of this 
section, a partner's interest in a partnership or partnership item is 
determined by adding the interests of the partner and any related party 
of the partner (as determined under section 59A), taking into account 
any interest owned directly, indirectly, or through constructive 
ownership (applying the section 318 rules as modified by section 59A 
(except section 318(a)(3)(A) through (C) will also apply so as to 
consider a United States person as owning stock that is owned by a 
person who is not a United States person), but excluding any interest to 
the extent already taken into account).
    (e) Other rules for applying section 59A to partnerships--(1) 
Partner's distributive share. For purposes of section 59A, each 
partner's distributive share of an item of income or deduction of the 
partnership is determined under sections 704(b) and (c) and takes into 
account amounts determined under other provisions of the Code, including 
but not limited to sections 707(a) and (c), 732(b) and (d), 734(b) and 
(d), 737, 743(b) and (d), and 751(b). See Sec.  1.704-1(b)(1)(iii) 
regarding the application of section 482. These amounts are calculated 
separately for each payment or accrual on a property-by-property basis, 
including for purposes of section 704(c), and are not netted. For 
purposes of section 59A, a partner's distributive share of a reduction 
to determine gross income is equal to a proportionate amount of the 
partnership's reduction to determine gross income corresponding to the 
partner's share of the partnership gross receipts (as determined under 
paragraph (e)(2)(i) of this section) related to that reduction.
    (2) Gross receipts--(i) In general. For purposes of section 59A, 
each partner in the partnership includes a share of partnership gross 
receipts in proportion to the partner's distributive share (as 
determined under sections 704(b) and (c)) of items of gross income that 
were taken into account by the partnership under section 703 or 704(c) 
(such as remedial or curative items under Sec.  1.704-3(c) or (d)).
    (ii) Foreign corporation. See Sec.  1.59A-2(d)(3) for gross receipts 
of foreign corporations.
    (3) Registered securities dealers. If a partnership, or a branch of 
the partnership, is a registered securities dealer, each partner is 
treated as a registered securities dealer unless the partner's interest 
in the registered securities dealer would satisfy the criteria for the 
exception in paragraph (d)(2) of this section. For purposes of applying 
the de minimis exception in Sec.  1.59A-2(e)(2)(iii), a partner takes 
into account its distributive share of the relevant partnership items.
    (4) Application of sections 163(j) and 59A(c)(3) to partners. See 
Sec.  1.59A-3(c)(4).
    (5) Tiered partnerships. In the case of one or more partnerships 
owning an interest in another partnership (or partnerships), the rules 
of this section apply successively to each partnership and its partners 
in the chain of ownership. Paragraphs (d)(2) and (f) of this section and 
the small partner exception in paragraph (e)(3) of this section apply 
only to a partner that is not itself a partnership.
    (f) Foreign related party. With respect to any person that owns an 
interest in a partnership, the related party determination in section 
59A(g) applies at the partner level.
    (g) Examples. The following examples illustrate the application of 
this section.
    (1) Facts. The following facts are assumed for purposes of the 
examples.
    (i) DC is a domestic corporation that is an applicable taxpayer for 
purposes section 59A.
    (ii) FC is a foreign corporation that is a foreign related party 
with respect to DC.
    (iii) UC is a domestic corporation that is not related to DC and FC.
    (iv) Neither FC nor any partnership in the examples is (or is 
treated as) engaged in a U.S. trade or business or has a permanent 
establishment in the United States.

[[Page 681]]

    (v) All payments apply to a taxable year beginning after December 
31, 2017.
    (vi) Unless otherwise stated, all allocations are pro-rata and 
satisfy the requirements of section 704(b) and all the partners have 
equal interests in the partnership.
    (vii) Unless otherwise stated, depreciable property acquired and 
placed in service by the partnership has a remaining recovery period of 
five years and is depreciated under the alternative depreciation system 
of section 168(g) using the straight line method. Solely for purposes of 
simplifying the calculations in these examples, assume the applicable 
convention rules in section 168(d) do not apply.
    (viii) No exception under Sec.  1.59A-3(b) or (c) applies to any 
amount paid or accrued.
    (2) Examples--(i) Example 1: Contributions to a partnership on 
partnership formation--(A) Facts. DC and FC form partnership PRS, with 
each contributing depreciable property that has a fair market value and 
tax basis of $100x, Property A and Property B, respectively. Therefore, 
the property contributed by FC, Property B, will generate $20x of annual 
section 704(b) and tax depreciation deductions for five years. The 
depreciation deductions will be allocated $10x to each of DC and FC each 
year. Before the transactions, for purposes of section 59A, DC is 
treated as owning a 100 percent interest in Property A and a zero 
percent interest in Property B, and FC is treated as owning a 100 
percent interest in Property B and a zero percent interest in Property 
A. After the formation of PRS, for purposes of section 59A, DC and FC 
are each treated as owning a 50 percent proportionate share of each of 
Property A and Property B.
    (B) Analysis. The treatment of contributions of property in exchange 
for an interest in a partnership is described in paragraph (c)(3)(iii) 
of this section. Under paragraph (c)(3)(iii) of this section, DC is 
treated as exchanging a 50 percent interest in Property A for a 50 
percent proportionate share of Property B. Under Sec.  1.59A-
3(b)(1)(ii), the payment to acquire depreciable property, Property B, 
from FC is a base erosion payment. The base erosion tax benefit is the 
amount of depreciation allocated to DC with respect to Property B ($10x 
per year) and is not netted with any other partnership item pursuant to 
paragraph (d)(1) of this section.
    (ii) Example 2: Section 704(c) and remedial allocations--(A) Facts. 
The facts are the same as in paragraph (g)(2)(i)(A) of this section (the 
facts in Example 1), except that Property B has a tax basis of $40x and 
PRS adopts the remedial method under Sec.  1.704-3(d).
    (B) Analysis. The analysis and results are the same as in paragraph 
(g)(2)(i)(B) of this section (the analysis in Example 1), except that 
annual tax depreciation is $8x ($40x/5) and annual remedial tax 
deduction allocation to DC is $2x (with $2x of remedial income to FC) 
for five years. Both the tax depreciation and the remedial tax 
allocation to DC are base erosion tax benefits to DC under paragraph 
(d)(1) of this section.
    (iii) Example 3: Sale of a partnership interest without a section 
754 election--(A) Facts. UC and FC are equal partners in partnership 
PRS, the only asset of which is Property A, a depreciable property with 
a fair market value of $200x and a tax basis of $120x. PRS does not have 
any section 704(c) assets. DC purchases 50 percent of FC's interest in 
PRS for $50x. Prior to the sale, for section 59A purposes, FC is treated 
as owning a 50 percent proportionate share of Property A and DC is 
treated as owning no interest in Property A. Following the sale, for 
section 59A purposes, DC is treated as owning a 25 percent proportionate 
share of Property A, all of which is treated as acquired from FC. The 
partnership does not have an election under section 754 in effect. 
Property A will generate $24x of annual tax and section 704(b) 
depreciation deductions for five years. The depreciation deductions will 
be allocated $12x to UC and $6x to both FC and DC each year.
    (B) Analysis. The sale of a partnership interest by a partner is 
analyzed under paragraph (c)(3)(ii) of this section. Under section 
(c)(3)(ii) of this section, FC is treated as selling to DC 25 percent of 
Property A. Under Sec.  1.59A-3(b)(1)(ii), the payment to acquire 
depreciable property is a base erosion payment. Under paragraph (d)(1) 
of this section, the base erosion tax benefit is

[[Page 682]]

the amount of depreciation allocated to DC with respect to the base 
erosion payment, which would be the depreciation deductions allocated to 
DC with respect to Property A. DC's annual $6x depreciation deduction is 
its base erosion tax benefit with respect to the base erosion payment.
    (iv) Example 4: Sale of a partnership interest with section 754 
election--(A) Facts. The facts are the same as in paragraph 
(g)(2)(iii)(A) of this section (the facts in Example 3), except that the 
partnership has an election under section 754 in effect. As a result of 
the sale, there is a $20x positive adjustment to the tax basis in 
Property A with respect to DC under section 743(b) (DC's $50x basis in 
the PRS interest less DC's $30x share of PRS's tax basis in Property A). 
The section 743(b) step-up in tax basis is recovered over a depreciable 
recovery period of five years. Therefore, DC will be allocated a total 
of $10x in annual depreciation deductions for five years, comprised of 
$6x with respect to DC's proportionate share of PRS's common tax basis 
in Property A ($30x over 5 years) and $4x with respect to the section 
743(b) adjustment ($20x over 5 years).
    (B) Analysis. The analysis is the same as in paragraph 
(g)(2)(iii)(B) of this section (the analysis in Example 3); however, 
because section 743(b) increases the basis in Property A for DC by $20x, 
DC is allocated additional depreciation deductions of $4x per year as a 
result of the section 743(b) adjustment and has an annual base erosion 
tax benefit of $10x ($6x plus $4x) for five years under paragraph (d)(1) 
of this section.
    (v) Example 5: Purchase of depreciable property from a partnership--
(A) Facts. The facts are the same as in paragraph (d)(2)(iii)(A) of this 
section (the facts in Example 3), except that instead of DC purchasing 
an interest in the partnership, DC purchases Property A from the 
partnership for $200x.
    (B) Analysis. DC must analyze whether the purchase of the 
depreciable property from the partnership is a base erosion payment 
under paragraph (c)(2) of this section. Under paragraph (c)(2) of this 
section, DC is treated as acquiring FC's proportionate share of Property 
A from FC. Because DC paid the partnership for the partnership's 
interest in Property A, under paragraph (c)(5)(iii) of this section, DC 
is treated as paying FC for FC's proportionate share of Property A. 
Under Sec.  1.59A-3(b)(1)(ii), the payment to FC to acquire depreciable 
property is a base erosion payment. DC's base erosion tax benefit is the 
amount of depreciation allocated to DC with respect to the base erosion 
payment, which in this case is the amount of depreciation deductions 
with respect to the property acquired with a base erosion payment, or 
the depreciation deductions from FC's (but not UC's) proportionate share 
of the asset. See Sec.  1.59A-7(d)(1).
    (vi) Example 6: Sale of a partnership interest to a second 
partnership--(A) Facts. FC, UC1, and UC2 are equal partners in 
partnership PRS1. DC and UC3 are equal partners in partnership PRS2. 
UC1, UC2, and UC3 are not related to DC or FC. PRS1's sole asset is 
Property A, which is depreciable property with a fair market value and 
tax basis of $300x. FC sells its entire interest in PRS1 to PRS2 for 
$100. For section 59A purposes, FC's proportionate share of Property A 
prior to the sale is one-third. Following the sale, for section 59A 
purposes, PRS2's proportionate share of Property A is one-third and DC's 
proportionate share of Property A (through PRS2) is one-sixth (50 
percent of one-third).
    (B) Analysis. Under paragraph (c)(5)(ii) of this section (the 
ordering rule), FC's transfer of its interest in PRS1 is first analyzed 
under paragraph (c)(3) of this section to determine how the transfer of 
the partnership interest is treated. Then, paragraph (c)(2) of this 
section applies to analyze how the acquisition of property by PRS2 is 
treated. Under paragraph (c)(3)(ii) of this section, FC is deemed to 
transfer its proportionate share of PRS1's assets, which is one-third of 
Property A. Then, under paragraph (c)(2) of this section, DC is treated 
as acquiring its proportionate share of PRS2's proportionate share of 
Property A from FC, which is one-sixth (50 percent of one-third). Under 
paragraph (c)(5)(iii) of this section, DC is treated as paying for the 
property it is treated as acquiring from FC. Therefore, DC's deemed 
payment to FC to acquire depreciable property is a base erosion payment

[[Page 683]]

under Sec.  1.59A-3(b)(1)(ii). DC's base erosion tax benefit is equal to 
DC's distributive share of depreciation deductions that PRS2 allocates 
to DC attributable to Property A. See Sec.  1.59A-7(d)(1).
    (vii) Example 7: Distribution of cash by a partnership to a foreign 
related party--(A) Facts. DC, FC, and UC are equal partners in a 
partnership, PRS, the assets of which consist of cash of $90x and a 
depreciable asset (Property A) with a fair market value of $180x and a 
tax basis of $60x. Each partner's interest in PRS has a fair market 
value of $90x ($270x/3) and a tax basis of $50x. Assume that all non-
depreciable assets are capital assets, all depreciable assets are 
nonresidential real property under section 168, and that no depreciation 
has been claimed prior to the transaction below. PRS has an election 
under section 754 in effect. PRS distributes the $90x of cash to FC in 
complete liquidation of its interest, resulting in gain to FC of $40x 
($90x minus its tax basis in PRS of $50x) under section 731(a)(1) and an 
increase to the tax basis of Property A under section 734(b) of $40x. 
Prior to the distribution, for section 59A purposes, each partner had a 
one-third proportionate share of Property A. After the distribution, for 
section 59A purposes, the remaining partners each have a 50 percent 
proportionate share of Property A. Each partner's pro-rata allocation of 
depreciation deductions with respect to Property A is in proportion to 
each partner's proportionate share of Property A both before and after 
the distribution. Half of the depreciation deductions attributable to 
the $40x section 734(b) step-up will be allocated to DC. In addition, 
DC's proportionate share of Property A increased from one-third to one-
half and therefore DC will be allocated depreciation deductions with 
respect to half of the original basis of $60x (or $30x) instead of one-
third of $60x (or $20x).
    (B) Analysis. Distributions of property that cause an increase in 
the tax basis of property that continues to be held by the partnership 
are analyzed under paragraph (c)(4) of this section. The $40x increase 
in the tax basis of Property A as a result of the distribution of cash 
to FC is treated as newly purchased property acquired from FC under 
paragraph (c)(4) of this section and therefore acquired with a base 
erosion payment under Sec.  1.59A-3(b)(1)(ii) to DC to the extent of 
DC's proportionate share. DC's base erosion tax benefit is the amount of 
DC's depreciation deductions attributable to that base erosion payment, 
which is DC's distributive share of the depreciation deductions with 
respect to the $40x increase in the tax basis of Property A. See Sec.  
1.59A-7(d)(1). In addition, FC transferred a partnership interest to DC 
(as defined in paragraph (c)(3)(iv) of this section), which is analyzed 
under paragraph (c)(3)(i) of this section. Under paragraph (c)(3)(i) of 
this section, DC is deemed to acquire a one-sixth interest in Property A 
from FC (the increase in DC's proportionate share from one-third to one-
half). DC's base erosion tax benefit from this additional one-sixth 
interest in Property A is the amount of DC's depreciation deductions 
attributable to this interest.
    (viii) Example 8: Distribution of property by a partnership to a 
taxpayer--(A) Facts. The facts are the same as paragraph (g)(2)(vii)(A) 
of this section (the facts of Example 7), except that PRS's depreciable 
property consists of two assets, Property A having a fair market value 
of $90x and a tax basis of $60x and Property B having a fair market 
value of $90x and a tax basis of zero. Instead of distributing cash to 
FC, PRS distributes Property B to DC in liquidation of its interest, 
resulting in an increase in the basis of the distributed Property B to 
DC of $50x (from zero to $50x) under section 732(b) because DC's tax 
basis in the PRS interest was $50x. For section 59A purposes, prior to 
the distribution, each partner had a one-third proportionate share of 
Property B and after the distribution, the property is wholly owned by 
DC.
    (B) Analysis. Distributions of property that cause an increase in 
the tax basis of property that is distributed to a taxpayer are analyzed 
under paragraph (c)(4) of this section. Under paragraph (c)(4) of this 
section, the $50x increase in tax basis is treated as newly purchased 
property that was acquired with a base erosion payment to the extent 
that the increase in tax basis is attributable to FC. Under paragraph 
(c)(4) of this section, the portion of the

[[Page 684]]

increase that is attributable to FC is the proportionate share of the 
Property B immediately before the distribution that was treated as owned 
by FC. Immediately before the distribution, FC had a one-third 
proportionate share of Property B. Accordingly, one-third of the $50x 
increase in the tax basis of Property B is treated as if it was newly 
purchased property acquired by DC from FC with a base erosion payment 
under Sec.  1.59A-3(b)(1)(ii). DC's base erosion tax benefit is the 
amount of DC's depreciation deductions with respect to the base erosion 
payment, which in this case is the depreciation deductions with respect 
to the one-third interest in the increased basis treated as newly 
purchased property deemed acquired from FC. See Sec.  1.59A-3(c)(1). In 
addition, PRS transferred Property B to DC, which is analyzed under 
paragraph (c)(2) of this section. Prior to the distribution, DC, FC, and 
UC each owned one-third of Property B. After the distribution, DC 
entirely owned Property B. Therefore, under paragraph (c)(2) of this 
section, DC is treated as acquiring one-third of Property B from FC. 
DC's depreciation deductions with respect to the one-third of Property B 
acquired from FC (without regard to the basis increase) is also a base 
erosion tax benefit.
    (ix) Example 9: Distribution of property by a partnership in 
liquidation of a foreign related party's interest--(A) Facts. The facts 
are the same as paragraph (g)(2)(viii)(A) (the facts of Example 8), 
except that Property B is not distributed to DC and, instead, Property A 
is distributed to FC in liquidation of its interest, resulting in a tax 
basis in Property A of $50x in FC's hands under section 732(b) and a 
section 734(b) step-up in Property B of $10x (because Property A's tax 
basis was reduced from $60x to $50x), allocable to DC and UC. For 
section 59A purposes, prior to the distribution, each partner had a one-
third proportionate share of Property B and after the distribution, DC 
and UC each have a one-half proportionate share of Property B.
    (B) Analysis. Distributions of property that cause an increase in 
the tax basis of property that continues to be held by the partnership 
are analyzed under paragraph (c)(4) of this section. Under paragraph 
(c)(4) of this section, because the distribution of Property A to FC 
from PRS caused an increase in the tax basis of Property B, the entire 
$10x increase in tax basis is treated as newly purchased property that 
was acquired with a base erosion payment under Sec.  1.59A-3(b)(1)(ii). 
DC's base erosion tax benefit is the amount of DC's depreciation 
deductions attributable to the base erosion payment, which is DC's 
distributive share of the depreciation deductions with respect to the 
$10x increase in the tax basis of Property B. See Sec.  1.59A-7(d)(1). 
In addition, under paragraph (c)(3)(i) of this section, DC is deemed to 
acquire a one-sixth interest in Property B from FC (the increase in DC's 
proportionate share from one-third to one-half). While this increase is 
a base erosion payment under Sec.  1.59A-3(b)(1)(ii), there is no base 
erosion tax benefit from this additional one-sixth interest in Property 
B because the tax basis in Property B (without regard to the basis) is 
zero and therefore the increase in DC's proportionate share does not 
result in any additional depreciation deductions.
    (x) Example 10: Section 704(c) and curative allocations--(A) Facts. 
The facts are the same as in paragraph (d)(2)(ii)(A) of this section 
(the facts in Example 2), except that DC's property is not depreciable, 
PRS uses the traditional method with curative allocations under Sec.  
1.704-3(c), and the curative allocations are to be made from operating 
income. Also assume that the partnership has $20x of gross operating 
income in each year and a curative allocation of the operating income 
satisfies the ``substantially the same effect'' requirement of Sec.  
1.704-3(c)(3)(iii)(A).
    (B) Analysis. The analysis and results are the same as in paragraph 
(d)(2)(i)(B) of this section (the analysis in Example 1), except that 
actual depreciation is $8x ($40x/5) per year and the ceiling rule 
shortfall under Sec.  1.704-3(b)(1) of $2x per year is corrected with a 
curative allocation of income from DC to FC of $2x per year. Solely for 
U.S. federal income tax purposes, each year FC is allocated $12x of 
total operating income and DC is allocated $8x of

[[Page 685]]

operating income. Both the actual depreciation deduction to DC and the 
curative allocation of income from DC are base erosion tax benefits to 
DC under paragraphs (c)(5)(v) and (d)(1) of this section.

[T.D. 9885, 84 FR 67017, Dec. 6, 2019, as amended by T.D. 9910, 85 FR 
64367, Oct. 9, 2020]



Sec.  1.59A-8  [Reserved]



Sec.  1.59A-9  Anti-abuse and recharacterization rules.

    (a) Scope. This section provides rules for recharacterizing certain 
transactions according to their substance for purposes of applying 
section 59A and the section 59A regulations. Paragraph (b) of this 
section provides specific anti-abuse rules. Paragraph (c) of this 
section provides examples illustrating the rules of paragraph (b) of 
this section.
    (b) Anti-abuse rules--(1) Transactions involving unrelated persons, 
conduits, or intermediaries. If a taxpayer pays or accrues an amount to 
one or more intermediaries (including an intermediary unrelated to the 
taxpayer) that would have been a base erosion payment if paid or accrued 
to a foreign related party, and one or more of the intermediaries makes 
(directly or indirectly) corresponding payments to or for the benefit of 
a foreign related party as part of a transaction (or series of 
transactions), plan, or arrangement that has as a principal purpose of 
avoiding a base erosion payment (or reducing the amount of a base 
erosion payment), the role of the intermediary or intermediaries is 
disregarded as a conduit, or the amount paid or accrued to the 
intermediary is treated as a base erosion payment, as appropriate.
    (2) Transactions to increase the amount of deductions taken into 
account in the denominator of the base erosion percentage computation. A 
transaction (or component of a transaction or series of transactions), 
plan, or arrangement that has a principal purpose of increasing the 
deductions taken into account for purposes of Sec.  1.59A-2(e)(3)(i)(B) 
(the denominator of the base erosion percentage computation) is 
disregarded for purposes of Sec.  1.59A-2(e)(3).
    (3) Transactions to avoid the application of rules applicable to 
banks and registered securities dealers. A transaction (or series of 
transactions), plan, or arrangement that occurs among related parties 
that has a principal purpose of avoiding the rules applicable to certain 
banks and registered securities dealers in Sec.  1.59A-2(e)(2) (base 
erosion percentage test for banks and registered securities dealers) or 
Sec.  1.59A-5(c)(2) (increased base erosion and anti-abuse tax rate for 
banks and registered securities dealers) is not taken into account for 
purposes of Sec.  1.59A-2(e)(2) or Sec.  1.59A-5(c)(2).
    (4) Nonrecognition transactions. If a transaction (or series of 
transactions), plan, or arrangement (the first transaction) increases 
the adjusted basis of property that the taxpayer acquires in a 
transaction (the second transaction) that qualifies for the specified 
nonrecognition transaction exception in Sec.  1.59A-3(b)(3)(viii)(A) (or 
would qualify, but for this paragraph (b)(4)), and a principal purpose 
of the first transaction was to increase the taxpayer's depreciation or 
amortization deductions without increasing the taxpayer's base erosion 
tax benefits, then Sec.  1.59A-3(b)(3)(viii)(A) does not apply to the 
property acquired in the second transaction to the extent of the 
increase in adjusted basis. For purposes of this paragraph (b)(4), if a 
transaction (or series of transactions), plan, or arrangement between 
related parties increases the adjusted basis of property within the six-
month period before the taxpayer acquires the property, the transaction 
(or series of transactions), plan, or arrangement is deemed to have such 
a principal purpose.
    (5) Transactions involving derivatives on a partnership interest. If 
a taxpayer acquires a derivative on a partnership interest (or 
partnership assets) as part of a transaction (or series of 
transactions), plan, or arrangement that has as a principal purpose of 
avoiding a base erosion payment (or reducing the amount of a base 
erosion payment) and the partnership interest (or partnership assets) 
would have resulted in a base erosion payment had the taxpayer acquired 
that interest (or partnership asset) directly, then the taxpayer is 
treated as having a direct interest instead of a derivative interest for 
purposes of applying section 59A. This

[[Page 686]]

paragraph (b)(5), however, does not apply to a derivative, as defined in 
section 59A(h)(4)(A)(v), on a partnership asset to the extent the 
payment pursuant to the derivative qualifies for the exception for 
qualified derivative payments in Sec.  1.59A-3(b)(3)(ii) and Sec.  
1.59A-6. A derivative interest in a partnership includes any contract 
(including any financial instrument) the value of which, or any payment 
or other transfer with respect to which, is (directly or indirectly) 
determined in whole or in part by reference to the partnership, 
including the amount of partnership distributions, the value of 
partnership assets, or the results of partnership operations.
    (6) Allocations to eliminate or reduce a base erosion payment. If a 
partnership receives (or accrues) an amount from a person not acting in 
a partner capacity (including a person who is not a partner) and 
allocates the income or loss with respect to that amount to its partners 
with a principal purpose of avoiding a base erosion payment (or reducing 
the amount of a base erosion payment), then the taxpayer transacting 
(directly or indirectly) with the partnership will determine its base 
erosion payment as if the allocations had not been made and the items of 
income or loss had been allocated proportionately. The preceding 
sentence applies only when the allocations, in combination with any 
related allocations, do not change the economic arrangement of the 
partners to the partnership.
    (c) Examples. The following examples illustrate the application of 
this section.
    (1) Facts. The following facts are assumed for purposes of the 
examples.
    (i) DC is a domestic corporation that is an applicable taxpayer for 
purposes section 59A.
    (ii) FP is a foreign corporation that owns all the stock of DC.
    (iii) None of the foreign corporations have income that is, or is 
treated as, effectively connected with the conduct of a trade or 
business in the United States under an applicable provision of the 
Internal Revenue Code or regulations thereunder.
    (iv) All payments occur in a taxable year beginning after December 
31, 2017.
    (2) Example 1: Substitution of payments that are not base erosion 
payments for payments that otherwise would be base erosion payments 
through a conduit or intermediary--(i) Facts. FP owns Property 1 with a 
fair market value of $95x, which FP intends to transfer to DC. A payment 
from DC to FP for Property 1 would be a base erosion payment. Corp A is 
a domestic corporation that is not a related party with respect to DC. 
As part of a plan with a principal purpose of avoiding a base erosion 
payment, FP enters into an arrangement with Corp A to transfer Property 
1 to Corp A in exchange for $95x. Pursuant to the same plan, Corp A 
transfers Property 1 to DC in exchange for $100x. Property 1 is subject 
to the allowance for depreciation (or amortization in lieu of 
depreciation) in the hands of DC.
    (ii) Analysis. The arrangement between FP, DC, and Corp A is deemed 
to result in a $95x base erosion payment under paragraph (b)(1) of this 
section because DC's payment to Corp A would have been a base erosion 
payment if paid to a foreign related party, and Corp A makes a 
corresponding payment to FP as part of the series of transactions that 
has as a principal purpose of avoiding a base erosion payment.
    (3) Example 2: Alternative transaction to base erosion payment--(i) 
Facts. The facts are the same as in paragraph (c)(2)(i) of this section 
(the facts in Example 1), except that DC does not purchase Property 1 
from FP or Corp A. Instead, DC purchases Property 2 from Corp B, a 
domestic corporation that is not a related party with respect to DC and 
that originally produced or acquired Property 2 for Corp B's own 
account. Property 2 is substantially similar to Property 1, and DC uses 
Property 2 in substantially the same manner that DC would have used 
Property 1.
    (ii) Analysis. Paragraph (b)(1) of this section does not apply to 
the transaction between DC and Corp B because Corp B does not make a 
corresponding payment to or for the benefit of FP as part of a 
transaction, plan, or arrangement.
    (4) Example 3: Alternative financing source--(i) Facts. On Date 1, 
FP loaned $200x to DC in exchange for Note A. DC pays or accrues 
interest annually on

[[Page 687]]

Note A, and the payment or accrual is a base erosion payment within the 
meaning of Sec.  1.59A-3(b)(1)(i). On Date 2, DC borrows $200x from 
Bank, a corporation that is not a related party with respect to DC, in 
exchange for Note B. The terms of Note B are substantially similar to 
the terms of Note A. DC uses the proceeds from Note B to repay Note A.
    (ii) Analysis. Paragraph (b)(1) of this section does not apply to 
the transaction between DC and Bank because Bank does not make a 
corresponding payment to or for the benefit of FP as part of the series 
of transactions.
    (5) Example 4: Alternative financing source that is a conduit--(i) 
Facts. The facts are the same as in paragraph (c)(4)(i) of this section 
(the facts in Example 3) except that in addition, as part of the same 
plan or arrangement as the Note B transaction and with a principal 
purpose of avoiding a base erosion payment, FP deposits $250x with Bank. 
The difference between the interest rate paid by Bank to FP on FP's 
deposit and the interest rate paid by DC to Bank is less than one 
percentage point. The interest rate charged by Bank to DC would have 
differed absent the deposit by FP.
    (ii) Analysis. The transactions between FP, DC, and Bank are deemed 
to result in a base erosion payment under paragraph (b)(1) of this 
section because DC's payment to Bank would have been a base erosion 
payment if paid to a foreign related party, and Bank makes a 
corresponding payment to FP as part of the series of transactions that 
has as a principal purpose of avoiding a base erosion payment. See Rev. 
Rul. 87-89, 1987-2 C.B. 195, Situation 3.
    (6) Example 5: Intermediary acquisition--(i) Facts. FP owns all of 
the stock of DC1 and DC2, each domestic corporations. FP is a 
manufacturer of lawn equipment. DC1 is in the trade or business of 
renting equipment to unrelated third parties. DC2 is a dealer in 
property that capitalizes its purchases into inventory and recovers the 
amount through cost of goods sold. Before Date 1, in the ordinary course 
of DC1's business, DC1 acquired depreciable property from FP that DC1 in 
turn rented to unrelated third parties. DC1's purchases from FP were 
base erosion payments within the meaning of Sec.  1.59A-3(b)(1)(ii). On 
Date 1, with a principal purpose of avoiding a base erosion payment, FP 
and DC2 reorganized their operations so that DC2 acquires the lawn 
equipment from FP and immediately thereafter, DC2 resells the lawn 
equipment to DC1.
    (ii) Analysis. The transactions between FP, DC1, and DC2 are deemed 
to result in a base erosion payment under paragraph (b)(1) of this 
section because DC1's payment to DC2 would have been a base erosion 
payment if paid directly to FP, and DC2 makes a corresponding payment to 
FP as part of a series of transactions, plan, or arrangement that has a 
principal purpose of avoiding a base erosion payment from DC1 to FP.
    (7) Example 6: Offsetting transactions to increase the amount of 
deductions taken into account in the denominator of the base erosion 
percentage computation--(i) Facts. With a principal purpose of 
increasing the deductions taken into account by DC for purposes of Sec.  
1.59A-2(e)(3)(i)(B), DC enters into a long position with respect to 
Asset with Financial Institution 1 and simultaneously enters into a 
short position with respect to Asset with Financial Institution 2. 
Financial Institution 1 and Financial Institution 2 are not related to 
DC and are not related to each other.
    (ii) Analysis. Paragraph (b)(2) of this section applies to the 
transactions between DC and Financial Institution 1 and DC and Financial 
Institution 2. These transactions are not taken into account for 
purposes of Sec.  1.59A-2(e)(3)(i)(B) because the transactions have a 
principal purpose of increasing the deductions taken into account for 
purposes of Sec.  1.59A-2(e)(3)(i)(B).
    (8) Example 7: Ordinary course transactions that increase the amount 
of deductions taken into account in the denominator of the base erosion 
percentage computation--(i) Facts. DC, a financial institution, enters 
into a long position with respect to stock in Corporation with Person 1 
and later on the same day enters into a short position with respect to 
stock in Corporation with Person 2. Person 1 and Person 2 are not 
related to DC and are not related to

[[Page 688]]

each other. DC entered into the positions in the ordinary course of its 
business and did not have a principal purpose of increasing the 
deductions taken into account by DC for purposes of Sec.  1.59A-
2(e)(3)(i)(B).
    (ii) Analysis. Paragraph (b)(2) of this section does not apply 
because the transactions between DC and Person 1 and Person 2 were not 
entered into with a principal purpose of increasing the deductions taken 
into account by DC for purposes of Sec.  1.59A-2(e)(3)(i)(B).
    (9) Example 8: Transactions to avoid the application of rules 
applicable to banks and registered securities dealers--(i) Facts. DC 
owns all of the stock of DC1 and Bank (an entity defined in section 
581). DC, DC1, and Bank are members of an affiliated group of 
corporations within the meaning of section 1504(a) that elect to file a 
consolidated U.S. federal income tax return. With a principal purpose of 
avoiding the rules of Sec.  1.59A-2(e)(2) or Sec.  1.59A-5(c)(2), DC and 
DC1 form a new partnership (PRS). DC contributes all of its stock of 
Bank, and DC1 contributes cash, to PRS. DC, DC1, and Bank do not 
materially change their business operations following the formation of 
PRS.
    (ii) Analysis. Paragraph (b)(3) of this section applies to 
transactions with respect to Bank because the transactions with respect 
to PRS were entered into with a principal purpose of avoiding the rules 
of Sec.  1.59A-2(e)(2) or Sec.  1.59A-5(c)(2). The contribution of Bank 
to a PRS is not taken into account, and Bank will be deemed to be part 
of the affiliated group including DC and DC1 for purposes of Sec.  
1.59A-2(e)(2) and Sec.  1.59A-5(c)(2).
    (10) Example 9: Transactions that do not avoid the application of 
rules applicable to banks and registered securities dealers--(i) Facts. 
The facts are the same as the facts of paragraph (c)(9)(i) of this 
section (the facts of Example 8), except that DC sells 90 percent of the 
stock of Bank to an unrelated party in exchange for cash.
    (ii) Analysis. Paragraph (b)(3) of this section does not apply to 
DC's sale of the stock of Bank because the sale was not made with a 
principal purpose of avoiding the rules of Sec.  1.59A-2(e)(2) or Sec.  
1.59A-5(c)(2). Bank will not be treated as part of the affiliated group 
including DC and DC1 for purposes of Sec.  1.59A-2(e)(2) and Sec.  
1.59A-5(c)(2).
    (11) Example 10: Acquisition of depreciable property in a 
nonrecognition transaction--(i) Facts. U, which is not a related party 
with respect to FP or DC, owns Property 1 with an adjusted basis of $50x 
and a fair market value of $100x. On Date 1, FP purchases property, 
including Property 1, from U in exchange for cash, and then FP 
contributes Property 1 to DC in an exchange described in section 351. 
Following the exchange, DC's basis in Property 1 is $100x.
    (ii) Analysis. Paragraph (b)(4) of this section does not apply to 
DC's acquisition of Property 1 because the purchase of Property 1 from U 
(first transaction) did not have a principal purpose of increasing DC's 
adjusted basis of Property 1 without increasing DC's base erosion tax 
benefits. The transaction is economically equivalent to an alternative 
transaction under which FP contributed $100x to DC and then DC purchased 
Property 1 from U. Further, the second sentence of paragraph (b)(4) of 
this section (providing that certain transactions are deemed to have a 
principal purpose of increasing the adjusted basis of property acquired 
in a second transaction) does not apply because FP purchased Property 1 
from an unrelated party.
    (12) Example 11: Transactions between related parties with a 
principal purpose of increasing the adjusted basis of property--(i) 
Facts. The facts are the same as paragraph (c)(11)(i) of this section 
(the facts in Example 10), except that U is related to FP and DC.
    (ii) Analysis. Paragraph (b)(4) of this section applies to DC's 
acquisition of Property 1 because the transaction that increased the 
adjusted basis of Property 1 (the purchase of Property 1 from U) was 
between related parties, and within six months DC acquired Property 1 
from FP in a specified nonrecognition transaction. Accordingly, the 
purchase of property from U (first transaction) is deemed to have a 
principal purpose of increasing the adjusted basis of Property 1 that DC 
acquires in the second transaction--the contribution (a transaction that 
qualifies as a specified nonrecognition transaction in part and would 
wholly qualify but for

[[Page 689]]

the application of paragraph (b)(4) of this section). Accordingly, the 
exception in Sec.  1.59A-3(b)(3)(viii)(A) for specified nonrecognition 
transactions does not apply to the contribution of Property 1 to DC to 
the extent of the increased adjusted basis from the first transaction 
($50x), and DC's depreciation deductions with respect to Property 1 will 
be base erosion tax benefits to the extent of the $50x increase in 
adjusted basis in Property 1.

[T.D. 9885, 84 FR 67017, Dec. 6, 2019, as amended at 85 FR 9370, Feb. 
19, 2020; T.D. 9910, 85 FR 64368, Oct. 9, 2020]



Sec.  1.59A-10  Applicability date.

    (a) General applicability date. Sections 1.59A-1 through 1.59A-9, 
other than the provisions described in the first sentence of paragraph 
(b) of this section, apply to taxable years ending on or after December 
17, 2018. However, taxpayers may apply these regulations in their 
entirety for taxable years beginning after December 31, 2017, and ending 
before December 17, 2018. In lieu of applying the regulations referred 
to in the first sentence of this paragraph, taxpayers may apply the 
provisions matching Sec. Sec.  1.59A-1 through 1.59A-9 from the Internal 
Revenue Bulletin (IRB) 2019-02 (https://www.irs.gov/irb/2019-02_IRB) in 
their entirety for all taxable years beginning after December 31, 2017 
and ending on or before December 6, 2019.
    (b) Exception. Sections 1.59A-2(c)(2)(ii) and (c)(4) through (6), 
1.59A-3(b)(3)(iii)(C), 1.59A-3(c)(5) and (6), and 1.59A-9(b)(4) apply to 
taxable years beginning on or after October 9, 2020, and Sec. Sec.  
1.59A-7(c)(5)(v) and 1.59A-9(b)(5) and (6) apply to taxable years ending 
on or after December 2, 2019. Taxpayers may apply those regulations in 
their entirety for taxable years beginning after December 31, 2017, and 
before their applicability date, provided that, once applied, taxpayers 
must continue to apply them in their entirety for all subsequent taxable 
years. Alternatively, taxpayers may apply only Sec.  1.59A-3(c)(5) and 
(6) for taxable years beginning after December 31, 2017, and before 
their applicability date, provided that, once applied, taxpayers must 
continue to apply Sec.  1.59A-3(c)(5) and (6) in their entirety for all 
subsequent taxable years.

[T.D. 9910, 85 FR 64368, Oct. 9, 2020]



Sec.  1.60  [Reserved]

[[Page 691]]



                              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 693]]



                    Table of CFR Titles and Chapters




                      (Revised as of April 1, 2023)

                      Title 1--General Provisions

         I  Administrative Committee of the Federal Register 
                (Parts 1--49)
        II  Office of the Federal Register (Parts 50--299)
       III  Administrative Conference of the United States (Parts 
                300--399)
        IV  Miscellaneous Agencies (Parts 400--599)
        VI  National Capital Planning Commission (Parts 600--699)

                    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 2--199)
        II  Office of Management and Budget Guidance (Parts 200--
                299)
            Subtitle B--Federal Agency Regulations for Grants and 
                Agreements
       III  Department of Health and Human Services (Parts 300--
                399)
        IV  Department of Agriculture (Parts 400--499)
        VI  Department of State (Parts 600--699)
       VII  Agency for International Development (Parts 700--799)
      VIII  Department of Veterans Affairs (Parts 800--899)
        IX  Department of Energy (Parts 900--999)
         X  Department of the Treasury (Parts 1000--1099)
        XI  Department of Defense (Parts 1100--1199)
       XII  Department of Transportation (Parts 1200--1299)
      XIII  Department of Commerce (Parts 1300--1399)
       XIV  Department of the Interior (Parts 1400--1499)
        XV  Environmental Protection Agency (Parts 1500--1599)
     XVIII  National Aeronautics and Space Administration (Parts 
                1800--1899)
        XX  United States Nuclear Regulatory Commission (Parts 
                2000--2099)
      XXII  Corporation for National and Community Service (Parts 
                2200--2299)
     XXIII  Social Security Administration (Parts 2300--2399)
      XXIV  Department of Housing and Urban Development (Parts 
                2400--2499)
       XXV  National Science Foundation (Parts 2500--2599)
      XXVI  National Archives and Records Administration (Parts 
                2600--2699)

[[Page 694]]

     XXVII  Small Business Administration (Parts 2700--2799)
    XXVIII  Department of Justice (Parts 2800--2899)
      XXIX  Department of Labor (Parts 2900--2999)
       XXX  Department of Homeland Security (Parts 3000--3099)
      XXXI  Institute of Museum and Library Services (Parts 3100--
                3199)
     XXXII  National Endowment for the Arts (Parts 3200--3299)
    XXXIII  National Endowment for the Humanities (Parts 3300--
                3399)
     XXXIV  Department of Education (Parts 3400--3499)
      XXXV  Export-Import Bank of the United States (Parts 3500--
                3599)
     XXXVI  Office of National Drug Control Policy, Executive 
                Office of the President (Parts 3600--3699)
    XXXVII  Peace Corps (Parts 3700--3799)
     LVIII  Election Assistance Commission (Parts 5800--5899)
       LIX  Gulf Coast Ecosystem Restoration Council (Parts 5900--
                5999)
        LX  Federal Communications Commission (Parts 6000--6099)

                        Title 3--The President

         I  Executive Office of the President (Parts 100--199)

                           Title 4--Accounts

         I  Government Accountability Office (Parts 1--199)

                   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)
        IV  Office of Personnel Management and Office of the 
                Director of National Intelligence (Parts 1400--
                1499)
         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 (Parts 2100--2199)
       XIV  Federal Labor Relations Authority, General Counsel of 
                the Federal Labor Relations Authority and Federal 
                Service Impasses Panel (Parts 2400--2499)
       XVI  Office of Government Ethics (Parts 2600--2699)
       XXI  Department of the Treasury (Parts 3100--3199)
      XXII  Federal Deposit Insurance Corporation (Parts 3200--
                3299)
     XXIII  Department of Energy (Parts 3300--3399)
      XXIV  Federal Energy Regulatory Commission (Parts 3400--
                3499)
       XXV  Department of the Interior (Parts 3500--3599)

[[Page 695]]

      XXVI  Department of Defense (Parts 3600--3699)
    XXVIII  Department of Justice (Parts 3800--3899)
      XXIX  Federal Communications Commission (Parts 3900--3999)
       XXX  Farm Credit System Insurance Corporation (Parts 4000--
                4099)
      XXXI  Farm Credit Administration (Parts 4100--4199)
    XXXIII  U.S. International Development Finance Corporation 
                (Parts 4300--4399)
     XXXIV  Securities and Exchange Commission (Parts 4400--4499)
      XXXV  Office of Personnel Management (Parts 4500--4599)
     XXXVI  Department of Homeland Security (Parts 4600--4699)
    XXXVII  Federal Election Commission (Parts 4700--4799)
        XL  Interstate Commerce Commission (Parts 5000--5099)
       XLI  Commodity Futures Trading Commission (Parts 5100--
                5199)
      XLII  Department of Labor (Parts 5200--5299)
     XLIII  National Science Foundation (Parts 5300--5399)
       XLV  Department of Health and Human Services (Parts 5500--
                5599)
      XLVI  Postal Rate Commission (Parts 5600--5699)
     XLVII  Federal Trade Commission (Parts 5700--5799)
    XLVIII  Nuclear Regulatory Commission (Parts 5800--5899)
      XLIX  Federal Labor Relations Authority (Parts 5900--5999)
         L  Department of Transportation (Parts 6000--6099)
       LII  Export-Import Bank of the United States (Parts 6200--
                6299)
      LIII  Department of Education (Parts 6300--6399)
       LIV  Environmental Protection Agency (Parts 6400--6499)
        LV  National Endowment for the Arts (Parts 6500--6599)
       LVI  National Endowment for the Humanities (Parts 6600--
                6699)
      LVII  General Services Administration (Parts 6700--6799)
     LVIII  Board of Governors of the Federal Reserve System 
                (Parts 6800--6899)
       LIX  National Aeronautics and Space Administration (Parts 
                6900--6999)
        LX  United States Postal Service (Parts 7000--7099)
       LXI  National Labor Relations Board (Parts 7100--7199)
      LXII  Equal Employment Opportunity Commission (Parts 7200--
                7299)
     LXIII  Inter-American Foundation (Parts 7300--7399)
      LXIV  Merit Systems Protection Board (Parts 7400--7499)
       LXV  Department of Housing and Urban Development (Parts 
                7500--7599)
      LXVI  National Archives and Records Administration (Parts 
                7600--7699)
     LXVII  Institute of Museum and Library Services (Parts 7700--
                7799)
    LXVIII  Commission on Civil Rights (Parts 7800--7899)
      LXIX  Tennessee Valley Authority (Parts 7900--7999)
       LXX  Court Services and Offender Supervision Agency for the 
                District of Columbia (Parts 8000--8099)
      LXXI  Consumer Product Safety Commission (Parts 8100--8199)

[[Page 696]]

    LXXIII  Department of Agriculture (Parts 8300--8399)
     LXXIV  Federal Mine Safety and Health Review Commission 
                (Parts 8400--8499)
     LXXVI  Federal Retirement Thrift Investment Board (Parts 
                8600--8699)
    LXXVII  Office of Management and Budget (Parts 8700--8799)
      LXXX  Federal Housing Finance Agency (Parts 9000--9099)
   LXXXIII  Special Inspector General for Afghanistan 
                Reconstruction (Parts 9300--9399)
    LXXXIV  Bureau of Consumer Financial Protection (Parts 9400--
                9499)
    LXXXVI  National Credit Union Administration (Parts 9600--
                9699)
     XCVII  Department of Homeland Security Human Resources 
                Management System (Department of Homeland 
                Security--Office of Personnel Management) (Parts 
                9700--9799)
    XCVIII  Council of the Inspectors General on Integrity and 
                Efficiency (Parts 9800--9899)
      XCIX  Military Compensation and Retirement Modernization 
                Commission (Parts 9900--9999)
         C  National Council on Disability (Parts 10000--10049)
        CI  National Mediation Board (Parts 10100--10199)
       CII  U.S. Office of Special Counsel (Parts 10200--10299)
       CIV  Office of the Intellectual Property Enforcement 
                Coordinator (Part 10400--10499)

                      Title 6--Domestic Security

         I  Department of Homeland Security, Office of the 
                Secretary (Parts 1--199)
         X  Privacy and Civil Liberties Oversight Board (Parts 
                1000--1099)

                         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)

[[Page 697]]

      VIII  Agricultural Marketing Service (Federal Grain 
                Inspection Service, Fair Trade Practices Program), 
                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  [Reserved]
      XVII  Rural Utilities Service, Department of Agriculture 
                (Parts 1700--1799)
     XVIII  Rural Housing Service, Rural Business-Cooperative 
                Service, Rural Utilities Service, and Farm Service 
                Agency, Department of Agriculture (Parts 1800--
                2099)
        XX  [Reserved]
       XXV  Office of Advocacy and Outreach, Department of 
                Agriculture (Parts 2500--2599)
      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  National Institute of Food and 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]

[[Page 698]]

      XLII  Rural Business-Cooperative Service and Rural Utilities 
                Service, Department of Agriculture (Parts 4200--
                4299)
         L  Rural Business-Cooperative Service, and Rural 
                Utilities Service, Department of Agriculture 
                (Parts 5000--5099)

                    Title 8--Aliens and Nationality

         I  Department of Homeland Security (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  Agricultural Marketing Service (Fair Trade Practices 
                Program), Department of Agriculture (Parts 200--
                299)
       III  Food Safety and Inspection Service, Department of 
                Agriculture (Parts 300--599)

                           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 1300--
                1399)
      XVII  Defense Nuclear Facilities Safety Board (Parts 1700--
                1799)
     XVIII  Northeast Interstate Low-Level Radioactive Waste 
                Commission (Parts 1800--1899)

                      Title 11--Federal Elections

         I  Federal Election Commission (Parts 1--9099)
        II  Election Assistance Commission (Parts 9400--9499)

                      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  [Reserved]
        VI  Farm Credit Administration (Parts 600--699)
       VII  National Credit Union Administration (Parts 700--799)
      VIII  Federal Financing Bank (Parts 800--899)
        IX  (Parts 900--999)[Reserved]

[[Page 699]]

         X  Consumer Financial Protection Bureau (Parts 1000--
                1099)
        XI  Federal Financial Institutions Examination Council 
                (Parts 1100--1199)
       XII  Federal Housing Finance Agency (Parts 1200--1299)
      XIII  Financial Stability Oversight Council (Parts 1300--
                1399)
       XIV  Farm Credit System Insurance Corporation (Parts 1400--
                1499)
        XV  Department of the Treasury (Parts 1500--1599)
       XVI  Office of Financial Research, Department of the 
                Treasury (Parts 1600--1699)
      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 (Parts 400--499)
         V  Emergency Oil and Gas Guaranteed Loan Board (Parts 
                500--599)

                    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--1199)
         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)

[[Page 700]]

      VIII  Bureau of Economic Analysis, Department of Commerce 
                (Parts 800--899)
        IX  National Oceanic and Atmospheric Administration, 
                Department of Commerce (Parts 900--999)
        XI  National Technical Information Service, Department of 
                Commerce (Parts 1100--1199)
      XIII  East-West Foreign Trade Board (Parts 1300--1399)
       XIV  Minority Business Development Agency (Parts 1400--
                1499)
        XV  Office of the Under-Secretary for Economic Affairs, 
                Department of Commerce (Parts 1500--1599)
            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) [Reserved]

                    Title 16--Commercial Practices

         I  Federal Trade Commission (Parts 0--999)
        II  Consumer Product Safety Commission (Parts 1000--1799)

             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  U.S. 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  U.S. Immigration and Customs Enforcement, Department 
                of Homeland Security (Parts 400--599) [Reserved]

[[Page 701]]

                     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  Office of Workers' Compensation Programs, 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 Service, 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)

                      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  United States Agency for Global Media (Parts 500--599)
       VII  U.S. International Development Finance Corporation 
                (Parts 700--799)
        IX  Foreign Service Grievance Board (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)
      XIII  Millennium Challenge Corporation (Parts 1300--1399)
       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)

[[Page 702]]

                          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)
        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) 
                [Reserved]
       XII  Office of Inspector General, Department of Housing and 
                Urban Development (Parts 2000--2099)
        XV  Emergency Mortgage Insurance and Loan Programs, 
                Department of Housing and Urban Development (Parts 
                2700--2799) [Reserved]

[[Page 703]]

        XX  Office of Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Parts 3200--3899)
      XXIV  Board of Directors of the HOPE for Homeowners Program 
                (Parts 4000--4099) [Reserved]
       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--899)
         V  Bureau of Indian Affairs, Department of the Interior, 
                and Indian Health Service, Department of Health 
                and Human Services (Part 900--999)
        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 (Parts 1200--1299)

                      Title 26--Internal Revenue

         I  Internal Revenue Service, Department of the Treasury 
                (Parts 1--End)

           Title 27--Alcohol, Tobacco Products and Firearms

         I  Alcohol and Tobacco Tax and Trade Bureau, Department 
                of the Treasury (Parts 1--399)
        II  Bureau of Alcohol, Tobacco, Firearms, and Explosives, 
                Department of Justice (Parts 400--799)

                   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)

[[Page 704]]

        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)

                      Title 30--Mineral Resources

         I  Mine Safety and Health Administration, Department of 
                Labor (Parts 1--199)
        II  Bureau of Safety and Environmental Enforcement, 
                Department of the Interior (Parts 200--299)
        IV  Geological Survey, Department of the Interior (Parts 
                400--499)
         V  Bureau of Ocean Energy Management, Department of the 
                Interior (Parts 500--599)
       VII  Office of Surface Mining Reclamation and Enforcement, 
                Department of the Interior (Parts 700--999)
       XII  Office of Natural Resources Revenue, Department of the 
                Interior (Parts 1200--1299)

                 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

[[Page 705]]

         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 Investment Security, Department of the 
                Treasury (Parts 800--899)
        IX  Federal Claims Collection Standards (Department of the 
                Treasury--Department of Justice) (Parts 900--999)
         X  Financial Crimes Enforcement Network, Department of 
                the Treasury (Parts 1000--1099)

                      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  Department of Defense, Defense Logistics Agency (Parts 
                1200--1299)
       XVI  Selective Service System (Parts 1600--1699)
      XVII  Office of the Director of National Intelligence (Parts 
                1700--1799)
     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)
    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, Department 
                of Defense (Parts 200--399)
        IV  Great Lakes St. Lawrence Seaway Development 
                Corporation, Department of Transportation (Parts 
                400--499)

[[Page 706]]

                          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 Career, Technical, and Adult Education, 
                Department of Education (Parts 400--499)
         V  Office of Bilingual Education and Minority Languages 
                Affairs, Department of Education (Parts 500--599) 
                [Reserved]
        VI  Office of Postsecondary Education, Department of 
                Education (Parts 600--699)
       VII  Office of Educational Research and Improvement, 
                Department of Education (Parts 700--799) 
                [Reserved]
            Subtitle C--Regulations Relating to Education
        XI  [Reserved]
       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)
        VI  [Reserved]
       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 (Parts 1500--
                1599)
       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  U.S. Copyright Office, Library of Congress (Parts 
                200--299)

[[Page 707]]

       III  Copyright Royalty Board, Library of Congress (Parts 
                300--399)
        IV  National Institute of Standards and Technology, 
                Department of Commerce (Parts 400--599)

           Title 38--Pensions, Bonuses, and Veterans' Relief

         I  Department of Veterans Affairs (Parts 0--199)
        II  Armed Forces Retirement Home (Parts 200--299)

                       Title 39--Postal Service

         I  United States Postal Service (Parts 1--999)
       III  Postal Regulatory 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)
      VIII  Gulf Coast Ecosystem Restoration Council (Parts 1800--
                1899)
        IX  Federal Permitting Improvement Steering Council (Part 
                1900)

          Title 41--Public Contracts and Property Management

            Subtitle A--Federal Procurement Regulations System 
                [Note]
            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)
   62--100  [Reserved]
            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)
  103--104  [Reserved]
       105  General Services Administration (Parts 105-1--105-999)

[[Page 708]]

       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)
  129--200  [Reserved]
            Subtitle D--Federal Acquisition Supply Chain Security
       201  Federal Acquisition Security Council (Parts 201-1--
                201-99).
            Subtitle E [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)
   II--III  [Reserved]
        IV  Centers for Medicare & Medicaid Services, Department 
                of Health and Human Services (Parts 400--699)
         V  Office of Inspector General-Health Care, Department of 
                Health and Human Services (Parts 1000--1099)

                   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 400--999)
        II  Bureau of Land Management, Department of the Interior 
                (Parts 1000--9999)
       III  Utah Reclamation Mitigation and Conservation 
                Commission (Parts 10000--10099)

             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 709]]

                       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)
        IX  Denali Commission (Parts 900--999)
         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  Administration for Children and Families, 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 of Fine Arts (Parts 2100--2199)
     XXIII  Arctic Research Commission (Parts 2300--2399)
      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)

[[Page 710]]

                      Title 47--Telecommunication

         I  Federal Communications Commission (Parts 0--199)
        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)
        IV  National Telecommunications and Information 
                Administration, Department of Commerce, and 
                National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 400--499)
         V  The First Responder Network Authority (Parts 500--599)

           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  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)

[[Page 711]]

        51  Department of the Army Acquisition Regulations (Parts 
                5100--5199) [Reserved]
        52  Department of the Navy Acquisition Regulations (Parts 
                5200--5299)
        53  Department of the Air Force Federal Acquisition 
                Regulation Supplement (Parts 5300--5399) 
                [Reserved]
        54  Defense Logistics Agency, Department of Defense (Parts 
                5400--5499)
        57  African Development Foundation (Parts 5700--5799)
        61  Civilian Board of Contract Appeals, General Services 
                Administration (Parts 6100--6199)
        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 (Parts 1000--1399)
        XI  Research and Innovative Technology Administration, 
                Department of Transportation (Parts 1400--1499) 
                [Reserved]
       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 712]]

        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)

[[Page 713]]





           Alphabetical List of Agencies Appearing in the CFR




                      (Revised as of April 1, 2023)

                                                  CFR Title, Subtitle or 
                     Agency                               Chapter

Administrative Conference of the United States    1, III
Advisory Council on Historic Preservation         36, VIII
Advocacy and Outreach, Office of                  7, XXV
Afghanistan Reconstruction, Special Inspector     5, LXXXIII
     General for
African Development Foundation                    22, XV
  Federal Acquisition Regulation                  48, 57
Agency for International Development              2, VII; 22, II
  Federal Acquisition Regulation                  48, 7
Agricultural Marketing Service                    7, I, VIII, IX, X, XI; 9, 
                                                  II
Agricultural Research Service                     7, V
Agriculture, Department of                        2, IV; 5, LXXIII
  Advocacy and Outreach, Office of                7, XXV
  Agricultural Marketing Service                  7, I, VIII, IX, X, XI; 9, 
                                                  II
  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
  Economic Research Service                       7, XXXVII
  Energy Policy and New Uses, Office of           2, IX; 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
  Information Resources Management, Office of     7, XXVII
  Inspector General, Office of                    7, XXVI
  National Agricultural Library                   7, XLI
  National Agricultural Statistics Service        7, XXXVI
  National Institute of Food and Agriculture      7, XXXIV
  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 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 of                          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
Architectural and Transportation Barriers         36, XI
   Compliance Board
[[Page 714]]

Arctic Research Commission                        45, XXIII
Armed Forces Retirement Home                      5, XI; 38, II
Army, Department of                               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
  Federal Acquisition Regulation                  48, 19
Career, Technical, and Adult Education, Office    34, IV
     of
Census Bureau                                     15, I
Centers for Medicare & Medicaid Services          42, IV
Central Intelligence Agency                       32, XIX
Chemical Safety and Hazard Investigation Board    40, VI
Chief Financial Officer, Office of                7, XXX
Child Support Enforcement, Office of              45, III
Children and Families, Administration for         45, II, III, IV, X, XIII
Civil Rights, Commission on                       5, LXVIII; 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 of                           2, XIII; 44, IV; 50, VI
  Census Bureau                                   15, I
  Economic Affairs, Office of the Under-          15, XV
       Secretary for
  Economic Analysis, Bureau of                    15, VIII
  Economic Development Administration             13, III
  Emergency Management and Assistance             44, IV
  Federal Acquisition Regulation                  48, 13
  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; 37, IV
  National Marine Fisheries Service               50, II, IV
  National Oceanic and Atmospheric                15, IX; 50, II, III, IV, 
       Administration                             VI
  National Technical Information Service          15, XI
  National Telecommunications and Information     15, XXIII; 47, III, IV
       Administration
  National Weather Service                        15, IX
  Patent and Trademark Office, United States      37, I
  Secretary of Commerce, Office of                15, Subtitle A
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 Financial Protection Bureau              5, LXXXIV; 12, X
Consumer Product Safety Commission                5, LXXI; 16, II
Copyright Royalty Board                           37, III
Corporation for National and Community Service    2, XXII; 45, XII, XXV
Cost Accounting Standards Board                   48, 99
Council on Environmental Quality                  40, V
Council of the Inspectors General on Integrity    5, XCVIII
     and Efficiency
Court Services and Offender Supervision Agency    5, LXX; 28, VIII
     for the District of Columbia
Customs and Border Protection                     19, I
Defense, Department of                            2, XI; 5, XXVI; 32, 
                                                  Subtitle A; 40, VII
  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, 2
  Defense Intelligence Agency                     32, I

[[Page 715]]

  Defense Logistics Agency                        32, I, XII; 48, 54
  Engineers, Corps of                             33, II; 36, III
  National Imagery and Mapping Agency             32, I
  Navy, Department of                             32, VI; 48, 52
  Secretary of Defense, Office of                 2, XI; 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
Denali Commission                                 45, IX
Disability, National Council on                   5, C; 34, XII
District of Columbia, Court Services and          5, LXX; 28, VIII
     Offender Supervision Agency for the
Drug Enforcement Administration                   21, II
East-West Foreign Trade Board                     15, XIII
Economic Affairs, Office of the Under-Secretary   15, XV
     for
Economic Analysis, Bureau of                      15, VIII
Economic Development Administration               13, III
Economic Research Service                         7, XXXVII
Education, Department of                          2, XXXIV; 5, LIII
  Bilingual Education and Minority Languages      34, V
       Affairs, Office of
  Career, Technical, and Adult Education, Office  34, IV
       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
Educational Research and Improvement, Office of   34, VII
Election Assistance Commission                    2, LVIII; 11, II
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 Policy, National Commission for        1, IV
Employment Standards Administration               20, VI
Endangered Species Committee                      50, IV
Energy, Department of                             2, IX; 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                   2, XV; 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
  Environmental Quality, Council on               40, V
  Management and Budget, Office of                2, Subtitle A; 5, III, 
                                                  LXXVII; 14, VI; 48, 99
  National Drug Control Policy, Office of         2, XXXVI; 21, III
  National Security Council                       32, XXI; 47, II
  Presidential Documents                          3
  Science and Technology Policy, Office of        32, XXIV; 47, II
  Trade Representative, Office of the United      15, XX
     States
[[Page 716]]

Export-Import Bank of the United States           2, XXXV; 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 Acquisition Security Council              41, 201
Federal Aviation Administration                   14, I
  Commercial Space Transportation                 14, III
Federal Claims Collection Standards               31, IX
Federal Communications Commission                 2, LX; 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                       5, XXXVII; 11, I
Federal Emergency Management Agency               44, I
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 Agency                    5, LXXX; 12, XII
Federal Labor Relations Authority                 5, XIV, XLIX; 22, XIV
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 Permitting Improvement Steering Council   40, IX
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
Financial Crimes Enforcement Network              31, X
Financial Research Office                         12, XVI
Financial Stability Oversight Council             12, XIII
Fine Arts, Commission of                          45, XXI
Fiscal Service                                    31, II
Fish and Wildlife Service, United States          50, I, IV
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

[[Page 717]]

  Federal Management Regulation                   41, 102
  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
Great Lakes St. Lawrence Seaway Development       33, IV
     Corporation
Gulf Coast Ecosystem Restoration Council          2, LIX; 40, VIII
Harry S. Truman Scholarship Foundation            45, XVIII
Health and Human Services, Department of          2, III; 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, XIII
  Community Services, Office of                   45, X
  Family Assistance, Office of                    45, II
  Federal Acquisition Regulation                  48, 3
  Food and Drug Administration                    21, I
  Indian Health Service                           25, V
  Inspector General (Health Care), Office of      42, V
  Public Health Service                           42, I
  Refugee Resettlement, Office of                 45, IV
Homeland Security, Department of                  2, XXX; 5, XXXVI; 6, I; 8, 
                                                  I
  Coast Guard                                     33, I; 46, I; 49, IV
  Coast Guard (Great Lakes Pilotage)              46, III
  Customs and Border Protection                   19, I
  Federal Emergency Management Agency             44, I
  Human Resources Management and Labor Relations  5, XCVII
       Systems
  Immigration and Customs Enforcement Bureau      19, IV
  Transportation Security Administration          49, XII
HOPE for Homeowners Program, Board of Directors   24, XXIV
     of
Housing and Urban Development, Department of      2, XXIV; 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
Immigration and Customs Enforcement Bureau        19, IV
Immigration Review, Executive Office for          8, V
Independent Counsel, Office of                    28, VII
Independent Counsel, Offices of                   28, VI
Indian Affairs, Bureau of                         25, I, V
Indian Affairs, Office of the Assistant           25, VI
     Secretary
Indian Arts and Crafts Board                      25, II

[[Page 718]]

Indian Health Service                             25, V
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
Inspector General
  Agriculture Department                          7, XXVI
  Health and Human Services Department            42, V
  Housing and Urban Development Department        24, XII, XV
Institute of Peace, United States                 22, XVII
Intellectual Property Enforcement Coordinator,    5, CIV
     Office of
Inter-American Foundation                         5, LXIII; 22, X
Interior, Department of                           2, XIV
  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
  National Indian Gaming Commission               25, III
  National Park Service                           36, I
  Natural Resource Revenue, Office of             30, XII
  Ocean Energy Management, Bureau of              30, V
  Reclamation, Bureau of                          43, I
  Safety and Environmental Enforcement, Bureau    30, II
       of
  Secretary of the Interior, Office of            2, XIV; 43, Subtitle A
  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 Development Finance Corporation,    5, XXXIII; 22, VII
     U.S.
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
Investment Security, Office of                    31, VIII
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 of                            2, XXVIII; 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
  Independent Counsel, Offices of                 28, VI
  Prisons, Bureau of                              28, V
  Property Management Regulations                 41, 128
Labor, Department of                              2, XXIX; 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
  Federal Acquisition Regulation                  48, 29

[[Page 719]]

  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
  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, VI
Labor-Management Standards, Office of             29, II, IV
Land Management, Bureau of                        43, II
Legal Services Corporation                        45, XVI
Libraries and Information Science, National       45, XVII
     Commission on
Library of Congress                               36, VII
  Copyright Royalty Board                         37, III
  U.S. Copyright Office                           37, II
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, LXIV
Micronesian Status Negotiations, Office for       32, XXVII
Military Compensation and Retirement              5, XCIX
     Modernization Commission
Millennium Challenge Corporation                  22, XIII
Mine Safety and Health Administration             30, I
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
Museum and Library Services, Institute of         2, XXXI
National Aeronautics and Space Administration     2, XVIII; 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   2, XXII; 45, XII, XXV
National Archives and Records Administration      2, XXVI; 5, LXVI; 36, XII
  Information Security Oversight Office           32, XX
National Capital Planning Commission              1, IV, VI
National Counterintelligence Center               32, XVIII
National Credit Union Administration              5, LXXXVI; 12, VII
National Crime Prevention and Privacy Compact     28, IX
     Council
National Drug Control Policy, Office of           2, XXXVI; 21, III
National Endowment for the Arts                   2, XXXII
National Endowment for the Humanities             2, XXXIII
National Foundation on the Arts and the           45, XI
     Humanities
National Geospatial-Intelligence Agency           32, I
National Highway Traffic Safety Administration    23, II, III; 47, VI; 49, V
National Imagery and Mapping Agency               32, I
National Indian Gaming Commission                 25, III
National Institute of Food and Agriculture        7, XXXIV
National Institute of Standards and Technology    15, II; 37, IV
National Intelligence, Office of Director of      5, IV; 32, XVII
National Labor Relations Board                    5, LXI; 29, I
National Marine Fisheries Service                 50, II, IV
National Mediation Board                          5, CI; 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                       2, XXV; 5, XLIII; 45, VI
  Federal Acquisition Regulation                  48, 25
National Security Council                         32, XXI; 47, II

[[Page 720]]

National Technical Information Service            15, XI
National Telecommunications and Information       15, XXIII; 47, III, IV, V
     Administration
National Transportation Safety Board              49, VIII
Natural Resource Revenue, Office of               30, XII
Natural Resources Conservation Service            7, VI
Navajo and Hopi Indian Relocation, Office of      25, IV
Navy, Department of                               32, VI
  Federal Acquisition Regulation                  48, 52
Neighborhood Reinvestment Corporation             24, XXV
Northeast Interstate Low-Level Radioactive Waste  10, XVIII
     Commission
Nuclear Regulatory Commission                     2, XX; 5, XLVIII; 10, I
  Federal Acquisition Regulation                  48, 20
Occupational Safety and Health Administration     29, XVII
Occupational Safety and Health Review Commission  29, XX
Ocean Energy Management, Bureau of                30, V
Oklahoma City National Memorial Trust             36, XV
Operations Office                                 7, XXVIII
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                                       2, XXXVII; 22, III
Pennsylvania Avenue Development Corporation       36, IX
Pension Benefit Guaranty Corporation              29, XL
Personnel Management, Office of                   5, I, IV, 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
  Human Resources Management and Labor Relations  5, XCVII
       Systems, Department of Homeland Security
Pipeline and Hazardous Materials Safety           49, I
     Administration
Postal Regulatory 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
Privacy and Civil Liberties Oversight Board       6, X
Procurement and Property Management, Office of    7, XXXII
Public and Indian Housing, Office of Assistant    24, IX
     Secretary for
Public Contracts, Department of Labor             41, 50
Public Health Service                             42, I
Railroad Retirement Board                         20, II
Reclamation, Bureau of                            43, I
Refugee Resettlement, Office of                   45, IV
Relocation Allowances                             41, 302
Research and Innovative Technology                49, XI
     Administration
Rural Business-Cooperative Service                7, XVIII, XLII, L
Rural Development Administration                  7, XLII
Rural Housing Service                             7, XVIII, XXXV, L
Rural Utilities Service                           7, XVII, XVIII, XLII, L
Safety and Environmental Enforcement, Bureau of   30, II
Science and Technology Policy, Office of          32, XXIV; 47, II
Secret Service                                    31, IV
Securities and Exchange Commission                5, XXXIV; 17, II
Selective Service System                          32, XVI
Small Business Administration                     2, XXVII; 13, I
Smithsonian Institution                           36, V
Social Security Administration                    2, XXIII; 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 of                              2, VI; 22, I; 28, XI

[[Page 721]]

  Federal Acquisition Regulation                  48, 6
Surface Mining Reclamation and Enforcement,       30, VII
     Office of
Surface Transportation Board                      49, X
Susquehanna River Basin Commission                18, VIII
Tennessee Valley Authority                        5, LXIX; 18, XIII
Trade Representative, United States, Office of    15, XX
Transportation, Department of                     2, XII; 5, L
  Commercial Space Transportation                 14, III
  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
  Great Lakes St. Lawrence Seaway Development     33, IV
       Corporation
  Maritime Administration                         46, II
  National Highway Traffic Safety Administration  23, II, III; 47, IV; 49, V
  Pipeline and Hazardous Materials Safety         49, I
       Administration
  Secretary of Transportation, Office of          14, II; 49, Subtitle A
  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 of the                       2, X; 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                   19, I
  Engraving and Printing, Bureau of               31, VI
  Federal Acquisition Regulation                  48, 10
  Federal Claims Collection Standards             31, IX
  Federal Law Enforcement Training Center         31, VII
  Financial Crimes Enforcement Network            31, X
  Fiscal Service                                  31, II
  Foreign Assets Control, Office of               31, V
  Internal Revenue Service                        26, I
  Investment Security, Office of                  31, VIII
  Monetary Offices                                31, I
  Secret Service                                  31, IV
  Secretary of the Treasury, Office of            31, Subtitle A
Truman, Harry S. Scholarship Foundation           45, XVIII
United States Agency for Global Media             22, V
United States and Canada, International Joint     22, IV
     Commission
United States and Mexico, International Boundary  22, XI
     and Water Commission, United States Section
U.S. Copyright Office                             37, II
U.S. Office of Special Counsel                    5, CII
Utah Reclamation Mitigation and Conservation      43, III
     Commission
Veterans Affairs, Department of                   2, VIII; 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
Wage and Hour Division                            29, V
Water Resources Council                           18, VI
Workers' Compensation Programs, Office of         20, I, VII
World Agricultural Outlook Board                  7, XXXVIII

[[Page 723]]







                      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.



PART 602_OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT--Table of Contents





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
1.25-1T....................................................    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
1.36B-5....................................................    1545-2232
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
1.42-5.....................................................    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
1.42-18....................................................    1545-2088
1.43-3(a)(3)...............................................    1545-1292
1.43-3(b)(3)...............................................    1545-1292
1.44B-1....................................................    1545-0219
1.45D-1....................................................    1545-1765
1.45G-1....................................................    1545-2031
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
1.47-1.....................................................    1545-0155
                                                               1545-0166
1.47-3.....................................................    1545-0155
                                                               1545-0166
1.47-4.....................................................    1545-0123
1.47-5.....................................................    1545-0092
1.47-6.....................................................    1545-0099
1.48-3.....................................................    1545-0155
1.48-4.....................................................    1545-0155
                                                               1545-0808
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

[[Page 724]]

 
                                                               1545-0241
                                                               1545-0244
                                                               1545-0797
1.52-2.....................................................    1545-0219
1.52-3.....................................................    1545-0219
1.56(g)-1..................................................    1545-1233
1.57-5.....................................................    1545-0227
1.58-1.....................................................    1545-0175
1.59-1.....................................................    1545-1903
1.61-2.....................................................    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
1.103A-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
1.108-7....................................................    1545-2155
1.108(i)-1.................................................    1545-2147
1.108(i)-2.................................................    1545-2147
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
1.132-2....................................................    1545-0771
1.132-5....................................................    1545-0771
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
1.162-24...................................................    1545-2115
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
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(i)-1.................................................    1545-1331
1.168-5....................................................    1545-0172
1.169-4....................................................    1545-0172

[[Page 725]]

 
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..................................................    1545-0074
                                                               1545-0123
                                                               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
1.170A-15..................................................    1545-1953
1.170A-16..................................................    1545-1953
1.170A-17..................................................    1545-1953
1.170A-18..................................................    1545-1953
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
1.179-2....................................................    1545-1201
1.179-3....................................................    1545-1201
1.179-5....................................................    1545-0172
                                                               1545-1201
1.179B-1T..................................................    1545-2076
1.179C-1...................................................    1545-2103
1.179C-1T..................................................    1545-2103
1.180-2....................................................    1545-0074
1.181-1....................................................    1545-2059
1.181-2....................................................    1545-2059
1.181-3....................................................    1545-2059
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
1.199-6....................................................    1545-1966
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)-1.................................................    1545-2248
1.263(a)-3.................................................    1545-2248
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
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....................................................    1545-2019
1.336-2....................................................    1545-2125
1.336-4....................................................    1545-2125
1.337(d)-1.................................................    1545-1160
1.337(d)-2.................................................    1545-1160
                                                               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
1.338-11...................................................    1545-1990
1.338(h)(10)-1.............................................    1545-1658
1.338(i)-1.................................................    1545-1990
1.351-3....................................................    1545-2019
1.355-5....................................................    1545-2019
1.362-2....................................................    1545-0123
1.362-4....................................................    1545-2247
1.367(a)-1T................................................    1545-0026
1.367(a)-2T................................................    1545-0026
1.367(a)-3.................................................    1545-0026
                                                               1545-1478
1.367(a)-3T................................................    1545-2183
1.367(a)-6T................................................    1545-0026
1.367(a)-7.................................................    1545-2183
1.367(a)-7T................................................    1545-2183
1.367(a)-8.................................................    1545-1271
                                                               1545-2056
                                                               1545-2183
1.367(b)-1.................................................    1545-1271

[[Page 726]]

 
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....................................................    1545-2019
1.371-1....................................................    1545-0123
1.371-2....................................................    1545-0123
1.374-3....................................................    1545-0123
1.381(b)-1.................................................    1545-0123
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)(22)-1.............................................    1545-1990
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....................................................    1545-1120
                                                               1545-1260
                                                               1545-1275
                                                               1545-1324
1.382-11...................................................    1545-2019
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)(9)-1..............................................    1545-1573
1.401(a)(9)-3..............................................    1545-1466
1.401(a)(9)-4..............................................    1545-1573
1.401(a)(9)-6..............................................    1545-2234
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
1.401-14...................................................    1545-0710
1.402(c)-2.................................................    1545-1341
1.402(f)-1.................................................    1545-1341
                                                               1545-1632
1.402A-1...................................................    1545-1992
1.403(b)-1.................................................    1545-0710
1.403(b)-3.................................................    1545-0996
1.403(b)-7.................................................    1545-1341
1.403(b)-10................................................    1545-2068
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(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
1.430(f)-1.................................................    1545-2095
1.430(g)-1.................................................    1545-2095
1.430(h)(2)-1..............................................    1545-2095
1.432(e)(9)-1T.............................................    1545-2260
1.436-1....................................................    1545-2095
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
1.448-2....................................................    1545-1855
1.448-2T...................................................    1545-0152
                                                               1545-1855
1.451-1....................................................    1545-0091
1.451-4....................................................    1545-0123
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
1.453A-1...................................................    1545-0152
                                                               1545-1134
1.453A-3...................................................    1545-0963
1.454-1....................................................    1545-0074
1.455-2....................................................    1545-0152
1.455-6....................................................    1545-0123

[[Page 727]]

 
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
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-3(h), 1.468A-7, and 1.468A-8(d).....................    1545-2091
1.468A-4...................................................    1545-0954
1.468A-7...................................................    1545-0954
                                                               1545-1511
1.468A-8...................................................    1545-1269
1.468B-1...................................................    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
1.468B-9...................................................    1545-1631
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(a)-4.................................................    1545-1945
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
1.482-9(b).................................................    1545-2149
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
1.501(r)-3.................................................    1545-0047
1.501(r)-4.................................................    1545-0047
1.501(r)-6.................................................    1545-0047
1.503(c)-1.................................................    1545-0047
                                                               1545-0052
1.505(c)-1T................................................    1545-0916
1.506-1....................................................    1545-2268
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)-4.................................................    1545-2157
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
1.529A-2...................................................    1545-2293
1.529A-5...................................................    1545-2262
1.529A-6...................................................    1545-2262
1.529A-7...................................................    1545-2262
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
1.561-1....................................................    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
1.597-2....................................................    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

[[Page 728]]

 
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
1.664-1....................................................    1545-0196
1.664-1(a)(7)..............................................    1545-1536
1.664-1(c).................................................    1545-2101
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....................................................    1545-0074
                                                               1545-0099
                                                               1545-0134
1.706-1T...................................................    1545-0099
1.706-4(f).................................................    1545-0123
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
1.752-2....................................................    1545-1905
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
1.822-5....................................................    1545-1027
1.822-6....................................................    1545-1027
1.822-8....................................................    1545-1027
1.822-9....................................................    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
1.832-4....................................................    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....................................................    1545-2035
1.853-4....................................................    1545-2035
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
1.860G-2...................................................    1545-2110
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
1.863-8....................................................    1545-1718
1.863-9....................................................    1545-1718
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
1.883-0....................................................    1545-1677

[[Page 729]]

 
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
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
1.904-7....................................................    1545-2104
1.904-7T...................................................    1545-2104
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
1.927(a)-1T................................................    1545-0935
1.927(d)-2T................................................    1545-0935
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
1.956-2....................................................    1545-0704
1.959-1....................................................    1545-0704
1.959-2....................................................    1545-0704
1.960-1....................................................    1545-0122
1.962-2....................................................    1545-0704
1.962-3....................................................    1545-0704
1.964-1....................................................    1545-0126
                                                               1545-0704
                                                               1545-1072
                                                               1545-2104
1.964-3....................................................    1545-0126
1.970-2....................................................    1545-0126
1.985-2....................................................    1545-1051
                                                               1545-1131
1.985-3....................................................    1545-1051
1.987-1....................................................    1545-2265
1.987-3....................................................    1545-2265
1.987-9....................................................    1545-2265
1.987-10...................................................    1545-2265
1.988-0....................................................    1545-1131
1.988-1....................................................    1545-1131
1.988-2....................................................    1545-1131
1.988-3....................................................    1545-1131
1.988-4....................................................    1545-1131
1.988-5....................................................    1545-1131
1.988-6....................................................    1545-1831
1.992-1....................................................    1545-0190
                                                               1545-0938
1.992-2....................................................    1545-0190
                                                               1545-0884
                                                               1545-0938
1.992-3....................................................    1545-0190
                                                               1545-0938
1.992-4....................................................    1545-0190
                                                               1545-0938
1.993-3....................................................    1545-0938
1.993-4....................................................    1545-0938
1.994-1....................................................    1545-0938
1.995-5....................................................    1545-0938
1.1001-1...................................................    1545-1902
1.1012-1...................................................    1545-0074
                                                               1545-1139
1.1014-4...................................................    1545-0184
1.1015-1...................................................    1545-0020
1.1017-1...................................................    1545-1539
1.1031(d)-1T...............................................    1545-1021
1.1033(a)-2................................................    1545-0184
1.1033(g)-1................................................    1545-0184
1.1039-1...................................................    1545-0184

[[Page 730]]

 
1.1041-1T..................................................    1545-0074
1.1041-2...................................................    1545-1751
1.1042-1T..................................................    1545-0916
1.1044(a)-1................................................    1545-1421
1.1045-1...................................................    1545-1893
1.1060-1...................................................    1545-1658
                                                               1545-1990
1.1071-1...................................................    1545-0184
1.1071-4...................................................    1545-0184
1.1081-4...................................................    1545-0028
                                                               1545-0046
                                                               1545-0123
1.1081-11..................................................    1545-2019
1.1082-1...................................................    1545-0046
1.1082-2...................................................    1545-0046
1.1082-3...................................................    1545-0046
                                                               1545-0184
1.1082-4...................................................    1545-0046
1.1082-5...................................................    1545-0046
1.1082-6...................................................    1545-0046
1.1083-1...................................................    1545-0123
1.1092(b)-1T...............................................    1545-0644
1.1092(b)-2T...............................................    1545-0644
1.1092(b)-3T...............................................    1545-0644
1.1092(b)-4T...............................................    1545-0644
1.1092(b)-5T...............................................    1545-0644
1.1211-1...................................................    1545-0074
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1.1244(e)-1................................................    1545-0123
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1.1248(f)-2................................................    1545-2183
1.1248(f)-3T...............................................    1545-2183
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1.1254-4...................................................    1545-1493
1.1254-5(d)(2).............................................    1545-1352
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1.1272-3...................................................    1545-1353
1.1273-2(f)(9).............................................    1545-1353
1.1273-2(h)(2).............................................    1545-1353
1.1274-3(d)................................................    1545-1353
1.1274-5(b)................................................    1545-1353
1.1274A-1(c)...............................................    1545-1353
1.1275-2...................................................    1545-1450
1.1275-3...................................................    1545-0887
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1.1294-1T..................................................    1545-1002
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1.1295-3...................................................    1545-1555
1.1298-3...................................................    1545-1507
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1.1311(a)-1................................................    1545-0074
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1.1366-1...................................................    1545-1613
1.1367-1(f)................................................    1545-1139
1.1368-1(f)(2).............................................    1545-1139
1.1368-1(f)(3).............................................    1545-1139
1.1368-1(f)(4).............................................    1545-1139
1.1368-1(g)(2).............................................    1545-1139
1.1374-1A..................................................    1545-0130
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1.1402(b)-1................................................    1545-0171
1.1402(c)-2................................................    1545-0074
1.1402(e)(1)-1.............................................    1545-0074
1.1402(e)(2)-1.............................................    1545-0074
1.1402(e)-1A...............................................    1545-0168
1.1402(e)-2A...............................................    1545-0168
1.1402(e)-3A...............................................    1545-0168
1.1402(e)-4A...............................................    1545-0168
1.1402(e)-5A...............................................    1545-0168
1.1402(f)-1................................................    1545-0074
1.1402(h)-1................................................    1545-0064
1.1411-10(g)...............................................    1545-2227
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1.1502-9A..................................................    1545-0121
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1.1502.21T.................................................    1545-0123
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1.1502-76..................................................    1545-1344
1.1502-76T.................................................    1545-2019
1.1502-77..................................................    1545-1699
1.1502-77A.................................................    1545-0123
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1.1502-77B.................................................    1545-1699
1.1502-78..................................................    1545-0582
1.1502-95..................................................    1545-1218
1.1502-95A.................................................    1545-1218
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1.1503-2...................................................    1545-1583
1.1503-2A..................................................    1545-1083
1.1503(d)-1................................................    1545-1946
1.1503(d)-3................................................    1545-1946
1.1503(d)-4................................................    1545-1946
1.1503(d)-5................................................    1545-1946
1.1503(d)-6................................................    1545-1946
1.1552-1...................................................    1545-0123
1.1561-3...................................................    1545-0123
1.1563-1...................................................    1545-0123
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1.1563-3...................................................    1545-0123
1.5000A-3..................................................    1545-0074
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1.5000C-2..................................................    1545-0096
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1.6015(a)-1................................................    1545-0087
1.6015(b)-1................................................    1545-0087
1.6015(d)-1................................................    1545-0087
1.6015(e)-1................................................    1545-0087
1.6015(f)-1................................................    1545-0087
1.6015(g)-1................................................    1545-0087
1.6015(h)-1................................................    1545-0087
1.6015(i)-1................................................    1545-0087
1.6017-1...................................................    1545-0074
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1.6031(a)-1................................................    1545-1583
1.6031(b)-1T...............................................    1545-0099
1.6031(c)-1T...............................................    1545-0099
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1.6038B-1..................................................    1545-1617
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1.6038B-1T.................................................    1545-0026
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1.6041-1...................................................    1545-0008
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1.6045-1(c)(3)(xi)(C)......................................    1545-2186
1.6045-1(n)(5).............................................    1545-2186
1.6045A-1..................................................    1545-2186
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1.6046A....................................................    1545-1646
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1.6050D-1..................................................    1545-0120
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1.6050E-1..................................................    1545-0120
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1.6050H-2..................................................    1545-0901
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1.6050J-1T.................................................    1545-0877
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1.6050S-2..................................................    1545-1729
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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
1.6694-2(c)(3).............................................    1545-1231
1.6694-3(e)................................................    1545-1231
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1.7701(l)-3................................................    1545-1642
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2.1-5......................................................    1545-0123
2.1-6......................................................    1545-0123
2.1-10.....................................................    1545-0123
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2.1-13.....................................................    1545-0123
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2.1-22.....................................................    1545-0123
2.1-26.....................................................    1545-0123
3.2........................................................    1545-0123
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4.954-2....................................................    1545-1068
5.6411-1...................................................    1545-0042
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                                                               1545-0619
5c.44F-1...................................................    1545-0619
5c.128-1...................................................    1545-0123

[[Page 734]]

 
5c.305-1...................................................    1545-0110
5c.442-1...................................................    1545-0152
5f.103-1...................................................    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
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
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
20.2010-2..................................................    1545-0015
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
20.6060-1(a)(1)............................................    1545-1231
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
20.6107-1..................................................    1545-1231
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
25.6060-1(a)(1)............................................    1545-1231
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
25.6107-1..................................................    1545-1231
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

[[Page 735]]

 
26.2642-1..................................................    1545-0985
26.2642-2..................................................    1545-0985
26.2642-3..................................................    1545-0985
26.2642-4..................................................    1545-0985
26.2642-6..................................................    1545-1902
26.2652-2..................................................    1545-0985
26.2654-1..................................................    1545-1902
26.2662-1..................................................    1545-0015
                                                               1545-0985
26.2662-2..................................................    1545-0985
26.6060-1(a)(1)............................................    1545-1231
26.6107-1..................................................    1545-1231
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(r)-1...............................................    1545-0029
31.3121(s)-1...............................................    1545-0029
31.3121(v)(2)-1............................................    1545-1643
31.3302(a)-2...............................................    1545-0028
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
                                                               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
31.3511-1..................................................    1545-2266
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
                                                               1545-0256
                                                               1545-0718
                                                               1545-2097
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
                                                               1545-2097
31.6011(a)-5...............................................    1545-0028
                                                               1545-0718
                                                               1545-2097
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

[[Page 736]]

 
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
31.6060-1(a)(1)............................................    1545-1231
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
31.6107-1..................................................    1545-1231
31.6157-1..................................................    1545-0955
31.6205-1..................................................    1545-0029
                                                               1545-2097
31.6301(c)-1AT.............................................    1545-0035
                                                               1545-0112
                                                               1545-0257
31.6302-1..................................................    1545-1413
31.6302-2..................................................    1545-1413
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
                                                               1545-2097
31.6413(a)-1...............................................    1545-0029
                                                               1545-2097
31.6413(a)-2...............................................    1545-0029
                                                               1545-0256
                                                               1545-2097
31.6413(c)-1...............................................    1545-0029
                                                               1545-0171
31.6414-1..................................................    1545-0029
                                                               1545-2097
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
40.6060-1(a)(1)............................................    1545-1231
40.6107-1..................................................    1545-1231
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
41.6060-1(a)(1)............................................    1545-1231
41.6071(a)-1...............................................    1545-0143
41.6081(a)-1...............................................    1545-0143
41.6091-1..................................................    1545-0143
41.6107-1..................................................    1545-1231
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
44.6060-1(a)(1)............................................    1545-1231
44.6071-1..................................................    1545-0235
44.6091-1..................................................    1545-0235
44.6107-1..................................................    1545-1231
44.6151-1..................................................    1545-0235
44.6419-1..................................................    1545-0235
44.6419-2..................................................    1545-0235
46.4371-4..................................................    1545-0023
46.4374-1..................................................    1545-0023
46.4375-1..................................................    1545-2238
46.4376-1..................................................    1545-2238
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
48.4041-19.................................................    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
                                                               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
48.4101-1..................................................    1545-1418
48.4101-1T.................................................    1545-1418
48.4101-2..................................................    1545-1418
48.4161(a)-1...............................................    1545-0723

[[Page 737]]

 
48.4161(a)-2...............................................    1545-0723
48.4161(a)-3...............................................    1545-0723
48.4161(b)-1...............................................    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...............................................    1545-0014
                                                               1545-0023
48.4223-1..................................................    1545-0023
                                                               1545-0257
                                                               1545-0723
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)(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
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
                                                               1545-0224
                                                               1545-0225
                                                               1545-0226
                                                               1545-0230
                                                               1545-0257
                                                               1545-0912
49.4271-1(d)...............................................    1545-0685
49.5000B-1.................................................    1545-2177
51.2(f)(2)(ii).............................................    1545-2209
51.7.......................................................    1545-2209
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)...............................................    1545-0257
                                                               1545-1153
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

[[Page 738]]

 
53.6060-1(a)(1)............................................    1545-1231
53.6065-1..................................................    1545-0052
53.6071-1..................................................    1545-0049
53.6081-1..................................................    1545-0066
                                                               1545-0148
53.6107-1..................................................    1545-1231
53.6161-1..................................................    1545-0575
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
54.6011-1..................................................    1545-0575
54.6011-1T.................................................    1545-0575
54.6060-1(a)(1)............................................    1545-1231
54.6107-1..................................................    1545-1231
54.9801-3..................................................    1545-1537
54.9801-4..................................................    1545-1537
54.9801-5..................................................    1545-1537
54.9801-6..................................................    1545-1537
54.9812-1T.................................................    1545-2165
54.9815-1251T..............................................    1545-2178
54.9815-2711T..............................................    1545-2179
54.9815-2712T..............................................    1545-2180
54.9815-2714T..............................................    1545-2172
54.9815-2715...............................................    1545-2229
54.9815-2719AT.............................................    1545-2181
54.9815-2719T..............................................    1545-2182
55.6001-1..................................................    1545-0123
55.6011-1..................................................    1545-0123
                                                               1545-0999
                                                               1545-1016
55.6060-1(a)(1)............................................    1545-1231
55.6061-1..................................................    1545-0999
55.6071-1..................................................    1545-0999
55.6107-1..................................................    1545-1231
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
56.6060-1(a)(1)............................................    1545-1231
56.6081-1..................................................    1545-1049
56.6107-1..................................................    1545-1231
56.6161-1..................................................    1545-0257
                                                               1545-1049
57.2(e)(2)(i)..............................................    1545-2249
145.4051-1.................................................    1545-0745
145.4052-1.................................................    1545-0120
                                                               1545-0745
                                                               1545-1076
145.4061-1.................................................    1545-0224
                                                               1545-0230
                                                               1545-0257
                                                               1545-0745
156.6001-1.................................................    1545-1049
156.6011-1.................................................    1545-1049
156.6060-1(a)(1)...........................................    1545-1231
156.6081-1.................................................    1545-1049
156.6107-1.................................................    1545-1231
156.6161-1.................................................    1545-1049
157.6001-1.................................................    1545-1824
157.6011-1.................................................    1545-1824
157.6060-1(a)(1)...........................................    1545-1231
157.6081-1.................................................    1545-1824
157.6107-1.................................................    1545-1231
157.6161-1.................................................    1545-1824
301.6011-2.................................................    1545-0225
                                                               1545-0350
                                                               1545-0387
                                                               1545-0441
                                                               1545-0957
301.6011(g)-1..............................................    1545-2079
301.6017-1.................................................    1545-0090
301.6034-1.................................................    1545-0092
301.6036-1.................................................    1545-0013
                                                               1545-0773
301.6047-1.................................................    1545-0367
                                                               1545-0957
301.6056-1.................................................    1545-2251
301.6056-2.................................................    1545-2251
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
                                                               1545-2242
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
301.6316-4.................................................    1545-0074
301.6316-5.................................................    1545-0074
301.6316-6.................................................    1545-0074
301.6316-7.................................................    1545-0029
301.6324A-1................................................    1545-0015

[[Page 739]]

 
301.6361-1.................................................    1545-0024
                                                               1545-0074
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
301.6511(d)-1..............................................    1545-0024
                                                               1545-0582
301.6511(d)-2..............................................    1545-0024
                                                               1545-0582
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
301.6903-1.................................................    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
301.7502-1.................................................    1545-1899
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
                                                               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
301.7705-1.................................................    1545-2266
301.7705-2.................................................    1545-2266
301.7805-1.................................................    1545-0805
301.9000-5.................................................    1545-1850
301.9001-1.................................................    1545-0220
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
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
------------------------------------------------------------------------


[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 
Finding Aids section of the printed volume and at www.govinfo.gov.

[[Page 741]]



List of CFR Sections Affected



All changes in this volume of the Code of Federal Regulations (CFR) that 
were made by documents published in the Federal Register since January 
1, 2018 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, parts and 
subparts as well as sections for revisions.
For changes to this volume of the CFR prior to this listing, consult the 
annual edition of the monthly List of CFR Sections Affected (LSA). The 
LSA is available at www.govinfo.gov. For changes to this volume of the 
CFR prior to 2001, see the ``List of CFR Sections Affected, 1949-1963, 
1964-1972, 1973-1985, and 1986-2000'' published in 11 separate volumes. 
The ``List of CFR Sections Affected 1986-2000'' is available at 
www.govinfo.gov.

                                  2018

26 CFR
                                                                   83 FR
                                                                    Page
Chapter I
1 Authority citation amended...........10785, 26588, 32532, 36421, 58485
    Authority citation amended; eff. 4-2-18........................13184
1.41-6 (c), (d)(1), (3), (e), (j)(4) and (5) revised; eff. 4-2-18 
                                                                   13184
1.41-6T Removed; eff. 4-2-18.......................................13185
1.45G-1 (f)(4), (5), (g)(4) and (5) revised; eff. 4-2-18...........13185
1.45G-1T Removed; eff. 4-2-18......................................13185

                                  2019

26 CFR
                                                                   84 FR
                                                                    Page
Chapter I
1 Authority citation amended........1874, 2988, 6079, 7284, 9232, 20794, 
         23717, 27952, 28413, 29334, 34780, 58478, 59301, 67017, 69058, 
                                                                   69316
1 Correction: authority citation amended....................64415, 65675
1 Technical correction.................14261, 15953, 37769, 38866, 68042
1 (b)(2)(iv)(B) Table 1, (vi)(B)(1) Table 1, and (2) Table 1 
        revised....................................................44223
1.23-1 Removed......................................................9232
1.23-2 Removed......................................................9232
1.23-3 Removed......................................................9232
1.23-4 Removed......................................................9232
1.23-5 Removed......................................................9232
1.23-6 Removed......................................................9232
1.36B-0 Amended....................................................28984
1.36B-2 (c)(3)(i) redesignated (c)(3)(i)(A); new (c)(3)(i)(A) 
        heading, (v)(A)(3), (5), and (e)(1) revised; (c)(3)(ii), 
        (v)(A)(1), (2), and (vi) amended; (c)(3)(i)(B), (5), and 
        (e)(3) added...............................................28984
1.42-0T Amended...............................................6079, 7284
1.42-2 Removed......................................................9232
1.42-5 (a)(2)(iii) and (i) removed; (c)(2)(ii), (iii), (c)(3), and 
        (h)(2) revised..............................................6079
1.42-5T Removed.....................................................6080
1.42-10 (e)(1)(i) introductory text, (B), and (iv)(B) revised; 
        (e)(1)(i)(C) and (D) added..................................7284
1.42-10T Removed....................................................7285
1.42-12 (a)(5)(i)(E) and (ii) revised; (a)(5)(iii) added............7285
1.46-11 Removed.....................................................9232
1.48-12 (a)(2)(i) and (c)(8)(i) amended............................50125
1.50-1 Revised.....................................................34780
1.50-1T Removed....................................................34782
1.52-1 (d)(1)(i) amended...........................................33002
1.56-1 Removed......................................................9232
1.56(g) -1 (d)(2)(ii)(A) removed....................................9232
1.56A-1 Removed.....................................................9232
1.56A-2 Removed.....................................................9232
1.56A-3 Removed.....................................................9232

[[Page 742]]

1.56A-4 Removed.....................................................9232
1.56A-5 Removed.....................................................9232
1.58-1 Removed......................................................9232
1.58-9 Removed......................................................9233
1.59A-0 Added......................................................67017
1.59A-1 Added......................................................67017
1.59A-2 Added......................................................67017
1.59A-3 Added......................................................67017
1.59A-4 Added......................................................67017
1.59A-5 Added......................................................67017
1.59A-6 Added......................................................67017
1.59A-7 Added......................................................67017
1.59A-8 Added......................................................67017
1.59A-9 Added......................................................67017
1.59A-10 Added.....................................................67017

                                  2020

26 CFR
                                                                   85 FR
                                                                    Page
Chapter I
1 Authority citation amended.....1953, 3837, 16248, 19830, 28870, 43080, 
         56756, 59430, 64033, 64392, 66224, 66476, 70964, 71752, 72031, 
                                74034, 76931, 76963, 76978, 79843, 81402
1 Technical correction....8725, 8726, 11841, 15061, 47027, 60358, 69500, 
                                                     72934, 79837, 82355
1 Correction: authority citation amended....................13483, 26848
1.24-1 Added.......................................................64385
1.36B-0 Amended....................................................76978
1.36B-1 (d) redesignated as (d)(1); new (d)(1) heading and (o) 
        revised; (d)(2) added......................................76978
1.36B-2 (c)(4)(i) and (e) heading revised; (e)(4) added............76978
1.36B-4 (a)(1)(ii)(B)(1) and (c) amended; (a)(1)(ii)(B)(2), (C), 
        and (c) heading revised....................................76978
1.47-7 Added.......................................................58267
1.59A-0 Revised....................................................64360
1.59A-1 Amended....................................................64363
1.59A-2 (c)(1) amended; (c)(2)(ii), (4) through (6), (9), and 
        (f)(2) added; (f)(1) heading revised.......................64363
1.59A-3 (b)(3)(iii)(C), (c)(5), (6), (d)(8), and (9) added.........64365
1.59A-7 (c)(5)(v) and (g)(2)(x) added; (e)(2)(ii) amended..........64367
1.59A-9 Correction: (b)(1) and (c)(2)(ii) revised; (c)(5)(ii) 
        amended.....................................................9370
1.59A-9 (b)(1) through (3) and (ii) amended; (b)(4), (c)(11)(ii), 
        and (12) revised; (b)(5) and (6) added.....................64368
1.59A-10 Revised...................................................64368

                                  2021

26 CFR
                                                                   86 FR
                                                                    Page
Chapter I
1 Technical correction......1255, 2973, 9285, 10457, 12821, 13648, 16530
1 Authority citation amended...........836, 4555, 4760, 4984, 5480, 5568
1.45Q-0 Added.......................................................4760
1.45Q-1 Added.......................................................4760
1.45Q-2 Added.......................................................4760
1.45Q-3 Added.......................................................4760
1.45Q-4 Added.......................................................4760
1.45Q-5 Added.......................................................4760

                                  2022

26 CFR
                                                                   87 FR
                                                                    Page
Chapter I
1 Authority citation amended................................61501, 80055
1 Technical correction......................................45021, 68048
1.36B-0 Amended....................................................62000
1.36B-2 (c)(3)(v)(A)(2) and (B) amended; (c)(3)(v)(A)(8) and 
        (e)(5) added; (c)(3)(v)(D) Examples 1 through 9 
        redesignated as (c)(3)(v)(D)(1) through (9) and amended; 
        (e)(1) revised.............................................62001
1.36B-2 Correction: (c)(3)(v)(D)(10) through (13) headings amended
                                                                   73937
1.36B-3 (d)(1)(i) and (n)(1) revised; (n)(3) added.................62002
1.36B-6 (a) and (g)(2) revised.....................................62002
1.42-0 Amended.....................................................61501
1.42-15 (c), (i), (l), and section amended; (c)(2) and (i)(2) 
        added......................................................61501
1.42-19 Added......................................................61502
1.42-19 Correction: (d)(1)(v) amended..............................68048
1.42-19 Correction: (e)(3)(i) Table 2 revised......................73458
1.42-19T Added (temporary).........................................61505

[[Page 743]]

                                  2023

   (Regulations published from January 1, 2023, through April 1, 2023)

26 CFR
                                                                   88 FR
                                                                    Page
Chapter I
1 Authority citation amended.......................................11763


                                  [all]